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Find out moreRobert C. Merton

Table of Contents

I. II. III.

Introduction ............................................................................................................. On the Arithmetic of Compound Interest: The Time Value of Money................ On the Theory of Accumulation and Intertemporal Consumption Choice by Households in an Environment of Certainty ............................................... On the Role of Business Firms, Financial Instruments and Markets in an Environment of Certainty............................................................................. The "Default-Free" Bond Market and Financial Intermediation in Borrowing and Lending .................................................................................................. The Value of the Firm Under Certainty ................................................................. The Firm's Investment Decision Under Certainty: Capital Budgeting and Ranking of New Investment Projects........................................................... Forward Contracts, Futures Contracts and Options............................................... The Financing Decision by Firms: Impact of Capital Structure Choice on Value............................................................................................................. The Investor's Decision Under Uncertainty: Portfolio Selection ......................... Implications of Portfolio Theory for the Operation of the Capital Markets: The Capital Asset Pricing Model ........................................................................ Risk-Spreading via Financial Intermediation: Life Insurance .............................. Optimal Use of Security Analysis and Investment Management .......................... Theory of Value and Capital Budgeting Under Uncertainty................................. Introduction to Mergers and Acquisitions: Firm Diversification ......................... The Financing Decision by Firms: Impact of Dividend Policy on Value ............ Security Pricing and Security Analysis in an Efficient Market.............................

1 8

34

IV.

57

V.

76 115

VI. VII.

134 151

VIII. IX.

165 185

X. XI.

225 241 249 270 287 296 312

XII. XIII. XIV. XV. XVI. XVII.

Copyright © 1982 by Robert C. Merton. These Notes are not to be reproduced without the author’s written permission. All rights reserved.

I. INTRODUCTION

Output Product Markets Consumption Labor Markets Manufacturing or Business Firms Investment Capital

Households Savings

Capital Markets • Stock • Bond • Money • Futures

Savings Financial Intermediaries (Borrowings) Domain of Finance

This course is an introduction to the theory of optimal financial management of households, business firms, and financial intermediaries. For the term "optimal" to have meaning, a criterion for measuring performance must be established. For households, it is assumed that each consumer has a criterion or "utility" function representing his preferences among alternatives, and this set of preferences is taken as "given" (i.e., as exogenous to the theory). This traditional approach to households and their tastes does not extend to economic organizations and institutions. That is, they are regarded as existing primarily because of the functions they serve instead of functioning primarily because they exist. Economic organizations and institutions, unlike households and their tastes, are endogenous to the theory. Hence, in the theory of the firm, it is not a fruitful approach to treat the firm as an "individual" with exogenous preferences. Rather, it is assumed that firms are created as means to the ends of consumer-investor welfare, and therefore, the criterion function for judging optimal management of the firm will be endogenous. In a modern large-scale economy, it is neither practical nor necessary for management to "poll" the owners of the firm to make decisions. Instead certain data gathered from the capital markets can be used as "indirect" signals for the determination of the optimal investment and financing decisions. What the labor and product markets are to the marketing, production and 1

Robert C. Merton product-pricing managers, the capital markets are to the financial manager. Hence, a good financial manager must understand how capital markets work. Since the capital markets are central, it is quite natural to begin the study of Finance with the theory of capital markets. To derive the functions of financial markets and institutions, we

investigate the behavior of individual households. Using portfolio selection theory, the households' demand functions for assets and financial securities are derived to develop the demand side of capital markets. Taking as given the supply of available assets (i.e., the investment and financing decisions of business firms), the demands of households are aggregated and equated to aggregate supplies to determine the equilibrium structure of returns of assets traded in the capital market. Inspection of the structure of these demand functions leads in a natural way to an introductory theory for the existence and optimal management of financial intermediaries. In the second part of the course, the supply side of the capital markets is developed by studying the optimal management of business firms (given the demand functions of households). The two elements which make Finance a nontrivial subject are time and uncertainty. Capital investments often require substantial commitments of resources to earn uncertain cash flows which may not be generated before some distant future date. It is the financial manager's responsibility to determine under what conditions such investments should be taken and to ensure that sufficient funds will be available to take the investments. Because future flows and rates of return are not known with certainty, to make good decisions, the financial manager must have a thorough understanding of the tradeoff between risk and return. While the basic mode of approach has universal application, it should be understood that the assumed environment is the (reasonably) large corporation in a large-scale economy with welldeveloped capital markets and institutions similar to those in the United States. Although the emphasis is on the private sector, most of the analysis can be applied directly to public sector financing and investment decisions. However, certain assumptions made in developing the theory (which are quite reasonable in the assumed environment) will require modification before being applied to small businesses with limited access to the capital markets or to foreign countries with significantly different institutional and social structures.

2

Finance Theory Summary of Different Parts of Finance

Households (Personal Finance) Taken as Given: 1. A criterion function for choice among alternative consumption programs 2. Initial endowments

To be Determined:

1. 2.

Optimal consumption-saving decision Optimal allocation of savings (portfolio selection)

Manufacturing or Business Firms (Corporate Finance) Taken as Given: 1. Owners of the firm are households [either directly or through financial intermediaries] 2. Proper management is to operate the firm in the best interests of the owners or shareholders 3. The technology or "blueprints" of available projects (including cost and revenue forecasts) are known either as point values (certainty) or as probability distributions.

To be Determined:

1. 2.

An operation criterion for measuring good management Investment decision in physical assets (capital budgeting) a. b. Which assets to invest in How much to invest in total

3.

The long-term financing decision a. b. Dividend policy Capital structure decisions and the cost of capital

4.

The short-term financing decision a. Management of working capital and cash

3

Robert C. Merton 5. 6. Mergers and Acquisitions: Firm diversification Taxation and its impact on 2-5 (above)

Financial Intermediaries (Financial Institutions) Taken as Given: 1. Owners of the intermediary are households [either directly or through other financial intermediaries] 2. Proper management is to operate the intermediary in the best interests of the owners or shareholders To be Determined: 1. 2. Why they exist and what services they provide How the management of financial intermediaries differs from the management of business firms 3. 4. Efficient management and measurement of performance The role of market makers

Capital Markets and Financial Instruments (Capital Market Finance) To be Determined: 1. 2. 3. Why they exist and what services they provide The characteristics of an "efficient" capital market How an efficient capital market permits decentralization of decision making 4. The role of capital markets as a source of information (or "signals") for efficient decision making by households and managers of business firms and financial intermediaries 5. The empirical testing of finance theories using capital market data

4

3. 4. supply equals demand for every item). Competition: The basic paradigm adopted is that markets operate such that the very best at their "job" will earn a "fair" return and those that are not will earn a less-than-fair return. and the market is said to be in equilibrium. In other cases. that equal information is available to all market participants. That is. 5 . "Perfect" or "Frictionless" Markets: At times.Finance Theory Basic Methodology and Approach of the Course 1. there are no transactions costs or other frictions.e. we will use the abstract concept of a perfect market. a profit opportunity)? If you and the market "disagree. is there an opportunity for improvement (and hence. it will be assumed that the markets are in or tending toward equilibrium. If each unit is choosing the "best" plan possible and the aggregation of the actions implied by these plans are such that the market clears (i. This is in contrast to the view that anyone can earn a "fair" return and the "smart" people will earn a "super" return. In certain situations. that there are no institutional restrictions against market transactions of any sort. we look at the aggregated resultant of the actions of each unit. 2. then these "best" plans can be realized.. In general. there are no divisibility problems with respect to the scale of transactions. To do so. How should the system work? Does it work that way? If not." then who is right? Frequently-Used Concepts Equilibrium: To understand each element of the system. In some cases. it provides a "benchmark" for the study of imperfections. it will be assumed that the capital markets satisfy the technical conditions of pure competition. one must frequently analyze the whole system. actual markets will be sufficiently "close" to this abstraction to use the resulting analysis directly.

Ibbotson and R. Financial Analysts Foundation (1979).2% Growth of $1000 (Average Compound Return) $89. and Inflation: Historical Returns (1926–1978).1%) $ 2.728 (2.2% Standard Deviation 22.5%) Type Common Stocks (S&P 500) Long-Term Corporate Bonds 4.9%) $ 7. Bills.6% 6 .6%) $ 965 (0.342 (3.4% 5.Robert C. Sinquefield.5% 2.377 (0.3% Growth of $1000 (Average Compound Return) $23. Merton Summary 53-Year Return Experience: Stocks and Bonds (1926–1978) Source: “Stocks.807 (4.3%) $ 1. Average Annual Return 11.6% Long-Term Government Bonds 3.S.7% U.0% 4.6% NA Long-Term Government Bonds 0.2% “Inflation-Adjusted” (Consumers Price Index) (“Real”) Returns Type Common Stocks (S&P 500) Average Annual Return 8.1% 5.0%) Long-Term Corporate Bonds 1. Bonds.” R.399 (6.018 (1.2%) $ 3.S.592 (8. Treasury Bills 0.G.7% Standard Deviation 22.A.0%) $ 5.9% NA U. Treasury Bills 2.

Finance Theory 7 .

many of the specific problems used to illustrate their application are of independent substantive importance. and the difference in value between the two is called the time value of money.. Although the emphasis of this section is on developing the formulas. is not difficult. Then. and hence a fundamental understanding of the time value of money is an essential prerequisite to the study of Finance. The assumption implicit in this common-sense choice is that having the use of money for a period of time. Virtually every area in Finance involves the solution of such intertemporal choice problems. therefore. the assumptions upon which the formulas are based may not be so familiar. we all recognize that we would not be indifferent to a choice between a dollar to be paid to us at some future date (e. three years from now) or a dollar paid to us today. For goods and services. natural to begin with those basic definitions and analytical tools required to develop this fundamental understanding. It is. and indeed many of the formulas to be derived may be quite familiar. all of us would prefer to receive the dollar today. it is appropriate to derive them in a careful and axiomatic fashion. A positive time value of money implies that rents are paid for the use of money. The earlier receipt of a dollar is more valuable than a later receipt. sometimes called the arithmetic of compound interest. This positive time value of money makes the choice among various intertemporal economic plans dependent not only on the magnitudes of receipts and expenditures associated with each of the plans but also upon the timing of these inflows and outflows. the most common form of quoting rents is to give a money rental rate which is the dollar rent per unit time per unit item rented. For example. armed with these analytical tools. ON THE ARITHMETIC OF COMPOUND INTEREST: THE TIME VALUE OF MONEY From our everyday experiences." However. Because these formulas are so fundamental and because their valid application depends upon the underlying assumptions being satisfied.g. the wheat rental rate 8 . has value.II. a rental rate can be denominated in terms of any commodity or service. Indeed. The formal analysis. A typical example would be the rental rate on an apartment which might be quoted as "$200 per month (per apartment). we can proceed in subsequent sections with the systematic development of finance theory. like having the use of an apartment or a car. However.

all financial obligations are paid in the amounts and at the time promised. So.II. that common per period rate will be 9 . and therefore.01 bushels of wheat per month per bushel of wheat rented. for example. the rental rate is called the own rental rate. Price-Taker: The interest rate in a given period is the same for a particular individual independent of the amount he borrows or lends. In particular." In general. and when such an assumption is made.e. Moreover.4) In addition. he is a creditor.II. (A.. and if he lends money. and to rent money to an entity is to lend. I. No Transactions Costs: The interest rate at which an individual can lend in a given period is equal to the interest rate at which he can borrow in that same period." then the rental rate would simply be stated as "1 percent per month. Throughout this section.e. an interest rate always has the form of a pure percentage per unit time.1) Certainty: There is no uncertainty about either the magnitude or timing of any payments. the choices made by the individual do not affect the interest rate paid or charged.II. the own rental rate on an item is called that item's interest rate.Finance Theory would have the form of so many bushels of wheat rent per unit item rented." In the special case when the unit of payment is the same as the item rented. Because it is so common to quote rental rates in terms of money. I. we maintain four basic assumptions: (A. if the wheat rental rate on wheat were ". the money rental rate (being an own rental rate) is called the money interest rate. and is quoted as a pure percentage per unit time.II. No Satiation: Individuals always strictly prefer more money to less.3) (A. So the wheat rental rate on an apartment might be quoted as "125 bushels of wheat per month (per apartment). he is a debtor.. If one borrows money.2) (A. we will frequently make the further assumption that the rate of interest in each period is the same. the borrowing and lending rates are equal. to rent money from an entity is to borrow. as is well known. and the rents received for the use of money are called interest payments. or simply the interest rate.

. the individual would have the initial amount V o plus the interest earned. Substituting into (II. for expositional convenience. n . redeposits V1 dollars for the 2 rV o .e.1. is given by 10 . n n and (1 + r ) is called the compound value of a dollar invested at rate r for n periods. individuals. Although no specific institutional structure for borrowing or lending is presumed. he will t have V t -1 and redeposited.1). at the end of period (t . At the end of the first period.. we have that the number of periods required. "deposits. If he at rate r. then second period V 2 = (1 + r) V 1 = (1 + r)[(1 + r) V o ] = (1 + r ) V o . Similarly. the compound value is given by (II. the reader may find it helpful to think of the described financial transactions as being between an individual and a bank. we will call loans made by Compound Interest Formulas Compound Value Let V n denote the amount of money an individual would have at the end of n periods if he initially deposits V o dollars and allows all interest payments earned to be left on deposit (i. Problem II. reinvested). V n is called the compound value of V o dollars invested for n periods.1) V n = (1 + r ) V o ." Indeed. Therefore. or V 1 = Vo + rV o = (1+ r)V o .Robert C. "Doubling Your Money": Given that the interest rate is the same each period. Merton denoted by r. Suppose the interest rate is the same each period.1). he will have V t = (1 + r) V t -1 = (1 + r ) V o at the end of period t. how many periods will it take before the individual doubles his initial deposit? This is the same as asking how many periods does it take before the compound value equals twice the initial deposit * (i.e. V n = 2 V o ).

to one decimal place. For example.e. in this day of hand calculators. I. Two "rules of thumb" used to approximate n in (II. is defined as the smallest number of dollars one would have to deposit today so that with it and cumulated interest. and solving for V o = V n /(1 + r ) = x/(1 + r ) .5) 11 . the Rule of 69 is the more precise although the Rule of 72 has the virtue of requiring only one number to remember. If one can earn at the same rate of interest r per period on all funds (including cumulated interest) for each of the n periods. Both rules provide reasonable approximations to n .9 years. n periods from now.2) are: (II. Moreover. equal to the number of dollars deposited today such that its compound value at the end of period n is $x.e. n PV n (x) = x/(1 + r ) .. any more accurate estimates should simply be computed using (II.35 + 69/100r (" Rule of 69" ) Of the two. It is therefore.Finance Theory (II.2). PV n (x). the Rule of 72 gives n = 12.69315/ log(1 + r) where "log" denotes the natural logarithm (i. if r equals 6 percent per annum.1). see Gould and Weil (1974).0 years while the Rule of 69 and the exact solution gives n = 11..4) * n ≈ 0. For further discussion of these rules.2) * n = log(2)/ log(1 + r) = . a payment of $x could be made at the end of period n. * * * Present Value of a Future Payment The present value of a payment of $x.3) * n ≈ 72/100r * (" Rule of 72" ) and (II. to the base e). (II. then the present value can be computed by setting V n = x in n n (II.

he would not buy it). instead of selling the future claim. for a total of (1 + r) PV n (x). If one owned a future claim on a payment of $x. suppose that instead of buying the future claim. r(1 + r) PV n (x) for a total of (1 + r )2 PV n (x).. If one were offered a payment of $x. and therefore he would be better off not to sell the future claim. then at the end of period n. then at the end of this (the second) period. The net of these transactions is that he will have received $ PV n (x) initially which by hypothesis is larger than $P. Suppose that. suppose that the cost of the future claim were P > PV n (x). If he continues to refinance the loans in the same fashion of n periods. is less than its present value. he "refinances" the loan). he would have more money at the end of n periods by simply depositing the money rather than by purchasing the future claim for P. P. If he sells.Robert C. To see this. In summary. he borrows $ PV n (x) today for one period. PVn(x). If the price of the future claim. If he pays off this loan and interest by borrowing $(1 + r) PV n (x) for another period (i. P. he would have more money initially by borrowing the money "against" the future claim rather than by selling the future claim for $P. Merton n and 1/(1 + r ) is the present value of a dollar to be paid n periods from now. Further. PV n (x).. the answer is PV n (x). he would have $P(1 + r ) which by hypothesis is larger than PV n (x)(1 + r ) = $x. he will owe PV n (x) plus interest.e. if the price of the future claim. n periods from now. n periods from now.e. At the end of n n n periods.e. Suppose that the price offered for the future claim today were P < PV n (x). then the individual would prefer to sell the claim rather than hold it (or if he did not own it. exceeds its present value. I. he will owe (1 + r )n PV n (x) or $x which he can exactly pay off with the $x payment from the claim he owns. what is the least amount that he would sell this claim for today? Again. he deposited $P today and reinvested all interest payments for n periods. I. he will owe (1 + r) PV n (x) plus interest. Therefore. he would be better off not to purchase the future claim. then he will have $P today. rPV n (x).. At the end of the first period. then the 12 . what is the most that he would pay for this claim on a future payment today? The answer is PV n (x).

then we would be able to make exactly the schedule of payments required... x 2 . we proceed as follows: Suppose that we establish today N separate bank accounts where in "Account #t.. the individual would have no preference between buying.2. t = 1. Present Value of Multiple Future Payments The present value of a stream of payments with a schedule of $ xt paid at the end of period t for t = 1..2... If we follow this procedure for each of the N separate accounts. x N )...6) = ∑ PV t ( x t ) . a payment of $ xt could be made at the end of period t for each period t. Hence.. the present value of a stream of payments is just equal to the sum of the present values of each of the payments... N. then the amount of money in the account at that time will equal the compound value of PV t ( x t )... N is defined as the smallest number of dollars one would have to deposit today so that with it and cumulated interest. Therefore. at P = PV n (x). or selling the future claim. t = 1.2. the present value of a future payment is such that the individual would be indifferent between having that number of dollars today or having a claim on the future payment.. holding. By the definition of the present value of a single future payment. t =1 N So. We denote this present value by PV( x1 . he would buy it). the present value of the stream of payments with this schedule is equal to the total amount of deposits required for these N accounts. if one can earn at the same rate of interest r per period on all 13 . To derive the formula for its present value. x 2 . we will have just enough money to make a payment of $ xt at the end of period t by liquidating Account #t.. If we let the interest payments accumulate in Account #t until the end of period t.." we deposit PV t ( x t ) dollars.. PV( x1 .... N. Hence.. + PV N ( x N ) (II. I.. Hence.. x N ) = PV 1( x1 ) + PV 2 ( x 2 ) + .Finance Theory individual would prefer to hold it rather than sell it (or if he did not own it.e.

... an individual would be indifferent between having $ PV t ( x t ) today or a payment of $ xt at the end of period t...2.7) PV( x1 .Robert C.2. x N ) today. x 2 . y N ) or $PV( x1 . x N ) .. y N ) > PV( x1 . Merton funds (including cumulated interest) for each of the N periods. and the second. Moreover.. x N ). call it "claim Y. one would prefer claim Y to claim X if PV( y 1 . N .. the former choice is trivial to make: Namely.... Hence to make a choice between having $PV( y 1 . a claim on a stream of future payments is formally equivalent to a set of claims with one claim for each of the future payments. y 2 .. and similarly...6)..." provides a stream of payments of $ xt at the end of period t for t = 1.... x N ) = ∑ xt /(1 + r ) . As may already be apparent.... x 2 . then one would be indifferent between the two claims.. So one would be indifferent between having claim Y or $PV( y1 . As was shown.. the present value concept is an important tool for the solution of intertemporal choice problems... y 2 .. one would be indifferent between having claim X or $PV( x1 .... and would prefer claim X to claim Y if PV( y 1 ..... N .. follows that he would be indifferent between having $PV( x1 . we have that (II. then from (II.2. x 2 .. if the two present values are equal.. one would always prefer the larger of $PV( y 1 . y N ) today or $PV( x1 .. Thus. x N ) today is formally equivalent to making a choice between claim Y or claim X... But.... x N ) today. x 2 .. N. For example... It. therefore..5) and (II... 14 ... y N ) today.. x 2 . Which claim would one choose? We have already seen that one would be indifferent between having a claim on stream of future payments or having its present value in dollars today. x 2 . y 2 ... y 2 ... call it "claim X. suppose that one has a choice between two claims: the first... as long as one prefers more to less. x N ) today or a claim on the stream of future payments with the schedule of $ xt paid at the end of period t for t = 1. y 2 ... t t =1 N As this derivation demonstrates." provides a stream of payments of $ y t at the end of period t for t = 1. x 2 . y N ) < PV( x1 .

. those claims with the k largest present values in the group). However. a receipt) a negative magnitude for these variables is interpreted as a cash payment from the owner of the claim (i. the timing of the payments need not be the same. Since the xt or y t represent cash payments to the owner of the claim (i. More generally. nowhere was it assumed that some of the xt or y t could not be negative.. the present value tool provides a systematic method for comparing claims whose schedules of payments can differ substantially both with respect to magnitude and timing.. then the present value of a N stream of payments is just equal to the sum of all the payments (i. computing the present values of all the claims. Its use in this intertemporal choice problem can be formalized as follows: Present Value Rule: If one must choose among several claims.e.e. Indeed. Third.. rank or order all the claims in terms of their present values from the highest to the lowest. Hence.e. Moreover. While our illustration applied it to choosing between two claims. then proceed by: first.. Note that if the rate of interest in every period were zero. the Present Value Rule would simply say "choose that claim which pays one the most money in total (without regard to when the payments are received). Thus." However.Finance Theory In the formal notation. x N ) = ∑ x t ). PV( x 1 . because of 15 ..e. if one must choose only one claim. t=1 In this case. This procedure for choosing among several claims is called the Present Value Rule... x 2 .. Second. it can obviously be extended to the problem of choosing from among several claims. then take the first k claims in the ordering (i. both claim X and claim Y had the same number of payments: namely N. if one must choose k claims out of a larger group. it is entirely possible for the present value of a stream of payments to be negative which simply means one would be willing to make an expenditure and pay someone to take the claim.e. the one with the highest present value). nowhere was it assumed that some of the xt or y t could not be zero. then take the first claim (i. an expenditure).

Hence. the interest rate will not be zero. however. one should choose Claim Y. without knowing the interest rate. r 0% 2% 5% 8% 10% 12% Present Value of Claim X $1000 898 772 671 614 565 Present Value of Claim Y $900 848 777 714 676 641 While the present values of both claims decline as one moves in the direction of higher interest rates. Hence. Note. That one cannot rank or choose between alternative claims without taking into account the specific interest rate available is demonstrated by the following problem: Problem II.Robert C. for interest rates below 5 percent. The result obtained here that one claim is chosen over the other for some interest rates and the reverse choice is made for other interest rates often occurs in choice problems and is called the switching phenomenon. So.2. one should choose Claim X and for rates above 5 percent. Given that the interest rate will be the same each year for the next ten years. the claim chosen depends upon the interest rate. Choosing Between Claims: Suppose that one has a choice between "claim X" which pays $100 at the end of each year for ten years or "claim Y" which provides for a single payment of $900 at the end of the third year. which one should be chosen? The Present Value Rule says "Choose the one with the larger present value. It is called this because an individual would "switch" his choice if he were faced with a sufficiently different interest rate. in general. the choice between two claims will. as the following table demonstrates. Interest Rate." However. unqualified questions like "which claim is better?" will not be well posed without reference to the specific environment in which the choice must be made. and no such simple rule will apply. that for a specified 16 . be ambiguous. in general. Merton the time value of money. the rate of decline in the present value of Claim Y is smaller than the rate of decline for Claim X.

the solution to the problem of choosing among alternative claims will depend upon the interest rate at which the individual can borrow or lend. From that formula. the solution does not depend upon whether he plans to use the payments received for current consumption or to save them for consumption in the future.e. further discussion is postponed to Section III where the general intertemporal choice problem for the individual is systematically examined.2. every month or twelve times a year). the account is credited with cumulated interest earned at the rate. compounded monthly (i. Moreover.8) 1 + i n = (1 + R/n )n . Specifically.Finance Theory interest rate.e. (R/n). and therefore. the present value of each claim is uniquely determined. it is equally important to stress that the solution depends only upon that interest rate. While this demonstrated independence of the solution to either the individual's tastes or endowments has far-ranging implications for the theory of Finance. one dollar will grow to $(1 + R/n )n in one year. given that rate of interest. 17 .. per period of (1/n) years. his endowment).1). such quotations can be interpreted to mean that n times a year. when there are n such compoundings per year can be derived using the compound value formula (II.e." For example. compounded quarterly (i.. the solution does not depend upon the individual's preferences or tastes for future consumption. and therefore the choice between them at that interest rate level is always unambiguous. a bank might quote its rate on deposits as "7% per year. in general. That is. call it in. The "true" annual rate of interest. (II.. the solution is not altered by the existence of other claims that an individual owns (i. it was stressed that. However." Provided that funds are left on deposit until the end of a compounding date. Continuous Compounding It is not uncommon to see an interest rate quoted as "R% per year. every three months or four times a year)" or "7% per year. In Problem II. compounded n times a year.

52 122.87 271. Compounded Continuously $ 110. and the limit of (II.10) as 18 . However.72 672. this difference will not be large.17 738.10). r c .75 1. at a stated rate of R = 5%.14 164.. Merton By inspection of (II. of course. and e R is called the exponential factor.05 259.7183. The difference between the true or effective annual rate i∞ and the stated rate R will be larger. invert the original question and ask "What continuously-compounded rate. the larger is R although for typical interest rates.9) 1 + i∞ = eR where "e" is a constant equal to 2.10) er c ≡ 1 + r .Robert C. for a given value of R. will produce a "true" annual interest rate.008. r?" From (II.91 2.00 161. or by taking (natural) logarithms of both sides of (II. The limiting case of n → ∞ is called continuous compounding.83 448. we have that (II. larger n) result in a larger "true" annual interest rate.55 One can. more frequent compoundings (i. we can rewrite (II.e. in . i∞ = 5..37 417.744.9).13%..8) is (II.00 121.. the cumulative difference in compound value for higher interest rates and over several years can be significant as is illustrated in the following table: Compound Value of $100 at the End of N Years N 1 2 5 10 15 20 30 At 10% per Year $ 110.93 At 10% per Year. For example.8).

7). it is frequently more convenient to work with the continuously-compounded rate. by a continuous stream of payments. can be approximated by the integral formula. How much money would one have at the end of year N if payments are immediately deposited in an account which earns r% 19 . Suppose that one owned an annuity claim which pays $y at the end of each year for N years.11) into (II.69315/ r c . one approximates the stream of payments from a claim. Annuity Formulas A claim which provides for a stream of payments of equal fixed amounts at the end of each period for a specified number of periods is called an annuity. we derived a formula for the number of periods required to double our money. For example. r.11) r c ≡ log(1 + r) . rather than the actual rate. {x(t)}.2). (II. then the discrete-time formula for the present value of a stream of payments. { x t } . Substituting from (II. n .xn ) ≈ ∫ x(t)e .1. If. we have that * II..12) * n = log(2)/ r c = .13) PV(x1 . r c ... (II. x2 .13) provides an easier way to compute formula for the present value than its discrete-time counterpart in (II. in Problem II.r ctdt. In the analysis of interest rate problems. the integral expression in (II.Finance Theory (II. 0 N and in some cases.7). in addition..

(II.15) N S N = y[(1 + r ) .14) From (II. . To further simplify the formula. we also have that (II. N -3 Hence. . The sum of a geometric progression. .14) with x = 1 + r to the expression for S N . S N . we have that: N -1 year 1's payment will grow to y(1 + r ) N -2 year 2's payment will grow to y(1 + r ) year 3's payment will grow to y(1 + r ) . . . 20 .1)/(x .Robert C.. Merton per year (on both cumulated interest and the initial deposit) in each year? Using the compound value formula. . is given by the formula t=0 N -1 (II. year (N-1)'s payment will grow to y(1 + r) year N's payment will grow to y . . we can rewrite it as (II.1). ∑ x = x( x t t =1 N N .e.14). . . 1 + x + x2 + .14a) ∑ x = (x t t=0 N .1]/r. . SN = ∑ y(1 + r ) t =1 N N -t = y ∑ (1 + r ) .1). . will be the sum of all N terms. . I. . we make a brief digression to t t =0 N -1 develop a mathematical N -1 formula. Applying (II.1)/(x . .1).. . . . + x N -1 = ∑ xt . the total amount accumulated..

we know that a N-year annuity paying $y per year is equivalent to a claim which provides a single payment of $ S N paid at the end of year N.16) N A N = y[1 . Hence.16).1]/r is called the annuity compound value factor.y/(1 + r ) . and at time t. and [(1 + r ) .Finance Theory SN N is called the compound value of an annuity. But. can be written as (II. we can rewrite the expression for the present value as (II. Inspection of (II. The reader may verify that this is the case by inspection of (II. Note that if one has a N-period annuity at time (t=) zero.1/(1 + r ) ]/r and [1 .AN . and N therefore A N = S N /(1 + r ) .1/(1 + r) ] /r is called the annuity present value factor.17) N AN -1 . then this same claim will become a (N-1) period annuity at time t = 1. t =1 t =1 From (II.15). However. we have that N N PV N ( S N ) = S N /(1 + r ) . Formula (II. From (II. we have that A N = ∑ y/(1 + r ) = y ∑ 1/(1 + r ) . Note further that the rate of decline is larger the closer the annuity is to its expiration date. the present values of two equivalent streams are the same.5).A N = . Maintaining the assumption that the interest rate is the same each year.16) could have been derived by a different (but equivalent) method. the change in the present value of an N-period annuity over one period is equal to AN -1 .16). and from (II. what is the present value N of an t annuity N (denoted t by AN )? From (II. in the special limiting case of a 21 .7). its present value is zero. From (II. it will be an (N–t) period annuity.17) shows that the present value of an annuity declines each period until at time t = N (called its expiration date).14a).

and the annual interest rate. The annuity present value factor for r = . In effect. $30. If the amount of money to be borrowed is $30.18) A∞ = y/r. then what will be the annual payments required? To solve this problem.16). Therefore. Problem II. Given this information. In addition to 22 . Although the size of the payments remains the same over the life of the mortgage.000. the periodicity of the payments is once a year. Mortgage Payment Calculations: Probably the annuity claim with which households are most familiar is the mortgage which is a specific form of loan used to finance the purchase of a house. the length of time.000. one can then determine the size of the periodic payments as a function of the amount of money to be borrowed. the amount of money actually borrowed (called the principal of the loan) does not. the required annual payments.08 and N = 25 equals 10. the present value remains unchanged through time. The number of payments.000/10.675 or approximately $2810 per year. Suppose the bank quotes its mortgage terms as follows: the length of the mortgage's life or term is 25 years. r. The amount of money received in return for the annuity. the periodicity of the payments. Merton perpetual annuity or perpetuity where N = ∞.08. Thus. equals . the house buyer "issues" to the lender (usually a bank) an annuity claim in exchange for cash today.675.3. equals 25.1/(1 + r )N ]. y = $30. y.19) y = rA N /[1 . Typically. we use formula (II. and is given by (II. The terms of a standard or conventional mortgage call for the borrower to repay the loan with interest by making a series of periodic payments of equal size for a specified length of time. N. equals the present value of the annuity. and the interest rate charged is 8 percent per year. AN . are given by the formula (II.Robert C. and the interest rate are quoted by the bank.

In the example above.9 63.1 70. but $29.17).039 208 85. the distribution of the payment is approximately half interest payment and half principal reduction.08 × $30.810 2.590 29. However. almost all of the total payment goes for interest payments. a portion of each year's payment is used to reduce the principal. Hence. The following table illustrates how the level of payments are distributed between interest payments and principal reduction over the life of the mortgage. is used to reduce the principal. 25-Year 8% Mortgage: Distribution of Payments Interest Payments Amount % of Total $2.990 1.810 2. is given by A N . by the seventeenth year.2 80.9 29. virtually all the payment goes for the reduction of principal.810 2.0 92. as 23 . and therefore. and as the mortgage approaches its expiration date.16) and (II.Finance Theory covering interest payments.252 1.605 1. the amount actually borrowed is not $30.4% 84. We can rewrite this expression in terms of the initial size of the mortgage.0 7. the balance after interest. the interest part of the payment is .205 1.855 11. because the total payment made is $2.810 2.000.810 Note that early in the life of the mortgage. The general case for the distribution of the payments between interest and principal reduction can be solved by using formulas (II.602 14. during the first year of the mortgage.400.590.8 19.1 37. AN .810 2.810 2.1/(1 + r ) N -t ]/r. However.147 27. the amount of money borrowed is $30.t = y[1 .6 Amount of Loan Outstanding $29.052 18.589 24.810.000 or $2.400 2. AN -t .000.2 42. the principal at time t.367 2.8 57. Because the amount of the mortgage outstanding always equals its present value. for the second year in the life of the mortgage. $410.771 2.220 0 Year 1 2 5 10 15 20 25 Total Payment $2.4 Principal Reduction Amount % of Total $ 410 443 558 820 1.6% 15.

the change in principal between t and t + 1 is equal to AN -t -1 . then at that time. a total of $X[(1 + r ) . the required number of years of saving is derived by equating the accumulated sum to the cost of the annuity. we have that (II. and the percentage of the total payment used to reduce principal between t and t + 1 written as (II. Saving for Retirement: A bank recently advertised that if one would deposit $100 a month for twelve years.11).21) N -t AN -t -1 . or alternatively.17) can be written as (II. Hence.t = A N [(1 + r ) .15). the bank would pay the depositor $100 a month forever.18). Merton (II.(1 + r ) ]/[(1+ r ) . then from formula (II.23) in terms of the equivalent continuouslycompounded interest rate as 24 .1]/r will have been accumulated by the retirement date. can be Problem II.22) [ AN -t .Robert C. it will take $C/r at that time to purchase a perpetual annuity of $C per year. This is an example of a regular saving plan designed to produce a perpetual stream of income later.AN -t = . and frequently arises in analyses of retirement plans.y/(1 + r ) . By taking the logarithms of both sides and rearranging terms. how many years in advance of retirement should one begin to save $X a year so that at retirement. we can rewrite (II.1].4.AN -t -1 ]/y = 1/(1 + r )N -t . For example.20) N t N A N . using (II. From formula (II.AN -t which from (II. Moreover.23) T = log [1 + C/X]/ log [1 + r]. one would receive $C a year forever? If it is assumed that the annual rate of interest is the same in each year and if one starts T saving T years prior to retirement.

Applying (II.25) T = 0. Comparing (II. the number of years of required saving is exactly equal to the number of years it takes to "double your money. the length of time required is inversely proportional to the (continuously-compounded) interest rate.48 percent per month or 5. such that the present value of the annuity is just equal to the lump-sum payment x. he should take the lump-sum payment.24) reduces to (II." and therefore a "quick" solution for T can be obtained by using either the Rule of 72 or the Rule of 69. it is not uncommon for the individual to be offered the choice at retirement between a single. We can determine the "switch point" in terms of life expectancy by solving for the number of years. Clearly. N . we have that * (II. then he should choose the annuity.25) to the bank advertisement.25) * N = log[y/(y . we can derive the monthly interest rate implied by the bank to be 0.Finance Theory (II. Otherwise.rx)]/ log[1 + r].25) with (II.69315 ≈ log(2).93 percent per year.16) and rearranging terms. (II. if that rate is doubled.5. then the required saving period is halved.24) T = log [1 + C/X]/ r c . Problem II. Note that for a fixed ratio of C/X. Substituting x for AN in (II.69315/ r c where 0.2). 25 . the proper choice depends upon the number of years that the individual will live. The Choice Between a Lump-Sum Payment or an Annuity at Retirement: Having participated in a pension plan. lump-sum payment or a lifetime annuity. if he expects to live long enough. Suppose one is offered a choice between a single payment of $x or an annuity of $y per year for the rest of his life. So. Given that the interest rate at which he can invest for the rest of his life is r. which should he choose? Provided that y > rx. In the special case where C = X.

These plans are called "tax-deferred" rather that "tax-free" because any amounts withdrawn from the plan are taxed at that time. Contributions to these plans are deductible from current income for tax purposes and interest on these contributions is not taxed when earned. Individual Retirement Accounts or Keogh Plans).Robert C.1]/r. Further suppose that he contributes $y each year to the plan until he retires N years from now at which time he begins a withdrawal program on an annuity basis for n years. instead. Moreover. he had chosen an ordinary saving plan. his total before-tax amount accumulated at retirement. then he should choose the annuity. However. he could only contribute $(1 . Merton Hence. the interest accumulation period. individuals are permitted to establish tax-deferred savings plans for retirement (e.τ )y earned in an ordinary saving plan is taxable at the time it is earned. if he expects to live longer than N years.15). instead of earning 26 .6. is $y[(1+ r ) . what is the economic benefit of the taxdeferred saving plan over an ordinary saving plan? Using formula (II.τ )y[(1 + r )N . Therefore. he must pay taxes of $τq each year on the withdrawals. From formula (II.1]/[1 . If.1/(1+ r )n ] per year for n years from this accumulated sum. he would have had to pay $τy additional taxes each year during the accumulation period because contributions to an ordinary saving plan are not deductible. So.1/(1 + r )n ]. N S N . without changing his expenditures on other items during the each year. Suppose that an individual faces a proportional tax rate of τ which is the same each period and that the interest rate r is the same each period.16). Hence. he can generate a withdrawal plan of $q = rS N /[1.26) $ q1 = (1 .g. the tax-deferred plan will produce an after-tax stream of payments for n years beginning at retirement of (II.. Assuming that his first contribution to the plan takes place one year from now. * Problem II. Tax-Deferred Saving for Retirement: Under certain provisions of the tax code.

15). the tax-deferred plan provides a positive benefit because q1 > q2.τ )r )n ] per year for n years which can be rewritten as (II. N is $(1 . Because property taxes can be deducted from income 27 .1]/[1 .26) and (II. If he buys the house. His problem is to choose the method of obtaining housing services with the lowest (present value of) cost.τ )r. (1 . Clearly. the tax-deferred plan is formally equivalent to having an ordinary saving plan where the interest earned is not taxed. Thus. Problem II.τ )r after tax. Again using formula (II.1]/(1 . S 2 . the $ S 2 accumulated is not subject to further tax.τ )y[(1 + (1 . Specifically.27) shows that this differential can be expressed in terms of a higher effective interest rate on accumulations in the tax-deferred plan. Suppose that the individual faces a proportional tax rate of τ which is the same each period and that the interest rate r is the same each period.τ )y[(1 + (1 . then he must spend $M for maintenance and $PT for property taxes each year.τ ) rS 2 /[1 . The present value of cost equals the discounted value of the after-tax outflows discounted at the after-tax rate of interest. he only receives rate (1 .. from formula (II. However.1/(1 + (1 . a house or car).τ )r )N . Because he has paid the taxes on contributions and interest along the way. Inspection of (II.τ )r )n ]. These are both included in the rent. the individual can either choose to buy the good or rent it. Suppose an individual faces the decision of whether to buy a house for $I or rent it where the annual rental charge is $X per year. he can generate an after-tax withdrawal plan of $ q 2 = (1 .Finance Theory at the rate r each year on invested money.16).τ )r ) . his total amount accumulated at retirement from the ordinary saving plan.τ )r. The Choice Between Buying or Renting a Consumer Durable: For most large consumer durables (e.7. any interest earned on invested money during the subsequent withdrawal period is taxed at rate τ.27) $ q 2 = (1 .1/(1 + (1 .g.

τ )PT]/(1 + (1 .τ )r. the relationship between PCR and PCO depends upon the rent charged. Hence. have that X must satisfy I = [(X-M-PT)(I . In computing his tax liability. (II.τ )r ) t =1 ∞ t (II.τ ).τ )r where we have assumed that the (properly-maintained) house continues in perpetuity and applied the annuity formula.29) = X/(1 . the cost of owning the house. Similarly. Discounting these after-tax cash flows at his aftertax interest rate. and (II. we have that the cost saving of owning over renting can be written as 28 . Therefore. then it is better to own rather than rent.τ )PT.30). Hence.τ )r )t t=1 ∞ (II. a non-cash item. Of course.Robert C. the cost of renting the house.τ )r or (II. Hence. In a competitive market. D.29). the landlord can deduct depreciation. The pretax net cash flow to the landlord each year is (X-M-PT). From (II.30) X = rI + M + PT . Merton for federal income tax purposes. we is his proportional tax rate. if PCR > PCO.τ )+τ D]/(I . his taxes are (X-M-PT-D)τ where τ (1 .28) = I + PT/r + M/(1 . his after tax cash flow is (X-M-PT)(1 -τ ) + τ D . can be written as PCR = ∑ X/(1 + (1 . PCR. the after-tax outflow for property taxes each year is (1 . can be written as PCO = I + ∑ [M + (1 .τ D/(1 . PCO. X should be such that the present value of the after-tax cash flows to the landlord equals the cost of his investment I. Hence.τ )r. the rent charged should be such that the landlord earns a return competitive with alternative investments.28).

31) PCR . Hence.PCO = τ [I + PT/r]/(1 . If one has a N-period discount loan at time (t=) zero. Hence.τ )(1 . If it is assumed that the interest rate is the same each period.32).S. and from (II.τ )r]. The disadvantage is that one cannot take a tax deduction for the (non-cash) depreciation item. "Pure" Discount Loan A pure discount loan calls for the borrower to repay the loan with interest by making a single lump-sum payment to the lender at a specified future date called the maturity or expiration date. the change in the present value of a N-period discount loan over one period is equal to D N -1 . Treasury Bills and corporate commercial paper.D N = rM/(1+ r ) = rD N . it will be a (N . unlike an annuity-type loan. and the best known examples are U.t) period discount loan. there are no interim payments made to the lender.Finance Theory (II.τ ) . if property taxes are high and the individual is in a high tax bracket. then this same loan will become a (N – 1) period discount loan at time t = 1.D N . N 29 .τ D/[(1 . On the other hand. This form of loan is most common for short maturity loans. then owning is probably less costly. So if the depreciation rate on the property is high or the individual is in a low tax bracket. can be written as (II. and at time t.32) N D N = M/(1 + r ) . then the present value of a discount loan (denoted by D N ) which has a promised payment of $M to be paid N periods from now can be written as (II.33) D N -1 . then renting is less costly. The advantage to ownership is that one is not taxed on the rent paid to oneself.

the present value of a discount loan increases each period until at t = N. If it is assumed that the interest rate is the same each period. Hence.33) shows that unlike an annuity.e. Merton Inspection of (II. This form of loan is most common for long maturity loans. in addition. then the present value of an interest-only loan (denoted by I N ) which has a coupon payment of $C per period and a balloon payment of $M can be written as t N I N = ∑ C/(1 + r ) + M/(1 + r ) t=1 N (II. "Interest-Only" Loans Another common form for a loan is an "interest-only" loan which calls for the borrower to make a series of periodic payments equal in amount to the interest payments for a specified length of time and.1/(1 + r )N ]/r + M/(1 + r )N . the principal). at the end of that length of time. the amount of money actually borrowed increases over the life of the loan. and the best known examples are U. With the exception of the principal payment.. The rate of increase each period is the same and equal to the interest rate r. 30 . to make a single payment equal to the initial amount borrowed (i.S. its present value is M.34) = C[1 . Treasury Notes and corporate bonds. The structure of "interest-only" loans is a mixture of the annuity and pure discount forms of loans. lump-sum (or "balloon") payment at the end is called the return of principal or simply the principal payment. the payment patterns are like those of an annuity because the size of the coupon payments are all the same. However.Robert C. the amount of the loan outstanding or the principal remains the same throughout the term of the loan. Like a discount loan. and the single. unlike both the annuity and discount loans. The periodic payments are called coupon payments. there is a lump-sum payment at the maturity date.

If. t=1 n For notational simplicity. then substituting into (II. Hence.e... the present value of the loan remains the same over the life of the loan.36) ⎡ n ⎤ = ⎢Π ( 1+ rt ) ⎥ V o Vn ⎣ t=1 ⎦ where "Π" is a shorthand notation for the "product of. and we denote by r t the one-period rate of interest which will obtain for the period beginning at time (t – 1) and ending at time t.34). We now consider the general case where the interest can vary.2 ). as before. the analogous formula to (II.e. C = rM). all the formulas were derived using the assumption that the interest rate at which the individual can borrow or lend is the same in each period. we define the number R n as that rate such that compounding at that (equal) rate each period for n periods 31 . ∏ (1+ rt ) ≡ ( 1+ r1 )( 1+ r2 ) .. then V 1 = (1 + r 1 ) V o . V 2 = (1 + r 2 ) V 1 = (1 + r 2 )(1 + r 1 ) V o .1) for the compound value is (II. and V t = (1 + r t )V t -1 = (1 + r t )(1 + r t -1 )(1 + r t .(1 + r 1 )V o . ( 1+ rn−1 )(1+ rn ) . V n denotes the compound value of Vo dollars invested for n periods.. Compound and Present Values When the Interest Rate Changes Over Time To this point. Hence..." I.Finance Theory If the initial amount borrowed is $M and the coupon is set equal to the interest on the amount borrowed (i. we have that (II.35) IN=M independent of N.

care should be exercised to ensure that one does not confuse the " R n" with the " r n " . x 2 . and the present value of a stream of payments with a schedule of $ xt paid at the end of period t. we can From (II. Merton will give the same compound value as compounding at the actual (and different) one-period rates. can be written as (II. 1 + R n is the geometric average of the {1 + r t }..Robert C.38) V n = (1 + R n ) V o . from (II. That is. (II.. we have that 32 ... t = 1.38) and the definition of present value. x N ) = ∑ PV t ( xt ) (II..36) as (II.2. t = 1... the compound and present value formulas when interest rates vary look essentially the same as in the constant interest rate case.39) n PV n (x) = x/(1 + R n ) ..37) (1+ R n ) ≡ Π (1+ r t ). n.40) t =1 = ∑ x /(1+R t t =1 N t )... n t=1 n and therefore. However.. entire path of interest rates from time t = 1 to time The former depends upon the t = n while the latter is simply the one- period rate that obtains between t = n – 1 and t = n.N.2. rewrite (II. n Hence..37). For example. n periods from now. the present value of a payment of $x. can be written as N PV( x1 . t Using the formalism of R n .

we now turn to the systematic development of finance theory. R n = r n if and only if R n = R n-1 . This completes the formal preparation on the time value of money. as promised. r n > R n-1 does not imply that r n > r n -1 .41) if and only if Hence.Finance Theory > R n = R n -1 < > r n = R n -1 . and. 33 . < (II. Moreover. Further discussion of the relationship between the { R t } and { r t } is postponed until Section V where they will be placed in substantive context.

while the manifest functions of the analysis are to show how intertemporal allocations are made and to show what role capital markets play in these allocations.II. Hence. ON THE THEORY OF ACCUMULATION AND INTERTEMPORAL CONSUMPTION CHOICE BY HOUSEHOLDS IN AN ENVIRONMENT OF CERTAINTY Begin the study of Finance with the analysis of an economy where all future outcomes are known with certainty. but households receive income (their endowments) and consume at different points in time. As was discussed in the Introduction.4). We prepare for the study of corporate finance by deducing here and in Section IV a rational criterion function for the firm and the management rules which optimize this criterion function in the simplified world of perfect markets and certainty.1) . Because the emphasis is on the intertemporal allocation of consumption. the results derived from this model form a basis for the rationalization of the more complex decision rules developed later. C1. It is assumed that the "correct" policies chosen will be those that maximize some criterion function (or performance index) specified by the firm. We begin the analysis by solving the two-period problem and then extend it in a natural fashion to the general case of many periods. In particular. an important latent function of the analysis is to provide a foundation for corporate financial theory. and next period's consumption. are maintained throughout the analysis. C0 . It is further assumed that each consumer has a well-behaved utility function expressing his preferences between current consumption. it is shown how the consumption-saving decision is made and why the introduction of a capital market and financial securities can improve consumer welfare. Despite the simplicity of the model relative to the "real" world. it is assumed that there 34 . the major decisions of the financial manager are to choose which (physical) investments to make and to choose the appropriate means for financing them.III. Consumer Behavior: The Two-Period Case The four assumptions of Section II (A.(A.II.

(C0. Figure 1 illustrates the general shape of the indifference curves. we rule out the possibility of satiation. they are curves of equal utility or iso-utility curves. An indifference curve is the set of all combinations of current and next-period consumption. The consumer's utility function is denoted by U[C0. can be exchanged next period for goods.C1].1) ⎛ dC 1 ⎞ ⎜ ⎟ = . such that the consumer is indifferent among these alternative combinations i.C1]/ ∂C0 > 0 and U2[C0. and as they are drawn.e. Analytically.. consumers will always strictly prefer more to less of either C0 or C1. by the Implicit Function Theorem or heuristically... in turn. So.C1). or that (III. I.C1] ≡ ∂U[C0. there is no way of using the current period's goods to produce additional goods next period.C 1 ] < 0.C1] = U at the point (C0. I. by using differentials.C1] = U .C 1 ]/ U 2 [ C 0 . where U is a constant. we have that d U = 0 = U 1 d C 0 + U 2 d C 1 . The Simplest Capital Market: Pure Exchange For this case.U 1 [ C 0 . we assume that there are no means of physical production. this slope is always strictly negative. Alternatively. he can 35 . Formally. ⎜ ⎟ ⎝ dC 0 ⎠U =U _ where (dC1/dC0) is the slope of the indifference curve defined by U[C0.C1]/∂C1 > 0. As shown in Figure 1.C1). suppose there does exist a market for trading current period's goods in return for a claim on goods next period. Because both period's consumptions are considered goods (in contrast to "bads"). 1 2 3 U >U >U .e. it is assumed that U1[C0. it is the functional relationship between C0 and C1 such that U[C0.Finance Theory is a single consumption good in each period.C1] ≡ ∂U[C0. However. Case 1. By assuming the strict inequality.e. We also assume sufficient regularity and concavity of U to ensure existence of unique interior maximums. an individual can go to the market and exchange current period goods for "pieces of paper" which.

1 Indifference Curves 36 . a unit of current period goods is numeraire). one unit of current goods can be exchanged for (1 + r) units of goods delivered next period. this price is also written as P ≡ 1/(1+ r) where r is the rate of interest. Figure III.. Merton receive current period goods by issuing "pieces of paper" which he must redeem for goods next period. In an intertemporal context. he is borrowing. Hence. by convention. If. So. P units of current period goods can buy a claim on one unit of next period goods. in the former case. he is lending and in the latter.Robert C. In effect. the price per unit of current period goods is set equal to one (i.e. then the (current) price per unit of next period goods. is the rate of exchange for claims on next period goods in terms of current period goods. P.

PC* .C1] subject to his budget constraint that W0 = C0 + PC1. So.C1 ] is the maximum feasible value of utility Hence.PC1 .3) as (III. then he will act so as to maximize U[C0.e.U 1 [ W 0 . The consumer's feasible consumption set is the set of all combinations (C0.II. C0 + PC1.4) * * * * * ( dC 1 / dC 0 )U = U * = . can be no larger than his wealth W0. if it is assumed that the consumer will choose the most preferred feasible consumption program.C1) which he can afford to buy. then the cost of that consumption program. 37 . Moreover. is equal to the value of his endowment i. Hence. 1 1 1 1 where (C0 . Substituting for C0 in U from the budget constraint.2) Max U[ W C1 0 .1/P = .PC* . where U ≡ U [C0 .4) that the consumer acts as a pure competitor or price-taker. the optimum occurs at . The consumer's current wealth. as long as a consumer prefers more consumption to less. the consumer treats the price (or interest rate) as a given number which does not change in response to the different consumption choices that he might make. Note that in arriving at the optimality condition (III. he would never choose a program which costs less than his wealth. W0.3) dU dC 1 * * = 0 = . if (C0.3)..(1 + r) .C1) are in the consumer's feasible consumption set.C* ]P + U 2 [ W 0 .C1 ) is the optimal consumption program.A consumer's endowment of exogenous income is denoted by (y0. C 1 ] which leads to the first-order condition for an interior maximum (III. we have used assumption (A.C* ] . the point where an indifference curve is tangent to the budget constraint as shown in Figure 2. Thus.PC 1 . W0 = y0 + Py1. in solving for his most preferred consumption program. we can write the consumer choice problem as (III.y1) where y0 is the number of units of current goods he owns and y1 is the number of units of goods that he will receive next period. Noting that C0 = W0 . we can rewrite (III.

if the solution to (III. That is. * Hence. then in the absence of an exchange market.Robert C. Merton Figure III. the feasible consumption choices are constrained to have C0 ≤ y0. Moreover.e. physical storage 38 . C1 ≠ y1 )..2 In the absence of an exchange market and without physical storage of goods through time. Even if physical storage of goods is feasible. he can be no worse off because he always has the option not to use the market and choose C0 = y0 and C1 = y1 which is called the autarky point. Co = yo and C1 = y1 . then the consumer will be better off as a result of the creation of an exchange market.3) yields C0 ≠ y0 * (and therefore. I. the optimal consumption program for the consumer will simply be to consume current income.

for example. In the absence of an exchange market. for C 0 = W0 . * * If r is the market rate of interest. suppose that one had an income stream of (y0 =) ten bushels of wheat this period and (y1 =) fifty bushels of wheat next period.PC1 = ⎡( 2+r ) y − C1 ⎤ (1 + r ) .Finance Theory allows one to "move" goods "forward" in time for consumption. So. then he would still be better off to save wheat for next period through the exchange market rather than by storage provided that the interest rate is positive. but it does not allow one to "move" goods "backward" in time. Even if his endowment had been y0 = 50 and y1 = 10.5a) and (III.5b) * C 1 = (2 + r)y/(2 + δ ) . From * * the the budget constraint. However.C1 ]/U2[C0 . then what is the optimal allocation * * * * * * (C0 . in the presence of an exchange market.1: Choosing an Optimal Consumption Allocation: Suppose that one has a preference function given by U[C0.3). C1 )? From (III.C1] = log(C0) + log(C1)/(1+δ) and an endowment of y0 = y1 = y. or that C1 = (1+r)C0 /(1+δ ).C1 ] = (1+δ)C1 /C0 = 1+r. Problem III. there is no way that he can consume more than ten bushels of wheat this period even if costless storage of wheat were available. he could consume up to 50/(1+r) bushels of wheat in the initial period where r is the market interest rate. * C 0 = { (1 + δ )(2 + r)/[(1 + r)(2 + δ )] } y * 39 . we have that U1[C0 . we have that (III. W0 = y + Py = (2+r)y/(1+r). in addition to the ten bushels he has. Substituting ⎣ ⎦ * * * into budget constraint C1 from the optimality condition.

b) such that b > a. then he has no time preference. Note that in that example.b]. and he does not trade.y1). He has no time preference if U[b. then he has positive time preference.. Merton Time Preference A consumer is said to have a positive time preference if for every (a. One may wish to think of the "good" as seed which can either be eaten (consumed) or planted (invested). then he has negative time preference. a "Robinson Crusoe" economy). In the example of preferences used in Problem III. physical production is the only means he has to increase his next period's consumption beyond next period's income. If δ = 0. then * * C0 > y and he borrows against next period's income to consume more than his current income. If δ > 0. However. A No-Exchange Market Economy: Pure Production As in the first case. Case 2. but in addition. if the interest rate exceeds his rate of time preference (r > δ).b].b]. If r = δ. we have illustrated one of the possible explanations for a positive rate of interest: namely.a] = U[a. we can compute the "equilibrium" rate of interest consistent with autarky and that rate clearly must be r = δ. we assume that the consumer has an endowment of exogenous income (y0. then C0 < y . Hence. but consumes exactly his income in each period. and if δ < 0. the autarky solution is the only feasible solution. because there is no exchange market.Robert C. the only way that he can 40 . because there is no exchange market.a] < U[a.e. Suppose that the consumer in this example were the only person in the economy (i.a] > U[a. U[b. and he will save some of his current period's income to consume next period. If r < δ. δ can be interpreted as the consumer's rate of time preference. However.1. Moreover. Because he can only trade with himself. and a negative time preference if U[b. then C0 = y. consumers' impatience to * consume or a positive time preference. by this example. he has the opportunity to use some of his current income to produce next-period goods.

d f / dX 0 ≤ 0 ) . It is assumed that f(0) = 0 and df/dX0 ≡ f′ (X0) > 0. f(y0) ≥ X1 ≥ 0. such that X0 units of current goods invested will produce X1 = f(X0) units of the good next period.C 0 ) 41 . The maximum output that he can produce is X1 max = f(y0) which corresponds to X0 = y0 and C0 = 0. It is further assumed that the production technology exhibits non-increasing returns to scale (i. His next period's consumption can be written as (III. then (III.e.C 0 > 0.. and for 0 ≤ X0 ≤ y0.7) C 1 = y1 + X 1 = y1 + f( y 0 .e. if X0 denotes the amount he invests in production. The technology available to him is described by a production function f. describes his Production Possibility Frontier.6) X 0 = y 0 .Finance Theory produce is by forgoing some current consumption i. Hence. Figure 3 illustrates 2 2 the production function for decreasing returns to scale..

