Two Fundamental Rules of Corporate Finance
Corporate finance is based on two fundamental rules. All tools and techniques of corporate finance are mere ways and means of implementing these rules. These rules can be found at the beginning of any and every corporate finance text book. One of these rules relates to the concept of return while the other relates to the concept of risk. We have described both these rules in this article. They are as follows:
Rule #1: Money today is worth more than money tomorrow
The fundamental rule of corporate finance is that the timing of cash flows is of paramount importance. Also, we want the timing of the cash flows to be as soon as possible. The sooner we get the cash, the better it is for our company. Every dollar that the company has in cash today is better than the same dollar in cash tomorrow because of the following reasons:
Rule #2: Risk free money is worth more than risky money
Corporate finance involves exchanging between present and future streams of cash flows. Companies may come across different projects which offer different future cash flows. However, it is important to realize that all cash flows are not equally likely to materialize in the future. Some cash flows may be almost certain like investing in treasury bonds while others may be highly uncertain like projected returns from stock market investments. Hence, the second rule states that the company must adjust each of these cash flows for their risk before making any comparisons and selections. The following factors must be considered:
The bottom line is that before making a choice, all projects have to be made comparable. This is done by adjusting for cash flow that will be received in different time periods as well as adjusting for the different amounts of risks that are involved in different projects.
- Corporate Finance - Introduction
- Nominal and Real Value of Money
- Present and Future Value of Money
- Net Present Value Calculations
- Compounding Intervals and Interest Rate
Authorship/Referencing - About the Author(s)
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