2.

Investment
Under Certainty

Inter-temporal
consumption
How does an investor decide between consuming
today and deferring consumption until next period?
Suppose his income is Y0 today and Y1 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 (Y0,Y1) with slope (1+R):

IB253 Principles of Finance 1

Lecture 3

Consumption
next period

Y0 (1+ R) + Y1

lend Y0 at rate R
+ consume Y0(1+R) + Y1 next period

Y1

Key readings
Hillier et al. Appendix 4A
Bodie et al. 1.1-1.6
Copeland, Weston & Shastri 1A-1E, 2A-2B
1

Y0

Y0 +

Y1
1+ R

Consumption
this period

2
borrow Y1/(1+R) at rate R
+ consume Y0 + Y1/(1+R) now

Consumption
vs. Investment

Capital Investment
Suppose investor can invest I now in a capital project
that will pay C1 for sure next period:
Consumption
next period

Rate of return RP on capital project is given by slope (1+RP)

of line that joins (Y0,Y1) to (Y0-I,Y1+C1)
If RP>R, capital project adds value
ALL investors will undertake project, regardless of their
individual preferences about when to consume their wealth

(Y0 I ) (1+ R) + (Y1 + C1)

Consumption
next period

Y1+C1
Y1

Y0 I +
NPV
Y0-I

Y0

Y0 +

Y1
1+ R

Y1 + C1
1+ R
Consumption
this period

invest I now in capital project

lend Y0 I at rate R
consume (Y0-I)(1+R) +Y1+C1 next period
invest I now in capital project
consume Y0 - I now
consume Y1+C1 next period

Y1+C1
Y1

Investor is better off now if net present value:

Y0-I

Y +C
Y
NPV = Y0 I + 1 1 Y0 + 1 > 0
1+ R
1+ R

Consumption
this period

Y0
invest I now in capital project
Y1 + C1
at rate R
1+ R
Y +C
consume Y0-I + 11+ R1 now

borrow
3

Different lending
and borrowing rates

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:
NPV = I +

C1
> 0
1+ R

Fisher separation principle breaks down if lending

rate RL and borrowing rate RB are not equal
in real world, RB > RL
Consumption
next period

Consumption
next period

slope RL

slope RL

Y1+C1

Decision to invest in capital project is separate from

consumption decision
individual investor preferences about when to
consume do not alter capital investment decision

Y1+C1

Y1

Y1

Y0-I

slope RB>RP

slope RB < RP

Y0

Consumption
this period

If RP > RB > RL,

both lenders and borrowers
will invest in capital project

Y0-I

Y0 Consumption
this period

If RB > RP > RL,

only lenders will invest
in capital project
6

Multi-period case

Net Present Value

Assume lending and borrowing rates are equal (to R),

so that Fisher separation holds
C1

One-period case
0

C1
> 0
1+ R

where R is rate at which investors can lend or borrow

Multi-period case:

C1

C2

CT

C3

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

invest if
NPV = I +

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 Ct is obtained

by multiplying the cash flow by the discount factor:
1
(1+ R)t

invest if NPV = I +

Net Present Value (or NPV for short) is obtained by

C3
C1
C2
CT
7 > 0
+
+
+ ... +
2
3
1+ R
(1+ R)T
(1+ R)
(1+ R)