EAE 813: THEORY OF

FINANCE
BY

STEVE MAKAMBI, PhD

Lecture iI
 INVESTMENT DECISION UNDER CERTAINTY
• From the proceeding class, we learned that given perfect and complete
capital markets, the production decision is governed solely by wealth
maximization objectives without regard to individuals' subjective
preferences that enter into their consumption decisions.
• Optimal investment decision maximizes the expected satisfaction
(expected utility) gained from consumption over the planning horizon
of the decision maker.
• An individual who saves does so because the expected benefit of future
consumption provided by an extra dollar of saving exceeds the benefit
of using it for consumption today.
 INVESTMENT DECISION UNDER CERTAINTY
• The previous lecture demonstrated that the individual can profitably
establish a marketplace and everyone will be better off. Markets place
create a central place and serve to efficiently reduce transaction costs.
As they enable operational efficiency of capital markets. The lower the
transaction costs are, the more operationally efficient a market can be
• The presence of transaction costs invalidates Fisher Separation because
the borrowing rate will be greater than the lending rate.
• In this scenario, financial intermediaries and marketplaces will provide a
useful service in harmonizing market prices. Financial institutions will
pay the lending rate for money deposited with them and then issue funds
at a higher rate to borrowers.
• The difference between the borrowing and lending rates represents their
(competitively determined) fee for the economic service provided.
 INVESTMENT DECISION UNDER CERTAINTY
• Individuals can profitably establish a marketplace and everyone will be
better off. Markets place create a central place and serve to efficiently
reduce transaction costs. As they enable operational efficiency of
capital markets. The lower the transaction costs are, the more
operationally efficient a market can be
• Managers of corporations, who act as agents for the owners
(shareholders) of the firm, must decide between paying out earnings in
the form of dividends, which may be used for present consumption, and
retaining the earnings to invest in productive opportunities that are
expected to yield future consumption
 INVESTMENT DECISION UNDER CERTAINTY
Assumptions
➢ Investment decisions are taken from the corporate sector of the economy, (but
the decision criterion, which is to maximize the present value of lifetime
consumption, can be applied to any sector of the economy).
➢ Intertemporal decisions are based on knowledge of the market-determined time
value of money (the interest rate).
➢ The interest rate is assumed to be known with certainty in all time periods. (It is
non-stochastic, that is, it may change over time, but each change is known with
certainty).
➢ All future payoffs from current investment decisions are known with certainty.
➢ There are no imperfections (e.g., transactions costs) in capital markets.
➢ The objective of the firm is to maximize the wealth of its shareholders (same as
maximizing the present value of shareholders' lifetime consumption, or
maximizing the price per share of stock).
 INVESTMENT DECISION UNDER CERTAINTY
ASSUMPTIONS
➢ Investment decisions are taken from the corporate sector of the economy,
(but the decision criterion, which is to maximize the present value of
lifetime consumption, can be applied to any sector of the economy).
➢ Intertemporal decisions are based on knowledge of the market-determined
time value of money (the interest rate).
➢ The interest rate is assumed to be known with certainty in all time
periods. (It is non-stochastic, that is, it may change over time, but each
change is known with certainty).
 INVESTMENT DECISION UNDER CERTAINTY
Assumptions Continues
➢ There are no imperfections (e.g., transactions costs) in capital markets.
➢ The objective of the firm is to maximize the wealth of its shareholders (same as
maximizing the present value of shareholders' lifetime consumption or
maximizing the price per share of stock).
What determines investment decisions under the assumption of Certainty?
Fisher Separation Theory
• The objective is to understand the separation of individual utility preferences
from the investment decision. How can a manager maximize shareholders'
utility when individual utility functions cannot be compared or combined? An
important implication for corporate policy is that the investment decision can
be delegated to managers.
Fisher Separation Theory
Figure 2.1: The investment decision is
*
w1
independent of individual preferences

A
1.
Investor 2
X1.
P1 B
2.

B
Y 2.
3.

