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    MODULE 2

    TEN AXIOMS THAT FORM THE BASICS OF FINANCIAL MANAGEMENT

    Axiom 1:The Risk-Return Tradeoff - We Wont Take on Additional Risk Unless We

    Expect to Be Compensated with Additional Return

    At some point we have all saved some money. Why have we done this? The answer is

    simple: to expand our future consumption opportunities. We are able to invest those savings and

    earn a return on our dollars because some people would rather forgo future consumption

    opportunities to consume more now. Assuming there are a lot of different people that would like

    to use our savings, how do we decide where to put our money?

    First, investors demand a minimum return for delaying consumption that must be greater

    than the anticipated rate of inflation. If they didnt receive enough to compensate for anticipated

    inflation investors would purchase whatever goods they desired ahead of time or invest in assets

    that were subject to inflation and earn the rate of inflation on those assets. There isnt much

    incentive to postpone consumption if your savings are going to decline in terms of purchasing

    power.

    Investment alternatives have different amounts of risk and expected returns. Investors

    sometimes choose to put their money in risky investments because these investment offer higher

    expected returns the more risk an investment has, the higher will be its expected return. This

    relationship between risk and expected return is shown in figure 1-1.

    Notice that we keep referring to expected return than actual return. We may have

    expectations of what the returns from investing will be, but we cant peer into the future and see

    what those returns are actually going to be. If investors could see into the future no one would

    have invested money in the dressmaker Leslie Fay, whose stock dropped 43 percent on April 5,

    1993, when it announced it was filing for bankruptcy. Until after the fact, you are never sure

    what the return on an investment will be. That is why General Motors bonds pay more interest

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    than U.S. treasury bonds of the

    to take on the added risk of purc

    This risk-return relation

    proposed new projects througho

    risk. Interestingly, much of th

    awarded centered on the graph i

    return relationship it depicts will

    Figure 2. The Risk-Return

    Axiom 2: The Time Value of

    Than a Dollar R

    A fundamental concept i

    dollar received today is worth m

    interest on money received toda

    economics courses, this concept

    of passing up the earning potenti

    ame maturity. The additional interest convinc

    asing a General Motors bonds.

    ship will be a key concept as we value st

    t this text. We will also spend time determinin

    work for which the 1990 Nobel Prize for

    Figure 3 and how to measure risk. Both the g

    reappear often in this text.

    elationship

    oney A Dollar Received Today is Worth

    ceived in the Future

    n finance is that money has a time value asso

    ore than a dollar received a year from now. Bec

    y, it is better to receive money earlier rather t

    of the time value of money is referred to as the

    al of a peso today.

    s some investors

    cks, bonds, and

    how to measure

    Economics was

    aph and the risk-

    ore

    ciated with it: A

    ause we can earn

    an later. In your

    opportunity cost

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    In this text we focus on the creation and measurement of wealth. To measure wealth or

    value we will use the concept of the time value of money to bring future benefits and costs of a

    project back to present. Then, if the benefits outweigh the costs the project creates wealth and

    should be accepted; if the costs outweigh the benefits the project does not create wealth and

    should be rejected. Without recognizing the existence of the time value of money, it is

    impossible to evaluate projects with future benefits and costs in a meaningful way.

    To bring future benefits and costs of a project back to the present, we must assume a

    specific opportunity cost of money, or interest rate. Exactly what interest rate to use is

    determined by Axiom 1, The Risk Return Tradeoff, which states investors demand higher

    returns for taking on more projects. Thus, when we determine the present value of future benefits

    and costs, we take into account that investors demand a higher return for taking on added risk.

    Axiom 3: Cash Not Profits Is King

    In measuring wealth or value we will use cash flows, not accounting profits, as our

    measurement tool. Cash flows are received by the firm and can be reinvested. Accounting

    profits, on the other hand, are shown when they are earned rather than when the money is

    actually in hand. A firms cash flows and accounting profits may not occur together. For

    example, capital expenses, such as the purchase of new equipment or a building, are depreciated

    over several years, with the annual depreciation subtracted from profits. However, the cash flow

    associated with this expense generally occurs immediately. Therefore cash outflows involving

    paying money out and cash inflows that can be reinvested correctly reflect the timing for the

    benefits and costs.

