Five principles that forms the foundations of finance These five principles guide the financial managers in the creation of value for the firm’s owners or the stockholders.
As you will see while it is not necessary to understand finance to understand these principles, Its necessary to understand these principles in order to understand finance.
Principle 1 : cash flow is what matters
The incremental cash flow to the company as a whole is the difference between the cash flows the company will produce both with and without the investment its thinking about making.
Principle 2 : money has a time value
the most fundamental principle of finance is that money has a time value very simple , a dollar you receive today is more valuable than a dollar received one year from now because we can invest the dollar we have today to earn interest so that at the of one year we will have more than one dollar.
For example , suppose you have a choice of receiving $10,000 either today or one year from now. If you decide to receive it a year from now , you will have passed up the opportunity to earn a year’s interest on the money. Economists would say you suffered an “opportunity loss ” or an “opportunity cost” the concept of opportunity cost its fundamental to the study of finance and economics. Very simply the opportunity cost of any choice you make is the highest valued alternative that you had to give up when you made the choices . opportunity cost is the cost of making a choice in terms of the next best alternative must be foregone.
Principle 3 : Risk Requires a Reward
Even the novice investors knows there are an unlimited number of investment alternatives to consider. But without exception , investors will not invest if they do not expect to receive a return on their investment . They will want a return that satisfies two requirements.
- A return for delaying consumptions : Why would anyone make an investment that would not at least pay them something for delaying consumptions? They won’t-even if there is no risk. In fact, investors will want to receive al least the same return that is available for risk-free investments.
- An additional return for takin on risk : Investors generally don’t like risk. Thus, risky investments are less attractive unless they offer the prospect of higher return. That said, the more ensure are about how an investment will perform, the higher the return they will demand for making that investment.
Principle 4 : Conflicts of interest Cause Agency Problems
There is a conflict of interest between what is best for the managers and the stockholders. For example , it may be the case that shutting down an unprofitable plants is in the best interest of the firm’s stockholders, but in so doing the managers will find themselves out of a job or having to transfer to a different job. This is very clear conflict of interest might lead the management of the plant to continue running the plant at a lose.
Conflicts of interest lead to what are referred to by economists as an agency cost or agency problem.
is problems and conflicts resulting from separating of the management and the ownership of the firm.
Principle 5 : Market Price are Generally Right
To understand 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 an efficient market. An efficient market is a market in which the price of securities at any instant in time fully reflect all publicly available information about the securities and their actual public values .
security markets such as the stock and the bond markets are particularly important to our study of finance since these markets are the place where firms can go to rise money to finance their investments. Whether a security market such as the New York Stock Exchange ( NYSE) is efficient depends on the speed with which newly released information is impounded into prices. Specifically , an efficient stock market is characterized by a large number of profit driven individuals who act very quickly by buying or selling shares of stock in response to the release of new information.