3 Production Function which for y0 . Substituting for C1 in U from (III. Because there is no exchange market and therefore. then he will act so as to maximize U[C0.Robert C. it is assumed that the consumer will choose the most-preferred feasible consumption program. no prices.7).7) which is called a technological budget constraint. describes his feasible consumption set of Consumption Possibility Frontier. if.C0 ≥ 0. Hence. the consumer does not have a budget constraint of the type in Case 1. we can write the consumer choice problem as Max U[ C C0 0 .C1] subject to his technological budget constraint. Merton Figure III. y 1 + f( y 0 . However. as in Case 1. his consumption choices are constrained by (III.C 0 )] which leads to the first-order condition for an interior maximum 42 .

8) as (III.C* )]. X 0 * is given by X 0 = y 0 .Finance Theory 0 = U 1 [ C* .C1 .C1 ]. (i. he cannot "borrow" against next period's income.C* )] .9) can be rewritten in terms of the slope of an indifference curve through (C0 . y 1 + f( y 0 . C1 ≥ y1 and C0 ≤ y0).f ′ X * ) ( 0 * * * * * (III. Hence. ( 0 0 0 0 0 (III. Because there is no exchange market. the Consumption Possibility Frontier has a vertical portion for C1 ≤ y1.C1 ) as ( dC 1 / dC 0 )U =U * = . Figure 4 plots the Consumption Possibility Frontier along with a graphical solution of the optimal consumption-production program (C0 .e.X0 ). * * * 43 .8) Assuming that the optimum is interior. As was done in Case 1. we can rewrite (III. to consume more in the current period. as shown in Figure 4.C 1 ] = f ′ X 0 ) where * C1 = y1 + f(X 0 ) * * * and the optimal amount to plant. we have from (III. y 1 + f( y 0 .10) where U = U[C0 .C0 .f ′ y 0 . y1.9) * * * * ( * U 1 [ C 0 .1) that (III.C* )U 2 [ C* ..C 1 ]/ U 2 [ C 0 .

we see that r serves as a surrogate for the market rate r. Production Within an Exchange Market Economy We maintain the same assumptions about the consumer's endowment of exogenous income and a production technology as in Case 2. In this environment his current wealth.4). Case 3. r . the productivity of (physical) investment. and hence illustrates a second reason for a positive rate of interest: namely. However. Merton Figure III. we can define an "implied" or ′ * "technological" rate of interest. by 1 + r ≡ f ( X 0 ). By comparing (III.Robert C. W0. we now allow for an exchange market as in Case 1 where the current market price of next period's goods is P = 1/(1+r). can be written as 44 .10) with (III.4 Although there is no market rate of interest in Case 2.

(III. X0. Note that unlike in Case 1. the consumer's current wealth is affected by one of his decisions: namely.PU 1 [ C* . As in Cases 1 and 2. if he buys inputs today with a current value of X0.C* ](Pf '( X * ) .C 1 } 0 + Py1 + Pf( X 0 ) . the amount of physical production he undertakes. 0 1 0 1 45 .C1 ) denotes the quantities chosen for the optimal investment-consumption program.e.X 0 where the first two terms on the right-hand side represent the current value of his endowment of exogenous income and the last two terms represent the net current value of operating his production technology with an input intensity of X0. C* ] + U 2 [ C* . so as to maximize U[C0.12b) where (X0 .C1] subject to the budget constraint that W0 = C0 + PC1. Because there now exists an exchange market. the consumer can borrow against future income to either consume or invest in physical production in the current period.X 0 .Finance Theory (III.PC 1 .. C* ] .11) W 0 = y0 + Py1 + Pf( X 0 ) . and * * * ∂U/ ∂ X 1 = 0 = U 1[ C * . (X0.C0. That is. The difference between the two is the net increment to his current wealth from operating the technology at that intensity. then he will receive an output next period of f(X0) which has a current value of Pf(X0). Substituting for C0 from the budget constraint.C1).C0 .12a) and (III.1) 0 0 1 ∂U/∂ C 1 = 0 = . the consumer chooses an investment-consumption program.6) in Case 2 is no longer a constraint i. we can write the consumer choice problem as Max U[ y { X 0 . C 1 ] which leads to the set of first-order conditions for an interior maximum (III.

we see that. and hence independent of who owns the production technology.y1).C1 ] > 0. the optimal amount to invest in physical production..PC1 .13a) can be derived as follows: as previously noted. U. X 0 . Merton C0 = y 0 + Py1 + Pf(X 0 ) .13a) ′ 0 f ( X * ) = 1/P = 1+ r . unlike in (III. Hence.X 0 .14) dW0 /dX 0 = 0 = Pf '( X 0 ) . * * * * * * By inspection of (III. two consumers with quite different preferences between current and future consumption and with quite different endowments. I. Such a result about physical production is called an efficiency condition because it is independent of either preferences or endowments. X0 is the solution to the problem: ** Max [ y { X0} 0 + P y 1 + Pf( X 0 ) . then from (III. and we can rewrite (III. the current wealth of the consumer is affected by the choice of production intensity. One interpretation of the optimality condition (III. (y0. but who face the same market rate of interest and have the same production technologies.1 ** 46 .9) of the Robinson Crusoe Case 2. or his endowment.11).12a) as (III. Because the consumer is assumed never to be satiated.13a). U1[C0 . will choose the same level of physical investment in their technologies. does not depend either upon the * consumer's preferences.Robert C.X 0 ] which leads to the first-order condition for an interior maximum (III. W0 can be written as W0(X0). X 0 . If * X0 ** denotes that amount of physical investment which maximizes the current wealth of the consumer.e.

1/P = . First. Hence.12b). optimality condition (III. the existence of an exchange or capital market will not only affect the patterns of consumption chosen but also will alter the allocation of physical investment among the various technologies. W0 ≡ y 0 + Py1 + Pf(X 0 ) . However. From (III. Consider now the second optimality condition (III.13b) with (III.(1 + r) .X 0 . choose physical investment so as to maximize current wealth. discussion of these implications is postponed until Section IV.1). * * * 47 . the consumer is better off in the presence of an exchange market than he was in the Robinson Crusoe framework of Case 2. a composite of Figures 3 and 4.Finance Theory which is identical to (III.13a) can be interpreted as saying "Choose physical investment so as to maximize one's current wealth. Figure 5 provides a graphical solution of the problem. i.e." This is called the Value Maximization Rule and it has significant implications for the theory of Finance..13b) * * ** * ( dC 1 / dC 0 )U =U * = . C1 ) as (III. one can describe the solution of the optimal investment-consumption program for the consumer as taking place in two steps. as in the case of pure exchange. As inspection of Figure 5 clearly demonstrates. X 0 = X 0 . and in so doing affect the total output for the economy. Hence. Hence. Second. Comparing (III.13a). feasible consumption allocation.4). use the exchange market to borrow or lend (against this maximized wealth) so as to achieve the most-preferred. in essence. we find that it is identical to the optimality condition in the Pure Exchange Case 1 if we use as current wealth. it can be rewritten in terms of the slope of an indifference curve through the point (C0 . and is.

Robert C. there are (T+1) different claims traded in units where the τ th 48 .5 Note: By trading.C1.. at each point in time.T. Specifically. There exists an exchange market which is open each period and allows for trading the current period's consumption good and claims on consumption goods in the future.. Merton Figure III.... Let yt denote the exogenous income he will receive in period t...CT] where Ct is his consumption in period t. t = 0.. t = 0. he reaches a higher indifference curve.. The Multi-Period Consumption and Allocation Decision: The T-Period Case We now extend the previous analysis to a consumer who lives for T-periods with a utility function for lifetime consumption described by U[C0..CT-1.T...

... τ =0 Provided that satiation is ruled out. and rewrite the problem as { C 1 .. the consumer's feasible consumption set is the set of all consumption programs that he can afford to buy. then Pt(0) = 1. it must satisfy ∑ P ( τ )C ≤ W 0 T τ 0 which defines the feasible consumption set.C T } Max U[ W 0 .C* ] P0 ( τ ) + U τ +1 [ C* .T...Finance Theory such claim gives its owner the right to one unit of the consumption good payable τ periods from the date at which it is issued. In effect.C T ] T τ =1 which leads to T first-order conditions (III.. for all t. these claims are pure discount loans as defined in Section II.CT] subject to the budget constraint that W 0 = ∑ P0 ( τ ) Cτ T ..16) 0 = -U 1 [ C* ... for a consumption program to be feasible....C 2 .. at date t = 0 can be written as (III. the consumer's current wealth. by convention.C* . Hence. If.. the current period's (or "spot") price of the consumption good is taken as numeraire'.e..τ = 1... 0 1 T 0 1 T th where Uτ ≡ ∂U[C0.....C* ...C T) * * * is the optimal consumption program with 49 ...C 1...T.. we can substitute for C0 from the budget constraint.2.15) W 0 = ∑ P0 ( τ T τ =0 ) yτ . As in the two-period analysis..CT]/∂Cτ-1 denotes the partial derivative of U with respect to its τ argument and (C 0...C 1 . Let Pt(τ) denote the price at date t of a discount loan which pays one unit of the consumption good τ periods from date t (i..C1... τ = 0. at date t + τ).C 2 . the T-period consumer allocation problem is formulated as maximize U[C0. In the absence of any production capabilities.. Noting τ =0 that P0(0) = 1..C* ].C1. W0.∑ P0 ( τ )C τ .

.. C 1 .......C 1 ...X1t. we can write the current wealth of the consumer as W 0 = ∑ P0 ( τ ) yτ + ∑ P0 ( τ ) f τ ( X 0τ .17) U t+1[ C 0 .11) in the two-period case.. * 0 T τ In words.T .T) where Xjt is the amount of input required to be invested in period j.∑ P0 ( τ τ =0 )Xτ where X τ ≡ j=τ +1 ∑ T X τ j is the total amount of inputs required in period τ to allow production plan {ft}.τ ) ..2...C T ]/ U s+1[ C 0 ..t–1). C T ] = P 0(t)/ P 0(s).T–1. τ =1 τ =0 50 .. s.. by (III. (III.. (t=1. X τ -1. P0(τ).. to the marginal cost of current consumption.18) τ =0 τ =1 T -1 .t) denote the production function for output in period t. Define the net increment to the consumer's current wealth of production plan {ft}.. Generalizing the production function description of the technology from the two-period case... let ft(X0t....16) says that at the optimum. P0(0) = 1. X 1τ .. (j=0.∑ P0 ( τ T T -1 ) Xτ . we have that (III.. V0..Xt-1.19) V 0 ≡ ∑ P0 ( τ ) f τ ( X 0τ . From (III. X 1τ .16)... Merton C =W 0 - * 0 ∑ P ( τ )C . τ = 0.1. we now expand the analysis of the T-period case to allow for production.. X τ -1. the ratio of the marginal τ =1 utility of consumption should just equal the ratio of the marginal cost of consumption in period τ to the marginal utility of current consumption in period τ..τ ) T T (III.1. t = 0.. in order to produce output ft in period t...2.Robert C. In an analogous fashion to (III. * * * * * * As with Case 3 of the two-period analysis.

1...13a) in the two-period case of choosing a physical production program so as to maximize the consumer's current wealth carries over exactly to the T-period case. Indeed..... C τ 0 0 =1 T 1 ⎤ . C* . j = 0.18) and (III...1.Finance Theory The combined investment-consumption choice problem is formulated as choose the production and consumption program so as to maximize U[C0..... and therefore the Value Maximization Rule applies in the general T-period case...13a) in the two-period case.. the set of {Xjt} which maximizes W0 are the ones that maximize V0. C * .20a) simply says choose physical production so as to maximize current wealth......... j = 0....20b) shows that it is identical to the first-order conditions for the pureexchange case (III.t-1 and t = 0.CT) and (Xjt..C1.. Substituting for C0 from the budget constraint.1. j = 0... 51 .. Hence.. the first-order conditions (III.CT] subject to the budget constraint that W 0 = ∑ P0 ( τ ) yτ + V 0 = ∑ P0 ( τ ) Cτ .... the interpretation given to (III. 0 1 T Noting that U1 > 0. and in that form.T-1) so as to ⎡T Max U ⎢∑ P0 ( τ ⎣τ =0 ) yτ + V . the τ =0 τ =0 T T problem can be rewritten as choose (C1. But... C* ] .∑ P ( τ ) Cτ . C* .U 1 [ C* ... Inspection of (III.T-1. the set of first-order conditions that maximize V0 are simply ∂V0/∂Xjt = 0. From (III.20b) ∂U/∂ C τ = 0 = . (III..1 and t = 0...T ...t-1 and t=1.16) where the level of current wealth used is the maximized value.. τ = 1. C T ⎥ ⎦ which leads to T(T+1)/2 first-order conditions for the production choices ∂U/ ∂ X jt = 0 = U 1[ C * .19).1 and T first-order conditions for the consumption choices (III.t .T .. C* ] P0 ( τ ) 0 1 T + U τ +1 [ C* ..20a) ∂V0 / ∂ X jt ... C * ] 0 1 T (III..20a) can be rewritten as ∂V0/∂Xjt = 0.. are simply the generalization of condition (III..

first. use the exchange market to borrow or lend so as to achieve the most preferred feasible consumption allocation. Suppose further that the consumer consumed C 0 units at date t = 0.. The consumer choice problem at date t = 1 can be formulated as choose (C1. In the previous analysis. in essence.1) Cτ where W1 is his τ =1 T 52 . We have already shown that the fundamental behavioral characteristics (such as the Value Maximization Rule) deduced in the two-period case carry over to the general T-period case.. On the Connection Between the T-Period and Two-Period Analyses While the T-period consumer choice is a more realistic description of the world than the two-period formulation...CT] subject to his budget constraint W 0 = ∑ P0 ( τ ) Cτ T .CT ] subject to his budget constraint W 1 = ∑ P1 ( τ . as was shown in the two-period case. * Hence.CT) so as to maximize U[C0.. Merton W 0. Not only does this connection between the two problems make the analysis of the T-period problem more tractable.. the analysis is more complex and is burdened by a barrage of notation.C1...Robert C. Second...CT) so as to maximize U[C0 .C1 .. Moreover... it does not readily lend itself to the relatively intuitive graphical display of the solution. Suppose we move ahead one period to τ =0 date t = 1. we solved the entire lifetime consumption choice problem by having the consumer choose at date t = 0. (C0.. the general T-period problem can always be structured so as to "look like" a two-period problem.C2. the solution of the T-period optimal investment-consumption program for the consumer can be described as taking place in two steps: namely.C1. but it also provides the appropriate framework for studying the intertemporal consumption-investment choice problem in an uncertain environment.. We now show that. choose physical investments so as to maximize current wealth..

W 1 ]. the choices made for C1..P1 (T-1)}.... Hence...C .. Note: C0 is not a choice variable at t = 1 because whatever was consumed at time t = 0 is now past history. we arrive at the (T-1) first-order conditions that 0 = .C2.16).C 1 .. a shortened form for J is simply to write it as " J[ C 0 . * W1.. they can be treated as parameters. at t = 0....C 2 .CT must be the best one can do 53 . 1 T * * * J is the "level" of utility associated with a consumption program of ( C 0 . and in analogous fashion to (III....21) + U τ [ C .. τ =2 ..1)] ≡ U[ C 0 . P 1(T ...1) Cτ . +1 0 1 * T * * C 1 = W 1 .. C * ...Finance Theory wealth at date t = 1....C ] P ( τ .... the prices Define the function J by (III." Return now to the original problem of selecting an optimal consumption program at time t = 0. We can solve the optimal choice problem at t=1 in the same way that the problem was solved at t = 0.C T ) . Of course. and the form of the utility function U.1) * * 2 * T 1 T where * * From (III....W 1.C .U 2 [ C 0 . P 1(1).CT ) will depend upon the amount of wealth {P1 (1)..22) J[ C 0 ..∑ P1 ( τ .. the consumer is free to choose any (feasible) level for C0.C ] .21).1) Cτ .C * ] . and is the maximal level of utility (corresponding to the most preferred feasible program) conditional on consuming C0 units at date t = 0 and having wealth W1 at time t = 1.. C 2 . it is clear that the optimal solution τ =2 (C1 . τ = 2.T.∑ P 1 ( τ T (III. A necessary condition for a consumption program to be optimal is that whatever level of consumption is chosen for C0.. Because the prices {P1(τ)} are not affected by the choices made by the consumer.W 1 . C0 .

whatever part of current wealth that is not currently consumed will grow in one period by the one-period interest rate.. can be expressed in terms of wealth at time t = 0 as (III. I. J will be a well behaved.e. Expressed in this way..e. we have that wealth at time t = 1.. In effect.W * ]/ P0 (1) 0 1 0 1 54 . J is sometimes called the indirect or derived utility function.C 0 )/ P0 (1)] which leads to the first-order condition (III.J 2 [ C* .... Merton conditional * * on * having chosen level C0 . is exactly what C1 . the consumer still only gets direct utility from consumption. (quasi) concave function in (C0. we can reformulate the consumer choice problem at t = 0 as: Choose current consumption.CT represent in the t = 1 problem just solved where they represent the best the consumer can do conditional on having chosen to consume C0 at time t = 0. is a well behaved. To solve the problem.C1]" and "W1" replaces next period consumption "C1" i. Hence.24) 0 = J 1 [ C* .( W 0 . C0. Further. That. wealth W1 acts as a "surrogate" for future consumption so that the utility "tradeoff" between C0 and W1 is really a tradeoff between current and future consumption. so as to maximize J[C0.Robert C. and provided that the direct utility function.. has utility depending upon (next period's) wealth. except for some notational differences.C 0 ]/ P0 (1) . the T-period consumption problem can be reformulated as a two-period problem. J. W1. of course.. having solved the conditional (on t = 0 consumption) optimization problem as of t = 1.C1.W1). U[C0.. this problem is in essence the same as the two-period choice problem solved in Case 1 of this section where the utility function "J" replaces "U[Co. Although in the formulation the utility function.23) W 1 = [ W 0 .CT].W * ] .W1] subject to the budget constraint W0 = C0 + P0(1)W1.. we substitute for W1 using the budget constraint to get: Max J [ C C0 0 .C 2 . (quasi) concave function.

While the explicit development of this technique is more appropriately the subject of an advanced treatment of Finance.4). Although the derivation presented here is more descriptive than rigorous. the analysis can be made rigorous by using the mathematical technique of dynamic programming. Figure 6 provides the graphical solution which is Figure III.W 1) as (III. we can rewrite (III.1/ P0 (1).24) in terms of the slope of an indifference curve through the point (C 0.W 1].6 analogous to the one displayed in Figure 2 for the two-period problem. 1 where J ≡ J[C 0. the interested 55 .Finance Theory where subscripts denote partial derivatives of J with respect to the appropriate arguments and W1 ≡ (W0 . As in (III.C0 )/P0 (1).25) * * * * * * * ( dW * /d C 0 )J = J * = .

In summary. Merton reader can find its development in the context of this problem in Fama [American Economic Review. 56 . While this manifest function of the exchange market more than justifies its existence (indeed. we have shown that the creation of financial securities and an exchange market will make the consumer better off. In so doing.Robert C. we showed that an exchange market was the only means by which an individual consumer can convert future income or output into current consumption. if such markets did not exist. In particular. it has an important latent function as the means for permitting an efficient organization of the economy's production. we would have to invent them). we have solved the general intertemporal consumption-investment problem in a certainty environment. This important latent function is the topic of the next section. March 1970].

In that model. capital markets. why is this the structure that we observe? What changes in the analysis of Section III are induced by this separation of ownership from management? How can an efficient allocation of resources be achieved with this (at least partial) centralization of production decisions? To answer these questions. and therefore the right to one hundred percent of the output of the firm.IV. Clearly. we begin with the following stylized description of the formation of a business firm. and business firms. the consumer has "turned over" the production and financing decisions to the manager but still retains complete (albeit indirect) ownership of the technology through his ownership of the firm's stock. and then raise the additional resources necessary to carry out the production plans. Second. it was shown that in the presence of a capital market the optimal production rule was to choose investment so as to maximize one's current wealth. for most modern economies. ON THE ROLE OF BUSINESS FIRMS. In the previous section. In return. since the manager is hired by the owner. In this structure. What is not so clear is how he can achieve this goal. we expand upon that analysis to explain the role of business firms. This empirical fact raises several questions. Of course. we saw that the creation of a capital market made households better off even in the simplistic environment of certainty. the consumer-owner of the technology made the production decisions. Specifically. the individual of Section III (the "founder") forms a corporation and contributes his technology described by the production function f to the firm. In Section III. and therefore all technologies were presumed to be owner-managed. he receives ownership of the whole firm. In particular. the manager's job is to make decisions which are in the best interests of the owner. In this section. FINANCIAL INSTRUMENTS. The former is called the investment decision and the latter is called the financing decision. AND MARKETS IN AN ENVIRONMENT OF CERTAINTY Every modern economy has as part of its institutional structure financial instruments. a majority of production is carried out by business firms whose managers are not the (sole or even majority) owners of the firm. the manager could review each decision with the owner 57 . the manager must choose the amount of physical production to undertake. he hires a manager (or technocrat) whose job it is to run the firm. First. However.

Merton including the production choices. the owner would have to have the same knowledge and spend essentially the same amount of time as he would as an owner-manager. to be feasible. Thus. and ask him which combination he prefers. There are a variety of ways to restate the operational criterion by which the manager should make the investment decision for the firm. for a large corporation in the United States. in that case. Therefore the manager can follow the "right rule" without polling the owners with respect to his decisions." To see this.20a) of Section III that an individual owner would choose the investment plan which maximizes his current wealth. However. etc. while this procedure might be feasible when there is a single owner of the firm. the "right rule" should not require the manager to know the tastes or endowments of the owner(s) because such data are virtually impossible to obtain. it does not depend upon the tastes or endowments of the owners. it follows that the right rule for the manager is to choose investment so as to maximize current stockholders' (owners') wealth." Because it was shown in (III. One such restatement is: "Choose investment so as to maximize profits. the owners of the corporation change every day.20a) will show that the optimal investment decision depends only upon the structure of the production technology and market interest rates (i. consider the two-period case of Section III where the 58 . and even if the data were available as of one point in time. Indeed. a feasible or operational rule for managing the firm should not require the manager to "poll" the owner(s) about his decisions. Moreover. since shares of stock change hands every day. bond prices). and therefore there would be little point in hiring a manager to "run the business".13a) and (III.13a) and (III. Specifically. inspection of (III. If a feasible rule for the manager to follow were found which would lead him to make the same investment and financing decisions that each of the individual owners would have made had they made the decisions themselves. Indeed. cost of obtaining capital.. Moreover.e. the right rule should be independent of who the owner or owners are.Robert C. the number of shareholders or "owners" can range from several thousand to over a million. it becomes increasingly more difficult as the number of owners becomes large. to be effective. then such a rule would clearly be the "right rule. Hence. Furthermore.. they would change over time. and so it can be made without any specific information about the owners.

Finance Theory production technology available to the firm is described by f(X0) with X0 denoting the input provided at time zero. If, as defined in Section III, P = 1/(1+r) is the price today of a unit of output delivered next period, then by selling the (future) output of the firm today, the current revenues of the firm are Pf(X0) and the current profit, ∏ , equals current revenues minus costs or ∏ = Pf(X0) - X0. If the manager chooses X0 so as to maximize ∏ , then the chosen amount of investment X 0 will satisfy Pf ‘(X 0) = 1 which is exactly condition (III.13a). This restatement of the operational criterion is also valid in the general case of T-periods and uncertain cash flows to the firm provided that "profit" is defined in a very technical fashion. However, it can be misleading if one applies the common (accounting or flow) usage for the word "profit": namely, "profit in period t" is equal to period t gross cash flow minus period t costs. So, for example, if the production process requires many periods, then which period's profit is to be maximized? Or if either future revenues or costs are uncertain, then what is the meaning of "maximize profits" when profits are described by a random variable? A second restatement of the operational criterion is: "Using market interest rates, choose investment so as to maximize the present value of the firm's net cash flows." This is the Present Value Rule deduced for choosing among claims in Section II where the discount rates used are the market interest rates because these represent the "cost of money" to the firm. In the twoperiod case of Section III, the net cash flow in period 0 is – X0 and in period 1 is f(X0). Hence, from (II.40), the Present Value Rule says "choose X0 so as to maximize – X0 + f(X0)/(1+r)." The maximizing amount of investment, (III.13a). In the general T-period case of Section III, P0(t) denotes the current market price of $1 payable t periods in the future. The discount rate for period t cash flows, Rt, is defined in (II.37). Because the Present Value Rule is to be applied using market interest rates, we have from the present value formula (II.39) with x = 1 that P0(t) = 1/(1+Rt) . If, as in Section III, ft denotes production output in period t and Xt denotes the total amount of inputs required in

t * *

X 0 , will satisfy f ' X 0 = 1 + r which is exactly

*

( )

*

59

Robert C. Merton period t, then (ft - Xt) is the net cash flow in period t, t = 0,1,...,T. Therefore, from (II.40), the Present Value Rules says "choose production inputs, (Xjt, j = 0,...,t-1 and t = 1,...,T-1) so as to maximize the present value of the net cash flows, PV0" which can be written as

(IV.1)

PV 0 ≡

∑ [ f τ ( X 0τ , X 1τ ,..., X τ -1,τ ) - X τ ]/(1+ Rτ )

τ =0

T

τ

.

**Noting that f 0 ≡ 0 and X T ≡ 0, we can rewrite (IV.1) as
**

τ PV 0 = ∑ f τ ( X 0τ , X 1τ ,..., X τ -1,τ )/( 1 + Rτ ) - ∑ X τ /( 1+ Rτ ) . τ τ =1 τ =0

T T -1

(IV.2)

τ However, P 0 ( τ ) = 1/(1 + Rτ ) . Therefore, from (III.19) and (IV.2), PV0 = V0. Hence, the set

of

choices

for

Xjt

which

maximize

PV0

will

satisfy

**∂ PV 0 / ∂ X jt ≡ ∂V 0 / ∂ X jt = 0, j = 0,1,...,t - 1 and t = 1,...,T-1 which is exactly condition
**

(III.20a). Thus, unlike the "Profit Maximization" restatement, the "Present Value Rule" restatement causes no ambiguities when the production process involves many periods. However, like the "Profit Maximization" restatement, the Present Value Rule is not well defined if the future net cash flows are uncertain i.e., what does it mean to maximize the discounted sum of T random variables? A third restatement of the operational criterion is: "choose investment so as to maximize the current market value of the firm." In the two-period case, we determine the current market value of the firm as a function of the investment decision X0 as follows. Suppose the firm chooses to operate its technology at the intensity X0, and makes known to the public what its plans are. At this time which is prior to the actual raising of the necessary funds to implement the production plan, a market price for the firm is established. Call this market value V_. Note: since, at this point, the original owner or "founder" still owns one hundred percent of the firm, V_(X0) is the market value of his ownership (contingent on the firm being operated at intensity X0). Moreover, although the firm has neither implemented its production plan nor even raised

60

Finance Theory the necessary funds to purchase the inputs, the founder could actually sell either all or part of his holdings for λV_ where λ is the fraction of his holdings that he chooses to sell. To determine V_, we first establish what value the firm will have after it has raised the necessary additional capital and entered into production. This value, call it V+(X0), is determined by noting that it must be priced to yield a return competitive with other securities available to investors. In the certainty environment, this competitive rate of return will be the interest rate r. Since the end of period value of the firm will be f(X0), V+ must satisfy (1+r)V+(X0) = f(X0), and therefore V+(X0) = f(X0)/(1+r). The firm can raise the additional capital by either issuing debt or more equity. In either case, it must raise $X0 to realize the production plan. If it is done by a debt issue, then the firm issues a claim promising to pay a fixed amount, b, at the end of the period. If investors are to provide $X0 to the firm today, then b must be chosen so that they will earn the competitive interest rate r on their investment i.e., b = (1+r)X0, and the current market price of the debt will be $X0. By definition, the market value of the firm is equal to the market value of its liabilities which in this case are debt and equity. Hence, the market value of equity will equal V+(X0) - X0. But, under this financing arrangement, the founder retains ownership of all the equity, and therefore

V_ (X 0 ) = V+ ( X 0 ) - X 0 or V_(X 0 ) = f(X 0 )/(1+r) - X 0 . Hence, if the

manager chooses X0 so as to maximize V_(X0), then that X0 will satisfy (III.13a) and will, therefore, coincide with the decision which would have been made by the owner had he made it. If the necessary capital is raised by issuing additional equity, then the original owner(s) must give up some percentage of the equity. As with debt, the additional equity must be priced to yield a competitive return. If γ is the percentage ownership given to the new shareholders, then the value of their holdings as of next period will be γ f(X0). Therefore, to raise $X0 today, γ must be chosen so that γ f(X0) = (1+r)X0 or γ = (1+r)X0/f(X0). Under this financing method, the original owner's holdings will be worth (1–γ)V+(X0) = f(X0)/(1+r) – X0 = V_(X0) which is the same as for the debt financed case. So, for either form of financing the right rule is to maximize V_(X0).

61

Robert C. Merton To complete the analysis, suppose that in fact the firm has other assets in addition to the production technology represented by f. Suppose these other assets are simply cash in the amount of $C. By an analysis similar to the ones just used, one can show that V_(X0) = f(X0)/(1+r) – X0 + C. Hence, even in the case where C ≥ X0 so that no external financing is required to implement the production plan, the value-maximization rule leads to the right decision: Namely, choose X0 = X 0 such as to satisfy f ‘(X 0) = 1+r. Using similar arguments in the general T-period case, one can show that the current market value of the firm, V_, is equal to V0 as defined in (III.14). Hence, if the manager chooses the production inputs {Xjt} so as to maximize V_, then the resulting choices will maximize V0 which is exactly condition (III.20a). Therefore, the "Maximize Current Market Value" Rule leads to the correct decisions when the production process involves many periods. Although we have not as yet analyzed the case where future cash flows are uncertain, it is clear that in that case the current market value of the firm is still well defined. (E.g., the future cash flows of the IBM corporation are uncertain, but there is a current price for its stock which is not uncertain). Hence, unlike the other two restatements, the "Maximize Current Market Value" Rule causes no ambiguities if future cash flows of the firm are uncertain. Moreover, as will be shown later in these Notes, provided that the capital markets are competitive, this Rule leads to the "right" decision even in an uncertain environment. In summary, the objective or criterion function for the firm is its current market value, and good management is to make decisions so as to maximize the firm's criterion function. Provided that managers operate in this fashion, an efficient allocation of the economy's productive resources can be achieved with the ownership and management functions separated. Note that the existence of a well-functioning capital market is essential to the feasibility of this efficient separation. Of course, the manifest function of the capital market in terms of the firm's actual transactions is to provide a means for the firm to raise the necessary resources to carry out its production plans. However, an equally important, but latent function is to provide information which is necessary for the manager so that he can make the "correct" decisions about operating the firm. Specifically, while it is reasonable to assume that a good manager will have

* *

62

Finance Theory as much information about his firm's production technology, {ft}, as anyone, such "internal (to the firm)" information is not sufficient to make decisions. Indeed, in the absence of a capital market, we saw in (III.9) that, in addition, the manager would require "external (to the firm)" information: Namely, the tastes and endowments of the owner. While, in the presence of a capital market, the manager no longer requires this specific set of external information, he still requires external information in the form of interest rates or prices. The existence of a capital market allows the manager to substitute one set of external information which is relatively easy to obtain for another set which is virtually impossible to obtain. In essence, prices in the capital market "capture" all the essential information about tastes, endowments, and other investment opportunities that the manager requires to make the correct decisions. In reaching these results about the appropriate criterion function for the firm and the role that capital markets play in the allocation of the economy's productive resources, we have made a number of abstractions from reality: Namely, we assume perfect certainty about all current and future events, and a "frictionless" world with no transactions costs, no indivisibilities, all information available to everyone at no cost; and no explicit labor costs including management's compensation. Moreover, we assumed that both individuals and firms behave competitively with respect to their transactions in the capital markets. While, under these hypothesized conditions, the owner would be just indifferent between the owner-manager structure or the separated structure of a non-owner manager who makes decisions so as to maximize market value, the introduction of the slightest "frictions" will generally lead to a definite preference for the separated structure. For example, a standard division of labor argument would lead to a definite preference for the separated structure if either the cost of paying the professional manager is less than that which the owner could earn in some other occupation or for the same cost, a professional manager could be found who has a superior understanding of the firm's technology. Indeed, in an owner-manager structure, the owner must have both the talents of a manager and the financial resources necessary to carry out production. In the separated structure, no such coincidence is

63

Robert C. Merton required. Further, there is the "learning curve" or "going concern" effect which favors the separated structure. Suppose the owner wants to sell all or part of his technology either now or at a later date. In an owner-manager structure, the new owner will incur additional costs while he becomes familiar with the operations of the firm. If there are economies of scale (a form of "synergism"), then the separated structure is again favored because more than one person's technology can be managed within a single entity at lower costs than within separate entities. As will be shown later in the Notes, the introduction of uncertainty will cause individuals to want to diversify their investments across many technologies, and diversification is difficult to achieve within an owner-manager structure. Finally, provided that the manager has the most accurate information about the firm's technology available (i.e., he is technically competent) and provided that he uses this information to maximize the market value of the firm (i.e., he is benevolent), then the owners of the firm need to know nothing about either the technology of the firm or the intensity at which it is being operated. Hence, the separated structure allows for savings in the costs of information gathering. Thus, in an economy with production activities and a well functioning capital market, one would expect to find that, in general, the owners of business firms will not be the managers and that the ownership of such firms is dispersed among many individuals. Further, one would expect to observe that, over time, the changes in the composition of the ownership would be far more volatile than the changes in the composition of the management. However, if the

management follows the value-maximization rule, then it will be acting in the best interests of the owners at each point in time. Of course, one might be skeptical about the realism of such "mutual-admiration society" behavior. It is certainly possible for the current management of a firm to be either incompetent or malevolent, or both. Of course, the owners could "fire" the management by voting them out. However, since a major benefit of the separated structure is that the owners can remain relatively uninformed about the operations of the firm, it is not apparent how these owners could know whether their firm is being mismanaged or not. The feasibility of voting rights being a solution to the problem is further aggravated if ownership of the firm is widely dispersed. If that is the

64

customer. ( ) In response to the current + management's announced plan.. V _ X 0 ( ) + is significantly less than V _ X0 . Suppose some entity has identified a significantly mismanaged firm (i. However. * * ( ) * * Moreover. then the holdings of any single owner are likely to be so small that he would not incur the expense to become informed and to convey this information to other owners. then it * + * * 65 . Hence. Thus. the entity now sells the shares of the firm at the new market price. Note: the entity did not have to add any tangible resources to the firm to achieve this profit. Having announced the change in the firm's investment plans. the firm has production technology f(X0) and the management has announced that their investment plan is to operate at intensity + + X 0 . voting rights alone can do little to solve this dilemma. Suppose that the entity buys all the shares of this firm at the current market value. one whose management has chosen an investment plan which leads to a market value that is significantly less than the maximum value that could be achieved). While the cost of identifying a mismanaged firm will vary.V_(X 0 ). the market value of the firm will be V_(X 0). the takeover mechanism can work even if resources are not spent for the explicit reason of identifying mismanaged firms. by supposition. can. For this reason. the only expenses incurred are the cost of identifying a mismanaged firm and the cost of acquiring the firm's shares. and X 0 ≠ X 0 where X 0 satisfies f ' X 0 = 1 + r. However. Specifically. it can be quite low if the entity happens to be a supplier. by taking over the firm and changing its investment plans. the entity earns an immediate profit of V_(X 0 ) . Hence. or competitor of the firm because much of the information required may have been gathered for other purposes already. based upon the new investment plan.e. if significant mismanagement of firms were widespread. at least in part.Finance Theory situation. V0 (X 0 ). it fires the management and installs a new management that will choose to operate the firm at intensity X 0 . Having done so. there is another mechanism called the takeover which.

Of course. the effectiveness of the takeover mechanism will depend upon how much of a threat it poses for current management. Merton would pay to spend resources in search for such firms in much the same way that resources are spent on research for new physical investment projects. For much the same reason. 66 . this example illustrates how public policy objectives can be in conflict with one another where no simple resolution of the conflict is available. Indeed.e. the external check of the takeover mechanism forces management to act as if its interests were coincident with the owners. the threat of a takeover and the subsequent removal of management provides a strong incentive for current management (acting in its own self interest) to act in the interests of the firm's current stockholders by maximizing market value. this public policy will tend to reduce the threat of takeover. the gains in efficient resource allocation and reduced costs from the combined institutional structure of a well functioning capital market and owner-separated-frommanager business firms does not rest upon the delicate and naive assumption of a mutualadmiration society with no conflicts between the interests of owners and managers. in an attempt to prevent the formation of monopolies in various product markets. Moreover. In summary.Robert C. or competitor will be the entity to identify a mismanaged firm.. Because it is more likely that a supplier. whether the current management are "fools" or "knaves"). As an aside. For example. Indeed." one might expect managers to move in the direction of value maximization as simply a matter of self-preservation. Therefore. the managements of larger firms are probably less vulnerable to a takeover bid. However. in the absence of any external "checks. even in the absence of any explicit instructions from the shareholders or knowledge of the theory for "good management. it should be noted that the analysis depends in no way on whether the source of the mismanagement is incompetence or malevolence (i. and therefore the takeover mechanism serves equally well to correct either one. the Justice Department will take legal action under the anti-trust laws to prevent mergers or acquisitions which might reduce competition. because a larger market value for the firm reduces the chances for a takeover and makes the owners better off." the management of a firm with dispersed ownership certainly has the opportunity to enrich themselves at the expense of the owners. customer.

the firm legally has a "corpus. investors may have given the firm physical assets (the inputs required for production) in return for a financial asset (either debt or equity in 67 .e. a financial asset." it does not have a "soul. and to do so require external information. bonds. its value is that of a used piece of paper). When the firm raised the necessary additional capital for production. For example. have management decisions based only upon data which are "internal" to the firm. Such decisions must take into account the economic environment in which the firm is operating. The decision as to whether or not a specific project is to be undertaken should not be based solely upon the engineering and economic specifications of the project. The switching phenomenon (illustrated in Problem II. the founder gave a physical asset (the technology) to the firm in exchange for a financial asset (shares of stock in the firm) giving him a claim on the output of the firm. Thus. as such. it is worthwhile to reiterate remarks made in the Introduction. but it may have great value as a financial asset because it represents a percentage ownership or claim on the firm's physical assets and their associated earnings flows. the reader should examine with care those theories that treat the firm "as if" it were an individual and then deduce the "proper" rules for good management based upon an exogenously specified utility function for the firm. Similarly. In its purest form. the reader should be skeptical of theories that treat the firm as if it were "an island unto itself" and. In our stylized description of the formation of a business firm." and therefore has no independent right to existence. Firms are economic organizations designed to serve people by performing specific functions. a stock certificate has virtually no value as a physical asset (i..2 of Section II) clearly demonstrates that the right decision will not be invariant to these external rates. has no value for itself but derives all its value from what it gives its owner a claim on. market interest rates provide the appropriate connection with the outside environment. as a physical asset. In the analysis presented here. unlike a physical asset. While in the corporate form.Finance Theory In concluding this analysis of the business firm. and other financial instruments which are an essential part of the proceeding analyses are all examples of financial assets. Stocks.

the capital markets could not exist without financial assets. Second. because to have a positive value as a physical asset is not required for a financial asset to serve its function. stud fees. more likely.Robert C. then its value will be determined as the maximum of its value as either a physical asset or a financial asset. financial assets are relatively easy to transport from one physical location to another. However. they are reasonably liquid in that they can be sold within a short period of time at something near to the current market price. it is necessary that 68 . Unlike many physical assets. coins made from metals (e. if a financial asset also has value as a physical asset.. a right to a certain percentage of all purses. the investors exchanged one financial asset (money) for another (debt or equity). then it will cease to serve the function of a financial asset.g.e. While these services alone would be sufficient to explain the existence of financial assets.e. Merton the firm).. there are two good reasons why it is preferable that it not have any significant value as a physical asset. The principal function of a financial asset is to serve as a store of value. and sales) accomplishes divisibility without affecting the underlying physical asset. silver or gold) have frequently had the value of their (melteddown) metal content exceed their stated monetary value in which case they have ceased to be used as money. In general. Hence. First. For example. Another function served by financial assets is to allow divisibility of ownership of physical assets which are not generally divisible. Or. to use something which has a significant physical value as a financial asset is to waste scarce economic resources. For example. If its value as a physical asset should exceed its value as a financial asset. the most important reason for their creation is that without financial assets. to physically divide a race horse would be to destroy virtually all its value. stock certificates could take the form of engravings on gold bars).. the existence of financial assets lowers the requirements for information needed by both parties in order to have trade. by issuing a financial asset which provides for a fractional ownership of the race horse (i. copper. While it is not necessary that a financial asset have no intrinsic worth (i. and then the firm gave this money to another firm in return for raw materials. The types of financial assets that are traded in markets are easily identified and are of a standard form. Indeed.

and y 2 = 300. In general. the saving of each unit would have to equal its investment in physical assets. y 1 = 1500 . C 1 .4) and II II II y0 = 2700. for all units. While. C 1 .Finance Theory saving must equal investment for each economic unit. II II II II II II II U ( C 0 . For households. I I I I I I I U ( C 0 . saving equals income minus consumption. C 2 ) = log( C 0 ) + log( C 1 ) + log( C 2 ) Note that in this example. and it was the relaxation of this constraint through the introduction of financial assets which allowed the individual to choose a better allocation. savings equals current income minus current expenditures. we illustrate the benefits of financial assets and a capital market for both the pure exchange and production cases with a three-period. y1 = 1500. it is still necessary that for the economy as a whole aggregate saving must equal aggregate investment. In every case without financial assets. even with financial assets. C 2 ) = log( C 0 ) + log( C 1 ) + log( C 2 ) Similarly. in the "Robinson Crusoe" economy with no financial assets in Section III. and y 2 = 2700 . for person #II.3) and I I I y0 = 300 . both people have identical preferences and similar magnitudes of income except the time patterns of their receipt are reversed.1: No Production and No Exchange Market: 69 . we assume that the preferences and "wage income" endowment of person #I are given by: (IV. two-person economy example. we assume that the preference and "wage income" endowment are given by (IV.6). In all cases. Problem IV. it is no longer necessary that saving must equal investment for each unit. As a form of summary. Indeed. this constraint was specifically stated in (III.

1. Problem IV.r2). Merton In this case. C1 = y1 = 1500. C 0 = y 0 = 2700.e. and therefore. C 2 = y 2 = 2700. we impose the equilibrium condition that aggregate (planned) saving must equal aggregate (planned) physical investment for the economy in each period." U II I Hence. r2 = 0).Robert C. C0 = y0 = 300.08. = 9. As j j j j discussed in Section III. The equilibrium set of interest rates that allow these conditions to be satisfied is (r1 = 0. Hence. C 2 = y 2 = 300. investment. To determine the market interest rates (r1.2: No Production with an Exchange Market: Suppose now that there is an exchange market with market interest rates (r1.. j = I. t = 0. person j will choose a consumption program as follows: Max { log( C 0j ) + log( C 1j ) + log( C 2j )} subject to the constraint that solution is given by j* j C 0 = W 0 /3 j* j* j C 1 = (1 + r 1 ) C 0 = (1 + r 1 )W 0 /3 j j* j* C 2 = (1 + r 2 ) C 1 = (1 + r 1 )(1 + r 2 )W 0 /3 W0 = C0 + C1/(1+r1 ) + C 2 /(1+r1 )(1+r2 ). The current wealth of person j is given by W0 = y 0 + y1 /(1+r1 )+ y 2 /(1+r1 )(1+r2 ).5) for j = I. must equal zero i.II.r2). Similarly. both individuals have no choice but to consume their current income each period because I I "no I production" I I implies I "no storage. The optimal j j j j (IV. Ct + Ct market = y t + y t . clearing 70 . aggregate hence II and aggregate saving.08. C1 = y1 = 1500. I* II* I Because there are no means of production (including storage).2. and U II II II II II II = 9.II.

1500. t = 0. Even though Person #I's technology provides for a 100 percent rate II of return per period. Suppose further that Person #II has the (storage) production technology which transforms one unit of input this period into one unit of output next period (i.. j j j* I II market than they were in Problem IV.Finance Theory W0 = W0 = 4500.1). f t+1 = 2X t .e.2 and that I II j* U = U = 9.3: Production and No Exchange Market Suppose that Person #I has. we have that C t = 1500 for j = I.1). I II St + St . 2700) allocation chosen in the absence of storage.2). However. The reason is that his current period's income (y 0 = 300) is so small by comparison with his later period's income that he prefers to consume all his current income rather than produce.1. Therefore. in addition to his wage income endowment. equals zero in each period where St ≡ y t . his optimal choice is to not use his technology to produce any goods. However. in Problem IV. II and t = 0. aggregate saving. Hence. St = St = 0 whereas in this problem.e. Person #II could achieve the optimal (1500. I II j Problem IV. t = 0.1. I 71 . both people are better off with an exchange Note that in both problems. St ≠ 0 i. Person #I would still choose the same (300. Note that even if we had relaxed the no-production condition in Problem IV.e .. even with storage. II and t = 0. the resulting solution would not have been the same as with an exchange market.1. 1500) consumption plan using storage. 1500. one can change his allocation in either direction..1 to allow for costless storage. I f t+1 = X t . This underscores the point that storage only allows one to "transport" goods forward in time and not backwards whereas by having financial assets and an exchange market. saving need not equal investment for each unit.5).53. a production technology which transforms one unit of input this period into two units of output next period (i. (j = I.1. and from (IV.C t .

Because Person #II is producing goods with a technology which is inferior to the one owned by Person #I who is not producing at all. there is a total of 3000 available to the economy in each period.5). Under this allocation.2. As a result of the introduction of an exchange market. and C2 = 2300 with U = 9. 1500). Hence. Otherwise. For a competitive exchange market and the given technologies the equilibrium interest rates (r1. there is an obvious "loss" to the economy. I* the optimal I* consumption I* program I chosen by Person for #I is C0 = 575. C 2 = 2350. Person #I would register an indefinitely large demand for current period goods. Person #II does use his production technology to achieve the optimal allocation (1500. However. the present value of the (superior) technology will be zero. both people are better off than they were in Problem IV. Thus.182.r2) must each be greater than or equal to 100 percent. 72 . and C2 = 4700 with U = 10. this inefficient allocation is corrected by the introduction of a competitive exchange market. the wealth of each person will be equal I to the present (or "capitalized") value II of his wage income.1. if the 1200 that Person #II carries over from the current period by storage had been employed in Person #I's technology. From (IV.4: Production with an Exchange Market Suppose we now combine the production technologies of Problem IV.113. On the other hand. 1500. II* II II* II C0 = 1175. then there would have been an extra 1200 available to the economy in the second period with a corresponding compound increase for the third period. Indeed. the equilibrium rates will just equal 100 percent. W0 = 300 + 1500/2 + 2700/4 = 1725 and W0 = 2700 + 1500/2 + 300/4 = 3525.3.3 with the exchange market in Problem IV. by requiring that markets clear.Robert C. As we now show. C1 = 1150. Similarly Person #II. Merton he derives no benefit from his technology. and has the same consumption allocation as in the noproduction case of Problem IV. At r1 = r2 = 1. Problem IV.

the outstanding stock of financial assets need not change even if some units have a saving deficit. Hence.IV.4. If investment exceeds saving for a given economic unit. While the analyses and examples have been centered around private sector investment for a closed economy with no government. the same analyses and resulting benefits would apply if the two people were reinterpreted as two countries where international capital flows replaced individual savings-investment deficits. with such a market. the same analyses could be applied to less developed countries where the government is the main investment unit. it can finance this "saving deficit" by either issuing a financial asset (a liability to the issuer) or by selling an already existing financial asset. While the analyses in Problems IV.1 . the need for financial assets arises form the discrepancy between (desired) saving and investment of individual economic units.4 were structured along the lines of two individuals. Primary and secondary markets are an efficient means of channeling required investment funds to the most productive units. The following flow and balance sheet statements provide a detailed description of savings and investment flows for the case examined in Problem IV.Finance Theory In summary. the same principles apply to public investment. Thus. 73 . Purchase and sale transactions of already existing financial assets take place in a secondary market.

150 2.250 1.525) 2.000 0 3.500 1.750 (1.525 2.000 –1.250 –3.525 Person #II Aggregate Person #I Person #II Aggregate Liabilities Debt 1.525) 3.525 3.025 –2.700 0 2.250 0 Balance Sheet t = 0+ Person #I Assets Capital Bonds Capitalized Wage Income 1.700 –1.250 –1.000 1.250 2.675 0 1.225 –1.025 Net Worth Flow Statement t = 1 Person #I Person #II Aggregate (I + II) Wage Income Production Income Operating Income Interest Income (Expense) Net Income –Consumption Savings –Investment Savings Surplus (Deficit) 1.025 1.500 0 1.350 675 0 675 3.750 1.Robert C.700 0 2.525 825 2.350 2.250 (1.425 2.500 750 –750 0 74 .500 5.250 0 4.250 4.350 1.250 0 1. Merton Flow Statement t = 0 Person #I Person #II Aggregate (I + II) Wage Income Production Income Operating Income Interest Income (Expense) Net Income –Consumption Savings –Investment Savings Surplus (Deficit) 300 0 300 0 300 –575 (275) –1.350 3.000 0 3.250 5.150 75 –750 (675) 1.175 1.525 0 1.525 0 (1.500 1.675 2.525) 1.

700 2.200) 0 75 .300 200 –(2.200 150 2.700 2.200) 3.000) –(2.500 –2.500 5.700 Net Worth Flow Statement t = 2 Person #I Person #II Aggregate (I + II) Wage Income Production Income Operating Income Interest Income (Expense) Net Income –Consumption Savings –Investment (Liquidation) Savings Surplus (Deficit) 2.000 2.000) 2.200 0 220 Person #II Aggregate Person #I Person #II Aggregate Liabilities Debt 1.Finance Theory Balance Sheet t = 1+ Person #I Assets Capital Bonds Capitalized Wage Income 2.200) 2.350 2.000 4.350 2.000 –7.200 2.150 3.350 0 2.350 2.000 0 5.000 2.200) 0 (2.500 –4.000 (2.200 300 0 300 2.700 (2.200 1.000 5.350 3.350 3.700 (2.000 0 1.500 5.

and therefore will be jettisoned beginning in Section VIII at the cost of introducing a more complex structure. The most common type of fixed-income security is debt. For example. what is "promised" is not always paid. These securities are not only important because they represent a not insignificant fraction of the capital market ($800 billion of federal government debt obligations are held by the private sector). fixed-income securities part of the capital market where maintaining the certainty assumption does the least violence to reality. However. fixed-income security is contained in that subset of fixed-income securities where the promised payments will be met with (virtual) certainty. However. A default-free.V. Unfortunately. because the promised payments on fixed income securities are also the maximum payments that their holders 76 . However. The most important of these abstractions in terms of simplification was the assumption of a perfect certainty environment. and the event of not meeting a promise on a fixed-income security is called default. we were able to derive these functional characteristics using a relatively simple structure. in practice. but also because their prices provide the base yield upon which other securities' prices are determined. the only securities that fall in this class are debt issues of the federal government and its agencies or debt issues which are guaranteed by the federal government and this is because the federal government can always meet money-fixed obligations by "printing" money. we continue (at least in part) with the assumptions of Sections III and IV to analyze the "default-free". the perfect certainty assumption is also the least realistic of the abstractions made. many state and some local government issues as well as some "gilt-edge" corporate debt issues are treated as if they were default-free. THE "DEFAULT-FREE" BOND MARKET AND FINANCIAL INTERMEDIATION IN BORROWING AND LENDING In Sections III and IV. we derived some of the important functions served by a capital market in the efficient allocation of the economy's productive resources. By making a number of abstractions from reality. Strictly interpreted. This assumption ensured that the future course of interest rates were known in advance and that the promised payments on all claims would be met at the time promised. in this section. Fixed income securities are claims with fixed or stated payments promised at specified times.

every investor would prefer the second bond to the first. Suppose that there is a market in which these discount bonds are traded and that this market is "open" for trading each period. then he will purchase N2 = I/P0(τ2) bond now which will be worth $N2P1(τ2 1) next period. Further. let the investor have $I to invest now.2. Consider two bonds with maturities τ1 and τ2 respectively at date t = 0. If instead he invests in the second bond now. To see this. Then. any investor who plans to invest in the first bond now would be better off to purchase the second bond now and wait (at least) until next period to purchase the first bond. Suppose that P1(τ1 – 1)/P0(τ1) < P1(τ2 – 1)/P0(τ2). default-free fixed income security. the second bond is said to dominate the first bond because independent of preferences or time horizon. the investor will have enough money next period to buy N1 of the first bonds plus he will have [N2P1(τ2–1) – N1P1(τ1–1) left over.1)/P0(τ1) > P1(τ2 . by following the second strategy. If P1(τ1 . then by a similar argument. the first bond would dominate the second bond. in 77 . j = 1. then he will purchase N1 = I/P0(τ1) bonds which will be worth $N1P1(τ1–1) next period. At these prices. the promised yield on a fixed income security must be at least as large as the yield on a corresponding. equilibrium. The return per dollar from holding bond j over the next period is equal to the ratio of bond j's price next period to its current price. P1(τj – 1)/P0(τj). i. Since no investor would be willing to hold a dominated bond. we have that Thus. As in Section III. Hence. a necessary condition for equilibrium is that no bond dominate any other bond. By hypothesis.e.1) and date t. If he buys the first bond. suppose that there are no transactions costs or taxes. Let rt denote the one-period rate of interest that can be earned between date (t . let Pt(τ) denote the price at date t of a default-free bond which promises a payment of $1 at date (t + τ).1)/P0(τ2).Finance Theory can receive. On the Pricing of Discount Bonds and the Term Structure of Interest Rates We begin the study of default-free income securities by examining how prices are determined for discount bonds which promise a payment of $1.. N2P1(τ2–1) > N1P1(τ1–1).

