Investment Principles and Case Studies

Sources and Case Studies of Finance – Investment Principles
School of Civil and

Environmental Engineering
CV4107 Engineering
Economics and Finance
Sources and Case Studies

of Finance –
Investment Principles
Assoc Prof Robert Tiong Lee Kong
Email: clktiong@ntu.edu.sg
Tel: 6790 5253
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Learning Outcomes
At the end of this lesson, you should be able to:
1. Describe the objectives of corporations.
2. Describe the types of financial decisions a firm makes to
increase its value.
3. Describe the role of the financial manager with regards
to financing and investment process.
4. Explain the types of capital a firm can access to finance
its operations.
5. Explain the effects of investments on real assets to the
welfare of the firm.
6. Explain how a firm maximises the net present value
(NPV) of its investment.
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Objectives of the Firm
Starting a Firm • Shareholders introduce

money.
Acquiring • Money is used in acquiring
Real Assets REAL ASSETS.
One Common
Objective
Financial
Decisions
Page 04 of 34
Starting a Firm • Tangible Assets:

• Buildings, Equipment,
Acquiring Cash, Goods
Real Assets • Intangible Assets:
• Brand names
One Common
Objective
Financial
Decisions
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Starting a Firm • To increase the stake

of the shareholders:
Acquiring • By increasing the value
Real Assets of real assets.
One Common
Objective
Financial
Decisions
Page 06 of 34
Starting a Firm • To increase the value

of assets:
Acquiring • Profitable investments
Real Assets must be made.
• Profitable investments
One Common must give:
Objective • A rate of return higher
than the interest rate of
Financial capital.
Decisions
Page 07 of 34
Model of a firm reflecting shareholders’ objective

Owner’s Money
Firm
Buildings Machines Goods Cash
Model of a Firm – Initial Setup

Page 08 of 34
Model of a firm reflecting shareholders’ objective

Owner’s Money
Firm
Buildings Machines Goods Cash
Model of a Firm – After Profitable Investments

Page 09 of 34
Types of Financial Decisions a Firm Makes
Investment
Decision Investment Decision
• Profitable investments must
Capital Rationing be identified:
Decision • Select among a group of
acceptable projects:
Financial Decision ‐ Acceptance based on the rate
of return.
• Depend on the availability of funds.
Capital Market
Decision
Page 10 of 34
Investment
Decision Capital Rationing Decision
• Funds for investment: How much?
Capital Rationing
• Internal funds
Decision
• Borrowed funds
Financial Decision
Capital Market
Decision
Page 11 of 34
Investment
Decision Financing Decision
• From the capital market:
Capital Rationing • What financial instruments?
Decision
‐ Issue new shares
‐ Issue bonds (Zhàiquàn)
Financial Decision • Obtain Loans:
• Long-term
Capital Market • Short-term
Decision
Page 12 of 34
Investment
Capital Market Decision
Decision
• Individuals and organisations with cash willing to
invest in firms to obtain a return.
Capital Rationing • Borrowing firm must trade its capital
Decision instruments or physical assets as securities.
Financial Method Securities
Financial Decision Equity Financing New Shares
Bond Financing Bonds
Loan – Long Term Physical Assets
Capital Market
Decision Loan – Short Term
Page 13 of 34
The Role of a Financial Manager
Investment Buy real assets that would acquire value

Decision more than they cost.
Financing Find financing instruments that can

Decision best meet the firm’s needs.
Valuation Estimates the value of the real assets.

Page 14 of 34
The Role of a Financial Manager

A financial manager acts as an intermediary between the firm’s
operations and the capital markets and manages the flow of cash
as shown in figure below.
(2) (1)
Firm’s Financial Capital

(5)
Operations Manager Markets
(3) (4)
1. Cash raised from investors

2. Cash invested in firm
3. Cash generated by firm’s operations
4. Cash returned to investors
5. Cash reinvested
Page 15 of 34
Capital Market (Financial Market)

Individuals or organisations that have extra cash assets and are
willing to invest on or lend to firms in order to earn a return on
their cash constitute the capital market. The firms that are in
need of cash to finance their operations trade in their securities
in return for cash.
Only projects yielding a rate of return

that is at least equal to that from the
capital market could be undertaken.
IRR > MARR
Other projects should be rejected.
Page 16 of 34
Effect of Borrowing and Lending (For Ref Only)

• Growth of business depends on the willingness of:
• Individuals to lend money to enterprises.
• Enterprises to borrow money and
make investments.
Page 17 of 34
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.
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Effect of borrowing & lending

• By borrowing OF from Period 1
$
the future, an extra BD r = Capital market interest rate
H BD = OF / (1 + r )
can be consumed now –
Total OD. FH = OB (1 + r )
• By lending OB now, Interest-rate Line

