It is not necessary to understand finance in order to understand these principles, it is however necessary to understand these principles in order to understand financial management.

Principle 1: The risk-return trade-off – we won’t take on additional risk unless we expect to be compensated with additional return.

Investors expect to be compensated with additional returns when they take on more risk. However, we are talking about ‘expected’ return, this means that on average the return is higher when grater levels of risks are taken, however given the very nature of this risk the returns can vary widely.

Principle 2: The time value of money – a dollar received today is worth more than a dollar received in the future.

A fundamental concept in finance is the time value of money, which states that money has a time value associated with it: a dollar received today is worth more than a dollar received a year from now.

As we can earn interest on money received today, it is better to receive money earlier rather than later. The concept also means that a dollar received in the future is not worth as much as a dollar today.

Principle 3: Cash – not profit – is king.

When measuring wealth or value, cash flows, not accounting profits, are generally used/recognized as a measurement tool. This is where one is more concerned with when the money hits our hand, when it can be invested to earn interest and when it can be distributed to the shareholders in the form of dividends.

Whilst successful firms may be those that generate high profits, profits are not the appropriate unit for measuring wealth. Accounting profits are ‘book’ figures, not cash flows.

Principle 4: Incremental cash flows – it’s only what changes that counts.

Incremental cash flow is an additional operating cash flow that a company earns when accepting a new project. If an organization has a positive incremental cash flow, they're more likely to increase the amount of overall cash flow if they work on new projects.

To correctly evaluate a capital budgeting project the critical question is ‘what additional cash flows will the firm receive or pay as a result of making the decision to undertake the project?’.

As these additional or incremental cash flows are only those amounts that specifically relate to the project being evaluated, the key test of whether a cash flow is incremental is the ‘with or without’ question.

If a cash-flow amount will occur if the project is accepted (‘with) and will also occur if the project is not accepted (‘without’), then the cash flow is not incremental and is not included in the evaluation of the project.

Conversely, if a cash-flow amount will only occur if the project is accepted (‘with’) and will not occur of the project is not accepted (‘without’) then the cash flow is incremental and must be included in the evaluation of the project.

Incremental cash flows can also be negative (incremental costs) or positive (incremental benefits).

Principle 5: The curse of competitive markets – why it’s hard to find exceptionally valuable projects.

In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat bleak scenario, how can managers find good projects – that is, projects that provide more than their expected rate of return given their risk level.

As competition makes these projects difficult to find, managers must invest in markets which are not perfectly competitive. Two most common ways that firms can make markets less competitive are (1) to differentiate the product in some key way or (2) to achieve a cost advantage over competitors.

Principle 6: Efficient capital markets – the markets are quick and the prices are right.

The goal of financial managers is to create wealth for the firm’s owners. Shareholder wealth is measured by the value of the shares that the shareholders hold. To understand what determines prices of securities, it is necessary to understand the concept of efficient markets.

Whether the market is efficient or not has to do with the speed with which relevant information is absorbed into security prices. An efficient market is characterized by a large number of profit-driven individuals who act independently and where the values of all assets and securities at any instant in time fully reflect all available information.

Implications of efficient markets for finance managers: first, the price is right – share prices reflect all publicly available information relative to the value of the company. The goal of maximization of shareholder wealth can be implemented, and over time good decisions with result in higher share prices.

Second, earnings manipulations through ‘cosmetic’ changes will not result in benefits to shareholders i.e., ‘bonus issues’ of shares of existing shareholders, which are merely cosmetic. Market prices reflect expected cash flows available to shareholders.

Principle 7: The agency problem – managers won’t work for owners unless it’s 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, particularly in large companies.

The agency problem refers to the fact that a firm’s managers will not work to maximize benefits to the firm’s owners unless it is in the managers interests to do so. This is as a result of a separation of the management and the ownership of the firm.

Managerial performance can be monitored by auditing financial statements and managers’ remuneration packages. Some companies have adopted practices such as issuing of stock options (share options) to their managers and senior executives in order to lessen the agency problem.

Principle 8: Taxes bias business decisions.

Hardly any decision is made by the financial manager without considering the impact of taxes.

Governments also realize that taxes can bias business decisions and so they use taxes to encourage spending in certain ways i.e., via tax rebates.

Principle 9: All risk is not equal – some risk can be diversified away, and some cannot.

‘Don’t put all of your eggs in one basket’. Diversification allows good and bad events to cancel each other out and thus reduce risk.

Risk relative to a project changes depending on whether it is measured standing alone or together with other projects that company may take on. If shareholders are diversified, they can eliminate part of the risk associated with movements in a given company’s share price.

Principle 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance.

Ethics in finance, or rather the lack of, is a recurring theme in both fact and fiction. Ethical behavior means ‘doing the right thing’. A difficulty arises, however, in attempting to define ‘the right thing’.

The problem is that each person has his or her own set of values, which forms the basis for their personal judgements about what is right and what is wrong. However, every society adopts a set of rules or laws that prescribe what ‘doing the right thing’ involves.

Beyond the question of ethics is the question of social responsibility, which means that a company has a responsibility to society beyond the maximization of shareholder wealth. It asserts that a company answers to a broader constituency than to shareholders alone.

These ten principles are as much common sense as they are theoretical statements.

Nigel Chetty MBA

www.nigelchetty.com

Ref: Financial Management: Principles and Applications, 6th Edition