1) / Pt ( τ ) = 1 + r t+1 for all dates t = 0.3) Pt+1 ( τ . and all maturities τ. we can rewrite equilibrium condition (V. Therefore. condition (V.2) can be rewritten more generally as (V. At date t = T. 2. At date t = T . the one-period return per dollar on bonds of all maturities must be the same. Pt(0)/Pt-1(1) ≡ 1 + rt. Hence.4) in terms of the average compound rate of return as 78 . Moreover.1) as (V. we have from (V. Pt(0) ≡ 1 for all t. Consider now a specific bond which at t = 0 has maturity T.3) that its price must satisfy PT-2(2) = PT-1(1)/(1+rT-1) = 1/[(1 + rT)(1 + rT-1)]. and by definition.Robert C. At date t = T-1. Because these bonds are default-free.1) P 1( τ 1 ." Further. using (II.3) that its price must satisfy PT-1(1) = PT(0)/(1 + rT) = 1/(1 + rT). .4) simply says that "the equilibrium price for a default-free.2. we can derive the price that this bond must have so that it neither dominates nor is dominated by a one-period bond at any point in time during its existence.2) P 1( τ . Continuing in this "backwards" recursive fashion. The price formula is given by (V. As the reader will note from (II.. (V.. discount bond is given by the present value formula using the current and future one-period. Merton (V. the bond matures and will therefore have price PT(0) = 1.4) ⎤ ⎡ T P0 (T) = 1/ ⎢ ∏ (1 + r j )⎥ ⎦ ⎣ j=1 and this must hold for all maturities T.37) and (II. the same argument can be used to show that for any starting date t. 1. we have again from (V. market interest rates. we can rewrite (V.38).1)/ P 0( τ ) = 1 + r 1 for all maturities τ.38).1)/ P 0( τ 2 ) for all maturities τ1 and τ2.1)/ P 0 ( τ 1 ) = P 1( τ 2 .

4).. and all maturities τ.P0(T). These yields are determined by the current prices using (V. 2. it is the practice to quote the average compound returns or yields on the different maturity bonds rather than their prices.. we have that (V. However. discount bonds of all maturities.}. I... .1)/ P0 (T)] .. In describing the cross-sectional structure of current bond prices.1)/ Pt -1 ( τ ) = P0 (t . However. from a cross section of current bond prices. This relationship can be written as (V. (V.. RT. {r1.. A "U-shaped" term structure is one where either RT+1 > RT for 79 .}.7) Pt ( τ ...Finance Theory (V.rT..1.3) and (V.6) specifies a condition on the price ratio of two bonds with different maturities at the same point in calendar time while (V.6) r T = [ P0 (T . given a complete set of current prices for default-free.8) RT = [ P0 (T) ] -1/T -1.4) to determine the current prices of default-free..6) can be combined to specify a relationship between the dynamics or time series of a specific bond's price over time and the statics or cross-sectional series of different maturity bond prices at the current time.5) P0 (T ) = 1/ (1 + RT ) .r2.. Note that the difference between (V.. given complete knowledge of the future course of one-period interest rates. one can use (V.. is called the yield curve or the term structure of interest rates.e. for all future dates t = 1.6) and (V. {P0(1). The curve generated by plotting the yield. ... Thus. discount bonds of all maturities. against maturity. the future course of one-period interest rates can be determined.1)/ P0 (t) .3) is that (V. the process can also be "reversed": namely. (V. T. one can deduce the dynamics of future bond prices and interest rates. T Thus...5). A "rising" term structure is one where RT+1 > RT for all T and is illustrated in Figure V. 2.3) specifies a condition on the price ratio of the same bond at two different points in calendar time. From (V...1 for T = 1.

if one buys a discount bond at a yield of RT(T > 1).1 illustrates these points by showing how the yields for different maturity bonds at the current time correspond to the time pattern of one-period interest rates.2. its rate of return or growth in value in each period will not be the same and. the only restrictions on the shape of the term structure are that the current bond prices implied by these yields satisfy (V. In addition. A "flat" term structure is one where RT = RT+1 for all T. While the {rT} can be deduced from {RT}. * * * * 80 . then. and indeed a plot of the rT versus T can look qualitatively quite different from the yield curve. and is illustrated in Figure V. As was discussed briefly at the end of Section II.4) and that the future one-period interest rates implied by these yields are non-negative. Moreover. in general.Robert C. the two are not equal to one another. R15. it also provides a comparison of the pattern of appreciation from an initial $1000 investment in a fifteen-period discount bond with the pattern which would be generated if each period the $1000 investment grew at the yield rate. Merton 0 < T < T and RT+1 < RT for T < T or RT+1 < RT for 0 < T < T and RT+1 > RT for T < T. in general. can be quite different from RT. one should not confuse "RT" with "rT" in interpreting the yield curve. Table V. Of course. indeed.

Finance Theory Figure V.1 A “Rising” Term Structure Figure V.2 A “U” Shaped Term Structure 81 .

Rt 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 2% 5 10 8 4 2 3 4 5 6 7 8 9 10 11 2. and hence.0% 3. the changes in 82 . this is a coincidence of the particular pattern in the one-period rates. Yields.1 Interest Rates.8 5.8 4. Although the actual and hypothetical investments are (virtually) equal at the end of period four. Similarly. t One-Period Interest Rate. and Investment Returns Comparisons Actual Value of $1000 Initial Investment Value of $1000 Initial Investment at R=6. Table V.1 and Figure V.7 4.9 5.3 demonstrates.5 5. In general.1 4.2 5. Because the bond's price dynamics must satisfy (V.6 6.Robert C.9 6.4 show that the cross-sectional pattern of yields is very different from the time series of one-period interest rates. the actual appreciation pattern from investing in a fifteen-period discount bond is very different from the hypothetical pattern generated by a constant rate of growth at that bond's yield rate.2% per Period At Calendar Time.1 along with Figure V. rt Yield.2 $1020 1071 1178 1272 1323 1350 1390 1446 1518 1609 1722 1860 2027 2230 2475 $1062 1128 1199 1273 1353 1437 1526 1621 1722 1830 1944 2065 2193 2330 2475 As Table V. As with any average.7 4. the rate of return on the bond in each period must equal that period's one-period interest rate.3). the observed erratic return pattern is a direct reflection of the variability in those rates.6 5. Merton Table V.3 5. the values of the two investments will coincide only at the maturity date of the bond. unless the term structure is flat.1 5.

the local "trough" in the yield curve between periods eight and nine occurs after the trough in the one-period rates at the end of period six. Moreover.2 percent.6 percent. from period six to period fifteen. From period one to period three. 83 . Note too that the longer-term yields are less sensitive than the shorter-term yields to a change in any one of the one-period rates.Finance Theory the yields are less pronounced than the changes in the one-period rates. for example.. because the yields are "geometric" averages. So. Finally.1 percent to 6. the one-period rates went from 2 percent to 10 percent while the yields went from 2 percent to 5. T RT < ( ∑r t t=1 )/T) . the T-period yield will always be less than the (arithmetic) average of the one-period rates for the T periods (i. However. the "turning points" or the (approximately) flat points in the yield curve always occur after the "turning points" in the one-period rates. Similarly.e. the oneperiod rates increased steadily from 2 percent to 11 percent while the yields only went from 5. the local "peak" in the yield curve at the end of period four occurs after the local peak in the one-period rates at the end of period three.

Robert C. Merton Figure V.3 84 .

Finance Theory Figure V.4 85 .

RT > RT-1 for T = 1. virtually all yield curves will exhibit a "flattening" pattern for very long maturities. for the peak in yields to coincide with the peak in one-period rates (i. then from (V...1 are patterns that hold in general. the yields for maturities in that region will also be rising (i. From (II.. Hence. Specifically. 2. 86 . the sensitivity of the yield curve between (T . if the yield curve rises significantly over an extended number of periods. From (V.Robert C.. r1 < r2 < . if he pattern of one-period rates between t = 0 and t = T is a rising one (i. the peak in the yield curve will occur after the peak in the one-period rates.RT–1)/ ∂rT → 0. RT*+1 < RT*). Moreover.9) (1 + RT +1 )/(1 + RT ) = [(1 + r T +1 )/(1 + RT ) ] 1/T +1 .41).. t = 1.T ).9). < rT*). we have that (V.1) and T to the one-period interest rate for that period can be written as (V. RT+1 = RT if and only if r T+1 = RT .. ∂(RT ..2..11) 1 ∂( RT .. the one-period rate rT*+1 would have to satisfy log(1 + r T *+1 ) < [ ∑ log(1 + r t )]/ T * which for T* much larger than one would require that rT*+1 1 T* * * << rT*.. Merton The relationships between the {rT} and {RT} illustrated in Table V.e. A similar argument applies for the trough in the yield curve occurring after the trough in one-period rates when the yield curve is declining. Therefore.4) and (V.. < > Therefore. Hence. flat or > < turning points in the yield curve correspond to maturities where rT+1 = RT. as was pointed out in (II.. we can derive the effect on the T-period yield from a change in one of the one-period rates to be (V. T Hence.e..RT -1 )/∂ r T = {(1 + RT )/(1 + r T )} .e. T Inspection of (V.10) 1 ∂ RT /∂ r t = {(1 + RT )/(1 + r t )}. Indeed. in the limit as T → ∞.T.11) shows that the longer is the maturity. the less sensitive the yield curve will be to distant future one-period rates. then almost certainly.37).5).

Using the notation developed in (II.12) Pt+dt ( τ .12) that bond prices at date t = 0 must satisfy (V. in the limiting case of continuous time. great care must be exercised in using the yield curve to draw inferences about the distant future one-period interest rates. "long-run" or "steady-state" one-period interest rate. for all maturities T. the relationship between the yield curve and future interest rates is given by (V. By using the same "backwards" recursive analysis which led to (V. For example. it is common practice to study the yield curve as if it were continuous and to assume that the one-period or "shortest" bond has an infinitesimal length of time until maturity: namely dt.4).14) P0 (T) = exp[.13) P 0(T) = exp [. such a pattern does not imply the existence of a stable. To further explore the relationship between the yield curve and future short interest rates. we differentiate (V.10) of Section II.15) to obtain 87 . then it follows that (V. While we have formulated the term structure analysis here in discrete time with an (as of yet) unspecified minimum time interval of "one period". let rc(t) denote the rate of interest between dates t and t + dt.dt)/ Pt ( τ ) = 1 + r c (t)dt.15) R c(T) = [ ∫ r c(s)ds]/T 0 T Hence. and from (V.13) and (V. we derive from (V. Equation (V. the average compound return is equal to a simple arithmetic average of the future short rates.Finance Theory Since this pattern will occur for virtually all time paths in future one-period rates.∫ r c(s)ds] 0 T .3) can be rewritten as (V. If Rc(T) denotes the average continuously-compounded rate of return on a discount bond that matures at time T in the future.Rc (T)T] .14).

Points of inflection or zero curvature in the yield curve will occur for those maturities {T } such that drc(T )/dt = 2dRc(T )/dT. Hence. The curvature of the yield curve can be studied using (V. and T ≡ 3A/4B. we have from (V. each turning point in the yield curve will always occur after the corresponding turning point in future short interest rates. T ≥ T where A > 0. and how does this pattern compare with the shape of the yield curve? From (V.2d R c(T)/dT}/T .Rc (T)]/T .17) 2 2 d R c(T)/d T = {d r c( τ )/dT .15) and (V.16) d Rc (T)/dT = [ r c (T) . we have that the time pattern of short rates implied by this yield curve can be written as 88 . B > 0. dRc(T)/dT tends to zero as T → ∞. As in the discrete time analysis. and therefore.9) in discrete time.BT .BT ]/T. > < In an analogous fashion to (V.l: Analyzing the Term Structure Suppose that the yield curve at the current time is given by: R c(T) = R + AT .Robert C. + + + * * * Problem V. turning points in the yield curve correspond to maturities < > {T } where rc(T ) = Rc(T ).16) that dR c(T)/dT = 0 if and only if r c(T) = R c(T) . independent of rc. the yield curve "flattens out" for large T. * * * At turning point maturities {T }. Therefore. What is the future time pattern of short interest rates implied by this yield curve. Merton (V. the yield curve will have a local peak if drc(T )/dt < 0 and a local trough if drc(T )/dt > 0.16).16) and its derivative which is given by (V. 3 4 2 3 0≤T ≤T = R + [AT .

e.4Bt).3BT). Moreover.4Bt) . it then declines monotonically until at t = T.. we have that t ≥T . the time path of short rates starts at r c (0) = R. we have from (V. it remains constant at R . Like the yield curve. the inflection 89 . * * To examine the curvature of the yield curve. the time path of the short rates rises more steeply and peaks earlier than the yield curve (i. t>T . 3 3 T > T. * While the two patterns are similar. the yield curve starts out convex until it reaches an inflection point at T = A/3B and becomes concave on the interval (T . 0≤t ≤ T =R .Finance Theory 2 r c(t) = R + t (3A .3BT) .16). dRc (T)/dT = T(2A . t < T ). 0 ≤ T < T = AT /2T . Although both the time path and the yield curve reach their inflection points midway between the starting point and the peak. From (V.17) that 2 2 d R c(T)/d T = 2(A . T ) . rises monotonically until it peaks at t = A/2B. the peak level of the short rates * 3 2 * 3 2 r c ( t ) = R + A /4 B is higher than the peak level of the yield curve Rc ( T ) = R + 4 A /27 B . 0 ≤ t ≤ T = 0. Hence. reaches an inflection point at + t = A/4B where it becomes concave until t = T. + Hence. we derive the second derivative of the path to be 2 2 d r c(t)/d t = 6(A . the time path of short rates starts out convex. To examine the curvature of the time path of future short rates. 0 ≤ T ≤ T .∞ ). + While the first derivative of the yield curve is continuous at T the second derivative is not. and Rc is again convex for (T.

the yield curve or term structure is a plot at a given point in time of a crosssection of discount bond yield which differ only with respect to their maturities. fixed-income security with a schedule of promised payments of $xt to be paid at the end of period t. as will be seen. Merton point of the time path occurs earlier than the inflection point for the yield curve (i. In such an environment. the term structure is still well-defined. In summary.. As a form of summary. or negative in which case the owner must pay out.2. xt can be either positive in which case the owner of the security receives a payment of $xt. Of course. there will be a set of prices for discount bonds {Pt(τ)} at each point in time.6). However. we studied the price relationships among default-free... the relationship derived between current prices and future interest rates. that the yield curve and the future time path of interest rates can differ significantly. and by the definition of yield. $|xt|. 90 ..T. the yield curve frequently provides sufficient information to solve problems involving the pricing of fixedincome securities.8) to uniquely determine a set of yields {RT} which can then be plotted against maturity to form a yield curve.. the analysis shows in continuous time what Figure V. the yield curve can still be used to make inferences about the structure of the stochastic processes which describe interest rate dynamics. + + On the Pricing of the General Default-Free Fixed Income Securities In preceding analyses. t = 1.....e. with some additional assumptions. (V.Robert C.xT). once future interest rates are stochastic. discount bonds with the same promised payment ($1) at maturity. will no longer be valid. Even in an environment where future interest rates are uncertain. Consider now a general default-free. these prices can be used in (V. t < T ). Although inherently a static construct. Moreover.4 illustrated for the discrete-time analysis: Namely. We denote the equilibrium market price of this security at time t = 0 by V0(x1. the yield curve derived from equilibrium bond prices in an environment of certainty has an exact relationship to the dynamics or time path of future interest rates.

x 2 .18) must hold in equilibrium is by contradiction. By hypothesis.T. the investor will receive each period a larger payment from the alternative investment than he would receive from the general security.... δ > 0 and therefore. Define δ by δ ≡ V 0( x 1 . the investor will receive a stream of payments of $Nt at the end of period t for periods t = 1..... and a necessary condition for equilibrium is that no such dominance exists.2. Namely. Because each of the t-period maturity bonds purchased will pay $1 at date t. 91 . then we will show that the general security either dominates or is dominated by other available securities.2. The cost of acquiring these bonds is ∑ N τ P0 ( τ ) = ∑ xτ P0 ( τ ) + δ τ =1 τ =1 T T and hence.. The general security is dominated by the alternative investment. Nt > xt for t = 1.18) does not hold....2... x 2 .. is the same as the cost of the general security. if (V.T. then the current equilibrium price of the general default-free. δ > 0..18) V 0 ( x1 . xT ) = ∑ xτ P0 ( τ ). every investor would strictly prefer the alternative investment to the general security. and therefore. the hypothesized condition is not consistent with equilibrium pricing. If an investor purchases the general security for V0 then he will receive in return a stream of payments of $xt at the end of period t for periods t = 1.. fixed-income security must satisfy (V. for the same initial cost.T....... So. Hence..2.. τ =1 T Suppose that V0 were larger than ∑ xτ P ( τ ) τ 0 =1 T and hence. x T ) - ∑ xτ P 0( τ ). Consider an alternative investment which calls for the purchase of a group of discount bonds in the following quantities: Buy N τ ≡ [ xτ + δ /( P 0( τ )T)] bonds each of which pays $1 at its maturity date τ periods from now and do this for bond maturities τ = 1.T.Finance Theory If there exists a set of default-free discount bonds with current equilibrium prices denoted as before by {P0(τ)}. τ =1 T The proof that (V.

Therefore. as long as δ < 0. the net resultant of the transaction is to replace the entity's liability to pay $xt at the end of period t with a liability to pay $Nt at the end of period t for t = 1. the general security dominates the specific package of discount bonds {Nτ}.. Nt < xt for each t.. By making the transaction. δ < 0 and hence. firm. From the viewpoint of an issuer.2. form the viewpoint of a buyer. The entity that issued the general security (e. Suppose the entity purchases the general security in the market and finances this purchase by issuing Nτ discount bonds of maturity τ for τ = 1. the total proceeds from issuing these bonds ∑ Nτ P (τ ) τ 0 =1 T is equal to V0 and hence. Thus... the hypothesized condition that δ < 0 is not consistent with equilibrium pricing. and this completes the proof that (V.. the entity can make itself better off by purchasing the general security and financing its purchases by issuing the appropriate quantities of discount bonds.T. By hypothesis. Merton Suppose instead that V0 were smaller than ∑ xτ P ( τ ) τ 0 =1 T and hence δ < 0. or financial institution) is required to make a payment of $xt at the end of period t to the owner of the general security for periods t = 1.Robert C. the existence of an arbitrage opportunity implies that it is possible to get something of value for nothing. In effect.2. An arbitrage opportunity is said to exit if there is a set of feasible transactions which require no cash payments at any time.18) must obtain in equilibrium.T. the general security (as a means of raising money) is dominated by the alternative of issuing discount bonds. On Arbitrage Opportunities: A Special Case of Dominance The requirement that prices be such that no investment dominates any other investment is frequently called a "No-Arbitrage" (or "No-Easy Money") condition although the two are not strictly the same..g.. the entity reduces the amount it has to pay in every period. the total transaction does not change the current cash position of the entity. an individual...T.. Of course. and the resultant of these transactions is to produce positive cash receipts at one or more points in time.2.... However. 92 . As was shown.

Finance Theory

A simple example of an arbitrage opportunity would be as follows: Suppose that shares of General Motors stock were selling for $54 a share on the New York Stock Exchange while at the same time, these shares were selling for $55 on the London Stock Exchange. An investor who simultaneously sold k shares of GM on the London Exchange for a total of $55k and bought k shares of GM on the New York Exchange for a total of $54k would immediately produce a positive cash receipt of $55k - $54k = $k. By delivering the shares purchased in New York to cover the shares sold in London, the investor would eliminate any further liabilities associated with these transactions, and hence, this set of transactions requires no cash payments by him at any time. However, as a result of these transactions, the investor has immediately increased his wealth by $k. Indeed, as long as the contemporaneous prices for GM on the two exchanges are different, the investor can continue to increase his wealth by making these transactions. The investor is truly getting something for nothing. Just as the laws of

thermodynamics rule out the existence of a perpetual-motion machine, so the laws of economics rule out the existence of persistent arbitrage opportunities. As a second, somewhat more-complicated example of an arbitrage opportunity, we reexamine the analysis used to derive (V.18) with the additional institutional assumption that at least one investor can buy or issue (sell) any of the available securities in arbitrary amounts. Consider the following set of transactions: buy xτ units of a τ-period discount bond for maturities τ = 1,2,...,T and simultaneously, issue (or sell) one unit of the general security. Let k denote the number of "units" of this "package" taken by an investor where k > 0 means "buy

k xτ units of the discount bonds τ = 1,2,...,T and issue k units of the general security" and k <

**0 means "issue | k | xτ units of the discount bonds and buy | k | units of the general security."
**

⎡T At the time that the transactions are made (t = 0), there is a cash outflow of $ ⎢∑ kxτ P0 ( τ ⎣ τ =1 ⎤ )⎥ ⎦

and a cash inflow of $kV0. Hence,

T ⎡ ⎤ $kδ ≡ $k ⎢V 0 - ∑ xτ P 0( τ )⎥ ⎣ τ =1 ⎦

is the current net cash flow

to the investor. So, by choosing the sign of k such that kδ > 0, the investor receives an immediate, positive cash payment of $kδ as a result of these transactions. Note that in period t

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(t = 1,2,...,T), the investor receives $kxt from the discount bonds which mature in that period and pays out $kxt on the k units of the general security issued. Hence, for any k chosen, the net cash flows associated with the investment package are zero in every future period. Just as in the first example, the result of these transactions is to immediately increase the investor's wealth by $kδ. By assumption, the magnitude of k is not bounded. Therefore, as long as δ ≠ 0 , the investor can continue to increase his wealth without bound. So, either the investor ends up with all of society's wealth or the prices of the discount bonds and the general security change so that δ = 0. Clearly, the latter is the sensible conclusion, and therefore, by his actions, the investor will "force" prices to adjust until δ = 0. Thus, under the hypothesized institutional conditions, prices must satisfy (V.18). Although subtle, the differences between a dominance situation and an arbitrage opportunity are important. The price conditions required to rule out dominance are formally the same as the ones that rule out arbitrage opportunities, and the existence of an arbitrage opportunity necessarily implies a dominance situation. However, the existence of a dominance situation does not necessarily imply an arbitrage opportunity. To see this, consider the case where δ > 0 and therefore, a collection of discount bonds dominates the general security. Suppose this dominance situation is recognized by a specific investor. If the institutional structure permits, he can and will enter into a set of arbitrage transactions, and by his actions in the market, he will unilaterally force prices to adjust until δ = 0. However, suppose that this investor owns none of the general security and further suppose that institutional restrictions prevent him from issuing the general security. Then, at least for this investor, δ > 0 does not provide an arbitrage opportunity because the set of transactions required to institute arbitrage is not feasible. The only action that he can take is simply not to purchase any of the general security, and this action provides little, if any, pressure on prices to adjust so that δ = 0. Of course, if it is feasible for some other investor to issue the general security and if this other investor recognizes that the dominance situation exists, then this other investor can perform the arbitrage transaction and prices will adjust. Or, as described in the dominance proof of (V.18), if the investors who own the general security recognize that the dominance situation exists, then these investors will sell their holdings of the general security, and their collective

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actions will tend to force prices to adjust until δ = 0. Thus, the significant difference between arbitrage and dominance is the mechanism by which such opportunities are eliminated. In the case of arbitrage, it takes only one investor who recognizes the opportunity to force prices to adjust until the opportunity is eliminated. In the case of dominance generally, several investors with specific endowments must recognize the opportunity for the same price adjustment to obtain. For this reason, price relationships derived from a "No-Arbitrage" condition are less likely to be violated than ones derived form a "No-Dominance" condition. However, it should be pointed out that the occurrence of a significant dominance situation is an infrequent event although it will occur far more frequently than a true arbitrage opportunity. As was the case in the arbitrage derivation of (V.18), most arbitrage opportunities can be exploited only if the arbitrageur can sell securities that he does not own. While in that

derivation, the term "issue" was used to describe all such sales, it is usually only used to describe the sale of a security whose obligations to the purchaser are those of the seller. For example, if General Motors sells a fixed income security which obliges General Motors to make the specified payments to the purchaser, then General Motors is said to have "issued" that fixed income security. Such sales are called primary (market) offerings, and are rarely, if ever, made by individuals. The purchase or sale of already-existing securities whose obligations are not those of the seller is called a secondary (market) transaction, and most arbitrage transactions are of this type. A secondary-market sale of a security not owned by the seller is called a short-sale. A short-sale is accomplished by borrowing the security from someone who owns it and then selling it in the market. The terms of the "loan agreement" are typically as follows: (1) Like a standard demand loan, either the borrower (short-seller) or the lender can terminate the loan at any time. At the time of termination, the borrower must return the security borrowed to the lender by either purchasing the security in the market ("covering" his short) or borrowing the security from another lender. (2) During the time that the security is borrowed, the borrower must reimburse the lender for all payments (including interest, dividends, and other distributions) that he would have received from the security had he not lent it to the borrower. (3) The borrower may be required to post and maintain sufficient collateral to ensure his ability to meet his obligations, (1) and (2), to the lender. Unlike a conventional money loan, the lender is not

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Robert C. Merton

paid interest for lending his security. Hence, the lender earns a return equal to the one he would have received had he remained the owner and not lent the security. However, because he is no longer the owner of record, he forgoes any non-cash benefits of ownership (e.g., voting rights) while the security is on loan. Hence, for this and other inconveniences associated with lending the security including the risk that the short-seller may not meet his obligations, the lender may require some additional compensation. The usual form of the compensation is to require that at least some of the collateral for the loan be cash which in effect, provides the lender with an "interest-free" loan. Alternatively, the borrower may pay a fee or premium for the loan. In summary, the short-sale is an important transaction for the exploitation of arbitrage opportunities. Therefore, in institutional environments which prohibit short-sales, one must rely on the weaker mechanism of dominance to ensure that price relationships such as (V.18) will obtain. Fortunately, the actual institutional structure that exists permits most securities traded in organized markets to be sold short. Thus, especially in environments which permit short-sales, one would expect the price relationship between pure discount bonds and general fixed-income default-free securities to satisfy (V.18). From (V.8), we can rewrite (V.18) as (V.19)

V 0 = ∑ xτ

τ =1

T

/(1+ Rτ )τ .

From (V.19), one can evaluate any default-free security using a properly-constructed yield curve. While (V.19) looks like a present value formula, nowhere in either the dominance or arbitrage derivation of (V.18) was it required that the future time path of interest rates be known with certainty. Hence (V.18), and therefore (V.19), provide the proper equilibrium price relationships even when interest rates are stochastic. Having established the fundamental price relationship between default-free discount bonds and default-free fixed-income securities, we now demonstrate its use in a number of specific applications.

96

**Finance Theory On Coupon Bonds and Estimating the Term Structure of Interest Rates
**

As the analysis leading to (V.18) demonstrates, it is sufficient to have a complete set of current discount bond prices to determine the equilibrium price of any default-free fixed-income security. It was also shown that such a set is sufficient to construct the term structure of interest rates and forward prices. However, while discount bonds are frequently issued with maturities of less than one year, they are rarely issued with longer maturities, and this is the case not only for government debt, but for corporate debt as well. Therefore, one cannot generate the term structure by simply observing the contemporaneous prices of discount bonds for all maturities because such an array of bonds does not exist. However, by using the current prices of the default-free bonds which are available, it is possible to estimate both the "missing" discount bond prices and the term structure. The most common form for intermediate and longer-term debt is the coupon bond. Like the "Interest-Only" loans discussed in Section II, the coupon bond calls for a stream of periodic and equal-in-size (coupon) payments and a single, lump-sum (principal) payment at maturity. If

**Cj denotes the coupon payment per period for periods 1,2,...,Tj and Mj denotes the principal
**

payment at the maturity date Tj, then, from (V.18), the equilibrium price of coupon bond #j, Bj must satisfy (V.20)

B j = ∑ C j P0 (t) + M j P0 ( T j ) .

t=1

Tj

**Equivalently, the price of the coupon bond can be written in terms of yields as (V.21)
**

Tj B j = ∑ C j /(1+ Rt ) + M j /(1 + RT j ) . t t=1 Tj

Again, it should be emphasized that (V.20) and (V.21) must be satisfied in equilibrium even if interest rates are stochastic. In the special case of nonstochastic interest rates and a "flat" term structure, (V.21) reduces to (II.34) and can be rewritten as (V.22)

T T B j = C j [1 - 1/(1 + r ) j ]/r + M j /(1 + r ) j

where r is the per period rate of interest common to all periods.

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Robert C. Merton

To estimate the missing discount bond prices using available coupon bond prices, we proceed as follows: Suppose there are n coupon bonds numbered in ascending order with respect to their maturities (i.e., T1, T2 <... < Tn ≡ T where T is the maximum maturity of any of the bonds). In equilibrium, the prices of these bonds must satisfy (V.20), which can be written as the system of equations

(V.23)

B1 = C 1 P0 (1) + C 1 P0 (2) + ... + ( C 1 + M 1 ) P0 ( T 1 ) B 2 = C 2 P0 (1) + C 2 P0 (2) + ... + C 2 P0 ( T 1 ) + ... + ( C 2 + M 2 ) P0 ( T 2 ) B n = C n P0 (1) + C n P0 (2) + ... + C n P0 ( T 1 ) + ... + C n P0 ( T 2 ) + ... + ( C n + M n ) P0 ( T n ) .

Because we know the terms {Cj,Mj,Tj} and current prices {Bj} of the coupon bonds, (V.23) can be viewed as a system of n linear equations for the T (unknown) discount bond prices {P0(1),P0(2),...,P0(Tn)}. (V.23) can be rewritten in compact vector-matrix notation as (V.24)

B = AP

where B denotes a n x 1 vector of the coupon bond prices {B1,...,Bn}; P denotes a T x 1 vector of the discount bond prices; and A denotes a n x T matrix whose elements aij are: for i = 1,...,n, aij = Ci, j = 1,2,...,(Ti - 1); aij = (Ci + Mi) for j = Ti; aij = 0 for j = Ti + 1,...,T. Because (V.23) is a linear set of equations, there are well-established procedures for solving it when a solution exists. If the number of equations is fewer than the number of unknowns (i.e., n < T), then clearly, there will not be a unique solution because not enough information is available. If n = T, then a unique solution will exist provided that the n equations in (V.23) are linearly independent (i.e., the rank of the matrix A in (V.24) is equal to

**T). Such linear independence will occur if the n bonds chosen are sufficiently different with
**

respect to their terms. In this case, the solution for P is obtained by matrix inversion (P = A B). Although matrix inversion is a difficult operation to do by hand, there exist very efficient computer programs which solve these equations with little difficulty even when n is quite large.

-1

98

T3 = 3). C3 = $50. M2 = $900. C2 = $100. we can value payments to be made during the first three periods on any default-free security.2 was to illustrate how one can compute the discount bond prices needed to use (V. The resultant is 783 = 900 P0(2) or P0(2) = $0.91 – 600 × . M1 = $900. x1 = $800.18). Finally. and R3 = 8. The reader should note that the only data required in this problem were the terms and current prices for the coupon bonds.91.8) to determine the term structure: Namely. R1 = 9. we have that V0 = 800 × . and x3 = $2500? Using the above prices in (V. what is the current value for a default-free security with a stream of payments. substitute $0.79 for P0(3) in (ii) to get 100 P0(1) + 100 P0(2) = 178 and subtract this from equation (i).Finance Theory Problem V. Having solved for the discount bond prices. Consider an investing "package" 99 . Substitute $0. T1 = 2). What are the implicit current discount bond prices for periods 1.2: Using Coupon Bond Prices to Estimate Discount Bond Prices There are three coupon bonds with the following terms and current prices: (B1 = $961. and 3.87 for P0(2) in equation (i) to get 100 P0(1) = 91 or P0(1) = $0.87 + 2500 × . R2 = 7. C1 = $100.79. the analysis used also illustrates how an investor can "manufacture" discount bonds when none exists provided that short-selling is permitted.79 = $2181. using these discount bond prices.87. Nowhere was it assumed that interest rates were nonstochastic. then we find that 790 = 1000 P0(3) or P0(3) = $0. Finally. suppose the situation is as in Problem V. M3 = $950. x2 = –$600. The central purpose of Problem V.2 and an investor would like to have a three-period discount bond.17%. we have that (i) (ii) (liii) 961 = 100 P0(1) + 1000 P0(2) + 0 P0(3) 968 = 100 P0(1) + 100 P0(2) + 1000 P0(3) 879 = 50 P0(1) + 50 P0(2) + 1000 P0(3) .89%. and (B3 = $879. For example.18) and to construct the term structure.23). we now use (V.2. T2 = 3). and what are the corresponding term structure yields? From (V. If we multiply equation (iii) by 2 and subtract equation (ii) from it. For example. However.21%. (B2 = $968.

In terms of (V. the formal mathematical manipulations used to deduce implicit discount prices are the same as the ones used to determine the combination of purchases and short-sales required to "manufacture" discount bonds when such bonds do not exist. In this case. we now examine the case where the number of bonds in the sample exceeds the number of maturities (i. then the row rank will exceed the column rank.18). for a solution to exist. and no solution will exist. the pattern of returns from this investment package is identical to those of a three-period discount bond with a promised payment at maturity of $1000k.24). there are more equations than unknowns. The cost of the package would be 2k × 879 – 968k or $790k. the "extra" equations must be redundant. n > T).23)..e. Specifically. but he must pay $100k in coupon payments and $900k to repurchase the bonds he has shorted. By the same analysis. the net cash flow from the investment package at the end of period 3 is $1000k.Robert C. Hence. Thus. Thus. The economic implication of nonexistence is that not all the coupon bond prices satisfy (V. and therefore. the net cash flow from the investment package at the end of period 1 is zero. To complete the analysis of (V. and he must pay $100k entity which lent him the bonds for short sale. 100 . Hence. This point is demonstrated in the following problem. k is simply a scale factor chosen by the investor in the same way that he would choose the number of discount bonds he wants to purchase. the net cash flow from the package at the end of period 2 is zero. he will receive coupon payments of $100k on the bonds that he owns. At the end of period 3. Merton where he buys 2k units of bond #3 and sells short k units of bond #2.T) equations. and the solution for each such linearly independent subset of equations satisfies the other (n . a unique solution will exist if and only if the number of linearly independent equations in (V. he will receive $2000k in coupon and principal payments on the bonds he owns. this condition implies that both the row and column ranks of A be equal to T. At the end of period 1. either a dominance or an arbitrage situation exists among the outstanding coupon bonds. If different linearly independent subsets of the n equations lead to different values for the discount bond prices.23) equals T. and hence.

if the institutional structure permits short-sales.6 k4 units of bond #3 for each k4 units of bond #4 sold short. let k4 denote the number of units of bond #4 either owned or to be purchased by an investor and let kj denote the number of units of bond #j in the proposed dominating investment package. P0(2) = . then these prices would imply an arbitrage opportunity where the arbitrageur would purchase 1. 101 .87. if there is a solution to this system. P0(3) = . k2 = 1. Thus. j = 1. the package dominates bond #4. then the price of bond #4 must satisfy (V. I.79}. the system of equations corresponding to (V. However. If there are to be no arbitrage opportunities.3: Arbitrage Opportunities in Coupon Bonds Assume the same environment as described in Problem V. C4 = $300.e.. 300 × .23) is (i). M4 = $4000. If the {kj} are selected so as to satisfy the conditions: (a) 100 k1 + 100 k2 + 50 k3 = 300 k4.2 and (iv). Therefore. bond #4 is "overpriced" in the sense that at these prices.2. then the cash receipts from the proposed package in periods 1.3.7 k4 units of bond #2 and 2. his wealth would increase by $69 k4. The cost of acquiring the k4 units of bond #4 is $4000 k4.87 × .2. Indeed. (ii). and (iii). (b) 1000 k1 + 100 k2 + 50 k3 = 300 k4. To show this dominance.91. T4 = 3). (iv) 4000 = 300 P0(1) + 300 P0(2) + 4300 P0(3) . For each such transaction. Of course. The cost of acquiring the "package" is $961 k1 + $968 k2 + $879 k3 = $3931 k4. Thus. and (iii) are a linearly independent subset of this system with a solution {P0(1) = . 2. (ii). and 3 will be identical to the cash receipts from k4 units of bond #4 in those periods. (c) 1000 k2 + 1000 k3 = 4300 k4.20).Finance Theory Problem V. These conditions are satisfied by: k1 = 0.6 k4. (i).91 + 300 × .7 k4. k3 = 2. the cost of acquiring these identical streams of payments is not the same. (iv) must be a redundant equation satisfied by the solution to (i).79 = 3931 which is not equal to B4 = 4000. but now add one more bond with a market price and terms given by (B4 = $4000. But. based upon the prices of the other three bonds.2. From the solution of Problem V. bond #4 is dominated by the purchase of some combination of the other three bonds. (iii) from Problem V. (ii).

Therefore. conditions for equilibrium. it was shown that bond #4 was "overpriced" relative to the prices of bonds #2 and #3 in the sense that at these prices. their diversity in terms of coupon. Hence. Because only a subset of securities are examined.3. For example. can also cause errors in the price estimates obtained from (V.23). While there are many (virtually) default-free coupon bonds traded in the market. In summary. they specify conditions under which a set of prices will be internally consistent with respect to one another. and maturity is usually not sufficient to generate a unique set of discount bond prices for all maturities. relative pricing formulas provide necessary.23) to estimate both the prices and the precision of the estimates. precise estimates for the {P0(τ)} can rarely be made. However... The yield-to- 102 . if the price of bond #4 were changed so as to be consistent with the other three bond prices (i. B4 = 3931). and how these estimates can be used to identify mispriced securities.Robert C. I. Yield-to-Maturity and Duration for Coupon Bonds A frequently suggested alternative to (V. Hence. The latter is especially important in the case of municipal bonds whose coupon payments are usually exempt from federal income taxes.e. price relationships deduced from the condition that no dominance situations exist are relative pricing formulas. differences in terms.e.23) for estimating the term structure and identifying mispriced default-free securities is the yield-to-maturity method. in the solution of Problem V. However. Moreover. anyone would prefer an appropriate mix of these bonds to holding bond #4. principal.20). Merton As in the case for (V. a set of prices that satisfies such relative pricing formulas need not be one which will clear markets in equilibrium. other than those discussed here. there is not sufficient information given in the problem to determine whether or not these prices would clear the market. but not sufficient. statistical techniques can be applied to the structural equations (V. the posited prices in that problem cannot be equilibrium prices. Some examples would be differences in sinking fund and call provision and the tax treatment of the returns earned from holding the bond. we have shown how discount bonds can be estimated using coupon bond prices.

Finance Theory maturity for a coupon bond r is defined as that value of r which causes (V. trivially.8). Moreover.. Cj = 0).e. one can be assured by Descartes' Rule of Sign that there is only one real-root solution to (V. (iii) future interest rates are nonstochastic.23) in terms of data requirements and computational simplicity. it is that common per period rate of interest which would obtain if: (i) the bond price is an equilibrium price. * * By manipulating (V. these features of the yield-to-maturity method are attractive only if it provides valid estimates for the term structure and correctly identifies mispriced securities. (ii) the term structure is "flat".23) which requires a simultaneous solution of a system of equations. Cj. Specifically. and there exist very fast and accurate numerical methods for finding the root of such a polynomial equation. I. Because Bj.. Inspection of (V.25) shows that the yieldto-maturity on a pure discount bond is simply its yield R T j as defined in (V." There is no harm in such a convention unless it is misused in the resolution of substantive issues. Undoubtably. The yield method also works in identifying mispriced securities when comparing 103 .22).( B j + C j ) xT j .25) 0 = B j xT j+1 . these attractive computational features provide the genesis of the standard practice of quoting coupon bond prices as "priced to yield 100 r*j percent. To determine the conditions under which this method does provide valid estimates.25).M j x + ( M j + C j ) . to identify RT using (V. the yield-to-maturity method appears to be an attractive alternative to (V.22) to obtain for the current market price of the bond. Both methods require only current bond prices and their terms to estimate the term structure. So.e. unlike (V.23) requires a minimum of two different coupon bonds whereas a single T-period bond can be used to compute that bond's yield-to-maturity. the yield-to-maturity equation can be solved separately for each bond. However. r j is equal to (x – 1) where x is the real-root solution to the polynomial equation (V. we have that the yield-to-maturity for coupon bond #j. Certainly. we begin by examining pure discount bonds (i. and Mj are all positive. the yield-to-maturity method applied to pure discount bonds provides a valid estimate for the term structure.

1. should you "swap" bond #1 for bond #2? 104 . for pure discount bonds with different maturities. To illustrate this point. the value of the investment at the end of four periods would be $1262. as the following problem demonstrates. However. Indeed. Merton pure discount bonds of the same maturity. a principal or "face value" M1 = $4865. by investing $1000 in the alternative. In a similar fashion. consider the time pattern of interest rates and yields presented in Table V. Suppose further that bond #2 which is a 15-year bond with an annual coupon C2 = $200 and a face value M2 = $1000 is currently selling for $1545. By construction.4: Bond Swapping with Coupon Bonds Investment strategies which attempt to improve the returns on a portfolio of fixed-income securities by exchanging bonds currently in the portfolio for other bonds with the same maturity and risk are called bond swapping strategies. inspection of Table V. the discount bond prices and their yields displayed there are "fair" in the sense that bonds of all maturities will have the same holding period returns.Robert C. it cannot in general be used to compare coupon bonds with the same maturity. As the investment manager of this portfolio. it is straightforward to show that the yield-to-maturity method cannot be used to identify the "better buy" when comparing coupon bonds with different maturities.5 percent while the yield on a four-period bond R4 equals 6.2 percent. the value at the end of four periods would be $1272.1 shows that the yield-to-maturity on a two-period bond R2 equals 3. the one with the higher yield-to-maturity need not be the better buy. if the price of a four-period bond were such that its yield were 6 percent and other bond prices were unchanged. That is. Suppose that a portfolio of default-free fixedincome securities contains bond #1 which is a 15-year bond with an annual coupon C1 = $50. Moreover. However. the four-period bond would be dominated by an initial investment in the two-period bond followed by a "rolling-over" of one-period bonds for periods three and four. and a current market price of $1545. then for the same time pattern of interest rates. Problem V. Yet. by investing $1000 in the four-period bond when it is priced to yield 6 percent.

5 percent which is significantly different from its 12 percent yield-to-maturity.Finance Theory Solving (V. To see this. the yield-to-maturity on a coupon bond does not. S15 = $6049.25) for bond #1 and bond #2. is this the correct decision? To answer this question requires additional information. we can use the actual time path of interest rates described in Table V. So. its yield-tomaturity will not be equal to the average compound return from holding it to maturity. the yield-to-maturity on coupon bonds does not provide a ranking for comparing bonds of the same maturity. In a similar fashion to the derivation of the annuity formula in Section II. Thus. then he will choose to swap bond #1 for bond #2. Moreover. in general. This 105 . for example. From (V.10 and r2 = . bond #1 is actually the better investment. t= 2 15 Doing this for all payments for both bonds. while the yield on a discount bond is always equal to the actual average compound return earned from holding the bond to maturity. this payment will have grown to $50 ∏ (1 + r t ) . we have that their yields-to-maturity are r1 = .1. if the manager uses the yield-to-maturity method for selecting bonds. the $50 received from bond #1 at the end of year 1 will be deposited for year 2 at 5 percent and then reinvested along with accumulated interest at 10 percent for year 3. note that bond #2 is formally equivalent to a 15-year pure discount bond which pays $6049 at maturity and has current market price of $1545. Thus. respectively. Because the initial investment required to acquire either bond is the same. Suppose that the future time path of interest rates is as described earlier in this section in Table V.12 or 10 percent and 12 percent. Hence. Therefore.1 to determine the accumulated sum at the end of fifteen years.8). clearly. At the end of year 15. unlike the yield on pure discount bonds. we find that the accumulated sum at the end of fifteen years 1 2 for bond #1 is S15 = $6127 and for bond #2. and so on. However. the proper choice is the bond which provides the larger cumulative increment to the value of the portfolio. S15 j * * from holding bond #j to maturity and reinvesting all coupon payments received in the interim. even if bond #2 had been the better investment. the average compound return on such a bond is given by (6049/1545) 1/15 – 1 or 9.

Two other yield terms frequently used in connection with coupon bonds are the coupon rate and the current yield.g. The reason that the yield-to-maturity on a coupon bond fails to provide either the correct return on the bond when held until maturity or the correct ranking of alternative bond investments can be traced to the derivation of the present value formula in Section II. The correct method is to estimate the pure discount bond prices using (V. market price of the bond (e.22) from which the yield-to-maturity is derived.2 in Section II. In that derivation.. as was demonstrated by Problem II.21). The + current yield r is defined to be the ratio of the coupon payment per period to the current # j.g. While the preceding analysis provides essentially a negative report on the yield-tomaturity method. in the study of corporate finance in Section VII. is a valid present value formula only if the coupon payments received can be reinvested each period at rate rj* . it was pursued in detail because this method is frequently used and mis-used. for bond # j . (V. unless the reinvestment rates each period happen to equal rj* . Also. the choice among claims cannot in general be made without reference to these reinvestment rates. Because the yield-to-maturity method makes no reference to such reinvestment rates. the average compound return from holding a coupon bond until maturity will not equal its yield-to-maturity.23) and then to evaluate individual coupon bonds using (V. the same issues will arise again with respect to the internal rate of return method for making capital budgeting decisions. for bond The current yield is the rate of return that would be earned from holding the bond for one period if the price of the bond does 106 . The coupon rate r is defined to be the ratio of the coupon payment + per period to the principal or face value of the bond (e. Merton significant discrepancy also demonstrates that the yield-to-maturity method as an alternative to solving (V. r j ≠ C j/ B j ) . Therefore.. it is perhaps not surprising that it cannot provide an unambiguous ranking among investments. it was essential that the interest rates used be the ones at which payments received could be reinvested. r j ≡ C j / M j ). In summary. Indeed.23) can produce significant errors in estimating the term structure. Hence.Robert C. the yield-to-maturity method is not a reliable one either for making bond swapping decisions or for estimating the term structure.

. The duration of a default-free coupon bond is the (value-weighted) average time of the payments received on the bond and is defined for bond #j by (V. then r j < r j < r j . Thus. the bond is a perpetuity) or Bj = Mj (i.4. + * + + * + As with the yield-to-maturity.22). it does not appear to have 107 .T j . the current yield equals the coupon rate).Tj. However. δ t is Tj the fraction of bond #j's total value attributable to the payment received in period t.r + ) = ( r j / r + )(1 + r*j )-T j j j So.26) ( r*j . If r j > r j . for example. the relationship among the coupon rate.. the current yield.Finance Theory not change.27) j D j ≡ ∑ tδ t t=1 j j j where δ t ≡ C j P 0(t)/ B j .e... Dj is equal to the (value- weighted) average maturity of this portfolio of bonds.. the time pattern of payments for coupon bonds with the same maturity date need not be the same. Hence. in Problem V..1 and δ T j ≡ ( C j + M j )P0( T j )/ B j . all payments are made on the maturity date. Because coupon bond #j is formally equivalent to a collection or portfolio of pure discount bonds j with $ δ t B j invested in pure discount bonds which mature at date t. However. for t = 1. bond #1 had a $200 per year coupon and a $1000 principal whereas bond #2 had a $50 per year coupon with a $4865 principal.r j )/( r*j . While duration does provide more information about the time pattern of payments than the maturity. then r j > r j > r j .. and if r j < r j . Using (V. a $1545 investment in bond $1 would receive a larger fraction of its total payments relatively earlier than the same investment in bond #2. and the yield-to-maturity for bond #j can be expressed by (V.. For example. t = 1. All pure discount bonds with the same maturity date have the same time pattern of payments: Namely. the current yield will equal the yield-to-maturity if and only if either Tj = ∞ (i.. depending upon the relationship between the relative size of the coupon and principal payments. neither the coupon rate nor the current yield is particularly useful for estimating the return from holding a coupon bond..e. both bonds had fifteen-year maturities.2.

. to raise money. Financial Intermediation and Interest Rate Spreads We have assumed throughout this section that the fixed-income securities are traded in organized markets. However. they purchase such securities directly in the market. That is.. An alternative definition of duration sometimes used is (V. the one with the higher yieldto-maturity is the better buy. Two attractive features of this measure are: (1) it can be computed without knowledge of discount bond prices {P0(t)}. That is.28) j -t where γ t ≡ C j(1+ r*j ) / B j . D j’ ≡ ∑ t γ t t=1 Tj j j -T for t = 1.2.Tj – 1 and γ T j ≡ ( C j + M j )(1+ r*j ) j/ B j . Ingersoll. discussion on the use and misuse of duration as a measure of price variability.. a bond with a longer duration than another bond may have a smaller percentage price change in response to a change in interest rates because the effect of this change on its yield-to-maturity may be smaller than the effect on the second bond's yield-to-maturity. and Ross (1979).D j’ . it is not a reliable measure because actual changes in interest rates do not affect the yield-to-maturity on different bonds in the same way. individuals or firms issue fixed-income securities directly in the market. (2) It does provide a measure of the sensitivity of the bond's price to a change in its yield-to-maturity. but excellent. Merton much operational importance for the evaluation of coupon bonds.29) ( r j / B j )∂ B j /∂ r j = . Specifically. * * Because it is equal to the (negative of the) price elasticity of a bond with respect to a change in its yield-to-maturity D'j is sometimes used as a measure of the relative price variability of a coupon bond with respect to a change in interest rates. and to invest money. For a short.(V..Robert C. it is not true in general that comparing two coupon bonds with the same durations. see Cox. For example. 108 . This measure differs from the original because it replaces the actual present value of the individual payments with the discounted value using the yield-to-maturity of the bond.

If the economic lot size required to support a market is large. It may also provide added flexibility over a market by allowing nonstandardized contracts. The advantages of using financial intermediation come when there are important economies of scale. For example.Finance Theory However. Further. insurance companies. such securities would have to be of standard form and available in reasonably large quantities. The market system works best when there are a large number of both buyers and sellers of the security willing to transact in minimum lot sizes sufficient to cover the costs of maintaining a market. As will be shown later. depend upon the relative costs associated with the two alternatives. A financial intermediary is defined as an economic organization whose principal function is to purchase financial securities and finance these purchases by issuing financial securities. there is an alternative to direct market participation: Namely. then the financial intermediary may provide divisibility otherwise unavailable. by its geographical location. it is not surprising that virtually all 109 . or course. Savings and loan associations and mutual savings banks specialize in making long-term loans (principally mortgages) and finance them by time deposits. Other examples of financial intermediaries are finance companies. Although the operational differences have become progressively less distinct. the banking function is further specialized by both the type of loan made and the form of deposits issued. In the light of these differences between the two alternatives. a bank may have significantly lower costs in gathering information about the local real estate market than would a nonlocal entity. fixed-income securities can be issued to or purchased from a financial intermediary. Whether a specific financial security is best handled by a market or financial intermediary will. information about the issuer which is relevant to the evaluation of the securities would have to be available to a large number of potential participants at a reasonable cost. Significant information asymmetries in general will favor financial intermediation. Probably the best-known type of financial intermediary is a bank which makes ("purchases") loans and finances them by ("issuing") deposits. In general. a financial intermediary may provide more-efficient risk-spreading at a lower cost than could be achieved with markets alone. commercial banks specialize in making short-term loans to business firms and individuals and finance them principally by demand deposits. For example. and investment companies.

one reason for these differences is that the observed securities are not all default-free. in effect. The average compensation per 110 . then promised yields will be different. In general. one must include not only the explicit cash payments but also the value of any "payments in kind" when comparing returns on fixed-income securities. The no-arbitrage pricing formulas derived for default-free fixed-income securities imply that there is a single interest rate for each period rt." Because interest income is taxable but service charges for a checking account are in general not tax-deductible. Instead of paying the market rate of interest on such deposits. Merton borrowing by individuals is done through financial intermediaries rather than by issuing claims directly in the market and the majority of fixed-income securities held by individuals are claims against financial intermediaries. Returns earned from price appreciation on a bond are taxed at a different (capital gains) rate than coupon payments. Coupon bond payments on municipal bonds are exempt from Federal and (sometimes) State income taxes. A third reason is that the tax treatment of the returns earned on the securities is different. As mentioned earlier. A second reason for these differences is that the terms (other than the maturity and promised payments) are different. the implicit interest received in the form of these "free services" is. Dealers and market-makers who provide the services of an orderly market for trading these securities are compensated for these services by buying at one price (the bid price) and selling at a higher price (the ask price). Two examples would be differences in sinking fund and call provisions. One series of US Government bonds (appropriately called "flower bonds") provided a means for reducing Federal estate taxes. A more subtle example of a tax difference occurs for demand deposits issued by banks. banks frequently provide the service and convenience of a checking account at "no charge. In fact.Robert C. tax-free. A fourth reason for the differences is a difference in the transactions costs associated with different fixed-income securities. and they occur both for fixed-income securities traded in markets and for similar securities available through financial intermediaries. different yields. When there are different probability assessments of receiving the promised payments. it is not uncommon to find fixedincome securities with the same maturities and promised payments that sell for different prices and hence. These persistent differences in promised yields are called interest rate spreads.

it is an annuity type loan). then the payment received by the bank per month net of servicing costs is $y ≡ $(x – . two identical securities could have different observed transaction prices if the last trade for one were a purchase and the last trade for the other were a sale. Because the reinvestment rate is the same each period. As is standard for such loans.5: Interest Spreads on Consumer Installment Loans A consumer goes to a bank to obtain a 36-month loan of $3000 to buy an automobile.5 illustrates. equilibrium promised yields on less-marketable securities will be higher. we 111 . If the marginal cost of making a market in fixed-income security #j is higher than the marginal cost of making a market in fixed-income security #i. then security #j is said to have lower marketability then security #i. what is the smallest monthly payment required by the bank so that it would make the loan? What would be the corresponding "quoted" interest rate on this loan? Because the bank can always invest its funds at 10 percent per year in default-free fixedincome securities.Finance Theory "round trip" trade is the difference between the ask price an the bid price which is called the bidask spread. If there is no chance that the consumer will default on the loan. Because a larger bid-ask spread implies a greater cost to the investor making transactions in that security. Other things the same. It is given that future market interest rates are nonstochastic and the term structure is "flat" at a level of 10 percent per year (i. 0. Interest rate spreads caused by costs are especially common for fixed-income securities available through financial intermediaries as Problem V.e.e. it will only make the loan on terms that will generate (at least) a 10 percent return on its funds and cover all costs.7974% per month). the terms call for a series of equal monthly payments to repay the loan with interest (i. The cost to the bank of closing the loan is $60 and the month cost to the bank of servicing the loan is $0.65).. To receive this stream of payments. If $x denotes the monthly payment by the consumer. a security which has lower marketability will have a larger bid-ask spread.65. the bank must initially pay out $3000 to the consumer and $60 in closing costs or a total of $3060. Because there are now two "prices" for a fixed-income security.. Problem V.

