Capital Market, Consumption and Investment (L1)

1
Capital Market, Consumption and Investment (L1)

• Consumption and investment without capital market
• Consumption and investment with capital market
• Fisher separation theorem
• Breaking down the separation transaction costs
• Breaking down the separation agency problem
• Application of Fisher Separation theorem capital
  budgeting and shareholder value maximization
• Materials from Chapters 12, CWS

2
Consumption Plane

• How individuals make choices among consumption
  bundles

C1
U
C0
Indifference curve time preference of
consumption in a consumption The slope of the
tangent line MRS
3
Investment Schedule and Production Opportunity Set
C1
Marginal rate of return
A
X
B
B
ri
y0
A
C0
Total Investments
y1
I0
X
Investment schedule and production opportunity
set are equivalent The slope for the tangent line
of production opportunity set in B is (1ri)
marginal rate of transformation (MRT)
4
Equilibrium in a Robinson Crusoe World
MRSMRT -(1ri)
C1
Individual 2
Individual 1
C0
Individual 1 consumes more than individual 2 in
period 0 No capital market, thus there is no
exchange.
5
Optimal Consumption in the Presence of Capital
Market
6
Capital Market Line
C1
W1
B
U2
A
U1
C0
W0
With capital market, an agent can move from A to
B, reaching a higher utility. On the capital
market line, ones wealth does not change. But
consumption differs. The slope of the capital
market line is (1r).
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Slope of Capital Market Line
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What Constitutes Consumptions?

• GDP C I G NX
• C consumption
• I investment
• G government purchases of goods and services
• NX net exports of goods and services
• http//research.stlouisfed.org/fred2/categories/18
  

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Consumption

• Spending by domestic households on final goods
  and services, accounting for about 2/2 of GDP in
  the United States, including
• Consumer durables
• Nondurable goods
• services

10
Investment

• Includes both spending for new capital goods,
  called fixed investment, and increases in firms
  inventory holdings, called inventory investment.
• Fixed investment includes
• business fixed investment
• residential investment

11
Joint effect of capital market and
production/investment

• See figure 1.8
• Two steps of the decision process related to
  production opportunity and capital market
  exchange opportunity
• Choose the optimal production decision by taking
  on projects until the marginal rate of return on
  investment equals the objective market rate --
  investment
• Choose the optimal consumption pattern by
  borrowing or lending along the capital market
  line equate your subjective time preference with
  the market rate of return -- consumption

12
Fisher Separation Theorem

• Given perfect and complete markets, the
  production decision is governed solely by an
  objective market criterion without regard to
  individuals subjective preferences that enter
  into their consumption decisions.
• See figure 1.9
• In equilibrium, the marginal rate of substitution
  for all investors is equal to the market rate of
  interest, and this in turn is equal to the
  marginal rate of transformation for productive
  investment.
• MRSiMRSj-(1r)MRT
• That is, the marginal return on investment (MRT,
  marginal rate of transformation) equals
  market-determined opportunity cost of capital (r)
• Irving Fisher's theory of capital and investment
  was introduced in his Nature of Capital and
  Income (1906) and Rate of Interest (1907),
  although it has its clearest and most famous
  exposition in his Theory of Interest (1930).

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Fisher Separation Theorem
C1
W1
Individual 1
P1
Individual 2
C0
P0
W0
Individuals choose their respectful consumptions,
where their consumptions can be delivered by
productive investments (P0, P1). This is what we
mean by separation a separation of investment
and consumption.
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Implications

• All the consumption decisions are made along the
  capital market line.
• The slope of the capital market line is (1r),
  where r is the interest rate, not stock return.
• This is the case of consumption choices under
  certainty.
• What is missing here?

15
Perfect Market

• Necessary conditions
• Markets are frictionless
• Perfect competition in securities markets
• Markets are informationally efficient that is,
  information is costless, and it is received
  simultaneously by all individuals
• All individuals are rational expected utility
  maximizers

16
Complete Market

• When the number of unique linearly independent
  securities is equal to the total number of
  alternative future states of nature. The market
  is said to be complete.
• Page 77, CWS
• Details will be provided in the lectures related
  Arrow-Debreu assets.

17
Role of Capital Market Reducing Transaction
Costs

• Trading is costly thus the market is not
  perfect
• Having marketplaces helps to reduce transaction
  costs page 12, CWS.
• Thus financial market has its role only when
• Trading costs are non-trival
• Demsetz (1968) Kyle (1985) Glosten and Milgrom
  (1985) Grossman and Miller (1988)
• Information asymmetry
• Akerlof (1970) Spence (1973) Myers and Majluf
  (1984)

18
Breakdown of the Separation Transaction Costs

• See figure 1.12
• Lending rate is lower than borrowing rate
• Then the optimal consumption decision depends on
  individuals subjective utility functions

19
Breakdown of the Separation Agency Problem

• Given Fisher separation theorem, the investment
  decision and consumption decision can be
  separated.
• In other words, shareholders can delegate
  managers to perform the investment function
• This separation leads to separation of ownership
  and control.
• Monitoring costs and compensation issue arise,
  which lead to the large literature on corporate
  governance and corporate finance.
• Berle and Means (1932) and Jensen and Meckling
  (1976)

20
Value to Shareholders

• Present value of shareholders wealth can be
  expressed as
• Note the above expression involves both capital
  gains and dividends (see page 20) all go to
  shareholders
• Economic definition versus accounting definition
  of profit

21
Capital Budgeting Techniques

• Maximizing shareholders wealth is equivalent to
  maximizing the discounted cash provided by
  investment projects.
• Decision rules payback period,
• Whats the point?
• Utility function collapses to the value function
• Given the Fisher separation theorem, maximizing
  shareholders wealth will lead to a social
  optimal at the presence of the capital.
• In reality, firms have the option to undo their
  decisions
• Thus the decision rule could be altered.

22
Exercises

• CWS, 1.51.6
• What is meant by separation in the Fishers
  separation theorem?