Financial Markets and Institutions

Optimal Intertemporal Allocation

 Objectives

• How does intertemporal exchange improve the utility of financial

market participants?
Optimal Intertemporal Allocation
Intertemporal Allocation
 Intertemporal Allocation

• We can think of capital as a durable good. It is created by

consumers who are willing to postpone some of their current
consumption in order to increase their consumption in future time
periods.
 Intertemporal Allocation

• Consumers expect to be rewarded for their postponement of

current consumption.
• This reward affects the price and quantity supplied of capital.
Greater reward leads to greater supply of capital. We can call this
reward as the interest rate.
 Intertemporal Allocation

• In order to understand how consumers decide between

consumption across two time periods, consider the following
scenario. Assume that:
• X1 = Consumption in period 1
• X2 = Consumption in period 2
• I1 = Income in period 1
• I2 = Income in period 2
•r = Interest rate at which consumers can borrow and lend
 Intertemporal Allocation

• In the next figure, we measure levels of income and consumption

in period 1 on the horizontal axis, and levels of income and
consumption in period 2 on the vertical axis.
 Intertemporal Allocation

x2
x1 < I1, x2 > I2
W2 Net Saver
C(x1,x2) x1 = I 1 , x2 = I2
B(x1,x2) Consumes Immediately
I2 x1 > I1, x2 < I2
A(x1,x2) Net Borrower

I1 W1 x1
 Intertemporal Allocation

• In the previous figure, W1 is the consumption that an individual

can afford in period 1 if he does not consume anything in period 2.
• X1 = W1 = I1 + I2/(1 + r)
• While, W2 is the consumption that an individual can afford in
period 2 if he does not consume anything in period 1.
• X2 = W2 = I2 + I1(1 + r)
 Intertemporal Allocation

• The slope of the line,W1W2, can be computed by differentiating the

following equation with respect to X1.
X 2  I 2  (I1  X1 )1  r 
d d
X 2   I 2  (I1  X1 )1  r 
dX1 dX1
d
X 2   1  r 
dX1
 Intertemporal Allocation

• In the previous expression, consumption in period 2 (X2) is equal

to the sum of income in period 2 (I2) and future value of savings in
period 1 (I1 – X1).
 Intertemporal Allocation

• The downward slope of the line,W1W2, represents the rate of

exchange in the capital market between today’s dollars and next
year’s dollars.
• By lending all of the present income, one can increase his future
consumption by I1(1 + r) or by I2W2.
• Alternatively, by borrowing against future income, one can increase his
present consumption by I2/(1 + r) or by I1W1.
 Intertemporal Allocation
Example 1

• Assume that you can borrow and lend at 7% and your income
potential is as follows:
• Current Income = $20000
• Income for period 2 = $25000
• What is the maximum that you can consume in both periods (period 1
and period 2)?
 Intertemporal Allocation
Example 1

• If you do not want to consume anything today, you can invest

$20000 in the capital market at 7%. It will allow you to increase
your consumption by $21400 (=$20000 * 1.07) next year.
• NOTE: This is I2W2 is the previous figure.
• Since you also have $25000 in period 2, your overall consumption
will be $46400 (= $21400 + $25000).
• NOTE: This is point W2 is the previous figure.
 Intertemporal Allocation
Example 1

• You can also decide to borrow against your future income and
increase your consumption in period 1.
• If you decide to do so, the capital markets will be willing to lend
you $23364 (=$25000/1.07). This is also the maximum amount by
which you can increase your consumption in period 1.
• NOTE: This is I1W1 is the previous figure.
 Intertemporal Allocation
Example 1

• Your overall consumption in period 1 can be as high as $43364

(=$20000 + $23364).
• NOTE: This is point W1 is the previous figure.
 Intertemporal Allocation
Example 1

• It is important to mention here that you can end up anywhere on

the line, W1W2, depending on how much you consume today.
Optimal Intertemporal Allocation
Capital Market and Smoothing of Consumption
Patterns
 Capital Market and Smoothing of Consumption Patterns

• Few of us save all of our current income or borrow fully against

our future income. We try to achieve a balance between present
and future consumption.
 Capital Market and Smoothing of Consumption Patterns

• Suppose, for example, that you favor current consumption over

future consumption. In this case, your preferred consumption
pattern might be indicated by the next figure.
Capital Market and Smoothing of Consumption Patterns
 Capital Market and Smoothing of Consumption Patterns

• The previous figure indicates that you choose to borrow BC

against future income and consume C today.
• However, this consumption pattern will oblige you to repay EF,
thereby reducing your future consumption to E.
 Capital Market and Smoothing of Consumption Patterns

• On the contrary to the previous case, if you prefer future

consumption over current consumption, you might prefer the
consumption policy as outlined in the next figure.
Capital Market and Smoothing of Consumption Patterns
 Capital Market and Smoothing of Consumption Patterns

• The previous figure indicates that you consume A today and lend
the balance AB.
• Next year, you receive a repayment of FG and are therefore able to
indulge in consumption of G.
Optimal Intertemporal Allocation
Production Opportunities and Intertemporal
Exchange
 Production Opportunities and Intertemporal Exchange

• In practice, individuals are not limited to investing in capital

market securities. They may also acquire plant, machinery, and
other real assets. Therefore, we can also introduce investment in
real assets in our analysis.
 Production Opportunities and Intertemporal Exchange

• In case of investment in real assets, one can assume that returns

from the “best” project may be substantially higher than returns
from capital market securities, such as lending capital to the bank.
 Production Opportunities and Intertemporal Exchange

