ECO562-Financial Economics Semester: Summer 2021: Dr. Zulfiqar Hyder

Creating Wealth by Investing The Entrepreneurial Firm Investment Decisions made by Managers Example: Aging Wine Conseque
ECO562-Financial Economics
Semester: Summer 2021
Dr. Zulfiqar Hyder
Institute of Business Administration, Karachi
June 12, 2021
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Plan of the Today: Chapter 3 of FNZ
How management can invest in firms so as to create wealth

1 Under proprietary firms
2 Under firms with many owners
Perfect capital market and the market value rule.
Separation principles

The Entrepreneurial Firm: Production & Investment

Decisions
Firm as a wealth-create device.
Conditional on proper operation.
What is a proper operation?
Start by assuming that the entrepreneur has a Knowledge of a

production technology.
Initial Supply of resources is also available - start up
What if there is no initial resources?

The Entrepreneur’s Opportunities
Two periods model.
How to represent the entrepreneur’s Opportunities set given

some resources?
A Transformation Curve having the general form

T (K1 , K2 ) = 0
Slope of the Transformation Curve may be interpreted as the

firm’s marginal rate of returns
Why marginal rate of returns is declining steadily?

Productive Opportunities

Example: Commodity Storage
Suppose at time 1, a farmer can sell 1000 units of a

commodity (in storage)
Current price is $1.00 per unit.
Alternatively, the farmer can wait until time 2 and sell the
commodity at $1.30 per unit.
Assuming no spoilage and storage charges, a linear

transformation curve as shown in next slide.

Example 1: Commodity Storage (conti. . . )

Example 2: Productive and Capital Market Opportunities

Example 2: Productive and Capital Market Opportunities

(conti. . . )
A policy of investing funds in the firm until their rate of

returns falls to equality with the market rate of return is a
policy that maximizes the entrepreneur’s initial wealth.

Joint Choice of Production & Consumption Decisions

Joint Choice of Production & Consumption Decisions

(conti. . . )
The decisions process has two distinct steps:

1 Choose the optimum production by equating what?
2 Choose the optimum consumption pattern by borrowing or
lending in the capital market until . . .
The Fisher Separation Theorem.

Entrepreneur Borrows Initial Capital

Entrepreneur Borrows Initial Capital (conti. . . )
Thus, in a perfect capital market entrepreneur with

economically viable ideas can create wealth for themselves
even though they do not have the funds to finance their
venture.

Entrepreneur Borrows Some of the Required Capital

Corporate Governance

Investment Decisions made by Managers
More realistic case
For simplicity, assume corporations. Two additional issues:

1 Many owners and owners’ preferences are not all the same.
2 These owners hire managers and delegates decisions-making
power to these managers.
work perfectly well if there is no Agency Problem arise.
Market Value Criterion.
In corporate finance, the agency problem usually refers to a

conflict of interest between a company’s management and the
company’s stockholders.

The Agency Problem

Corporations and Market Value Criterion
Recall two tangency conditions of the Entrepreneurial Firm

1 between the transformation curve and the capital market
opportunity line
2 between an indifference curve and the capital market
opportunity line
The first condition can be satisfied without needing to know
anything about second condition.
Hiring of professional manager: knowledge of technology,

determine production plan and fulfill first condition.

Maximizing Market Value is equivalent to maximizing

Profits
Let K be the cash flow net of operating expenses and I be the

total amount invested, then the firm’s market value at time 1
is:
K3 K2 ∗
MV1 = (1+r )2
+ (1+r ) − I1
Suppose, investment outlays are are borrowed and that a loan

repayment schedule is established requiring payment of
principal and interest I2 and Is at time 2 and 3 respectively
such that:
I3 I2 ∗
(1+r )2
+ (1+r ) = I1
substituting I1∗ in first equation yields:

K2 I2 K3 I3
MV1 = (1+r ) − (1+r ) + (1+r )2 − (1+r )2

Maximizing Market Value is equivalent to maximizing

Profits (conti. . . )
substituting I1∗ in first equation yields:

K2 I2 K3 I3
MV1 = (1+r ) − (1+r ) + (1+r )2 − (1+r )2
Lets Define π = K − I , we can re-write the above equation as:

π2 π3
MV1 = (1+r ) + (1+r )2
Hence it shows that Maximizing Market Value is equivalent to
maximizing Profits.

Wine Aging Example

Consequences for Investment & Financing Decisions
1 The Market-value-maximizing firm will invest to the point

where marginal rate of return equals the capital market rate of
interest. Decision: How much to invest, Total Capital
Budget.
2 It does not matter whether the firm is owned by many

stockholders or a single owner.
3 Whether the firm uses its own money (retained earnings) or

external financing makes no difference.

Consequences for Investment & Financing Decisions

(conti. . . )
1 What about market imperfections?
2 The source of financing does make a difference.
3 Optimal capital structures do exists.
4 Market value criterion and the economic theory of agency

(chapter 20)

Separations of Operating & Financing Decisions

Separations of Managers’ & Owners’ Decisions

ECO562-Financial Economics Semester: Summer 2021: Dr. Zulfiqar Hyder

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Creating Wealth by Investing The Entrepreneurial Firm Investment Decisions made by Managers Example: Aging Wine Conseque

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

June 12, 2021

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Plan of the Today: Chapter 3 of FNZ

How management can invest in firms so as to create wealth

Perfect capital market and the market value rule.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

The Entrepreneurial Firm: Production & Investment

Firm as a wealth-create device.

Conditional on proper operation.

What is a proper operation?

Start by assuming that the entrepreneur has a Knowledge of a

Initial Supply of resources is also available - start up

What if there is no initial resources?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

The Entrepreneur’s Opportunities

Two periods model.

How to represent the entrepreneur’s Opportunities set given

A Transformation Curve having the general form

Slope of the Transformation Curve may be interpreted as the

Why marginal rate of returns is declining steadily?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Example: Commodity Storage

Suppose at time 1, a farmer can sell 1000 units of a

Current price is $1.00 per unit.

Assuming no spoilage and storage charges, a linear

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Example 1: Commodity Storage (conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Example 2: Productive and Capital Market Opportunities

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Example 2: Productive and Capital Market Opportunities

A policy of investing funds in the firm until their rate of

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Joint Choice of Production & Consumption Decisions

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Joint Choice of Production & Consumption Decisions

The decisions process has two distinct steps:

The Fisher Separation Theorem.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Entrepreneur Borrows Initial Capital

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Entrepreneur Borrows Initial Capital (conti. . . )

Thus, in a perfect capital market entrepreneur with

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Entrepreneur Borrows Some of the Required Capital

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Investment Decisions made by Managers

More realistic case

For simplicity, assume corporations. Two additional issues:

In corporate finance, the agency problem usually refers to a

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

The Agency Problem

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Corporations and Market Value Criterion

Recall two tangency conditions of the Entrepreneurial Firm

Hiring of professional manager: knowledge of technology,

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021