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
    with additional return.

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

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

        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

   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
            Result? Prices and profit levels rise for remaining
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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