The Fundamental Principles of Finance
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The Fundamental Principles of Finance

Robert Irons

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eBook - ePub

The Fundamental Principles of Finance

Robert Irons

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Finance is the study of value and how it is determined. Individuals, small businesses and corporations regularly make use of value determinations for making strategic decisions that affect the future outcomes of their endeavors. The importance of accurate valuations cannot be overestimated; valuing assets too highly will lead to investing in assets whose costs are greater than their returns, while undervaluing assets will lead to missed opportunities for growth. In some situations (such as a merger or an acquisition), the outcome of the decision can make or break the investor. The need for solid financial skills has never been more pressing than in today's global economy.

The Fundamental Principles of Finance offers a new and innovative approach to financial theory. The book introduces three fundamental principles of finance that flow throughout the theoretical material covered in most corporate finance textbooks. These fundamental principles are developed in their own chapter of the book, then referred to in each chapter introducing financial theory. In this way, the theory is able to be mastered at a fundamental level. The interactions among the principles are introduced through the three precepts, which help show the impact of the three principles on financial decision-making.

This fresh and original approach to finance will be key reading for undergraduate students of introduction to finance, corporate finance, capital markets, financial management and related courses, as well as managers undertaking MBAs.

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1 The Fundamental Principles of Finance

Finance is the study of value and how it is determined. While different types of assets are valued using different specific methods, the underlying principles are the same for each method. It is those underlying principles, and their impact on value, that are the subject of this chapter. The material covered here will be seen in various forms throughout the next seven chapters of the book; this present chapter serves as an introduction to these principles and a guide to their comprehension. A command of these principles will aid in understanding the theory introduced in the coming chapters.
The chapters that follow this one introduce the theory of finance as applied to such things as determining the value of an asset (such as a security, or even a firm); assessing risk and ascertaining the appropriate return for the perceived level of risk; and establishing the optimal level of each source of funds to minimize the firm’s costs and thereby maximize its intrinsic value. Each remaining chapter offers theory in a different specific area of finance—for example, valuing bonds, valuing stocks or valuing a potential investment in operating assets. The current chapter serves to explain in detail the fundamental principles of finance, to show that the fundamental principles flow through the remaining chapters and to promote how comprehension of these fundamental principles can aid in understanding how the theory in the remaining chapters is interrelated.
There are three fundamental principles that flow throughout the theory of finance and that interact within the theory discussed in the following chapters. These three principles are not directly related to each other—each stands on its own—but they work together in shaping financial theory. The interactions among these principles are highlighted in the three precepts that are discussed later in the chapter. These precepts show how the principles combine to affect theory, and therefore how we can better understand the theory through the use of the fundamental principles.

The Three Fundamental Principles of Finance

  • The First Fundamental Principle (FP1): The value of any asset is equal to the present value of the cash flows the asset is expected to produce over its economic life.
This first principle is at the heart of the valuation process and is the basis of all methods used for determining the value of virtually anything: a stock or bond being issued by the firm, an investment project the firm is considering or even the firm itself. This principle can be clarified by deconstructing it into smaller phrases that can be understood at a more basic level.

The value of any asset is equal to:

