Finance principles and concepts are the foundations on which financial management is built. The following are the finance principles and concepts which relate to the context of the Guillermo scenario.
The Principle of Self-Interested Behavior
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 (Emery, Finnerty, & Stowe, 2007).
For years, Guillermo Navallez had ready supply of timber and relatively inexpensive Labor, yet he priced his products at a premium.
The Principle of Two-Sided Transactions
According to Emery, Finnerty, & Stowe, 2007, the principle of Two-Sided Transactions recognizes that the accounting system always records two sides to every transaction, a debit and a credit, and there are real people or real firms on each side of the transaction. When this principle is applied, Total Assets=Total Liabilities + Equity, as seen on the balance sheet of Guillermo.
The Principle of Valuable Ideas
According to Emery, Finnerty, & Stowe, 2007, the Principle of Valuable Ideas says that 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 ability to hold a patent granting the exclusive rights to produce a unique product further enhances the product’s value.
Guillermo was able charge a higher price for his furniture because of the value added by his patented coating process.
The Principle of Incremental Benefits
According to Emery, Finnerty, & Stowe, 2007, the Principle of Incremental Benefits says the value derived from choosing a particular alternative is determined by the net extra—that is, incremental—benefit the decision provides compared with its alternative. Financial statements and the accounting system are used to help identify and estimate the incremental expected cash flows for making financial decisions.
Guillermo has prepared an income statement comparing net income in the current scenario, under Hi-Tech, and as a broker. The respective cash flows would only occur if he selects the specific alternatives.
The Signaling Principle: Actions Convey Information
The Signaling Principle is another extension of the Principle of Self-Interested Behavior. It addresses the problem of asymmetric information. Assuming self-interested behavior, we can guess at the information or opinions behind the decisions we observe (Emery, Finnerty, & Stowe, 2007).
For example in the Guillermo scenario, the low prices that the foreign competitor charged indicated that the costs of production could be much lower than what Guillermo was spending.
The Behavioral Principle
The Behavioral Principle states that “When All Else Fails Look at What Others Are Doing for Guidance” (Emery, Finnerty, & Stowe, 2007).
This is a direct application of the Signaling Principle. The Signaling Principle says that actions convey information, while the Behavioral Principle says, in essence, “Let’s try to use such information.” (Emery, Finnerty, & Stowe, 2007). In the Guillermo scenario for example, many of firms in the furniture industry were merging into fewer but bigger firms.
Reference
Emery, D., Finnerty, J., & Stowe, J. (2007). Corporate Financial Management. Prentice Hall: Pearson Education, Inc.