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Every field of endeavor has fundamental laws, principles or tenets that help guide you in understanding that field. Finance is no exception. There are important, basic principles that can help you understand mundane practices in finance as well as new and complex situations financial accounting concepts and applications describe as under.
If you wanted to sell your ear, would you want to get the highest possible price? Sure. Do you think a person who wanted to buy it would want to pay the lowest possible price? Undoubtedly. Suppose you wanted to invest some money. Would you like to triple your money in the next year? That would be nice. But do you want to risk losing all your money? Not really, Do you think you might have to take some risk to get a superior return? Probably. If someone guaranteed to double your money in six months with absolutely no risk, would you doubt them? We hope so. If we owed you $100, would you rather have it today or in three years? Today, of course.
The answers to these questions are obvious in such straightforward situations. They come from intuition you have developed, based on an understanding of the world. In more complex situations, answers are not always so easy. So you need principles to help you.
In this post we describe the principles of finance. They are the foundation on which financial management is built. We will help you understand their application to the practice of finance.
We also take a quick look at the capital markets. Recall that a financial security, which we'll call simply a security, is issued by a company to finance itself. A security, such as a stock or bond, is essentially a claim on future cash flows, such as dividend and interest payments. Capital market transactions (buying and selling securities) are important, both as a part of financial management and as a place to observe and apply the principles of finance.
Our first group of principles deals with competition in in an economic environment.
It may be hard to swallow the Principle of Self Interested Behavior at first. One reason is that most of us realize money is not everything. The Principle of Self Interested Behavior does not deny this truth. Nor does it deny the importance of "human" considerations. Also, it is not saying money is the most important thing in life.
This principle says that when all else is equal, all parties to a financial transaction will choose the course of action most financially advantageous to themselves. It explains actual behavior very well. This is because most business interactions are "arm's length" transactions. In such impersonal transactions, getting the most good out of available resources is the primary consideration.
You also might think that giving money to a charity, having children and being honest on your tax return are violations of the Principle of Self Interested Behavior. These decisions involve more than money. But even if certain actions do violate the Principle of Self Interested Behavior, the principle is still useful for our purposes. This is because it is right on average. So it's a very good approximation of human behavior.
There is an important corollary to the Principle of Self Interested Behavior, Frequently competing desirable actions can be taken. When someone takes an action, that action eliminates other possible actions. The difference between the value of one action and the value of the best alternative is called an opportunity cost.
An opportunity cost provides an indication of the relative importance of a decision. When the opportunity cost is small, the cost of an incorrect choice is small. Similarly, when the opportunity cost is large, the cost of not making the best choice is large.
To help you understand the Behavioral Principle, we want you to imagine that you have already earned your degree and have been working for a medium size corporation for about a year and a half in three different positions. Recently, your hard work and the long hours you have been putting in have been noticed by your boos, Mr. Womack, the financial vice president. In recognition of your accomplishments, Mr. Womack has invited you and your spouse to his home for dinner, along with several other members of the department and their spouses.
You and your spouse are just congratulating each other for having successfully navigated the very formal cocktail hour when you arrive at the dining room. It's larger than your whole apartment. As you seat yourselves in your assigned seats, you and your spouse simultaneously nudge each othe, motioning toward the silverware. There's more silverware at your place setting alone than you have in your entire kitchen. you have not got a clue about which piece should be used for which food. What do you do?
There is only one reasonable way to proceed. Discreetly look down the table as each course is served and use the same piece of silverware that Mr. Womack is using. But suppose this is not possible you can not see Mr. Womack very well from where you sit. What should you do? You can simply check out the people immediately around you. Most of us will go with the majority if there is not someone we especially trust.
Now change the scenario from dinner to finance. Suppose you are a financial manager. You are facing a major decision that seems to have no single, clearly correct course of action. For example, suppose the board of directors has asked you to assess how the company is currently being financed and perhaps recommend changes. As it turns out there is no prescribed single optimal capital structure for a company manager must make an informed judgment. What should you do?
One reasonable approach is to look for guidance in what other companies similar to your company are currently doing and have done in the recent past. Either you can imitate the companies that you feel are most likely to be the best guides or you can imitate the majority. In particular, the policy choices made by other companies in the same industry can provide useful guidance. This form of behavior is sometimes referred to as the "industry effect". This is what we mean by the Behavioral Principle of Finance. When all else fails, look at what others are doing for guidance.