    At this point, the first three axioms we have presented can be used to determine the value

    of any asset, be it a business, a new project, or a financial asset like a share of stock or a bond. In

    future chapters we will provide the techniques for determining the value of an asset based on

    these axioms.

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    Axiom 4: Incremental Cash Flows Its Only What Changes That Counts

    In making business decisions, we are concerned with the results of decisions: What

    happens if we say yes versus what happens if we say no? Axiom 3 states that we should use

    cash flows to measure the benefits that accrue from taking on a new project. We are now fine

    tuning our evaluation process so that we only considerincremental cash flows. The incremental

    cash flow is the difference between the cash flows if the project is taken on versus what they will

    be if the project is not taken on.

    Not all cash flows are incremental. For example, when Leaf Inc., a manufacturer of sports

    card, introduced Donruss Triple Play Baseball Cards in 1992, the product competed directly with

    the companys Leaf and Dunuss Baseball cards. There is no doubt that some of the sales dollar

    that are ended up with Donruss triple Play Cards would have been spent on Donruss or Leaf

    Cards if Triple Play Cards had not been available. Although the Leaf Corporation meant to target

    the low-cost end of the base cards market held by tops, there was no question that Triple Play

    sales bit into actually cannibalized sales from the companys existing product lines. The

    difference between revenues generated by introducing the new cards versus maintaining the

    original series are the incremental cash flows. This difference reflects the true impact of the

    decision.

    What is important is that we think incrementally. Our guiding rule in deciding whether a

    cash flow is incremental is to look at the company with and without the new product. In fact, we

    will take this incremental concept beyond cash flows and look at all consequences from all

    decisions on an incremental basis.

    Axiom 5: The Curse of Competitive Markets Why Its Hard to Find Exceptionally

    Profitable Projects

    Our job as financial manager is to create wealth. Therefore, we will look closely at the

    mechanics of valuation and decision making. We will focus on estimating cash flows,

    determining what the investment earns and valuing assets and new projects. But it will be easy to

    get caught up in the mechanics of valuation and lose sight of the process of creating wealth. Why

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    is it so hard to find projects and investments that are exceptionally profitable? Where do

    profitable projects come from? The answers to these questions tell us a lot about how

    competitive markets operate and where to look for profitable projects.

    In reality, it is much easier evaluating profitable projects than finding them. If an industry

    is generating large profits, new entrants are attracted. The additional competition and added

    capacity can result in profits being driven down to the required rate of return. Conversely, if an

    industry is returning profits below the required rate of return, then some participants in the

    market drop out, reducing capacity and competition. In turn, prices are driven back up. This is

    precisely what happened in the VCR video rental market in the mid-1980s. this market

    developed suddenly with the opportunity for extremely large profits. Because there were no

    barriers to entry, the market quickly was flooded with new entries. By 1987 the competition and

    price cutting produced losses for many firms moving out of the video rental industry, profits

    again rose to the point where the required rate of return could be earned on invested capital.

    In competitive markets, extremely large profits simply cannot exist for very long. Given

    that somewhat bleak scenario, how can we find good projects that is, projects that return more

    than the required rate of return? Although competition makes them difficult to find, we have to

    invest in markets that are not perfectly competitive. The two most common ways of making

    markets less competitive are to differentiate the product in some key way to achieve a cost

    advantage over competitors.

    Product differentiation insulates a product from competition, thereby allowing prices to

    stay sufficiently high to support large profits. If products are differentiated, consumer choice is

    no longer made by price alone. For example, in the pharmaceutical industry, patents create

    competitive barriers. Smith Kline Beckmans Tagamet, used in the treatment of ulcers, and

    Hoffman-La Roches Valium, a tranquilizer, are protected from direct competition by patents.

    Service and quality are also used to differentiate products. For example, Caterpillar

    Tractor has long prided itself on the quality of its construction and earth-moving machinery. As a

    result, it has been able to maintain its market share. Similarly, much of Toyota and Hondas

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    brand loyalty is based on quality. Service can also create product differentiation, as shown by

    McDonalds fast service, cleanliness and consistency of product that brings costumers back.

    Whether product differentiation occurs because of advertising, patents, service, or

    quality, the more the product is differentiate from competing products, the less competition it

    will face and the greater the responsibility of large profits.