Solving this equation. Substituting r = .12 . Of course.. As discussed in Problem II. This "quoted" interest rate is the yield-to-maturity r * (annualized) on an annuity which pays $x per month for 36 * * months and has a present value of $3000.e. Therefore. Beginning in Section VIII. the bank only earns the market rate of 10 percent on * 12 its funds. The difference in rates just covers the cost of creating and servicing the loan. Merton can use the present value formula for an annuity derived in Section II to determine the monthly payments y which will generate a 10 percent annual return. N = 36.2. Although the quoted rate is 200 basis points higher than the market rate (100 basis points equals 1 percent on an interest rate). In Sections VI and VII.30) where Bj = $3000. r is the solution to equation (V. and the spread between the quoted and market rates would be even larger. This completes our study of default-free fixed-income securities.007974.77.009488 or . we have emphasized the intertemporal aspects of financial markets and instruments with little or no explicit consideration of uncertainty.19). then the additional costs associated with repossessing the automobile and selling it would have to be covered by the promised monthly payments.30) y = r AN /[1 . corporate investment decisions are examined in such an environment. the monthly payment made by the consumer x is equal to $98. the practice is for the bank to quote the terms of the loan in the form of an annual interest rate based upon the amount of money borrowed by the consumer. The annualized interest rate implied by this monthly rate is given by (1 + r ) – 1 or 12 percent. the balance of this Volume will be devoted to the role of uncertainty in financial theory. Cj = x and Mj = 0. In Sections II-V. and AN = 3060 in (II. we have that r = .Robert C.1/(1 + r )N ] = $98.9488% per month. 112 . we have that (V. if there is a chance that the consumer will default on the loan. I.

000 minimum trading unit.37 4. No forward market.S. Federal Funds No secondary market. Futures Market One-week forward market sometimes available on bid side. Interest based on 360-day year. 1976 $188 billion outstanding in June. Issued in odd denominations.$3-5 billion per day in secondary market. Usually overnight. Government Obligations Secondary Market Excellent secondary market. There is a forward market or one to two weeks.94 Discounted or occasionally interest bearing. 3-5 year 8. Interest paid on actual days in 360-day year. Forward. GNMA futures traded on Chicago Board of Trade. traded in $100.66 5.000 to $1. 30-180 days. 13. $26.000 $100.000 $50. quoted in dollars per hundred dollars face value.000.00 Certificates of Deposit Good secondary market 1-12 months and occasionally up to 18 months Bankers Acceptances Obligation of bank against which draft is drawn and which accepts draft Obligations of the bank borrowing funds Good secondary market.$6 billion per wk. Futures traded on International Monetary Market.000 minimum. Discounted. No forward market.000 $15. $1.000.000 $1. No futures market. 1976.50 5. 3-5 day forward market for some “when issued” securities some trading for delayed delivery. No futures market. 30-270 days $5. Based on actual days in 360-day year. agencies established by Congressional acts Good secondary market 30 days to 40 years $87 billion outstanding in May. $100. $50.S. U. $19. $500. No futures market. Interest based on 30-day month or 360-day year. 1976 in CDs of over $100.000 most common trading unit.000 lots. No forward market. Varies with each issue and maturity. 12.16 4. 1976.6 billion outstanding in June. Interest & principal paid at maturity.S.000. In 3. Negotiated among participants.000 to $100.9 billion— average weekly volume for July.000.000 and up.5 billion outstanding in May. $70. Yield basis. Government obligation Limited secondary market—good for some short terms but very thin for long terms 1-10 year notes and 10-40 year bonds.55 4.71 Par basis—interest paid based on 360-day year. 1976 12. $10. No futures market.and 6-month maturities . generally $1 million units. Volatility (Range over 2 years) (high) (low) 9. Price basis.000 basic trading unit. Maturities 3 month 6 month 1 year Summary of Selected Financial Instruments Markets Denominations $10. 113 . Prime Commercial Paper Promissory notes of issuing companies (industrial & financial) Obligation of bank accepting the deposit No secondary market.000 $1.S.5 billion outstanding in May. No futures market. Interest & principal paid at maturity.Robert C. 90 days is most common primary market maturity. 1976. Discounted or interestbearing.000 $500. Agency Paper Obligations of U.69 Long term 6.73 Long Term & Intermediate Term Government Securities U.76 Quotation Basis Discounted interest based on actual days in 360-day year.000 to $5 million $100.000 Volume . Merton Table III Obligation Treasury Bills U. standby commitments available.56 12. No forward market.

Finance Theory 114 .

However. Approaches which explicitly recognize uncertainty and take into account risk in a market context. THE VALUE OF THE FIRM UNDER CERTAINTY In Sections III and IV. While category (i) techniques are frequently used in practice (especially in security analysis). One important purpose of this course is to help develop this judgment. Category (iii) to be examined in Section XIV is the least abstract of the three and therefore. they are less useful for corporate financial decisions because of the difficulty in determining the impact of alternative management decisions on market value. As will be demonstrated. the capital budgeting or the firm's investment decision problem is studied within this same framework. it was shown that the maximization of the current value of the firm is the appropriate primary objective for good management. and care must be exercised in applying them in practice. the investment decision by firms is reexamined in the context of uncertainty. 115 . Approaches based upon the economic theory of market value under certainty. Valuation techniques can be separated into three categories: (i) (ii) (iii) Rules of thumb intended to facilitate comparisons of value among similar assets. the most rigorous. we begin the study of value with these techniques. Moreover. the reader is warned that because they assume certainty. Which technique to use will depend upon the situation and the judgment of the manager. most Rules of Thumb are simplified abstractions of the techniques in category (ii). However. In Sections XIV and XV. In this section. valuation formulas are derived in a certainty environment where the future cash flows of the firm are known. It is therefore natural to begin the study of corporate finance by developing first techniques for determining the value of the firm and then examine how that market value is affected by these investment and financing decision variables which are under management's control. and in Section VII. the use of such techniques can be "dangerous" unless the user understands the set of implicit assumptions upon which their valid application depends and the associated limits within which they can be relied upon. the valuation formulas derived in category (ii) are themselves significant abstractions. Since these techniques also permit the analysis of alternative management decisions on firm value.VI. these techniques are also the most complicated and require more information and analysis to implement.

1). (The "Discounted Cash Flow" approach. Merton There are four basic approaches used to determine value in a certainty context: (I) The value of the firm is the present value of the stream of dividends paid by the firm. approach. we derive a price restriction from the (arbitrage) condition under certainty that all securities must yield the interest rate. are correct. If Z(t) is the return per dollar from investing in the equity of the firm between time t and t+1. 116 .. we start from first principles. a glossary of notation used in the analysis to follow is presented on the next page. that (VI.) (III) The value of the firm is the present value of the earnings generated by the firm. To determine which (if any) of the four statements of values.1) Z(t) ≡ d(t + 1) + S(t + 1) S(t) where d(t+1) is the dividend per share paid at time (t+1) and S(t+1) is the price per share (exdividend paid at time t+1).) (II) The value of the firm is the present value of the cash flows generated by the firm. I-IV.) (IV) The value of the firm is the present value of earnings generated from assets currently in place plus future investment opportunities.2) 1 + r(t) = Z(t) ≡ d(t + 1) + S(t + 1) S(t) where r(t) is the one-period rate of interest from time t to t+1. we first go forward in time and then work backwards to today. To deduce the value of the stock today. (The "Discounted Earnings" approach. I.e. Consider a firm which will remain in business for T periods (from now) and then liquidate.) (The "Growth Opportunities" As an aid to the reader. by definition (VI. then.Robert C. From the identity (VI. (The "Dividend-Discount" approach.

s periods in the future). d(T).. the firm will pay its last dividend.e. which is assumed to be paid out as either a liquidating dividend or return of capital. per share and the exdividend price per share at that time will be the salvage value (per share) of the firm.Finance Theory At time T in the future. one-period riskless interest rate for period t 117 . SALV. Glossary of Notation ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ V(t) n(t) S(t) V(t) D(t) d(t) Z(t) REV(t) O(t) π(t) market value of the firm at time t number of shares of the firm's stock outstanding at time t price per share of stock at time t (ex-dividend paid at time t) n(t)S(t) if the firm is all equity-financed total dividends paid by the firm at time t dividend per share = D(t)/n(t–1) return per dollar to the investor in the firm total revenues in period t = stream of cash receipts total operating cash outflow in period t after-tax profits in period t depreciation in period t cost of goods sold in period t taxes paid in period t gross investment (both new and replacement) in period t net (new) investment in period t i(t) + DEP(t) "gross" profit or net cash flow in period t π(t) + DEP(t) price of a default-free discount bond at time t which pays $1 at time t+s (i. DEP(t) ≡ CGS(t) ≡ τ(t) I(t) i(t) I(t) X(t) X(t) Pt(s) ≡ ≡ ≡ ≡ ≡ ≡ ≡ ≡ r(t) short-term.

3') S(T . and again to avoid arbitrage. we could assume that d(T) includes this payment in which case SALV = 0.1)] Consider an investor who at time (T–2) is going to buy the stock.5) S(T .2) = d(T .6) 1 + r (T .1) [1 + r(T .2) = d(T .4'). we have that (VI.2) + S(T .2)] Substituting for S(T–1) from (VI.2) that (VI.2)][1 + r(T . the total return in dollars for holding one share for one period [from (T–2) to (T–1)] will be d(T–1) + S(T–1). 118 .3') into (VI.5) and (VI.2).3) or from (VI.2)] [1 + r(T .1) S(T .1) S(T .2) S(T .1) d(T) + SALV + .2) that (VI.1) = Z(T . we have from (VI.1) + S(T . From (VI.Robert C. Merton Except for some tax implications. we have that (VI.3) = d(T . [1 + r(T .1) or (VI.6).3) 1 + r(T . [1 + r(T .2) = d(T .1)] At time (T–3) from now. we have from (VI.1) + S(T .4) 1 + r(T .1) = d(T) +SALV .4') S(T .2) or (VI.1) = d(T) + S(T) d(T) + SALV = S(T .2) = Z(T .

2) + S(T . we arrive at the price per share today (time zero) which ensures that an investor buying the stock at any time and selling at any other time will earn a fair return and no arbitrage opportunities will be created. 119 .Finance Theory d(T . S(0) = d(1) d(2) d(T) + SALV + + .18) and (V.1)] S(T . From (VI.2) + = [1 + r(T .1)]) s=1 T t + SALV (VI. we have (VI.+ [1+ r(0)] [1+ r(0)][1+ r(1)] [1+ r(0)].2) [1 + r(T . Indeed.1)] S(0)= ∑ t=1 T d(t) ( ∏[1+ r(s .2)][1 + r(T .7). (VI.7) ∏[1+ r(s .3)] [1 + r(T . then we have that the current market value of the firm is V(0) ≡ n(0)S(0) where n(0) is the number of shares currently outstanding.1) d(T .3)][1 + r(T .3) = (VI..2)] d(T) +SALV + [1 + r(T . we rewrite (VI.3)] d(T .8) as 1 An assumption maintained until we reach Section IX.1)] s=1 T =∑ T SALV d(t) + t [1+ R(T) ] T t=1 [1+ R(t) ] = ∑ P0(t)d(t) + P0(T) SALV t=1 where R(t) and P0(t) are as defined in Section V.6') Proceeding inductively in this backwards fashion..[1+ r(T ..8) V(0) ≡ ∑ n(0)SALV n(0)d(t) + t [1+ R(T) ] T t=1 [1+ R(t) ] T for notational convenience.7) follows directly as a special case of valuation formulas (V.19) in Section V. I.e..7) and (VI.3)][1 + r(T .. If it is assumed that the firm is financed entirely by equity (of a single-homogeneous class)1.

(I) is valid provided that it is more carefully stated to say that the current market value of the firm is equal to the present (discounted) value of the stream of dividends paid by the firm to the current shares outstanding.7') S(0) = ∑ t =1 ∞ d(t) [1 + R(t) ] t and (VI. unless the firm neither issues any t t [1 + R(t) ] new shares (to raise additional capital) nor purchases any shares ("share repurchase") for treasury stock. (VI. will be S(3) ≡ Z(2) = 1 + r(2). and any salvage value is incorporated in d(T). if d(3) = 0.. Returning to our four approaches to valuation: From (VI. Total dividends paid by the firm at time t. I. the investor will earn the market return on his investment over any subperiod of time even if no dividends are paid during that time. S(2) To work out the dynamics of how an all-equity-financed firm's value changes through time.g. in general. then the return from period 2 to period 3. By definition.e. Merton (VI. Note: Even though the value of the firm (or an individual share) is written as the present value of future dividends. V(0) ≠ ∑ t =1 ∞ ≡ D(t) unless n(t) n(0). 120 2 . are equal to n(t–1)d(t).2).Robert C.2 So. E. it is important to distinguish between the change in an individual investor's wealth from the return earned by the firm and the change in the firm's total value.8'). D(t). V(t +1) ≡ n(t +1)S(t +1)= n(t)S(t)+ [n(t +1). we have that Substituting (partly) for S(t+1) form Note it is "n(t–1)" because we have assumed that dividends paid at time t go only to shares outstanding as of time (t–1).8') V(0) = ∑ t =1 ∞ d(t)n(0) [1 + R(t) ] t where it is understood that a finite-lived firm will have d(t) = 0 for t > T.n(t)]S(t +1)..

d(t + 1)] + m(t + 1)S(t + 1) = (1+ r(t))V(t) . Hence. for example. or equal to the change in shareholders wealth.12) REV(t+1) + m(t+1)S(t+1) = O(t+1) + D(t+1) 121 .5 billion while the net gain to investors would be $2 billion. AT&T could have a beginning-of-the-year market value of $20 billion.5 billion. From (VI. and it could issue $4 billion worth of new shares (and debt).5}billion = $4. can be written as (VI. [1 + r(t)] Having established the validity of the stream-of-dividends approach. smaller.9) where m(t+1) ≡ n(t+1) – n(t) = number of new shares issued by the firm at the (ex-dividend) price S(t+1).D(t + 1) + m(t + 1)S(t + 1) (VI. the change in the market value of the firm can be larger.9). the change in firm value would be ∆V = $2 billion + {$4-1.11) V(t) = 1 { V(t + 1) + D(t + 1) .Finance Theory V(t + 1) = n(t)[(1+ r(t))S(t) . AT&T could pay out dividends (and interest) of $1. the basic cash flow accounting identity can be written as (VI.10).9).] From (VI. investors could average a 10% return for the year (or $2 billion). From (VI. ∆V ≡ V(t+1) . the change in firm value.m(t + 1)S(t + 1) } . then this corresponds in absolute value to the number of shares purchased by the firm from shareholders. we also have (VI. what can be said about the other three methods? Using REV(t+1) to denote the total revenues [or stream of cash receipts during period (t to t+1)] and O(t+1) to denote total cash (operating) outflow.V(t). [If m(t+1) < 0.D(t + 1)] + [m(t + 1)S(t + 1)] = r(t)V(t) + {m(t+1)S(t+1)–D(t+1)} _______________ ____________________ Total change in Net new financing by shareholder's the firm or net new wealth from capital raised by the investing in firm company So.10) ∆V = [r(t)V(t) .

i(t + 1)}.13b) D (t + 1) − m(t + 1) S (t + 1) = π (t + 1) + DEP (t + 1) − I ( t + 1) = X (t + 1) − I (t + 1) (VI. from the accounting identity (VI.(VI.Robert C.12). we can work backward to solve (VI.13c).I(t + 1)} [1 + r(t)] 1 V(t) = {V(t + 1) + π (t + 1) .14b) (VI.13c) D(t + 1) .i(t + 1) From (VI. by employing the same backward technique used in deducing the value of a share of stock in (VI.O(t +1)} [1+ r(t)] 1 V(t) = {V(t + 1) + X(t + 1) .11c) and (VI.14a) (VI. we have that (VI.15a) V(0) = ∑ t=1 T V(T) [REV(t) .13a) .14a) . Moreover. then. we have that (VI.(VI. [1 + r(t)] V(t) = Let V(T) denote the value of the firm at time T in the future.14c) 1 {V(t +1)+ REV(t +1) .m(t + 1)S(t + 1) = π (t + 1) .O(t)] + t [1+ R(t) ] [1+ R(T) ] T 122 .14c) which can be rewritten as (VI. Merton Total cash inflow Total cash outflow REV(t) and O(t) can be expressed in terms of their component parts as REV (t ) = π (t ) + τ (t ) + CGS (t ) + DEP(t ) and O(t ) = I (t ) + τ (t ) + CGS (t ) where the terms are defined in the glossary.13a) D(t + 1) − m(t + 1) S (t + 1) = REV (t + 1) − O(t + 1) (VI.7).

O(t)] [1+ R(t)] t (VI.15a') V(0) = ∑ t=1 ∞ [REV(t) .15c) for a firm that is T → ∞ [1 + R(T) ] T going to continue indefinitely as (VI.I(t)] V(T) + t [1 + R(t) ] [1 + R(T) ] T (VI.15a) . From (VI.. it is necessary to make capital expenditures in the future. it is not a valid claim that the current value of the firm can be written as the present discounted value of future earnings (i. then the present value of this opportunity cost is i(t)/[1+R(t)]t.i(t)] V(T) + t [1 + R(t) ] [1 + R(T) ] T Provided that lim V(T) { } = 0. if it is necessary to make (net new) investment expenditures i(t) in the ith period.15'). we see that the value of the firm can be written as the present value of the cash flows generated by the firm and hence.i(t)] [1 + R(t) ] t (VI. 123 . Summing over all t.I(t)] [1 + R(t) ] t [ π (t) .(VI.15a'). to generate a specific earnings flow.e. V(0) ≠ ∑ [1 + R(t) ] t =1 ∞ π (t) t ) because in general. Working in net terms.15c) V(0) = ∑ t =1 T [ π (t) .15b') V(0) = ∑ t =1 ∞ [X(t) . we get the total additional cost required to generate the stream of earnings {π(t)} to be ∞ ∑ [1 + R(t) ] t =1 i(t) t .Finance Theory (VI. approach (II) is a valid description of value. we can rewrite (VI.15c') V(0) = ∑ t =1 ∞ From (VI.15b) V(0) = ∑ t=1 T [X(t) .

e..15c') in net terms. capacity would decline over time. approach (III) is valid if interpreted in the sense of (VI.15b') in gross terms or in (VI. and is the most natural approach for a (single) owner planning to take over the firm. gross investment might just match replacement requirements (i. ∑ [1+ R(t)] t t=1 ∞ π (t) will be a biased estimate for market value.e. So. i(t) ≈ 0). the earnings potential of the existing assets of the firm. a "flat" term structure). (Due to special advantages of the firm. let us assume that r(t) = r and R(t)= r . To determine the value of the firm.. i (t) > 0). It is an especially useful form for the investor planning to invest in the firm. the opportunities (if any) for the firm to invest in real assets that will yield more than the competitive rate of return.Robert C. one might expect to find that gross investment may not be as large as required for replacement (i. Although equivalent to the other three statements of value. Note: ∞ ∑ [1 + R(t) ] t =1 π (t) t may either overstate or understate the correct market value because i(t) can be negative or positive although i(t) ≥ – DEP(t). the take-over investor is not concerned with dividends patterns because he can choose any pattern he wishes. and hence.) Clearly. In a stable or stagnant industry.. 124 .e. To avoid notational complexities. and capacity would increase over time. In a contracting industry. Merton Subtracting these costs from the present value of the earnings will give the value of the firm which is verified in (VI. the "current earnings and future investment opportunities" approach (IV) is probably the most interesting.. for all t (i. and capacity would remain about constant over time. unless the economy as a whole is stagnant.15c'). gross investment would probably exceed replacement requirements (i.e. In an expanding industry. Nonetheless. i(t) < 0). the take-over investor considers three things: (1) (2) (3) the competitive ("normal" or "alternative") rate he can make in the market which is r.

Finance Theory To evaluate the earnings potential of the existing physical (tangible) assets, one can use the regular discounted cash flow formula. Using the annuity formula (Section II, formula (II.16)), we can compute an equivalent perpetual constant flow. Call it X ce , and the value of the firm's tangible

assets is

X ce . r

To evaluate the (intangible) assets associated with future investment opportunities, first, consider those projects beginning in period t requiring investment in that period of I(t). Second, using the discounted cash flow method, evaluate the projects as of date t . Third, using the annuity formula, convert this value into an equivalent perpetual annuity with a constant flow of F(t) dollars at the end of each year. Define: r*(t) ≡ period on projects taken in period t (and F(t) . Then r* (t) is the average rate of return per I(t) F(t) is the (equivalent) dollar return on projects

**undertaken in period t). The present value at the beginning of period t of these projects is
**

F(t) r* (t)I(t) = . r r

Note: r*(t) is an average rate of return. Since one can always earn at least r by buying market securities, one would not (voluntarily) take investments yielding less than r . Therefore

r*(t) ≥ r.

* * (t)I(t) r (t) - r The "goodwill" difference between worth and cost is r - I(t) = I(t)[ ], and the r r * r (t) - r -t ](1 + r ) ; and the present value of all such r

present value of this "goodwill" is

I(t)[

"goodwill" for all the future is

∑

t=1

∞

1 r* (t) - r I(t)[ ]. (1+ r) r

The current value of the firm will be the sum of the value of current assets plus the current value of "goodwill." I.e.,

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Robert C. Merton

∞ * 1 (t) - r V(0) = X ce + ∑ I(t)[ r ]. t r r t=1 (1 + r )

(VI.16)

**To show that (VI.16) is equivalent to the other formulations for value, note that by definition of
**

* r (t ) and X ce,

X (1) = X ce X (2) = X ce + r *(1) I (1) X (3) = X ce + r *(1) I (1) + r *(2) I (2) = X (2) + r *(2) I (2) X (t ) = X (t -1) + r *(t -1) I (t -1) = X ce + ∑r *(s) I (s).

s =1 t -1

From (VI.15b'), we have that

V (0) = ∑

=

[ X (t ) − I (t )] X (1) − I (1) ∞ [ X (t ) − I (t )] = +∑ [1 + r ]t (1 + r ) (1 + r )t t =1 t =2

∞ t −1 X ce − I (1) ∞ 1 +∑ [ X ce + ∑ r *( s ) I ( s ) − I (t )] t (1 + r ) t = 2 (1 + r ) s =1

V (0) =

X ce ∞ t −1 r *( s ) I ( s ) ∞ I ((t ) + ∑∑ −∑ t r (1 + r )t t = 2 s =1 t =1 (1 + r )

Note:

∑ ∑ r (1 + r )

t = 2 s =1 ∞

∞

t -1

*

( s) I ( s)

t

= r *(1) I (1) ∑

k =2

∞

∞ 1 1 + r *(2) I (2)∑ + ... k k (1 + r ) k =3 (1 + r )

+ r *( s ) I ( s ) 1 1 ∑1 (1 + r ) k = (1 + r ) s k =s+

∞

1 + ... k k = s +1 (1 + r )

∑

∞

∞ 1 1 1 1 1 = ∑1 (1 + r ) k -s (1 + r ) s ∑ (1 + r ) j = r • (1 + r ) s k =s+ j =1

So, r *( s ) I ( s ) ∞ r *( s ) I ( s ) ∑∑ (1 + r )t = ∑ r (1 + r )s t = 2 s =1 s =1

∞ t −1

or

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Finance Theory

∞ * * r (s) I ( s) r (s) I (s) =∑ ∑ ∑ (1 + r )t s=1 r (1 + r ) s or t = 2 s =1 t -1 ∞ * 1 (t ) - r V (0) = X ce + ∑ I (t )[ r ] t r r t =1 (1 + r ) ∞

which is (VI .16).//

____________ Value of tangible assets

__________________________ Value of future opportunities

Inspection of (VI.16) demonstrates two important points: (1) a firm can have positive value without any physical assets; (2) the current value of the firm will only be affected by future investment opportunities if those opportunities have rates of return on physical assets that exceed the market rate. To summarize, the four major approaches to valuation (appropriately interpreted) are equally valid, and in fact, equivalent. Because each follows from the other using the basic accounting identity, none is "more primal" than any other. Which one uses is more a matter of convenience. The above analysis is precise and without controversy. If the world were certain, then there would be nothing more to do in terms of valuation formulas. However, the future is uncertain, and the impact of uncertainty on valuation is non-trivial. As will be shown in Section XIV, it is possible to develop precise valuation formulas under uncertainty, but these (or the underlying assumptions) are subject to controversy. Before going into the use of these formulas in the firm's investment decisions, we conclude this section with a brief discussion of "growth" and "glamour" stocks which gives a precise definition for such stocks and may clear up some misconceptions about what growth stocks are.

Growth Stocks

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Robert C. Merton

A common rule of thumb used to value a firm is to compute the average or "normal" priceto-earnings ratio ("PE") for companies within the same industry (or risk class), and to estimate the value of the firm by assuming that it should have the same price-to-earnings ratio. I.e., if there are

n firms in the industry, and π i (0) and V i (0) denote current earnings and firm value for the ith

firm, then PE i ≡

1 n V i(0) and the industry average is PE ≡ ∑ PE i . To find the "fair value" for n i=1 π i(0)

the firm, we set V(0) = ( PE ) • π (0). A variate of this "quick-and-dirty" method is to compute the average earnings-to-price ratio,

EP = 1 n 1 n π i(0) π (0) . and set V(0) = EP i ≡ ∑ ∑ n 1 n i=1 V i(0) EP

The crude

justification for this method goes as follows: Earnings are what is available to shareholders; if the current earnings of the firm are reasonable estimates of future earnings and if the firm is expected to remain in business indefinitely, then the shareholders can reasonably expect to receive in payment (or in equivalent increase in share value) π (0) each period indefinitely. Viewed in this light, ownership of shares is essentially the same as owning a perpetual annuity or consol bond (page II-17, formula (II.18)). From page II-17, if A∞ is the value of such an annuity; y is the payment per period; k = required rate of return (or discount rate) on the stream, then A∞ = Applying the analog to the ith firm, we have that

y . k

V i(0)

π i(0) =

EP i ≡ k i and

1 V i(0) = PE i = . π i(0) ki

If it is assumed that, on average, the required return on

all firms in the same industry (or risk class) is the same, then k ≡ EP is the required return for the stream of the firm, and therefore, V(0) should equal

π (0) π (0)

k = EP

.

In the light of our previous analysis, is there a rationale for this approach, and if so, under what conditions is it valid? From the analysis of the stream-of-earnings approach to valuation, we found ((VI.15c')) that the firm's value could be written as

V(0) = ∑

t=1 ∞

π (t) - i(t)

[1 + R(t) ] t

.

Under what conditions will

128

Finance Theory V(0) =

π (0)

k

where k is the return per period on the firm? If current earnings are an estimate of and the firm requires no net new investment to generate these

≡ future earnings ( π (t) π (0)) t

**≡ earnings (i.e., i(t) 0) and if the term structure is essentially "flat" (at least, in "real" terms), then t
**

V(0) =

π (0)

r

where r is the per period rate of return. In simple terms, if the firm's investment

(gross) is essentially matched by depreciation (i.e., maintenance); if current earnings are representative of future earnings; if the reinvestment rate is reasonably constant, then the rule of thumb method is reasonable. Further, if one interprets the earnings used in computing the

PE or EP as a kind of "long-

term average earnings," then even for cyclical-type companies, the rule of thumb has some validity. Thus, by using the discounted cash flow method to convert the flows from current tangible assets to an equivalent equal annual flow { π (0)}, then provided the other conditions hold, V(0) =

π (0)

r

.

In early empirical studies, when earnings were "smoothed" in this fashion to eliminate transient earnings, the PE rule of thumb was at times a reasonably good forecaster of value except for an important subset of stocks. These stocks had unusually high price-to-earnings ratios, and such stocks have traditionally been identified as "glamour" or "growth" stocks.

Note: It should be noted that the type of stocks in this category have a consistently higherthan-average PE ratio. I.e., many stocks may have current PE ratios, high (or even undefined, if π (0) ≤ 0), but have long-run

V(0)

V(0) , which are very π (0)

π (0)

which are not "out-of-line." Such

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Robert C. Merton

stocks are not what is meant by growth or glamour stocks. Rather growth stocks are stocks with

V(0)

π (0)

that are unusually high persistently. In earlier times, such stocks were thought to be outside the traditional mode of analysis and

were simply excluded from such discussions. The problem was that EP =

1 was treated as an PE

estimate for the required rate of return k, and often, when "normal" companies would have PE's of 10 or 12 implying a k = 10% - 8.5%, growth stocks would have PE's of 25-50 implying a

k = 4% - 2% which would often be below the riskless rate r. Did this mean that investors in such

stocks were "fools," and that investment in such stocks could only be justified on the basis that somehow investors would be willing to pay even more for them later, independent of the "rational," implicitly-low return? An alternative, rational explanation can be found in the previous analysis of growth opportunities. From (VI.16), we can rewrite the expression for

PE =

V(0) π (0)

(noting that

π (0) = X ce ) as

PE =

(VI.17)

* 1 ∞ 1 (t) - r) V(0) 1 = + I(t)[ r ] ∑ (1 + r )t r π (0) r π (0) t=1 1 > if r* (t) > r. r

Thus, if a company has some special advantages (e.g., patents, superior distribution capabilities, monopoly, etc.) so that it can reasonably be expected to find investment opportunities in the future which yield (non-competitive) rates of return r* (t) which exceed the market required return r, then from (VI.17), it is quite rational to bid the price of the firm beyond the normal PE associated with the profits generated by the assets currently in place. Moreover, from the derivation of (VI.16), the investor will earn a rate of return r on such investments. The magnitude of the difference between the PE ratio and 1/r will depend on the size and number of investment opportunities that have returns that exceed r (i.e., I(t)) and the size of the spread between r* (t) (the average return on projects) and r (the required rate of return by investors).

130

r (t). 131 . is the same in every period.. Then.Finance Theory Examples of companies that have at times been termed "growth" stocks are IBM. the constant-growth case displays some of the qualitative characteristics of growth stocks. we have that X(t) = X(t .2) Is a company whose earnings per share are growing over time a growth stock? (Q. Xerox. and several drug companies. what are the main questions you would want answered in deciding whether a firm was a growth company or not? Example: The Constant-Growth Case Although not exactly empirically relevant.1) Is a company whose total asset size and earnings are growing over time (in a steady trend) a growth stock? (Q. X(1) = π (0) . Identification of "Growth" Stocks Questions for thought (Q.3) Is a company whose earnings per share are growing over time at a rate less than the required rate of return r not a growth stock? (Q. ≡ * r*(t) r > r.1) + r* I(t . Assume that the firm does have investments such that * * r (t) > r and further that the average return on investments per period.5) As an investor. Polaroid. I.. i.e. Assume that the firm's investment policy leads to a total investment each period which is a constant fraction of that period's gross earnings.e. Coca Cola. I(t) = δX(t) where 0 ≤ δ ≤ 1 .1) .4) Is a company whose earnings per share are growing over time at a rate greater than the required rate of return r a growth stock? (Q. t From the previous analysis.

r* δ ⎥ ⎦ So.r*δ V(0) = (VI. we have that ⎛ r * − r ⎞ δ π (0)[1+ r*δ ] t-1 V(0) = +∑⎜ ⎜ r ⎟ ⎟ r [1+ r ] t t=1 ⎝ ⎠ π (0) ∞ = π (0) ⎡ δ (r * − r) ∞ 1+ r*δ t-1⎤ ] ⎥ ⎢1+ ∑[ r ⎣ (1+ r) t=1 1+ r ⎦ From p. Merton X(t) = X(t . V(0) = π (0) ⎡ δ ( * .16).1 ⎡ 1+ 2 ⎤ = =⎢ . II-15.Robert C.X(t . y .1) * = r δ = rate of growth of earnings. V(0) = model.δ )π (0) .1) = X(t .1) + r* δX(t .δ )π (0) where g ≡ r*δ = rate of growth of earnings. r-g Note that D(0) = (1 . (y ≡ ∞ 1+ r*δ ) 1+ r ∞ ∑ = y t −1 = ∑ y j = t=1 j=0 1 y∞ .1)[1 + r* δ ] = π (0)[1 + r* δ ] t -1 and X(t) . and therefore. Substituting for X(t .1) I(t) = δX(t) = δ π (0)[1 + r* δ ] t -1 into (VI.r) 1+ r ⎤ • 1+ r ⎢ ⎥ r ⎣ (1+ r) r − r *δ ⎦ or (1.δ )π (0) r . provided that r > δ r* .1 1.y ⎣ r . Question: D(0) .18) = (1. a version of the "dividend-discount" r-g What is the interpretation of the g ≥ r case? 132 .

Finance Theory What is the model telling you? 133 .

and to some extent in Section V. Mergers and acquisitions are important topics for financial management and will be discussed in Section XV.X(2). and if X(t) is negative. and (ii) the acquisition of external alreadyexisting assets from other firms by either direct purchase of the assets or the acquisition of the whole firm by merger. THE FIRM'S INVESTMENT DECISION UNDER CERTAINTY: CAPITAL BUDGETING AND RANKING OF NEW INVESTMENT PROJECTS The most important decisions for a firm's management are its investment decisions. However. if undertaken. VI.. consolidation. we begin with some definitions: A project is defined by the series of net cash flows it generates at the end of each period. {X(1). to put these tools in a more specific framework... create new assets. and it is this form of investment which is the topic of this section. we will also denote –I0 by "X(0)". Investments by the firm take two forms: (i) internally-generated projects which. Since most projects require an initial outflow.. While it is surely possible to get the firm into "trouble" through poor financing decisions or improper management of working capital. The capital budgeting problem is how to select those physical investments or projects so as to maximize the value of the firm. then the project provides a net flow of cash into the firm at the end of period t. If X(t) is positive. the primary function of the business firm is to find and undertake profitable new projects. it is a common convention to denote this flow by "–I0" where I0 is the (positive) outflow or initial investment in the project. Much of the formal apparatus has already been developed in Sections II.VII. However. X(t) = [Revenues–Costs–Depreciation] × (1 – tax rate) + Depreciation – Investment (in the project) 134 . then it causes a new flow of cash out of the firm. Before proceeding. we examine the various traditional capital budgeting methods used to evaluate projects. the net cash flow at the end of the "zeroth" period (or the beginning of the first period). with the exception of a few specialized firms. For symmetry. the value of the firm is principally determined by the prospects for its investments.X(N)}. or takeover. These flows {X(t)} can be either positive or negative.

k. to simplify the analysis. we follow tradition of using "k" rather than "r" to include the possibility in a quasiuncertainty sense (made rigorous in Section XIV) that different risk projects will have different required returns (and in particular. the cost of capital is simply the market rate of interest. t Independent Projects are project such that the firm can decide to do both or either one or neither. Traditional Methods of Project Selection I. Merton = After-tax Operating Profits – net new investment (in the project) Let k denote the cost of capital to the firm (measured in percent per period) where the cost of capital is the (external) rate of return required by investors for providing funds to the firm and it reflects all the market opportunities available to investors. but not both. is constant over time. In a world of certainty (which is the formal setting for this section). then in an analogous fashion to R(t) in Sections II and V. Pay-Back Method 135 . we could t t define K(t) by [1+ K(t) ] ≡ ∏[1+ k(t)]. (Note: this definition has no implications of statistical independence among projects. If k were changing over time. and use "[1 + K(t)] " everywhere in the formulas when j=1 t "[1 + k] " appears. r.) Mutually Exclusive Projects are projects such that the firm can only do one or the other. it is assumed that the explicit opportunity cost to investors for investing in the firm. required rates different from the riskless interest rate). However. Following the practice of Section II.Robert C.

PV = . then the payback period is that value of T such that I 0 = ∑ X t . t t t =1 (1 + k ) t =0 (1 + k ) N X(t) As described in Section II.Finance Theory If I0 is the initial investment.e.I 0 + ∑ N X(t) =∑ . is that discount rate such that the present value of the project (computed at that rate) is zero. select the one with the smaller payback period. zero) present value. When choosing among mutually exclusive projects. T . When choosing among mutually exclusive projects. and then take all investments with positive (or as a matter of indifference. i.I 0 + ∑ t =1 N X(t) [1 + K(t) ] t and the method is still applicable III. The payback method says rank all (independent) projects from the shortest to the longest and then take (invest in) all projects with a payback period less than or equal to some given time. Note: If the cost of capital were changing over time. II. Internal Rate of Return Method (Review Section V on Yield-to-Maturity) The internal rate of return for a project. I. i is the solution to 136 . the present value rule says rank all (independent) projects from the highest to the lowest.e.. I. then the present value of the project will be . select the one with the largest present value. it is the minimum length of time until the net cash flows sum to the value of the initial t=1 T investment. Present Value Method (Review Section II) * The (net) present value of a project is PV = ..

i. i = k). unlike k (the cost of capital).e. Merton 0= . The internal rate of return rule says rank all (independent) projects from the highest to the lowest. Neglects the time value of money (no discounting) Neglects all flows beyond the payback period (implicit "infinite" discounting) Therefore. misses future negative or positive flows. IV. It is called an internal rate because. Profitability Index Method ⎡ T X(t) ⎤ / I0 Profitability Index = PI = ⎢∑ t⎥ ⎣ t=1 (1 + k ) ⎦ Method: Rank all (independent) projects form the highest to the lowest and take all investments with profitability index greater than one. When choosing among mutually exclusive projects.. which is an (external) market (opportunity cost) rate. A related method sometimes used is the "Modified" Payback Method.I0 + ∑ t =1 N X(t) [1 + i ] t . select the one with the largest profitability index. Evaluation of these Methods: Problems with Payback 1. and then take all investments whose internal rate of return is greater than some specified rate i * * (usually taken to be the cost of capital. i depends only on the nature of the time-flow patterns of the project and is completely unrelated to any market rate. 2. The modified payback period is defined as the minimum T such that I0= ∑ t =1 T X(t) (1 + k )t 137 .Robert C. select the one with the largest internal rate of return. When choosing among mutually-exclusive projects.

There may be either more than one value of i or no value of i which makes the present value of the project zero. Internal Rate of Return Assume k = . It is sometimes called a conservative rule because the firm always has available investments which will earn k: namely. the firm should never take negative PV projects. the present value rule maximizes the value of the firm. In general. the rule can be modified according to the "risk-adjusted" method to be discussed later: Namely.I 0 + ∑ t =1 N α t X (t) (1 + r )t where α t = a certainty equivalent and X (t) is the expected cash flow. Internal Rate of Return While the present value method assumes that the flows can be reinvested at the cost of capital (which is always possible). In uncertainty. the value of the firm is equal to the present value of all its future flows discounted at the (market-determined) cost of capital. the internal rate of return assumes that the flows can be reinvested at the internal rate of return i. PV = . If the cost of capital is varying over time. Hence. Thus. present value is the most appropriate of these four traditional techniques. Technical Problems that Can Arise with Internal Rate of Return 1. 2. Example: Present Value vs. it can buy its own stock. the "cut-off" rule of taking only projects with i = k is not well-defined.05 138 .Finance Theory Present Value In perfect capital markets and certainty.

800 -2.080 1 . A is preferred to B.224.920 -3.114.000.605 -4.457 1.057.000 3.500 1.630 1 .548 Present Value of B = Sum of PV = So. Merton Present Value Project A (Mutually Exclusive of B) Year End Net Cash Flow Discount 1 t (1+k) Present Value 0 1 2 3 -1.992 1.864 -1.001.210.055.907 .000.952 .907 .952 .000 -3.000 3.000 2.800 1.192 0 Present Value of A = Sum of PV = Project B (Mutually Exclusive of A) Year End Net Cash Flow Discount 1 t (1+k) Present Value 0 1 2 3 -1.999.433.Robert C.000.157.864 -1.150. by the Present Value Method.998.000 -3. Example (continued) Internal Rate of Return Project A: Let x = 1 + i 139 .307.000 3.000.

x3 ) are x1 = 1 + i1 = 1.000 3.15763 = 0 ( x1 .080 + =0 2 3 x x x or find the roots of the cubic equation: − x3 + 3.150.3.10 B B B So there are three internal rates of return i 1 = . i 3 = .05 3 roots: x 3 = 1 + i 3 = 1.307.630 =0 + 2 3 x x x or find the roots of the cubic equation: .Finance Theory PV = . x3 ) are x1 = 1 + i1 = 1.x 3 + 3.07 x 3 = 1 + i 3 = 1.1.21x 2 − 3.1.000.224.10 140 .000 + 3.22408 = 0 3 roots: ( x1 .3075x + 1.05 Project B: Let x = 1 + i PV = .000 + 3.500 1.157.15 x 2 .000 3.04 x 2 = 1 + i 2 = 1.000. x 2 .07.210.433.05 so i A = .800 1.04. i 2 = . x 2 .4338 x + 1.05 x 2 = 1 + i 2 = 1.

05 at k = .08 take A over B take B over A 141 . Merton Example (continued) "Switching Points" at k = .Robert C.

for t = 1.. this is not a paradox because different interest rates imply different "worlds" with different alternatives. In the example...2. + a n = 0.. wood bridge versus a steel bridge) rarely can be answered with knowledge of the technology only. The switching problem (or multiple-roots problem) occurs when there is more than one positive root which makes the present value equal to zero.. both the payback and the modified payback methods would have picked Project B over Project A. note that a plot of present value versus cost of capital will look like: 142 .. It should be noted that from the tables in this example. then the Present Value Rule and Internal Rate of Return Rule will lead to the same answer with respect to which projects will be taken. and hence. for all the projects being considered and if the projects are independent. More on Present Value versus Internal Rate of Return If X(0) = – I0 < 0 and all X(t) ≥ 0. both projects had three sign changes. Thus. To see this. then (Descarte's rule of signs) the number of positive roots either is equal to the number of variations of signs of the ai's or is less than this number of variations by an even integer. One can use the following rule to check to see whether n n -1 n-2 more than one such root can occur: if x + a1 x + a 2 x + .g.Finance Theory As noted in Section VII. either three or one positive roots. which technology to use (e.

the internal rate of return on A is iA = . We know by Descarte's rule of signs that both bonds have only one positive root. on a IRR basis.e.177 and = ..e. Using the present value tables and the formula for an annuity. if i > k..e. However. B is preferred to A.1000 + (15x214) Clearly. which should you take? Project A: Pay $1000 today (i. danger lurks for evaluating mutually exclusive projects using i or in using it in the case of capital rationing as the following example illustrates.10 and on B is iB = .1000 + PV B = .177 (i. Given that the only investment alternative available in future years for any money received will be to stuff it in a mattress or bury it in a coffee can (i. x(1) = x(2) = x(3) = . we have $4177 and for Project B. = x(14) = x(15) = 214). Merton Hence..e..20. it is easy to compute how much money we will have at the end of fifteen years from each project: for Project A. which do 143 . by the Present Value Rule. A is preferred to B..1000 + ∑ 1 15 4177 (1 + 0 )15 214 (1 + 0 ) = 2210 t = 3. the internal rate of return for both is unique. we will have only $3210. Project B: Pay $1000 today (i. = x(14) = 0 and x(15) = 4177). even in the case of a single positive root.Robert C. I0 = 1000) and you receive $214 at the end of each year for fifteen years (i. note that since all interim payments cannot be invested to earn a positive return. x(1) = x(2) = x(3) = . k = 0).e. then the present value will be positive. Example: Suppose that you have $1000 and you can purchase either Project A or Project B. Hence. Hence. the rankings of projects by the two methods can be different. Which is "more" correct? Fist.. What about present value? At k = 0. Clearly. I0 = 1000) and you receive no payments until the end of fifteen years when you will receive $4. Since they both cost the same.. PV A = ...

. In bond evaluation. This done. as noted in Section V. and (1 + R B ) = true return per year from B is 8.e.2%. in the face of certain imperfections. then there should be little problem in raising the necessary (additional) funds in the capital market. this decision rule may require modification. Note: the procedure to be described is contrary to the one an individual consumer would follow in allocating his income (and wealth) over various consumption goods at different points in time. If the estimates of the cost of capital and the cash flows are accurate.2%. E.e. the 1000 3210 has the solution RB = 8. However. 20% versus 8. then a budget is established to determine how much capital is needed (and from which sources it will be raised) to carry out the program.2% NOT 20%. and therefore. Note: the internal return. Imperfections and Capital Budgeting If the firm is a "perfect competitor" for capital (i. (1 + R A ) = 4177 has the solution RA = .g. is a number and need not bear a close relationship to the actual returns earned. Hence. the firm's cost of capital is unaffected by the scale of its investments) and capital markets are "reasonably" perfect. iB.10. since we know the final amounts. Further. yield-to-maturity is just an internal rate of return calculation. the same warnings apply to comparing alternative bond investments by yield-to-maturity even when the bonds have the same maturity date.. Capital Rationing: an examination of all the decision rules given shows that each assumes that there is no budget constraint for profitable investments. I. we can compute an actual average 15 compound return per year for both. then the correct capital budgeting decision rule is present value.. each period. So. the firm looks over all available project proposals and selects all projects with positive present value. this procedure is optimal relative to the (efficiency) criterion of maximizing market value. the 1000 15 true return per year from A is 10%. I. So.Finance Theory you prefer? Further.e. Present Value is a better ranker. 144 ..

it does not reflect future budgetary constraints. While it is true that the profitability index gives the most Present value per dollar of initial investment which is highly suggestive of what one should do in a constrained situation. in each period. Merton However. particularly if the costs are high. in certain situations. it is sometimes suggested that the Profitability Index (or "Benefit/Cost" ratio) is a better rule than present value. This situation is called capital rationing. but violate all future constraints. It may occur for the firm in countries where there are no (or poorly-organized) capital markets. These values can often be used to argue for the elimination of the constraints. or for divisions of firms where (incorrectly determined) decentralization rules dictate a fixed budget for each division prior to the examination of the projects available. Thus. if k depends on the scale. Under capital rationing. it does produce a feasible program. then programming techniques must be employed. ask yourself: why the constraint? How much is it costing? Is it rational? Rising Cost of Capital. Moreover. However. there may be a (predetermined) absolute limit to the amount that can be invested by the firm in any one period. It is typically assumed that the cost of capital is a constant function of the amount of investment. it is not an infrequent case in the public sector where resources are at times allocated (prior to specific knowledge of projects) on the basis of "last year's" allocation (of I0)". Always. While such a procedure is not optimal relative to (unconstrained) maximizing of market value. the "shadow prices" or dual variables will give an explicit estimate of the marginal costs of the rationing. a plan may satisfy the current budget constraint. 145 . The best technique in this situation is to maximize present value subject to the budget constraint in each year using mathematical programming techniques.Robert C.

Finance Theory Application of Present Value: The Replacement Problem The product decisions are already made and the decision is to choose between two alternative machines to produce the product. Replacement time for each machine is known. Life of machine B is T2 years. 146 . I. Technical change is neglected and the optimal horizon for the product run is given. Same product for T years: which machine? Life of machine A is T1 years.

Robert C. the present value of costs will be PB again because it is used for its full life.C B . because it is not used for its full life t=1 1 Ct S If we choose machine B. today.(1+ k )T -T . of S. 1 2 Machine B costs IB and has operating costs per year C B .C T1 and has salvage value with A (2 T 1 ....C A .C T 2 . At that time. Assume replace each B machine with the same machine... then it must be replaced at time T1. At that time. 1 2 The present value of the costs of machine A over its life is PA= I A + ∑ CA t t =1 (1 + k ) T1 t For machine B PB = I B + ∑ CB t t =1 (1 + k ) T2 t If we choose machine A..T) years (to go). we compare the present values of costs for the entire product life. then it must be replaced at time T2. Merton Machine A costs IA and has operating costs per year C A . ⎡ ⎢ IA + ⎢ ⎣ T −T1 ' PA = PA + 1 (1 + k )T 1 ∑ t =1 t CA (1 + k ) t − ⎤ ⎥ T −T 1+ k) 1 ⎥ ( ⎦ S and 147 .. which are.. To decide which machine to use. the present value of costs will be T -T 1 I A+ A ∑ (1+ k )t .

X X -1 j =0 j So substituting for X.Finance Theory ' PB = PB + 1 (1 + k ) T2 ⎡ 1 PB = PB ⎢1 + T (1 + k ) 2 ⎢ ⎣ ⎤ ⎥ . T = ∞). as above.14). ⎥ ⎦ ' ' and choose the smaller one between PA and PB .. the present value of costs over the product life will be t t =1 (1 + k ) P' = P + P (1 + k ) n + P (1 + k ) 2n + P (1 + k ) 3n + P (1 + k ) 4n +K ⎡ ⎤ 1 1 1 1 ⎢ ⎥ = P ⎢1 + + + + + K⎥ 1 2 3 4 n n ⎡(1 + k ) n ⎤ ⎡(1 + k )n ⎤ ⎢ ⎡(1 + k ) ⎤ ⎡(1 + k ) ⎤ ⎥ ⎦ ⎣ ⎦ ⎣ ⎦ ⎣ ⎦ ⎣ ⎣ ⎦ ' or P' = P N -1 ∑X j =0 ∞ j where X ≡ 1 (1 + k ) n N 1 X -1 as N → ∞ for X < 1.e. we have ⎡ ⎢ 1 P' = P ⎢ 1 ⎢ ⎢1 − 1 + k n ) ⎣ ( ⎤ n ⎥ ⎡ ⎤ ⎥ = P ⎢ (1 = k ) ⎥ n ⎥ ⎢ (1 + k ) − 1 ⎦ ⎥ ⎣ ⎥ ⎦ ' So to determine which machine to choose. = From (II. take the one with the smaller P . we anticipate replacing the machine every replacements. 148 . A common situation is when the length of the product run is anticipated to run indefinitely into the future (formally. Hence. P= I +∑ n n years and making an "infinite" number of If P is the present value of costs of the machine over one cycle. we have that ∑ X = 1. Ct . i. then. if a machine has life of length n.

it was assumed that the machines' replacement times were known and that they corresponded to their physical lengths of life.. The present value of the annuity is P. This approach would be useful for comparison between the choice between buying and maintaining the machine or renting (or leasing) the machine with a service contract from another firm. assume that we will always be replacing old machines with new machines and that replacement goes on indefinitely. 149 . we have that the formula for a N-year annuity is y(1 AN = 1 (1 + k ) k N ) where y = the annual payment. Optimal Replacement Time In the previous analysis.Robert C. the decision to replace a machine is an economic one. Merton An alternative representation (due to Lewellen) is to convert the present value calculations into a constant annual cost (flow) comparison. II.e. this represents an annuity payment problem. Corresponding to the perpetuity (N = ∞). i. find the annual payments implied: From Section II. what is the (maximum) constant annual payment that you would be willing to pay at the end of each year for renting the machine and having it serviced? Clearly. the (maximum) rate to be paid is k. As before. we have A∞ = y k ⎤ ⎡ ⎥ ⎢ k ⎥ ⎢ so the annual flow (cost) will be y = kP = P 1 ⎥ ⎢ ⎢1 n⎥ ⎣ (1 + k ) ⎦ Again. Rarely is this the case. and if a leasing contract is available for less than y. we can select between two machines by choosing the one with the smaller y. Normally. then take it.

.Finance Theory Let I = initial investment and C1. let P(τ) = present value of costs for one cycle for the machine replaced every τ years. i. etc.Sτ ....2..T We can also write the conditions in terms of equalized annual costs by: yτ = kP( τ ) and then τ * is such that yτ * ≤ yτ for all possible τ . will the be τ such that P( τ * ) ≤ P( τ ) for all possible τ = 1. τ .e. 150 . To "convert" the problem to the type of the previous section. Then ⎡1 1 P (τ ) = ⎢ τ ⎢1 (1+ k ) ⎣ * ⎤ ⎥ P(τ ) . Note: τ * will depend on k.. it will never be optimal to replace every two years for a while and then switch to replacing every three years.C3. Let τ = length of time between replacements (0 < τ ≤ T).. Thus. and hence will be different for different cost of capital.. Then P(τ ) = I + ∑ t =1 τ Ct . and the salvage values.. let S1. (1 + k )t (1 + k )τ Let P(τ) be the present value of costs of the machine (replaced every τ years) over the product life. etc.. T.ST (= 0) be the salvage value of the machine at the end of each year.C2. an optimal replacement time solution will be the same for all time.S3. ⎥ ⎦ The optimal replacement time.CT be the annual operating costs up to the end of the physical life of the machine.S2.3. From the assumptions of the problem..ST-1. the structure of the operating costs. consider that each of T different replacement strategies defines a "different" machine (which it does in the economic sense)...

Specifically. the current spot price for a discount bond which pays $1 at date T is P ( T ) . it is a forward contract where the firm agrees to deliver to the bank at date T a τ-period discount bond on which the firm promises to pay $M at maturity and the bank agrees to pay the firm $L (the delivery price) on delivery. Forward or futures contracts have long been traded on basic commodities and in recent years. therefore. The spot price for an item is defined as the price for that item delivered immediately. the assumption of certainty is removed and we begin the study of financial instruments in an uncertain environment. Although most organized markets use futures contracts. FUTURES CONTRACTS AND OPTIONS In this section. Futures and option securities permit investors to modify the patterns of returns which would otherwise be received from the underlying securities and in particular. The reader may find it helpful to review the analysis of default-free fixed income security pricing in Section V before proceeding to the example It is a common practice for borrowers to obtain a commitment for a loan in advance of actually receiving the money. However. Although not necessary. what is the equilibrium value for M . Such an agreement is an example of a forward contract. and 0 at date t. have been widely expanded to include financial securities (see chart on the last page of Section V). While the terms of such agreements are variable. The forward price associated 151 . the spot price for that same bond will be P t (T . the firm may enter into an agreement with a bank now to borrow the money at a specified future date. For example. and therefore. the more-intuitive contract is the forward contract. Under this assumption and the assumption that the loan is default-free.VIII. a typical example would be a τ-period term discount loan where the bank agrees to lend $L to the firm at date T and the firm agrees to pay back to the bank $M at date T + τ. typically no money changes hands at the time that the forward contract is made. As an introduction. we analyze the forward contract in the context of a forward loan agreement. a firm may undertake a project that does not require investment until some future date. FORWARD CONTRACTS. the firm may have no need for funds now. to ensure the availability and terms of a loan sufficient to finance this future investment. For example.t). to eliminate or hedge against the uncertainties of price changes in these securities.

nothing is paid by either party to the other for making the contract. Thus.T.Finance Theory with a forward contract is defined as that delivery price which makes the value of the forward contract equal to zero at the time that the contract is made.F t (L. and the borrower (lender) would be giving something of value away for nothing.1) can be rewritten as (VIII.t)/ P 0 (T + τ )] . so the borrower is equally committed to 152 . Otherwise.T. while F 0 = 0 .τ ) denotes the value of the forward contract (to the lender) at time t then.T.T. T.τ ) = . Because in the case at hand.1) . it must satisfy (VIII. M.t] and the return per dollar from holding a T-period discount bond for the same period.18). the value of the contract at date t . However. then the value of the contract to the borrower (lender) would be negative. This can happen if interest rates are stochastic.τ ). Ft will not equal zero if the holding period returns on the two bonds are not the same.2). we have that M = L P 0 (T)/ P 0 (T + τ ). and will happen whenever the ex-post time path of interest rates is different from what was expected ex-ante. the value of the forward contract to the lender at date t is proportional to the difference between the return per dollar from holding a (T + τ)-period discount bond for the period [0. F t (L.τ ) = 0. Of course.1. (VIII. Hence. –Ft . M. to avoid arbitrage from (V.t)/ P 0 (T)] } From (VIII. the terms must be such that the value of the forward contract (not to be confused with the forward price of the contract) is zero at the time it is made. If F t (L. The proportionality factor is equal to the value at the time the contract is made of a discount bond which pays $L at its maturity date T. M.t) + M Pt (T + τ .t) for t = 0. the borrower is worse off than if he had not entered into the agreement because the value of the contract to him. Of course. M.[ P t (T .2.2) F t = L P 0 (T){ [ P t (T + τ .…. and therefore. is negative. the value of the forward contract to the borrower at time t is From the condition that F 0 (L. then. ex-post. if Ft is positive. the relationship between L and M must be such that L is equal to the forward price of the contract. just as the lender is committed to making the loan on the terms agreed upon. if the value of the contract to the lender (borrower) were positive.L Pt (T .

from (VIII. fixed-income security can be computed.e. where it is assumed that the security is delivered at date s but ex-the-period s-payment (i. after the payment of $ xs has been made)..1. Because $L is the T-period forward price for a default-free discount bond which pays $M at date (T + τ). the forward price associated with a forward contract for any default-free. the more-common practice is to quote a forward yield rate. Since P 0 (T) is the amount one would pay today for one dollar delivered at date T and P 0 (T + τ ) is the current price of the bond.. Merton take the loan on these terms. the current term structure of interest rates.Robert C. With a complete set of these forward prices for all T and τ..8) in Section V. is defined by 153 .. T .2. ..3) T TP0(τ) = L/M and therefore. then the agreement would not be a forward contract but rather an option contract. The only data required to compute forward prices for all default-free securities are the current spot prices of discount bonds or equivalently.3) the forward price TP0(τ) is equal to the current price of the bond measured in units of dollars paid at date T.. P 0(τ) = P 0(T + τ)/ P 0(T) . L/M is the T-period forward price for a default-free discount bond which pays $1 at date (T + τ). TR0(τ) rather than the forward price TP0(τ) where in an analogous fashion to (V..T then (VIII. If we define TP0(τ) to be the forward price for delivery at time T of a discount bond which pays $1 at date (T + τ)...s) x t for s = 0.4) sV 0 = ∑ t=s+1 T s P (t 0 . Indeed.. then (VIII.1. TR0(τ)..1. If sV0 denotes the s-period forward price for a default-free security which pays $ xt at date t. τ = 0 .. t = 1. If the borrower had the choice of not taking the loan.

