10 BASIC PRINCIPLES OF FINANCE (AXIOMS)

1. The Risk-Return
Tradeoff
We won´t take on additional risk unless we expect to be
compensated with additional return
Remember the Casino!!
Expected Returns
- Because the future is uncertain, we use expected returns as
a measure of profitability
-An investor who gives up the satisfaction of current
expenditures expects a reward, even if there is no risk
involved (the return would be “certain”)
-The Risk Free Asset in the economy pays the Risk Free
Rate (Rf) that all riskless investments must pay
-Risky Assets compensate this risk offering an expected
return above Rf. Thus, this additional return above Rf is
called “Risk Premium”
-The more risky the investment, the higher its risk premium.
So, to compensate additional risk, a higher expected return
would be required (“equilibrium”)
Risk
- Risk means variability of outcomes in reference to the
expected return
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History
 2. The Time Value of
Money
An euro received today is worth more than an euro received in the future
- If we have an euro today, we can spend it. If we decide to
sacrifice this immediate pleasure, giving up de euro now to
invest it in order to receive another sum next year, this other
sum has to be higher than the initial euro (investment return)
-Again, even if there is no risk, we want a reward for postponing
our consumer-related satisfaction and to make sure that
inflation does not diminish the purchasing power of our money
over time
- It is the opportunity cost of not using the euro today
- This reward is what makes money profitable just as time goes
by (Time value of money)
- The risk free rate (Rf) represents this time value of money (it
rewards the passing of time)
An euro today would be equivalent to an amount higher than an euro
next year
An euro next year would be equivalent to an amount lower than an euro
today
Amounts in different moments in time cannot be 3
added Present values can be added
3. Cash is King
1. Cash-flows represent the actual money that is going in and out
It is the only money we can use: to pay bills, make investments,
pay out interest or dividends…
2. Cash-flows measure accurately the timing of costs and benefits
Accounting policies produce differences between profits and cash-
flows (e.g.):
- Not all revenues have already been paid (not all revenues are
cash inflows)
- Not all expenses have already been paid (not all expenses are
cash outflows)
- Investments made now are distributed in the income of several
years (and the cash outflow may have been done now)
3. Cash-flow is a fact, Profit is an opinion
The choice between accounting policies, the use of depreciations
and provisions, may produce different incomes out of the same
economic year
In a given year, the net cash flow generated is the difference of
cash inflows and cash outflows, that amount cannot be other
than the one it is 4
4. Incremental Cash-
Flows
1. It´s Only What Changes That Counts

2. Incremental cash flows are the difference between the cash

flows resulting from a certain decision, and the cash-flows
that would result without making that decision

3. The real impact of any decision is better measured by the

increments this decision causes
E.g. a change in an equipment has to be
measured comparing what the new equipment
would produce (and cost) versus what the old
equipment would stop producing

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5. The Curse of Competitive
Markets
1. Why it´s hard to find exceptionally profitable projects
- Remember that value creation means that our
investments should yield a return higher than the
cost of our funds
- In a competitive market, these value creation
investments would attract attention from
competitors, who will try to grab a piece of the cake
- New competitors would put pressure on prices and
returns would decrease.
- If there are too many competitors and returns
decrease too much (thus destroying value), some
competitors would end up leaving the market
- In the long run, if there is competition, returns
would approach the cost of capital

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5. The Curse of Competitive Markets
2. Markets are not perfectly competitive
Try to identify these imperfections and take
advantage of them, so you can keep creating
value:
1. Product differentiation (brand
name, patents, quality, service…)
2- Cost advantage (barriers of entry,
economies of scale)
Make innovations, explore growth
opportunities, try to enjoy high returns
before pressure from competitors make it
harder
6. Efficient Capital
Markets
1. What is an Efficient Market?
- Prices in an Efficient Market always reflect all relevant
information that affects the value of an asset.
- The price in an Efficient Market is a good estimate of
the intrinsic value of an asset :
2. The Markets Are Quick and the Prices are Right
- Information is spread quickly, uniformly and free. The
market reacts immediately to all information available
- Therefore, it is not possible to beat the market and
anticipate its moves using that information
- Kinds of Market Efficiency (depending on what
information is embedded in the price)
 Strong (all information relevant to the share
price)
 Semi-strong (all public information)
 Weak (public information regarding
historical prices and traded volumes) 8
7. The Agency
Problem
1. Managers Won´t Work for the Owners Unless It´s in
Their Best Interest
- Separation of ownership and management within
the corporation
- Conflicts of interest between shareholders (principal)
and managers (agents) may arise
2. Agency costs: the cost of the conflict of interest
between management and stockholders.
- Hard to calculate, but should be minimized

3. Managers need to be monitored and their interest

aligned with those of the shareholders
- Incentive plans, management compensations
(shares, stock options)
- Use of debt, dividends
- M&A: ultimate mechanism of the market of
corporate control
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8. Taxes Bias Business
Decisions
1. Corporate taxes represent a cash outflow and should
always be included when calculating incremental cash-
flows
2. The company would always try to minimize tax payments
3. The tax effect has to be considered in many situations
- Taxes on capital gains; tax saving on capital losses
- Corporate taxes on Profits
- Financial interests are tax deductible; dividends are
not. Effect on WACC and on optimal leverage (tax
shield)
- Returns on investment, or returns to shareholders
should be done after-tax
- Certain activities (R&D) or events may receive a
favorable tax treatment from the Tax Authority for
several reasons
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9. Not All Risk is
diversifiable
1. Remember axiom 1: Risk-Return tradeoff
2. But: not all Risk is the same
3. DIVERSIFICATION: do not put all your eggs in one single
basket Diversification allows rational investors to reduce
risk and to achieve better risk return packages
However, there is usually a limit to how much risk you
can eliminate by means of diversification.
4. TOTAL RISK = Unique risk (you can diversify away) +
Systematic risk (you cannot diversify away)
5. A rational investor would only care about the risk he cannot
avoid So, the risk premium he is going to demand,
would depend only on that risk: systematic risk,
measured by β (CAPM)

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10. Ethical Behaviour Is Doing the
Right Thing
1. Ethical Dilemmas Are Everywhere in Finance
Even if an action is not legally wrong, an ethical dilemma
may arise if that action is against what most people
think, at a given moment, is the right thing to do
2. Non ethical behavior damages trust among
companies, and throughout the market
3. Corporate responsibility
 Despite assuming as the ultimate corporate goal
the maximization of shareholder value, corporations
have a responsibility to other stakeholders beyond
this value creation
 Not everything is allowed to pursue value creation

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