Investor 1

P0 W0* C0
 Fisher Separation Theory
• Given the same opportunity set, every investor will make the same
production decision (Po, P1) regardless of the shape of his or her indifference
curves as shown in fig. 1.9.
• Both investor 1 and investor 2 will direct the manager of their firm to choose
production combination (Po, P1). They can then take the output of the firm
and adapt it to their own subjective time preferences by borrowing or lending
in the capital market.
• Investor 1 will choose to consume more than his share of current production
(point B) by borrowing today in the capital market and repaying out of his
share of future production.
• Alternately, investor 2 will lend because he consumes less than his share of
current production. Either way, the two individuals are both better off with a
capital market. The optimal production decision is separated from
individual utility preferences.
 Fisher Separation Theory
• In equilibrium, the marginal rate of substitution for all investors is
equal to the market rate of interest, and this in turn is equal to the
marginal rate of transformation for productive investment.
• Because exchange opportunities permit borrowing and lending at the
same rate of interest, an individual's productive optimum is
independent of his or her resources and tastes.
• This is known as the unanimity principle. It implies that the managers
of the firm, in their capacity as agents of the shareholders, need not
worry about making decisions that reconcile differences of opinion
among shareholders.
 Agency Problem
Do managers have the correct incentive to maximize shareholders' wealth?
• The Principal-Agency conundrum is based on the supposition that there
is a difference between ownership and control, and there is no reason to
believe that the manager, who serves as an agent for the owners, will
always act in the best interest of the shareholders.

• Discuss the agent-Principle conflict????

• In general, we always assume that managers always make decisions

that maximize the wealth of the firm's shareholders. To do so, they must
find and select the best set of investment projects to accomplish their
objective
 Maximization of Shareholders Wealth
• Managers seek to maximize the wealth of the shareholders. We need to establish a
usable definition of what is meant by shareholders' wealth.
• An economist uses the word profits to mean rates of return over the opportunity cost
for funds employed in projects of equal risk. To estimate economic profits, one must
know the exact time pattern of cash flows provided by a project and the opportunity
cost of capital.
• The pattern of cash flows is the same thing as the stream of dividends paid by the
firm to its owners. Therefore the appropriate profits for managers to use when making
decisions are the discounted stream of cash flows to shareholders—in other words,
‘dividends’.
• The definition of dividends includes capital gains, spinoffs to shareholders, payments
in liquidation or bankruptcy, repurchase of shares, awards in shareholders' lawsuits,
and payoffs resulting from merger or acquisition
• Financial managers are frequently misled when they focus on the accounting
definition of profit, or earnings per share. The objective of the firm is not to maximize
earnings per share. The correct objective is to maximize shareholders' wealth, which
is the price per share that in turn is equivalent to the discounted cash flows of the
firm.
 Capital Budgeting Techniques
• Investment decision rules are usually referred to as capital budgeting
techniques. The best technique will maximize shareholders' wealth. This
essential property can be broken down into separate criteria:
➢ All cash flows should be considered
➢ The cash flows should be discounted at the opportunity cost of funds.
➢ The technique should select from a set of mutually exclusive projects the one that
maximizes shareholders' wealth.
➢ Managers should be able to consider one project independently from all others
(this is known as the value-additivity principle).
• There are four common capital budgeting techniques
➢ Payback Period
➢ Accounting rate of return (ARR)
➢ Net Present Value (NPV)
➢ Internal rate of Return (IRR)
 Capital Budgeting techniques
• We will use the following example to demonstrate investment decision
under certainty. The objective is to evaluate the suitability of each of the
techniques when the objective is to maximize shareholders wealth
YEAR CASHFLOWS PVIFA=10%
A B C D
0 -1000 -1000 -1000 -1000 1
1 100 0 100 200 0.900
2 900 0 200 300 0.826
3 100 300 300 500 0.751
4 -100 700 400 500 0.683
5 -400 1300 1250 600 0.621
 Gordon Growth Model
For a project with an unspecified life period, the Gordon Growth Model is
applied where the terminal value is calculated. The Gordon growth model
assumes that cash flows will grow evenly in perpetuity from the period
immediately preceding the valuation date. Terminal value is then discounted
back to today’s ‘value’ at an appropriate discount rate.

𝑁𝐶𝐹0 (1 + 𝑔)
𝑃𝑉 =
𝑘−𝑔
Where: PV = Present value, NCF0 = Net cash flow in period 0, the period
immediately preceding the valuation date, k = Discount rate (cost of
capital), g = Expected long-term sustainable growth rate in net
cash flow to the investor
 Gordon Growth Model
The present value of the terminal value is then added to the present value of the
projected cash flows from the specified projection period to arrive at the total estimated
present value of the investment
𝑁𝐶𝐹0 (1 + 𝑔)
𝑁𝐶𝐹1 𝑁𝐶𝐹2 𝑁𝐶𝐹3 𝑁𝐶𝐹𝑛 𝑘−𝑔
𝑃𝑉 = 1
+ 2
+ 3
+ ⋯.+ 𝑛
+
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘)𝑛

Example
You are given the following information on the expected net cash inflow from a firm.
Assume that the discount rate is 20% and the expected long term growth rate following
year 6 is 10%; calculate the value of the firm.
YEAR 1 2 3 4 5 6
NCF (KES Millions) 1200 1300 1500 1700 1800 1900