VYE Keown PPCh01B - B 10 Principles that Form the Basics of...

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Unformatted text preview: B 10 Principles that Form the Basics of Financial Management Chapter 1 Chapter An Introduction to Financial Management By Keown, Martin, Petty & Scott Keown, The decision rules and underlying logic spring from 10 simple principles that do not require knowledge of finance to understand. However, while it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance. Though these principles appear simple and trivial, they will provide the driving force behind all that follows. all 1. The Risk-Return Trade-Off RiskTrade We all save some money. To expand our future consumption opportunities. Ex. Save for a house, a car, or retirement We are able to invest those savings & earn on it Some people would rather forgo future consumption opportunities to consume more now now Ex. Borrow money to open a new business, or Ex. a company borrowing to build a new plant company 1. The Risk-Return Trade-Off RiskTradeWe won’t take on additional risk unless we won’ expect to be compensated with additional return. The Risk-Return Relationship Expected return 10 Principles that Form the Basics of Financial Management Expected return for delaying consumption } { Expected return for taking on added risk Risk 1. The Risk-Return Trade-Off RiskTrade How do investors decide where to put their money? They demand a minimum return for delaying consumption > anticipated rate of inflation i.e. increase in terms of purchasing power Investment alternatives have different amounts of risk and expected returns. The more risk an investment has, the higher will be its expected return. Expected return rather than actual return. 2. The Time Value of Money 2. A peso received today is worth more than a peso received in the future. P1.00 (1 + 0.10)0 0 1.00 1.00 0.91 0.83 0.75 0.68 0.62 1 1.00 > 2 1.00 (1 + 0.10)1 3 1.00 4 1.00 5 1.00 In creation and measurement of wealth, we bring the future benefits and costs of a project to the present. If benefits > costs, the project creates wealth accepted. If costs > benefits, the projects does not create wealth 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. 3. Cash – Not Profits – Is King. To bring future benefits and costs of a project back to the present, we assume a specific opportunity cost of money, or interest rate. We take into account that investors demand a higher return for taking on added risk. 3. Cash- not Profits- is King. CashProfits P1.00 2. The Time Value of Money 2. The Time Value of Money In measuring wealth or value, we use cash flows, not accounting profits as our measurement tool. when the money hits our hand, when we can invest it, and start earning interest on it, and when we can give it back to the shareholders when in the form of dividends. in vs. 3. Cash- not Profits- is King. CashProfits A firm’s cash flow and accounting profits may firm’ not be the same. Ex. A capital expense, say purchase of new equipment or building is depreciated over several years, with the annual depreciation subtracted from profits. Cash flow of this expense occurs immediately. Cash inflows and outflows involve the actual receiving and payout of money, thus reflects the timing of the benefits and costs. 4. Incremental Cash Flows 4. It’s only what changes that counts. It’ 4. Incremental Cash Flows 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. i.e. cash flows with and without the new project Increase in cash revenues = P1,000,000 Increase in cash expenses = (700,000) Incremental cash flow = P 300,000 5. The Curse of Competitive Markets Why it’s hard to find exceptionally profitable it’ projects. 5. The Curse of Competitive Markets 5. The Curse of Competitive Markets First understand how and where competitive markets exist. create or take advantage of some imperfection in the market, rather than looking to new markets or industries that appear to provide large profits. thru product differentiation (advertising, patents, service, or quality) thru creation of a cost advantage (economies thru of scale, proprietary technology, or of monopolistic control of raw materials) As financial managers, our task is to: look closely at valuation and decision making focus on estimating cash flows, determining what the investment earns, and valuing assets and new projects not losing sight of the process of creating wealth In competitive markets, extremely large profits simply cannot exist for very long. 6. Efficient Capital Markets The markets are quick and the prices are right. 6. Efficient Capital Markets 6. How do we measure shareholder wealth? Value of the shares of the shareholders We need to understand what causes changes in stock prices, how securities (bonds and stocks) are valued and priced in the financial market Efficient markets Market in which the values of all assets and securities at any instant in time fully reflect all available public information. 7. The Agency Problem Managers won’t work for owners unless it’s in won’ it’ their best interest. 6. Efficient Capital Markets 7. The Agency Problem 7. The Agency Problem Need to monitor managers and align their interest with the shareholders. Monitor managers - Auditing financial statements - Managers’ compensation packages Managers’ Align interests thru incentive structure - Management stock options - Bonuses - Profit sharing Efficient markets With a large number of profit-driven profitindividuals who act independently New info on securities arrive in the market at New random random Investors adjust to new info immediately and Investors buy and sell the security until they feel the buy market price correctly reflects the new info Price is right Earnings manipulation thru accounting changes will not result in price changes. The agency problem results from the separation of management vs. ownership of the firm. firm. An agent is someone who is given authority to act on behalf of another, i.e. the principal In the corporate setting: Principals – Shareholders Agents – board of directors, the CEO, corporate board executives, all others with decision-making decisionpower Agents may not make decisions in the best interest of the shareholders/ the principal. 8. Taxes Bias Business Decisions. 8. Taxes Bias Business Decisions. 8. After-tax incremental cash flows are evaluated. AfterGovernment uses taxes to encourage spending in certain ways. Tax credits on investments - Research and development - Employment generation - Environmental awareness 9. All Risk is Not Equal Saying: Don’t put all your eggs in one basket. Don’ Diversification allows good and bad events or observations to cancel each other out, thus reducing total variability without affecting affected return. A project’s risk changes depending on whether project’ you measure it standing alone or together with other projects the company may take on. Diversification can reduce risk, and as a result, measuring a project’s risk is very difficult. project’ 10. Ethical Behavior Is ethics really relevant? Although business errors can be forgiven, ethical errors tend to end careers and terminate future opportunities. Unethical behavior eliminates trust, and without trust, businesses cannot interact The most damaging event a business can experience is a loss of the public’s confidence public’ in its ethical standards 9. All Risk Is Not Equal Some risk can be diversified away, and some cannot. 10. Ethical Behavior is doing the right thing, and ethical dilemmas are everywhere in finance. 10. Ethical Behavior Social responsibility- responsibilities to society responsibilitybeyond maximizing shareholder wealth A corporation answers to a broader constituency than shareholders alone. ...
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