TEN PRINCIPLES THAT FORM THE BASICS OF FINANCIAL MANAGEMENT

Principle 1
The RiskReturn Trade-OffWe Wont 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. We are able to invest those savings and earn a return on our dollars
because some people would rather borrow money and forgo future consumption opportunities to consume
more now. Maybe theyre 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 who would like to use our savings, how do
we decide where to put our money?
First, for delaying their consumption investors demand a minimum return that must be greater than the
anticipated rate of inflation. If they didnt 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 isnt much incentive to postpone
consumption if your savings are going to decline in terms of their purchasing power, due to inflation.
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 over and
above inflation. The more risk an investment has, the higher will be its expected return. This relationship
between risk and expected return is shown in Figure 1-2.
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 cant know for certain. This riskreturn relationship is a
key concept as we value stocks, bonds, and proposed new projects throughout this text. We 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 1-2 and how to measure risk. Both the
graph and the riskreturn relationship it depicts reappear often in this text.

Principle 2
The Time Value of MoneyA Dollar Received Today Is Worth More Than a Dollar Received in the
Future
As we mentioned, 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 rather than later. In your economics courses, this concept of the time value of
money is referred to as the opportunity cost of passing up the earning potential of a dollar today.
In this text, we focus on the creation and measurement of wealth. To measure wealth or value, we use the
concept of the time value of money to bring the future benefits and costs of a project back to the present.
Then, if the benefits outweigh the costs, the project creates wealth and should be accepted; if the costs
outweigh the benefits, the project does not create wealth and should be 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.
To bring future benefits and costs of a project back to the present, we must assume a specific opportunity
cost of money, or interest rate. Exactly what interest rate to use is determined by Principle 1: The Risk
Return Trade-Off, which states that investors demand higher returns for taking on more risky projects?
Thus, when we determine the present value of future benefits and costs, we take into account that
investors demand a higher return for taking on added risk.

Principle 3
CashNot ProfitsIs King
In measuring wealth or value we use cash flows, not accounting profits, as our measurement tool. That is,
we are concerned with when we have money in hand, when we can invest it and start earning interest on
it, and when we can give it back to the shareholders in the form of dividends. Remember, it is cash flows,
not profits that are actually received by the firm and can be reinvested. Accounting profits, on the other
hand, are shown when they are earned rather than when the money is actually in hand. As a result, a
firms cash flows and accounting profits may not occur together. For example, capital expenses, such as
the purchase of new equipment or a building, are depreciated over several years. Consequently, the annual
depreciation subtracted from the firms profits occurs only gradually. However, the cash flow associated
with this expense generally occurs immediately. Therefore, cash outflows involving paying money out
and cash inflows that can be reinvested correctly reflect the timing of the benefits and costs.

Principle 4
Incremental Cash FlowsIts Only What Changes That Counts
In making business decisions, we are concerned with the results of those decisions: What happens if we
say yes versus what happens if we say no? Principle 3 states that we should use cash flows to measure the
benefits that accrue from taking on a new project. We are now fine-tuning our evaluation process so that
we consider only incremental cash flows. The 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.
In 2006, when General Mills, the maker of Cheerios, Honey Nut Cheerios, Frosted Cheerios, Apple
Cinnamon Cheerios, Berry Burst Cheerios, and Team Cheerios, introduced Yogurt Burst Cheeriosthe
lightly sweet flavor of yogurt with the whole grain goodness of Cheeriosit introduced a product that
competed directly with General Mills other cereals and, in particular, its Cheerios products. In fact, the
Strawberry Yogurt Blast Cheerios, with its strawberry flavor sweetened with yogurt, tastes very much like
Berry Burst Strawberry Cheerios. Certainly some of the sales dollars that ended up with Yogurt Burst
Cheerios would have been spent on other Cheerios and General Mills products if Yogurt Burst Cheerios
had not been available. Although General Mills was targeting health conscious consumers with this
sweetened cereal, there is no question that Yogurt Burst Cheerios sales bit intoactually cannibalized
sales from Cheerios and other General Mills lines. Realistically, theres only so much cereal anyone can
eat. The difference between revenues General Mills generated after introducing Yogurt Burst Cheerios
versus simply maintaining its existing line of cereals is the incremental cash flow. This difference reflects
the true impact of the decision. What is important is that we think incrementally. Our guiding rule in
deciding whether a cash flow is incremental is to look at the company with and without the new product.
In fact, lets take this incremental concept beyond cash flows and look at all consequences from all
decisions on an incremental basis.

