VALUE and CAPITAL BUDGETING

Firms and individuals invest in a large variety of assets. Some are assets such as machinery and
land, and some are financial assets such as stocks and bonds. The objective of an investment is to
maximize the value of the investment.

Finance is the study of markets and instruments that deal with cash flows over time. It is the
process by which special markets deal with cash flows over time. These markets are called
financial markets. Making investment and financing decisions requires an understanding of the
basic economic principles of financial markets.

THE FINANCIAL MARKET ECONOMY

Financial markets develop to facilitate borrowing and lending between individuals.

Suppose Tom and Leslie, both have a current income of $100,000. Tom is very patient person,
and some people call him a miser. He wants to consume only $50,000 of current income and
save the rest. Leslie is a very impatient person, and some people call her extravagant. She wants
to consume $150,000 this year. Tom and Leslie have different intertemporal consumption
preferences.

Suppose they made a deal, with Tom giving up $50,000 this year in exchange for $55,000 next
year.

Tom’s cash flows Leslie cash flows

Cash inflow $55,000 next year $50,000 current year
Cash outflows $50,000 current year $55,000 next year

The results of their bargaining it creates a financial instrument.

Financial intermediaries are institutions that perform of market function, matching borrowers
and lenders or traders (such as stockbrokers and banks).

Market Clearing means that the total amount that people like Tom wish to lend to the market
should equal the total amount that people like Leslie wish to borrow.

If the lenders wish to lend more than the borrowers want to borrow, then presumably the interest
rate is too high.

Example: if the lenders wish to end $20million when interest rate are at 15% and the borrowers
wish to borrow only $8 million. This mean, 8/20 of each dollar or $0.40 from each of the lenders
and distribute it to the borrowers.

MAKING CONSUMPTION CHOICES OVER TIME

A person is assumed to have an income of $50,000 this year and an income of $60,000 next year.
The market allows him only to consume $50,000 worth of goods this year and $60,000 next year,
but also to borrow and lend at the equilibrium interest rate.