  • the present value—present value and its calculation are discussed in Chapter 2, “The Time Value of Money.” For now, it is enough to understand that a dollar today does not have the same value as a dollar one year from today. A dollar today can be invested to earn interest and will therefore be worth more than a dollar in one year’s time. Thus, the ability to invest and earn interest means that a dollar today is worth more than a dollar one year from today. This basic truth indicates the need for evaluating investments in terms of dollars today—their present value.
  • of the cash flows—the basis of value for an asset stems from the cash flows the asset will produce. Those cash flows, put into current dollar terms (their present value), are summed to determine the value of the asset. The nature of the asset will determine the nature and timing of the cash flows produced by the asset. The cash flows produced by a bond are different from the cash flows produced by a stock and are also different from the cash flows produced by an asset used in production. In any case, value will be calculated as the sum of the present values of the expected future cash flows.
  • the asset is expected to produce—the word “expected” is underlined here to emphasize the fact that the cash flows to be produced by the asset are to be forecasted and therefore are a matter of judgment. It is possible that three different analysts attempting to value the same asset will produce three slightly different sets of expected cash flows, since they may each make different assumptions. There is much use of judgment in finance, and analysts who develop good judgment get paid very well. You are not expected to have good judgment in business at this time in your career, when you are just starting out. However, college is your opportunity to develop your judgment. Firms hire people with good judgment to manage their business, and those managers whose judgment proves effective climb the corporate ladder successfully. Therefore, it is in your best interests to put your own judgment to the test, in this course as well as in other courses. Even if finance is not your chosen field, if you wish to succeed in business, it is your judgment that will convince others of your value to the firm.
  • over its economic life—different assets have different expected lives. For example, when a firm purchases a new machine for use in production, it assigns an economic life, based on the nature of the asset, for purposes of depreciation. Some production assets have shorter lives (5–10 years), while others have much longer lives (20–30 years). Also, while bonds have a limited expected life (they have a date at which they mature), stocks are expected to last forever. Therefore, the economic life of the asset in question will have an impact on the cash flows it is expected to produce.
Thus, when we are attempting to value an asset, we must determine:
  • The discount rate (i.e., the cost) that is appropriate for the perceived level of risk for the given asset (which will be used to calculate the present value of the cash flows);
  • The size and the timing of the cash flows the asset is expected to produce; and
  • When the asset is expected to be sold or taken out of service (when its economic life ends).
The discount rate to be used for calculating the present value of the cash flows is determined by the level of risk associated with the asset in question, and thus will vary from asset to asset and from firm to firm. This will be discussed further in Chapter 3, “Risk and Return,” as well as in the discussion of the second fundamental principle. It is enough at this point to understand that different types of assets will use different discount rates to determine the present value of their cash flows.
The cash flows associated with an asset can take on different forms. When a firm offers a new product, or improves an existing product, it does so with the expectation that the new (or improved) product will increase sales, and thus the cash flows for the product will include additional sales revenue. In a different scenario, a firm may invest in a new technology to produce an existing product because the new technology will decrease production costs, leading to higher profitability on the product. In that case, the cash flows for the project will include the reduced operating costs offered by the new technology.
The economic life of the asset will be determined by the nature of the asset as well as the intended use of the asset. Most physical assets (trucks, machines or buildings) fit into predetermined asset classes that estimate their economic life (e.g., the MACRS asset classes used for calculating depreciation). In addition, the firm may have reasons for using a different economic life than the one suggested by the asset class. For example, if the product in question will no longer be sold after a future date, then the asset used to produce the product may have effectively reached the end of its economic life at that date. The expected economic life of the asset must be established in order to be able to determine the time span over which cash flows can be expected and, with that, its value.
The general method outlined in the first fundamental principle will be used to establish the value of a firm’s bonds, their common stock, their preferred stock, any capital investments they are considering and even the firm itself. Thus, the current market value of any asset can be seen as the sum of the value of the cash flows it is expected to produce, assuming all of the cash flows were to be received today, rather than over an extended period of time.
  • The Second Fundamental Principle (FP2): There is a direct relationship between risk and return; as perceived risk increases, required return will also increase (and vice versa), holding other things constant.
Risk is typically understood as the chance of a bad outcome. In finance, risk is identified as the probability of not earning the return you expect from your investment over a given period of time. In statistics class, you are taught that the expected value of a variable is the mean, or the arithmetic average, of the variable. In the same way, the expected value of a data set is its mean, and the perceived risk of the data set is the likelihood of the outcome being other than its mean. That likelihood is measured using the standard deviation of the data set.
The standard deviation of a data set essentially measures the average deviation from the mean among the observations in the data set. In other words, it shows how likely the actual observations are to vary from their average. If the actual observations are very close to their mean, the standard deviation will be small, indicating that there is a small tendency for the observations to be different from their mean, or a large likelihood of achieving the expected value. If the actual observations are very different from their mean, the standard deviation will be larger, indicating a larger tendency for the observations to be different from their mean, or a smaller likelihood of achieving the expected value. This tendency reflects the behavior of the returns over the period in question—some period of time in the past. If we assume that the data will behave similarly in the future as they did in the past (a big assumption), then we can use the standard deviation as a measure of the likelihood of the observations varying from their mean in the future. There are two issues with using the standard deviation in this way.
First, as mentioned above, assuming that past behavior will be replicated in the future is a big assumption, and there is no basis in fact for making such an assumption. However, barring any specific reason to believe otherwise, it is as good an assumption as any we can possibly make. If we have reason to believe certain things about the future, things that may or may not differ from the past, we can build that knowledge into our calculations of the mean and standard deviation of the returns in the future by using a probability distribution. We will in fact use this method in Chapter 3, “Risk and Return.”
Second, there is an issue with using the standard deviation as a measure of risk, since it measures any deviation from the mean, lower or higher. While returns lower than the mean are disappointing, returns higher than the mean are welcome—they increase our wealth. Treating higher-than-expected returns the same as lower-than-expected returns doesn’t seem right. However, until statistical theory offers a better metric, we will use the standard deviation, since it does in fact offer some insights into the behavior of the data. A simple example will help to make this point.
Table 1.1 contains the annual returns for two different stocks (Stock A and Stock B) over a five-year period. The arithmetic mean (or expected) return over the period is the same for both stocks:
x¯A=.048+.058+.055+.059+.055=.054 or 5.4%x¯B=−.025+.031+.094+.026+.1445=.054 or 5.4%
However, if you look at the raw data in the table, it is apparent that these two stocks’ returns are not the same. Stock A’s returns get as low as 4.8% and as high as 5.9%, while over the same period Stock B’s returns get as low as −2.5% and as high as 14.4%. Clearly, Stock ...