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Principles of finance, Value and Economic Efficiency
New products or services can create value, so if you have a new idea, you might then transform it into extraordinary positive value for yourself.
The Principle of Valuable Ideas, Extraordinary Returns are Achievable with New Ideas
Most valuable new ideas occur in the physical asset markets. Physical assets are more likely than financial asset to be unique. For example, the founders of Apple Computer became wealthy by inventing and successfully introducing the personal computer.
Physical assets can be unique in a number of ways. Consider patents. Thomas Edison became a very wealthy man from having invented a large number of unique products, such as the light bulb, the phonograph, the motion picture, and many others. If patent protection had not been available, it is unlikely that he would have become so wealthy. The ability to hold the exclusive rights to produce a unique product enhances the value of a physical asset. Even without patent protection, some companies have been successful at building brand loyalty. They convince consumers that they are the only companies that can produce particular types of products and this conviction generates more repeat purchases and purchases of related products.
New ideas may also take the form of improved business practices or marketing. For example a man name Ray Kroc bought a small chain of hamburger stands. By applying his ideas about how to operate the business, he made himself and a large number of other people very wealthy. You might have heard of Ray's little chain it is called McDonald's. The list of such products and services is almost endless and potential for new products and services is endless.
The Principle of Comparative Advantage, Expertise Can Create Value
The Principle of Comparative Advantage may be familiar. In a broad sens, it's the very idea underlying our economic system. If everyone does what they do best, we will have the most qualified people doing each type of work. This creates economic efficiency. We pay others to do what they can do better than we can and they pay us to do what we can do better than they can.
The Principle of Comparative Advantage is the basis for foreign trade. Each country produces the goods and services that it can make most efficiently. Then, when countries trade, each can be better off.
The Options Principle, Options are Valuable
An option is a right, without an obligation, to do something. In other words, the owner (the buyer of the option) can require the writer (the seller of the option) to make the transaction specified in the option contract (for example, sell a parcel of land), but the writer cannot require the owner to do anything. Often, in finance, an explicit option contract refers to the right to buy or sell an asset for a prespecified price.
The right to buy is a call option and the right to sell is a put option. Call options are frequently used by real estate developers. A call option allows the developer to gain the consent of all necessary parties before investing a large amount of money ..... money that could be lost if any of the parties later refused to sell their land.
Insurance is a kind of put option. Suppose you have insurance on your car and while it is parked the car is destroyed by a cement truck. The insurance settlement can be viewed as selling the destroyed car to the insurance company. Now you may or may not decide to buy another car, but that's your choice.
The Options Principle also has a corollary: An option can not have a negative value to the owner. This is because the owner can always decide to do nothing. Of course, the option can be worthless. However, even the smallest chance of a positive payoff at any time in the future gives the option some positive value, however tiny that value might be.
The word options makes some people think of explicit financial contracts such as call options and put options. However, we use the tern in its broadest sense, a right with no obligation attached. With such a broad definition, you can see that options are widespread. In fact, they exist in many situations without being noticed. The importance of options extends well beyond their easily identified existence, because many assets contain "hidden" options.
One important hidden option is created by what is called limited liability. Limited liability is a legal concept within bankruptcy that limits an investor's possible loss to what has already been invested. For example, suppose a corporation fails to repay a debt. The debt-holder can not sue the stockholders for the money. So the most the stockholders can lose is the money they have already invested.
Limited liability creates the option to default, the option to not fully repay a debt. of course, this is not an option you think of right away as being valuable, but it is nevertheless a valuable option.
Hidden options dramatically complicate the process of measuring value. In some cases, such options actually provide an alternative way to value an asset, as will see when we consider valuing shares of common stock. We'll discuss options in greater detail at several points in this text. For now, we hope you can see that an asset plus an option is more valuable than the asset alone.
The Principle of Incremental Benefits, Financial Decisions are Based on Incremental Benefits
The Principle of Incremental Benefits states that the value derived from choosing a particular alternative is determined by the net extra--that is, incremental--benefit the decision provides compared to its alternative. The term incremental is very important. The incremental costs and benefits are those that would occur with a particular course of action but would not occur without taking that course of action.
For example, if General Motors spends nothing this year on advertising its products, some people will nevertheless buy GM products. So the value to GM of advertising its products is based on the difference between whatever future sales they would make with the advertising expenditure and whatever future sales they would make without the advertising expenditure. GM's decision, whether and how much to advertise, is based on the profit from the incremental sales that results from the advertising compared to the cost of the advertising. In other words, the advertising decision is based on the net (incremental) change in profit. The incremental benefits are cash flows in many situations. The incremental cash flow is the cash flow that would occur as a result of the decision minus the cash flow that would occur without the decision.
As with other principles, the Principle of Incremental Benefits can get lost when things become complex. But this principle is easily overlooked even in some relatively simple situations. There is one situation in which it may be difficult to accept and apply this principle. It involves the concept of a sunk cost. A sunk cost is a cost that has already been incurred, subsequent decisions cannot change it.
Another example of a sunk cost you've probably seen, or even confronted yourself, involves changing majors. Suppose an economics major is considering changing majors, to marketing. Some people have difficulty making such a decision because operations of what they have already "invested" in economics. In fact, this past history is a sunk cost. Given today's situation, the decision to continue in economics or change to marketing should be based on the future costs and benefits of each choice. Of course, an important cost is that of completing either degree and the past investment in economics reduces the incremental future cost of completing that major. Nevertheless, the decision to change should be based on whatever the incremental benefits and costs are now. That requires ignoring sunk costs.
In spite of the Principle of Incremental Benefits, some individuals seem to have an emotional attachment to sunk costs, operational efficiency and effectiveness are also involve. These people continue to own an asset even though they know they could sell the asset and reinvest their money more profitably elsewhere. Clearly, these individuals are not applying the Principle of Incremental Benefits. They are continuing to incur an opportunity cost. unfortunately, identifying such situations can be very difficult. Still, remember that an asset is not like a family member. Most of us are emotional about people, but we recommend you not be emotional about your investments.
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