Question

Explain and elaborate on the following axioms of finance:
1. Risk-return trade-off
2. Time value of money
3. Cash is king
4. Incremental cash flows
5. The agency problem
6. Taxes bias business decisions
7. All risk is not equal
8. Ethical dilemmas are everywhere in finance
What is meant by the phrase: “Although it is not necessary to understand finance in order to
understand these axioms, it is necessary to understand these axioms in order to understand finance"?

Answer 1

1. Risk and returns are directly related. Higher returns will come with the probability of higher risks. Lower risks will result in probable lower return. This relatioship between risk and return is termed as risk reward trade off. like: The established and blue-chip companies will have low risk but the returns are also limited as the companies have already grown. on the other hand, new and penny companies will have higher risk but the probability og returns are also higher as there is enough scope of growth is available for these companies.

2.Time value of money (TVM): The simple, explaination of this term is that the value of money today is not same as the value of money tomorrow. The value of money keeps discounting every day because of inflation or opportunity cost. TVM explains that the returns of n amount which are received today are greater than the same amount of returns which are received later. The concept is used to calculate present value of cash-flows to know the actual financial profit or loss.

3. Cash is king: Cash is considered to be the most liquid asset of any company. Cash can be easily converted into any asset at any time. It is the most acceptable mode of payment or transaction. cash can buy anything anytime anywhere. therefore, it is king.

4. Incremental cash flows (ICF): When a company pcompares the projects and machines, it uses ICF. ICF is the additional net inflow of cash which are generated by the particular project and machine. It is derived by deducting all the annual expenses which are incurred for running the project from its income generated. The initial cost will also get deducted.

Thus: ICF = Annual income - annual expenses - initial cost + salvage value

The above values are time adgusted values. Present values are calculated of all the costs and revenues to calculate ICF.

5. Agency problem: Agency is link between two party. In finance, this agency is manager and the parties are shareholders and management. Shareholders want to maximize their worth and management want to maximize their wealth and both are contrary. Shareholders wealth is maximized when the salary distributed to managers are low. this kind of problem is rationally solved by managers to rationalize the returns for both parties.

6. Taxes bias business decisions( TBD): Such decisions are made with the intention to lower the tax burdens of the company or individulas. For example: Interest on loan is deductable from taxable income. A comapny may shift its financing to debt for enhancing the interest expenses so that the taxable amount comes down.

Other example is depriciation. The decisions related to depriciation are also form of TBD. more depriciation is charged when the taxable income needs to be reduced. These decisions are important in capital-structuring.

7. All risk are not equal: The risks are of different types. The external factor risks which can not be controlled by an organisation. Risks arised from internal factors can be controlled. Risks can be production-risks, human-resourse risks, capital risk, market risks or other economic risks. all risks have different attributed and effects.

8. Finance focuses on minimising costs and maximizing returns. The objectives can create ethical dilemmas. for example: Minimizing costs may want to reduce salaries and wages but ethically employees should be well paid. other example is: maximizing returns may want to increase the value of product but ethically product should be rationally priced so that consumer protection can be ensured. Different laws and regulations are working to reduce the ethical dilemmas of finance.

the knowledge of finance is required to know trhe meaning of these axioms but the knowledge of finance is incomplete without knowing and understanding them clearly. Finance is a whole subject which works for an organisation whith whole ethics. These axioms magnifies the understanding of finance. If one does not undertand the above terms, he/she may end up taking hazardeous decisions for the financial health of a company. For example:The net inflow from a project can be positive but the Present value of net inflow can be negative. The understanding to thuis axiom will result in rejecting the project.