TCHE341 - Chap 2 (Lecture 2-3)

TCHE341:
FINANCIAL ECONOMICS
CHAPTER 2: Investment decisions: the

certainty case
Đỗ Khánh Hiền
Introduction: capital markets, consumption and investment
Recap - Exercises
Suppose your production opportunity set in a world with perfect certainty

consists of the following possibilities:
a) Graph the production opportunity set in a C0, C1 framework.

b) If the market rate of return is 10%, draw in the capital market line for the
optimal investment decision.
Investment decisions: the certainty case
CHAPTER 2: OUTLINE
❖ Fisher separation: the separation of individual utility

preferences from the investment decision
❖ The agency problem
❖ Shareholder wealth maximization
❖ Capital budgeting techniques
❖ Comparison of net present value with internal rate of
return
❖ Cash flows for capital budgeting purposes
LECTURE 3: OUTLINE
❖ Fisher separation: the separation of individual utility

preferences from the investment decision
❖ The agency problem
❖ Shareholder wealth maximization
❖ Objectives: Fisher separation theorem; The agency
problem; Shareholder wealth maximization; The
Economic vs. Accounting definition of profit
Investment decisions
Now
Future
➢ The investment decision is essentially how much NOT to

consume in the present in order that more can be consumed in
the future.
➢ The optimal investment decision maximizes the expected
satisfaction (expected utility) gained from consumption over the
planning horizon of the decision maker.
➢ The consumption/investment decision is important to all sectors
of the economy.
➢ Individual? Managers of corporations? Public sector managers?
➢ Managers of corporations?
Paying out dividends vs Retaining the Earnings???
Future
Now
Current assumptions
➢ Intertemporal decisions are based on knowledge of the

market-determined time value of money the interest rate.
➢ Interest rate is known with certainty in all time periods (but may
change over time/nonstochastic).
➢ All future payoffs from current investment decisions are known
with certainty.
➢ No imperfections (e.g., transactions costs) in capital markets
➢ Oversimplification much?!
Recap
Fisher separation theorem
Given perfect and complete capital markets, the production decision is

governed solely by an objective market criterion (represented by
maximizing attained wealth) without regard to individuals' subjective
preferences that enter into their consumption decisions.
Fisher separation: The separation of individual

utility preferences from the investment decision
➢ Interpersonal comparison of individuals' utility functions is not

possible!
➢ If capital markets are perfect (no frictions that cause the
borrowing rate ≠ lending rate) then Fisher separation obtains
(individuals can delegate investment decisions to the manager
of the firm they own). Regardless of the shape of the
shareholders' individual utility functions, the managers
maximize the owners' individual (and collective) wealth
positions by choosing to invest until the rate of return on the
least favorable project is exactly equal to the market-determined
rate of return.
Fisher separation
➢ The optimal production/investment decision (P0, P1) maximizes the
present value of the shareholders' wealth W0
➢ If the marginal return on investment equals the market-determined
opportunity cost of capital, then the shareholders' wealth, W0, is
maximized.
Fisher separation
➢ Individual shareholders can then take the optimal production
decision (P0, P1) and borrow or lend along the capital market line
in order to satisfy their time pattern for consumption.
➢ Maximizing the shareholders' wealth is identical to maximizing the
present value of their lifetime consumption.
The unanimity principle
➢ Because exchange opportunities permit borrowing and lending at

the same rate of interest, an individual's productive optimum is
independent of his or her resources and tastes. Therefore if asked
to vote on their preferred production decisions at a shareholders'
meeting, different shareholders of the same firm will be
unanimous in their preference.
➢ Managers of the firm, in their capacity as agents of the
shareholders, need not worry about making decisions that
reconcile differences of opinion among shareholders (All
shareholders will have identical interests).
The agency problem

Principal Agent
The agency problem

➢ Ownership vs Control
➢ Agent for the owners always act in the best interest of the
shareholders? (Do managers have the correct incentive to
maximize shareholders' wealth?)
➢ In most agency relationships the owner will incur nontrivial
monitoring costs in order to keep the agent in line (a trade-off
between monitoring costs and forms of compensation to align
managers’ interests).
➢ Award them shares of the firm?
➢ BLOCKCHAIN?
➢ Non pecuniary benefits?
Dividends vs Capital Gains
Assuming that managers behave as though they were maximizing the

wealth
of the shareholders
➢ Shareholders' wealth is the discounted value of after-tax cash
flows paid out by the firm, which is the stream of dividends
➢ in which ks is the market-determined rate of return on equity

capital (common stock)
The Economic Definition of Profit
➢ For an all- equity firm:
➢ in which: m, S, Div, (W&S), I are the number of new shares

issued, the price of these shares, dividends, wages, salaries, and
materials, and services and investment respectively.
➢ Assume that the firm issues no new equity:
➢ The definition of shareholders' wealth now can be rewritten as:

