Financial Markets and Net Present Value Lecture Outline I. Introduction II

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Financial Markets and Net Present Value Lecture Outline I. Introduction II. Perfect markets and arbitrage III. Two-period model IV. Real investment opportunities V. Corporate investment decision making VI. The separation Theorem VII.Summary and conclusions

Individuals may desire to consume amounts different from their incomes. Financial markets facilitate this.

The interest rate is the price of money in borrowing or lending transactions.

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.

For simplicity, consider a perfect market where Trading is costless. Information about borrowing and lending is freely available to all participants. Everyone is a price taker: many competitive traders; no one can move market prices. The result is that only one equilibrium interest rate will exist otherwise arbitrage opportunities would arise. Under such assumptions, the one interest rate would apply to both borrowing and lending transactions.

Arbitrage – the ability to earn a risk-free profit from a zero net investment.

Consider a simple model where an individual lives for 2 periods, has an income endowment, and has preferences about when to consume. Endowment (or given income) is $40,000 now and $60,000 next year

Without the ability to borrow or lend using $120 financial markets, the $100

Thousands individual is restricted to $80 just consuming his/her $60

umption t+1 endowment as it is earned: $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

Assume a market for borrowing or lending exists and the interest $120 rate is 10%. This opens up a large $100

Thousands set of consumption patterns $80 across the two periods. $60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

1. What is the slope of the consumption opportunity set?

2. What is the maximum possible consumption today and how is this achieved?

3. What is the maximum possible consumption in t+1 and how is this achieved?

$120

$100 Thousands $80

$60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

Present value of a cash flow received in one time period

Future value in one time period of a cash flow received today

A person’s preferences will

$120 impact where on the

$100 consumption opportunity set

Thousands they will choose to be. $80

$60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

ds $120 n a

1 $100 Thous

on t+ $80

$60 umpti

ns $40 o C $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

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.

Consider an investment opportunity that costs $35,000 this year and provides a certain cash flow of $36,000 next year.

Is this a good opportunity?

$120

$100 Thousands $80

$60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

Should the individual take the real investment opportunity?

$120

$100 Thousands $80

$60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

What rate of return does the investment earn? Time 0 1

Cashflows -$35,000 +$36,000

What is the most that can be consumed today if the real investment is taken? Time 0 1

Investment Cf.s: -$35,000 +$36,000 Endowment Cf.s +$40,000 +$60,000 Net Cfs: + $5,000 +$96,000

What is the most that can be consumed today if the real investment is taken?

What is the most that can be consumed today if the real investment is NOT taken?

Net Present Value (NPV)

Consider an investment opportunity that costs $25,000 this year and provides a certain cash flow of $47,500 next year.

Is this a good opportunity?

$120

$100 Thousands $80

$60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

Should the individual take the real investment opportunity?

$120

$100 Thousands $80

$60 umption t+1 $40 Cons $20

$0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today

Verify with NPV

Verify with IRR

© 2002 David A. Stangeland V. Corporate Investment Decision-Making Real investments may be done through corporations where investors buy shares of the firm. Shareholders will be united in their preference for the firm to undertake positive net present value projects, regardless of their personal intertemporal consumption preferences.

Positive NPV projects shift the shareholder’s opportunity set out, which is unambiguously good.

All shareholders agree on their preference for positive NPV

umption t+1 projects, whether they are borrowers or lenders. Cons

Consumption Today

In reality, shareholders do not vote on every investment decision faced by a firm and the managers of firms need decision rules to follow. All shareholders of a firm will be made better off if managers follow the NPV rule — undertake projects with NPV ≥ 0 and reject negative NPV projects.

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. Separation between consumption preferences and real investment decisions Logistically, separating investment decision making from the shareholders is a basic requirement for the efficient operation of the modern corporation. Managers don’t need to worry about individual investor consumption preferences – just be concerned about maximizing their wealth.

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 and should be accepted. NPV, IRR, PV and FV concepts are useful for working with cash flows through time and analyzing consumption and investment opportunities.