NATURE OF INVESTMENT MANAGEMENT

Definition of Investment:

Investment is defined differently by different authors:

1. Commitment of funds now in expectation of a return at a future date, which is above

what was committed initially;
2. Purchase of an asset that produces a return proportional to the risk assumed over some
future investment period;
3. The sacrifice of a certain present value for (possibly uncertain) future value;
4. Any asset tangible or intangible that has potential of providing a periodic return and/or to
increase in value.

Investment should be contrasted with savings in that savings is the forgone consumption
while investment is expected to increase in value with time.

The investment environment encompasses the kinds of marketable securities that exist and
where and how they are bought and sold. The investment process is concerned with how an
investor should proceed in making decisions about marketable securities to invest in, how
much extensive the investments should be and when the investments should be made.

Characteristics of an Investment

There are three factors or characteristics of an investment:

1. Return: The income or cashflow that an investor gets from an investment and it is
sometimes calculated as a percentage of the market price of a financial asset. For current
income, the return is called current yield whereas for capital gains, it is called capital
gains yield:
Dividend yield = current dividend/market price of a share = 10/100 = 10% or
Interest yield = interest (coupon)/market price = 100/1000 = 10%

It can also include appreciation of the value of an investment to give capital gains yield
where r = (P1 – P0)/P0

2. Risk: An investment has some risk. You are committing funds now in expectation of
income in the future. The actual might deviate from the expected due to, say, interest rate

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 fluctuation, business risk, exchange risk, financial risk, etc. If the risk is diversifiable, it
is called unsystematic risk (company specific or financial asset specific). If it is
undiversifiable, it is called systematic or market risk.

The higher the risk associated with an investment, the higher the return expected. The
return must be commensurate with the risk assumed in an investment.

3. Time: Commitment of funds now and expecting a future return. The future could be
short term, medium term or long term. The longer the time, the higher the risk because of
the growing uncertainty about what the future will be. Which time horizon to invest in
depends on the expectations of the future that the investor has. If he thinks the future is
bright, he will invest long term in expectation of a higher return.

Investment Vs Speculation Vs Gambling

While you speculate because you expect a return and there is also risk and time involved,
speculation is considered to be of a relatively shorter time as compared to investment. One
speculates because he expects to benefit from short term market fluctuations in the price of
the assets.

Gambling is different from investment in that the risk involved in gambling is too high and
not commensurate with the expected return.

Types of Investment – Financial Versus Real Investments

Investments or assets are of two types – real assets and financial assets.

1. Real investments or tangible assets are those expected to provide future or present
benefits to the owners based on their fundamental qualities. These include buildings, land,
houses, equipment, machinery, etc. For example, a person’s home provides benefits
commensurate with its location, size and quality of construction.
2. Financial investments or intangible assets are those expected to provide benefits to the
owners based solely on another party’s performance i.e. they are claims against counter
parties for future benefits. They involve contracts written on pieces of paper. For example, a
bank’s savings account will provide benefits only if the bank continues to operate and pay
interest on the account; the account holder depends upon the bank’s performance for any
benefits from the financial asset. It follows then that one party’s financial asset is another

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party’s financial liability – that the latter has an obligation, usually a legal one, to provide
future benefits to the owner of the financial asset.

Financial assets are of three types: money (notes, coins and demand deposits); debt
(borrowed or lent funds and their derivatives) and stocks/shares and their derivatives.

Financial assets or financial instruments are sometimes called securities. A security is a legal
representation of the right to receive prospective future benefits under stated conditions.

Primary Objectives of Investments

The options for investing are continually increasing, yet every single investment vehicle can
be categorised according to three fundamental characteristics – safety, income and growth –
which also correspond to types of investor objectives. While it is possible for an investor to
have more than one of these objectives, the success of one must come at the expense of
others.
1. Safety
Perhaps there is truth to the axiom that there is no such thing as a completely safe and secure
investment. Yet we can get close to ultimate safety for our investment funds through the
purchase of government-issued securities in stable economic systems, or through the
purchase of the highest quality corporate bonds issued by the economy’s top companies. Such
securities are arguably the best means of preserving principal while receiving a specified rate
of return.

