Finance Principles

Essay text:

Summary of Finance Principles every MBA Should Know I) Market values are the only important values in finance; market values are cash values in a sale or purchase; book values are based on historical accounting numbers II) Wealth is the present value of current and future consumption; cash is the only way you can pay for consumption goods and services III) The goal of corporate managers should be to maximize shareholders' wealth; positive net present value projects represent increases in wealth; maximizing shareholders' wealth implies finding and investing in positive net-present value projects IV) Investment decisions should be evaluated in terms of their impact on incremental expected future cash flows V) Present value analysis discounts expected future cash flows at investors' opportunity costs (the rate of return on alternative investments of equal risk); net present value is the present value of cash flows minus their cost VI) Expected cash flows are the probability-weighted possible future cash flows; no one knows the future, thus projecting expected future cash flows requires making assumptions concerning future revenues, operating costs, and investments in fixed and working capital VII) Investors acquire portfolios to diversify the risk of individual assets; relevant risks to diversified investors are the additions to portfolio risk resulting from the inclusion of particular assets in diversified portfolios VIII) In the CAPM, systematic risk is variations in total market returns affecting all assets; systematic risk is measured by an asset's beta coefficient (reflecting the asset's correlation with the market return) and is the only priced risk; unsystematic risk (uncorrelated with the market) is not priced because that risk can be diversified away and not affect portfolio returns IX) In efficient markets, all investors are informed and there are no barriers (such as transaction costs or regulations) preventing arbitrage from eliminating any possible profits to be made without investing cash, assuming risk, or both X) Expected cash flows should be discounted at the appropriate risk-adjusted rate: projects should be discounted at the project-risk rate; equity cash flows should be discounted at the risk-adjusted cost of equity; and debt cash flows from interest and principal payments should be discounted at the risk-adjusted cost of debt XI) Entity or total firm cash flows or cash flows from investments with average firm risk not requiring changes in financial structure of the firm should be discounted at the weighted-average cost of capital (WACC) XII) Capital structure differences do not affect the total market value of the firm in efficient markets without taxes; in efficient markets with taxes and no bankruptcy costs, firms should maximize debt (Modigliani-Miller capital structure analysis) XIII) In efficient markets, dividend policy does not affect the value of the firm because the value of the firm is determined by its investments (Modigliani-Miller dividend analysis)