Chapter Outline
The Financial Market Economy
Making Consumption Choices Over Time
The Competitive Market
The Basic Principle
Practicing the Principle
Illustrating the Investment Decision
Corporate Investment Decision‑Making
Summary and Conclusions
The Financial Market Economy
Individuals and institutions have different income streams and different intertemporal consumption preferences.
Because of this, a market has arisen for money. The price of money is the interest rate.
The Financial Market Economy: Example
Consider a dentist who earns $200,000 per year and chooses to consume $80,000 per year. He has $120,000 in surplus money to invest.
He could loan $30,000 to each of 4 college seniors. They each promise to pay him back with interest after they graduate in one year.
Dentist
Student #1
Student #2
Student #3
Student #4
$30,000
$30,000
$30,000
$30,000
$30,000×(1+r)
$30,000×(1+r)
$30,000×(1+r)
$30,000×(1+r)
The Financial Market Economy: Example
Rather than performing the credit analysis 4 times, he could loan the whole $120,000 to a financial intermediary in return for a promise to repay the $120,000 in one year with interest.
The intermediary in turn loans $30,000 to each of the 4 college seniors.
Student #1
Student #2
Student #3
Student #4
$30,000
$30,000
$30,000
Bank
$120,000
Dentist
$30,000
$30,000×(1+r)
$30,000×(1+r)
$30,000×(1+r)
$30,000×(1+r)
$120,000×(1+r)
The Financial Market Economy: Example
Financial intermediation can take three forms:
Size intermediation
In the example above, the bank took a large loan from the dentist and made small loans to the students.
Term intermediation
Commercial banks finance long-term mortgages with short-term deposits.
Risk intermediation
Financial intermediaries can tailor the risk characteristics of securities for borrowers and lenders with different degrees of risk tolerance.
Market Clearing
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.
The price of money is the interest rate.
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Making Consumption Choices over Time
An individual can alter his consumption across time periods through borrowing and lending.
We can illustrate this by graphing consumption today versus consumption in the future.
This graph will show intertemporal consumption opportunities.
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Intertemporal Consumption Opportunity Set
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
A person with $95,000 who faces a 10% interest rate has the following opportunity set.
One choice available is to consume $40,000 now; invest the remaining $55,000; consume $60,000 next year.
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption at t+1
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Intertemporal Consumption Opportunity Set
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
Another choice available is to consume $60,000 now; invest the remaining $35,000; consume $38,500 next year.
Taking Advantage of Our Opportunities
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
A person’s preferences will tend to decide where on the opportunity set they will choose to be.
Ms. Patience
Ms. Impatience
Changing Our Opportunities
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
A rise in interest rates will make saving more attractive …
…and borrowing less attractive.
Consider an investor who has chosen to consume $40,000 now and to consume $60,000 next year.
The Competitive Market
In a competitive market:
Trading is costless.
Information about borrowing and lending is available
There are many traders; no individual can move market prices.
There can be only one equilibrium interest rate in a competitive market—otherwise arbitrage opportunities would arise.
The Basic Principle
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.
Practicing the Principle: A Lending Example
Consider an investment opportunity that costs $50,000 this year an provides a certain cash flow of $54,000 next year.
Is this a good deal?
It depends on the interest rate available in the financial markets.
The investment has an 8% return, if the interest rate available elsewhere is less than this, invest here.
Cash inflows
Time
Cash outflows
0
1
-$50,000
$54,000
Illustrating the Investment Decision
Consider an investor who has an initial endowment of income of $40,000 this year and $55,000 next year.
Suppose that he faces a 10-percent interest rate and is offered the following investment.
Cash inflows
Time
Cash outflows
0
1
-$25,000
$30,000
Illustrating the Investment Decision
$0
Consumption today
Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate.
One choice available is to consume $15,000 now; invest the remaining $25,000 in the financial markets at 10%; consume $82,500 next year.
$0
$99,000
Consumption at t+1
$55,000
$82,500
$40,000
$15,000
$90,000
Illustrating the Investment Decision
$0
Consumption today
A better alternative would be to invest in the project instead of the financial markets.
He could consume $15,000 now; invest the remaining $25,000 in the project at 20%; consume $85,000 next year.
$0
$99,000
Consumption at t+1
$55,000
$82,500
$40,000
$85,000
$15,000
$90,000
With borrowing or lending in the financial markets, he can achieve any pattern of cash flows he wants—any of which is better
than his original opportunities.
Illustrating the Investment Decision
$0
Consumption today
Note that we are better off in that we can command more consumption today or next year.
$0
$99,000
Consumption at t+1
$55,000
$82,500
$40,000
$85,000
$15,000
$101,500
$101,500 = $15,000×() + $85,000
$92,273 = $15,000 + $85,000÷()
$90,000
$92,273
Net Present Value
We can calculate how much better off in today’s dollar the investment makes us by calculating the Net Present Value:.
Cash inflows
Time
Cash outflows
0
1
-$25,000
$30,000
Corporate Investment Decision‑Making
Shareholders will be united in their preference for the firm to undertake positive net present value decisions, regardless of their personal intertemporal consumption preferences.
Corporate Investment Decision‑Making
Consumption today
Consumption at t+1
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.
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 operate by.
All shareholders of a firm will be made better off if managers follow the NPV rule—undertake positive NPV projects and reject negative NPV projects.
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.
Logistically, separating investment decision making from the shareholders is a basic requirement of the modern corporation.
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.
*
The point at which the intertemporal opportunity set pivots depends upon where your endowment is when interest rates change. If the person had $95,000 in current consumption and no future consumption, the pivot would have been at the x-axis intercept. Such a pivot