Slope = (1+r)
an extra FH can be F
consumed in period 1 – Future

Total OH. CF
Period 0
$
O B D
Present CF
Page 19 of 34
Effect of borrowing
$
• Prodigal borrows BC H Period 1

against future cash flow
Interest-rate Line
now to consume: Slope = (1+r)
• OC in period 0 and
F
• OE in period 1
E
Future
Consumption
Period 0
$
O B C D
Present Consumption
The prodigal borrows BC from period 1 and consumers OC now.
Page 20 of 34
Effect of Lending
$
• Miser lends AB now H Period 1

to consume
Interest-rate Line
• OA in period 0 and Slope = (1+r)
• OG in period 1 G
F
Future
Consumption
Period 0
$
O A B D
Current Consumption
Page 21 of 34
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
Page 22 of 34
Effect of Investment on Real Asset

• Investments are not limited to capital markets.
• Better returns can be obtained from investments
on real assets.
• Example:
Page 23 of 34

$
Period 1
Cash Flow from
investment Investment – Opportunity
(I – O) Line
3rd best
$7,000
2nd best
$15,000
Best
$20,000
$
Period 0
3rd Best 2nd best Best Investment

($10,000) ($10,000) ($10,000)
Notice the diminishing return on

additional units of investment.
Page 24 of 34

Period 1
Slope = (1+r)
R
I – O Line
Y Slope = (1+y)
Period 0
L J D
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.
Page 25 of 34
Investment in Real Assets Improves Welfare

Period 1
H
X
G Slope = (1+r)
Period 0
O J D K
• 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, better off decision.
Page 26 of 34
Investment in Real Assets Improves Welfare

Period 1
H
X
G Slope = (1+r)
Period 0
O J D K
• 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
Page 27 of 34
NPV of Investment
Period 1
Earning in period 1 from
investing JD is JX. M
Present value of JX is JK H
NPV = JK – JD G
X
Slope = (1+r)
= DK (Maximum NPV)
Period 0
O J D K
Page 28 of 34
NPV of Investment
Period 1
i. Investment JD:
Interest-rate line (ii) Interest-rate line
tangent to investment- W X Slope (1+r)
opportunity line Optimum

NPV = DK G investment point
JD represents the (i)
OPTIMUM investment. Q
Period 0
O X J N D Y P K
Page 29 of 34
NPV of Investment
Period 1
ii. Investment ND < JD:
NPV = DP < DK (ii) Interest-rate line
Investment not W X Slope (1+r)
large enough to
Optimum
maximise earnings. G investment point
(i)
Q
Period 0
O X J N D Y P K
Page 30 of 34
NPV of Investment
Period 1
iii.Investment XD > JD:
NPV = DY < DK (ii) Interest-rate line
Return on additional W X Slope (1+r)
units of investment Optimum

less than that from G investment point
the capital market. (i)
Q
Period 0
O X J N D Y P K
Page 31 of 34
Only projects yielding a rate of return

that is at least equal to that from the
capital market could be undertaken.
IRR > MARR
Other projects should be rejected.
Page 32 of 34
Summary
In this lesson, you learnt to:
1. Describe the objectives of corporations.
2. Describe the types of financial decisions a firm make to
increase its value.
3. Describe the role of the financial manager with regards
to financing and investment process.
4. Explain the types of capital a firm can access to finance
its operations.
5. Explain the effects of investments on real assets to the
welfare of the firm.
6. Explain how a firm maximises the net present value
(NPV) of its investment.
Page 33 of 34
Resources
Click here to download this course in PDF.

Page 34 of 34
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Investment Principles and Case Studies

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Sources and Case Studies of Finance – Investment Principles

School of Civil and

Sources and Case Studies

Objectives of the Firm

Starting a Firm • Shareholders introduce

Objectives of the Firm

Starting a Firm • Tangible Assets:

Objectives of the Firm

Starting a Firm • To increase the stake

Objectives of the Firm

Starting a Firm • To increase the value

Model of a firm reflecting shareholders’ objective

Buildings Machines Goods Cash

Model of a Firm – Initial Setup

Model of a firm reflecting shareholders’ objective

Buildings Machines Goods Cash

Model of a Firm – After Profitable Investments

Types of Financial Decisions a Firm Makes

Types of Financial Decisions a Firm Makes

Types of Financial Decisions a Firm Makes

Types of Financial Decisions a Firm Makes

The Role of a Financial Manager

Investment Buy real assets that would acquire value

Financing Find financing instruments that can

Valuation Estimates the value of the real assets.

The Role of a Financial Manager

Firm’s Financial Capital

1. Cash raised from investors

Capital Market (Financial Market)

Only projects yielding a rate of return

Effect of Borrowing and Lending (For Ref Only)

Effect of borrowing & lending

• By lending OB now, Interest-rate Line

consumed in period 1 – Future

• Prodigal borrows BC H Period 1

• Miser lends AB now H Period 1

a. Nothing is consumed now

Effect of Investment on Real Asset

Effect of Investment on Real Asset

3rd Best 2nd best Best Investment

Notice the diminishing return on

Effect of Investment on Real Asset

Investment in Real Assets Improves Welfare

Investment in Real Assets Improves Welfare

• Prodigal can now borrow JK against JX and consume

opportunity line Optimum

units of investment Optimum

Only projects yielding a rate of return

Click here to download this course in PDF.

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