    Economies of scale and the ability to produce at a cost below competition can effectively

    deter new entrants to the market and thereby reduce competition. The retail hardware industry is

    one such case. In the hardware industry there are fixed cost that are independent of the stores

    size. For example, inventory costs, advertising expenses, and managerial salaries are essentially

    the same regardless of annual sales, therefore, the more sales that can be used to full potential.

    Regardless of how the cost advantage is created by economies of scale, proprietary

    technology, or monopolistic control of raw materials the cost advantage deters new market

    entrants while allowing production at below industry cost. This cost advantage has the potential

    of creating large profits.

    The key to locating profitable investment projects is to first understand how and where

    they exist in competitive markets. Then the corporate philosophy must be aimed at creating or

    taking advantage of some imperfection in these markets, either through product differentiation or

    creation of a cost advantage, rather than looking to new markets or industries that appear to

    provide large profits. Any perfectly competitive industry that looks too good to be true wont be

    for long.

    Axiom 6: Efficient Capital Markets The Markets are Quick and the

    Prices Are Right

    Our goal as financial managers is the maximization of shareholder wealth. Decisions that

    maximize shareholder wealth lead to an increase in the market price the existing common stock.

    To understand this relationship, as well as how securities such as bonds and stocks are valued or

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    priced in the financial markets, it is necessary to have an understanding of the concept of

    efficient markets.

    Whether a market is efficient has to do with the speed with which information is

    impounded into security prices. An efficient market is characterized by a large number of profit-

    driven individuals who act independently. In addition, new information regarding securities

    arrives in the market in a random manner. Given this setting, investors adjust to new information

    immediately and buy and sell the security until they feel the price correctly reflects the new

    information. Under the efficient market hypothesis, information is reflected in security prices

    with such speed that there are no opportunities for investors from publicly available information.

    Investors competing for profits ensure that security prices appropriately reflect the expected

    earnings and risks involved and thus the true value of the firm.

    What are the implications of efficient markets for us? First, the price is right. Stock prices

    reflect all publicly available information regarding the value of the company. This means we can

    implement our goal of maximization of shareholder wealth by focusing on the effect each

    decisionshouldhave on the stock price if everything else were held constant. Second, earnings

    manipulations through accounting changes will not result in price changes. Stock splits and other

    changes in accounting methods that do not affect cash flows are not reflected in prices. Market

    prices reflect expected cash flows available to shareholders. Thus, our pre-occupation with cash

    flows to measure the timing of the benefits is justified.

    As we will see, it is indeed reassuring that prices reflect value. It allows us to look at

    prices and see value reflected in them. While it may make investing a bit less exciting, it makes

    corporate finance much less uncertain.

    Axiom 7: The Agency Problem Managers Wont Work for the Owners Unless Its

    in Their Best Interest

    Although the goal of the firm is the maximization of shareholder wealth, in reality the

    agency problem may interfere with the implementation of this goal. The agency problem results

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    from the separation of management and the ownership of the firm. For example, a large firm may

    be run by professional managers who have little or no ownership in the firm. Because of this

    separation of the decision makers and owners, managers may make decisions that are not in line

    with the goal of maximization of shareholder wealth. They may approach work less energetically

    and attempt to benefit themselves in terms of salary and perquisites at the expense of

    shareholders.

    The costs associated with the agency problem are difficult to measure, but occasionally

    we see the problems effect in the marketplace. For example, if the market feels management of

    a firm is damaging shareholder wealth, we might see a positive reaction in stock price to the

    removal of that management. In 1989, on the day following the death of John Dorrance, Jr.,

    chairman of Campbell Soup, Campbells stock price rose about 15 percent. Some investors felt

    that Campbells relatively small growth in earnings might be improved with the departure of

    Dorrance. There was also speculation that Dorrance was the major obstacle to a possible positive

    reorganization.

