The Ten Axioms The Foundations of Financial Decision Making Aug 27, 2012

1. The Risk-Return Trade-off  The more risk an investment has, the higher its expected return should be  If you bet on a horse, you want greater odds on the long shot  If you invest in a risky business (Semiconductor, oil wells, junk bonds), you should demand a greater return  Every decision you make should be evaluated for risk

2. The Time Value of Money  A dollar received today is worth more than a dollar received in the future  If you receive a dollar today, you can invest it and earn more  Because of inflation, a dollar you receive today will buy more than a dollar you receive in the future  So the sooner you get the money, the better  The sooner you invest your money, the better (i.e. retirement)

3. Cash is King  You can not spend “profit” or “net income”. These are paper figures only  Cash is what is received by the firm and can be reinvested or used to pay bills  Cash flow does not equal net income; there are timing differences in accrual accounting between when you record a transaction and when you receive or pay the cash

4. Incremental Cash Flows  It’s only the net increase or decrease in cash that really counts  It’s the difference between cash flows if the project is done versus if the project is not done  Consider all related cash flows, i.e., equip., inventory, etc.  “Brief case” example

5. Curse of Competitive Markets  It’s hard to find and maintain exceptionally profitable projects  High profits attract competition  How to keep very profitable projects –Product differentiation (Kleenex, Xerox) –Low cost (Costco, Honda) –Service and quality (Mercedes, Lexus) –Give examples for each of the above

6. Efficient Capital Markets  The markets are quick and the prices are right – right?  Information is incorporated into security prices at the speed of light!  Assuming the information is correct, then the prices will reflect all publicly available information regarding the value of the firm  Example: announcing a stock split

7. The Agency Problem  Managers are typically not the owners of a company  Managers may make decisions that are in their best interests and not in line with the long term best interests of the owners  Example, cutting Research and Development costs on new products to maximize current income  Pay for performance; stock options

8. Taxes Bias Business Decisions  Because cash is king, we must consider the after-tax cash flow on an investment  The tax consequences of a business decision will impact (reduce) cash flow  Companies are given tax incentives by the government to influence their decisions  Examples : investment tax credit and environmental credits reduce taxes; purchase of Prius’

9. All Risk is Not Equal  Some risk can be diversified away and some cannot  Don’t put all your eggs in one basket  Diversification creates offsets between good results and bad results  Example: drilling for oil wells

10. Ethical Behavior Means Doing the Right Thing  Ethical Dilemmas are everywhere in finance; just read the news (Enron, Madoff, etc.)  Unethical behavior eliminates trust, results in loss of public confidence  Shareholder value suffers and it takes a long time to recover  Social responsibility means firms have to be responsible to more than just owners - all stakeholders! i.e., Japan nuclear disaster