Financial Markets and Net Present Value Lecture Outline

1. Financial Markets and Net Present ValueLecture Outline • Introduction • Perfect markets and arbitrage • Two-period model • Real investment opportunities • Corporate investment decision making • The separation Theorem • Summary and conclusions

2. 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.

3. 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.

4. 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.

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

6. 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

7. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today 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:

8. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today 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.

9. Intertemporal Consumption Opportunity Set • What is the maximum possible consumption in t+1 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?

10. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today Intertemporal Consumption Opportunity Set

11. 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

12. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today Intertemporal Consumption Opportunity Set A person’s preferences will impact where on the consumption opportunity set they will choose to be.

13. An increase in interest rates

14. 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.

15. 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?

16. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today Real Investment Opportunities – Example 1

17. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today Real Investment Opportunities – Example 1 Should the individual take the real investment opportunity?

18. Time 0 1 Cashflows -$35,000 +$36,000 Real Investment Opportunities – Example 1 – Methods to Analyze What rate of return does the investment earn?

19. Time 0 1 Investment Cf.s: -$35,000 +$36,000 Endowment Cf.s +$40,000+$60,000 Net Cfs: + $5,000 +$96,000 Real Investment Opportunities – Example 1 – Methods to Analyze What is the most that can be consumed today if the real investment is taken?

20. 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?

21. Real Investment Opportunities – Example 1 – Methods to Analyze Net Present Value (NPV)

22. 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?

23. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today Real Investment Opportunities – Example 2

24. $120 Thousands $100 $80 Consumption t+1 $60 $40 $20 $0 $0 $20 $40 $60 $80 $100 $120 Thousands Consumption Today Real Investment Opportunities – Example 2 Should the individual take the real investment opportunity?

25. Real Investment Opportunities – Example 2 • Verify with NPV • Verify with IRR

26. 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.

27. Corporate Investment Decision‑Making Positive NPV projects shift the shareholder’s opportunity set out, which is unambiguously good. All shareholders agree on their preference for positive NPV projects, whether they are borrowers or lenders. Consumption t+1 Consumption Today

28. 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.

29. 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 don’t need to worry about individual investor consumption preferences – just be concerned about maximizing their wealth.

30. 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.