In Practice, the Behavioral Principle is typically applied in two types of situations. In some cases, such as the choice of a capital structure, theory does not provide a clear solution to the problem. In other cases, theory provides a clear solution, but the cost of gathering the necessary information outweighs the potential benefit. Valuing certain assets is an example of the latter case. The value of some assets, such as stock or a piece of real estate, can often be estimated at relatively low cost from the observed recent purchase prices of similar assets. In cases such as these, managers use the Behavioral Principle to arrive at an inexpensive approximation of the correct answer.
We have just cited two appropriate applications of the Behavioral Principle: (1) the case where there is a limit to our understanding and (2) the case where its use is more cost effective than the most accurate method. One application that sometimes occurs in practice is not appropriate: "blind imitation" to minimize personal cost and risk. We want to leave you with an important warning to avoid this misapplication.
The Behavioral Principle can be tricky to apply. You have to decide when there's no single, clearly correct, best course of action. Furthermore, having decided this, you must decide whether there is a "best" other or group of others to look to for guidance. Finally, you must determine from their actions what your best course of action would be. The Behavioral Principle is, admittedly, a second best principle. It leads to approximate solutions in the best of situations and, in the worst, to imitating the errors of others. Still, it is useful in certain situations, despite its potential shortcomings.
This principle also has an important corollary, financial, accounting concepts and applications are very useful. Its application can lead to what is called the free rider problem. In such situations, a "leader" expends resources to determine a best course of action and a "follower" receives the benefit of the expenditure by simply imitating. So the leader is subsidizing the follower. For example, McDonald's does extensive research and analysis concerning the placement of its restaurants. Other fast food chains have at times chosen their new restaurant locations by simply building near a McDonald's restaurant. Patent and copyright laws are designed to protect innovators, at least to some extent, from the free rider problem and reward the introduction of valuable new ideas that improve society.
The answers to these questions are obvious in such straightforward situations. They come from intuition you have developed, based on an understanding of the world. In more complex situations, answers are not always so easy. So you need principles to help you.
In this post we describe the principles of finance. They are the foundation on which financial management is built. We will help you understand their application to the practice of finance.
We also take a quick look at the capital markets. Recall that a financial security, which we'll call simply a security, is issued by a company to finance itself. A security, such as a stock or bond, is essentially a claim on future cash flows, such as dividend and interest payments. Capital market transactions (buying and selling securities) are important, both as a part of financial management and as a place to observe and apply the principles of finance.
Principles of Finance and the Competitive Economic Environment
The principles of finance, described in this section and the two that follow are based on logical deduction and on empirical accept the principles as a valid way to describe their world.Our first group of principles deals with competition in in an economic environment.
The Principle of Self Interested Behavior and People Act in Their Own Financial Self Interest
To make good business decisions you need to understand human behavior. Although there may be individual exceptions, we assume that people act in an economically rational way. That is people are in their own financial self interest.It may be hard to swallow the Principle of Self Interested Behavior at first. One reason is that most of us realize money is not everything. The Principle of Self Interested Behavior does not deny this truth. Nor does it deny the importance of "human" considerations. Also, it is not saying money is the most important thing in life.
This principle says that when all else is equal, all parties to a financial transaction will choose the course of action most financially advantageous to themselves. It explains actual behavior very well. This is because most business interactions are "arm's length" transactions. In such impersonal transactions, getting the most good out of available resources is the primary consideration.
You also might think that giving money to a charity, having children and being honest on your tax return are violations of the Principle of Self Interested Behavior. These decisions involve more than money. But even if certain actions do violate the Principle of Self Interested Behavior, the principle is still useful for our purposes. This is because it is right on average. So it's a very good approximation of human behavior.
There is an important corollary to the Principle of Self Interested Behavior, Frequently competing desirable actions can be taken. When someone takes an action, that action eliminates other possible actions. The difference between the value of one action and the value of the best alternative is called an opportunity cost.
An opportunity cost provides an indication of the relative importance of a decision. When the opportunity cost is small, the cost of an incorrect choice is small. Similarly, when the opportunity cost is large, the cost of not making the best choice is large.