Lt .9). T) = X(t) .1) ⎣ X(t) Combining (VIII.T) = X(t)⎢ ⎥.F t ( Lt .t) From the definition of the forward price at time t .T) .8) and (VIII.5) R 0 (τ ) ≡ ⎡ T P 0 (τ ) ⎤ ⎣ ⎦ −1/ τ T − 1 Consider the more general case of a forward contract which calls for delivery of one unit (e. we have from (VIII.1) ⎤ F t +1 ( Lt .7) L t = X(t)/ P t (T . is given by 154 ..t) ⎦ Pt +1 (T .g. The dollar gain on a forward contract entered into at time t between t and t + 1 is given by (VIII.t .t . If shortsales are permitted.F t ( L t . if there are no shortage or transactions costs.Finance Theory (VIII. The change in the value of a contract entered into at time t = 0 between t = 0 and t = T. Let X(t) denote the spot price of the commodity at time t. Pt (T . Pt (T .1) ⎤ X(t) ⎢ ⎥.6) F t (L.8) ⎡ X(t + 1) Pt+1 (T .10) F t +1( Lt . we have that (VIII. share) of a security or commodity at date T at a price L. the delivery date.t) . then it follows from the condition of no arbitrage that the value of the forward contract is (VIII.9) L t+1 . and if the commodity or security provides no payouts prior to T.t .L t ] .t .6) that (VIII.T) .Lt = ⎡ X(t + 1) P t+1 (T .LP t (T .t) ⎦ ⎣ X(t) The change in the forward price is given by (VIII.T) = P t+1(T .1)[ L t+1 .

The increment to value between t and t + 1 is given by (VIII.1) = ∑ [ Lt +1 .12) t =0 T -1 t +1 ( Lt . then he is required to purchase at date T one unit of the security (or commodity) at the then futures price (denoted by) f(T). Now enter into a new forward contract.L 0 = LT .Lt .f(t) | in cash.11).. T) .T) = ∑ [ F t+1( L 0 .f(t) < 0. the increment from holding a single forward contract for the entire period until delivery. the difference between the futures price at that date and the futures price at date t [i.F t ( L t . The total value of this investment strategy at time T will..T) .T)] t=0 T -1 (VIII. f(t + 1) ..] If a person is short in a futures contact. the difference between the futures price at that date and the futures price at date 155 .10).1) = Lt +1 . settle the contract and put the proceeds into a discount bond which matures at time T .L0 t=0 T -1 which is identical to (VIII.t . This increment (invested in a discount bond) will be worth at time T .. and he also must pay in cash at date t + 1.11) = X(T) . and he also will receive in cash at date t + 1.F t ( Lt . [Note: If f(t + 1) . then he must pay out | f(t + 1) .. therefore.t . { F t +1 ( Lt .F t( L 0 .F 0( L 0 .T) .L 0 In preparation for the analysis of futures contracts. At time t + 1. T) } / Pt +1 (T .Robert C.T)} / Pt +1 (T .f(t)] for t = 0. then he is required to sell at date T one unit of the security (or commodity) at the then futures price.1 .T) . consider the following investment strategy in forward contracts: enter into a forward contract at time t.e. f(T). The initial value of the investment is zero.T . If a person is long in a futures contract.Lt ] = LT . Merton F T ( L 0 . be given by ∑{ F (VIII.

f(t) < 0 . [So. enter into N t futures contracts. t +1 Consider the case where we choose N t = 1.13) V T = ∑ N t [f(t +1) t =0 T -1 f(t)]/ P (T . f(t). I.14) t =0 t =0 1 -1] P t +1(T ..P t +1(T ..t -1)] / P t +1(T . the dollar return from entering into a futures contract and remaining long one contract until the delivery date will not.t -1).12) was shown to be equivalent to simply holding a forward contract until delivery. It follows immediately that the futures price at the delivery date T is equal to the spot price at that date..f (t )] + ∑[ f (t + 1) . f(T) = X(T). At the end of the period (i.e...1) from this transaction.f(t)]. then he will receive The futures price at date t.f(t)]/ P t +1 (T .t . Invest this money in bonds that mature at date T . f(t + 1) . The accumulated sum at date T . in general.T .t .] [Note: If f(t + 1) . f(T).f (t )][1.] Adjust your position so that you have N t +1 contracts for the period t + 1 to t + 2. t + 1 ). is defined to be that price such that the value of a futures contract is zero.Finance Theory t.f (0) + ∑[ f (t + 1) . at date T . unlike a forward contract.. you will receive $ N t [f(t + 1) . produce a dollar return equal to the difference between the futures price at the time of initial entry.t -1) = f (T ) . Note that holding a futures contract long until the delivery date is quite similar to the examined investment strategy of "rolling over" forward contracts which from (VIII.f(t) | in cash. the accumulated sum will be V T = ∑[ f (t + 1) . and the price at delivery.1) .. 156 . from (VIII.f (t )[ T -1 T -1 (VIII.. from this strategy will be (VIII. In this case. you will have $ N t [f(t + 1) . f(0)..T . for t = 0.14).1). t =0 T -1 Thus. V T . | f(t + 1) .13).e. Consider the analogous investment strategy in futures contracts: At the beginning of each period t (t = 0..1. by inspection of (VIII.f(t).

Hence.16) ' V T = f(T) . and therefore (VIII.18) f(t) = X(t)/ P t (T .e.17) and from (VIII. can be written as (VIII. f(t) = Lt . V T ' From (VIII. we have that. Then. Suppose that changes in interest rates over the life of the futures contract are known with certainty. we have that (VIII. T not too large). these combined positions.f(t)] t=0 T -1 = f(T) .7) LT = X(T). 157 .t .7). to avoid arbitrage. the accumulated value from .Robert C. if L0 ≠ f(0). for most practical cases of relatively short-lived futures contacts (i. Moreover. that (VIII.15). a feasible strategy would be to set N t = P t+1 (T .] Substituting for N t in (VIII. [Note: since this strategy requires one to know at time t .1).17) should be an excellent approximation. for nonstochastic interest rates. these positions require zero investment.15) V T = ∑[f(t + 1) . Merton However. to achieve V T ' requires no investment.[ L T . But. then an arbitrage opportunity would exist.L 0 ] = L 0 .f(0) f(T) = X(T) because and from (VIII. Thus.f(0) . Suppose that simultaneously with following this strategy.f(0).13).. we also go short one forward contract at time t = 0.11) and (VIII. the uncertainty about the bond price at time t + 1 viewed from time t will be small. there is one case where a strategy in the futures contracts will exactly replicate the outcome of a forward contract.t) . (VIII. it is not feasible in a world of uncertain interest rates. Because both the forward contract and the futures contract have zero value. the price that a bond will have at time t + 1.

If T denotes the expiration date and if S(t) denotes the stock price per share at date t.S(T)] where E denotes the exercise price. then it expires and becomes worthless.18) need not obtain without creating an arbitrage opportunity. if the underlying item is a commodity which is not being stored.t) can be a stable result because it is not possible to shortsell the commodity spot. Options: Insurance for the Value of Risky Securities A Put Option gives it owner the right to sell a specified number of shares of stock at a specified price per share (the "exercise price") on or before a specified date (the "expiration date". if there are payouts on the security prior to the delivery date or storage costs for the commodity.17) will hold whenever interest rates are nonstochastic. then f(t) < X(t)/ P t (T .Finance Theory The reader is warned that while the relation between the futures and forward price derived in (VIII. E . 158 .18) will only obtain under the posited assumptions about the security or commodity underlying the contract. Similarly. then (VIII. then the value of the put option per share on its expiration date is Max [0. That is. the relation between the futures and spot price in (VIII.) If the option is not exercised on or before the expiration date.

$S Time until expiration of the put Exercise Price of the Put. and therefore.00 Maximum Insurance Coverage [Face Value of Policy (maximum loss to insurer) Amount of the Deductible (maximum loss to insured) Insurance Premium Important Differences $[S – E] $3. Merton Put Option Viewed as a Term Insurance Policy General Asset Insured Asset's Current Value Term of Policy Stock Stock Price. Figure VIII.875 7 months and 14 days (10/20/79) $300. then such an investment strategy is called a "Protective Put" or "Insured Equity" strategy. Note that the payoff structure is a nonlinear function of the price of IBM stock.25 • Early Exercise and Marketability • Dividends Three Ways of Reducing Risk 1) 2) 3) Diversification: "Mixing" less-than-perfectly correlated risky assets Substituting the riskless security for risky assets Insurance: options If an investor holds a risky security and reduces his risk by the purchase of a put option on that risky security.Robert C.875 Put Price/per share $15.1 illustrates the basic payoff structure to a "Protective Put" strategy for the case when the risky security is IBM stock. this method of reducing risk is fundamentally different 159 . $E Example (3/6/79) IBM $303.

Finance Theory from the alternative method of reducing risk which is to reduce one's holdings of IBM and invest in the riskless security. Reducing the risk of a portfolio of stocks by the purchase of put options can be accomplished by either purchasing a put option on each individual stock within the portfolio or by purchasing a put option on the portfolio itself. The following table provides the simulated return experience from following a protective put strategy where one purchases a put option on each stock in the portfolio. The pattern of returns achieved by these alternate approaches to the Protective Put Strategy will be somewhat different. 160 .

9% 1. No provisions for taxes or transaction costs.8% 6.8% 3.0% 37.1% 1.4% 40. Same as footnote 1 plus a six-month put option with exercise-price-equal-to-initialstock price for each share of each stock.7% 49.339 *Source: "The Returns and Risks of Alternative Put Option Portfolio Investment Strategies.9% 35.1% –1.7% $2.9% 26.7% 3.8% $2.2% $3.218 Semi-Annual: 75% Stocks 25% Paper 1/ 50% Stocks 50% Paper 1/ Commercial Paper Average Rate of Return Standard Deviation Highest Return Lowest Return Average Compound Return Growth of $1000 4.8% 4." by Robert C.9% –10.gS) Average Rate of Return Standard Deviation Highest Return Lowest Return Average Compound Return Growth of $1000 4.June 1977 Protective Semi-Annual: Stocks 1/ Protective Put 3/ Put 2/ (E = S) (E = .8% –7.1% –16.6% 13. January 1982). Equal-dollar Weighted Portfolio of 30 Dow Jones Industrial stocks rebalanced semiannually.3% 3. Returns include reinvesting all dividends.6% $2. Scholes.2% $3. Merton Summary Statistics for Rate of Return Simulations * Stocks Mixed With Commercial Paper Strategies Versus "Protective Put" Strategies July 1963.4% 3.0% 4.829 4.Robert C.812 3.0% 5. and Mathew Gladstein (Journal of Business.209 4.8% –5. Myron S.5% 7. 161 2/ 1/ 1/ .7% 10. Merton.717 3.1% $2.2% 10.

04% 0. The portfolio chosen was a value-weighted portfolio of all New York Stock Exchange stocks and the particular Protective Put Strategy examined was to purchase a one-month put on the portfolio with an exercise price equal to the initial value of the portfolio times one plus the one-month interest rate. then it expires and becomes worthless.19% 0.14% -7.S. show that the value at the expiration date of a protective put strategy levered by going short (i.604 2.527 8.December 1978 NYSE Stocks Protective Put 30-Day U.49% $21.400 6.E]. The value of the call option per share on its expiration date is Max [0. borrowing) in a riskless discount bond with face value of $E and maturity date equal to the expiration date of a put is exactly equal to the value of a call option on 162 .89% 38.85% 5. If the option is not exercised on or before the expiration date.e.12% 0..21% 0.06% 0.55% 3.24% 0.Finance Theory 3/ Same as except exercise price is equal to 90% of initial stock price.21% $3.68% $67. Treasury Bills Per Month: Average Rate of Return Standard Deviation Highest Return Lowest Return Average Compound Return Growth of $1000 Average Annual Compound Return 0.47% 0.55% 30.55% -29. The following table provides the simulated return experience from following a protective 2/ put strategy where one purchases a put option on the whole portfolio.81% -0. S(T) . As an exercise.55% A call option gives its owner the right to buy a specified number of shares of stock at a specified price per share (the "exercise price") on or before a specified date (the "expiration date"). Summary Statistics for Rate of Return Simulations January 1927 .

if the value of the firm is less than the amount of the promised payment (i. then the total promised payment to the debtholders is $B ≡ nM on the maturity date T. Merton the same stock with exercise price and expiration date the same as for the put.Robert C. not in their interests to do so. by definition. In summary.e. the value of the debt issue in that event will be B. and the value of equity will be V(T) . Thus. The original equityholders will receive nothing in that event. homogeneous class of debt with the following terms: 1. then the firm cannot make the promised payment. The debt is a "pure" discount loan where the firm promises to pay $M ("face value") for each bond on the maturity date T. and the value of equity will be 0. then the firm is turned over to the debtholders. On the maturity date of the debt.. On the Relationship Between Risky Debt and Options Consider a firm with two classes of liabilities: equity and debt. In the event that the firm does not make the promised payment ("default").B. you will have proved that the purchase of a call option is equivalent to buying the stock. Assume that there is a single. 2.e. if the value of the firm exceeds the amount of the promised payment (i. clearly. then it is in the interest of the equityholders (who elect management) to have the debt paid. on the maturity date. Having shown this. the equityholders cannot be compelled to contribute the "short fall" to pay the bondholders. and it is. the 163 . If there are n bonds outstanding. V(T) < B). the firm will default. levering the position by borrowing. Because corporate equity enjoys limited liability. and each bondholder will receive his pro rata share of the "reorganized" firm. On the maturity date of the debt. will always be equal to the sum of the market value of debt plus equity). Thus.. V(T) > B). Let V(t) denote the market value of the firm at date t (which. and the value of the debt issue in that event will be V(T). and insuring the risk by purchasing a put option.

Max [0.B]. but is also issuing insurance to the equityholders against declines in the asset value of the firm below $B. the theory of option price determination has much broader application beyond simply evaluating puts and calls. Some examples would be deposit insurance and loan guarantees. be negative].Finance Theory (VIII.B + Max [0.V(T) . Most kinds of insurance of guarantees of the value of a security can be viewed as options.V(T)] = B . B . 164 . then the value of the equity at maturity would be V(T) .B [which could. Similarly.V(T)] = V(T) . then one is not only borrowing money.Min [B. Inspection of the value formula for equity (VIII. B . of course. if one buys corporate debt. If there was not limited liability or equivalently. (VIII. Inspection of the above value formula shows. Thus. the promised amount. if the equityholders had chosen to get leverage by personal (unlimited liability) borrowing where the aggregate face value of the loan were B.V(T)] = Max [0.V(T)] and the value of equity = V(T) . then one is not only lending money.19) value of debt issue = Min [B. then the value of the debt at maturity would always equal B. if one issues corporate debt. Hence.20) Note: If the debt issue were default-free. therefore. but is also purchasing insurance against a decline in the value of the firm's assets below $B.20) shows that equity levered by corporate borrowing "looks like" a combined position of levering equity with an unlimited liability loan and purchasing a put option on the firm's value with an exercise price = B and expiration date T. that risky corporate debt "looks like" a combined position of buying a default-free discount bond with face value B and maturity T and issuing (short-selling) a put option on the firm's value with an exercise price = B and an expiration date T.

IX. some typical examples are bank loans. debentures. It will be helpful to develop a feel for typical debt-to-asset ratios in various industries. and therefore that the firm had the simplest structure possible: namely. all claims on the firm are homogeneous equity. In addition to common stock equity. does the financial structure of the firm "matter"? That is. Thus. THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE The capital structure of a firm is defined to be the menu of the firm's liabilities (i. commercial paper. secured bonds. the answer to this fundamental question depends upon the assumed environment. Therefore. income bonds. While the traditional treatment of capital structure is to examine each of these types of securities separately. the reader should become familiar with the meaning (and effects) of financial leverage and with the distinction between financial risk and asset (or business) risk. In the study of the firm's investment decisions in Section VII. each of these "hybrid" securities can be represented as a "mixture" (albeit at times a complicated one) of pure" "default-free" debt and "pure" (as if 100%-financed by common stocks) equity. the total cash flow generated by the firm will not be affected by the capital structure choice. preferred stock. That is. convertible bonds. the "right-hand side" of the balance sheet). if the capital structure matters (and thereby.e. will a change in the firm's mix between debt and equity cause a change in the market value of the firm? As one might expect. As background. the investment policy of the firm is fixed. the analysis in this section of the capital structure choice and its impact on the total market value of firm will focus almost exclusively on the choice between debt and equity in providing the firm's external financing. it was assumed that all external financing was done by issuing equity. this approach avoids many of the pitfalls and misconceptions about the costs and benefits of different capital structure choices. the modern approach (as was suggested in Section VIII) views all these types as part of a unified theory of contingent claims pricing. 165 . A great variety of types of securities can be and are used in firms' capital structures. and warrants. a change in it will cause a change in the market value of the firm). for a fixed investment policy. The fundamental question explored here is: Given the investment decision of the firm. by hypothesis. Beyond simply providing a unified theory of pricing. Since.

1) No income taxes (to be modified later). This environment includes the following assumptions: (A. 5. we begin by studying the impact of capital structure in a specific environment and use this as a benchmark for insights into why financing decisions might affect value. 4. Are there costs to bankruptcies? Are there tax features unique to corporate debt? What are the effects on control of the firm? Does the existence of outstanding debt "induce" changes in investment policy? Other factors which are often considered by managers in deciding on the debt/equity ratio are: 1. Merton then. as shown in Section VII. then it is necessary for the manager to consider simultaneously both the investment and financing decision in making an overall optimal set of decisions for the firm. if the capital structure matters. debt and equity are essentially indistinguishable. [The only exception would be if the capital structure choice changes either the tax liabilities or the level of government subsidies to the firm. 166 . the cost of capital is used in determining the (optimal) investment decision.e.Robert C. from the valuation formulas derived in Sections VI and VII. it is necessary to assume some type of uncertainty to give this question serious meaning because otherwise. Possibilities are: 1. Does the issuance of debt create a new set of securities which were previously not available? (i. Why should the financial structure matter? With the exception of certain tax features. 4. a topic addressed later in this section.] Since. growth rate of future sales stability of future sales the competitive structure of the industry the asset structure of the industry lender attitudes toward the firm and its industry. 3. 3. a capital structure change must cause a change in the cost of capital. 5.. how substitutable is personal leverage for corporate leverage?) 2. 2. To analyze the problem.

(A.e. and are taken as constant. i. a change in the capital structure is affected immediately and there are no transactions costs.. (A.6) All investments that the firm considers are from the same risk class. dividend policy is to pay dividends equal to earnings). the business risk characteristics are independent of the number of projects taken.1) Let F B0 = (expected) annual interest payments on debt outstanding = market value of debt outstanding 167 .3) The firm finances all investment by external means (i. (A.e.4) The expected values of the (subjective) probability distributions of future (operating) earnings for each firm are the same for all investors ("homogeneous investor beliefs"). Then.2) The debt-to-equity ratio is changed by issuing debt to repurchase stock or by issuing equity to pay off debt. Moreover.Finance Theory (A..5) No growth of earnings: the expected value of operating earnings for all future periods are the same. the market value of this firm is: V0 = X k0 (IX. and it is assumed to be constant over time. (A. A "Benchmark": The "Pure Equity" Case (100% Financing by Equity) Let X ≡ average expected dollar return per period for the firm Let k 0 ≡ cost of capital for 100% equity financed firm = expected rate of return required for the firm's particular risk characteristics.

2) ⎛ B0 ⎞ ⎛ S0 ⎞ ⎛ B0 ⎞ ⎛ S0 ⎞ k0 = ⎜ ⎟ ki + ⎜ ⎟ k e = ⎜ ⎜ ⎟ ⎜ ⎟ ⎜ + ⎟ ki + ⎜ + ⎟ ke . ⎟ ⎜ ⎟ ⎝V 0 ⎠ ⎝V 0 ⎠ ⎝ B0 S 0 ⎠ ⎝ B0 S 0 ⎠ k 0 is called the "weighted" cost of capital and is the relevant number to use in the investment (capital budgeting) decision of Sections VI and VII. for a given level of business or asset risk.Robert C. The question "Does financial structure `matter'?" can be restated as "does k 0 change for different mixes of debt and equity (given a fixed investment policy)?" Or. does changing the financial risk of equity change the total value of the firm? 168 . Merton E = (expected) annual earning available to shareholders = X -F S0 ki ≡ F B0 = market value of equity outstanding = cost of debt = required (expected) return by investors to hold this amount of debt in the firm ke ≡ E S0 = cost of equity = required (expected) return by investors to hold this amount of equity in the firm V 0 = S 0 + B0 k0 ≡ X V0 = F+E V0 + = k i B 0 k e S 0 or V0 (IX.

net operating earnings = $1000 Case 1: B 0 = $3000 which implies F = $150 and so.05) + ⎜ ⎟ (. Net Operating Earnings $ 1000 ⎛ B0 ⎞ ⎛ S0 ⎞ k0 = ⎜ ⎟ ki + ⎜ ⎟ k e ⎜ ⎟ ⎜ ⎟ ⎝V0 ⎠ ⎝V0 ⎠ ⎛ 3000 ⎞ ⎛ 8500 ⎞ ⎟ (.7% 13000 169 .10 (300) $ 700 ______ = 1000 ≈ 7.7% 11500 Market Value of Equity ( S 0 ) + Market Value of Debt ( B0 ) Market Value of Firm ( V 0 ) $8500 3000 $11500 = Leverage Factor ≡ B0 = 3000 S 0 8500 ≈ .10) =⎜ ⎝ 11500 ⎠ ⎝ 11500 ⎠ minus interest payments (150) Earnings available to equity ÷ k e = .10) k0 = ⎜ ⎟ ( .Finance Theory "Extreme" Classical Theory: The "Net Income" Approach Assumption: k e and k i are constants with k e > k i Example: k e = 10% and k i = 5%.35 Case 2: B0 = $6000 which implies F = $300.10 $ 850 ______ = 1000 ≈ 8. so Net Operating Earnings $1000 7000 ⎛ 6000 ⎞ (.05) + 13000 ⎝ 13000 ⎠ minus interest payments Earnings available to equity ÷ k e = .

k e rises at an increasing rate. 3.86 Classical Approach (generally) as is illustrated in figure above 1. Assumes that beyond some point of leverage. Merton Market Value of Equity ( S 0 ) + Market Value of Debt ( B0 ) Market Value of Firm ( V 0 ) $7000 6000 $13000 Leverage Factor ≡ B0 = 6000 S0 7000 ≈ . 170 . through the appropriate choice of leverage. Assumes that there is an optimal capital structure and hence. k i may rise. the value of the firm can be increased. Assumes that beyond some point of leverage. 2.Robert C.

k 0 .Finance Theory Modigliani-Miller (as is illustrated in figure above) Assume perfect capital markets: equal information. no taxes. free access to borrowing and lending. are independent of its capital structure (the total market value of a firm is calculated by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class). Their basic propositions are: (1) The total market value of the firm and its cost of capital. no transactions costs. 171 . investors are rational and believe everyone else is. firm debt is default-free.

the M .k i ) ⎝ S0 ⎠ (IX. times the leverage factor ( B0 / S 0 ). (3) Therefore.3) 172 .M result is: Proposition 2 can be derived formally from equation (IX. k i is constant).Robert C. Merton (2) The required expected return on equity. the "cut off" rate for asset selection (investment policy). Graphically. is equal to the capitalization of a "pure" equity stream. is independent of the financing decision. plus a premium for financial risk which equals the difference between the "pure" equity capitalization rate and k i . under the assumption that the debt has no risk of default (hence. k 0 .⎜ ⎟ k i ⎝ S0 ⎠ ⎝ S0 ⎠ S0 S0 or ⎛ B0 ⎞ k e = k0 + ⎜ ⎟ ( k0 .2) as follows: ⎛ S0 ⎞ ⎛ B0 ⎞ k0 = ⎜ ⎟ ki + ⎜ ⎟ ke ⎝V 0⎠ ⎝V0⎠ ⎛V 0⎞ ⎛ B0 ⎞ ( B0 + S 0 ) B0 ke = ⎜ ⎟ k0 ki = k0 . k e .

e. rate of interest.. I. times the portion of earnings available to shareholders. (IX. 2 2 Step 2: borrow ( α B0 ) dollars.. k i = constant ≡ r.. will be his 2 fractional claim. If S 1 = number of dollars invested in company #1's shares.rB 0 .e. α .e. his return in dollars. 2 2 2 2 2 173 . If the investor continues to hold his present portfolio.e. 2 2 Suppose that V 0 > V 1 .. Y 2 . (the debt is default-free).Finance Theory (First) Proof of M–M result by arbitrage Suppose the borrowing and lending rates are equal and the same for all investors and corporations.4) 2 Y 2 = α (X . i. by the "right" choice of leverage. Step 3: with the proceeds from steps 1 and 2. we have that S 2 = α S 0 . Consider two companies with identical anticipated earnings. buy shares in company #1. X . i. company #2 will have a larger value 0 than #1.r B0 ) The investor could sell out his present holdings and choose an alternative portfolio as follows: Step 1: sell his current holding for S 2 (= α S 0 ) dollars. X 1 = X 2 = X. If α = % of total shares of company #2 held by this investor. i. Suppose that company #1 has no Company #1 Company #2 X 1= X 1 B0 = 0 at rate k i = r Earnings: Debt: Equity: Firm Value: Earnings: Debt: Equity: Firm Value: X 2= X 2 B0 > 0 at rate k i = r 1 1 S 0 (= V 0 ) S0 2 V0 1 V 0 (= B0 + S 0 ) 2 2 2 Consider an investor who currently owns S 2 dollars of stock in company #2. debt (financed completely by equity) and company #2 has some debt. then S 1 = α S 0 + α B0 = α ( S 0 + B0 ) = α V 0 .

then the investor can earn a higher return in the second portfolio than in the first. 174 .5) ⎛ V2 ⎞ ⎛ V 2 − V1 ⎞ 2 2 = α⎜ 01 X − rB 0 ⎟ = α X − rB 0 + αX⎜ 0 1 0 ⎟ ⎜V ⎟ ⎜ V ⎟ 0 ⎝ 0 ⎠ ⎝ ⎠ ( ) or ⎛ V 2 − V1 ⎞ Y1 = Y2 + αX⎜ 0 1 0 ⎟ ⎜ V ⎟ 0 ⎝ ⎠ so for V 0 > V 0 . Y 1 > Y 2 . will be 2 ⎛ S1 ⎞ αV0 2 2 Y1 = ⎜ 1 ⎟ X − r αB0 = 1 X − rαB0 . Because #1 has no debt. we have demonstrated that for the same number of dollars 2 1 2 1 invested in either case. 0 0 The return in dollars on his new portfolio. The argument goes through in precisely the same way. S0 = V 0 1 1 and so. he has claim on ( S 1 / S 1 )X = ( S 1 / V 1 )X dollars of return. Hence.6) 1 2 V 0 =V 0 . Therefore. to avoid arbitrage or dominance. rational investors will "switch" to portfolio #2 from portfolio #1 until V 0 ≤ V 0 . if it was assumed that V 0 > V 0 . X. for every possible outcome of earnings. from step 3 ⎜V ⎟ V0 ⎝ 0⎠ ( ) (IX.M proposition using the same notation and company data as in 1 2 the first proof is as follows (where firm #1 has no debt and firm #2 has some debt): Case I: 1 1 Hold as an investment: $ S 1 of shares of company #1 = α S 0 = α V 0 . The return from the investment will be = αX . if V 0 > V 0 . Merton 1 Step 4: as an owner of $ S 1 worth of shares of company #1. 1 2 Therefore. Y 1. he will have claim on ( S 1 / S 0 ) percent of #1's earnings. A second proof of the M . (IX.Robert C.

V 0) fewer dollars invested. then the investor gets the same return for α (V0 -V0 ) fewer dollars.Finance Theory Alternative Investment: Transaction Investment 2 2 2 α S0 ≡ α ⎡ V0 − B0 ⎤ ⎣ ⎦ Return (1) (sell $ S1 of #1 and) buy the same fraction α of the shares of #2 ( ) 2 α X .α rB0 ( ) 2 − α B0 Total 1 2 α V0 − B0 ( 2 α X . V0 = V0 . if V 0 > V 0. Case II: Hold α% of shares of firm #2: $S2 of shares of #2 = 2 2 2 2 α (S0 = α (V0 -B0 ). the investor gets the same return for α(V 0 . 175 . The return will be α (X-rB0 ).rB0 ) 2 1 2 1 If V0 > V0 .rB0 ( ) (2) buy α percent of the bonds of firm #2 2 α B0 2 rα B0 Total 1 2 2 α V0 αX 1 2 So. Alternative Investment: Transaction Investment 1 α S1 ≡ α V0 0 Return (1) buy fraction α of the shares of #1 2 (2) borrow α B0 dollars ( ) ) ( αX 2 . to 1 2 avoid dominance or arbitrage. Hence.

then M-M holds because investors will not pay more for firms that borrow for them if they can do it themselves. Or. To review the difference between personal and corporate borrowing. 5. Moral Hazard: management makes decisions in the best interests of the shareholders that may conflict with the interests of the bondholders. the most important are (1) and (2). The risks of personal versus corporate leverage (limited liability and bankruptcy). reduce the overall market value of the firm. To disagree with the conclusions of M-M one must therefore disagree with their assumptions. Merton Thus. Of these items. by far. 3. by a powerful arbitrage argument. that the capital structure or financing decision among alternative instruments does not affect the market value of the firm or its (average) cost of capital for determining which assets to purchase. Tax deductibility of interest payments by the firm. The classical view of the capital structure simply assumes that leverage "matters. and therefore. given their assumptions. Items that could affect the M-M Conclusion 1. Institutional restrictions may prevent institutional investors from "levering". 4." M-M showed why it does not. In the proofs of M-M. it is assumed that both corporate debt and personal borrowing is default-free. M-M demonstrate. Cost of borrowing may be higher for the investor than the firm. Margin requirements restrict individuals. The intuition is that a purely financial transaction for a fixed amount of real assets should not affect any "real" decisions or values.Robert C. 2. Transactions costs in establishing the arbitrage position. and therefore. this will no longer be the case when there is a possibility of default on the debt of the firm. 6. investors who levered equity by personal borrowing could exactly replicate the payoffs to investors who held shares levered by corporate borrowing. if personal borrowing is a perfect substitute for corporate borrowing. As was already demonstrated in Section VIII. we maintain the assumption 176 .

Ep. would be Ep = V0 – B/[1 + R(T)] . The payoffs are: 177 . and at time T in the future if the firm is worth V(T). Then the value of levered equity. the payoffs to the debt and levered equity will be T Consider a corporate loan with the same terms except limited liability for the shareholders.Finance Theory that personal borrowing is default-free and briefly reexamine the case of a pure discount term loan: Consider a personal term loan (with no interim interest payments) with a face value of B dollars due at time T in the future. Let the firm (unlevered) have a current value of V0.

Therefore. disruption of the operations of the firm). Merton By inspection. Ec(T) – Ep(T) = B – V(T).e.. Correspondingly.g’ where g′ is the "liability" associated with issuing the put insurance (its cost).. if there are significant "dead-weight" losses to the firm's liability holders from a bankruptcy (e.. As noted in Section VIII.B / [1+ R(T) ]T + g where g is the value of this "downside insurance" (i. Of course. we can write the value of corporate debt as T Dc = D p . the payoff to the debtholders in the corporate case is less favorable than in the personal case.g’ = B / ([1 + R(T) ] . Ec > Ep. attorney fees. the current value of the corporate-levered equity will exceed the current value of the personal-levered equity.e.e. Similarly.. is "insuring" the equityholder.g. the current value of the corporate debt will be less valuable than the current value of the personal debt. That is. i. So. in the event that V(T) < B.e. the corporate debtholder is not only lending money but. M-M will hold if either put options on the stock exist or if these options can be created by low-transaction cost investment strategies. by definition. the payoff to the equityholders in the corporate case is more favorable than in the personal case. then M-M holds even when bankruptcy is possible. i. the corporate-levered equityholders are "insured" against losses that would occur for the personal-levered equityholders if V(T) < B. we can write the value of the corporate-levered equity as Ec = E p + g = V 0 . the promised yield (for the period) is simply [B/Dc] – 1 which can be rewritten (for T = 1) as 178 .Robert C. then corporate leverage can matter. the put option insurance premium). This analysis should serve to underscore once again (as noted in Section VIII) that one cannot compare the "true" or "economic" cost of the debt of one firm with that of another by simply comparing promised yields on debt. Dc < Dp. i. Correspondingly. If V0 is the value of the unlevered firm and if g = g′. even in the presence of default possibilities. Inspection of the payoffs to Ep versus Ec shows that. That is.. in addition.

V0 = value of unlevered firm and V = value of levered firm.T c )(1 . Then (IX. Let k0 = required pre-tax expected return on the unlevered firm. On the levered firm. Tp = personal tax rate. If the value of the put option on one firm is larger than the value of a corresponding put option on the other.8) V0= X (1 . Effect of Corporate and Personal Taxes on the M-M Result The federal tax law allows corporations and individuals to deduct interest payments from their income before computing taxes. then it is entirely possible that the debt with the higher promised yield could have a lower economic cost than the debt with the lower promised yield. Taxation in the M-M Model Let X = operating income (before interest and taxes) and XT = after-tax earnings before interest.T p ) k 0 = (1 . This tax shield is a subsidy to borrowers and may induce corporations and individuals to borrow when they otherwise might not.R)(1 . Tc = corporate tax rate. The analysis also makes clear why the promised yield on a personal loan will be lower than on a (comparable) corporate loan because in the former.T c )X + T c R 179 . the investor pledges all his assets and in the latter (with limited liability) he pledges only his share of the corporate assets.T c ) X k0 .T c ) + R = (1 . X T = (X . Bc = "long-run" amount of debt outstanding and R = interest payments.Finance Theory (IX.7) Promised yield = R + g(1 + R) B .T p ) (1 .(1 + R)g where g is the value of the (implicit) put option.

the levered firm is equivalent to the unlevered firm plus a certain number (TcBc) of riskless bonds.10) Y = [( X -r Bc )(1 . then the value of the debt is and they show. The latter is not of substantive importance because the value of the tax shield can be shown to equal TcBc.T p )r Bc = Bc .B p (IX.T p )r = V 0 .T p )] and the value of this stream will be V( Y ) = V 0 r[ Bc (1 . (IX.T c ) . Let Bp = amount of personal borrowing.Robert C. that (1 . then 180 .T p )r (IX.T c ) X k0 = V 0 + T c Bc + Tc r R In essence. they assumed that the magnitude of the tax shield is certain which need not be so if Bc is "pegged" to V. Moreover.T c )(1 . MM argue that R = rBc. even if there is a possibility of default.T p )] (1 . then dBc = –dBp and (IX. Alternatively to corporate borrowing.T c )(1 .12) dV dBc = . because of the tax subsidy.T p ) . let all the flows be riskless and let Y = after-tax income to an investor who maintains a fixed total leverage (corporate + personal borrowing = constant) position. (1 . However. Merton If the debt is riskless. MM assume that all earnings are paid out as dividends which are taxable at Tp.r B p (1 .(1 . Then. by their arbitrage argument.Bc (1 .11) If Bc + Bp = constant.T c ) + 1 = T c as MM claim .T p ) + B p (1 . suppose that one pays capital gains on the income of the firm.9) V= (1 .

T p > (1 .r B p (1 . the effects of capital structure on the firm's cost of capital will not be large enough to make a capital budgeting project worth undertaking when it would not have been undertaken if financed entirely by equity.14) V(Y ) = V 0 − r[ B c(1 . T g . and if we capitalize at (1 – Tp)r.Finance Theory (IX.T g ) + B p(1. On the Cost of Bank Borrowing Loan Commitment = Maximum that can be Borrowed = "Line" ≡ L Principal Amount Borrowed = Gross Borrowings ≡ B Stated Interest Rate on Loan ≡ R = r + δ where r = "prime" rate and δ ≡ amount "over prime" charged. The example is that of a bank loan with compensating balances and line fees.T c )(1.T p ) and dV (IX.T p ) > 0 if T p < T c In summary. or tax exemption for corporate debt. exceptions to this general rule especially when projects are subsidized by government and the subsidy takes the form of below-market interest rate loans.T p )] r(1. 181 .13) Y = [ ( X -r B c )(1 . loan guarantees. it is probably a reasonable conclusion that generally.T p )] .T c )(1 .T g ) < 0 depending on T c . In completing this section.1. There are.T c )(1 .T g ) . while the theoretical and empirical evidence is hardly conclusive on whether or not capital structure matters. Problem IX.15) =1- dB c (1 . we present another example of the care that must be exercised in computing the cost of borrowing. of course. then (IX.

.84 ≈ 1. L–B].16 must be maintained at the Federal Reserve. Merton CB ≡ required (by the bank) amount to be kept on deposit in free balances in the form of noninterest-bearing demand deposits.e. D≡ d≡ amount of noninterest-bearing demand deposits maintained by firm amount of noninterest-bearing demand deposits which would have been maintained by the firm even if there were no loans. so that only $.Robert C. Therefore.D+d I ≡ $ charges paid for money (IX.. ("Compensating Balances") = c1L + c2B (i. CB = . $.84D or D = CB/.e.17) I = R • B + R L (L . Of each $1 deposited.84 represent free-balances. Let RL ≡ rate paid as a line fee M ≡ actual amount of money available for corporate purposes (IX.19CB Fee is payable to the bank for the unused part of the line [i. a fraction of the line plus a fraction of the principal) P ≡ penalty charged for not maintaining sufficient compensating balances __ = Rp[CB–CB] where Rp ≡ penalty rate and CB ≡ compensating balances actually maintained.16) M = B .B) + R p [ CB -CB] Let RT ≡ the "true" interest rate cost of borrowing = I/M 182 .

84 − c 2 ) R p ⎤ / M ⎦ dD M fixed ⎣ dR T dD < 0 if R p > M (R − RL ) (.18') { } Should the firm maintain the compensating balance or pay the penalty? [i. M.84 D / [ B − D + d ] { } (IX. choice of D dR T dD > 0 if R p > M [ R − RL ] ⇒ D optimum (..84 − c2 ) =d A Numerical Example: Prime = r = 18%.84 R p dD M − { } R [ dB − dD ] M But dM = 0 ⇒ dB = dD.19CB + d dR T dD = 0 if R p > M [ R − RL ] (.Finance Theory (IX.84 − c2 ) ⇒ indifference w.19CB + d]. Therefore .84 − c2 ) ⇒ D optimum = 1. Holding fixed the amount of money available for corporate purposes.19) dR = ⎡( R − R L ) − (.e.r. δ = 2% so that R = 20% 183 .t. (IX. how is RT R affected by the choice of D? dRT = [ R + R p c2 − RL ] dB − . which D should be chosen for d ≤ D ≤ 1.18) ⎢ ⎥ ⎢ ⎥ RT = ⎣ R + RPC2 − RL ⎦ B + ⎣ RL + RPC1 ⎦ L − RPCB / M ⎢ ⎥ ⎢ ⎥ RT = ⎣ R + RPC2 − RL ⎦ B + ⎣ RL + RPC1 ⎦ L − RP .

000.] 184 .000.000 2.81 32. Since Rp is such that for fixed M.000.e. no penalties) Amount for Corporate Purposes (M) "True" Interest Cost RT $1.000 9..62 25.000 53.84 (i.000.000. the level of deposits has no effect upon RT .25 ∂r [i. d = 0.61 26. Line = L = $10.5%.e.000.000.000 8.000. assume that D __ is chosen such that D = CB/.000 5.000 6..000 10.000.36 26.49% 37.000 7.05 25.000 4.000 3.59 29. c1 = c2 = .000.Robert C.e.41 27.97 28. Payments of interest and fees once a year.000.000.27 This RT should be compared with "stated" rate of R = 20% Note: ∂RT ≈ 1. Merton Compensating Balance Requirement: 10% of the Line plus 10% of the Principal [i.10] Compensating Balance Penalty Rate: Rp = [R – RL]/[. an increase in prime of 100 basis points will cause (at least) a 125 basis point increase in the cost of the loan..84 – c2] Line fee: RL = 0.

a rational criterion function for the firm was deduced and rules for investment choice by firms were established. we postulate that the criterion of choice for individuals satisfies the von Neumann-Morgenstern Expected Utility Maxim. the investor has many assets to choose from. the certainty assumption is dropped. That is. Beginning with Section VIII. The basic formulation of the portfolio selection problem is as follows: Assume that the investor has a von Neumann-Morgenstern utility function for end-of-period wealth. strictly defined. in choosing among uncertain alternatives. and for the balance of these Notes. and within limits of divisibility and transactions costs. To do so. Let W 0 185 . The introduction of uncertainty substantially complicates decision making by all economic units. and to answer (at least in part) the question of why certain types of assets exist. The solution to the general problem of selecting the best asset mix is called portfolio theory. Thus.X. In making an allocation of his wealth. each person's rankings of those alternatives can be represented by computing the expected value of some utility function of the random variable payoffs to these alternatives. we begin with the analysis of the individual household or consumer allocation problem. the structure of the capital market and the types of financial instruments and intermediaries required for an efficiently functioning economy are greatly expanded. to determine what information about the distributions is required by investors to make optimal decisions. It takes as given the menu of available assets where assets are operationally-defined by their joint probability distribution of end-of-period values. portfolio theory has nothing to say about where these distributions come from or about why some assets exist and others do not. we will use the theory in an equilibrium context to deduce certain properties of these distributions. THE INVESTOR'S DECISION UNDER UNCERTAINTY: PORTFOLIO SELECTION By assuming certainty and perfect exchange markets in Sections II-VII. As in the certainty case. U(W) and assume further that U is strictly concave (such investors are called "globally risk averse"). As a result. he can choose mixes or combinations of these assets to form alternative portfolios. However. the optimal consumption and investment decisions by households were derived.

Robert C. Merton

denote his initial wealth and suppose that there are n different assets or securities available in units called "shares". Let Pi

o

denote the current price per share of asset i , i = 1,2,..., n. which is known.

The investor can buy or sell all the shares he wants at the current price (i.e., he acts as a "price taker"). Denote by N i the number of shares (or units) of the i security that he chooses to purchase. His set

0 of feasible choices is determined by his budget constraint: W o = ∑ N i Pi . i=1 n

th

Suppose that he has a

1 probability distribution for the end-of-period price per share, Pi , for each asset. Then, his end-of-

**period wealth will be the random variable W 1 =
**

th

∑N P

i i=1

n

1 i

. Define wi ≡

N i Pi to be the fraction of Wo

o

his wealth invested in the i security and define the (random) variable return (per dollar invested)

**in the i asset to be Z i ≡
**

th

Pi . Then, we can write the expression for W 1 as o Pi

1

(X.1)

n n n ⎛ N o⎞⎛ 1⎞ i = ∑ N i P1 = ∑ ⎜ i Pi ⎟ ⎜ Po ⎟ W o = W o ∑ wi Z i W1 i ⎜ ⎟⎜ ⎟ i=1 i=1 ⎝ W o ⎠ ⎝ P i ⎠ i=1

Note: by definition of wi and the budget constraint:

∑w = 1 .

i i=1

n

**So the investor's problem of portfolio selection can be written as either
**

Max

(X.2)

{ N 1 , N 2 ,..., N n }

E{U( ∑ N i P1 )} subject to W 0 = ∑ N i Po i i

1 1

n

n

or equivalently

(X.2′)

Max { w1 , w2 ,..., wn }

E{U( W o ∑ wi Z i )} subject 1 = ∑ wi .

1 1

n

n

186

Finance Theory

Suppose that one of the available securities is "riskless" and offers a return per dollar of R with

certainty. If, by convention, we choose the n security to be riskless, then we have that Z n =

n n -1 with certainty. Note that 1 = ∑1 wi = ∑1 wi + wn m or wn = 1 - ∑1 wi where m ≡ n - 1 .

th

Pn =R o Pn

1

Define:

n Z ≡ ∑ 1 wi Z i =

W1 = return per dollar on the portfolio. With a riskless asset, we can rewrite Z as Wo

n m m m m Z = ∑1 wi Z i = ∑1 wi Z i + wn Z n = ∑1 wi Z i + (1 - ∑1 wi ) Z n = ∑1 wi ( Z i - Z n ) +

**Z n = ∑1 wi ( Z i - R) + R . Hence, the investor problem becomes:
**

m

(X.3)

⎛ ⎡ m ⎤⎞ E { U ⎜ W o ⎢ ∑ wi( Z i - R) + R ⎥ ⎟ } Max ⎜ ⎟ { w1 ,w2 ,...,wm } ⎣ 1 ⎦⎠ ⎝

**where { w1 ,..., wm } are "free" decisions variables since the budget constraint was substituted out. To
**

solve (X.3), the usual calculus technique gives us that the maximum

(X.4)

∂(EU) = 0 = E{U ′( W 1 ) ( Z 1 - R)} ∂ w1 ∂(EU) = 0 = E {U ′( W 1 )( Z 2 - R)} ∂ w2 M M M ∂(EU) = 0 = E {U ′( W 1 )( Z m - R)} ∂ wm

or

(X.4')

E{U ′( W 1 ) Z i } = R E{U ′( W 1 )} i = 1,2,..., m .

Call

{ w* , w* ,..., w* } 1 2 m

(and by the budget constraint,

wn = 1 - ∑1 wi )

* m * *

the optimal portfolio

(proportions) which will be the solution to (X.4). Suppose some wi < 0 . This means that the investor will short-sell security i . To short-sell, the investor borrows shares today and sells them (using the proceeds of the sale to purchase other securities). He must return the same number of units of that security at the end of the period. Unlike borrowing money, the short-seller has a liability for returning the specified number of shares instead of a specified number of dollars. If wn < 0 , then we call it

*

187

Robert C. Merton

borrowing. Since the n

m

th

asset is riskless, the liability can be denoted as a specified dollar amount.

* * Let Z ≡ ∑1 wi ( Z i - R) + R = return per dollar on the optimal portfolio.

E{U ′( W 1 ) Z * } = E{U ′( W 1 )( ∑ w* ( Z i - R) + R)} i

1

m

= ∑ w E{U ′( W )( Z - R)}+RE{U ′( W )} .

* i 1 i 1 1

m

But from (X.4), E{U’ ( W 1 )( Z i - R)} = 0, 1 = 1,2,..., m. So

(X.5)

E{U ′( W 1 )Z * } = RE{U ′( W 1 )} .

**Example: Quadratic Utility
**

b U(W) = W - W 2 0 ≤ W ≤ 1/b, b > 0 2 1 1 = W≥ . 2b b

Suppose that there are just two securities: asset #1 has (uncertain) return Z 1 and asset #2 has a

**certain return Z 2 = R. If w1 = w = the fraction of his wealth invested in the "risky" asset #1 and W2
**

= 1–W1 = 1–W = fraction of his wealth invested in the "safe" asset #2, then the investor's portfolio problem can be described by:

**Max E{U (W 1)} = Max E{U (W o[ w( Z 1 - R) + R])} {w} {w}
**

b 2 = Max E{W o[ w( Z 1 - R) + R] - W o[ w 2( Z 1 - R) 2 + 2 wR( Z 1 - R) + R 2]} 2 {w}

* Maximizing, by the usual calculus, gives the condition that w = w , the optimal portfolio, when

0=

dEU 2 2 = E{ W o ( Z 1 - R) - bW o [ w* ( Z 1 - R ) + r( Z 1 - R)]} dw

188

Finance Theory

or by dividing by W o and rearranging terms

E( Z 1 - R) = bW o w* E{( Z 1 - R )2 } + b W o RE( Z 1 - R) or

(X.6)

* w=

(1 - bW o R)E[ Z 1 - R] 2 bW o E[( Z 1 - R ) ]

If W o R >

**1 (i.e., if it is not possible to achieve the "satiation" level of wealth for certain), then a b
**

* w > 0)

necessary condition for him to hold some amount of the "risky" asset (i.e.,

is that

**E( Z 1 - R) > 0 or E( Z 1 ) > R, i.e., the expected return on the "risky" asset must exceed the certain
**

* * return R . Note: the expected return on the portfolio = E(Z) = E[ w ( Z 1 - R) + R] > R for w > 0

only if E( Z 1 ) > R .

Mean-Variance Portfolio Selection and the Effects of Diversification

While in general, the expected utility maxim requires knowledge of the complete joint distribution of asset returns to determine the optimal portfolio, under certain conditions, it is sufficient to know only the first two moments of the joint distribution. That is, the criterion function for choice can be written as a function of just the expected value (mean) of end-ofperiod wealth and the variance of end-of-period wealth V[E( W 1 ) ,Var( W 1 )] where V is an

increasing function of its first argument and a decreasing function of its second argument). Under these conditions, the choice problem is called the Mean-Variance portfolio selection problem. While beyond the scope of these Notes, it can be shown that if the time interval between successive portfolio revisions is small, the optimal portfolio choice can be wellapproximated by the mean-variance problem's solution. For the balance of these Notes, we shall focus exclusively upon environments in which the mean-variance criterion is appropriate.

189

Robert C. Merton

The mean-variance model is the first step in introducing uncertainty quantitatively into the ranking of portfolios or investments. Classical methods of ranking investments use a single parameter measure such as (expected) rate of return or (expected) present discounted value. Although such one parameter measures make ranking quite easy (highest to lowest), they clearly do not reflect differences among alternatives due to uncertainty. With a two parameter ranking, there is no simple ranking like highest to lowest. The purpose of the mean-variance model is to determine optimal portfolios and to make explicit, the tradeoff between risk and return.

A digression on some characteristics of probability distributions

1.

**The first moment or expected value or the mean of the random variable X which can
**

take on value x1 with probability P1 ; value x 2 with probability probability P n is defined as

P2; ...; value x n with

E(X) = X = ∑ Pi xi

i=1

n

2.

**The second (central) moment or variance of the random variable
**

2 σ = E[(X - X ) ] = ∑ Pi ( xi - X ) 2 X 2 i=1 n

X

is defined by

.

The standard deviation is a measure of the

dispersion of possible outcomes around the expected value, as is illustrated in Figure X.1.

190

Finance Theory

Figure X.1.a Figure X.1.b

In Figure X.1, the distribution in (b) is more disperse than in (a), and (b) has a larger standard deviation (and variance) than (a). Note: in the special case when there is only one possible outcome for X, call it y, then E(X) = X = y and

σ 2 = 0 = σ X . An alternative useful formula for σ 2 is: X X

σ = ∑ P i( x i -X )

2 X i=1

n

2

where X = ∑ Pi x i

i=1 n n n i=1 i=1 i=1

n

= ∑ P i( x i2 -2 x i

i=1 n

n

X + X 2 ) = ∑ P i xi2 - 2X ∑ Pi x i + X 2∑ P i

= ∑ P i xi2 - 2 X 2 + X 2 = E[ X 2 ] - ( X )2

i=1

3.

The covariance between two random variables X and Z is defined by

σ XZ = Cov(X, Z) = E{(X - X )(Z - Z )}

= ∑ ∑ Pij ( xi - X

i=1 j=1 n m

)( Z -Z )

j

where Pij is the probability that

191

if they are independent.e. I. Cov(X.X )} = Cov(Z.e. 192 .X )2 } = σ 2 X (3) if X and Z are independent. i. Z) = 0. Roughly.X ∑ PiX = X . Z) = E{(X . If X and Z are independent. | ρ XZ | ≤ 1 . It is a measure of the co-relationship between variations in possible outcomes of the two random variables X and Z around their expected outcome.X =0 X and so Cov(X. Merton X = xi and Z = Z j ..X )(X . Z) σ XσZ = σ XZ .X ) ∑ P ( Z -Z ) i Z j j j=1 X i ][ n i=1 )( Z -Z ) = j m ] but ∑ PiX ( xi . Z) = ∑ ∑ Pij ( xi .X )} = E{(X . X) = E{(X . then Pij = P i P j where Z P iX = prob{X = X i } and P j = prob{Z = Z j } Hence. then X and Z are perfectly negatively correlated. X) (2) the covariance of a random variable with itself is the variance. n m X Z Cov(X.e. Of course. ρ XZ = 0 and X and Z are said to be uncorrelated.X i=1 n )= ∑ P i=1 n xi .X [∑ n i=1 i=1 j=1 X i P ( x .X )(Z . then Cov(X. If ρ XZ = 1.. Its sign says whether X and Z tend to move in the same or opposite directions.Robert C.Z )} = E{(Z .Z )(X . ρ XX = 1 . i. Note: (1) the covariance is symmetric. then X and Z are perfectly positively correlated and if ρ XZ = − 1 . Note: ρ XZ = ρ ZX . its absolute magnitude represents the percentage of the σ XσZ variation in X explained by the variation in Z .. The correlation coefficient between the random variables Z is defined by ρ XZ ≡ Cov(X. Cov(X. Z) = 0. 4.

