What are the five basis principles of finance? Briefly explain them (no more than 250 words). (10 marks)

1. Time Value Money

2. Agency Problem

3. Cash Flow Matters

4. Risk Should be Rewarded

5. Market Prices Reflect Information

Explanation:

Time Value of Money

A very important Principle in Finance. Time Value of money refers to the fact that what money is worth today is not what it will be worth tomorrow. Tomorrow, that money will probably be worth less due to the effects of inflation eroding it's value. For this reason it is therefore possible to invest in the present and expect a higher value in future because your money becomes stronger. For example, rent for a building could be $2,000 in 2015 but is now $3,000 in 2020. This is because Inflation we the value of the Dollar and so prices went up to compensate.

Agency Problem.

This principle states that the goals of management and the goals of shareholders may differ sometimes. When this happens there is a conflict of interest and the managers might just undertake actions that are not in the interest of the shareholders.

CashFlow Matters

Actual cash is needed in finance to run the business and engage in transactions that help move the business forward. Simply having potential income is not good enough and so cash is Paramount. For this reason there is a very important financial statement called the Cash Flow Statement which a company uses to see how much cash it actually has on hand.

Risk Should be Rewarded

In finance there is a basic premise that the more risk you undertake, the more you should be compensated. If the risk you are taking is high then the benefit must be high as well. This is why riskier financial instruments are ascribed higher rewards and lower risk instruments have a lower reward. For example, US T-bills are known as the safest of instruments and for this reason have very low rates.

Market Prices Reflect Information

Market Prices in finance are considered right because they reflect the information in the market surrounding the asset in question. This means that Financial markets regulate their own prices based on information available and so that is the price trades should be conducted at.

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