10 Axioms of Finance

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```					8 Axioms of Finance

Professor Paul Bolster
Axioms 1&2
   We won’t take on additional risk unless we expect to be compensated

Ri = Rf + i(Rm – Rf) <= Capital Asset Pricing Model

   A dollar received today is worth more than a dollar received in the
future.

   Present value < Future Value as long as interest rates are positive

   Example: Present Value of \$1000 to be received in 1 year if interest rate is 7.5%

   \$1000/(1.075) = \$930.23
Axiom 3
   Cash, not profit, is king!

   Note that Axioms 1, 2, and 3 together allow us to value any
asset!

   Example: Project X will generate a net cash inflow of
\$10,000 (prob=50%) or \$20,000 (prob=50%) next year. The
project must earn a 10% return. What’s the most we should
bid for the rights to Project X?

   Value of asset = Present value of expected future cash flows
it will generate!
Axiom 4
   Incremental Cash Flows: It’s only what
changes that counts

   Example: Vanilla coke!
Axiom 5
   The Curse of Competitive Markets.
   It is very difficult to find profitable projects!
   New, profitable industries attract new entrants
   Result? Profits decline to a level where they are
comensurate with the industry risk level
   Old, unprofitable industries experience
consolidation
   Result? Prices and profit levels rise for remaining
competitors
Axiom 6
   Capital Markets quickly reflect new
information as changes in prices
   Financial markets are very efficient!
   News released in today’s Wall Street Journal has
already been incorporated into stock prices.
Axiom 7
   Managers won’t work for owners unless it
is in their best interest
   “Agency problem”
   Managers have different incentives than owners
   example: John Dorrance, chairman of Campbell
Soup, passed away in 1989. Stock price went up
15% the next day.
   Stock ownership and stock options: + and -?
Axiom 8
   All risk is not equal. Some risk can be
diversified away and some can not.
   Example: Equal investment in a sunscreen project
and an umbrella project will diversify the portion of
revenue risk due to weather.
   Example: Part of Apple Computer’s risk is due to
risk in future economic conditions (non-
diversifiable). Part of Apple’s risk is due to unique
events that affect only Apple. An investor can
diversify this source of risk by holding many stocks

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