Question

Six Principles of Finance:

1.Time

2.Risk

3.Diversification

4.Efficiency

5.Objectives

6.Reputation

******* (500 words explanation)

** Which is “MOST” Important?

** Do Any Cause Others? (Specifically, does the one you pick as most important cause any of the others?)

Answer 1

Below are the five principles of Finance

- Cash flow is what matters

- Money has a time value

- Risk requires a reward

- Market prices are generally right

- Conflicts of interest cause agency problems

These are the pillars of Finance and each principle has a different meaning but is important. The most important principle is Cash flow is what matters, because without cash no business can be done. Cash is the king, if cash is not realised the receivables might become bad debt, leading to losses in business.

Principles in detail are as below:

Cash flow is what matters: Profit can be earned in a business but that is different than cash flow. Accounting profit is just a but profit, but cash flow is the real cash which is required to finance the business, to payoff the liabilities and expenses. At the end of the day what matters is how much cash the business is able to generate. Many businesses fail due to poor cash flows. Good management of cash is really needed to expand any business. We must determine incremental cash flows when making financial decisions.

Money has a time value- A dollar received today is worth more than a dollar received in the future. Since we can earn interest on money received today, it is better to receive money earlier rather than later.

It to the notion that money available now is worth more than the same amount in the future, because of its ability to grow. If you wait one year to get your money, you are losing out on the opportunity to have that money in the bank now earning interest.

The time value of money is an idea that a dollar today is worth more than a dollar tomorrow due to inflation or its buying capacity.

Risk requires a reward: People take risks only where there is some reward expected out of that risk. No one will be willing to take risk unless they are compensated with extra benefits.

All investments carry some degree of risk. The rule of thumb is “the higher the risk, the higher the potential return,” Investors can control some of the risks in their portfolio through the proper mix of stocks and bonds. Low risks are associated with low potential returns. High risks are associated with high potential returns. The risk return trade-off is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return.

Most experts consider a portfolio more heavily weighted toward stocks riskier than a portfolio that favors bonds. Risk is a natural part of investing. Investors need to find their comfort level and build their portfolios and expectations accordingly.

Market prices are generally right: Market price are generally decided by the force of demand and supply. A financial market is most efficient to decide price t any point of time. A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price. In an efficient market, the prices of all traded assets (such as stocks and bonds) at any instant in time fully reflect all available information

Conflicts of interest cause agency problems: The agency problem arises in business when one party, known as the agent, is expected to act in the best interest of another party, known as the principal. Conflicts of interest can arise if the agent personally gains by not acting in the principal’s best interest. Agency conflict is reduced through monitoring, compensation schemes, and market mechanisms