Principle 5
The Curse of Competitive MarketsWhy Its Hard to Find Exceptionally Profitable Projects
Our job as financial managers is to create wealth. Therefore, we look closely at the mechanics of
valuation and decision making. We focus on estimating cash flows, determining what an investment
earns, and valuing assets and new projects. However, it is easy to get caught up in the mechanics of
valuation and lose sight of the process of creating wealth. Why is it so hard to find projects and
investments that are exceptionally profitable? Where do profitable projects come from? The answers to

these questions tell us a lot about how competitive markets operate and where to look for profitable
projects.
In reality, it is much easier to evaluate profitable projects than find them. If an industry is generating large
profits, new entrants are usually attracted. The additional competition is likely to drive profits down to the
rate of return investors require. Conversely, if an industry is returning profits below the required rate of
return, then some participants in the market drop out, reducing supply and competition. In return, prices
are driven back up. This is precisely what happened in the VCR video rental market in the mid-1980s.
This market developed suddenly with the opportunity for extremely large profits. Because there were no
barriers to entry, the market quickly was flooded with new entries. By 1987 the competition and price
cutting produced losses for many firms in the industry, forcing them to flee the market. As the
competition lessened and firms moved out of the video rental industry, profits again rose to the point at
which the required rate of return could be earned on invested capital.
In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat
bleak scenario, how can we find good projectsthat is, projects that return more than their expected rate
of return given their risk level (remember Principle 1)? Although competition makes them difficult to
find, we have to invest in markets that are not perfectly competitive. The two most common ways of
making markets less competitive are to differentiate the product in some key way and to achieve a cost
advantage over ones competitors.
If products are differentiated, the consumers choice is no longer made on the basis of price alone. For
example, many people are willing to pay a premium for Starbucks coffee. They simply want Starbucks
and price is not important. In the pharmaceutical industry, patents create competitive barriers. For
example, HoffmanLa Roches Valium, a tranquilizer, is protected from direct competition by patents.
Service and quality are also used to differentiate products. For example, Levis has long prided itself on
the quality of its jeans. As a result, it has been able to maintain its market share. Similarly, much of
Toyotas and Hondas brand loyalty is based on quality. Service can also create product differentiation, as
shown by McDonalds fast service, cleanliness, and consistency of product, which bring customers back.
Whether product differentiation occurs because of advertising, patents, service, or quality, the more the
product is differentiated from competing products, the less competition it will face and the greater the
possibility of large profits.
Economies of scale and the ability to produce at a cost below competition can effectively deter new
entrants to the market and thereby reduce competition. Wal-Mart is one such case. For Wal-Mart, the
fixed costs are largely independent of the stores size. For example, inventory costs, advertising expenses,
and managerial salaries are essentially the same regardless of annual sales. Therefore, the more sales that
can be built up, the lower the per sale dollar cost of inventory, advertising, and management. Restocking
from warehouses also becomes more efficient because delivery trucks can be used to full potential.

Regardless of how the cost advantage is createdby economies of scale, proprietary technology, or
monopolistic control of raw materialsit deters new market entrants willowing production at below
industry cost. This cost advantage has the potential of creating large profits. The key to locating profitable
investment projects is to first understand how and where they exist in competitive markets. Then the
corporate philosophy must be aimed at creating or taking advantage of some imperfection in these
markets, through either product differentiation or creation of a cost advantage, rather than looking to new
markets or industries that appear to provide large profits. Any perfectly competitive industry that looks
too good to be true wont be for long. It is necessary to understand this to know where to look for good
projects and to accurately measure the projects cash flows. We can do this better if we recognize how
wealth is created and how difficult it is to create.

Principle 6
Efficient Capital MarketsThe Markets Are Quick and the Prices Are Right
As we have said, our goal as financial managers is the maximization of shareholder wealth. But how do
we measure shareholder wealth? It is the value of all the shares that the share-holders own. To understand
what causes stocks to change in price, as well as how securities such as bonds and stocks are valued or
priced in the financial markets, it is necessary to have an understanding of the concept of efficient
markets. These are markets in which the values of all assets and securities at any instant in time fully
reflect all available information. Whether a market is efficient has to do with the speed with which
information is impounded into security prices. An efficient market is characterized by a large number of
profit-driven individuals who act independently. In addition, new information regarding securities arrives
in the market in a random manner. Given this setting, investors adjust to new information immediately
and buy and sell a security until they feel the market price correctly reflects the new information. In
efficient markets information is reflected in security prices with such speed that there are no opportunities
for investors to profit from publicly available information. Investors competing for profits ensure that
security prices appropriately reflect the expected earnings and risks involved and, thus, the true value of
the firm.
What are the implications of efficient markets for us? First, the price is right. Stock prices reflect all
publicly available information regarding the value of the company. This means we can implement our
goal of maximization of shareholder wealth by focusing on the effect each decision should have on the
stock price if everything else is held constant. That is, over time good decisions result in higher stock
prices and bad ones in lower stock prices. Accounting changes, for example, do not result in price
changes because they do not affect cash flows. Rather, market prices reflect the expected cash flows
available to shareholders.
Thus, our preoccupation with cash flows to measure the timing of the benefits is justified. As we will see,
it is indeed reassuring that prices reflect value. It allows us to look at prices and see value reflected in
them. Although it may make investing a bit less exciting, it makes corporate finance much less uncertain.

