1

2. Investment
Under Certainty
IB253 Principles of Finance 1
Lecture 3
Key readings
Hillier et al. Appendix 4A
Brealey et al. 2.1-2.2, 3.1
Copeland, Weston & Shastri 1A-1E, 2A-2B
2
Inter-temporal
consumption
How does an investor decide between consuming
today and deferring consumption until next period?
Suppose his income is Y
0
today and Y
1
next period
If investor can lend or borrow at (same) rate R, then he
can position himself anywhere on the budget line that
passes through (Y
0
,Y
1
) with slope (1+R):
1 0
) (1 Y R Y + +
Consumption
this period
Consumption
next period
Y
0
Y
1
R
Y
Y
+
+
1
1
0
borrow Y
1
/(1+R) at rate R
+ consume Y
0
+ Y
1
/(1+R) now
lend Y
0
at rate R
+ consume Y
0
(1+R) + Y
1
next period
3
Capital Investment
Suppose investor can invest I now in a capital project
that will pay C
1
for sure next period:
Investor is better off now if net present value:
R
Y
Y
+
+
1
1
0
Consumption
this period
Consumption
next period
Y
0
Y
1
Y
0
-I
Y
1
+C
1
R
C Y
I Y
+
+
+
1
1 1
0
) ( ) (1 ) (
1 1 0
C Y R I Y + + +
0
1 1
NPV
1
0
1 1
0
>
+
+
+
+
+ =
(
(
(

(
(
(

R
Y
Y
R
C Y
I Y
NPV
4
Consumption
vs. Investment
Rate of return R
P
on capital project is given by slope (1+R
P
)
of line that joins (Y
0
,Y
1
) to (Y
0
-I,Y
1
+C
1
)
If R
P
>R, capital project adds value
ALL investors will undertake project, regardless of their
individual preferences about when to consume their wealth
Consumption
this period
Consumption
next period
Y
0
Y
1
Y
0
-I
Y
1
+C
1
invest I now in capital project
lend Y
0
I at rate R
consume (Y
0
-I)(1+R) +Y
1
+C
1
next period
R
C Y
+
+
1
1 1
invest I now in capital project
borrow at rate R
consume Y
0
-I + now
R
C Y
+
+
1
1 1
invest I now in capital project
consume Y
0
- I now
consume Y
1
+C
1
next period
5
Fisher Separation
Provided lending and borrowing rates are equal,
then all investors agree on whether capital project
adds value or not
Criterion for capital investment is that NPV should
be positive:
Decision to invest in capital project is separate from
consumption decision
individual investor preferences about when to
consume do not alter capital investment decision
0
1
NPV
1
>
+
+ =
R
C
I
6
Different lending
and borrowing rates
Fisher separation principle breaks down if lending
rate R
L
and borrowing rate R
B
are not equal
in real world, R
B
> R
L
If R
P
> R
B
> R
L
,
both lenders and borrowers
will invest in capital project
If R
B
> R
P
> R
L
,
only lenders will invest
in capital project
Consumption
this period
Consumption
next period
Y
0
Y
1
Y
0
-I
Y
1
+C
1
slope R
B
< R
P
slope R
L
Consumption
this period
Consumption
next period
Y
0
Y
1
Y
0
-I
Y
1
+C
1
slope R
L
slope R
B
>R
P
7
Multi-period case
Assume lending and borrowing rates are equal (to R),
so that Fisher separation holds
One-period case
invest if
Multi-period case:
invest if
0
1
NPV
1
>
+
+ =
R
C
I
0
) (1
...
) (1 ) (1
1
NPV
T
3
3
2
2 1
>
+
+ +
+
+
+
+
+
+ =
T
R
C
R
C
R
C
R
C
I
C
1
C
2
C
T
0
C
3
1 2 3 T

I
0 1
I
C
1
8
Net Present Value
Net Present Value (or NPV for short) is obtained by
calculating the present value of each cash flow
adding up all of the present values
netting out (i.e. subtracting) initial investment
Present value of individual cash flow C
t
is obtained
by multiplying the cash flow by the discount factor:
where R is rate at which investors can lend or borrow
Thus far in our story, there is no uncertainty about
the size (or timing) of the future cash flows
so R is the rate for riskless lending or borrowing
We will learn later how to adjust R for the fact that
future cash flows are risky
t
R) (1
1
+