The Principle of Two Sided Transactions and Each Financial Transaction has at Least Two Sides
The Principle of Two Sided Transactions may seem very straightforward, yet it is sometimes forgotten when things become complex. Understanding financial transactions requires that we not become self centered. Don't forget that while we are following self interested behavior, others are also acting in their own financial self interest. That includes those with whom we are transacting business. Consider the sale of an asset or should we say the purchase? That's just the point. For every sale, there is a purchase. For each buyer, There is a seller. When we analyze our side of a transaction, we must keep in mind that there is someone else analyzing the other side.The Signaling Principle and Actions Convey Information
The Signaling Principle is another extension of the Principle of Self Interested Behavior. Assuming self interested behavior, we can guess at the information or opinions behind the decisions that we observe. For example, a decision to buy or sell an asset can imply information about the condition of the asset or about a decision maker's expectations or plans for the future. Likewise, a company's decision to enter a new line of business may reveal something about the company's position and its belief in the venture's potential. Similarly, when a company announces a dividend, stock split, or new securities issue, people frequently interpret these actions in terms of the company's future earnings. In fact, when actions are at odds with announcements the actions are usually louder than words.The Behavioral Principle and When all Else Fails, Look at What Others are Doing for Guidance
The Behavioral Principle is a direct application of the Signaling Principle. The Signaling Principle says that actions convey information. The Behavioral Principle says, in essence, "Let's try to use such information".To help you understand the Behavioral Principle, we want you to imagine that you have already earned your degree and have been working for a medium size corporation for about a year and a half in three different positions. Recently, your hard work and the long hours you have been putting in have been noticed by your boos, Mr. Womack, the financial vice president. In recognition of your accomplishments, Mr. Womack has invited you and your spouse to his home for dinner, along with several other members of the department and their spouses.
You and your spouse are just congratulating each other for having successfully navigated the very formal cocktail hour when you arrive at the dining room. It's larger than your whole apartment. As you seat yourselves in your assigned seats, you and your spouse simultaneously nudge each othe, motioning toward the silverware. There's more silverware at your place setting alone than you have in your entire kitchen. you have not got a clue about which piece should be used for which food. What do you do?
There is only one reasonable way to proceed. Discreetly look down the table as each course is served and use the same piece of silverware that Mr. Womack is using. But suppose this is not possible you can not see Mr. Womack very well from where you sit. What should you do? You can simply check out the people immediately around you. Most of us will go with the majority if there is not someone we especially trust.
Now change the scenario from dinner to finance. Suppose you are a financial manager. You are facing a major decision that seems to have no single, clearly correct course of action. For example, suppose the board of directors has asked you to assess how the company is currently being financed and perhaps recommend changes. As it turns out there is no prescribed single optimal capital structure for a company manager must make an informed judgment. What should you do?
One reasonable approach is to look for guidance in what other companies similar to your company are currently doing and have done in the recent past. Either you can imitate the companies that you feel are most likely to be the best guides or you can imitate the majority. In particular, the policy choices made by other companies in the same industry can provide useful guidance. This form of behavior is sometimes referred to as the "industry effect". This is what we mean by the Behavioral Principle of Finance. When all else fails, look at what others are doing for guidance.
In Practice, the Behavioral Principle is typically applied in two types of situations. In some cases, such as the choice of a capital structure, theory does not provide a clear solution to the problem. In other cases, theory provides a clear solution, but the cost of gathering the necessary information outweighs the potential benefit. Valuing certain assets is an example of the latter case. The value of some assets, such as stock or a piece of real estate, can often be estimated at relatively low cost from the observed recent purchase prices of similar assets. In cases such as these, managers use the Behavioral Principle to arrive at an inexpensive approximation of the correct answer.
We have just cited two appropriate applications of the Behavioral Principle: (1) the case where there is a limit to our understanding and (2) the case where its use is more cost effective than the most accurate method. One application that sometimes occurs in practice is not appropriate: "blind imitation" to minimize personal cost and risk. We want to leave you with an important warning to avoid this misapplication.
The Behavioral Principle can be tricky to apply. You have to decide when there's no single, clearly correct, best course of action. Furthermore, having decided this, you must decide whether there is a "best" other or group of others to look to for guidance. Finally, you must determine from their actions what your best course of action would be. The Behavioral Principle is, admittedly, a second best principle. It leads to approximate solutions in the best of situations and, in the worst, to imitating the errors of others. Still, it is useful in certain situations, despite its potential shortcomings.
This principle also has an important corollary, financial, accounting concepts and applications are very useful. Its application can lead to what is called the free rider problem. In such situations, a "leader" expends resources to determine a best course of action and a "follower" receives the benefit of the expenditure by simply imitating. So the leader is subsidizing the follower. For example, McDonald's does extensive research and analysis concerning the placement of its restaurants. Other fast food chains have at times chosen their new restaurant locations by simply building near a McDonald's restaurant. Patent and copyright laws are designed to protect innovators, at least to some extent, from the free rider problem and reward the introduction of valuable new ideas that improve society.
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