The safest securities are usually found in the money market and include such securities as
treasury bills, certificates of deposit, commercial paper, and bankers’ acceptances; or in the
fixed income (bond) market in the form of municipal and other government bonds, and in
corporate bonds. The securities listed above are ordered according to the typical spectrum of
increasing risk and, in turn, increasing potential yield.

2. Income

The safest investments are also the ones that are likely to have the lowest rate of income
return or yield. Investors must inevitably sacrifice a degree of safety if they want to increase
their yield. This is the inverse relationship between safety and yield – as yield increases,

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safety generally goes down, and vice versa. In order to increase their rate of investment return
and take on risk above that of money market instruments or government bonds, investors may
choose to purchase corporate bonds or preferred shares with lower investment ratings.

3. Growth

Most investments have a potential to provide a rate of return from an increase in value, often
referred to as a capital gain. Capital gains are entirely different from yields in that they are
only realised when the security is sold for a price that is higher than the price at which it was
originally purchased. (Selling at a lower price is referred to as a capital loss). Therefore,
investors seeking capital gains are likely not those who need a fixed, ongoing source of
investment returns from their portfolio, but rather those who seek the possibility of long-term
growth.

Growth of capital is most likely associated with the purchase of common stock, particularly
growth securities, which offer low yields but considerable opportunity for increase in value.
For this reason, common stock generally ranks among the most speculative of investments as
their return depends on what will happen in an unpredictable future.

It is also important to note that capital gains offer potential tax advantages by virtue of their
lower tax rate in most jurisdictions. Funds that are garnered through common stock offerings,
for example, are often geared towards the growth plans of small companies, a process that is
extremely important for the growth of the overall economy. In order to encourage
investments in these areas, governments choose to tax capital gains at lower rate than income.
Such systems serve to encourage entrepreneurship and the founding of new businesses that
help the economy grow.

Secondary Objectives of Investments

4. Tax minimisation

An investor may pursue certain investments in order to adopt tax minimisation as part of his
or her investment strategy. A highly paid executive, for example, may want to seek
investments with favourable tax treatment in order to lessen his or her overall income tax
burden. Making contributions to a suitable pension scheme or other tax-sheltered retirement
plans can be an effective tax minimisation strategy.

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5. Marketability/Liquidity
Many of the investments discussed above are reasonably illiquid, which means that they
cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity,
however, requires the sacrifice of a certain level of income or potential for capital gains.

Common stock is often considered the most liquid of investments, since it can usually be sold
within a day or two of the decision to sell. Bonds can also be fairly marketable, but some
bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market
instruments may only be redeemable at the precise date at which the fixed term ends. If an
investor seeks liquidity, money markets assets and non-tradable bonds aren’t likely to be held
in his or her portfolio.

The Role of the Financial Services Industry

The world is becoming increasingly integrated and interdependent, as trade and investment
flows are global in nature. Therefore, it is important to understand the core role that the
financial services industry performs within the economy and some of the key features of the
global financial services sector.

The financial services industry provides the link between organisations needing capital and
those with capital available for investment. For example, an organisation needing capital
might be a growing company, and the capital might be provided by individuals saving for
their retirement in a pension fund. It is the financial services industry that channels money
invested to those organisations that need it, and provides execution, payment, advisory and
management services.

It is accepted that the financial services industry plays a critical role in all advanced
economies and many developing economies, and that the services it provides can be broken
down into three core functions:

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i) The Investment chain
Through the investment chain, savers and borrowers are brought together. Savers provide
financing to businesses, and businesses that wish to grow offer opportunities for savers to
take part in the growth and resulting potential returns. The efficiency of this chain is critical
to allocating what would otherwise be uninvested capital to businesses that can use it to grow
their enterprises, as well as the savings pools of the investors. This chain therefore raises
productivity and, in turn, improves the competitiveness of those financial markets within the
global economy.

ii) Risk management

In addition to the opportunities that the investment chain provides for pooling investment
risks, the financial services sector allows other risks to be managed effectively and efficiently
through the use of insurance, and increasingly through the use of sophisticated derivatives.
These tools help businesses cope with global uncertainties as diverse as the changing value of
currencies, the incidence of major accidents or extreme weather conditions. They also help
households protect themselves against everyday contingencies.

iii) Payment systems

Payment and banking services operated by the financial services sector provide the practical
mechanisms for money to be managed, transmitted and received quickly and reliably. It is an
essential requirement for commercial activities to take place and for participation in
international trade and investment. Access to payment systems and banking services is a vital
component of financial inclusion for individuals.

