Chapter Outline

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Chapter Outline

• 3.1 The Financial Market Economy
• 3.2 Making Consumption Choices Over Time
• 3.3 The Competitive Market
• 3.4 The Basic Principle
• 3.5 Practicing the Principle
• 3.6 Illustrating the Investment Decision
• 3.7 Corporate Investment Decision-Making
• 3.8 Summary and Conclusions

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3.1 The Financial Market Economy

• Individuals and institutions have different
  income streams and different intertemporal
  consumption preferences.
• Because of this, a market has arisen for money.
  The price of money is the interest rate.

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The Financial Market Economy Example

• Consider a dentist who earns 200,000 per year
  and chooses to consume 80,000 per year. He has
  120,000 in surplus money to invest.
• He could loan 30,000 to each of 4 college
  seniors. They each promise to pay him back with
  interest after they graduate in one year.

30,000(1r)
Student 1
30,000
30,000(1r)
Dentist
Student 2
30,000
Student 3
30,000
30,000(1r)
Student 4
30,000
30,000(1r)
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The Financial Market Economy Example

• Rather than performing the credit analysis 4
  times, he could loan the whole 120,000 to a
  financial intermediary in return for a promise to
  repay the 120,000 in one year with interest.
• The intermediary in turn loans 30,000 to each
  of the 4 college seniors.

30,000(1r)
Student 1
30,000
120,000
30,000(1r)
Bank
Student 2
Dentist
30,000
Student 3
30,000
30,000(1r)
Student 4
30,000
120,000(1r)
30,000(1r)
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The Financial Market Economy Example

• Financial intermediation can take three forms
• Size intermediation
• In the example above, the bank took a large loan
  from the dentist and made small loans to the
  students.
• Term intermediation
• Commercial banks finance long-term mortgages with
  short-term deposits.
• Risk intermediation
• Financial intermediaries can tailor the risk
  characteristics of securities for borrowers and
  lenders with different degrees of risk tolerance.

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Market Clearing

• The job of balancing the supply of and demand for
  loanable funds is taken by the money market.
• When the quantity supplied equals the quantity
  demanded, the market is in equilibrium at the
  equilibrium price.
• The price of money is the interest rate.

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3.2 Making Consumption Choices over Time

• An individual can alter his consumption across
  time periods through borrowing and lending.
• We can illustrate this by graphing consumption
  today versus consumption in the future.
• This graph will show intertemporal consumption
  opportunities.

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Intertemporal Consumption Opportunity Set
A person with 95,000 who faces a 10 interest
rate has the following opportunity set.
One choice available is to consume 40,000 now
invest the remaining 55,000 consume 60,000
next year.
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Intertemporal Consumption Opportunity Set
Another choice available is to consume 60,000
now invest the remaining 35,000 consume
38,500 next year.
120,000
Consumption at t1
100,000
80,000
60,000
40,000
20,000
0
0
20,000
40,000
60,000
80,000
100,000
120,000
Consumption today
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Taking Advantage of Our Opportunities
A persons preferences will tend to decide where
on the opportunity set they will choose to be.
120,000
Consumption at t1
100,000
80,000
60,000
40,000
20,000
0
0
20,000
40,000
60,000
80,000
100,000
120,000
Consumption today
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Changing Our Opportunities
Consider an investor who has chosen to consume
40,000 now and to consume 60,000 next year.
120,000
Consumption at t1
100,000
A rise in interest rates will make saving more
attractive
80,000
and borrowing less attractive.
60,000
40,000
20,000
0
0
20,000
40,000
60,000
80,000
100,000
120,000
Consumption today
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3.3 The Competitive Market

• In a competitive market
• Trading is costless.
• Information about borrowing and lending is
  available
• There are many traders no individual can move
  market prices.
• There can be only one equilibrium interest rate
  in a competitive marketotherwise arbitrage
  opportunities would arise.

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3.4 The Basic Principle

• The basic financial principle of investment
  decision-making is this
• An investment must be at least as desirable as
  the opportunities available in the financial
  markets.

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3.5 Practicing the Principle A Lending Example

• Consider an investment opportunity that costs
  50,000 this year and provides a certain cash
  flow of 54,000 next year.

Is this a good deal? It depends on the interest
rate available in the financial markets. The
investment has an 8 return, if the interest rate
available elsewhere is less than this, invest
here.
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3.6 Illustrating the Investment Decision

• Consider an investor who has an initial endowment
  of income of 40,000 this year and 55,000 next
  year.
• Suppose that he faces a 10-percent interest rate
  and is offered the following investment.

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3.6 Illustrating the Investment Decision
One choice available is to consume 15,000 now
invest the remaining 25,000 in the financial
markets at 10 consume 82,500 next year.
Consumption at t1
99,000
Our investor begins with the following
opportunity set endowment of 40,000 today,
55,000 next year and a 10 interest rate.
0
0
90,000
Consumption today
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3.6 Illustrating the Investment Decision
A better alternative would be to invest in the
project instead of the financial markets.
He could consume 15,000 now invest the
remaining 25,000 in the project at 20 consume
85,000 next year.
Consumption at t1
99,000
0
0
90,000
Consumption today
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3.6 Illustrating the Investment Decision
Note that we are better off in that we can
command more consumption today or next year.
101,500 15,000(1.10) 85,000
101,500
Consumption at t1
99,000
92,273 15,000 85,000(1.10)
0
0
90,000
92,273
Consumption today
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Net Present Value

• We can calculate how much better off in todays
  dollar the investment makes us by calculating the
  Net Present Value.

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3.7 Corporate Investment Decision-Making

• Shareholders will be united in their preference
  for the firm to undertake positive net present
  value decisions, regardless of their personal
  intertemporal consumption preferences.

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Corporate Investment Decision-Making
Positive NPV projects shift the shareholders
opportunity set out, which is unambiguously good.
Consumption at t1
All shareholders agree on their preference for
positive NPV projects, whether they are borrowers
or lenders.
Consumption today
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3.7 Corporate Investment Decision-Making

• In reality, shareholders do not vote on every
  investment decision faced by a firm and the
  managers of firms need decision rules to operate
  by.
• All shareholders of a firm will be made better
  off if managers follow the NPV ruleundertake
  positive NPV projects and reject negative NPV
  projects.

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The Separation Theorem

• The separation theorem in financial markets says
  that all investors will want to accept or reject
  the same investment projects by using the NPV
  rule, regardless of their personal preferences.
• Logistically, separating investment decision-
  making from the shareholders is a basic
  requirement of the modern corporation.

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3.8 Summary and Conclusions

• Financial markets exist because people want to
  adjust their consumption over time. They do this
  by borrowing or lending.
• An investment should be rejected if a superior
  alternative exists in the financial markets.
• If no superior alternative exists in the
  financial markets, an investment has a positive
  net present value.