HOW THE THREE FUNDAMENTAL CONCEPTS ARE RELATED

There are three fundamental concepts that underlie the process of making many financial decisions.  They are also the three fundamental concept that determine the economic value of any project, investment, or business organization.  The three concepts are;

1. Time Value of Money,
2. Risk-Return Relationship
3. Cash Flows. 

Creating Business Value

These three fundamental concepts provide the basis for the procedures and processes that are used for making business decisions that will increase the economic value of the firm.   They represent the three sided foundation for the creation of economic value in the business. 

Every single purchase or investment decision made in a business enterprise affects the present and future after-tax cash flows of the firm.  Every decision also has some level of  associated risk attached to it.  By considering these implications of an investment decision and adjusting for the timing of the cash flows with the the appropriate time value calculations, every decision made by the firm can be an economic value increasing decision.

The most common type of financial decision made is the decision of whether or not to invest money into some type of productive asset or production process.  This process making this type of investment decision is referred to as Capital Budgeting because decisions are being made as to how the firm’s capital is to be invested.  When we make capital budgeting decisions, we must be sure that we incorporate the three fundamental concepts of finance.  In order to do this, we first estimate all future incremental after-tax cash flows associated with the business investment. Next, we then incorporate the time value of money concept by calculating the net present value of all of the incremental (after-tax) cash flows.  During this net present value calculation, we incorporate the concept of the risk-return relationship using any one of a number of different possible approaches.  The resulting risk adjusted net present value reflects the intrinsic value of the investment project.  Finally, by only accepting investment projects that add value to the firm, management (and owners) can increase firm value through the use of financial decision making processes that reflect these three fundamental concepts.

Valuation of Businesses and Investments

Since a business is nothing more than a collection of project investments, the fundamental (or economic value) of a business firm can be found by summing the values of each of the investment projects the company owns.  The value of each project reflects the discounted cash flows the project will generate over its life.  The value of all projects combined reflects the net present value of the discounted cash flows the firm will generate for its owners and so reflects the value of the business to the owners.

For an individual assessing the value of an investment opportunity, the net present value of the discounted cash flows arising from the investment reflects the addition to personal wealth associated with making the investment.  The greater the net present values associated with a particular investment, the greater the addition to personal wealth if the assumptions about the investment's future cash flows are correct.

Conclusion

A firm understanding of the three fundamental concepts introduced in this section is a necessity for sound financial decision making.  The next three sections of this training program will look at each of these concepts in greater depth and will train students in the methods associated with their use.