10 Principles of Financial Management

Topics: Cash flow, Time value of money, Rate of return Pages: 12 (4738 words) Published: December 12, 2014
10 Principles of Financial Management

The 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. Keep in mind that although these principles may at first appear simple or even trivial, they will provide the driving force behind all that follows. These principles will weave together concepts and techniques presented in this text, thereby allowing us to focus on the logic underlying the practice of financial management. In order to make the learning process easier for you as a student, we will keep returning to these principles throughout the book in the form of "Back to the Principles" boxes-tying the material together and letting you son the "forest from the trees."

PRINCIPLE 1 The Risk-Return Trade-Off-We won’t 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-for example, save for a house, a car, or retirement. We are able to invest those savings and earn a return on our dollars because some people would rather forgo future consumption opportunities to consumer now-maybe they’re borrowing money to open a new business or a company is borrowing money to build a new plant. 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 didn’t 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 isn’t 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 investments offer higher expected returns. The more risk an investment has, the higher will be its expected return. Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns from investing will be, but we can’t 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 software maker Citrix, whose stock dropped 46 percent on June 13, 2000. Citrix’s stock dropped when it announced that unexpected problems in its sales channels would cause second-quarter profits to be about half what Wall Street expected. 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 than U.S. Treasury bonds of the same maturity. The additional interest convinces some investors to take on the added risk of purchasing a General Motors bond. This risk-return relationship will be a key concept as we value stocks, bonds, and proposed new projects throughout this text. We will also spend some time determining how to measure risk. Interestingly, much of the work for which the 1990 Nobel Prize for Economics was awarded centered on the graph in Figure 1-3 and how to measure risk. Both the graph and the risk-return relationship it depicts will reappear often in this text.

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 that money has a time value associated with it: A dollar received today is worth more than a dollar received a year from now. Because we can earn interest on money received today, it is better to receive money earlier...
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