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TIME VALUE OF MONEY

One of the most important principles in asset valuation is the relationship between K1.00 in
the future and K1.00 today. For most of us, K1.00 in the future is less valuable because “a
bird in the hand is worth two in the bush”. Moreover, K1.00 two years from now is less
valuable than K1.00 one year from now. As a result, investors are willing to pay more for an
investment that promises to pay returns over years 1 to 5 than will pay for years 6 through 10.
This relationship is known in financial circles as the time value of money and it permeates
almost every nook and cranny of finance.

Compound Value

The concept of compound value is cardinal to understanding the mathematics of valuation of

assets. The term means the value of a sum at a future date when interest is compounded on
the principle and on interest from prior periods. As a result, interest is earned on interest. Put
in an equation form, the statement above translates to:

CV = PV + I............................................................................................(1)

Where P = Principal = Par value = Present value

I = Interest amount = rP or rPV
r = Interest rate

The equation (1) above becomes:

CV = PV + Rp........................................................................................(2)
CV = PV(1 + r).......................................................................................(3)

This concept can be used to solve a class of problems exemplified below:

Example:

Consider a person who has K1000.00 in an account. If interest rate is 8% and is compounded
annually, how much will the K1000.00 be worth at the end of a year?

Solution:

Using equation (3) we have:

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CV = PV(1 + r)
= 1000 (1 + 0.08)
= K1,080
If the same amount of K1000.00 was left in the account for a period of two years, the
K1000.00 initial investment will become K1,080.00 at the end of the first year at 8% interest.
Going to the end of the second year, K1,080.00 becomes K1,166.40, as K80 in interest is
earned on the initial K1000.00 and K6.40 is earned on K80 interest paid at the end of the first
year. In other words, interest is earned on previously earned interest, hence the name
compound interest. i.e.:

CV2 = PV (1 +R)t
= 1000 (1.08)2
= K1,166.40
At the end of 3 years a person would earn:

CV3 = PV (1 + r)t
= 1000(1.08)3
= K1,259.71

Using the fundamental equation (3), we can determine the level of so many years for other
problems involving compound growth. The principle is particularly important when we
consider certain valuation models for common stock.
(Note: Students need to be conversant with the use of financial tables)

Compounding for more than once in a year:

Thus far, we have assumed that interest is paid annually. Although this assumption is easiest
to make, we now need to consider the relationship between compound value ad interest rates
for different rates of compounding. To begin, we suppose interest is paid semi-annually and
K1000.00 is deposited in an account at 8%. This implies that for the first 6 months the return
is half of 8% (i.e. 4%). Thus, the compound value at the end of 6 months will be:
CV1/2 = K1000 (1 + 0.08/2) = K1040.00. And at the end of year 1:
CV1 = K1000(1 + 0.008/2)2 = K1081.60

Contrast the compound value with K1080.00 if interest were paid once a year. The K1.60
difference is attributed to the fact that during the second 6 months, interest is earned on the

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K40.00 interest paid at the end of the first 6 months. Hence the more times during the year
that interest if paid, the greater the terminal value at the end of a given year. The general
formula for solving for terminal value at the end of year n, where interest if paid m times a
year is:
CVt = PV0 (1 + r/m)t X m .......................................................................(4)

Present Value

Present value (PV) is the current value of a future sum discounted back to the present at an
appropriate interest rate. The formula for the present value can be derived from the
fundamental equation (3) above i.e. CV = PV (1 + r) t, by making PV the subject of the
formula:

PV = CV / (1 + r)t .............................................................................(5)

Example:

Consider a person who wishes to buy a K7000.00 worth of an item 1 year from now. How
much will he have to put aside on a bank paying 8% on a 1 year deposit?

