Axiomas De Administracion Financiera

MODULE 2

TEN AXIOMS THAT FORM THE BASICS OF FINANCIAL MANAGEMENT

Axiom 1: The Risk-Return Tradeoff - 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. We are able to invest those savings and earn a return on ourdollars because some people would rather forgo future consumption opportunities to consume more now. 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 foranticipated 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. Investorssometimes choose to put their money in risky investments because these investment offer higher expected returns the more risk an investment has, the higher will be its expected return. This relationship between risk and expected return is shown in figure 1-1.

Notice that we keep referring to expected return 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 dressmaker Leslie Fay, whose stock dropped 43 percent on April 5, 1993, when it announced it was filing for bankruptcy. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bondspay more interest

than U.S. treasury bonds of the same maturity. The additional interest convinces some investors same to take on the added risk of purchasing a General Motors bonds.

This risk-return relationship will be a key concept as we value stocks, bonds, and return proposed new projects throughout this text. We will also spend time determining how to measure risk. Interestingly, muchof the work for which the 1990 Nobel Prize for Economics was awarded centered on the graph in Figure 3 and how to measure risk. Both the graph and the risk riskreturn relationship it depicts will reappear often in this text. picts

Figure 2. The Risk-Return Relationship Return

Axiom 2: The Time Value of Money – A Dollar Received Today is Worth More Than a Dollar Received in the Future

Afundamental 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 rather than later. In your rather economics courses, this concept of the time value of money is referred to as the opportunity cost of passing up theearning potential of a peso today.

In this text we focus on the creation and measurement of wealth. To measure wealth or value we will use the concept of the time value of money to bring future benefits and costs of a project back to 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 notcreate 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 Axiom 1, The Risk...