Principle 7
The Agency ProblemManagers Wont Work for the Firms Owners Unless Its 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. The agency problem results from the separation of the
management and the ownership of the firm. To begin with, an agent is someone who is given the authority
to act on behalf of another, who is referred to as the principal. In the corporate setting, the shareholders
are the principals, because they are the actual owners of the firm. The board of directors, the CEO, the
corporate executives, and all others with decision-making power are agents of the share-holders. Because
of this separation of the decision makers and owners, managers may make decisions that are not in line
with the goal of maximizing shareholder wealth. They may approach work less energetically and attempt
to benefit themselves in terms of their salaries and perks at the expense of shareholders. The firms top
managers might also avoid any projects that have risk associated with themeven if theyre great
projects with huge potential returns and a small chance of failure. Why is this so? Because if the project
doesnt turn out, these agents of the shareholders may lose their jobs.
The costs associated with the agency problem are difficult to measure, but occasionally we see the
problems effect in the marketplace. For example, if the market feels the management of a firm is

damaging shareholder wealth, we might see a positive reaction in the stock price following the removal of
that management. In 2005, on the announcement of the death of Roy Farmer, the CEO of Farmer
Brothers, a seller of coffee-related products, Farmer Brothers stock price rose about 28 percent.
Generally, the tragic loss of a companys top executive raises concerns over a leadership void, causing the
share price to drop, but in the case of Farmer Brothers, investors thought a change in management would
have a positive impact on the company.
If the managers of the firm work for the owners, who are the shareholders, why dont the managers get
fired if they dont act in the shareholders best interest? In theory, the share-holders pick the corporate
board of directors and the board of directors in turn picks the managers. Unfortunately, in reality the
system frequently works the other way around. Managers select the board of director nominees and then
distribute the ballots. In effect, share-holders are offered a slate of nominees selected by the management.
The end result is that the directors may have more allegiance to the managers than to shareholders. This in
turn sets up the potential for agency problems, with the board of directors not monitoring managers on
behalf of the shareholders as they should.
We spend considerable time discussing monitoring managers and trying to align their interests with
shareholders. The interests of managers and shareholders can be aligned by establishing management
stock options, bonuses, and perquisites that are directly tied to how closely their decisions coincide with
the interest of shareholders. The agency problem will persist unless an incentive structure is set up that
aligns the interests of managers and shareholders. In other words, what is good for shareholders must also
be good for managers. If that is not the case, managers will make decisions in their own best interest
rather than maximizing shareholder wealth.

Principle 8
Taxes Bias Business Decisions
Hardly any decision is made by the financial manager without considering the impact of taxes. When we
introduced Principle 4, we said that only incremental cash flows should be considered in the evaluation
process. More specifically, the cash flows we consider are the after-tax incremental cash flows to the firm
as a whole.
When we evaluate new projects, we will see income taxes play a significant role. For example, when the
company is analyzing the possible acquisition of a plant or equipment, the returns from the investment
should be measured on an after-tax basis. Otherwise, the company is not evaluating the true incremental
cash flows generated by the project. The government also realizes taxes can bias business decisions and
uses taxes to encourage spending in certain ways. If the government wants to encourage spending on
research and development projects, it might offer an investment tax credit for such investments. This
would have the effect of reducing taxes on research and development projects, which would in turn
increase the after-tax cash flows from those projects. The increased cash flow would turn some otherwise
unprofitable research and development projects into profitable projects. In effect, the government can use
taxes as a tool to direct business investment to research and development projects, to the inner cities, and
to projects that create jobs.

