financial markets and net present value lecture outline i. … lecture 2... · 2002-09-03 ·...

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Financial Markets and Net Present ValueLecture Outline

I. IntroductionII. Perfect markets and arbitrageIII. Two-period modelIV. Real investment opportunitiesV. Corporate investment decision

makingVI. The separation TheoremVII.Summary and conclusions

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© 2002 David A. Stangeland

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

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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

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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

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?

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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

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A person’s 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

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Real Investment Opportunities –Example 1 – Methods to Analyze

What rate of return does the investment earn?

Time 0 1

Cashflows -$35,000 +$36,000

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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?

Time 0 1

Investment Cf.s: -$35,000 +$36,000

Endowment Cf.s +$40,000 +$60,000

Net Cfs: + $5,000 +$96,000

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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

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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 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.

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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 TheoremThe 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.

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VII. Summary and ConclusionsFinancial 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.