INVESTMENT PRINCIPLES Starting of Firm Shareholders introduce money Money is used in acquiring REAL ASSETS Real Assets Tangible

ble Assets Buildings Cash Intangible Assets Brand names Equipment Goods

Objective of Firm To increase the stake of the shareholders By increasing the value of real assets Financial Decisions To increase the value of assets Profitable investments must be made Profitable investments must give A rate of return higher than the interest rate of capital

Owners Money Firm

Owners Money Firm

Buildings Machines

Goods

Cash

Buildings Machines

Goods

Cash

Model of a Firm - Initial Set-up

Model of a Firm After profitable Investments

Types of Financial Decisions Investment Decision Capital Rationing Decision Financing Decision Capital Market Decision

Investment Decision Profitable investments must be identified Select among a group of acceptable projects Acceptance based on the rate of return Depend on the availability of funds Capital Rationing Decision Funds for investment: How much ? Internal funds Borrowed funds

Capital Market Decision Financing Decision From the capital market What financial instruments? Issue new shares Issue bonds Obtain Loans Long-term Short-term Individuals and organizations with cash Willing to invest in firms to obtain a return Borrowing firm must trade its capital instruments or physical assets as securities Financing Method EQUITY financing BOND financing LOAN Long-term LOAN short-term Securities New shares Bonds Physical asset

Effect of Borrowing and Lending

(2) Firms Operations (3) (1) (2) (3) (4) (5) Financial Manager (1) (5) (4) Capital Markets

Growth of business depends on the willingness of Individuals to lend money to enterprises Enterprises to borrow money and make investments

Cash raised from investors Cash invested in firm Cash generated by firms operations Cash returned to investors Cash reinvested

EXAMPLE Suppose an individual Has a cash flow ( = OB) now Expects to get a cash flow ( = OF) in the next period Alternatives Available Consume OB now and OF during next period Have increased consumption now by borrowing against expected future cash flow OF Forego consumption and lend OB now to have increased consumption later

r = capital market $ Period 1 H interest rate Interest - rate Line Slope = ( 1 + r ) BD = OF / (1 + r ) F Future CF

$ D Period 0

FH = OB (1 + r )

Current CF

By borrowing against OF, an extra BD can be consumed now Total OD By lending OB now, an extra FH can be consumed in period 1 Total OH

$ Period 1 H F
Future E consumption

$ Period 1 H
G F Future consumption

$ D Period 0

A B

$ D Period 0

Current consumption

Current consumption

Effect of Borrowing Prodigal borrows BC now to consume OC in period 0 and OE in period 1

Effect of Lending Miser lends AB now to consume OA in period 0 and OG in period 1

EXAMPLE Cash on hand (now) = $20,000 Cash expected 1 year from now = $25,000 Discount rate = 7% (a) Nothing is consumed now 20,000 now will become 1.07 * 20,000 = 21,400 Total available in year 1 = 21,400 + 25,000 = 46,400 (b) Borrow against future cash flow 25,000 one year later = 25,000 / 1.07 = 23,364 Total available now = 20,000 + 23,364 = 43,364

Effect of Investment on Real Assets Investments not limited to capital markets Better returns can be obtained from investments on real assets Example Investment Rank Amount ($) Best 2nd Best 3rd Best 10 000 10 000 10 000 Net Income in Period 1 ($) 20 000 15 000 7 000

Period 1 $ Investment Opportunity (I O) Line Period 1

Cash flow from investment 3d best $7,000 2d best $15,000 Best $20,000

Slope = (1 + r ) R I O line Slope = (1 + y )

Y $ Period 0
3rd best 2nd best Best Investment ($10,000) ($10,000) ($10,000)

Period 0

y = Marginal rate of return if investment is up to JD r = Capital market interest rate Market interest-rate line is tangential to the investment opportunities line at R corresponding to investment LD. LD represents the limit on profitable investments

Notice the diminishing return on additional units of investment

Investment in Real Assets Improves Welfare

Period 1 M H G

Investment in Real Assets Improves Welfare

Period 1 M H

X Slope = (1 + r )

X Slope = (1 + r )

K Period 0

K Period 0

Available now = OD Retain OJ and invest JD on real assets Earning in period 1 from investing JD is JX Present value of JX is JK

Prodigal can now borrow JK against JX and consume OJ + JK = OK > OD Miser can now lend OJ and consume in period 1 OG + GM = OM > OH

NPV of Investment
Period 1 M

Period 1 (ii) W x Interest-rate line Slope (1 + r) Optimum investment point (i) x Period 0 O X J N D Y P K

H G

X Slope = (1 + r )

G Q

K Period 0

Earning in period 1 from investing JD is JX Present value of JX is JK NPV = JK - JD = DK (Maximum NPV)

(i) Investment JD : Interest-rate line tangent to investmentopportunity line NPV = DK JD represents the OPTIMUM investment

Period 1 (ii) W G Q x Interest-rate line Slope (1 + r) Optimum investment point (i) x Period 0 O X J N D Y P K O W G Q

Period 1 (ii) x Interest-rate line Slope (1 + r) Optimum investment point (i) x Period 0 X J N D Y P K

(ii) Investment ND < JD : NPV = DP < DK Investment not large enough to maximize earnings

(iii) Investment XD > JD : NPV = DY < DK Return on additional units of investment less than that from the capital market

Only projects yielding a rate of return that is at least equal to that from the capital market could be undertaken. Other projects should be rejected.