Principle 9
All Risk Is Not EqualSome Risk Can Be Diversified Away, and Some Can Not
Much of finance centers around Principle 1, the RiskReturn Trade-Off. But before we can fully use
Principle 1, we must decide how to measure risk. As we will see, risk is difficult to measure. Principle 9
introduces you to the process of diversification and demonstrates how it can reduce risk. We also provide
you with an understanding of how diversification makes it difficult to measure a projects or an assets
risk.
You are probably already familiar with the concept of diversification. There is an old saying, dont put
all your eggs in one basket. Diversification allows good and bad events to cancel each other out, thereby
reducing the total variability of a project, or investment, without affecting its expected return. To see how
diversification complicates the measurement of risk, lets look at the difficulty Louisiana Gas has in
determining the level of risk associated with a new natural gas well-drilling project. Each year Louisiana
Gas might drill several hundred wells, with each well having only a 1 in 10 chance of success. If the well
produces, the profits are quite large, but if it comes up dry, the investment is lost. Thus, with a 90 percent
chance of losing everything, we would view the project as being extremely risky. However, if each year
Louisiana Gas drills 2,000 wells, all with a 10 percent, independent chance of success, then it would
typically have 200 successful wells. Moreover, a bad year may result in only 190 successful wells,
whereas a good year may result in 210 successful wells. If we look at all the wells together, the extreme
good and the bad results tend to cancel each other out and the well drilling projects taken together do not
appear to have much risk or variability of possible outcome.
The amount of risk in a gas well project depends on our perspective. Looking at the well standing alone, it
looks like a lot of risk. However, if we consider the risk that each well contributes to the overall firm risk,
it is quite small. This occurs because much of the risk associated with each individual well is diversified
away within the firm. The point is we cant look at a project in isolation. Later, we will see that some of
this risk can be further diversified away within the shareholders portfolio.
Perhaps the easiest way to understand the concept of diversification is to look at it graphically. Consider
what happens when we combine two projects, as depicted in Figure 1-3. In this case, the cash flows from
these projects move in opposite directions, but when they are combined, the variability of their
combination is totally eliminated. Notice that the return has not changedboth the individual projects
returns and their combinations return average 10 percent. In this case the extreme good and bad
observations cancel each other out. The degree to which the total risk is reduced is a function of how the
two sets of cash flows or returns from the projects move together.
As we will see for most projects and assets, some risk can be eliminated through diversification, whereas
some risk cannot. This becomes an important distinction later in our studies. For now, we should realize
that the process of diversification can reduce risk, and as a result, measuring a projects or an assets risk
is very difficult. A projects risk changes depending on whether you measure it standing alone or together
with other projects the company may take on.

Principle 10
Ethical Behavior Means Doing the Right Thing, but Ethical Dilemmas Are Everywhere in Finance
Ethical behavior means doing the right thing. The difficulty arises, however, in attempting to define
doing the right thing. The problem is that each of us has his or her own set of values, which forms the
basis for our personal judgments about what is the right thing to do. However, every society adopts a set
of rules or laws that prescribe what it believes to be doing the right thing. In a sense, we can think of
laws as a set of rules that reflect the values of the society as a whole, as they have evolved. For purposes
of this text, we recognize that people have a right to disagree about what constitutes doing the right
thing, and we seldom venture beyond the basic notion that ethical conduct involves abiding by societys
rules. However, we point out some of the ethical dilemmas that have arisen in recent years with regard to
the practice of financial management. So as we embark on our study of finance and encounter ethical
dilemmas, we encourage you to consider the issues and form your own opinions.
Many students ask, Is ethics really relevant? This is a good question and deserves an answer. First,
although business errors can be forgiven, ethical errors tend to end careers and terminate future
opportunities. Why? Because unethical behavior eliminates trust, and without trust businesses cannot
interact. Second, the most damaging event a business can experience is a loss of the publics confidence
in its ethical standards. In finance we have seen several recent examples of such events. Ethics, or rather a
lack of ethics, in finance is a recurring theme in the news. Scandals like those at Salomon Brothers,
Enron, WorldCom, and Tyco seem to make continuous headlines. But as the lessons of these companies
illustrate, ethical errors are not forgiven in the business world. Not only is acting in an ethical manner
morally correct, but also it is congruent with our goal of maximization of shareholder wealth.
Beyond the question of ethics is the question of social responsibility. In general, corporate social
responsibility means that a corporation has responsibilities to society beyond the maximization of
shareholder wealth. It asserts that a corporation answers to a broader constituency than its shareholders
alone. As with most debates that center on ethical and moral questions, there is no definitive answer. One
opinion is that because financial managers are employees of the corporation and the corporation is owned
by the shareholders, the financial managers should run the corporation in such a way that shareholder
wealth is maximized and then allow the shareholders to decide if they would like to fulfill a sense of
social responsibility by passing on any of the profits to deserving causes. Very few corporations
consistently act in this way. For example, Bristol-Myers Squibb Co. has an ambitious program to give
away heart medication to those who cannot pay for it. This program came in the wake of an American
Heart Association report showing that many of the nations working poor face severe health risks because
they cannot afford such medications. Clearly, Bristol-Myers Squibb felt it had a social responsibility to
provide this medicine to the poor at no cost. How do you feel about this decision?