Solution:

Here PV = ?; CV = 7000; r = 0.08

PV = CV/(1 + 0.08)1
= 7000/(1.08)
= K 6, 481.48

This means that if he deposited K6,481.48 today, he will take home K7,000.00 one year
hence. Stated in another way, K6,481.48 is the present value of K7000 to be received at the
end of 1 year, when interest rate involved is 8%.

Beyond one year period:

The present value of a sum to be received 2 years from now is given by:

PV = CV/(1 + r)2 which for our example problem above, would be:

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PV = 7000 / (1+0.08)2
= K6,001.40

Thus, K7000.00 two years from now has a lower present value than K7000.00 one year from
now. This is the whole idea of the time value of money.

We note that CV rises as t rises whereas PV falls as t rises. PVIF is the reciprocal of CVIF
and that only happens at the same rate of interest and same t.

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PVIF10%,3 yrs = 𝐶𝑉𝐼𝐹 = 1.331 = 0.7513

This means that we can calculate the present value in two ways:

PV = CV(PVIF) = 10,000(0.7513) = 7513

𝐶𝑉 10000
PV = 𝐶𝑉𝐼𝐹 = = 7513
1.331

Annuities and Uneven Cashflows

Present value of an annuity

An annuity is a series of uniform or equal payments or receipts occurring over a specified

number of years at predetermined times, which result from an initial deposit or result into a
fulfilment of an obligation in the future. There are two types of annuities – annuity due and
ordinary/regular annuity. Annuity due is where the instalment payments or receipts are made
in advance e.g. rentals are usually made in advance. Ordinary/regular annuities are paid at the
end of the period. Most annuities are of this ordinary type (we’ll concentrate on ordinary
annuities).

Suppose K1.00 is to be received at the end of each of the next 3 years. The calculation of the
present value of this stream using 10% discount rate is as follows:

PV of K1.00 to be received in 1 year = K0.90909

PV of K1.00 to be received in 2 years = K0.82645
PV of K1.00 to be received in 3 years = K0.75131
Therefore the present value of the series is K2.48685

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With an even series of future cashflows, it is unnecessary to go through these calculations.
The discount factor can be applied directly i.e. simply multiply K1.00 by 2.48685 to obtain
K2.48685.

Putting it in a formula form:

𝑎 a a
PV = + (1+𝑟)2 + ⋯ + (1+𝑟)𝑡
(1+𝑟)

In case of large numbers of years use the interest factor annuity tables:

PVa = a(PVIFAr,t) where r = rate; t = time

For compound value of an annuity, the for is CVa = a(CVIFAr,t)

Finding the discount rate, r

There are times when the cashflows are given but the interest rate is not specified. For
example, if you borrowed K5,000,000.00 and you have to pay back K6,500.000.00 at the end
of 3 years as a lump sum. How much is the bank charging you?

CV = PV (CVIF r,3 yrs)

𝐶𝑉 6,500,000
CVIF = 𝑃𝑉 = = 5,000,000 = 1.3

Check in the financial tables at 3 years for CVIF that is close to 1.3. We note that the rate
applicable is between 9% (interest factor 1.2950) and 10% (interest factor 1.331).

To get the exact rate we can use linear interpolation:

(𝑟−𝑟𝐿)
IF = = (𝑟𝐻−𝑟𝐿) [IFH – IFL] + IFL

Where IF = interest factor for r (an intermediate interest rate)

L = lower rate of IF
H = Higher rate of IF

(𝑟−9)
IF = = (10−9) [1.331 – 1.295] + 1.295

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Simplifying the above equation should give us r = 9.1389 = 9.1389%

Uneven Cashflows

If we had an uneven series of cash flow, K10.00 one year hence, K30.00 two years hence,
and K20.00 three years from now, our present value at 10% discount rate would be:

𝐾10 K30 K20

PV = (1.10)^1 + (1.10)^2 + 3!(1.10)^3 = 𝐊𝟒𝟖. 𝟗𝟏

In general, for uneven cashflows:

𝐶𝐹1 CF2 CFn

PV = (1+𝑟) + (1+𝑟)^2 + ⋯ + (1+𝑟)^𝑛 ..........................................................(6)

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