Z j )] = ∑ ∑ wi w j E[( Z i . wn ) n invested in each asset.Z i )⎤ ⎣ i=1 ⎦ n 2 = n (∑ ( n i=1 n wi Z i . Then.Z ) ] . n The expected return on the i i. E { [ ∑ wi ( Z i .Z ) ] = E[( ∑ wi Z i .Z j ) i=1 j=1 Hence.Z i=1 n n n i=1 ⎡∑wi( Z i .Z i )( Z j . with proportions portfolio. E ( Z ) = Z i . w2 ..Z i )( Z j .Z i )( Z j .Z i ) ] i=1 n n n 2 }= E [ ∑ ∑ w w ( Z i j i=1 j=1 n .. if wi = fraction (of each dollar invested in the portfolio) invested in the i th asset. σ ij ≡ E{( Z i .Finance Theory Characteristics of Portfolios and the Effects of Diversification Consider the case of n assets with (random) variable returns (per dollar) Z i .e.. i=1 j=1 n n 193 . 2 σ i2 = E{[ Z i .Z i ) ) (∑ n i w j( Z j .Z j )} and σ ii = σ i2 ). i=1 n Note : ∑wi( Z i .Z i )( Z j .. Let σ i be the variance of the return on the i 2 asset (i.. As done in the general case. ( w1 .Z j )] i=1 j=1 = ∑ ∑ wi w j σ ij = σ 2 ..Z ] } and σ ij be the covariance between the returns on the ith and jth assets (i.Z i ) = ∑wi Z i . is E ( Z ) = E[∑ wi Z i ] = ∑ wiE (Z i) 1 1 = ∑w Z 1 n the weighted sum of the th expected returns on the individual assets.Z j ) j=1 ) =∑∑ wi w j( Z i . then we can n define Z = ∑1 wi Z i as the (random) variable return (per dollar invested) on the composite security or portfolio. the variance of the portfolio can be computed to be 2 2 σ 2 = E[(Z .e.

to see the effect on σ .ρ 12 )w(1 ..e.w ) ] = v 2 [1 .m) + w2 ( Z 2 .Z 1 )2 ] = σ 1 = E[( Z 2 .m)( Z 2 . for any mix ( w1 . i. The expected return on Z Z = E(Z) = E( w1 Z 1 + w2 Z 2 ) = w1 E( Z 1 ) + w2 E( Z 2 ) = w1 m + w2 m = ( w1 + w2 )m = m . between asset #1 and #2. Let 2 σ 12 = E{( Z 1 . a risk-averse investor would want to choose the portfolio with the smallest variance 194 . suppose that 2 E[( Z 1 .w.w1 = 1 . 2 So σ .Z ) ] = E[( w1 ( Z 1 .m) + w2 ( Z 2 . they have the same expected return. 2 Since w1 + w2 = 1.e. Let Z = return on the portfolio mix of #1 and #2: Z = w1 Z 1 + w2 Z 2 can be computed as (for w1 + w2 = 1 ).m) ) ] 2 = E[ w1 ( Z 1 .m)( Z 2 . the variance of the portfolio is changed.m )2 ] 2 2 2 = w1 σ 1 + 2 w1 w2 σ 12 + w2 σ 2 2 2 2 2 = w1 v2 + 2 w1 w2 ρ 12 v 2 + w2 v2 = v 2 [ w1 + 2 w1 w2 ρ 12 + w2 ].w)] . we first substitute w1 = w and w2 = 1 .Z 1 )( Z 2 .Robert C. i. as a function of the "mix parameter" w. Hence.m)] + w2 E[( Z 2 . ρ 12 . is a parabola. as σ 12 = ρ 12 σ 1 σ 2 = ρ 12 v .Z 2 )2 ] = σ 2 = v 2 .2(1 . 2 2 Hence. in this example. w2 ) ..w) ρ 12 + (1 . and suppose that E( Z 1 ) = Z 1 = E( Z 2 ) = Z 2 = m . What about the variance of Z ? 2 2 2 σ = E[(Z . Since the expected return is the same for all mixes. Merton Example: The effects of diversification Suppose there are two risky assets with (random) variable returns Z 1 and Z 2 . the expected return on the portfolio will be the same. as the relative proportions ( w1 .m )2 ] + 2 w1 w2 E[( Z 1 .m )2 ] 2 2 = w1 E[( Z 1 . namely m. to get 2 σ 2 = v 2 [ w2 + 2w(1 .Z 2 )} = covariance of the returns which can be written in terms of the 2 correlation coefficient.m )2 + 2 w1 w2 ( Z 1 . w2 ) are varied. they have the same variance of return.

w)]] w dσ 1 |w=w* = 0 = .v 2 [2(1. the minimum variance (corresponding to w = 1 ) for a given ρ 12 is 2 2 σ min = v (1 + ρ 12 ) 2 2 195 .Finance Theory (dispersion).2 presents the graph of σ 2 for various correlation coefficients and mixes. Figure X.2 w* )] or w* = dw 2 which is not exactly a big surprise because of the symmetry of the problem.ρ 12 )w(1. From above.2(1. we can calculate the "variance minimizing" mix.ρ 12 )(1. Formally. calculus as follows: * w . by using the min σ w 2 2 = min [ v 2 [1. this general technique is applicable even if the individual variances are not equal. However.

Robert C. the diversification effect holds generally. Constructing Portfolios and Composite Securities 196 . then the variance is halved.e. ρ 12 = 0 ). the existence of such assets in the real world is rare. risk-averters will tend to diversify if they act rationally. these quantitative results will lead to a number of new qualitative insights.. This phenomenon is called the diversification effect.2 shows. the greater the effect. Hence. If they are independent (i. as long as the two assets are not perfectly positively correlated. the investor can lower the variance of his return by mixing.2 As Figure X. Note that the less positively correlated are the returns. Although this example was very specialized. Later. Merton Figure X. Although negative correlation is even better. our systematic approach will allow us to measure quantitatively how much diversification is provided by adding securities to a portfolio and how much the investor should diversify. While diversification is not a new idea (or rule).

assume 2 E{( Z 1 . but now allow E( Z 1 ) = Z 1 and E[ Z 2 ] = Z 2 not to be equal. 1 .w) Z 1 = Z 1 + w( Z 2 . Denote its 2 2 random variable return by Z and its expected return by Z and variance by σ . then 197 . Further.3.Z 1 )2 } = σ 1 and E{( Z 2 . assume that 2 2 σ 2 > σ 1 .w) Z 1 ) = w Z 2 + (1 . and by convention.Finance Theory Consider the two-risky asset case of the previous example.w = fraction invested in #1. If Z 2 > Z 1 .a If Z 2 < Z 1 .Z 2 )2 } = σ 2 are not equal. Form a composite security from a combination of security #1 and security #2. Let w = fraction of each dollar of the composite security invested in security #2.Z 1 ). then Figure X. Then Z = E(w Z 2 + (1 .

2 (i.σ 1 ]w + σ 1 2 The rest of this section is devoted to finding the characteristics of Z changes and for different assumptions about Z 1 and Z 2 .e.Robert C. 198 .w)ρ 12σ 1σ 2 + (1.w ) σ 1 2 2 2 = [ σ 2 + σ 1 .w)σ 1 | i. and linear in w for ρ 12 = + 1..w)σ 1σ 2 + (1.e. σ is in a linear relationship to σ 1 and σ 2 . Merton Figure X.3..w ) σ 1 = [wσ 2 +(1. then 2 σ 2 = w 2σ 2 + 2w(1.w)σ 1 ] 2 2 2 or σ = | wσ 2 +(1.2 ρ 12σ 1σ 2 ] w2 + 2[ ρ 12σ 1σ 2 .e.. is given by 2 2 2 2 2 σ = w σ 2 + 2w(1 .b 2 The variance of Z. ρ 12 = + 1.σ . Z . i.σ ) as w Case 1: Suppose that Z1 and Z 2 are perfectly (positively or negatively) correlated.

2 ρ 12σ 1σ 2 ≥ 0 and = 0 only if ρ 12 = 1. Then σ = w σ 2 and σ = | w | σ 2 Figure X4..e.b 2 Proposition: σ 2 + σ 1 . i.Finance Theory Figure X. 2 199 . 2 2 2 security #1 is riskless.4a The only other case where σ is in a linear relationship to σ 2 and σ 1 is when σ 1 = 0.

2 But ρ 12 ≤ 1.7b) dσ2 2 2 = 2 {w[ σ 1 + σ 2 . then σ 2 + σ 1 . 2 σ 1 + σ 2 < 2 ρ 12 σ 1 σ 2 . so it must be that ( σ 1 . Hence. So the only way for equality to hold is if ρ 12 = 1 and σ 1 = σ 2.2[ σ 1 .2 σ 1 σ 2 = 2( ρ 12 . 2 clearly. Suppose σ 1 + σ 2 .[ σ 1 . But ρ 12 ≤ 1 and 2 ( σ 1 .2[ ]w + σ 1 1st derivative of σ with respect to w (X.2 ρ 12σ 1σ 2 ≥ 0.ρ 12 σ 1 σ 2 ]} 2 dw 2 2 dσ w[ σ 1 + σ 2 .2 ρ 12 σ 1σ 2 < 0.σ 2 ) = 2( ρ 12 .2 ρ12 σ 1 σ 2 ] w2 . if ρ 12 ≥ 0.1)σ 1 σ 2 .e. or ( σ 1 .[ σ 1 .1) σ 1 σ 2 . 2 But that means that which cannot be.ρ12 σ 1 σ 2 ]w + σ 1 2 and σ = 2 [ ] w2 . Merton Proof: 1.7a) (X. Case 2: Z 1 and Z 2 are not perfectly correlated. 2 3.2 ρ 12 σ 1 σ 2 ] . 2 2 2 σ 2 = [ σ 2 + σ 1 . . Then. it were possible that σ 2 + σ 1 .Robert C.σ 2 )2 < 0 2 σ 1 + σ 2 < 2 σ 1σ 2 2 or 2 σ 1 + σ 2 . 2 σ 1 + σ 2 .2 ρ 12 σ 1σ 2 = 0. i.σ 2 )2 ≥ 0. 2. ρ 12 < 1.2 ρ 12σ 1σ 2 > 0 2 2 2 suppose for ρ 12 > 0.2 σ 1σ 2 < 0.2 ρ 12 σ 1 σ 2 ] . Then 2 2 2 2 σ 1 + σ 2 .ρ 12 σ 1 σ 2 ] 2 = dw σ 2nd derivative of σ with respect to w 200 ..

But.2 ρ 12 σ 1 σ 2 ] σ1 2 σ 2 > σ 1 or σ 2 > σ 1 . Thus.1-wmin) Because σ 2 is a (strictly) convex parabola.9). then from (X.8a) d 2σ 2 = 2[ 2 + 2 . wmin .7b) we | dw w=wmin dσ2 dσ < 0 (and < 0) and for Thus. Hence. for w < wmin . From (X.ρ 12 ) > 0 for ρ 12 < 1 2 dw σ2 2 2 2 2 2 and σ . The minimum point will occur where the 1 have that (X. i. From (X.2 σ 1 σ 2 ρ 12σ 1σ 2 ] > 0.e.9) wmin = 2 σ 1 . dw dw Can wmin > 1 ? Suppose so. Of course. both σ and σ are strictly convex functions of w.ρ 12 σ 1 σ 2 > 1 or ρ 12 > σ 2 . ρ 12 > 1 which is impossible.ρ 12 σ 1 σ 2 ) 2 [ σ 1 + σ 2 .. So. Can wm < 0? From 2 (X. The minimum variance composite security with "mix" (wmin. σ as a function of w is a parabola and σ as a function (X. dσ2 dσ > 0 ( and > 0).8a) and (X.Finance Theory (X. this value of w minimizes σ as well. dw dw w > wmin .8b) From the formulae for σ 2 of w is a hyperbola.2 ρ 12 σ 1 σ 2 ] 2 st derivative is zero.9) wmin = 2 ( σ 1 . wmin < 1. which is possible since σ 2 > σ 1 . if σ2 σ2 201 .8b). by convention. there exists a unique minimum value corresponding to proportion. dσ 2 = 0. this would imply that ρ 12 > σ1 > σ1 ρ 12 . 2 2 [ σ 1 + σ 2 . from the Proposit ion dw2 d σ σ 1σ 2 = (1 .7a) or (X.

it will be much more useful to work with the relationship between σ and Z rather than with σ and w .σ 2 ). Because Z = Z 1 + w( Z 2 . then 0 < wmin < 1. Merton σ1> ρ 12 ).8b).5 Note in Figure X.5: because σ is a convex function of w.3b) with (X. combine graphs Figures (X.3a) or (X..10) 202 .Z 1 ) dw dσ dσ dw (X.Z 1 ). the curve will always lie below the straight line (w = 0. (X. Given (X. we can graph σ as a function of w as: Figure X. (i. For our purposes. if σ 2 is not too much larger than σ 1 then 0 < w min < 1 (Note : if ρ 12 ≤ 0. and (X.e.9). then σ2 or if Z1 and Z 2 are not too highly (positively) correlated.Robert C.7b).σ 1 ) and (w = 1.5)). So. we have by the "chain rule" (valid for Z 2 ≠ Z 1 ) that dσ dσ = = dw = dw d Z dw d Z d Z ( Z 2 .

10). the > 0.6a 203 . then dσ dZ will have the same (opposite) sign as 2 dσ .Z 1 )2 2 From (X. if Z 2 > (<) Z 1 . 2 d σ d σ .11) d σ 2 2 d σ dw = .8b) two cases are: d 2σ d σ > 0 and σ is a convex function of Z . 2 will have the same sign as 2 dZ dw But. So. d Z 2 ( Z 2 . 2 dZ2 dw Figure X. From dw 2 (X. from (X.11).Finance Theory and (X. independent of the relative sizes of Z 2 and Z 1 . Graphically.

6b By convention.1 . there corresponds a unique portfolio of these assets described by (w. And to each ( Z . Merton Figure X. graphs such as Figures (X.6). are plotted with the expected return on the ordinate and standard deviation on the abscissa: Figure X.7) traces out all the feasible expected return-standard deviation (or meanvariance) combinations possible from the two risky assets.Robert C.σ ) point on that curve. 204 .w).7 σ min occurs where Note: dσ dZ = 0 or where dZ =∞ dσ The curve in Figure (X.

II .II ). variance. form a composite security with return Z.σ 14 ) and Z 2 has mean.σ 2 . and covariance a( Z I .σ 24 ). and covariances ( Z 4 . variance. and covariances ( Z 1 .σ 23 .σ 21 . variance. from knowledge of the variances and covariances of Z 1 . Z II ) ≡ σ I. variance.σ 1 .σ 4 . one can compute the covariance between composite securities #I and #II.σ 13 . and covariances ( Z 3 .wI ) is the fraction invested in security #2.w ) Z 2 and Z I has an expected return and variance σ2 I as constructed in the previous section.Finance Theory General Composite Securities The preceding analysis examined the simplest composite security constructed from two securities.σ 2 .w ) Z 4 . If w is the proportion of the II composite security #II invested in Z 3 and (1 . then the II II 2 return of #II.σ 32 . Fourth.σ 3 . where 2 Z 1 has mean. ZI I I Z I .σ 12 . Z 2 .σ 34 ) and Z 4 II 2 has mean. Cov( Z 1. First. Third. consider the composite security #II constructed from other securities with returns 2 Z 3 and Z 4 . and Z II has expected return Z II and variance σ II as constructed in the previous section. We now analyze composite securities constructed from many assets. If I w is the fraction of the composite security invested in security #I and 205 .w ) is the proportion invested in Z 4 . I 2 and covariances ( Z 2 .σ 42 . variance. Z II = w Z 3 + (1 .σ 41 . is Z I = w Z 1 + (1 . where Z 3 has mean. then the return on #I. and Z 4 . constructed from (composite) securities I and II with returns Z I and Z II . If w is the fraction of composite security #I invested in security 1 and (1 . Second.σ I.σ 31 .σ 43 ). Z 3 . where ZI has expected return. consider composite security #I constructed from securities with return Z 1 and Z 2 .

. risk-averse mean-variance maximizers will choose 206 . Portfolios and Efficient Portfolios Suppose that there are n securities with (random) variable returns Z i with expected returns E( Z i ) = Z i .4) will be the description." Otherwise.7) will describe the mean-variance "tradeoff. variances of returns σ i2 . the graph of the meanvariance "tradeoff" will be like either Figures (X. we can generate any portfolio by this process and each portfolio will have an expected return and variance. covariances of returns σ ij .7) or Figure (X.5) -(X.w) w II ) Z 3 + [(1. then Z = wZ I + (1 .Robert C.. etc. variances. we see that composite securities containing many securities can be constructed by combining securities to form composite securities and combining these composite securities to form (more complicated) composite securities.2. and the mean and variance as a function of w can be computed as was done in the previous section. Further.w I ) Z 2] + (1.w)[ w II Z 3 + (1. asked to choose a portfolio from a group of portfolios all with the same expected return. Note: Z = w[ w I Z 1 + (1. one can create "new" (composite) securities which will also have expected returns.(X. Merton (1 .w II ) Z 4] = ( ww I ) Z 1 + ( w(1. j = 1. 2 suppose that all n securities have uncertain returns (i. and covariances with the other (both "basic" and "composite") securities.w) Z II .w) is the fraction invested in security #II.w I )) Z 2 + ((1.5) . 2 2 if σ I > 0 and σ II > 0 and Z I and Z II are not perfectly correlated. then Figures (X.w)(1.4) as in the two-security case.w II )]Z 4 = µ 1Z 1 + µ 2 Z 2 + µ 3Z 3 + µ 4 Z 4 So. one can create an infinite number of securities from the original n. Hence. n . Hence... for i.. Is there a way to reduce the number of securities (or portfolios) that one need consider as possibilities for selected portfolios? We know that. Further. Further.e. σ i > 0 for all securities). By mixing these securities together to form portfolios. Figure (X.

any portfolio selected by a risk-averter (as an optimal portfolio) must be an efficient portfolio. We can reduce the possibilities even more: given a choice between two portfolios with the same variance. A portfolio is a member of the Frontier portfolio set if and only if among all portfolios possible with the same expected return. then determine. a risk-averter will prefer the one with the larger expected return. it has the smallest variance. The collection of "winner" portfolios from each group is called the Frontier portfolio set. This final collection of portfolios is called the Efficient Portfolio Set. for each group. which member has the smallest variance. So. among Frontier portfolios. Clearly.Finance Theory the portfolio with the smallest variance. Clearly. A portfolio is a member of the Efficient portfolio set if and only if there does not exist another portfolio which has a variance smaller or equal to its variance and which has an expected return greater than or equal to its expected return. 207 . Suppose that we classify or subdivide all the possible portfolios into groups where each portfolio within a given group has the same expected return. it is a necessary condition that a portfolio be a Frontier portfolio if it is ever going to be chosen by a risk-averter (as an optimal portfolio). compare all portfolios with the same variance and select the one with the largest expected return.

Robert C. The point ( Z min .8 In Figure X. the boundary line (which is a parabola) is the Frontier portfolio set. 208 . Merton Figure X. it is common practice to plot the portfolio sets in Expected Return-Standard deviation space where it is a hyperbola. the heavy-lined part of the boundary is the 2 Efficient portfolio set. the cross-hatched area represents feasible (possible) portfolios. As noted. and is a part of the Efficient portfolio set.8.σ min ) is called the minimum-variance portfolio.

given the expected returns.8 and X. variances.9 We now present an analytical derivation of the Frontier and Efficient Portfolio sets to show that the qualitative results presented in Figures X.Finance Theory Figure X.9 are correct and to demonstrate that in practice..12) Z = ∑ wi Z i i=1 n where the portfolio weights are restricted to satisfy 209 .e. the efficient frontier can be computed. (X. i. Let Z be the random variable return on any portfolio (constructed from the n "primary" securities) which has expected return m . and covariances of the primary securities.

Formally.12b) Z = E(Z) = ∑ wi E( Z i ) = ∑ wi Z i = m.. wn . wn which satisfy the constraints (X. or (X. to obtain the optimality conditions 0 = ∑ w j σ ij .. we must determine the particular combination ( w1 .12b) represent all the possible portfolios with expected return m. this is a constrained minimization problem which can be solved by using Lagrange multipliers.. we differentiate (X... all possible combinations of w1 . n j=1 n n (X.. w2 . w2 .12a) and (X.. To determine a i=1 j=1 critical point.12b).∑ wi Z i ]} ∑ ∑ wi w j 2 i=1 j=1 i=1 i=1 n n σ2 2 2 where λ1 and λ2 are the multipliers and remember that σ = ∑ ∑ wi w j σ ij . minimize subject to (X. λ 1 ..13) Min{ n n 1 n n σ ij + λ 1 [1 .14) m = ∑ wi Z i i=1 1 = ∑ wi i=1 n These are (n + 2) linear equations to be solved for the (n + 2) unknowns w1 . Let [ vij ] be the elements of the inverse of the variance 210 .. w2 . λ 1 . To find the Frontier portfolio set.12a) and (X. λ 2 and set each partial derivative equal to zero.12b) and minimizes the variance... and λ 2 . w2 .λ 1 .12a) and (X.2.. wn .. i..λ 2 Z i for i = 1...e.12a) and (X. Merton 1 = ∑w i=1 n i (X....Robert C.. i=1 i=1 n n Obviously.. wn ) which satisfies constraints (X.13) with respect to w1 .∑ wi ] + λ 2 [m .

Finance Theory -covariance matrix of returns [ σ ij ] .2Am + B D (X. What 2 st happens if a (n + 1 ) riskless security becomes available with (certain) return R? Before answering that question.A) + ∑v ij(B . Then.15) λ2 = D Cm. we can compute the portfolio variance. B ≡ ∑ ∑ vij Z i Z j . One can solve for the expected return as a function of the standard deviation [using (X. C ≡ ∑ ∑ vij i=1 j=1 i=1 j=1 i=1 j=1 n n n n n n n .15). if we call: A ≡ ∑ ∑ vij Z j . m. P Suppose that there is now available a riskless security with 211 . D ≡ BC .16) σ = 2 Note: the variance of the Frontier portfolio set is a parabola as a function of the expected return. σ i > 0 ).17b) m= A 1 + C C D(C σ 2 .Am D 2 From (X.Z P )2 ] = σ 2 .e.16)] to be: (X.17a) m= A 1 + D(Cσ 2 .A D λ1 = B. 2 n the solutions are: m wi = ∑ (CZ j . we digress: Digression: Suppose that you already have a composite security or portfolio (containing only risky assets) with (random) variable return Z P . to be 2 Cm .1) Frontier C C and the Efficient (part of) Frontier to be (X. expected return E( Z P ) = Z P . σ .1) Efficient Set More on the Role of Financial Instruments and Intermediaries: A Mutual Fund Theorem The previous analysis assumed that all the securities available were risky (i. variance of return E[( Z P .A ..AZ j ) v ij j=1 j=1 (X.

212 .Z P ) .Z ) ] = E[ w2 ( Z P .w)R = w( Z P .Z P ) ] = w2 σ 2 . If variable return on the new portfolio.Z P ) ] = w2 E[( Z P . σ . The variance of the new portfolio is 2 2 2 σ 2 = E[(Z . Merton (certain) return R. Figures X.R) + R. and expected return vary as one alters the mix.R) + R . P The standard deviation of the new portfolio.10 illustrate how the variance.R) .R) + R Z is the (random) and the expected return is E(Z) = Z = w( Z P . is σ 2 or σ =| w |σ P Note: the standard deviation is linear in the "mix" w. then Z = w( Z P ) + (1 .Robert C. Let w = fraction of your wealth invested in the "old" (risky) portfolio and (1 . as was shown earlier.R = w( Z P .w) = fraction of your wealth invested in the riskless asset. and you want to construct a new portfolio by combining the "old" portfolio with the riskless security.w( Z P . standard deviation.Z = w( Z P . Note: Z .

Graphically. σP 213 .b Figure X.c Z We can also solve for the expected return as a function of the standard deviation: since σ = | w | σ P .R) Z = w( Z P .10.10. ( .10.Finance Theory Figure X.R) + R = Z P σ + R . then. if w ≥ 0 .a Figure X.

214 . Merton Figure X.12) by combining Figure X.11). .Standard Deviation plane (Figure X.Robert C.11.11 The important point to remember from this analysis is that various combinations of a risky security with a riskless security plot as straight lines in the Expected Return .End of Digression - Return now to the question posed before the digression: What is the effect on the efficient portfolio frontier of adding a riskless security? Using the result displayed in Figure X. we can determine the answer geometrically (as is done in Figure X.11 with the "old" frontier for (risky) assets as displayed in Figure X.9.

( w1 . In that case. w2 .. except for point B) above points on DBE.. Thus. wn ) are called 215 . line ABC in Figure X. the new efficient portfolio frontier is the straight line ABC. * * Because of the importance of the particular portfolio ( Z . Therefore. and hence.10. a portfolio containing only risky securities in the proportions described by point B and a (trivial) portfolio containing only the riskless security (point A). take * * Z P = Z and σ P = σ ). Think of this specific portfolio as the "old" risky portfolio analyzed in the digression (i.Finance Theory Figure X. and it represents various (possible) positive mixes of the "old" portfolio with the riskless security. the point B is a portfolio which contains only risky assets because it lies on DBE.11 corresponds exactly to the line in Figure X.. In particular. every point on line ABC is now a feasible portfolio with the introduction of the (additional) riskless security.e..12 The curve DBE is the "old" efficient frontier when only risky assets were available. the * * * specific weights of the holdings of basic securities in that portfolio..σ ) represented by point B. every portfolio in the efficient portfolio set can be interpreted as a "mix" of two portfolios: namely. Note that every point on ABC is (strictly.

216 . (III) the proportions described in (X.11)..R) ij j n (X. * Note: the proportions...18) do not depend on the individual investors' utility functions or on how much wealth they have.18). variances. wi . Proof: follows from (I) and (II) and the definition of the efficient portfolio set.Robert C. A "Mutual Fund" or "Separation" Theorem Every risk-averse.2. Merton the optimal combination of risky assets.12) depend only on the expected returns.18) wi = j=1 (A.RC) . mean-variance utility maximizer would be indifferent between selecting his optimal portfolio from among the original (n + 1) securities or from just the two mutual funds described in (II). (II) we know that every efficient portfolio can be constructed by mixing two particular portfolios (or "mutual funds"). i = 1. in (X.σ ij ) used to form the (optimal) risky mutual fund. The proportions are (using the notation of that analysis) ∑ v ( Z . and that one "fund" holds just the riskless asset and the other holds only risky assets in the proportions described in (X.n We now summarize: (I) we know that risk-averters in selecting an optimal portfolio from among the (n + 1) individual securities will always choose a portfolio which lies along the Efficient Portfolio Frontier (line ABC in Figure X. Further we can determine explicitly what these optimal proportions are from the (formal) analysis previously done. provided that the investor agrees with the estimates of ( Z i ..R) σ * and intercept R . which is a straight line with slope ( Z * . and covariances of the "primary" securities and require no other information to compute.

then one can solve for indifference curves (lines of constant utility level) showing the tradeoff between expected return and standard deviation (or variance). variances. σ * ) to make their decisions. they would be indifferent between his handling production or each of them doing it individually. and these curves will have a shape as displayed in Figure X. and provided that he followed the "right" rule (i. If the investor makes his decisions solely on the basis of the mean and variance of his portfolio and if he is risk-averse. How the Investor selects the optimal "mix" between the two funds: A Graphical Solution. Here.Finance Theory Remember the first such separation theorem was deduced in an earlier set of lectures where it was shown that the individual investors could hire a "technocrat" to make all production decisions. but only the aggregate ( Z * .12.. we find that all the individual risk-averse investors can hire a "technocrat" portfolio manager and give him the rule to hold proportions w* in his fund. 217 . of the securities. and covariances of the individual securities and need not know what the investors' preferences or wealth levels are to do his job. the problem solved in the digression). and the investors do not need to know the individual expected returns. variances. and the only decision that the i individual investor need make is what proportion of his wealth to hold in the riskless asset. (Essentially.e. maximize market value). It is a true separation or decentralization because the portfolio manager need only "worry" about determining the expected returns. covariances. etc.

R) to choose his optimal portfolio. Merton Figure X.σ .13 His individual optimal portfolio will be the point where one of his indifference curves is tangent to the Efficient Frontier. 218 . From the lower half of the graph. we see that implies putting woptimal percent of his wealth in the "risky" fund and the rest in the riskless asset. and ( Z optimal .Robert C. Note: He * * only required knowledge of ( Z .σ optimal ) are the expected return and standard deviation of the return on his optimal portfolio.

Domain of Investment Management: Stages of Production Process Passive Well-Diversified Efficient Portfolio “Efficient Exposures” Active Asset-Class Allocation Macro Sector Market Timing Super Efficient Portfolio of Risky Assets (Optimal Combination of Risky Assets) Optimal Portfolio of Assets Alter Shape of Payoffs on Underlying Optimal Portfolio Structured Efficient Form of Payouts to Client Client Households Entrepreneurs Endowment Corporation Superior Performing Micro Aggregate Excess-Return Portfolio “Alpha Engines” Riskless Asset Portfolio (Derivative Securities with Non-Linear Payoffs) • Components of Best Performing Risky Assets Only Portfolio: •Diversification Risk Modulation •Risk Modulation through Hedging or Leveraging • Risk Modulation through Insurance or non-linear leverage • Pre-programmed dynamic trading • “Building Block” State-Contingent Securities to create specialized payout patterns • Tax efficient • Regulatory efficient • Liquidity allocation •Market Timing Active Management 219 .

Robert C. Merton Passive Management: Efficient Exposures to Various Asset Classes Macro Asset Classes Small-Cap Domestic Equities Mid-Cap Domestic Equities Large-Cap Domestic Equities Fixed-Income Real Estate Other Weighted to match a benchmark Passive Well-Diversified Efficient Portfolio Implementing Diversification as one of the Three Risk Management Tools Indexing of portfolios 220 .

Finance Theory Active Management: Enhancing Portfolio Performance Asset-Class Allocation: Macro-Sector Market Timing “Long-Short” combinations to change fractional allocations from Benchmark Weights ASSET CLASS Small-Cap Equity Mid-Cap Equity Large-Cap Equity Emerging Market Equity Domestic FixedIncome Real Estate BENCHMARK WEIGHT 5% 10% 30% 15% 30% 10% LONG (SHORT) INCREMENTAL +5% 0% (10%) (5%) 5% 5% REVISED WEIGHT 10% 10% 20% 10% 35% 15% 100% 0% 100% Micro “Excess Return” Portfolio: Security Selection: “Alpha Engines” Engine #1 U.S. Risk Arbitrage Hedge Fund Engine #2 Technical Analysis of Equities Fund Engine #3 Fundamental Analysis of Equities Fund Engine #4 Foreign Currency Forecast Fund Engine #5 Private Equity Fund Engine #N Mortgage-back Security Relative Value Fund Optimal Weighting •Security Analysis •Technical Analysis •Proprietary Derivative-Security Pricing Models Super-Performing Micro Aggregate Excess-Return Portfolio 221 .

Merton Creating the Optimal Portfolio of Assets: Mix of Optimal Combination of Risky Assets (“OCRA”) and the Riskless Asset Expected Reward OCRA Reward Optimal Portfolio Reward Riskless Reward Risk/Expected Reward “Menu” 0 Percentage of Optimal Portfolio Invested in OCRA Optimum Percent Risk Optimal Risk OCRA Risk 100% • Hedge or Leverage OCRA to obtain Optimal Portfolio • Implement Macro Market timing of Risky versus Riskless Asset Performance 222 .Robert C.

000 Value of Optimal Portfolio.000 Minimum Guarantee Floor 0 0 $95.000 $190. $ “Uninsured Equity” Payoff • Insurance and non-linear leverage • Transform Payoff Pattern to fit precise preferences: custom design $95.000 Minimum Guarantee Floor “Insured Equity” Payoff 0 0 Value of Investor Custom Pattern Portfolio . $ “Ceiling” Maximum Payout $95.000 Value of Optimal Portfolio. $ 223 . $ $190.Finance Theory Transform Shape of Payoffs from Investing in the Optimal Portfolio: Derivatives Value of Investor Insured Portfolio.000 $100.

Merton Structured Holdings to Create Most Efficient Form of Payouts to Client • Tax efficient (income. 224 . Forwards. estate/inheritance) • Regulatory efficient • Liquidity efficient Tools Derivatives: Futures. wealth.Robert C. Bermuda for insurance) Location of Assets and Liabilities: on or off-balance sheet.g.. investment versus trading account. taxable or non-taxable part of one’s accounts. Swap Contracts Special Purpose Vehicle (SPV): Custom-created targeted-purpose security Asset Substitution: Municipal (tax-exempt) bonds for taxable bonds liquid “on-the-run” US Treasury Bonds for “off-the-run” less-liquid US Treasury or Agency bonds Location of Entity: (e.

Define: M= n equilibrium market value of all risky assets ("the market") = ∑N i=1 i Pi where N i = number of shares of security i outstanding 225 . Suppose that everyone in the market agreed on expectations.. it was shown that all investors would be indifferent between selecting an optimal portfolio from the n risky assets and the riskless asset and from just two assets: the "risky" mutual fund composed of the optimal combination of risky assets and the riskless asset. for expositional purposes. Let w* k = fraction of the k th investor's wealth invested in the risky fund in his optimal portfolio. k = 1.. the prices of securities are such that when investors are holding their optimal portfolios. Wo k = amount of initial wealth of the k th investor.K. the aggregate supply of each security is equal to the aggregate amount of that security demanded).e.18). if the market is in equilibrium (i. assume that the investors just invest in the risky fund and the riskless asset and that the fund then invests the money in the primary risky securities according to formula (X.. variances. Let there be K investors and consider investor #k. Then.. what must be the composition of the "risky" portfolio represented by point B in X. mean-variance utility-maximizers who agree on the expected returns.e. th k k d k ≡ w* W o = number of dollars invested by the k investor in the fund = demand for the fund..11 in Section X (i. the optimal combination of risky assets with mean Z * and variance 2 σ * )? In Section X. IMPLICATIONS OF PORTFOLIO THEORY FOR THE OPERATION OF THE CAPITAL MARKETS: THE CAPITAL ASSET PRICING MODEL We have shown that for all risk-averse.2. Hence. We now consider the implications of these results for equilibrium expected returns and asset prices.. and covariances of the individual basic securities.XI. the optimal portfolio chosen can be represented as a mix of two securities (portfolios): one security is the riskless security with return R and the other is a particular combination of risky assets.

2. n.4). M is the total number of dollars invested in the fund. k k =1 k =1 K K ∑ (1 .. From (XI. Merton and Pi = equilibrium price per share of firm i Define: VR = equilibrium market value of the aggregate supply of riskless asset (which may be zero)..3) * Di ≡ wi M.e..... (XI. i = 1. i. i. i = 1. (XI.4) Di = N i Pi . In equilibrium. i = 1. n. in equilibrium. M ∑ N i Pi i=1 226 .3) and (XI. So.. aggregate demand = aggregate supply....Robert C.2.e.. the supply of asset i must equal the demand.18) the total dollars of investment demanded in security i is (XI.1) k W ≡ ∑W o = M k =1 K +V = ∑N R i=1 n i Pi + V R In equilibrium. (XI.w k =1 K k * k )W o = V R .. How much is (implicitly) invested in risky primary asset i ? From (X.2) ∑ d k = ∑ w*k W o = M. But.. n ..2. aggregate wealth W must satisfy (XI.5) wi = * N N i Pi = n i Pi .

Further. (XI. i=1 i=1 j=1 The following derivation is designed to avoid using any mathematics beyond the elementary calculus.. can we deduce the relationship among expected rates of return on securities and develop a systematic. n n In equilibrium. we have that in equilibrium. since the relative holdings of risky assets by each investor are the same as in the market portfolio and since prices cannot be negative. we have that in equilibrium. the optimal combination of risky assets must be a market portfolio. Since each investor's optimal portfolio is a combination of the optimal combination of risky assets and the riskless asset.18). Further. σ M = σ * = ∑ ∑ wi w j σ ij where wi is as defined in (X. "Analytical Derivation. Question: In equilibrium. p. A direct analytical proof can be found in Merton. then E( Z M ) ≡ Z M is the expected return on the market and E{( Z M . A portfolio which holds assets in proportion to their market value is called a market portfolio.Finance Theory Thus. each investor holds a combination of the market portfolio and the riskless asset. no investor will optimally short-sell any risky asset. and therefore.Z M )2 } ≡ σ 2 = M n the variance of the return on the market.. the prices must be such that the fraction of the optimal-combination-ofrisky-assets portfolio allocated to security i must equal the ratio of the market value of the i th security to the market value of all risky assets. in equilibrium. * 2 2 * * * * Z M = Z = ∑ wi Z i . all investors' portfolios are perfectly correlated. 1868-1871.5) states that in equilibrium. quantitative measure of the "risk" of a security? 227 . Can we say more? Let Z M be the random variable return per dollar invested in the market portfolio. since we have that every efficient portfolio (except just holding the riskless asset alone) is perfectly positively correlated. Portfolio Frontier". is somewhat tedious.

R) + R 228 . Z .R) + w2 ( Z M .e.7) E(Z) = Z = w1 ( Z i . point A) The return on the portfolio. Merton Figure XI.1 Consider a Portfolio of Three Securities Let w1 = % invested in security i (any security not on efficient frontier) w2 = % invested in the market portfolio (optimal combination of risky assets) 1 .R) + w2 ( Z M . is (XI.6) Z = w1 Z i + w2 Z M + (1 .w2 )R = w1 ( Z i .w1 .Robert C.R) + R The expected return is (XI.w1 .w2 = % invested in the riskless asset (security i has expected return Z i and standard deviation σ i i..

8) to get 2 ⎡ (m .10') with respect to w1 229 . only consider mixes of the three securities which lead to an expected return on the portfolio = m(= Z i ). Now. no investor would hold this portfolio as an optimal portfolio unless w1 = 0. by rearranging terms.1.R) σ 2 (m .R )2 ⎢ ⎥ ⎣ ⎦ 2 (XI.R ( .R Substitute for w2 from (X1.8) 2 Var(Z) = σ 2 = E{(Z . to find the minimum variance portfolio.R ) M w1 + ⎥• ( Z M .R) w1 ( Z i .Z )2 } = w1 σ i2 + w2 σ 2 + 2 w1 w2 σ iM 2 M th where σ iM = the covariance between the return on the i security and the market portfolio.w1 Z i ⎥ σ iM ( Z M .R) ⎣ 2 ⎤ (m . Clearly. ⎡ 2 ( Z i ..9) into the expression for the variance (XI. (In Figure XI.R) ⎤ 2 2 = w1 σ i2 + ⎢ + w1 σ ⎥σ M 2 ( Z M .R) ⎦ ⎣ZM . this is represented by the dotted line through AC .R )2 ⎥ ⎢( Z M .R )2 ⎦ 2 Now.R 2 (XI.R )2 2 2( Z i .R) + w2 ( Z M .w1 ) .R) ( Z M . I.R) ⎤ 2 σ = ⎢σ i + σM σ iM ⎥ w1 ( Z M .R)( Z i .R (m .R ) ⎣ ⎦ ⎡ m.w1 Z i = (1 .10) or.10') ⎡ ( .9) w2 = -R m.R) + R) (using Z i = m).R )2 ( Z M . we differentiate σ and the minimizing w1 will be where in (XI.R) ( Z M . ( ZM .R) .) How do we find the minimum-variance portfolio constructed from these three securities with expected return m ? Set m = E(Z) = Z = w1 (m .e. the only times that this three-asset portfolio is efficient is when w1 = 0. Then (XI.Z i σM ( Z M .R) 2 + 2 ⎢σ iM .R) ⎤ + 2 w1 ⎢ .R Z -R ZM .Finance Theory and the variance is (XI. from the definition of efficient portfolio.R )2 2(m .

R) 2 ⎤ σ M ⎥ ≡ 0.R) 230 .1) where w1 = 0. ⎢σ iM ( Z M .10').R ⎞ ⎟ + 2 ⎢ σ iM . 1 But. Differentiating (XI. d w1 Call w1 the w1 which minimizes (XI. we have that dσ2 ⎡ 2 ( Z i .R )2 dw1 ⎢ ⎣ ⎡ ( .R) ⎣ ⎦ Since we chose security i arbitrarily.Robert C.10). * But. unless the expected return on all securities = R . we have that either (a) m = Z i = R.R) 2 ⎤ ⎛ m .R) ( Z M . or (b) ⎡ ( Z i . So that in equilibrium.13) ⎛ σ iM ⎞ Z i . from this condition (XI.R) -R ⎟ ⎠ ⎣ ⎦ ⎝ ZM * 1 * ⎤ ⎥ ⎥ ⎦ (XI. (XI.R) = 2 w ⎢σ i + σM σ iM ( Z M .14) Z i .R = β i ( Z M . it must be that condition (b) holds.Z i σM ⎥⎜ ⎜ ( Z M . (XI.13) is more commonly written as (XI.R )2 2 2( Z i . we know that the variance-minimizing portfolio will be on the efficient frontier (point C in Figure XI. Merton dσ2 = 0.12) w1 = 0 .11) = 0 at w1 = w* .R) ⎜ ⎟ ⎝σM ⎠ for any security. Therefore.12) and (XI.R = ⎜ 2 ⎟ ( Z M .11). (XI.

in equilibrium.R . or (XI.15) Z = R + reσ . must be on the line.14) is the fundamental equation relating the equilibrium expected returns on any security with any other. 2 σM (XI. This equation is called the Security Market Line. and hence. the market portfolio is an efficient portfolio.2 The equation of that line can be written as (XI.16) re ≡ ZM .13) and (XI. the efficient portfolio frontier is called the Capital Market Line. Z M = R + r e σ M .Finance Theory where (" beta" ) βi ≡ σiM . and. Figure XI.e. Under conditions of homogeneous expectations and equilibrium. σM 231 . I..

one can still form a market portfolio. The conditions that the market is in equilibrium and that there is agreement. even if the market is not in equilibrium..14) as (XI.13) or (XI.2 can be formed. While the Capital Market Line describes the equilibrium expected return relationship among efficient portfolios. even if people are not mean-variance maximizers. imply that the Capital Market Line is the locus of efficient portfolios and that there are no feasible portfolios with mean-variance combinations above that line.Robert C. It will be important for later analysis to remember that: even if there is not homogeneous expectations. the Capital Market Line in Figure XI.17) Z i .. and by computing its mean and standard deviation.R ⎞ where r s ≡ ⎜ 2 ⎟ is called the price of risk-reduction for securities.13) or (XI. This line represents all portfolio combinations of the market portfolio with the riskless asset (where the market portfolio is never sold short).. the Security Market Line (XI.. ⎜ ⎟ ⎝ σM ⎠ 232 . We can rewrite (XI.2. n ⎛ Zi .R = r s σ iM i = 1. Merton where r e is called the price of risk-reduction for efficient portfolios.14) describes the equilibrium expected return relationships among all individual securities or portfolios (efficient or not).

3 Note: σ kM can be negative in which case the equilibrium expected return on that security.14).Finance Theory Figure XI.3. The Risk of a Security If risk is defined as that measure such that as it increases. from Figure XI. a risk-averse investor would have to be compensated by a larger expected return in order that he would continue to hold it in his optimal portfolio. the "beta" of the security. only the risk of efficient portfolios can be measured by its standard deviation or variance. An equivalent measure is from (XI. we can rewrite (XI.17) in terms of r e [in (XI. Note: From Figure XI.16)] as 233 .3 the measure of a security's (relative) risk is its covariance with the market. By definition. Z k . will be less than R. σ iM ≡ ρ iM σ iσ M between the return on the i th where ρ iM ≡ correlation coefficient security and the market portfolio. then. So.

ρ iM = 1. The intuition behind the Security Market Line can be developed in a variety of ways. Note: when ρ iM = 1. namely.4 Note: For ρ iM = 0. (XI. what value for ρ iM allows σ i to be as small as possible? Clearly. So again. Merton (XI.15) are the same.R. For a fixed risk premium. r e . Z i .18) Z i . One way is by using a marginal analysis to study the effect of a small change in portfolio composition. the largest value of ρ iM . 234 .R = r e σ i ρ iM . we see that all efficient portfolios (with σ > 0 ) are perfectly correlated with the market portfolio.18) and (XI. and fixed price of risk-reduction.Robert C. Z i = R. independent of σ i . Figure XI.

20a) [d Z /dδ ] δ =0 = Z i .R) + R Z * = w* Z M + (1. The effect of this small change on the mean and variance can be determined by differentiating (XI.w* )R . one could reduce the variance of the portfolio and not reduce its expected return. this would contradict the efficiency of Z * and therefore. The expected return on this portfolio is 2 and its * 2 * variance is Var( Z ) = [ w ] σ M . Consider the effect of a small change in this portfolio achieved by increasing the fraction held in asset i by δ and decreasing the holding in the riskless asset by δ . The return on this portfolio can be written as Z = w* Z M + (1 . Hence.R < 0. the efficiency of the market portfolio.w* )R + δ Z i . 235 . That is.R ≥ 0. and it follows that (XI.R and (XI.δR = Z* + δ ( Z i .R) . if the market portfolio is efficient and σ iM < 0 . If Z i .19a) Z = Z * + δ ( Z i . then by moving δ from δ = 0 to δ > 0 .R) and (XI.19) with respect to δ and evaluating the derivative at δ = 0.Finance Theory If the market portfolio combined with the riskless asset is an efficient portfolio. Consider an investor who has selected a portfolio with return given by * * Z = w ( Z M . Case (i): Suppose that σ iM < 0. then Z i . But.19b) Var(Z) = Var( Z * ) + 2 w* δ σ iM + δ 2 σ i2 . then one cannot both increase the expected return and reduce the variance by combining this portfolio with another asset. (XI.20b) [d Var(Z)/dδ ] δ =0 = 2 w* σ iM .

From the definition of ε k and ε M and from (XI.18) lack some intuitive appeal. If Z i < R.ε M .14) for the Security Market Line has generally been the preferred form in popular use." To see why.R) + ε k σ2 M = R + σ kM ( Z M . σ iM > 0. one could increase the expected return on the portfolio and not increase its variance at the margin. then by moving δ variance. one could increase the expected return and not increase its Because either possibility would violate the efficiency of the market. "Beta" in (XI. one could reduce the variance of the portfolio and not reduce its expected return. Merton Case (ii): Suppose that σ iM > 0 . then by moving δ from δ = 0 to δ > 0. then Z i .13). So. Perhaps because equations (XI.R ≤ 0.Robert C. from δ = 0 to δ < 0. expression (XI.R > 0. we proceed as follows: Define the random variables ε k ≡ Z k . ε k and ε M are the unanticipated M k parts of the returns on asset k and the market portfolio. if the market portfolio is efficient and Case (iii): Suppose that σ iM = 0.14) is frequently called the (relative) "volatility coefficient of the security. If Z i > R. we can write the return on asset k as Zk = R+ (XI. If Z i .Z M .21) σ kM ( Z M . Again.17) and (XI. by construction E( ε k ) = E( ε M ) = 0 and Var( ε k ) = σ 2 and Var( E M ) ≡ σ 2 . Then. it follows that Z i = R if σ iM = 0. such a possibility would contradict the efficiency of the market. then by moving δ from δ = 0 to δ < 0 .Z k and ε M ≡ Z M .R) + ε k σ2 M = ak + β k Z M + uk 236 . respectively.

14).ρ kM )σ 2 . u k would be called the residual and represent that part of the return on asset k . (neglecting the "residual. and if the market goes down 10%. securities (or portfolios) with large "betas" ( β k ) are called "volatile" or "aggressive" securities and in a similar fashion. Z M . if the market goes up 10%. which is not "explained" by the return on the market." u k ). we can draw the Security Market Line in terms of beta: 237 . Viewing (XI.β k Cov( ε M . u k is uncorrelated with the return on the market.Finance Theory where a k ≡ (1. βk is equal to the (theoretical) regression coefficient from regressing Z k on Z M and a constant. Thus. As is well-known. For the reader familiar with basic single variable regression theory.ε M ) (XI. then the return on security k would be 20% (plus a k ). securities with small "betas" are called "defensive" securities. Z k .21) as a regression equation is probably the reason that β i is thought of as a relative volatility measure.β k σ M = (1. If (XI. That is. That is. By construction. Further we have k k that Cov( Z M .22) = σ kM . (XI.21) were viewed formally as a regression equation. the residual in a least-squares regression is always uncorrelated with the independent variable: Hence.β k σ 2 M =0 2 since β k = σ kM / σ M .22) simply reaffirms that result.ε k ) . then the return on security k would be –20% (plus a k ). and if β k = 2. From (XI.β k )R. the random variable M 2 2 2 u k has the property that E( u k ) = 0 and Var( u k ) = σ 2 . β k ≡ σ kM / σ 2 and u k ≡ ε k .u k ) = Cov( ε M .β k ε M .

238 .21) to be a valid regression equation. Moreover. any investor who holds a (inefficient) portfolio where u k ≡ 0 is exposing himself to an (unnecessary) additional risk. then he will not be subjected to the (additional) uncertainty of return caused by u k . this interpretation does provide some intuition for what beta is. if an investor holds an efficient portfolio. securities with β k = 0 have expected returns = R. Further. Systematic (or "Market") Risk and Unsystematic (or "Pure" or "Unnecessary") Risk Equation (XI. Merton Figure XI. Since all investors can satisfy their portfolio demands (in equilibrium) by holding efficient portfolios. in general. even if this condition were satisfied. the regression interpretation of βk is only a heuristic. Hence.21) was derived simply by construction with no assumptions about the joint distribution of Z k and Z M . Hence. Nonetheless. the stronger condition that E( u k | Z M ) = 0 is required for (XI. if the portfolio k is efficient. The reader is warned that. then u k ≡ 0 .Robert C. by construction. Although.21) holds for all securities or portfolios in equilibrium. (XI. uk is always uncorrelated with ZM . one cannot attribute strict causality between Z M and Z k .5 Note: All securities with β k = 1 have expected returns = Z M .

it is often called the market risk of security k.. is called the systematic risk of security k and because it is proportional to the market return. This is an irreducible or "necessary" risk that he must take to get the expected return Z k . hold each security available in proportion to its value relative 239 . is proportional to β k σ M .23) ε k = β k ε M + uk . Z k . or really β k ( Z M . the market does not reward investors for choosing inefficient portfolios and exposing themselves to more risk than is necessary.Z M ) = β k ε M .22) and (XI. Implications of the Capital Asset Pricing Model for Portfolio Selection The analysis of the previous section provides a very simple portfolio selection strategy (independently of whether the CAPM holds in the "real" world): Namely. as (XI. can always be written as the sum of systematic and unsystematic risk: namely. or alternatively. the total variance of the return can be written as σ2 = k β2 σ2 k M (XI.e. the equilibrium. From (XI.R. the standard deviation of the systematic part of the total risk.14). the return on the portfolio (for beta ≠ 0 ) is uncertain because the return on the market is uncertain. Thus β k Z M . ε k . the standard deviation of total risk. (1) diversify your holdings as much as possible (i. investors only get extra (expected) return from bearing larger systematic risk. (expected) reward or risk-presmium or excess return. The uncertain part of a security's return. and not σ k . Hence.Finance Theory u k is called the unsystematic or unnecessary risk of security or portfolio k.23). Note that even if the investor holds an efficient portfolio ( u k ≡ 0) .24) + Var (u k ) Variance of Unsystematic Part Variance of Systematic Part Note: From (XI.

Except for certain bookkeeping and purchasing economy of scale. (2) Borrow (or lend) to lever (or "cool down") this portfolio until one achieves the "right" expected return-standard deviation tradeoff. This selection rule is called a naive or passive rule because it requires little analysis (only an estimate of the market expected return and variance) and nothing about individual securities. provide at least as good performance (after deducting costs) as the passive policy. as a minimum. Merton to the market). Since it is always a feasible portfolio policy. Clearly. one can use this rule to provide a benchmark for comparison of overall portfolio performance of active portfolio selection rules as will be shown in Section XIII. the naive strategy eliminates the need for a portfolio manager all together. 240 . such active portfolio management should.Robert C.

government bonds. the classical case of pure life insurance is examined to show how efficient risksharing can be achieved using a combination of financial intermediation and the capital market. personal loan. Assume that the mortality tables are such that E( y i ) = ρ . or insurance) are handled through financial intermediaries. Var( Y N ) = NV 2 241 . financial assets can be traded directly in the capital markets or indirectly through financial intermediaries. wheat futures. shares of IBM) while "custom" contracts (e. Suppose further that each person purchases a one-year term life insurance policy which pays $c in the event of death and we define q ≡ c/W amount of insurance coverage purchased by each person as a fraction of his wealth. Let random variable describing the death of the i th to be the yi be a person where yi = 0 if person i survives the year and yi = 1 if person i dies during the year. In general. Hence... RISK-SPREADING VIA FINANCIAL INTERMEDIATION: LIFE INSURANCE As discussed briefly at the end of Section V. individual mortgage. the same for all people. "standardized" securities are traded in markets (e.. The Life Insurance Company Suppose that there are N people in the economy each with wealth (per capita) W. In this section...2. ρ is the expected number of deaths per person (0 < ρ < 1) . then E[ Y N ] = Nρ .XII. N and Var( y i ) = V 2 which is also the same for all people. Hence. national wealth ≡ W = NW. Let Y N = ∑y i=1 N i be the random variable for deaths of all people and it is equal to the number of deaths in the economy. i = 1.g..g. If the death of one person is independent of another (a crucial but reasonable assumption).

P N The amount of equity capital required by the company to do business. then the analysis will determine the: • • • Premium per policy charged. then the return per dollar invested in equity of the insurance company is Z N ≡ R( NP N + K N ) . we have that Z N must satisfy the basic equilibrium condition for the CAPM: supply = K N = Demand for asset. and so.Robert C. supply must equal demand.C N KN . If R = 1 + rate of interest. Benefits are paid at the end of the year in the (random variable) amount C N ≡ cY N . K N . The required (expected) return on the equity by investors in the insurance company. E[ C N ] = C N = Nc ρ Var( C N ) = σ 2 = Nc 2 V 2 N Suppose that investors are mean-variance maximizers and that the conditions for the Capital Asset Pricing Model (Section XI) hold. Merton If a single competitive insurance company writes all the policies. Premiums are received at the beginning of the year in the amount.Ncρ KN Var [ Z N ] = σ 2 N = Z σ = Nc 2 V 2 2 K 2 N 2 N KN In equilibrium. for the equity of the insurance company to be held. Hence. or KN = w* N = fraction of the market portfolio Z NW where W Z N is also the fraction in optimal combination of risky assets given by: * 242 . NP N . and E[ Z N ] = Z N = R[( NP N ) + K N ] .