    If the management of the firm works for the owners, who are actually the shareholders,

    why doesnt the management get tired if they dont act in the shareholders best interest? In

    theory, the shareholders pick the corporate board of directors and the board of directors in turn

    picks the management. Unfortunately, in reality the system frequently works the other way

    around. Management selects the board of director nominees and then distributes the ballots. In

    effect, shareholders are offered a slate of nominees selected by the management. The end result

    is management effectively selects the directors, who then may have more allegiance to managers

    than to shareholders. This is turn sets up the potential for agency problems with the board of

    directors not monitoring managers on behalf of the shareholders as they should.

    We will spend considerable time monitoring managers and trying to align their interests

    with shareholders. Managers can be monitored by auditing financial statements and mangers

    compensation packages. The interests of managers and shareholders can be aligned by

    establishing management stock options, bonuses and perquisites that are directly tied to how

    closely their decisions coincide with the interest of shareholders. This agency problem will

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    a corporations taxable profits.

    and this in turn lowers taxes

    opposed to dividends reduces ta

    Axiom 9: All Risk Are Not Eq

    and Some Canno

    Much of finance centers

    use Axiom 1 we must decide h

    Axiom 9 introduces you to the

    risk. We will also provide you

    measure a project or an assets ri

    Figure 3. Reducing risk t

    You are probably alread

    saying dont put all your eggs

    observations to cancel each ot

    expected return.

    To see how diversificat

    difficulty Louisiana Gas has in

    well drilling project. Each year

    nterest payments lower profits, which are not

    ue, which are a cash flow item. In effect, p

    es.

    al Some risk Can Be Diversified Away,

    on Axiom 1, The Risk-Return Tradeoff. But be

    w to measure risk. As we will see, risk is dif

    process of diversification and demonstrates h

    ith an understanding of how diversification ma

    sk.

    rough diversification.

    y familiar with the concept of diversification.

    in one basket. Diversification allows good a

    er out, preferably reducing total variability

    ion complicates the measurement of risk, le

    determining the level of risk associated with a

    ouisiana Gas might drill several hundred well

    cash flow item,

    aying interest as

    fore we can fully

    icult to measure.

    w it can reduce

    kes it difficult to

    There is an old

    d bad events or

    ithout affecting

    us look at the

    new natural gas

    s, with each well

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    having only a 1 in 10 chance of success. If the well produces, the profits are quite large, but if it

    comes up dry the investment is lost. Thus, with a 90 percent chance of losing everything, we

    would view the project as being extremely risky. However, if Louisiana Gas each year drills

    2000 wells all with a 10 percent, independent chance of success, then they would typically have

    200 successful wells. Moreover, a bad year may result in only 190 successful wells, while a good

    year may result in 210 successful wells. If we look at all the wells together the extreme good and

    the bad results tend to cancel each other out and the well drilling projects taken together do not

    appear to have much risk or variability of possible outcome.

    The amount of risk in a gas well project depends upon our perspective. Looking at the

    well standing alone, it looks like a lot; however, if we consider the risk that each well

    contributes to the overall firm risk, it is quite small. This occurs because much of the risk

    associated with each individual well is diversified away within the firm. From the point of view

    of a diversified shareholder, much of the risk that a project contributes to the firm is further

    diversified away as the shareholder adds the Louisiana Gas stock to other stocks in his or her

    portfolio. The risk of an investment varies depending upon the perspective of the individual

    considering the risk.

    Perhaps the easiest way to understand the concept of diversification is to look at it

    graphically. Consider what happens when we combine two projects as depicted in Figure 4. In

    this case, the cash flows from these projects move in opposite directions, and when they are

    combined, the variability of their combination is totally eliminated. Notice that the return has not

    changed-both the individual projects and their combinations return averages 10 percent. In this

    case the extreme good and bad observations cancel each other out. The degree to which the total

    risk is reduced is a function of how the two sets of cash flows or returns move together.

    As we will see for most projects and assets, some risk can be eliminated through

    diversification, while some risk cannot. This will become an important distinction later in our

    studies.For now, we should realize that the process of diversification can reduce risk, and as a

    result, measuring a project or an assets risk is very difficult. A projects risk changes depending

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    on whether you measure: (1) the projects risk when it is standing alone, (2) the amount of risk a

    project contributes to the stockholders portfolio.

