Introduction to Finance

Lecture 2

Blair Robertson
Lecture 2: Overview
• Why do we need financial markets?
– A simple 2 period model of financial markets
– The investment rule
– The separation principle

This material can be tricky the first time through it.

Practice [problems] makes perfect!

• Readings: Chapters 4

• Practice Problems:
– Section 4.5: “A Lending Example”; “A Borrowing Example”
– End of Textbook Practice Problems: 4.6, 4.7ac, 4.9

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Financial Markets
• Financial markets develop over time to facilitate borrowing
and lending (buying and selling)

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Why didn’t we all starve to death?
Or how to match uneven consumption and income

• Lifetime Consumption Smoothing

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Why didn’t we all starve to death?
Or how to match uneven consumption and income
• Lifetime Consumption Smoothing

Caveman Way: Implicit Family Financial Contracts

Modern Way: Financial Markets
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 Consumption Over Time Example
 Market interest rate (“r”) is 10%
 Income in period 0 (present): $50,000
 Income in period 1 (future): $50,000
Consumption
period 1

$50k

Consumption
$50k period 0
 What is the most you can consume in the future? 6

 What is the most you can consume in the present?

Consumption Over Time Example
 What is the most you can consume in period 1?
$50k + $50k*(1+r) = $105k
Future Value = Present Value* (1+r)

 What is the most you can consume in period 0?

$50k + $50k/(1+r) = $95.45k
Future Value /(1+r) = Present Value

An Interest Rate is like an exchange rate across time

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Consumption Over Time Example
Consumption Period 1

105k
Slope = - (1 + r)
50k

95.45k Consumption Period 0

50k

 What does the line represent?

 Where do you want to be in the line?
 What is the slope of the line?
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Example (with an Investment Project)

 Suppose again $50,000 in income each year

 Market Interest rate = 10%

Now there is the opportunity to investment in a

project that costs $30,000 in period 0 that pays
off $32,000 in period 1.
 Should the project be undertaken?

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Example (with an Investment Project)
 One way to solve this is to assume all your
consumption is in period 1

Without Investment Project With Investment Project

Consumption today: Consumption today:

$0 $0

Consumption tomorrow: Consumption tomorrow:

$50k + $50k*1.1 = $105k $50k + $20k*1.1 + $32k = $104k

$105k > $104k

Reject Project!

Note that this is a $105k - $104k = $1k difference in period 1 dollar terms 10
Example (with an Investment Project)
 Or you could assume all your consumption is in
period 0

Without Investment Project With Investment Project

Consumption today: Consumption today:

$50k + $50k/(1.1) = $95.45k $20k+$32k/1.1+$50k/1.1 = $94.54k

Consumption tomorrow: Consumption tomorrow:

$0 $0

$95.45k > $94.54k

Reject Project!

Note that this is a $95.45k - $94.54k = $0.91k difference in period 0 dollar terms ($1k
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/ 1.1 = $0.91k)
Development of Investment Valuation Rule
  $0.91 is the difference between the Present Value (PV) of two
alternatives.
 By comparing the two present values, we develop our investment
rule.
A. PV of financial market investment

B. PV of project investment that pays off $32k

Net Present Value (Difference in PV of project and

financial markets)

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When Should We Undertake the Investment Project?
  Net Present Value (NPV): the present value of the
investment’s future cash flows minus the initial
cost of investment.

 When B > A, or equivalently, when:

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Investment Rule: The Basic Principle
• The basic financial principle of investment decision-making is
this:

• An investment must be at least as desirable as the

opportunities available in the financial markets.

• In mathematical terms: NPV > 0

Recall: The notion of “opportunity cost” from your introduction

to economics course

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Investment Rule: Example 2
Our investor begins with the following opportunity
set: endowment of $40,000 today, $55,000 next
Consumption at t+1

year and a 10% interest rate.

$55,000

$0
$0 $40,000
Consumption at t

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Investment Rule: Example 2
We can extend this to show if the investor consumes
everything in:
Period 1: $40K*1.1+$55K = $99K
Consumption at t+1

Period 0: $55K/1.1 + $40K = $90K

With borrowing or lending in the financial markets, the
$99,000 investor can achieve any pattern of cash flows they want

$55,000

$0
$0 $40,000
Consumption at t $90,000

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Investment Rule: Example 2
Suppose the investor now has the option to invest $25K in a
Consumption at t+1 From the project that returns 20%
From the $40,000 at t $55,000 at t+1

[$25,000×(1.20)] + [$15,000×(1.10)] + $55,000 = $101,500

$101,500
$99,000

From the
From the $40,000 at t $55,000 at t+1

$55,000
$15,000 + [$25,000×(1.20)] ÷(1.10)+ $55,000÷(1.10) = $92,273

$0
$0 $40,000 Consumption at t $90,000 $92,273

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Investment Rule: Example 2
With borrowing or lending in the financial markets, he can achieve any pattern
of cash flows he wants, any of which is better than his original opportunities
Consumption at t+1

$101,500
$99,000

$55,000

$0 $90,000 $92,273
$0 $40,000 Consumption at t
*Note that an individual’s preference for Separation
consumption did NOT impact the decision. principle 18
Investment Rule: Example 2
• We can calculate how much better-off we are in “today’s dollars” by
calculating the Net Present Value of the investment:

Cash inflows $25,000*(1+0.2)=$30,000

Year 0
Time
Year 1
Cash outflows
-$25,000

*Note that an individual’s preference for Separation

consumption did NOT impact the decision. principle
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The Fisher Separation Theorem

Fisher separation theorem:

All investors will want to accept or reject the

same investment projects by using the NPV
rule, regardless of their personal consumption
preferences.

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A Little History: Irving Fisher
• Founding father of finance

• Developed theory of capital

and interests rates still used.

• Named  "the greatest

economist the United States
has ever produced“ by Nobel
Laureates James Tobin and
Milton Friedman.

Sadly his is often remembered for a different reason

"Stock prices have reached what looks like a permanently high plateau.“
-Irving Fisher, October 21, 1929

Lesson: Be cautious
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From Individuals to Corporations
 All shareholders of a firm (regardless of individual
preferences) will be made better off if managers follow
the NPV rule—undertake positive NPV projects and reject
negative NPV projects.
• In reality, shareholders do not vote on every
investment decision faced by a firm.
• They do not need to as long the managers follow the NPV rule

• Separation principle allows the existence of a modern

corporation

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Other Factors : Changing Our Opportunities

Consider an investor who has chosen to

consume $40,000 now and to consume
Consumption at t+1

$120,000
$60,000 next year.

$100,000
A rise in interest rates will make
$80,000
saving more attractive …

$60,000
…and borrowing less attractive.
$40,000

$20,000

$0
$0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000
Consumption today
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Investment Decision Making

Positive NPV projects shift the

Consumption at t+1

shareholder’s opportunity set out,

which is unambiguously good

All shareholders agree on their

preference for positive NPV projects,
whether they are borrowers or
lenders

Consumption today
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To Summarize:
• Financial markets exist because people want to adjust
their consumption over time. They do this by
borrowing or lending. An Interest Rate is like an
exchange rate across time

• An investment has positive NPV and should be

accepted if no superior alternative exists in the
financial markets.

• An investment has negative NPV and should be

rejected if a superior alternative exists in the financial
markets.

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Lecture 2: Knowledge Checks
• Have an understanding of:
 The Financial Market Economy: facilitation of
borrowing and lending
 Consumption Over Time
 Consumption Choices
 Investment Rule/Net Present Value

• Readings: Chapters 4
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