KN 243 . then Cov( Z N . R NR R NR ZN = R+ r S cq V .Nc ρ KN ⎛ c 2V 2 ⎞ . we have that R[ NP N + K N ] . Z j ) = 0 for Z N ≠ Z j ).R) N n j=1 w* N = Z (A-RC) Suppose (as is reasonable) that Z N is independent of the returns on all other assets (i.q ρW = r S ⎜ ⎜ N ⎟ ⎟ ⎝ ⎠ The (equilibrium) premium per policy can be written as PN = 2 qWρ 1 cρ 1 2 2 2 + r S q WV = r S cq V and therefore . NW K N From Section XI. Z M ) = r S ⎜ c V ⎟ ZN ⎜ ⎟ ⎝ WK N ⎠ Substituting for Z N .. the (equilibrium) expected return on equity in the insurance company. Z M ) = ∑ j=1 n w*j Cov( Z N .Z j ) = w* N Var Z ( Z N )= ( KN NW )( Nc 2V 2 K2 N )= Nc 2V 2 .R= rS ⎜ ⎟ or ⎝ WK N ⎠ ⎛ c 2V 2 ⎞ RNP N .Finance Theory ∑v Z j( Z j . we have from the Security Market Line that ⎛ 2 2⎞ .Nc ρ = r S ⎜ ⎟ or substituting for c = qW ⎝ W ⎠ ⎛ q 2WV 2 ⎞ RP N .e. Cov( Z N .R = r S Cov( Z N .

the larger is K N the less likely is default. the nature and quantity of policies written for other customers. In doing so. and the customer in purchasing the policy does not get the simple security he wanted which pays $c for sure in the event of his death. the customer takes a (partial) equity position in the company. Merton Note: In this formal analysis. then by limited liability on equity. conditional on the company not being solvent. c N . the customer will not receive the full benefits promised. is larger than the company's total assets. Essentially. the equity capital should be large enough to (virtually) eliminate the chance of default. conditional on the company being solvent. c. then the probability of default is higher. there is a one-to-one correspondence between reserves and capital (equity). yN Obviously. the amount of reserves required to ensure with absolute certainty that all customers will be paid in every state of the world would come by 244 . Now. R( NP N + K N ). Define: reserves as the amount of assets required to be held by the insurance company to ensure that payment will be made to customers with some probability.v. In short.) amount in the event of his death. Clearly. we have not taken into account the limited liability feature of the equity of the insurance company which leads us to the last question to be answered: What is the appropriate value for K N ? To answer this question. if the total number of deaths is such that the (ex-post) benefits required to be paid. If K N is "too small". the probability of these customers dying. but only R ( NP N + K N ) < c. etc. one must go back and ask what service is the financial intermediary to provide to the customer? What does he want? The customer wants a certain payment. the customer would have to know the amount of capital the firm has. given the premium. to assess the probabilities about possible payoffs. nearly everything about the company that the management knows. in the event of death. pays the R ( P N N + K N ) in the event of death. R N = reserves requires = R (NPN + K N ) Let So. the separation between customer and equityholder (or general liability or debtholder) is made as large as possible. but rather has the more complicated security which pays $c (r. yN Clearly. the customer would have to know and analyze.Robert C. Since one purpose of the financial intermediary is to limit the amount of information required by customers to make a decision and because the service wanted is basically life insurance.

let µ = number of standard deviations. N N For large N.e.e. there is a one-to-one correspondence between p * and the number of standard deviations to the right of the mean. Var(X ) = 1 . p . the amount of capital required to meet the maximum reserves could be prohibitively large.Finance Theory requiring that assets be large enough to payoff everyone in the event that everyone dies. Further.e.. * Prob{C N > R N } = 2 Prob{(∑ yi)c 1 n > R K N(p ) + Ncρ + rscqV } = Prob{X N > ( ) * R KN p ( *) + rs cqV V c N N where X N ≡ ∑ yi-Nρ 1 N and E(X ) = 0.. I. .. then 245 . Hence. * * R K N ( p ) r S qV R K ( p ) r S qV ) + } ≈ 1 . X N will be V N distributed approximately standard normal (Gaussian). it may not be necessary for the company to hold the maximum reserves while still performing the essential service required. Suppose that instead it was required that reserves be such that the probability of default is * * less than some assigned level. max C N = Nc I.rS R R Nc large and ρ reasonably small. there is a very small chance that everyone will die (especially since the events of death are independent) and one would expect that for large N. Note: K N (0) = K N . if ρ is small. Prob{C N > R N } ≤ p . Hence. for = Nc = R( NP N + K max ) N K max N = Nc( 1 cq V 2 . For this distribution. i. and define the associated required max capital as K N ( p ). there would be some diversifying effects.ρ ) .Φ [( ) N + ] = p* Vc Vc N N N N Prob{ X N > ( where Φ[ ] is the cumulative density function for the normal distribution. or or R max = N maximum required reserves However.

0025 R = 1 [ µ ( p* ) = 4] 246 .0100 .10 3. 2 µ ( p* ) 2 limit N →∞ ( * Required Equity K (p ) ) = limit ( N ) = 0.5000 .00004 (1 chance in 25. or K N ( p ) = ( Hence.0025.Robert C.0001 (1 chance in 10. c = $30.0010 . R lim ( Z N ) = R.70 4.000 2 V = . 1 * Asymptotic Results for large N(N → ∞) ( > p > 0) 2 * KN( p ) ≈ ( Vc )µ( p* ) N R limit ( P N ) = N →∞ cρ .000) .0 2. Merton µ(p ) * p * 0 1. Thus. N →∞ limit ( σ 2Z N ) = N →∞ R > 0.000) * Vc R K N ( p ) r S qV * + )µ ( p* )N .r SqV for large N. µ ( p ) = ( ) R Vc N N * * * for a given p (or µ ( p )) .0 2. we have an expression for the required equity capital for large N.0230 .00004 = 1 25. NW * Required Equity KN( p ) limit Maximum Equity = limit ( K max ) = 0 N →∞ N →∞ N * Suppose Suppose ρ = .00 .1600 . Total Premiums N PN N →∞ lim ( N →∞ * KN( p ) ) = 0.33 3.000 p = .

000.000 $75.000 $675.000 $18.60 per policy for the intermediary! (50.000 $6.000 $7. less than 1%). then the minimum premium for a $30.000 $1.16 probability of one standard deviation to the right which translates into a $15 million loss! Few max 247 .000.000.00004) NPN . The benefits of the financial intermediary in this case are obvious: if each insurance policy were written by one person for one other person (and if r S ≈ 2 and q ≈ 1).0800 .000 $2.000 6 (1x10 ) one million 9.0080 10.000.250.8000 .7 billion) $30.000 4 (9x10 ) 1.00004) K N (.000 (60 million) 7 (6x10 ) Thus.000.5 billion) $299.000.500.000 times as much!) Note despite the tremendous diversifying power of many policies.000. it is doubtful if such an organization could occur without substantially higher premiums. etc.000. Of course.250.000.000 (or K 1 ) per policy versus $. Suppose one (wealthy) individual provided all the capital ($60 million): (at the derived rates with R = 1) the expected rate of return is zero and there is a .000 $60. sales and other operating expenses would have to be added to the premium and other assets (buildings.Finance Theory N NPN K max = K N (0) N K N (.0267 . the reserves required would be $30. that net worth is a small fraction of total assets (in the example.000 ($30 billion) $270 billion $3 trillion 12 (3x10 ) $600.) have been excluded. Further.800.693.000 policy would be $225 versus $75 charged by the company.000 $6.2667 .000 ($7.000 6 (9x10 ) 8 1x10 one hundred million $750. we observe a characteristic property of (many) financial intermediaries: namely.000 4 (1x10 ) 90. if there were no equity capital market to raise the funds.000 ($2.000. further total (potential) liabilities are many orders of magnitude larger than total assets or reserves.750.

then the loss would be around 15¢ per investor which is trivial for an investor with initial wealth of $30. the individual investor can get the service or asset he wants (virtually no-default life insurance) to eliminate a substantial non-systematic risk.000. 248 . through the combined use of the capital market and the financial intermediary. at minimum cost. by diversifying the risk by issuing equity in the capital market and if individuals hold well-diversified equity portfolios (as they should). But. Merton risk-averse utility maximizers would accept such an investment.Robert C. Thus.

. Hence. This analysis suggested a naive or passive portfolio strategy (namely. this information is only required so that the investor can pick the right efficient portfolio for his specific preference function. if distributional beliefs about security returns are homogeneous). In this section. One simple method for estimating ZM and σM . However. security prices will be such that expected returns will satisfy the Security Market Line. it was further shown that all efficient portfolios can be represented as a simple combination of the market portfolio and the riskless asset. he will receive the highest expected return available (based upon his information set) for whatever level of risk he in fact did bear. Nonetheless.XIII. then he will select the wrong efficient portfolio for his specific tastes. no matter what combination of the market and riskless asset he selects. relative to the investor's information set. If his estimates of ZM and σM are in error.R and σ M or ( ZM . observable) is to use historical data to estimate ZM . an estimate of ZM and σM . of course. we used portfolio analysis to derive the Capital Asset Pricing Model which provides a relationship between expected return and risk in equilibrium. Who these “informed” investors are as well as how successful they are. The passive strategy presumes that market prices for securities reflect the information that the investor has. In an environment where there is no significant differential information among investors (i.R)/ σM . This strategy provides the best “protection” to such investors from those investors who do have significant differential information (the “information traders”). That is. in an empirical question which will be addressed in Section XVII. That is.e. hold the market mixed with the riskless asset) which does not require the investor to undertake security analysis of individual firms. it is appropriate for those investors with information sets that do not reveal mispriced securities. the strategy's success depends upon at least some entities undertaking individual security analysis and acting on this information to ensure that market prices reflect information available to the investor. we develop the procedures for optimal use of such 249 . (R is. this strategy is still appropriate for those investors who do not have such information available to them. and therefore. OPTIMAL USE OF SECURITY ANALYSIS AND INVESTMENT MANAGEMENT In Section XI. This passive strategy does require some forecasting of the “macro” type: namely. the investor will have chosen an efficient portfolio. In an environment where some investors may have differential information.

1). The reader should note that all distributional estimates are computed from a particular entity's information set. An overvalued security has an expected return less than that predicted by the SML. Merton differential information if one were to have it. Write the expected return on security k as 250 . security i in Figure XIII.g. Figure XIII.. the final part of the section combines both micro and macro forecasts.Robert C. We begin by using the Capital Asset Pricing Model to develop an operationally useful definition of “under” and “over-priced” securities. While the emphasis of the analysis is an optimal utilization of security analysts who do only “micro” or individual security forecasts.1 An undervalued security has an expected return greater than that predicted by the SML (e.

” Figure XIII.R . then security k is "over priced" A portfolio with a consistent positive “alpha” (α) shows evidence of ability to forecast a security (or securities) better than the “market. An inferior-performing σR σM On the Relationship Between Superior Stock Selection & Super-Efficiency 251 .1) Zk = R + βk ( ZM . then security k is "fairly priced" α k > 0.R > ZM .R .R) + αk if α k = 0.R < ZM .2 A superior-performing portfolio (“super efficient”) has portfolio (“sub efficient”) has ZP . then security k is "under priced" α k < 0.Finance Theory (XIII. σP σM ZP .

An analytical demonstration is as follows: Form a portfolio of three securities: 252 .4 Question 2: Is it always possible to construct a super-efficient portfolio if one has available a portfolio with a positive alpha? Yes. Merton Consider a portfolio constructed by a manager with superior stock selection skills that has a positive alpha.Robert C.3 Figure XIII. ZP . I.e.R) + α P . α P > 0 σP = βP σM + Var[U P] 2 2 2 Question 1: Is it possible to have a portfolio with a positive alpha that is a subefficient portfolio? Yes. Figure XIII.R = βP ( ZM ..

R ) 2 dVar(Z) dw1 * w1 = ⎡ σ2 αP ⎤ M * * * = 2 ⎢ w1 Var[UP ] .w1 .R ) 2 ⎥ ⎢ ⎣ ⎦ αP * Note : αP > 0 implies that w1 > 0 α2 U P ( ZM .w 2 Z ≡ w1 ( Z p-R) + w 2( ZM -R) + R Z = w1(ZP -R) + w 2( ZM -R) + R = w1α P + [ w1β P + w 2][ Z M .w1[βP ( ZM .w1 αP ] ⎥ = 0 at w1 = w1 ( ZM .R) σM Exercise: Show that ( Z-R) ( .R) > ZM Var(Z) σM when * Z = w1( Z P -R) + w * ( Z M -R) + R= ZM 2 * * and Var(Z) = ( w1) 2Var[ U P ] + [ ZM -R-w1α p ]2 σ2 M ( ZM -R) 2 Hint: just show that Var(Z) < σ2 M 253 .R) + αP ]/(ZM .R) 2 Var(Z) = w1 Var[ U P ] = [ ZM .R .R)[Var[ 2P ] + ( ZM .w1 α P ]2 σ2 M ( ZM .R] + R 2 2 Var(Z) = w1 σ 2 + w 2σ 2 +2w1w 2σ PM = w1 σ 2 + w 2σ 2 + 2w1w 2β P σ 2 P P M 2 M 2 M 2 2 2 = w1Var[ U P ] + [w1 β 2 + 2w1w 2β P + w 2]σ 2 M P 2 = w1Var[U P ] + [ w1β P + w 2]2σ 2 M Find the minimum-variance portfolio with expected return equal to ZM . Z = ZM = w1 αP + [ w1βP + w 2][ZM .Finance Theory Let w1 = fraction invested in portfolio P w 2 = fraction invested in market portfolio w 3 = fraction invested in riskless security = 1 .R .[ ZM .R] + R w 2 = 1 .

a portfolio could have “bad performance” even though the analyst is doing his job because of poor portfolio management or vice versa. Merton If a single entity has micro forecasts for the means. E. and further.g. 254 . This portfolio can then be mixed with the riskless asset to produce an efficient frontier as described in Section X. operationally. (iii) a control mechanism should be employed to keep the portfolio manager from making decisions based on forecasts which are inaccurate. (ii) a particular unit may have superior forecasting capability only with respect to a subset of available securities.18) (the “optimal combination of risky assets”). it is necessary to develop performance measures for each of the roles leading to the “best” portfolio. to reward analysts for doing a “good job” at what they were hired to do. variances. and covariances of all available securities. this may not be feasible because: (i) the large number of available securities make it unlikely that any single unit would be able to make estimates for all available securities.Robert C.. However. then the optimal utilization of such information is to form the risky portfolio using formula (X.

Finance Theory Figure XIII.5 ACHIEVING SUPER EFFICIENCY FROM SUPERIOR STOCK SELECTION 255 .

.2..m.... Define: U k ≡ α k + εk where ε k is a random variable such that E(εk ) = 0. without knowledge of ZM : I.. and (2) movements individual to the stock which are independent of the market. Let w ia ≡ fraction of the portfolio invested in the i a th stock..e. where E( U k ) ≠ 0...k = 1..βk )R + βk ZM + α k + ε k .. one can think of the return on Zk as coming from two sources. restrict the portfolio weights to satisfy 256 .. The capital asset pricing model predicts that if security k is “fairly” priced.2. i = 1.2) Zk = (1 . and the riskless asset....3) Zk = (1 . However. “Active” Portfolio Consider the following portfolio constructed from (m+2) securities: the m stocks being analyzed...2) as (XIII..... E( U k ) = 0.Robert C.. I. k = 1..βk )R + βk ZM + U k . m σM σkM where ZM is the return on the market.. m. Merton Suppose that we are doing security analysis on the shares of m companies whose returns are represented by Zk . ZM ) = 0. Since from (XIII. Cov(ε k . (1) movements in the market. this type of forecasting implies estimates of αk and εk by the analysts. βk ≡ 2 . the market portfolio.m.. ZM ) = 0. k = 1. Further... Rewrite (XIII..m. the purpose of security analysis is to find securities that are either under- or over-valued. k = 1. U k is a random variable such that Cov( U k . as (XIII.3). Cov(ε k.m..2. M w R = fraction of the portfolio invested in the riskless asset. k = 1. m Suppose that we do micro forecasts on the m stocks. but no forecasts on the market.ε j) ≡ σ’kj. We can always write the returns as is done in Section XI. w a ≡ fraction of the portfolio invested in the market portfolio. j=1.

εi) which we have forecasts on and not on Z M (about which we are assumed to have no forecasts).4a) i =1 m (XIII. All active portfolios satisfying (XIII.6) Za = (1 . Za .R) + w M ( ZM ..3) = R + ∑ w ia αi + ∑ w ia εi i =1 i =1 m m from (XIII. ZM ) = 0 .R) + R from (XIII.4b) ∑ w ia βi + w a = 0 M i =1 m If Za ≡ return per dollar invested in the active portfolio.βa )R + βa ZM + αa + εa where: Note that: β a = 0. β a ≡ Cov( Za .R) + R M i =1 m from (XIII.5). then (XIII.4b) Note: since Cov(εi .4a) ∑ w ia + w a + w a = 1 M R i =1 (XIII.5) = ∑ w ia [βi ( ZM .7) ∑w ia αi + R = Za. i=1 m m 2 σ a ≡ Var( Z m) = ∑ ∑ w ia w aj σi′j i=1 j=1 m 257 .4a) and (XIII.R) + αi + εi] + w a ( ZM . ZM ) σ2 M = 0. from (XIII. depend only on the (αi .4b) are uncorrelated with the market.Finance Theory m (XIII.e. Cov ( Za .3). ZM ) = 0 I. then a a Za = ∑ w i ( Zi . the returns on the portfolio. If we write Z a in the form of (XIII. α a ≡ ∑ i=1 m w ia α i. By constructing the active portfolio in this way. εa ≡ ∑w ia εi i=1 m E( Za ) = α a + R = (XIII.

e.8′) ⎛ -R ⎞ m 0 = αi . then a { w 1 . Mathematically. The first-order conditions are (XIII. m m m ∂ 2 : 0 = σ a .m to get 0 = ∑ w a αi .. m j ⎜ ⎟ ⎝ σa ⎠ j=1 258 ...9).λ ∑ ∑ w ia w a σi′j j i i =1 i =1 j=1 m m m (XIII. from (XIII.. i = 1.. λ ≥ 0.λ ∑ w a σ i′j j j =1 i = 1.Robert C.. So. Merton Consider the efficient portfolio set constructed from all such active portfolios..2.. we have that (XIII. the set of portfolios with maximum expected return for a given variance)... fix the variance 2 at σa .8) and (XIII.∑ ∑ w i w j σ i ′j ]} 2 i = 1 j=1 Max { w ia } {R + ∑ i =1 m w ia α i + λ 2 [σ a 2 ∑ ∑ w ia w aj σ i′j]} i =1 j=1 m m where λ is the Lagrange Multiplier..9) Za -R 2 σa =λ The “efficient” part will have Za ≥ R or from (XIII..... (I. w a } m Max = { Za + λ 2 m m a a [ σ a ..∑ ∑ w ia w a σ i′j j ∂λ i =1 j =1 Multiply the first equation by wia and sum i = 1.8) ∂ ∂ wa i m : 0 = α i .⎜ Za 2 ⎟ ∑ w a σi′j .9).2..

m.8') becomes ⎛Z −R⎞ 0 = α i − ⎜ a 2 ⎟ wiaσ i'2 . (XIII.. Thus all “efficient” portfolios constructed from the active portfolio can be thought of as a combination of a risky-asset only portfolio and the riskless asset. i ≠ j).2.10) or (XIII. and therefore they are perfectly correlated. this portfolio also contains the market risky asset (unless βi = 0.. However... m or ⎜ σ ⎟ a ⎝ ⎠ (XIII.10) 2 ⎛ σa ⎞ m a ⎟ wi = ⎜ ⎜ .. To find the particular “efficient” active 259 . then [in an analogous fashion to (X.11) w ia = ( 2 σa αi ) '2 Za -R (σ i ) i = 1. i = 1..... i ≠ j and σi′i = (σi′ ) and (XIII. Cov(εi .2.. it is also true that a m wi wM = . then σi′j = 0.18)].. note that the ratio of “risky assets” a a w i / w k = (∑ Vi j′ α j)/(∑ V k j′ α j) or j=1 j=1 m m αi σ k 2 α k σi 2 is independent of the point chosen on the frontier.R ⎟ ∑ vi′j α j .11)..4b). ε j) = 0. m ⎝ Za ⎠ j=1 In the special case where the unsystematic parts of the returns on the securities are uncorrelated 2 with each other (i... j element of the inverse of the variance-covariance matrix [σi′j] .Finance Theory If th th vi′j = i . m)..m From either (XIII.∑ a βi a wk i =1 w k a is the same for all points on the frontier... i = 1... From (XIII. i = 1.e. Risky assets is put in “ “ because it refers only to risky assets 1..2..

such an all-risky asset portfolio may not be efficient although it will be on the frontier).δ1 σ 2 . w1 . δ2 be the fraction invested in the active portfolio. a technical point is that even if βi ≠ 1 .e. Merton portfolio with risky assets only.. and let δ1 be the fraction of that portfolio invested in the market.. Note: he is not only allowed to pick δ1 and δ 2 . the important point is that from (XIII..R) + R. ZM . w a . σ2 ) and the riskless asset M R.δ 2 σ a ]} p M 2 a a 2 {δ1..11) the holdings depend only on the forecasted variables (αi . σp = δ1 σM + δ2 σa cov( Za . he can select which active portfolio he wants.δ1 . w1 . Mixing the “Active” Portfolio with the “Passive” (Market) Portfolio to Produce an Optimal Combination of Risky Assets Consider an investor presented with the active portfolio ( ZM .. but in a addition.R) + δ 2 ( Z a ... In any event. ZM ) = 0.βi) = 1 .δ2 be the fraction invested in the because: riskless asset. II. and R.R) + δ2 ( Za . w m} Max where γ is a Lagrange multiplier. I.Robert C.. I. δ2 . we set wR = 0 a in (XIII. becomes γ 2 2 {R + δ1 ( Z M . So the investor's choice m 260 .10) or (XIII. 1 .e.4a) and require therefore that ∑ w ia + w a = 1. M i =1 m This can be done by requiring that the wia satisfy ∑ w a (1 . (This is possible i i =1 m provided that β i ≡ 1 for all i. let Zp be the return on a portfolio constructed from Za .. The efficient portfolio set can be generated by maximizing the mean for a given variance. σij) and not on ZM ..R) + [σ 2 . Then The problem 2 2 2 2 2 Zp = δ1 ( ZM .

12a) and (XIII.δ1 σ 2 . i = 1. From (XIII.13).⎜ a ⎜ 2 ⎟ ∑ w j σ i ′j ⎝ σ a ⎠ j =1 Comparing (XIII. the correct combination of the securities in the active portfolio can be determined by choosing an “efficient” portfolio for the active portfolio without knowledge of the characteristics of the market portfolio..R . we have that (XIII.12b) we have that (XIII..γ δ 2 σ a ∂ δ2 ∂ 2 2 : 0 = σ 2 .14) with (XIII..12c) and (XIII. m provided δ 2 ≠ 0 0 = αi .14) ⎛Z -R⎞ m a ⎟ .R .8')..12b) (XIII. and he is using the analysts' forecasts of 2 Z M and σ M .δ 2 σ a .. p M 2 ∂γ ∂ a ∂ wi : 0 = δ 2 { α i .. α i .15) 2 δ 2 ( Z a .13) Since ∂ Za a ∂ wi ∂ : 0 = Z M .Finance Theory is not limited.R) ⎛ σ M ⎞ ⎜ ⎟. m j j =1 m = α i and 2 ∂[σ a ] a ∂ wi = 2 ∑ w a σ i ′j ..12b). γ δ 2 = 2 σa -R and substituting into (XIII.γ δ 2 ∑ w a σ i ′j } i = 1.12a) (XIII. Thus.R) ⎜ σ a ⎟ ⎝ ⎠ 261 . j j =1 m Za From (XIII. they are identical. σ’ ij as well as an estimate of The first-order conditions are (XIII. = 2 δ1 ( Z M .γ δ1σ 2 M ∂ δ1 ∂ 2 : 0 = Za ..

R) ( Za ⎢ ( Z a .R)/ σ a * ⎥ ( .R) ⎥ + ⎥ ⎢ 2 σ2 ⎥ ⎢ σa M ⎦ ⎣ ⎤ ⎡ ⎥ ⎢ 2 ⎢ ( Z M .R) ( Z M .R)/ σ M ⎥ ⎢ ( Z M .R ⎞ + ⎛ Z M .R ⎞ > Z M .R))/ σ a ⎥ ⎢ ⎢ ( Z a .R) ⎥ Z M Za Z M . the optimal combination of risky assets will have the active portfolio in the amount ⎤ ⎡ ⎥ ⎢ 2 ( Z a .R = ⎛ Z a .R) ⎥ + + ⎥ ⎢ ⎥ ⎢ 2 2 σ2 σ2 ⎥ ⎢ σa ⎥ ⎢ σa M M ⎦ ⎣ ⎦ ⎣ ⎡ ⎤ ⎡ ⎤ 2 2 ⎢ ⎥ ⎢ ⎥ ( Za -R)/ σ a ( ZM -R)/ σ M 2 2 2 ⎥ σa + ⎢ ⎥ σM σ* = ⎢ ( Za -R) ( Za -R) ( ZM -R) ⎥ ( Z M -R) ⎥ ⎢ ⎢ + + 2 2 2 2 ⎢ σa ⎥ ⎢ σa σM ⎦ σM ⎥ ⎣ ⎣ ⎦ 2 2 * Z . 262 .Robert C.R for { Z a ≠ R ⎜ ⎟ ⎜ ⎟ ⎟ ⎜ ⎟ ⎜ σ* σM σa < ∞ ⎝ σa ⎠ ⎝ σM ⎠ 2 2 So. Merton Thus.R) ⎥ + ⎥ ⎢ 2 2 σa ⎥ ⎢ σM ⎦ ⎣ and the market in the amount Compare the “new” optimal combination of risky assets (using forecasting) with the “old” optimal combination (with no forecasting): Note ⎤ ⎡ ⎤ ⎡ ⎥ ⎢ ⎥ ⎢ 2 2 ( Z a . the “new” combination is super-efficient.R) Z = R + ⎢ ( .R) + ⎢ ( Z M .R) ( Z a .R) ( Z M .R)/ σ M ⎥ ( ⎢ .

bad Micro Analysts e 1.Finance Theory Summary: Organizational Structure for Portfolio Management [here] Product Customers (good. Form a Market Portfolio at minimum cost (good. σ´ ij estimates? ⎛ Z2 . bad Control 1. Form Final Portfolio by mixing Active and Passive Portfolio 2. How good are αi . Passive Portfolio Manager 1.bad) Final Risky Portfolio Zp . bad good. Is correlation of portfolio with Market = 17 Beta Analyst 1. Estimate α i Micro Analysts 1. bad 1. Correct Analyst bias 2. σa Passive Portfolio Z M . ZM . σ2 ⎞ ⎜ M M⎟ ⎝ ⎠ 1. Estimate σ´ ij e αi good. Monitor Performance of Passive (Market) Portfolio ⎛ Z . σ 2 p Final Portfolio Manager good. σ ⎞ ⎜ a α⎟ ⎝ ⎠ good. σ' ⎞ ⎜ i ij ⎟ ⎝ ⎠ ⎛ Z . Is Za − R − βa . How good are beta estimates? 3. Is βa ≈ 0? Control βi ⎛ α . bad (ZM − R ) > 0 ? 2. Estimate β Group Analyst i 1. Estimate 2 Z M. bad Product Product Active Portfolio 2 Za . bad good. σ 2 M Active Portfolio Manager 1. Monitor Performance of Active Portfolio 3. bad) good. Form Active Portfolio 2. σ2 ⎞ ⎜ p p⎟ ⎝ ⎠ Control Is Final Portfolio Super-Efficient? good. Za . Zp . σ M 263 .

but constructed at minimum cost. The Final Portfolio Manager 1. 2. responsibilities of the “boxed-in” sub-units are now described. Estimates of Z M and σ 2 are produced. He receives (complaints/compliments) on the portfolio's performance from customers (external) and his Control Management (internal). The dotted line shows decentralized units which could be feasibly separate organizations. Its final product is a risky portfolio (and the information ( Z p . (3) the producer of a passive portfolio which should be as close as possible to the market portfolio. 264 . σ 2 and forms the final portfolio M with return Z p according to the rule (XIII. Z M . in general.R) σ 2 ]/[( Z M .Robert C. σ a . σ 2)) which is suitable for mixing with the riskless p asset and being held as a final portfolio by individual investors. (2) the producer of an active portfolio which has a zero-beta and makes optimal use of the micro-analysis done by the security analysts. Merton This rough chart lays out the organizational structure of product and information flows and responsibility.15) 2 δ 2 / δ1 = [( Z a . be suitable for a final portfolio for individual investors.R) σ a ] M (b) He computes Z p and σ 2 and announces them to his customers. there are three separate units: (1) the producer of the final product which is a risky portfolio that should be (at least) efficient and hopefully super-efficient. it will not. Thus. Its final product is a risky portfolio (with a zero-beta) whose expected return is greater than the riskless rate (lies above the Security Market Line). However. (a) 2 He receives estimates of Z a . Its final product is a well-diversified portfolio suitable M for a final portfolio for individual investors who want to follow the naive or passive strategy or for mixing with active portfolios for those investors willing to try for superior performance through a blending of “managed” and “unmanaged” portfolios. The various roles and In Unit 1 (Product: Final Risky Asset Portfolio for Individual Investors) A. He also p supplies these figures to his Control Management.

σ a and announces them to his customer (unit 1). β a (= 0) accurate? Was Z a . either compliment or complain to the Final Portfolio σM Manager. They monitor the performance of the final portfolio by comparing Zp .R ..10) or (XIII. (a) He receives estimates of β i from the beta analyst and of (α i . m. The three sources are: (a) himself: did he follow the " (δ 2 / δ1)" rule? (b) the 2 active portfolio: were Z a .R σp to ZM . He is responsible for tracing back to the source of the (poor/good) performance.∑ w i .β a ( Z M .11): m a w i / w a = ∑ v i ′j α j / ∑ v k ′j α j . He receives (complaints/compliments) on the portfolio's performance from the Final Portfolio Manager (“external”) and his Control Management (internal). 2. i. and then. M i =1 (b) 2 He computes Z a . k = 1.β i) = 1. w a = 1 . and to his control management. 265 .. Active Portfolio Manager 1. (c) the passive portfolio: was the passive portfolio highly correlated with the market? Were the estimates of Z M and σ 2 accurate? He either complains to or M compliments the passive portfolio manager.. (Final) Control 1. B. σ a .R) > 0? He either complains to or compliments the active portfolio manager. k a a ∑ w i (1 . σ’ ) from ij the group analyst and forms the active portfolio according to the rule (XIII. In Unit 2 (Product: Zero-Beta Risky Asset Portfolio representing superior Micro Forecasting) A.Finance Theory 3..R .

Merton 3. is it because the β i estimates supplied were inaccurate? (c) the group analyst: were the α i and σ ij estimates accurate? After finding the source(s).e.. Does the active portfolio have a zero beta (β a = 0)? They either compliment or complain to the Active Portfolio Manager. Beta Analyst 1. he then complains to or compliments the responsible analyst. They monitor the performance of the active portfolio by measuring whether the portfolio shows evidence of superior forecasting capabilities: I. 2.β a ( Z M . 3. B.Robert C. he must also estimate σ’2 and σ i ′j . It is his job to provide the estimates of the betas on those stocks being actively considered by the micro-security analysts. A (rough) measure would be the ratio 266 .R .10) rule?” (b) the beta analyst: if the active portfolio does not have a zerobeta (β a = 0).R) > 0? 2. 3. He is responsible for rating the individual analyst's performance and deciding on whether the analyst is worth keeping. These estimates are provided to the i Active Portfolio Manager. did he follow the “(XIII. It is his job to get the individual micro-security analyst's estimate (α ie) of the α i and correct them for bias (historical) of each analyst to get (an unbiased) estimate αi . does it lie above the Security Market Line? Is Za . He is responsible for tracing back to the source of the (poor/good) performance of the active portfolio. Group Analyst 1. He receives (complaints/compliments) on these estimates from the Active Portfolio manager. The three sources are: (a) himself. D. (Active Portfolio) Control 1. C.

Micro Security Analysts 1.R ratio and a buy-andσM 267 . They are not responsible for that part of the returns which can be explained by macro-market effects. He receives estimates Z M and σ 2 from the Macro Analysts and then reports M them to his customer (unit 1) and to his control management.e. He measures their performance by comparing a strategy of a variable position in the market depending on the estimated hold strategy.. Passive Portfolio Manager 1. he registers the appropriate compliment or complaint with them. ZM . If the estimates by the MacroAnalysts are (good/poor). He is responsible for the portfolio's performance.Finance Theory 2 (α i / σ i ) . the more valuable the analyst. 4. 2. In Unit 3 (Product: A portfolio which is perfectly correlated with the Market and estimates of ZM and σ2 showing superior Macro Forecasting capabilities) M A. how highly correlated it was with the market) and on the estimates Z M and σ 2 from M the Final Portfolio Manager (“external”) and his Control Management (internal). 3. E. The larger (in absolute value) this ratio is on average. He receives (complaints/compliments) on the portfolio's performance (i. He must form a well-diversified portfolio which is as nearly perfectly correlated with the market portfolio as possible at minimum cost. They are responsible for estimating the mean return on the nonsystematic part of the return on individual securities.

All measurements of performance are net of operating costs (e. then independent of α i . the active portfolio “extra” returns do not cover costs. C. (Passive Portfolio) Control 1.R ⎞ ⎟ ⎜ ⎜ σ2 ⎟ a ⎠ ⎝ 268 . Macro Analysts 1. transactions costs.. In the special case where σ i ′j = 0 (i ≠ j). salaries. If.). Note that each level of decision making is subject to two forms of control: external and internal. it does have the property that the three major sub-units operate in a decentralized fashion. it should be dropped. “his” security does not get into the portfolio.Robert C. Note: that throughout there is a kind of “automatic” control which keeps “poor” performers from having much impact on the final product.g. However. if the aggregate error in the active portfolio estimates are large.. They monitor the performance of the passive portfolio by estimating its correlation with the market. etc. σ i2′ large). Each decision-maker's performance is judged on that aspect of the operation for which he is responsible and over which he has the authority to do something about. for example. like an unprofitable division of a manufacturing firm. management fees. computer costs.e. Similarly. Many of the basic techniques used here could be applied to the management of a manufacturing corporation. then. They are responsible for estimating the expected return and variance of the market portfolio or equivalently. the weight of the individual micro analyst in the active portfolio is proportional to which means that if his error in estimating is large (i. and then complain to or compliment the Passive Portfolio Manager. the slope of the Capital Market Line. Of course. this is not the only way the organization could be structured. Merton B. then ⎛ Za .

R ⎞ ⎟ ⎜ ⎜ σ2 ⎟ → 0 . 269 . In the limit as ⎛ Za . a ⎠ ⎝ the final portfolio is the market portfolio as it should be for someone with no forecasting capability.Finance Theory will be small and it will have little weight in the final portfolio.

THEORY OF VALUE AND CAPITAL BUDGETING UNDER UNCERTAINTY The valuation formulas and capital budgeting rules developed in Sections VI and VII take into account the intertemporal characteristics of the firm's cash flows. and therefore. Let x i ≡ E(~i) and νi2 ≡ Var (~i) . suggests that the method of financing should generally have little. we begin with the simple case of a one-period firm whose end-of-period output is distributed to its stockholders through liquidation. exceptions to this rule as for example. the capital budgeting and financing (capital structure) decisions cannot be made independently. of course. in principle. the study of the financing decision in Section IX and. if any. In this section. a good rule of thumb is to be suspicious of projects which do not look attractive when evaluated on an all-equity financed basis but which do appear attractive when presented in conjunction with a "creative" financing plan. Although. the analysis is extended to explicitly recognize the uncertainty associated with these flows. Indeed. in equilibrium. then the return per dollar on the shares of the firm is given by 2 2 I % ≡ I i x i with Z i ≡ E( Z i ) = i x i and Var( Z i ) = I i ν i . It is assumed throughout this section that the firm is all-equity financed. σiM . impact on the choice of investment projects by the firm. we then derive the valuation formulas for a multi-period firm.] With this as background. when the government provides subsidies to certain private sector projects by using below-market interest rate loans or guarantees loans. securities are priced so as to satisfy the Security Market Line. is given by 270 . Suppose that firm i has made (or is considering making) an investment of $ Ii in a x x project with end-of-period random variable cash flow of Ii ~i where ~ i is the random variable x x average cash flow per dollar of investment. The introduction of uncertainty makes the analysis much more complex. the derived Modigliani-Miller Theorem. Having analyzed this case. in particular. [There are. Zi Vi Vi V i2 The covariance of the return of the firm's equity with the market. it is further assumed that the equity market is such that the Capital Asset Pricing Model (of Section XI) holds. Hence. If Vi is the current market value of the firm after the investment is made and if the firm has no other projects. we now turn to the analysis of a one-period firm.XIV. In studying this case.

it should take the project if Vi .λ e νi ρiM ] R i Ii x i Vi . we have that rearranging terms.Ii > 0 . Substituting for Zi into (XIV.1).R . that (XIV.Ii = Ii [ x . R i 271 .Ii = 0 . then it should take all projects which increase its market value. be indifferent if Vi . Under what conditions should the firm make this expenditure and take on the investment? If the firm operates so as to maximize its market value.Ii < 0 .1) σiM σ ( . we have that (XIV.2) Vi = Ii [ x .3) Vi . and not take projects which will lower its market value. and not take it if Vi . the equity of firm i will be priced so as to satisfy the Security Market Line: Zi .λe νi ρiM ] .2). From (XIV. or (XIV. Z M ] = Cov ⎢ ZM ⎥= ⎣ Vi ⎦ ⎡ % ⎤ I iν iσ M ρ iM Vi x where ρiM ≡ the correlation coefficient between ~i and ZM .R = (XIV.R) = λe iM 2 ZM σM σM Ii νi ρiM = λe ( ) Vi where λ e ≡ ( Z M . be indifferent to projects which leave its value unchanged. σ iM ≡ Cov[ Z i .R = λe ( Ii νi ρiM Vi ).R)/ σ M is the Market Price of Risk and it does not depend upon the decisions made by firm i .2) gives the equilibrium market value of the firm after having expended $ Ii in resources in the project. In equilibrium.Finance Theory I i xi . Thus.

λe νi ρiM] = 0 . by β ip ≡ Cov[ x i . βip = βi < Consider a concept similar to the Security Market Line except use project instead of market p betas: I. Var( Z M ) σ2 σM M Note: The beta of the equity of firm i (its "market beta") is given by βi ≡ > > as Vi . Define the Project Market Line by x . βi . p Define: The beta of a project or project beta. if [ x i .R . do not take it.R) where x is the expected cash p flow per dollar of investment in the project and β is the project beta.R . 272 .. < σ iM = ( ν i ρ iM )( I i ) = I i p . take it.R . Z M ] ν iσ M ρ iM ν i ρ iM % = = . and if [ x i .Ii = 0 .e. if [ x i .R = β ( ZM . for a given Ii . βi σ2 σM Vi Vi M Hence. Merton So. be indifferent.λe νi ρiM ] > 0 .Robert C.λe νi ρiM] < 0 .

3). this graph relates non-market assets or projects returns to market returns.Finance Theory The graph of the Project Market Line is analogous to the Security Market Line in Section XI.R) ⇒ V i < I i ⇒ Do not take theProject In the graph. unlike the SML. project #3 corresponds to (XIV.4a).R) ⇒ V i > I i ⇒ Take the Project p x i = R + β i ( Z M . That is. From (XIV.4b) (XIV.4a) (XIV. we express the capital budgeting rule as (XIV. project #1 corresponds to (XIV. the firm should take all projects that lie above the Project Market Line and reject all those that lie below the line.4b).R) ⇒ V i = I i ⇒ Indifference to the Project p x i < R + β i ( Z M .4c). However. 273 . project #2 corresponds to (XIV.4c) p x i > R + β i ( Z M .

That is. exceeds the associated cost of capital. To see this. note by inspection of (XIV. As with securities. it is p the project's systematic risk (βi ) that matters in making the decision whether to invest or not. the two must be equal to avoid arbitrage. xi . it was noted there that the distinction was made in preparation for the analysis of projects whose future cash flows are uncertain.R) . by XIV. Although in the certainty environment of that section. we defined the cost of capital k and used it for deriving capital budgeting rules rather than the riskless rate of interest. Define the cost of capital for project #i. and not the project's total risk ( νi2) . as defined in Section VII) projects whose expected return per dollar of investment. k i .Robert C. the cost of capital to be used for evaluating a project is the one associated with the project and not the firm evaluating the project. The larger is βi .4) that the correct rule for choosing projects is to take all (independent. ki is also called the "hurdle rate" for project i . two different firms evaluating the same project (by x "same" we mean that ~i has the identical distribution from both firm's perspectives) should use the same cost of capital [given by (XIV. p It follows from (XIV. Merton In the capital budgeting analysis in Section VII. It does not x in addition depend upon the joint distribution of ~i with other projects that the firm may have 274 . k i . In analogous fashion to securities. and the riskier is the project. and to reject all projects whose expected return per dollar is less p than its cost of capital.5) k i ≡ R + β i ( Z M . Two important implications for firm investment behavior (which were not evident from the certainty analysis of Section VII) follow from the derived capital budgeting rule: First. To connect the results here with the rules of this earlier section. βi is the appropriate measure of the risk of project i.5)]. the higher is its hurdle rate.5) that k i x depends only upon the distribution of ~i and its joint distribution with the market. we restate the capital budgeting rule in terms of the cost of capital. the larger is the hurdle rate or the minimum required expected return on the project in order to justify p taking the project.

. x 2 . yk ) be the probability that X = x j and Y = yk j. yk ) . y)} is called the joint distribution for X and Y and {f(x)} and {g(y)} are called the marginal distributions for X and Y. P{Y = yk} = g( yk ) be the probability that Y = yk .... . we now turn to the evaluation of the firm and its projects in a multi-period or intertemporal framework. since the correct decision on the project depends only upon its systematic risk (and not its total risk).. unlike a person selecting his optimal portfolio. P{X = x j . j = 1. yk ) . a firm has no need to consider (internal) diversification. given that X = x j .Finance Theory (or plan to undertake). .. k = 1.2.. we provide a quick review of conditional expectation.6) Let f(x j) = ∑ p( x j . k j P{Y = yk | X = x} be the conditional probability that Y = yk . y3 .. consult any reasonable book on probability.. (For further discussion... .. Theory of Value Under Uncertainty (Multi-period Cash Flows) Before proceeding to the development of the valuation formulas.. g( yk ) = ∑ p( x j .2. This important conclusion will be discussed in depth in Section XV. Let Let Let P{X = x j} = f(x j) be the probability that X = x j ... Y = yk} = p( x j . 275 . y2 . Second. {p(x. x3 .2. . Having established the correct capital budgeting rule in a one-period model.) Digression: Review of Expectation and Joint Probabilities Let X be a random variable which can take on the values x1 .3.. respectively.3. Let Y be a random variable which can take on the values y1. (XIV. k = 1.

~ (t) may be a random variable describing profits for date t.1). If X(t) depends on Y(t .9) j j k = ∑ yk (∑ p(x j..Robert C.g.. the distribution for such a random variable..8) yk p( x j . Y (t . E. yk ) (XIV.. yk )) = ∑ yk g( yk ) = E(Y) k j k If X and Y are mutually independent. E t {X(t)} = x(t). conditional on knowing all (relevant) information that has occurred up to and including time t .7) P{Y = yk | X = x j} = p( x j . yk ) f(x j) E(E(Y | X)) = ∑ E(Y | X = x j)f(x j) = ∑ ∑ yk p(x j . Then. Let Let E(X) = (unconditional) expected value of X = ∑ x j f(x j) . E(Y | X = x j) = ∑ yk p {Y = yk | X = x j } = ∑ k k (XIV. j E(Y | X = x j) = conditional expected value of Y .2).. Merton (XIV. For purposes of this course. In general. then the expected value of X(t) will depend on the point in time at which the expectation is computed. will depend on outcomes which occur at an earlier date: denote these random variables by Y(t .1)....10) E{XY} = E(X)E(Y) . Let " E t " denote the conditional expectation operator. If the value of X(t) = function of these random variables = F (Y (t -1). X(t). yk ) = f( x j)g( yk ) . Y(t . given that X = x j .2). then 276 ~ ~ . yk ) f(x j) .. we will be dealing primarily with random variables describing an π outcome as of a given date t .. the particular value that X(t) took on at time t and X(t) is not a random variable relative to time t.. p( x j . . ). then (XIV.

Y t . (Again.13) s(t) = ~ 1 ~ E t [ s (t + 1) + d (t + 1)] . we have that (XIV. Then. If Z(t) is the (random variable) return per dollar from investing in the equity of the firm between time t and t+1.11) or more generally.2 .12) ~ d (t + 1) + ~ (t + 1) s ~ Z(t) = s(t) ~ where tildes ~ denote random variables relative to time t (e. in equilibrium. it is known).. conditional on knowing that conditional on knowing that Y t -1 = y t -1 ..g.2 = y t . (XIV. the price per share of the stock at time t must be such that E t {Z(t)} = 1 + k(t) or (XIV. E t -1{X (t)} will be the conditional expectation.j[X (t)]} = E t-k [X(t)] for k ≥ j ≥ 0 ~ ~ E t -2 {E t -1[X (t)]} = E t -2 {X (t)} End of Digression - Valuation Under Uncertainty: The General Case The derivation of the valuation formula follows the same format as the certainty analysis in Section VI. Let k(t) be the equilibrium market required expected rate of return for investing in the firm between t and t+1. s(t) will be known for certain at time t).Y 0 = y 0 . From (XIV. then.11') ~ ~ E t -k {E t.Finance Theory ~ E0 {X(t)} will include the joint distribution over all {Y(t)} ~ Y(0) = y0 . but at time t.. [1 + k(t)] ~ 277 . k(t) may be a random variable relative to dates earlier than t. (XIV.. by definition.9)..

14) into (XIV. his expected dollar return at time T is ET-1[ d (T)] .15). and as discussed in the parallel analysis in Section VI.1) = ~ 1 ET-1[ d (T)] . Consider a firm which will remain in business for T periods (from now) and then liquidates. (XIV. Merton and for equilibrium. we can assume that the salvage value at that time is zero. we have that 278 .e. [1 + k(T . (XIV. [1 + k(T .e.2) = ~ ~ 1 ET-2 [ d (T . I.Robert C.16) ~ ~ 1 1 [ d (T .1)] because k(T–1) is not a random variable relative to time (T-1). d(T). a random variable). work backwards to today (time zero). At time T in the future.2)] Substituting for S(T–2) from (XIV. we have that S(T–1) must be such as to satisfy (XIV. In order for the market to be in equilibrium S(T–2) must again satisfy (XIV.1) + S(T .13)..13). without loss of generality. Consider an investor at time (T–1): If he buys one share of stock.2)] [1 + k(T .2)] [1 + k (T .1)] where k(T-1) has a ~ over it because relative to time (T–2) it may be uncertain (i.14) S(T . the ex-dividend price per share at time T will be zero (i. the firm will pay its last dividend per share..15) S(T .13) must hold for each t. Noting that ~ ~ 1 d (T) [ d (T)] = ET-1{ } ET-1 [1 + k(T .1)] . For the market to be in equilibrium.1)] ~ Consider when we reach time (T-2). I.1)] + S(T ..e. (XIV. to deduce the value of the stock today. we have that (XIV. we first go forward in time and then.2) = ET-2 E T -2 { ET-1[ d (T)]} ~ [1 + k(T . with probability one.. As in the certainty analysis. and hence. S(T) = 0).1)] [1 + k(T .e.

3) = ~ 1 ~ ET-3 {d (T . we arrive at the price per share today (time zero) which ensures that an investor buying the stock at any time and selling at any other time will face an ex-ante expectation of a fair return and that the markets will clear.1)] ~ ~ d (T .2)][1 + k (T .18) S(T .Finance Theory % % 1 d (T ) d (T ) % { [d (T )]} = E T -2{E T -1[ ]} = E T -2[ ] using the fundamental E T -2 E T -1 % % % [1 + k (T -1)] [1 + k (T -1) [1 + k (T -1) relationship on conditional expectations given in (XIV.17) At time (T-3).13) or (XIV.2) = ET-2 {d (T .1) d (T) = ET . 279 . we have that for markets to clear that S(T-3) must satisfy (XIV.3)] [1 + k(T .11) or (XIV.2)] [1 + k (T ..3)][1 + k (T .17) into (XIV.1)] (XIV.1) + ~ [1 + k(T .2) d (T .18).3)] [1 + k(T .2 { + }.1) = ET-3{ + ~ [1 + k(T . Thus.2)] [1 + k(T .19) Proceeding inductively in this backwards fashion.11').3) = ~ ~ ~ 1 d (T . we can rewrite (XIV.16) as ~ ~ 1 d (T) } S(T .3)] Substituting from (XVI.1)] ~ ~ d (T .2)] ~ d (T) } + ~ ~ [1 + k(T . noting that k(T-2) may be a random variable relative to time (T-3) and using the result that ET-3 • ET-2 = ET-3 .3)][1 + k (T .2)][1 + k (T .2)] [1 + k(T . I.2)][1 + k(T .2)} [1 + k(T .18) as S(T . ~ [1 + k(T .2) + S(T . we can rewrite (XIV.e.1)] (XIV.1) d (T) {d (T .2) + + } ET-3 ~ ~ ~ [1 + k(T .

if k(t) = r(t) . (XIV.20') and (XIV.Robert C. ]= and (XIV.20').20) in its infinite-lived form and for an all-equity financed firm. Moreover. I.. there are some obvious similarities.[1 + k (T .20) with the certainty case.. we can write (XIV. we have that V(0) = n(0)s(0) .20) becomes the same as in VI.20).e. and (XIV.1)] ~ d (T) = E0 {∑ ~ t} t =1 [1 + K (t) ] T s =1 (XIV.. As in the certainty case.20) where K (t) is a random variable defined for notational convenience as ⎡ t ⎤ % % ≡ ⎢ [1+k(s . future dividends are known with certainty). (XIV. E0 [ ~ d (t) = d(t) ~ d (t) [1 + k(t) ] t (i. 280 ~ ~ . then by arbitrage d(t) [1 + k(t) ]t .e. in Section VI.1)] ⎥ K(t) ∏ ⎣ s=1 ⎦ 1/t ~ -1 Comparing (XIV.. Merton ~ ~ d (1) d (2) S(0) = E0 { + + .1)] ~ T d (t) } E0 {∑ t ~ t =1 ∏ [1 + k (s ..21) represent a completely general valuation formula. + [1 + k(0)] [1 + k(0)][1 + k(1)] ~ d (T) } ~ ~ [1 + k(0)][1 + k (1)].21) ~ n(0)d (t) V(0) = E0 { ∑ ~ t} t =1 [1 + K (t) ] ∞ ~ d (t) S(0) = E0 { ∑ ~ t} t =1 [1 + K (t) ] ∞ While (XIV. they are operationally of little use without some further specification of the structure for the probability distributions for both the {d (t)} and the {k (t)} ..

.Finance Theory The balance of this section will be devoted to specific forms for (XIV. k (t) ) and the firm-specific characteristic (i.22) S(0) = ∑ ∞ d(t) t t =1 [1 + ρ(t) ] and 281 .20') and (XIV. It is definitely an external (to the firm) rate.e.10). and in any given situation.21). it may be appropriate to return to the general form (XIV. and is usually defined as the opportunity cost (expressed as a rate of return) to investors of a given risk project. Nonetheless. the term is usually taken to describe the structure of the {k(t)} . ~ It should be remembered that these cases are only representative. ~ d (t) ). % d(t) ≡ E 0 [ d(t)] = expected dividend per share at time Then. While in certainty analysis. equal to the {r(t)}).30') and (XIV. we have that ~ ~ 1 d (t) E0 [ ~ t ]= ~ t ] = E0 [ d (t)] • E0 [ [1 + K (t) ] [1 +K (t) ] d (t) [1 + ρ(t) ] t where ρ(t) is defined by 1 [1+ ρ (t) ] t ≡ E0 [ 1 ] . In this case.. Suppose that the required expected returns {k (t)} and the dividend stream per share {d (t)} ~ ~ are mutually independent. Special Cases of Valuation Under Uncertainty Case A. % [1+K(t) ] t (XIV. it is well-defined (namely.21) deduced from special characteristics assumed for the structure of the market (i. under uncertainty.20') and (XIV.21) can be written as (XIV. from (XIV. it is a "fuzzy" notion.e. Define t. Cost of Capital: "The cost of capital" is a term often used in corporate finance.

discounted at the cost of capital. A slight generalization of Case B is when the {k (t)} are nonstochastic.24') (XIV.. the required expected return is not K(t). k (t) = k(t).e. Merton V(0) = ∑ ∞ (XIV. K(t) is not the cost of capital. I. i.25') S(0) = ∑ ∞ ~ d (t) n(0)d (t) t t =1 [1 + K(t) ] and . the cost of capital.e.e.1)} . Warning: ~ ~ ρ(t) ≠ E0 [K (t)] and ρ(t) ≠ E0{ k (t ." ~ Case C. However. However. V(0) = ∑ t =1 ∞ In this case. k(t) k . Then (XIV.21) can be rewritten as ~ ≡ t (XIV. but vary in a deterministic way over time.25) S(0) = ∑ ∞ d (t) n(0)d(t) [1 + k ]t t t =1 [1 + k ] and . This is very close to the certainty formula in VI where "expected dividends" replace "dividends received" and the market "expected rate of return" replaces the market "realized rate of return. Case B: Suppose that the {k (t)} are nonstochastic and constant. and in an analogous fashion to the R(t) in the certainty case.21) can be written as (XIV.20') and (XIV. V(0) = ∑ ∞ t t =1 [1 + K(t) ] Note: the K(t) are nonstochastic because the k(t) are not. K(t) is the average expected compound return from investing in the 282 .20') and (XIV. Then (XIV.23) n(0)d (t) t t =1 [1 + ρ(t) ] ..Robert C. i. Therefore. the value of the stock is equal to the present discounted value of expected dividends per share..24) (XIV. k is the required expected rate of return by investors in the firm.

283 . Suppose that the {k (t)} are nonstochastic and constant. we have that ∞ ∞ 1+ g t S (0) = ∑d (0)[ ] = d (0) ∑ y t 1+ k t =1 t =1 for y equiv 1+ g 1+ k (XIV.e. the cash flow accounting identity was used to show that the four statements of what determines the value of a firm are equivalent.Finance Theory stock (including reinvesting dividends paid) from time zero to time t. Fortunately. one invested W0 dollars in the stock and reinvested all dividends received in the stock.27) % % % V (0) = n(0) S (0) because D(t ) ≡ n(t -1)d (t ) % % E 0{D(1)} = D(1) = E 0[n(0)d (1)] % = n(0) E 0[d (1)] = n(0)d (1) In the certainty analysis of Section VI. if at time zero.. k > g ) because d (1) = d (0)[1+ g ] (XIV.26) = d (0)[1+ g ] k -g = d (1) k -g .e.24). then the ~ expected value of the position at time t would be E0 [ W t ] = W0 ∏ [1 + k(s .e. I. the analysis presented in that section carries over almost completely to the uncertainty case. Under the assumption that the firm is financed entirely by equity.1)] = W0 [1 + K(t) ] or t s =1 t % ⎡ E [ % ]⎤ E 0[W t ] = [1 + K (t )]t or ⎢ 0 W t ⎥ W0 ⎣ W0 ⎦ ~ 1/ t -1 = K (t ) . the current market value of the firm is given by V(0) = n(0)S(0) where n(0) is the number of shares currently outstanding.. Case D. and the expected dividend per t share grows at a constant rate per period g. d (t) = d(0)[1 + g ] Substituting for d (t) into (XIV. I. provided y < 1 (i..

m(t + 1)S(t + 1) = X (t + 1) . Merton Moreover. [1+ k(t)] Moreover.i (t + 1) π Substituting from (XIV.13).I (t + 1)} [1 + k(t)] ~ 1 ~ ~ E t {V(t + 1) + π (t + 1) .[ n(t +1) . that (XIV.m(t + 1)S(t + 1) = ~ (t + 1) .n(t)]S(t +1)} [1+ k(t)] 1 % % % % = E t{V (t +1)+D(t +1) -m(t +1)S(t +1)}.30b) (XIV.O(t + 1)} [1 + k(t)] 1 ~ ~ ~ E t {V (t + 1) + X (t + 1) . and from (XIV.e. at each point in time t.29) ~ ~ ~ ~ ~ R (t + 1) + m(t + 1)S(t + 1) = O(t + 1) + D(t + 1) Or equivalently.I (t + 1) ~ ~ ~ ~ D(t + 1) .31a) (XIV. it states that (XIV.31c) V(t) = V(t) = V(t) = ~ 1 ~ ~ E t {V (t + 1) + R(t + 1) . we have that V(t) = n(t)S(t) = = (XIV.28) = n(t) % % E t [ S(t +1) + d(t +1)] [1+ k(t)] 1 % % E t {n(t)S(t +1) + n(t)d(t +1)} [1+ k(t)] 1 % % % % % E t{ n(t +1)S(t +1)+ n(t)d(t +1) . I. V(t) = n(t)S(t). [1 + k(t)] 284 . is an identity..m(t + 1)S(t + 1) = R (t + 1) .30a) (XIV.30c) ~ ~ ~ ~ ~ D(t + 1) . the accounting identity in Section VI.30) into (XIV. holds for each possible outcome.i (t + 1)} .28). we have that (XIV.31b) (XIV.O(t + 1) ~ ~ ~ ~ ~ D(t + 1) .21) gives an expression for V(0). and therefore. Equation (XIV.Robert C.