    Axiom 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are

    Everywhere in Finance

    Ethics, or rather a lack of ethics in finance, is a recurring theme in the news. During the

    late 1980s and early 1990s the fall of Ivan Boesky and Drexel, Burnham, Lambert, and the near

    collapse of Salomon Brothers seemed to make continuous headlines. Meanwhile, the movie Wall

    Street was a hit at the box office and the book Liars Poker, by Michael Lewis, chronicling

    unethical behavior in the bond markets, became a best seller. As the lessons of Salomon Brothers

    and Drexel, Burnham, Lambert illustrate, ethical errors are not forgiven in the business world.

    Not only is acting an ethical manner morally correct, it is congruent with our goal of

    maximization of shareholder wealth.

    Ethical behavior means doing the right thing. A difficulty arises, however, in

    attempting to define doing the right thing. The problem is that each of us has his own set of

    values, which forms the basis for our personal judgments about what is the right thing to do.

    However, every society adopts a set of rules or laws that prescribe what it believes to be doing

    the right thing. In a sense, we can think of laws as a set of rules that reflect the values of the

    society as a whole as they have evolved. For purposes of this text, we recognize that individuals

    have right to disagree about what constitutes doing the right thing, and we will seldom venture

    beyond the basic notion that ethical conduct involves abiding by societys rules. However, we

    will point out some of the ethical dilemmas that have arisen in recent years with regard to the

    practice of financial management. These dilemmas generally arise when some individual

    behavior is found to be at odds with the wishes of a large portion of the population even though

    that behavior is not prohibited by law. Ethical dilemmas can therefore provide a catalyst for

    debate and discussion, which may eventually lead to a revision in the body of the law. So as we

    embark on our study of finance and encounter ethical dilemmas, we encourage you to consider

    the issues and form your own opinion.

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    Many students as, Is ethics really relevant? This is a good question and deserves an

    answer. First, although business errors can be forgiven, ethical errors tend to end careers and

    terminate future opportunities. Why? Because unethical behavior eliminates trust, and without

    trust business cannot interact. Second, the most damaging event a business can experience is a

    loss of the publics confidence in its ethical standards. In finance we have seen several recent

    examples of such events. It was the ethical scandals involving insider trading at Drexel,

    Burnham, Lambert that brought down that firm. In 1991 the ethical scandals involving attempts

    by Salomon Brothers to corner the Treasury bill market led to the removal of its top executives

    and nearly put the company out of business.

    Beyond the question of ethics is the question of social responsibility. In general,

    corporate social responsibility means that a corporation has responsibilities to society beyond the

    maximization of shareholder wealth. It asserts that a corporation answers to a broader

    constituency than shareholders alone. As with most debates that center on ethical and moral

    questions, there is no definitive answer. One opinion is that because financial managers are

    employees of the corporation, and the corporation is owned by the shareholders, the financial

    managers should run the corporation in such a way that shareholder wealth is maximized and

    then allow the shareholders to decide if they would

    like to fulfill a sense of social responsibility by passing on any of the profits to deserving causes.

    Very few corporations consistently act in this way. For example, in 1992 Bristol-Myers Squibb

    Co. announced it would start an ambitious program to give away heart medication to those who

    cannot pay for them. This announcement came in the wake of an American Heart Association

    report showing that many of the nations working poor face severe health risks because they

    cannot afford heart drugs. Clearly, Bristol-Myers Squibb felt it had a social responsibility to

    provide this medicine to the poor at no cost.

    How do you feel about this decision?

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    A Final Note on the Axioms

    Hopefully, these axioms are as much statements of common sense as they are theoretical

    statements. These axioms provide the logic behind what is to follow. We will build on them and

    attempt to draw out their implications for decision making. As we continue, try to keep in mind

    that while the topics being treated may change from chapter to chapter, the logic driving our

    treatment of them is constant and is rooted in these ten axioms.

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    Activity 2

    Make sure that you have read the previous chapter before answering this activity. DONE? If yes,

    you may answer the following questions briefly.

    1. Enumerate the 10 Axioms that form the basics of Financial Management.a.

    b.

    c.

    d.

    e.

    f.

    g.

    h.

    i.

    j.

    2. Among the 10 Axioms / Principles in Financial Management, which one has been appliedto your life recently? Is it Axiom 1, Axiom 2, Axiom 9 or other Axioms? Try to share

    your experience and what actions did you make by posting it in our egroup.