EC5603 Lecture 1 landscape

Brunel University

Department of Economics and Finance

EC5603 Business Finance

Lecture 1: Financial Management and Single Period Consumption-

Investment Decision Model

______________________________________________________________ Reading: Lumby Chap 4

Pike and Neale Chap 3

_______________________________________________________________ (1) THE INVESTMENT DECISION (Capital Budgeting Decision)

- is the decision to acquire assets.

Real Assets - assets employed within the business to produce goods and services to satisfy consumer demand e.g. land and buildings, plant and equipment, stock etc...

Financial Assets - claims to receive income from others e.g. firms can buy shares and debt of other companies.

The basic problems facing the financial manager (FM) concerning investments are:

(a) How much should the firm invest?

(b) In which assets (projects) should the firm invest?

(2) THE FINANCING DECISION

- is the decision of how to acquire the finance to fund the firm’s operations - both existing and proposed.

(3) THE ROLE OF THE FINANCIAL MANAGER

Essentially, the FM runs and organises both the investment and financing decisions of most modern corporations.

They are concerned with

(a) investing funds in productive opportunities and

(b) obtaining funds to finance these investments and determining the best (optimal) mix of financing in order to

MAXIMISE THE COMPANY’S OVERALL VALUE.

Thus, the FM acts as a financial intermediary between financial markets and the firm.

This is clearly illustrated in the handout given.

(4) THE SINGLE-PERIOD CONSUMPTION-INVESTMENT DECISION MODEL.

Simple model that illustrates the financing and investment decisions. Although simplifying assumptions have been made - which may seem unrealistic - it does enable us to reach conclusions that have real world applications.

(a) SIMPLIFYING ASSUMPTIONS

(i) It is a one-period model

t t 0single period 1−→−−−−

(ii) Initially, we will assume that only physical investment opportunities exist i.e. there is no opportunity to invest in the capital market where money can be lent or borrowed at a rate of interest.

(iii) It is a single owner firm i.e. the company only has one shareholder who is also the FM.

(iv) Investors are wealth maximises.

(v) All decision relevant information is known with certainty.

(vi) Investment projects are independent and divisible.

(b) THE TIME VALUE OF MONEY AND THE OWNER’S INDIFFERENCE CURVES

Assume that the company can do one of two things with its retained earnings:

(i) Pay them to shareholders as dividends at t0, or

(ii) Invest them with the aim of obtaining an increased dividend later. -This is all an investment decision is - delaying current consumption (divs now) in order to increase future consumption (divs later).

-The ‘tr ade-off’ between current and future consumption is called the owners ‘time value of money’ or the ‘marginal rate of time preference.’