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Chapter Three
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Financial Markets and Corporate Finance Ross Westerfield Jaffe Net Present Value

Sixth Edition

Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut
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Chapter Outline
3.1 The Financial Market Economy 3.2 Making Consumption Choices Over Time 3.3 The Competitive Market 3.4 The Basic Principle 3.5 Practicing the Principle 3.6 Illustrating the Investment Decision 3.7 Corporate Investment Decision-Making 3.8 Summary and Conclusions

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3.1 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.

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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.
$30,000(1+r) $30,000 $30,000(1+r) $30,000

Student #1 Student #2 Student #3 Student #4

Dentist
$30,000 $30,000(1+r) $30,000
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$30,000(1+r)

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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.
$30,000(1+r)

$120,000
$30,000(1+r)

$30,000 $30,000

Student #1 Student #2 Student #3 Student #4

Dentist

Bank
$30,000 $30,000(1+r) $30,000

$120,000(1+r)
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$30,000(1+r)
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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.
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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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3.2 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

Consumption at t+1

$120,000

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.
$60 ,000 ! $55,000 v (1.10 )1

$100,000

$80,000

$60,000

$40,000

$20,000

$0 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000

Consumption today
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Intertemporal Consumption Opportunity Set

Consumption at t+1

$120,000

$100,000

$80,000

Another choice available is to consume $60,000 now; invest the remaining $35,000; consume $38,500 next year.

$60,000

$40,000

$38 ,500 ! $35 ,000 v (1.10 )1

$20,000

$0 $0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Consumption today
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Taking Advantage of Our Opportunities

Consumption at t+1

$120,000

$100,000

A persons preferences will tend to decide where on the opportunity set they will choose Ms. Patience to be.

$80,000

$60,000

$40,000

Ms. Impatience

$20,000

$0 $0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Consumption today
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Changing Our Opportunities

Consumption at t+1

$120,000

Consider an investor who has chosen to consume $40,000 now and to consume $60,000 next year. A rise in interest rates will make saving more attractive and borrowing less attractive.

$100,000

$80,000

$60,000

$40,000

$20,000

$0 $0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Consumption today
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3.3 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 marketotherwise arbitrage opportunities would arise.
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3.4 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.

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3.5 Practicing the Principle: A Lending Example

Consider an investment opportunity that costs $50,000 this year and provides a certain cash flow of $54,000 next year.
Cash inflows Time Cash outflows 0 1 -$50,000 $54,000

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.
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3.6 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
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$30,000

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3.6 Illustrating the Investment Decision

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. Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate.
Consumption at t+1

$99,000 $82,500

$55,000

$0 $0 $15,000 $40,000 $90,000

Consumption today
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3.6 Illustrating the Investment Decision

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. With borrowing or lending in the financial markets, he can achieve any pattern of cash flows he wantsany of which is better than his original opportunities.
$0 $15,000 $40,000 $90,000

Consumption at t+1

$99,000 $85,000 $82,500

$55,000

$0

Consumption today
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3.6 Illustrating the Investment Decision

Consumption at t+1

Note that we are better off in that we can command more consumption today or next year.
$101,500 $99,000 $85,000 $82,500

$101,500 = $15,000(1.10) + $85,000 $92,273 = $15,000 + $85,000(1.10)

$55,000

$0 $0 $15,000 $40,000 $90,000 $92,273

Consumption today
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Net Present Value

We can calculate how much better off in todays dollar the investment makes us by calculating the Net Present Value:.
Cash inflows Time Cash outflows 0 1 -$25,000 $30,000

$30 ,000 NPV ! 25,000  ! $2,272 .73 1.10

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3.7 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.

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Corporate Investment Decision-Making

Consumption at t+1

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 today
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3.7 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.

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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 decisionmaking from the shareholders is a basic requirement of the modern corporation.

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3.8 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.

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