Study Session 1: Purposes and Goals of Investing

Introduction: What to Expect

Lets begin by discussing the details you need to know about investment capital. As you
proceed through the chapter, you will see how an individual’s investment objectives are

determined by his or her risk tolerance and the return on investment required.

This topic will comprise about 3% of the CSC Vol.1 examination; however, keep in mind
that additional questions will require cumulative knowledge. In these cases, although

you may not be directly tested on these topics, you will still need to understand the
concepts to answer the questions correctly.

Investment Capital

Capital is the most important commodity: you need it to purchase goods and services,
finance business operations, and so on. Individuals, governments, and businesses are

all users of capital, whether they use it to purchase durables or assets, to fund a deficit
budget, or to carry out operations.



The Three Characteristics of Capital
o

Mobile

o

Sensitive

o

Scarce



Capital Creation
o

Savings are the only source of capital

o

Direct sources of capital are real assets such as land or buildings.

o

Indirect sources of capital include items such as stocks, bonds, and savings
deposits in a bank.

As you read the next section, note that some exam questions will require you to
recognize the difference between capital sources and capital users.

Sources and Users of Capital:
In general, savings and investments are the main sources of capital. Individuals,

business, governments and foreigners make these contributions. These same entities
can also be classified as users of capital, as capital is required for purchases,
operations, and more.

As we progress through the upcoming study sessions, we will describe how various

economic events affect the net flow of capital.

In the meantime, to ensure you understand the differences between entities functioning
as sources of capital versus entities functioning as users of capital, the following tables

will illustrate the specific details you should know.

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Study Session 1: Purposes and Goals of Investing

Table 1-1

Sources of Capital in Canada

Individuals

-Through saving and investment, individuals inject capital into the

economy.
- Savings are those funds placed into retirement plans, pension

plans, insurance, savings accounts, and other forms of
investment.

Businesses

- Investment capital is generally created from retained earnings.

- Financing is also obtained from financial intermediaries or
through financial markets by offering stocks or bonds to the

public.

Government

- Governments obtain capital by issuing various financial
instruments.

- The federal government issues Canada Savings Bonds (CSB)
and Canada Premium Bonds (CPB).
- Provincial governments obtain capital through the Canada

Pension Plan (CPP) or short-term debt instruments.
- Municipal governments borrow money based on credit rather

than an underlying security.

Foreign

Investors*

- Foreign investors inject capital into the economy through
investment in stocks, bonds, real estate, etc.

- Some investors choose to invest in another country, as the rate
of return for foreigners may be higher in another country than

what they can earn domestically.

*We will discuss the consequences of foreign investment in Study Session 2

Table 1-2

Users of Capital in Canada

Individuals

- Require capital to purchase durables and other assets

- Use loans, mortgages, and other forms of financing to
facilitate consumption

Businesses

- Require capital to carry out operations and increase output,

efficiency, competitiveness and innovation

Government - Require capital to fund a deficit budget

Foreign

Investors

- Require capital to fund projects in their home countries
- Borrowing capital from another country can be a cheaper form

of financing.



Capital is transferred from its sources to users through these elements:
o

Financial instruments such as stocks and bonds. We will discuss these
instruments in Study Sessions 4 and 5.

o

Financial markets such as stock exchanges. These will be discussed within Study
Session 2.

o

Financial intermediaries such as investment firms and banks. We will detail the
players in capital markets in Study Session 3.

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© Investopedia Inc. 2005

Study Session 1: Purposes and Goals of Investing



To determine where capital will flow, you need to analyze five factors

:

o

Political environment

o

Economic trends

o

Fiscal and monetary policies

o

Labour force

o

Return on investment (ROI)

Investment Objectives

Savers of capital have varying investment objectives and a number of different
investment methods to choose from. Often, the tradeoff between risk and return is a

key factor in determining a person’s investment objectives and, thus, investment
vehicles.

The risk and return tradeoff is an important concept to know, as it is central to many
investment decisions and products. You can learn more about this topic in the

following Investopedia article:

Weblink 1.1

Article: “Determining Risk and the Risk Pyramid”

http://www.investopedia.com/articles/basics/03/050203.asp



Primary Investment Objectives

The following three primary investment objectives are the most important to
consider when devising a financial plan for a client. These objectives, when coupled

with knowledge of a client’s current financial situation and risk tolerance will
determine their appropriate asset mix. Note that a client’s goals may also be a mix
of these objectives.

1) Safety

o

Client’s with this objective want to maintain their capital position. As a result
they are:
-

Willing to accept a lower rate of return in exchange for reduced risk

-

Willing to give up opportunities for capital growth

o

Appropriate investments are low risk securities such as federal, provincial,

and municipal bonds, high grade corporate bonds, and Treasury bills.

2) Income

o

Client’s with this objective are willing to forego some safety in order to

maximize income return.

o

Investments that provide income include corporate bonds and/or preferred

stocks that pay regular dividends.

3) Growth

o

Client’s in higher tax brackets often seek capital gains rather than income,
since only 50% of capital gains is added to an individual’s taxable income.

o

Companies with growth stock tend to be expanding companies and
innovative industries. These companies tend to reinvest retained earnings to

fuel growth rather than pay a dividend.

© Investopedia Inc. 2005

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Study Session 3: Players in the Financial Industry



Secondary Investment Objectives

In addition to the primary objectives described above, the following secondary
factors must also be considered when determining the appropriate asset mix for a
client.

1) Liquidity

o

What is the likelihood that a client will need to withdraw a portion or all of
their investment on short notice? If there is a high likelihood of this

occurrence, investments with a high degree of liquidity are required.

o

With the exception of some real-estate investments, most Canadian
securities are easy to liquidate.

2) Minimize Tax

o

How you achieve this objective depends on the investor’s chosen investment
and its details. For example, does it include dividends or interest?

You may be given a person’s profile and be asked to identify his or her
investment objectives. Remember that safety, income, and growth are primary
objectives, while liquidity and tax minimization are secondary objectives.

Conclusion

Capital is required in order to purchase goods and services, expand business

operations, save for retirement, and more. Individuals, business’, governments and
foreign investors serve as both sources and users of capital, which demonstrates how
net capital flows within the economy. For savers of capital, five investment objectives

must be considered before determining what combination of financial instruments is
most important for their investment portfolio.

Here is a brief summary of the topics we have just discussed:

Investment Capital

-

Capital is used to purchase goods and services and run businesses, therefore
both sources and users of capital exist.

-

Capital is mobile, sensitive, and scarce.

Primary Investment Objectives

-

The three primary investment objectives are safety, income, and growth.

Secondary Investment Objectives

-

The two secondary objectives are tax minimization and liquidity.

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© Investopedia Inc. 2005

Study Session 3: Players in the Financial Industry

Top 15 Terms to Know

1)

Bonds

2)

Canada Pension Plan (CPP)

3)

Canada Premium Bonds (CPB)

4)

Canada Savings Bonds (CSB)

5)

Capital

6)

Deficit

7)

Dividends

8)

Growth Stock

9)

Liquidity

10) Loans

11) Mortgages
12) Preferred Stock

13) Real Assets
14) Return on Investment (ROI)

15) Treasury Bills

Notes:
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