Principles of Corporate Finance
In order to begin our study of financial management, it’s important to understand some of the principles that guide financial decisions. There are five general principles or concepts that we need to consider when making financial decisions. The five principles are shown on the slide. Let’s go over each one in some detail.
- Principle one; Cash flows, rather than accounting income, matter in financial decisions. When analyzing mergers, acquisitions, or capital projects, the focus is always on the timing and amounts of cash flows.
- Principle two; Financial decisions must consider the time value of money. Cash flows received sooner will be worth more than cash flows occurring later, all things being equal. Since most financial decisions are long-term in nature, then the value of cash flows will need to be discounted. Discounting means that we apply the time value of money concepts.
- Principle three; Risk requires a reward. Investors will not take on additional risk in their investment unless they expect to be compensated with higher returns. Riskier projects and acquisitions must have higher returns on investment. This graph shows the amount of normal risk an investor is willing to take on; that’s the flat line, the flat horizontal line. If an investor takes on more risk by investing in riskier investments, then the expected return needs to be higher. This is the diagonal line showing greater risk, which requires greater expected returns.
- Principle four; Market prices are generally right. This is because markets are generally efficient and are driven by supply and demand. Stock prices are usually a good indicator of the value of a firm because the market price of a stock is the equilibrium price where supply and demand intersect.
- Principle five; Conflicts of interest are real and cause agency problems. Because most corporations have separate management from ownership, this creates potential agency problems. The management, like the CEO and other senior staff, might not always deal in the best interest of the company. We’ve seen many frauds where they sometimes deal in their own best interest rather than the shareholders. An example might be senior staff compensation and perks.
These are sometimes very large expenses, and they occur at the cost of income that could be paid out to shareholders in the form of dividends.