The Economic Definition of Profit
➢ Economist uses the word profits to mean rates of return in excess of

the opportunity cost for funds employed in projects of equal risk.
➢ To estimate economic profits, one must know the exact time pattern
of cash flows provided by a project and the opportunity cost of
capital.
➢ The appropriate profits for managers to use when making decisions
are the discounted stream of cash flows to shareholders or dividends
(any cash payout to shareholders)
➢ Dividends here includes capital gains, spinoffs to shareholders,
payments in liquidation or bankruptcy, repurchase of shares, awards
in shareholders' lawsuits and payoffs resulting from merger or
acquisition but not stock dividends (no CF).
Compared with accounting definition

➢ The accounting definition of profit is net income:
➢ in which dept is the change in accumulated depreciation during

the year
➢ With
➢ Shareholders' wealth now can be rewritten as:
➢ The main difference between the accounting definition and the

economic definition of profit is that the former does not focus
on cash flows when they occur, whereas the latter does. The
economic definition of profit, for example, correctly deducts the
entire expenditure for investment in plant and equipment at the
time the cash outflow occurs.
➢ The objective of the firm (maximize shareholders' wealth, not
to maximize EPS)
Eg: FIFO vs LIFO

LECTURE 4: OUTLINE
❖ Capital budgeting techniques

❖ Comparison of net present value with internal rate of
return
❖ Cash flows for capital budgeting purposes
❖ Objectives: Different capital budgeting techniques;
Finding cash flows for capital budgeting purposes
Capital budgeting techniques

Assumptions:
➢ The stream of cash flows provided by a project can be
estimated without error
➢ Opportunity cost of funds provided to the firm (cost of
capital) is also known
➢ Frictionless capital markets (financial managers separate
investment decisions from individual shareholder
preferences, zero monitoring costs, managers will maximize
shareholders' wealth)
➢ Need to know: cash flows and the required market rate of
return for projects of equivalent risk
Major problems faced by managers when making investment

decisions:
➢ Search out new opportunities in the marketplace or new
technologies (basis of growth)
➢ Estimate the expected cash flows from the projects
➢ Evaluate the projects according to sound Investment decision
rules (capital budgeting techniques)
The best technique will maximize shareholders' wealth, or meet the

following criteria:
➢ All cash flows should be considered
➢ The cash flows should be discounted at the opportunity cost of
funds
➢ Select from a set of mutually exclusive projects the one that
maximizes shareholders' wealth.
➢ Managers should be able to consider one project independently
from all others (value-additivity principle)
Widely used Capital budgeting techniques
➢ The Payback method

➢ Accounting rate of return
➢ NPV
➢ IRR
In reality? The theory and practice of corporate finance: Evidence from
the field John R. Graham , Campbell R. Harvey
https://people.duke.edu/~charvey/Research/Working_Papers/W45_The_
theory_and.pdf
Widely used Capital budgeting techniques

The Payback Method
Projects A, B, C, D has payback period (the number of years it takes to

recover the initial cash outlay) of 2; 4; 4 & 3 years respectively =>
Chose A?!
Problems with the Payback Method
➢ Hurdle is arbitrary (A project is acceptable if its payback period

is less than a prespecified maximum payback period).
➢ Ignores the time value of money
➢ Fails to account for the cash flows that occur after the payback
period cutoff date
➢ Biased against projects that have longer development periods
(For mutually exclusive projects, the project with the shortest
payback period is preferred (assuming they all meet the
maximum payback period threshold)

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TCHE341:

CHAPTER 2: Investment decisions: the

Suppose your production opportunity set in a world with perfect certainty

a) Graph the production opportunity set in a C0, C1 framework.

❖ Fisher separation: the separation of individual utility

❖ Fisher separation: the separation of individual utility

➢ The investment decision is essentially how much NOT to

➢ Intertemporal decisions are based on knowledge of the

Fisher separation theorem

Given perfect and complete capital markets, the production decision is

Fisher separation: The separation of individual

➢ Interpersonal comparison of individuals' utility functions is not

The unanimity principle

➢ Because exchange opportunities permit borrowing and lending at

The agency problem

The agency problem

Dividends vs Capital Gains

Assuming that managers behave as though they were maximizing the

➢ in which ks is the market-determined rate of return on equity

The Economic Definition of Profit

➢ For an all- equity firm:

➢ in which: m, S, Div, (W&S), I are the number of new shares

➢ The definition of shareholders' wealth now can be rewritten as:

The Economic Definition of Profit

➢ Economist uses the word profits to mean rates of return in excess of

Compared with accounting definition

➢ in which dept is the change in accumulated depreciation during

Compared with accounting definition

➢ The main difference between the accounting definition and the

Compared with accounting definition

Eg: FIFO vs LIFO

❖ Capital budgeting techniques

Capital budgeting techniques

Capital budgeting techniques

Major problems faced by managers when making investment

Capital budgeting techniques

The best technique will maximize shareholders' wealth, or meet the

Widely used Capital budgeting techniques

➢ The Payback method

Widely used Capital budgeting techniques

The Payback Method

Projects A, B, C, D has payback period (the number of years it takes to

Problems with the Payback Method

➢ Hurdle is arbitrary (A project is acceptable if its payback period

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