Eight principles of finance

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Eight principles of finance

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On the simplest level, making optimal financial decisions has to do with buying assets that add value and advoid those that don't. For example, you need to decide whether to keep using your old, inefficient photocopying machine or buy an expensive new one that works faster, doesn't break down as often, and uses less ink and energy. The finance question about these two alternatives is: Which- keeing the old photocopier or buying a new one- adds more value to your business? To make a determination about hou valuable things (such as stocks, bonds, machines, companies) are, you need to be......

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  1. Eight principles of finance Principle 1: Buy assets that add valua; Avoid buying asset that don't On the simplest level, making optimal financial decisions has to do with buying assets that add value and advoid those that don't. For example, you need to decide whether to keep using your old, inefficient photocopying machine or buy an expensive new one that works faster, doesn't break down as often, and uses less ink and energy. The finance question about these two alternatives is: Which- keeing the old photocopier or buying a new one- adds more value to your business? To make a determination about hou valuable things (such as stocks, bonds, machines, companies) are, you need to be sure that you are comparing apples with apples and oranges with oranges. This sounds like a simple principle to follow, but it can be surprisingly tricky to implement! Principle 2: Cash is king The value of an asset is determined by the cash flows it produces over its life. The cash flow of an asset is the after-tax cash the asset produces at a given point in time. Given that it is too early to give you the full flavor of the difference between a cash flow and a profit number, we can give a small example. Suppose your pizza parlor sells $500 of pizzas on Tuesday night, and suppose the same day you bought $300 worth of indredients. Looking in the cash register at the end of the day, you expect to find $200, but instead you are surprised to find $300. The explanation: of the $500 of pizzas sold, you collected only $400- the other $100 of pizzas were sold to a campus fraternity that maintains an account with you and settles at the end of each month. Of the $300 ingredients you bought, you paid for only $100- the other $200 will be billed to you for payment in ten days. Cash flows are different from accounting prfits or sales receipts. The pizza parlor's accounting profit for the day is $200, but its cash flow for the day is $300 (=$400 collected from sales minus $100 paid for supplies). The difference between the two is due to the timing difference between inflows and outflows. (Of course, then days from now the pizza parlor will have a negative cash flow of $200 of paying for the ingredients.) In finance, cash flow is all-important. Most corporate financial data comes from accountants, who do a very good job at representing the economic realities of corporate activities. When making financial decisions, we have to translate the accounting data to their cash equivalents. Much of finance involves first translating accounting information into cash flows.
  2. Principle 3: The time dimension of financial decisions is important Many financial decisions have to do with comparing cash flows at different points in time. As an example: you pay for that new photocopy machine today (a cash outflow), but you save money in the future (a cash inflow).Finance has to do with correctly dealing with this time dimension of cash flows. Principle 4: Know how to compute the cost of financial alternatives Financial alternatives are often bewildering: is it more expensive to buy or lease a photocopier? When your credit card charges you "daily interest," it is more or less expensive than the bank loan, which charges you "monthly interest?" In making financial decisions, you need to know how to compute the cost of two or more competing alternatives. Principle 5: Minimize the cost of financing Many financial decisions have to do with choosing the right alternative. Should you finance that photocopier with a loan from the dealer or with a loan from the bank? Should you invest in a real estate project or leave your moneyin the stock market? Choosing the right financial alternative is, in many cases, a decision made separately from the investment decision: You've decided to purchase the opier (the investment decision), and now you have to choose whether to finance it through a bank loan or through the dealer's "zero interest financing" (the financing decision). Principle 6: Take risk into account Many financial alternatives cannot be compared directly without taking into account their risk. Should you take money out of the bank and inest it in the stock market? On the one hand, people who invest in the stock market on average earn more than those who leave their money in the bank. On the other hand, a bank deposit is safe, whereas a stock market investment is much leass safe (riskier). "Risk" is the magic word in finance. Principle 7: Markets are efficient and deal well with information Financial markets are awash in information. In making a financial decision, how can we possibly know or obtain all the information we need to make a sensible, well-informed decision? The bad news is that we probably can't incorporated all available information into our decsion-making process. The good news is that we may not have to: The confluence of many market participants striving to make
  3. use of what information they have leads markets to work to eliminate profitable opportunities. In many caseses, financial markets work so well thatwe can't add anything to their information-gathering abilities. In short: It may well be that the stock market's valuation of XYZ stock is correct given all the information available about the stock. This market efficiency can simplify the wa you think about assets and their prices when making financial decisions. Principle 8: Diversification is important "Don't put all your eggs in one basket." The financial equivalent of this hackneyed expression is: Diversify the assets you hold; don't hold just a few stocks or bonds- buy a porfolio. Simmon Benninga, Principles of Finance with Excel
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