Question

write a short note on the following financial axioms

Write a short note on the following Financial Management Axioms:

a)  Risk – return trade-off
b)  Cash is King.

c)  Incremental Cash flows count
d)  The agency problem

e)  Ethical decisions are everywhere in Finance

f)Efficient Capital markets.

Answer 1

As per rules I am answering the first 4 subparts of the question A. Risk and return are inversely related and hence there is always a trade off between risk and return. Higher the risk lower is the return and vice versa. Classic example is that of investment choice between stocks and bonds. Generally stocks yield a greater rate of return but they carry bigger risk due to the fluctuations in the stock markets. Bonds yield a lower rate of return they are generally risk free due to fixed interest rates and a fixed maturity amount receivable.

B. Cash is King implies that liquidity holds the highest value. Cash is the most liquid form of an asset and hence cash has Great Value in a business. Businesses prefer cash to credit to increase liquidity and to prevent default. Business is also willing to give discount to customers to convert receivables to cash as quickly as possible.

C. Incremental cash flows refer to the increase in cash flows due to a certain decision. This is particularly useful in capital budgeting decisions. Only those cash flows which are incremental are taken into account and cash flows which are irrelevant or which are sunk are disregarded. Incremental cash flows can occur due to higher expenses or loss of revenue due to a particular investment project or decision.

D. The agency problem refers to the problem when the interest of the agent and the principal clash. This is commonly seen in case of corporations where stockholders are the owners of the company and the management and board are their agents. The management is commonly faced with the decision of investing in high risk projects which will maximize the returns. However they can result in loss of wealth of shareholders due to decreasing share prices. Hence the agency problem arises where in the management and the shareholders have a clash in their interest.