Financial Markets and Net Present Value Lecture Outline

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Financial Markets and Net Present ValueLecture
Outline

1. Introduction
2. Perfect markets and arbitrage
3. Two-period model
4. Real investment opportunities
5. Corporate investment decision making
6. The separation Theorem
7. Summary and conclusions

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I. Introduction Financial Markets

• 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.

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Introduction Financial Markets

• 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.

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II. Perfect Markets and Arbitrage

• 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.

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Arbitrage Defined

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

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III. Two-period model

• 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

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Two-period model no market
Without the ability to borrow or lend using
financial markets, the individual is restricted
to just consuming his/her endowment as it is
earned
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Intertemporal Consumption Opportunity Set
Assume a market for borrowing or lending exists
and the interest rate is 10. This opens up a
large set of consumption patterns across the two
periods.
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Intertemporal Consumption Opportunity Set

• What is the maximum possible consumption in t1
  and how is this achieved?
• What is the maximum possible consumption today
  and how is this achieved?
• What is the slope of the consumption opportunity
  set?

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Intertemporal Consumption Opportunity Set
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Notes on calculations

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

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Intertemporal Consumption Opportunity Set
A persons preferences will impact where on the
consumption opportunity set they will choose to
be.
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An increase in interest rates
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IV. Real Investment Opportunities

• 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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Real Investment Opportunities Example 1

• 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?
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Real Investment Opportunities Example 1
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Real Investment Opportunities Example 1
Should the individual take the real investment
opportunity?
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Real Investment Opportunities Example 1
Methods to Analyze

• What rate of return does the investment earn?

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Real Investment Opportunities Example 1
Methods to Analyze

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

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Real Investment Opportunities Example 1
Methods to Analyze

• 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?

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Real Investment Opportunities Example 1
Methods to Analyze

• Net Present Value (NPV)

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Real Investment Opportunities Example 2

• 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?
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Real Investment Opportunities Example 2
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Real Investment Opportunities Example 2
Should the individual take the real investment
opportunity?
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Real Investment Opportunities Example 2

• Verify with NPV
• Verify with IRR

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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.

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

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VI. 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.
• 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 dont need to worry about individual
  investor consumption preferences just be
  concerned about maximizing their wealth.

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VII. 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 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.