21) provide four alternative but equivalent expressions for the value of the firm under uncertainty.30). the valid application of the former has been shown to be limited to cases of projects with specific distributional characteristics and specific market structures (e.E t {X(t + 1) .e.E t {R (t + 1) .33c) (XIV. we have that (XIV.g. While the formulas for value under certainty derived in Section VI do bear some resemblance to the ones derived here. While further development of these techniques are beyond the scope of the course.i (t + 1)} so. we have the following expressions for the expected change in the value of the firm from time t to t+1: (XIV.32b) ~ ~ [X (t) .i (t)] π V(O) = E0 {∑ ~ t} t =1 [1 + K (t)] ∞ (XIV. (XIV.32c) Coupled with (XIV. the expected change in the value of the firm is not equal to the expected change in shareholders' wealth {i. we 285 .. CAPM)..O(t + 1)} ~ ~ E t {∆ V t} = k(t)V(t) .33d) ~ ~ ~ ~ E t [V (t + 1) . k(t)V(t)}.13).V(t)] = E t {∆ V t} = k(t)V(t) + E t [m(t + 1)S(t + 1) -D(t + 1)] ~ ~ E t {∆ V t} = k(t)V(t) . from (XIV.32a) V(O) = E0 {∑ ∞ ~ ~ [R (t) -O(t)] ~ t } t =1 [1 + K (t)] ∞ (XIV.33).33b) (XIV.E t {π (t + 1) .31) using the same backward technique used to solve for S(0) starting with (XIV. the evaluation of projects in an uncertain environment is considerably more complex than in the certainty case. As promised.21) and (XIV.Finance Theory We can solve (XIV.32) and (XIV.33a) (XIV.I (t + 1)} ~ ~ E t {∆ V t} = k(t)V(t) . Namely.I (t)] V(O) = E0 {∑ ~ t} t =1 [1 + K (t)] ~ [~ (t) .21). Using (XIV.

it need not be as for example in the CAPM if X(t) has a negative beta. in general. the market % would be willing to exchange X ce(t) dollars for certain for the X (t). Since. While. α(t) need not be a decreasing function of t. Moreover. ~ 286 .Robert C. The certainty equivalent to a particular cash flow X(t) is defined to be that number of dollars. such that an investor would be indifferent between receiving Xce (t) for certain % at time t or the random variable cash flow X (t) at time t. Xce (t). it is not always true that the farther in the future a cash flow will occur. it must be that (XIV. by definition. That is. the more uncertainty or risk it must have. one might expect α(t) < 1.34) V(0) = ∑ t =1 ~ ∞ α(t)X (t) [1 + r ]t % where α (t) ≡ X ce(t)/ X (t) and X ( t ) ≡ E 0 [ X (t)] . Merton end this section with a brief discussion of the certainty equivalent method of valuation.

Such synergy will occur if there are economies of scale in marketing.e. and distribution system. if a combination of two firms can reduce the combined present values of these firms' tax payments taken separately. purchasing of materials. Having examined the former there and again in Section XIV. this combination does not increase the total value to society. It can also occur through the elimination of duplicate efforts in management or research and development. However. Synergy: By combining the two companies. we now turn to the latter. In essence. the value of the firm to society is increased with a corresponding increase in both the market and shadow values of the firm. but it does redistribute the total between the 287 . since the firm pays taxes (or may pay taxes in the future). there is an additional "shadow" value of the firm to the public sector in the form of the present value of its tax payments. In the case of synergy.XV. there are essentially three reasons for considering the acquisition of another company: 1. INTRODUCTION TO MERGERS AND ACQUISITIONS: FIRM DIVERSIFICATION In the introduction to Section VII. The sum of the market value and this "shadow" value is the value of the firm to society. 2. Taxes: The market value of the firm reflects its value to the private sector. it was noted that firms can acquire assets by either undertaking internally-generated new projects or by acquiring existing assets of other firms. I. the value of the operating assets of the combined firm will exceed the sum of the values of the operating assets of the two companies taken separately. Such economics are most likely to occur with either horizontal or vertical mergers. plant size. then the market value of the combined firm can exceed the sum of the values of the two firms taken separately even if the value of the combined firm to society is just equal to the sum of the values to society of the two firms. the value goes up because the factors of production are more efficiently organized in the combined firm. Of course.. Under the operational criterion for good management of maximizing current shareholders' wealth.

Hence. the stock market is not efficient in the sense to be discussed in Section XVII. That is. through either incompetence or malevolence. The first is that relative to the acquiring firm's information set. the market value of the firm to be acquired would be higher than its acquisition cost. this reason is completely consistent with an efficient capital market. the management of the acquiring firm believes that it has information such that if this information were widely-known. A second reason why a firm could be selling for less than its "fair value" is that the firm to be acquired is currently being mismanaged. Merton shareholders of the firms and the public sector. In terms of the CAPM and Section XIII. then by acquiring the firm. There are two distinct reasons why a firm could be selling for less than "fair" value. Unlike the first reason. the current management is not managing the firm's resources so as to maximize the market value of the firm. If this is the principal reason for the acquisition. 288 . Indeed. as discussed at length in Section III. the management of the acquiring firm can increase its stockholders' wealth. (b) increased debt capacity for the combined firm which may reduce taxes if there is a "tax-shield" value to the deductibility of interest [see Section IX for further discussion]. all the warnings about being able to "beat the market" given in that section apply equally well here. this reason is probably the most important one for permitting mergers and takeovers. The Firm to be Acquired is a "Bargain": If the firm to be acquired has a market value which is less than its "fair" value.Robert C. from society's point of view. Two examples are: (a) a more-effective use of a tax-loss carryover. the management believes it is purchasing a security with a positive "alpha" (α) . 3. then the management's behavior is identical to that of a security analyst whose job it is to identify mispriced securities. That is.

why the acquisition route is inefficient. R i Suppose that firms #1 and #2 merge to form firm #3. if diversification is the real reason. the value of firm i (i = 1. this type of argument simply illustrates the pitfalls of treating the firm "as if" it were an individual household with exogenous preferences rather than as an economic organization designed to serve specific economic functions. From formula (XIV.δ )Cov( .Finance Theory Firm Diversification Notable by its absence among the three reasons for acquisitions is diversification: That is. More often than not. To show why firm diversification is not an important activity for management and if it is undertaken. Although "diversification" is a frequently cited reason for an acquisition. it is often not the "real" reason. The argument for firm diversification is often presented by analogy with an individual investor where we have seen that diversification is quite important. However. we begin with an explicit analysis of the value of the firm under the capital asset pricing model.λ e νi ρiM ]. However.2). ). then the acquisition route will in general be an inefficient way to achieve it. it will be for one of the three reasons already given.2) is given by (XV. Let there be two firms where each firm has a single project as described in the beginning of Section XIV. then where x I3 ≡ I1 + I2 and ~3 ≡ δ ~1 + (1 .1) Vi = Ii [ x . the acquisition of another firm for the sole purpose of reducing the volatility (variance or "total" riskiness) of the firm's operations. 2 ≡ VAR( ) = 2 2 + (1.δ 2 2 + 2δ (1.δ) ~ 2 x x δ≡ I 1 . i = 1. x define I3 as the investment in firm #3 and ~3 as the random variable end-of-period cash flow of firm #3 per dollar of investment. ) ν2 % % % ν3 x3 δ ν 1 x1 x 2 I 1+ I 2 289 . In an analogous fashion to firms #1 and #2. If no changes in the investment plans of the firms occur as a result of the combination.2.

δ) x 2 . 290 . In connection with both mergers and firms possibly undertaking many (independent) capital budgeting projects.λ eν 2 ρ 2M ]} R But I3δ = I1 and I3(1–δ) = I2 . the value of the combined firm will just equal the sum of the values of the two firms prior to the merger. Merton (XV.6) V3 = I1 I [ x1 .5) V 3= I3 { δ [ x1 .2). ZM ] δCov[ x x = ν3 σ M δ ν1 σM ρ1M + (1 .λe ν3 ρ3M] R 3 Substituting into (XV.δ) ν 2 ρ2M = ν3 From Section XIV.δ )[ x 2 .δ) ν 2 σM ρ2M = ν3 σM δ ν1 ρ1M + (1 .δ) ν 2 ρ2M]} R 3 x Noting that x ≡ E[~3] = δ x1 + (1 . Hence.2). from (XV.5).3) for ρ3M from (XV.λ e ν1 ρ1M ] + 2 [ x 2 .δ)Cov[~ 2 . the value of firm #3 will satisfy (XV.3) V3 = I3 [ x . we generalize the above demonstration to a firm with m projects. we have that (XV. ZM] x ν3 σM ~1 .2) ρ3M ≡ V Cov[~3 .4) V3 = I3 { x .λ eν 1 ρ 1M ] + (1. Thus. (XIV.λe ν 2 ρ2m] R R = V1 + V 2 . we have that (XV. ZM] + (1 .Robert C. we have that (XV.λe [δ ν1 ρ1M + (1 .

ZM ) = ρPM ν P σ M (XV. i =1 m 291 .Finance Theory Let firm P take on m different projects where physical investment in project i is Ii and the random variable end-of-period cash flow is IP = ∑ Ii . i=1 m It follows from (XV. x j ) .10) = ∑ δi ρiM νi σM .8) x P = ∑ δi x i i =1 m and (XV.7) = ∑ δi x i i =1 i =1 m where δ i ≡ I i / I P and ∑δ i = 1 . and total firm end-of-period cash i =1 m flow per dollar of physical investment x P .7) that (XV.9) Var( x P ) ≡ ν 2 = P ∑∑δ iδ j Cov( xi . can be written as x P = [∑ Ii x i]/ IP m (XV. i=1 j=1 m m It follows also that Cov( x P .

we have that VP = = IP [ x . according to the value-maximization criterion. the investor could purchase the shares of firm #1 to firm #2 in the ratio V1 / V 2 which is exactly the ratio implicit in the combined firm.10) is called value additivity and can be shown to obtain in quite general structures (provided that there exists a well-functioning capital market).λe νi ρiM )] R i =1 ∑ Vi i =1 m where Vi = Ii ( x i . i. it is possible that the combined firm could sell for less than the sum of the values of the two separate firms.11) = = IP m [∑ δi ( x i . Merton From (XIV. An intuitive explanation of why the market values are unaffected even though the combined firm may have a smaller total risk (variance) than the individual firms is as follows: In order for investors to be willing to pay a higher price for the combined firm than they were willing to pay for the two firms separately. prior to the combination. Although it will not be the case for the capital asset pricing model.. diversification does nothing to the market values of the firms and hence. the merger provides no new diversification opportunities to investors. And. Hence.Robert C.10). investors have fewer choices for portfolio construction than they did pre-consolidation.λ e ∑ δi νi ρiM ] R i =1 i =1 (XV. The reason is that post-consolidation. Hence. The result shown in (XV. each investor could achieve for himself (prior to the merger) the same amount of diversification (of the risks of the firms #1 and #2) as is provided by the combined firm. that firm diversification could "hurt" market value. any investor could purchase shares of either or both firms in any mix he wants.e. prior 292 . (XV. For example. investors would not pay a premium for the combined firm.2). in the case of the merger.8). For that reason. and (XV. in particular.6) and (XV. the act of combining the two firms must provide a "service" to the investors which they were previously unable to obtain.λe ν P ρPM ] R P m IP m [∑ δi x i .λe νi ρiM )/R is the "stand-alone" value of project i . it is not important. However. and therefore.

at a 293 . Since anyone of these three reasons will increase the value of the acquiring firm's shares.Finance Theory to the merger. then the reason for their making a takeover attempt must be one of the three reasons discussed at the outset of this section. but almost certainly. and therefore. it might appear that no consolidation could be consummated because whatever price is offered. worth more. an investor could hold positive amounts of firm #1 and none of firm #2 or vice versa.. Post the merger. he can only invest in firm #1 if he is willing to invest in firm #2 in the relative proportion V1 / V2 . the fact that the acquiring firm believes it is worth more does not mean that it is. The premium can range from 5 to more than 100 percent with an average somewhere around 20 percent. the acquired firm's shareholders will demand some positive share. it is optimal for all investors to hold firm #1 and firm #2 in the relative proportions V1 / V 2 which is exactly the proportion provided by the combined firm #3. Note that this "negative" aspect of firm diversification applies even in a "frictionless" world of no transactions costs and where the merger takes place on terms where no premium above market value is paid for the acquired firm by the acquiring firm. A natural question to ask is "Why do the owners of the firm to be acquired demand a premium for their shares?" While there are several possible explanations. the acquired firm's shareholders are demanding compensation for providing the means for this increase in value. How this potential increase in value is shared between the acquiring and acquired firms' shareholders cannot be determined in general (as is the usual case for bilateral bargaining). clearly. indeed. Hence. Indeed. The reason that this "loss of freedom" does not have a negative effect on the combined firm's value is the CAPM is that in that model. Of course. their beliefs may be wrong. the acquired firm's shareholders should demand more. However. the acquiring firm's management believes it is worth more. the acquiring firm must usually pay a premium above the market value to acquire a firm.e. In the real world. I. the acquired firm's shareholders do not know what the acquiring firm's management believes the value of the acquired firm is. one that is consistent with our previous analyses is as follows: If the acquiring firm's management is behaving optimally. the only way that an investor can hold firm #1 is to invest in the combined firm #3 which means he must also invest in firm #2. Hence.

it is decided that the volatility or total risk of the firm should be reduced.. In an uncontested merger." Whether or not the acquired firm's shareholders or the acquiring firm's shareholders come out ahead on these takeovers is still an open empirical question. Don't pay $12 to $20 to acquire $10 in cash! If it is costly for your shareholders to diversify their portfolios by direct purchase of individual firms' shares. In summary. at lower cost) by simply purchasing a portfolio of equities and fixed-income securities where no premium must be paid over market and no significant transactions costs must be paid. and other financial intermediaries. then it is almost certainly less costly to issue securities and raise the funds in the capital markets. Even if it is decided that firm diversification is warranted. There are uncertainties created for the acquired firm's management. and let the acquiring firm take the risk (and earn the possible reward) that its information is sufficiently superior to the market's that the acquired firm is still a "bargain. then achieving this diversification through acquisition is very costly. there are three types of reasons for a firm to consider the acquisition of another firm: 294 . suppliers. then litigation costs will be substantial.e. However. there are other costs as well which can frequently be substantial. Of course. because of management risk aversion or debt capacity or supplier concerns. investment companies.Robert C. and customers which could affect the operations of that firm during the negotiations and subsequent transition. the acquired firm's shareholders will take the "sure" premium. While the premium paid over market for the acquiring firm is usually the principal cost of an acquisition. If. it is clear that acquiring another firm for the sole purpose of diversification is a losing proposition for the acquiring firm because it must pay a premium for a firm whose acquisition promises no increase in market value even if it is purchased at market. then this can be achieved much more efficiently (i. if the merger is contested. there are legal costs and management's time which could be spent on other activities. then this service can be provided at less cost by mutual funds. If diversification is desired to provide "cash flow" from these operations to fund growth investments in current operations. Merton high enough price above market.

295 . Hence. Specifically. if pursued. then a minimum of resources should be used to achieve it. and the real reasons will be one or more of the three (proper) reasons for making an acquisition. the acquisition of another firm is a costly way to achieve diversification. The possibility of a takeover of one firm by another is an important "check" which serves to force managements to pursue policies which are (at least approximately) value-maximizing.Finance Theory 1) 2) 3) Synergy Taxes The firm to be acquired is a "Bargain" They all have in common that the acquisition should increase the value of the acquiring firm's current stockholders' wealth. in general. not an important objective for the management of the firm. Diversification by the firm is. If carefully investigated. (most of the time) the meaning of "diversification" as used is not the one described here. Warning: "diversification" is frequently given as the reason for acquiring a firm by the acquiring firm's management.

(as will be shown using the basic cash flow accounting identity). neither answer is universally correct. THE FINANCING DECISION BY FIRMS: IMPACT OF DIVIDEND POLICY ON VALUE In Section IX. and investments over time {I(t)}. That is. we briefly digress to list some factors which appear to influence dividend policy: 296 . "Does dividend policy ‘matter’?" As with the analysis of the capital structure issue in Section IX. V(0) cannot change by changing the payout stream. we address the question." From the valuation formula (XIV. it remains to be determined under what conditions this lack of dependence will obtain." In fact. In a parallel fashion. From the valuation formulas (XIV.XVI. Thus. an equally obvious answer is that "given that the distribution for {X(t)} and {I(t)} is fixed. Using the notation of Sections VI and XIV. But. dividend policy affects the value of the firm. this question is well posed only if it is qualified to reflect what are the "givens" of the environment. {k(t)}. As in Section IX. the choice of capital structure part of the firm's financing decision was examined to determine if this choice has a significant effect on the market value of the firm. given that the firm has already set its investment plan in real assets. can alternative choices among dividend policies change the market value of the firm? In this framework. we examine here the impact of dividend policy on the market value of the firm.32b). asking the question in this context is equivalent to asking whether or not it matters that the firm finances its investments by internally-generated funds or by raising the necessary money externally in the capital markets (or through financial intermediaries). {X(t)}. the second answer is correct provided that the cost of capital. dividend policy does not affect the value of the firm. Before exploring this issue. That is. a seemingly obvious answer is that "of course.20) or (XIV. does not depend on dividend policy.21). an investment policy or plan corresponds to a specific set of cash flows over time. and hence. however. we ask this question in the context of a given or prespecified investment policy.

For simplicity. Where n1 and n2 are the number of shares issued by the two firms. V 2 (0) > V1 (0) .Finance Theory Factors influencing dividend policy: (1) (2) legal restrictions cash position (6) (7) profit rates access to capital markets (tradeability of equity) control of the firm tax position of shareholders corporate tax liabilities (3) (4) (5) need to repay debt restrictions in debt contracts rate of asset expansion (8) (9) (10) Observed stability of dividend policy with respect to earnings or cash flows..e. ~ ~ ~ ~ X1 (t) ≡ X 2 (t) and I 1 (t) ≡ I 2 (t) Suppose that the dividend policies of the two firms for time t > T are identical. Suppose there are two firms with identical investment policies. By convention. Since V2(0) > V1(0). Consider the following portfolio strategy: At time zero. Suppose that their values today are different. i. but their dividend policies differ from t ≤ T . my total 297 . assume that n1(0) = n2(0) . buy λ% of firm #1 and sell short λ% of firm #2. Modigliani-Miller Theorem on Dividend Policy First proof that "dividends do not matter" Assume an environment in which short sales are allowed with full use of the proceeds.

Let N2(t) = number of shares of firm #2 which you are short at time t.1b) N 1(t + 1) = N 1(t ) + λ m1(t + 1). Merton position is at this point: (a) (b) (c) cash = λ[V2(0) – V1(0)] > 0 long λn1(0) shares of firm #1 short λn2(0) shares of firm #2 Suppose that the portfolio policy is pursued of always maintaining a long position in firm #1 equal to λ% of its value and a short position in firm #2 equal to λ% of its value. Let N1(t) = number of shares of firm #1 which you are long at time t. Then N1(0) = λn1(0) and N2(0) = λn2(0) and (XVI. Let C(t) = total cash flow from this portfolio strategy at time t. and N 2(t + 1) = N 2(t ) + λ m 2(t + 1) Where m1 and m2 are the changes in n1 and n2 . 298 .N 2(t )d 2(t + 1) + λ m 2(t + 1) S 2(t + 1) .1a) (XVI.Robert C.λ n1(0) S 1(0) = λ[V 2(0) .V 1(0)] > 0 Where S1 and S2 are the share prices for firms #1 and #2.λ m1(t + 1) S 1(t + 1) Where d1 and d 2 are the dividends per share. T-period discount bonds with yield to maturity of R(T).2) C (t + 1) = N 1(t )d 1(t + 1) . we have that (XVI. Assume that C(0) is invested in riskless-in-terms-of-default. Then: C (0) = λ n 2(0) S 2(0) . For t > 0 and t < T–1 .

5). Therefore.I2 (t + 1) ≡ Y 2 (t + 1) .4).m1(T ) S 1(T )] .12).5b) D1(t + 1) . V1(t) = V2(t) for t ≥ T . we have that: 299 .3b) N 1(t )d 1(t + 1) = λ D1(t + 1) N 2(t )d 2(t + 1) = λ D 2(t + 1) Where D1 and D2 are the total dividends paid by the two firms respectively. and by hypothesis of a fixed investment policy.6) C (t + 1) = 0 for 0 < t < T -1 If the positions are liquidated at time T.3) to (XVI.m1(t + 1) S 1(t + 1)]-[ D 2(t + 1) .[ D 2(T ) . we have that: (XVI.7) C (T ) = λ{[ D1(T ) . we have that: (XVI..e.2).5a) (XVI. From this and (XVI. Y 1(t + 1) ≡ Y 2(t + 1) for all t. Substituting from (XVI. then we have that: (XVI. the dividend policies of the two firms are identical.4) C (t + 1) = λ D1(t + 1) . T By assumption. In particular.λ D 2(t + 1)+λ m 2(t + 1) S 2(t + 1)-λ m1(t + 1) S 1(t + 1) = λ{[ D1(t + 1) .m 2(t + 1) S 2(t + 1)]} From the cash flow accounting identity (VI. it must be that the two firms have identical market values. we have that: (XVI. V1(T) = V2(T) . substituting into (XVI. So after the dividend payments at time T.m1(t + 1) S 1(t + 1) ≡ X 1(t + 1) .1).m2 (t + 1) S2 (t + 1) ≡ X 2 (t + 1) .Finance Theory From the strategy design described in (XVI. after date T.3a) (XVI.I 1(t + 1) ≡ Y 1(t + 1) D 2 (t + 1) . we have that: (XVI. i.m 2(T ) S 2(T )]} +λV1(T) sale of shares long -λV2(T) purchase of shares short + C(0)[1+R(T)] cash and interest on maturity of bonds.

independent of the form an increment in wealth may take. Merton C (T ) = C (0)[1 + R(T )]T = λ[V 2(0) . – λ[m1(T)S1(T) – D1(T) + D2(T)] = – λm2(T)S2(T). if every trader is both rational in behavior and imputes rationality to the market. From (XVI. (2) Symmetric Market Rationality (SMR): Market as a whole satisfies SMR. Therefore. because V1(T) = V2(T) . in forming expectations. or if D1(T) > D2(T) ." Second proof that "dividends do not matter": Assume that: 1. he will then have ${λD1(T) + λ[D2(T) – D1(T)]} = $λD2(T) in cash and ${λ[V1(T) – m1(T)S1(T)] + λ[D1(T) – D2(T)]} worth of firm #1's stock. in stock. At this point. in cash." Suppose that at time t = T–1 there is an investor who is considering buying λ% of firm #2 for $λV2(T–1). Therefore. our investor would have: $ λD2(T) . each individual investor assumes that every other trader in the market (A) is rational in the sense of preferring more wealth to less. C(T) ≡ 0 or: (XVI. we have that D1(T) – m1(T)S1(T) = D2(T) – m2(T)S2(T). then he buys $λ[D1(T) – D2(T)] of the stock of firm #1.Robert C. by investing no money at any time during the interim. We do not assume that short sales can be made with the full use of the proceeds. So.V 1(0)][1 + R(T )]T >0 if V 2(0) > V 1(0) (XVI. Consider two firms as in the "first proof.5). 300 . he will receive λD1(T) in dividends. and $ λ[V1(T) – m2(T)S2(T)] = $ λ[V2(T) – m2(T)S2(T)] . Suppose instead he bought λ% of firm #1 and did the following: at time T. and (B) imputes rationality to all other investors. Imputed Rationality: If.9) V 2(0) = V 1(0) Therefore. to avoid arbitrage.8) Therefore. the values of the two firms must be equal and dividend policy "does not matter. Suppose he sells (ex-dividend) $λ[D2(T) – D1(T)] of his stock for cash if D2(T) ≥ D1(T). the investor can earn C(T) at time T .

(i) Managers are reluctant to cut the dividend rate for fear that this would be interpreted as a sign of poor earning prospects. Hence. unless V1(T–1) = V2(T–1). (ii) Dividends are increased only when management is reasonably confident that 301 . V1(T–1) = V2(T–1) . Both proofs neglect transactions costs and personal taxes. If unanticipated through other means. then. Hence.Finance Theory But. (ii) because capital gains are taxed at a lower rate than dividends and only at the time of their realization through sale. no one. we have that V1(0) = V2(0). we have that V1(τ–1) = V2(τ–1). there will be a dominance of one of the firms over the other. the announcement of an increase in dividend payments implies that management has raised its estimate of average future earnings. Dividend Policy & Market Imperfections: It appears that reductions in current dividends per share (for fixed investment policy) may increase stockholders' wealth. If V1(T–1) < V2(T–1). Suppose at some date τ. V1(τ) = V2(τ) . by the same argument (with "τ" replacing "T"). Informational Content of Dividends Since the practice is that dividend payments are smoothed to conform to managers' estimates of average earnings. Proceeding inductively. If one firm dominates the other. or who would hold it? Clearly. such an announcement would be expected to affect the stock price. this is exactly the amount of cash and stock which he would have had if he bought λ% of firm #2. (i) because substantial underwriting costs are incurred in issuing stock. who would buy the dominated firm. We now explore what effect these might have. then every investor (who prefers more to less) would be better off to buy firm #1 instead of firm #2. Generally. shareholders should prefer a reduction in dividends to a stock issue.

6-20 and 6-21. D(1) = [1 .δ )π (0) r .e.10) V (0) = (1. Let δr = fraction of current earnings retained (i. we have that 302 . But.. Let δe = the amount of external financing required expressed as a fraction of current earnings. From (XVI. D(t) = [1–δr]X(t).r *δ * where r δ = rate of growth of earnings and δ = fraction of profits allocated to new investment. we have that: (XVI.11) V (0) = D(1) r-g where g is the rate of growth of dividends per share. A typical ratio is . D(t) – m(t)S(t) = X(t) – I(t). It follows that [1–δr]X(t) – δeX(t) = [1δ]X(t) or δe = δ – δr.. If I(t) = δX(t) . Consider the constant growth examined there: We have from (VI.18) that: (XVI.Robert C. From the accounting identity. (iii) Payout ratios ⎜ ⎜ ⎛ Dividends ⎞ ⎟ fluctuate because dividends are more stable than ⎟ ⎝ Earnings ⎠ earnings. a firm's target payout ratio is normally stable over time. pp. then D(t) – m(t)S(t) = [1–δ]X(t). (iv) Target payout ratios vary widely from company to company. so.11). From (XIV. X (1) = π (0).δ r ] π (0).10) and (XVI. Merton the increase can be maintained. Example: The Constant-Growth Case: Growth Stocks Review Section VI.27).60 .50 .

12) = V (0) = [1.δ )π (0) r .δ r ) r .r δ * (XVI.δ 303 .12') g= δ r * (1.g or (XVI.δe (1.Finance Theory (1.δ r ]π (0) r .δ ) 1.

6)(100) 60 = = = $3.20 .000 $3.δ ) Example: three firms all with π (0) = $100 and identical investment policies: Firm π (0) I $100 .20 .40 .000 $40 1.δ )π (0) (.40 0 .10 .r ) .20 $3. i.02 r -δ r I (1) = δ X (1) = .e. (1. From (XVI.10). even if the firm pays out all of its current earnings in dividends.000 * .40 and δe = 0 . dividends and price per share will grow over time.00 II $100 .2) .000 $40 1. no external financing).10 . the rate of growth of dividends..40 . V (0) = (1.20 . Merton Note: Unless δe = 0 (i. is less * than the rate of growth of profits. i.e. δr = δ = .4($100) = $40.40 0 $3.40 $3. δr = 0 . g = δ (r * .00 r r* δ δr δe V(0) I(1) n(0) S(0) Firm I: Finances all its investment internally through retained earnings. 304 . Further..000 $3..10 .20 .e.000 $40 1. g ..00 III $100 .Robert C.4(.000 $3. i.e. δ r .10-.

D(1) = dividends = X(1) – I(1) = $100 – 40 = $60. Hence. but at that point.10 -. X (2) = X (1)[1 + r *δ ] = 100(1. and they depend on the profitability of current assets and future investment opportunities which are independent of dividend policy.m(1) S (1) = n(0) 3240-40 or S(1) = $3. from (XVI. will be g = δr* (1. 240 .2 1. V(1). S(0) 3. the value of the firm next period will be: V (1) = X (2)(1.4 x .δ ) $108(1-.4) = = $3. since the investment policy is the same for all three firms. the firm will not belong completely to the shares outstanding at time zero. I.000 shares.24 .00 = = 10% = r .δ S (1) . m(1)S(1) = I(1) = $40. g.3.δ ) 1. The total rate of return to the stockholder will be: d(1) + S(1) . Dividends per share. by the accounting identity. As has been demonstrated previously.12'). V(0). it must issue m(1) new shares at price S(1) to finance investment I(1). and S(0) will be the same for all firms. n(1) = n(0) = r .08 = 8% = rate of growth of the firm V (0) (1.Finance Theory Since this firm does no external financing.S (0) = rate of growth of price per share .06 + 3.V (0) δ r .. the price per share will be $3. So. X (t ) = X (t -1) + r * I (t -1) = π (0)[1 + r *δ ]t -1. V(1) = n(0)S(1) + m(1)S(1) or S (1) = V (1) .δ r ) V (1) . X(1).S(0) . Therefore. S (0) Firm II: Finances all new investment by issuing new shares and pays out all earnings as dividends.06 per share.5. Since no new shares are issued.00 The rate of growth of dividends. V(1) = $3240 for this firm.e. Namely.08) = $108.24.20 and m(1) = 12. We n(0) 1. X(2).rδ . d (1) = have that 60 D(1) = = $. 000 Hence. The return to the 1000 305 .e = δ r * .

S (0) = d (1) + g = current dividend yield + growth . Firm III: Uses a mix of one-half internal and one-half external financing. S (1) D(1) d (1) g = = V (1) .4)(.1) S (1) .00 (1.6 .22 per share n(0) 1000 = X (1) .07334 (1.0667 = rate of growth of price per share = .S (0) = = 0.2)(1-0) .1) δr* = = . Hence.δ r ) δ er (.S (0) .6 Note: The growth of dividends is smaller than for Firm I.6 S (1) .8) (.08 and = = 10% = r n(0) S (0) 3.S (0) = = 10% = r since D(1) = X(1) = $100 S (0) 3.δ .m(1) S (1) 3240-20 = = $3. S (0) 1.12') is g= δ r * (1.08+3. m(1)S(1) = .00 d (1) + S (1) . S (0) Note: r = 10% = On Corporate Earnings and Investor Returns What is the relationship between total dollar returns to shareholders in a particular period 306 .δ .6 .20-3.10 .4(. Note that the larger dividend of Firm II is offset by a smaller capital n(0) 1000 The rate of growth of dividends. from (XVI.8)(.δ ) 1. g. .S (0) = rate of growth stock price .22-3.00 100 D(1) = = .00 = = $0.10+3.2)(. Merton shareholders is and d (1) = gain.Robert C.δ r ) δ er (.δ 1.40 + 20 = $80 and D(1) d (1) S (1) .5I(1) = $20 and again.I (1) + m(1) S (1) = 100 .

δ r )(1.δ r ) r .Finance Theory (i.δ er } rX (t ) [1. Hence. and from (XVI.δ e .δ r ) + δ r * (1.δ ) δ r *(1. in general.δ ) X (t ) r .10). dividends plus capital gains) and total dollar earnings of the firm. that g = (1. is equal to the rate of growth of price per share.r *δ {r (1. X(t)? If G(t) = capital gains to shareholders between period t – 1 and t.δ ) (1.12'). r. = r .r *δ So. Does dividend policy "matter"? Empirical Evidence Graham & Dodd (early work) As the result of a cross-sectional fit of companies.r *δ δ r * (1. they found the following relationship: 307 . because (1–δr)X(t) is the amount of earnings not retained. the rate of growth of dividends.e. (1..r *δ D(1) = = .r *δ = 1 for r * = r for 0 < δ < 1 > 1 for r * > r for 0 < δ <1 < 1 for r * < r X (1) π (0) r .δ ) r . V (0) V (0) 1.δ r .δ ) (r .δ r ) . neither the earnings-to-price nor the dividends-to-price ratio is an unbiased estimate of the cost of capital.δ r * (1. then D(t) + G(t) = (1–δr)X(t) + gV(t–1) .δ V (0) So.δ ) r-r δ rX (t ) = {1. r .δ ) } (r . Note: From (XVI.δ ] since δ = δ r + δ e .r *δ )(1.11).δ r ) + = X (t ) * δ er (1.δ ) - D(t ) + G (t ) = X (t ){(1.δ e} = r . We have that V (t -1) = and from (XVI. and g.g.δ r ) . D(t ) + G (t ) X (t ) = r (1.r *δ )(1.

change in retained earnings = ∆RE. Because E = D + ∆RE .Robert C. the higher the price. 3 The weighted average is important and the dividends have a large weight. Implied policy: make the dividend as large as possible. Is there any problem with this analysis? 308 . IBM). m = constant. P = price of stock.. the higher the payout ratio. The equation was "derived" by looking at the data (although it did not do well for growth stocks. we also have P = m [4 D + ∆RE ] . e.g. Regression or "fit" was done as follows: Implication: Other things equal. D = dividends. Merton P = m[ D + E ] 3 where E = earnings.

such a finding does not imply that a firm can raise its PE ratio by increasing its payout ratio if it maintains the same risk level for its assets. will not bid down the price. suppose that low-risk firms tend to also have high payout policies. Similarly. Then in a crosssection of firms. for example. the market. Hence.. using long-run "smooth" earnings (i. recognizing that price is dependent on "long-run" earnings.. that dividend payout policy and the risk (as. some firms' earnings will be transitorily lower than their long-run average. At the same time. are independent of each other).e. At a point in time.e. For the same reasons. Because of their concern over the information effect of dividends. Does it follow that because P plotted against D gives a good fit. Hence D / E < D /π (0) and P / E < π (0) . measured by beta) of a firm's underlying assets are not independent. P / E > P /π (0). some firms' earnings will be transitorily higher than their long-run average.e. π (0) and the "target" payout ratio. Moreover (as seems to be the case).. I. 309 . one can raise price by increasing the dividend payout if the anticipated future earnings stream remains the same? I. that high (or low) dividend payout policies are not randomly distributed across firms. the strong positive fit between D/E and P/E could merely reflect transitory earnings coupled with managements having a target payout based on long-run "smoothed" earnings. Hence. one would expect to find that high-payout ratios would be associated with high price-earnings ratios. D / E > D /π (0) . management does not "cut" the dividend which is based on "longrun" earnings trend.Finance Theory Suppose: P = price is a function of future earnings and managements choose dividends as a function of future earnings. In a cross-section. Suppose: (as seems to be the case empirically). Realizing the transitory nature of the lower earnings. D /π (0) . is the Graham-Dodd result a causal relationship? Suppose: the price-earnings ratio properly computed. management may well "smooth" dividend payments to match their long-run expectations about the earnings of the firm. Yet. management does not raise the dividend nor does the market bid up the price.

Robert C. δM = current dividend yield on the market. If γ1 < 0 . Thus. 310 . if γ1 > 0 . then the data suggest that dividend policy does differentially affect returns." (ii) If γ1 ≠ 0 . Moreover.13) E ( Z j ) = γ 0 + [E ( Z M ) . Merton Black-Scholes Dividend Paper As was discussed in the beginning of this section. γ0 = expected return on a "zero-beta" portfolio. if they could not reject γ0 = R and γ1 = 0 . In constructing the test procedure. the {k (t )}) . In their dividend paper. and γ1 is the "expected return" on the dividend factor. they begin with a (generalized) Capital Asset Pricing Model specification for expected returns on securities: (XVI. their test is a combined time-series and cross-sectional analysis.δ M ] / δ M where δj = current dividend yield on security j. Black and Scholes provide a test of the hypothesis that alternative dividend policies differentially affect required expected returns. Further. Their findings were that while they could reject the hypothesis that γ0 = R. To overcome the inherent difficulties with simple cross-sectional analysis. they could not reject the hypothesis that γ1 = 0 . a fixed investment policy) is if alternative choices for dividend % policy affects the required expected return on the firm (i. we cannot reject the CAPM and we cannot reject the hypothesis that dividend policy "does not matter. then this would imply that investors prefer lowdividend yielding stocks. the only way that dividend policy can affect the value of the firm (given. their test attempts to correct for the different risks inherent in a cross-section of stocks.e.γ 0]β j + γ 1[δ j . the riskless rate γ1 = 0 . Possibilities: (i) The classical security market line relationship of the CAPM would predict γ0 = R.. then this would imply that investors prefer high-dividend yielding stocks.

investors prefer low-dividend yielding stocks. he does not know if he would prefer high or low-dividend paying portfolios unless he knows the "spread" between pre-tax yields. the investor must hold a less-than-well-diversified portfolio. Since both exist in the real world. Hence. The Black-Scholes explanation of this result is as follows: because payout policies are not randomly distributed across the firms and risk classes. it does not pay to adjust one's portfolio to avoid dividends. one must pay a price in the form of increased variance. one's prior might be that γ1 > 0 . to achieve dividend yields that are significantly different from the market's.e. Because dividend-yield is only a small fraction of the total return on the market and the maximum tax-saving is even smaller. to achieve a higher (or lower) dividend-yielding portfolio. they conclude that for stock portfolios (in the world as it is) investors neglect tax differentials between dividends and capital gains. I. Moreover. Thus.. unless a taxpayer is in the maximum tax bracket. 311 .Finance Theory Their results seem somewhat surprising in the light of our proof that dividend policy does not matter in the absence of transactions costs and personal taxes.

he must also give consideration to the range of possible future prices. unforeseen events which may occur. time "zero") of the stock price at a future date (time "one"). the better his information. the more of the stock he will want to buy.e. which is Z = P(1) . the smaller will be the dispersion and the less risky the investment. the less accurate the information that he has). In particular. SECURITY PRICING AND SECURITY ANALYSIS IN AN EFFICIENT MARKET Consider the following somewhat simplified description of a typical analyst-investor's actions in making an investment decision. Analysts' estimates may differ for two reasons: (1) they may have access to different 312 . he must estimate how dispersed this range is about his best estimate and how likely is a deviation of a certain size from this estimate. Obviously. he must make an investment decision and determine how much of the stock to buy or sell. This best estimate is the expected stock price at time one which we denote by P (1) .XVII.. the smaller the position he will take in the stock. P(0) However. his analyst's job is not finished. The larger the dispersion (i.e. To see how the current market price of the stock is determined. subject to error.e. armed with his estimates of the expected rate of return and the dispersion. How much will depend on how good the risk-return tradeoff on this stock is in comparison with alternative investments available and on how much money he has to invest (either personally or as a fiduciary). First. I.. This analysis then gives him an estimate of the deviations of the rate of return from the expected rate and the likelihood of such deviations. From looking at the current stock price. on average. etc. he collects the information or "facts" (both fundamental and technical) about the company and related matters which may affect the company. Because he recognizes that his information is not perfect (i. Third. The higher the expected return and the more money he has (or controls). Z . and assume that on the average the market is in equilibrium. the price will be such that total (desired) demand equals total supply.. he analyzes this information in such a way so as to determine his best estimate (as of today. P(0). he can estimate an expected return on the stock. Second.). we look at the aggregation of all analysts' estimates.

Or. you have either better than average information about future events which may affect stock price and/or you do a better than average job of analyzing information. P(0). the market price of the stock will reflect a weighted average of the opinions of all analysts.. P(0). (2) they may analyze the information differently with regard to its impact on future stock prices. The aggregation of these decisions gives us the total demand for shares of the company at the price. we conclude that the market price of the stock will reflect the weighted average of analysts' opinions with heavier weights on the opinions of those analysts with control of more than the average amount of money and with better than average amounts of information. Suppose that the price were such that there were more shares demanded than supplied (i. Hence. the estimate of "fair" or "intrinsic" value provided by the market price will be more accurate than the estimate obtained from an average analyst. then there is no point being in the analyst business). because an analyst who consistently overestimates the accuracy of his estimates will eventually lose his customers. on average. (2) others have better information than you do or 313 . From all this. each analyst comes to a decision as to how much to buy or sell at a given market price. and vice versa. the ones that believe that they have better information. the ones who have the strongest "opinions" about the stock will be the most important. Now. Nonetheless. Note: the ones with the strongest "opinions" have them because (they believe that) they have better information (resulting in a smaller dispersion around their best estimate). if there were more shares available at a given price than were demanded. there are two possibilities: (1) you do have a bargain─your estimate is more accurate than the market's. From the above discussion. probably do. I.. the analysts with the biggest impact will be the ones who control the larger amounts of money. it is too low). The key question is: what is the nature of this weighting? Because "votes" in the marketplace are cast with dollars.Finance Theory amounts of information (although presumably public information is available to all).e. Further. suppose that you are an analyst and you find a stock whose market price is low enough that you consider it a "bargain" (if you never find this situation. then one would expect the price to rise. one would expect that among the analysts who control large sums.e. Hence. and among these.

Ask any analyst if he is better than average. its cornerstone is that enough analysts remain and 314 . and invariably he answers "yes." and it becomes more difficult to find profit opportunities. depends on how good the other analysts are relative to oneself. There are important reasons why one would expect the quality of analysts to be high: (1) the enormous rewards to anyone who can consistently beat the average attract large numbers of intelligent people to the business. This also explains why the performance of most "managed" portfolios will be no better than the performance of an "unmanaged" well-diversified portfolio. (2) the relative ease of entry into the (analyst) business implies that competition will force the analysts to get better information and better techniques for processing this information just to survive. and your "bargain" is not a bargain. Merton process available information better." It does not imply that a better-than-average analyst cannot make greater than fair returns. And it is in this sense that the fluctuations in stock prices can be described by a random walk. is equivalent to a "managed" portfolio whose manager is a no-worse-than-average analyst! The investor who buys such a portfolio is simply "piggy-backing" on the actions taken by active analyst-investors competing with each other. the tendency is to underestimate the capabilities of other analysts. this cannot be true for all analysts by the very definition of average. why aren't most of them rich? Precisely because they compete with each other. the analyst must develop new ideas continually. To stay ahead." Clearly. In fact. (3) the stock market has been around long enough for these competitive forces to take effect. and in fact. the market price becomes a better and better estimate of "fair value. As the limiting case of this process. This is essentially the story behind the "Random Walk Theory.Robert C. the fluctuations of stock prices around the expected "fair return" will be solely the result of unanticipated events and new information. Unfortunately. one would expect that as market prices become better estimates of "fair value" in the sense of fully reflecting all relevant known information. If the analysts are so good. Hence. the "unmanaged" portfolio. these fluctuations are random and not forecastable. One's assessment of which it is. It does not imply that all analysts should quit their jobs. because it takes market prices as the best estimate of value.

e..72 I.e.. S3 = $363. If an investor can identify an analyst with above-average capabilities and is willing to bear the risk of his capabilities. the greater the number of participants.. 363. then the correct price per share.Finance Theory actively compete so that market prices are good estimates of "fair" value..64 = = 1. or t E t +1 = E t + (-1) 50 denotes earnings in period t . The theory does imply that to make "extra" profits. 386.. and from time 1 to time 2. the return per dollar from investing in the shares from time 0 to time 1.36. An Example to Illustrate the Efficient Market Concept Consider a firm in a cyclical business whose earnings are completely predictable but vary in the following fashion: If the earnings per share this period are $50... St +1 = St + (-1) t +1 22.20. Further.36 = = 1.4 S1 315 .. then a "bargain" can be struck so that both are rewarded for the effort. it does not imply that all investors should hold "unmanaged" portfolios. then next period's earnings per share will be $50. E 2 = 50. and if If the firm pays out all earnings as dividends (Dt = E t ) and if the required return ("fair market return") is 20% per period. I.36 S0 D2 + S2 50 + 386. and so forth. It is only in this way that the "piggy-backing" by investors can be justified. and if the earnings per share this period are $100. E3 = 100.64. if Et E0 = $50 then E1 = 100.20. Z1 = Z2 = D1 + S1 100 + 363.36. S1 = $363. one must have superior techniques which process information in a way not generally known in the market and that the longer that the market is in existence.64. St (ex-dividend) is given by S0 = $386. S2 = $386. then next period's earnings per share will be $100. the more difficult it is to make these "extra" profits.

2 .6 or . r .2 r .2 t ' St' +1 = St + (-1) 250 or The return per dollar from investing in the shares from time 0 to time 1 under this pricing is ' Z1 = ' 100 + 500 D1 + S1 = = 2. r r . their best guess of future dividends is that they will be equal to ' current dividends. then ' S0 = ' S2 50 100 D0 D ' = = $250.e.40% ' 500 S1 ' Z2 = and it continues to alternate. Merton Suppose that investors are myopic and assume that current earnings (and hence.. S1 = 1 = = $500. Z 2 is ' 50 + 250 D 2 + S2 = = 0.4 or 140% ' 250 S0 ' and from time 1 to time 2 . current dividends) are permanent. 316 .. I.2 50 100 D2 D3 ' = = = $250.Robert C.. If St denotes price per share under this belief.. S3 = = = $500.

there are three questions to be answered: (i) How does the "random walk" theory hold up against the data? (ii) Is the security market line specification a reasonable description of returns on securities? (iii) How does the performance of the naive strategy compare with managed portfolio strategies? 317 . Specifically. by applying the mean-variance model and aggregating demands. we deduced a rationale for random selection of securities or the naive strategy as possible portfolio strategies. we deduced the Capital Asset Pricing model. which provided a specification for equilibrium expected returns among securities. we developed a theory for the capital markets based on essentially rational behavior and optimal portfolio selection. Since these models have important implications for both corporate finance and financial intermediation.Finance Theory Empirical Studies of Capital Market Theory In Sections IX and X. it is most important that empirical testing of the models is performed. we deduced a naive or benchmark portfolio strategy. From our analysis of an efficient speculative market. Based on this model. Basically.

Average Return (1-year): including dividends.3% 318 . To the extent that any serial correlation in the returns were present. Other studies of brokerage house and general service recommendations.8% 32. both the random walk hypothesis and the asset pricing model are implicitly tested.5% 41. serial correlation.8% 15. Merton The answer to (i) is simply that a large number of technical trading strategies (filtering. charting services.1% 16. volume analysis. "Dart throwing" or more careful random selection of portfolios provide no evidence against the random walk hypothesis.) have produced no evidence to refute the random walk hypothesis. or commissions Average Annual Return (Arithmetic Average) Standard Deviation (Annual) Years 1926-1945 1946-1965 1926-1965 17. In the study of managed portfolio performance. Returns on the "Market" NYSE index: value-weighted index of all stocks on the New York Stock Exchange ≈80% in market value of all securities) S&P index: Standard & Poors 500-stock index including the largest companies (in 1965 representing ≈80% of market value of NYSE stocks) Random Selection of Stocks (Fisher & Lorie): Equally-weighted portfolio of all stocks on the New York Stock Exchange 1926-1965.Robert C. no taxes. etc.2% 19. dividend announcements and earning reports have shown no evidence of providing trading profits. it was of such small magnitude and "short-lived" nature that no profitable trading was possible.

but including purchase commissions: Years Average Compound Return (Geometric Average) 1926-1945 1946-1965 1926-1965 6.3% 12.Finance Theory "Market" (in this sense) was much more volatile in the pre-war versus post-war period.6% 9. this is additional evidence in favor of the Random Walk.3% All Stocks on the New York Stock Exchange: Value-Weighted Cowles (1871-1937): Average Compound Return: 6. no taxes. 319 .6% Since the Fisher Lorie results for average performance of randomly selected portfolios is as good as managed portfolios on average over the same period. Average Compound Return: including dividends.

53% 4.58% 3.000 Average Annual Compound Return P=1.47% *Buy the market when the forecast is for stocks to do better than bonds.94% 4.69% 5.50 0.65% 28.13% 37.06% 2.47% $9.52% 0.85% $199.41% 8.32% 19.98% 38.212.27% -17. 320 .85% 5.55% -29.64% 0.12% -25.44% $15.56% 4.75 1.362.19% 36.Simulated Rate of Return Experience for Successful Market Timing* Monthy Forecasts: P = Probability of Correct Forecast January 1927 – December 1978 Market Timing P=.602 34.18% 35.14% 10.90 2.12% 0.68% $67.10% $418.0 2.144 P=.000 P=.89% 38.61% -22.82% 38.02% 1.05% 2. Buy bonds when the forecast is for bonds to do better than stocks.41% -24.17% 3.55% -0.718 P=.60 0.527 Per Month Average Rate of Return Standard Deviation Highest Return Lowest Return Average Compound Return Growth of $1.146.722 NYSE Stocks 0.902.51% $5.

71% Avg.25% 13.2.99% 14.52% Years Total: 10 Years: 5 Years: 1953-1972 1953-1962 1963-1972 1953-1957 1958-1962 1963-1967 1968-1972 Avg. Cov(~ j (t)..k)) = 0 i.15% 9.92% Jensen Performance of Mutual Funds Study 1945-1964 Testing 115 Funds ability to Forecast (relative to Security Market Line): Model Specification: Test: Z j (t) = R(t) + β j[ ZM (t) .45% 10.90% 13.R(t)] + (t) + ~ (t) αj εj Zj j ZM E(~ j (t)) = 0. Merton Average Annual Compound Return on the Market (value-weighted.19% 10. Excess Return 7.. Assumes: β j is stationary.e. or taxes) (Scholes) NYSE Average Return 11. then Cov ( U j .79% 7. larger α j ).63% 13.70% 9. ε ε ε k = 1.25% 4.31% S&P Average Return 11.53% 7.34% 7.R(t)] + α j (t) ~ (t) = R(t) + β [ ~ (t) . Suppose not: ~ ~ β j (t) = β j + U j (t) estimated ~ ~ ) < βj if you can forecast the market. j = 1. ZM ) > 0 which would imply E(β j and biases tests in favor of superior performance (i. no commissions.11% 10. 321 .57% 10.00% 5.86% 12.22% 10.26% 12. ~i (t .Robert C.50% 13. including reinvesting dividends. Excess Return 7.50% 0...38% 9.70% 0.52% 9.98% 13.

Merton 115 Funds Studied.1% 39 funds had measured α j ≥ 0 The statistical significance of the positive α j were no more than would have been expected by chance when the true α j = average α . The differential returns were computed gross of management fees. What about individual funds? Even if funds as a whole do not show evidence of superior forecasting.011 = – 1. and. what about the overtime performance of particular funds? Is it true that funds with observed positive α j in the past tend to have positive α j in the future? Jensen & Black studied the 115 funds for the years 1955-1964 computing the realized α j for each year (a total of 10 × 115 = 1150 observations). Returns net of all costs including management fees. Conclusions: Funds taken as a whole do not show evidence of superior forecasting capability. Using Returns Gross of Management Fees 55 funds had measured α j < 0 Average α = – . The results were 322 . 76 funds had measured α j < 0 Average α = – .004 = –0.Robert C.4% 60 funds had measured α j ≥ 0 Statistical significance of the positive α j were no more than would have been expected by change when the true α j = 0. of course. do not show evidence of sufficient superior forecasting to cover costs.

3. On average.085 Further. With respect to providing efficient (or well-diversified) portfolios..Finance Theory Number of Successive Years of Observed Positive "α" Number of Times Observed Percent of Cases Followed by Another Positive "α" 1 2 3 4 574 312 161 79 50.4% 55.4% 52. Overall Summary 1.. 2. Jensen found that 85% of the variance of the funds' returns were due to market movements. before expenses. 323 . Over the last forty years. funds tended to keep about the same level of βp or σp through time.085) σM βp = 1.e. any better than a naive strategy portfolio with the same beta.8% Conclusion: It appears that funds that did well in the past show little evidence of continuing to do so.0% 53.e. have reasonably low nonsystematic risk).085 ρpM σp or ρpM ≈ 1 = . funds did not perform.9216 1. I. on average. Jensen also found that there was no significant evidence of serial correlation in the return series in support of the Random Walk Hypothesis. σp ≈ (1. on the whole. Most mutual funds are reasonably well diversified (i. randomly selected portfolios have returns greater than or equal to randomly selected managed portfolios.

R] and E( ZM) > R. no load funds.e. expected excess return on a security is proportional to its beta. 324 . choose a mix of a few well-diversified. Using monthly returns from 1931-1965 on 600-1100 securities. Investment prescription: Since these results did not include sales commissions on "load" funds which run from 1½ . I. 2.8½%. 5. funds did worse. Most funds spend too much money trying to forecast returns on stocks: either explicitly in analyst salaries and support and implicitly through brokerage commissions and spreads through excess turnover. The Black-Jensen-Scholes paper is one of the most sophisticated tests of the capital asset pricing model. Merton 4. Few. investors are risk-averse. Expected return on individual securities (portfolios) is an increasing function of its beta and the excess returns are linear in beta. Expected return depends on beta. 6. they found the following: 1. 3. after expenses.Robert C. Select funds with the lowest costs (management fees and turnover).. On average. is linear in beta. if any. individual funds showed any consistent performance superior to the naive strategy over time. The expected return on the market is greater than the riskless rate ( ZM > R). it is dependent only on beta. To achieve an efficient investment strategy. Black-Jensen-Scholes) The capital asset pricing model specifies that E( Z j) = R + β j [E( ZM ) . than the naive strategy portfolio with the same beta. clearly one should buy "no load" funds (with no sales commissions). (ii) Testing the Capital Asset Pricing Model (Miller and Scholes.

and has been the cause for much concern as well as new research in this area. It is evident that the simple form of the Capital Asset Pricing Model as a means for estimating expected returns on individual securities is not sufficient. such analyses are beyond the level of this course.. dβ While there are many possible theoretical and empirical explanations for this finding. and this portfolio had realized returns significantly greater than the riskless rate. The empirical Security Market Line is too "flat. its specification is not unreasonable.Finance Theory 4. however.e. 325 ." I. Results 1-3 are consistent with the capital asset pricing model..R = β j( Z M . zero-beta portfolio constructed from stocks.R) + γ(β j)( Z 0-β .e. the main results implied by that model (1-3) do seem to describe returns and. BJS constructed a "zero-beta" portfolio by combining stocks only (so it has variance). The specification that they fit was Z j . where γ(1) = 0 and dγ < 0. To analyze this problem.R) . Z0-β > R where Z0-β is the expected return on the minimum-variance. result 4 is not. I. as a good approximation. the returns on "low beta" (β < 1) stocks were higher than predicted by the Capital Asset Pricing Model and the returns on "high beta" (β > 1) stocks were lower than predicted by the Capital Asset Pricing Model.

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