• Therefore, the investment-opportunity line may be very steep in

the beginning. However, it will become progressively flatter
because the “best” projects will attract competition. The
competition will, eventually, drive down the desirability (profits)
of the project.
 Production Opportunities and Intertemporal Exchange

• This is illustrated in the next figure, where the first $10000 of

investment produces a subsequent cash flow of $20000, whereas
the next $10000 offers a cash flow of only $15000. In the
terminology of economics, there is a declining marginal return on
capital.
Production Opportunities and Intertemporal Exchange
 Production Opportunities and Intertemporal Exchange

• We can now inquire how our welfare would be affected by the

possibility of investing in real assets. The solution is illustrated in
the next figure.
Production Opportunities and Intertemporal Exchange
 Production Opportunities and Intertemporal Exchange

• The previous figure assume that you have maximum initial

resources of D. Part of this may come from borrowing against
future income.
• If you choose to invest any part of this sum in the capital market,
you can attain any point along the line DH.
 Production Opportunities and Intertemporal Exchange

• However, if you invest in real assets, you can attain any point along
the line DL.
• For example, assume that you can retain J of your initial resources
and invest the balance JD in plant and machinery. The curved
investment-opportunity line indicates that such an investment
would produce a future cash flow of G.
 Production Opportunities and Intertemporal Exchange

• Previous figure also indicates that whether you favor current

consumption or future consumption, you are better off if you
invest JD in real assets and then borrow or lend in the capital
market.
• By borrowing from the capital market, you can increase your
current wealth to K and by lending in the capital market, you can
increase your future wealth to M.
 Production Opportunities and Intertemporal Exchange

• In other words, by both investing JD in real assets and borrowing

or lending in the capital market, you can obtain any point along
the line KM.
• Regardless of whether you prefer current consumption or future
consumption, you have more to spend either today or next year
than if you invest only in real assets (choose a point along the
curve DL).
 Production Opportunities and Intertemporal Exchange

• The previous figure shows that ability to simultaneously invest in

real assets and capital market increased your wealth.
• Without such ability, you would be obliged to choose a point along
DH if you invest only in the capital market and you would be
obliged to choose a point along DL if you invest only in real assets.
 Production Opportunities and Intertemporal Exchange

• It also leads us to an important conclusion: Investing and

consumption decisions are independent of each other. This result
is also known as “Fisher Separation Theorem”.
Optimal Intertemporal Allocation
An Application: Theoretical Foundation of the Net
Present Value (NPV) Rule
 Theoretical Foundation of the NPV Rule

• Suppose some investors in a corporation have come across a project

that yields a positive NPV. Will every investor accept this project?
• Yes
• Why???
• Accepting a project with positive NPV will add value to the corporation and
therefore increase the wealth of shareholders.
 Theoretical Foundation of the NPV Rule

• However, it is important to know that there are certain assumptions

that have to be met before every investor agrees on investing in a
positive NPV project.
• Some of the examples to illustrate this are shown in the following
slides.
 Theoretical Foundation of the NPV Rule

• Consider an investor who is short on cash and is risk-averse. Would

she be really willing to part with significant amount of her wealth
immediately in exchange for a forecasted future payoff – that may or
may not be realized for the next 5 or 10 years.
 Theoretical Foundation of the NPV Rule

• Consider another scenario where you are CFO of a large privately held
corporation with many shareholders who differ widely in age, wealth,
and tolerance towards risk. Do you expect all shareholders to agree
on the value added by a positive NPV investment?
 Theoretical Foundation of the NPV Rule

• The answer in both cases may be “Probably Not”.

 Theoretical Foundation of the NPV Rule

• In the first case, one can argue that if an investor invest everything
she has in an investment, how will she be able to support her
current consumption.
 Theoretical Foundation of the NPV Rule

• In the second case, one can argue that an old shareholder of the
corporation may say that the new project will payoff too late (may be
after decade, if project is development of oil field or construction of a
port), therefore she does not want corporation to invest in this
project. She would want to have huge dividends to meet her current
consumption.
 Theoretical Foundation of the NPV Rule

• However, in this case, younger shareholder of the corporation may

be happy with this investment. It is because she invested in a
corporation to pay for college education of her child. The long-
term investment will ensure that when her child starts going to
college, she has enough funds to finance her education.
 Theoretical Foundation of the NPV Rule

• Is it possible that old shareholder and young shareholder agree on a

positive NPV investment that may not be able to produce cash flows
at the time desired by each of them?
 Theoretical Foundation of the NPV Rule

• Yes. As long as the shareholders have access to efficient capital

markets, they should agree on any positive NPV investment,
irrespective of the timings of the cash flows.
• Why???
 Theoretical Foundation of the NPV Rule

• If you don’t have any means of storing income, you will be compelled
to consume your income as it arrives.
• For example, if the bulk of your income comes late in life, the result
could be hunger now and over-consumption later and vice versa.
 Theoretical Foundation of the NPV Rule

• Capital markets solve this problem by allowing you to trade

between dollars today and dollars in future and vice versa.
• You can, therefore, consume moderately now and in future, no
matter when your income comes.
 Theoretical Foundation of the NPV Rule
Example 1

• Suppose initial investment in a positive NPV project is $370000

and it will produce a single cash flow of $420000 at the end of the
year. Assume that the interest rate prevailing in the economy is
5%.
• If you do not invest in the project, you can consume all of it now.
Else, you can invest your money at 5% interest rate and can
consume $388500 (= 1.05 * $370000) one year from now.
 Theoretical Foundation of the NPV Rule
Example 1

• You can also split your capital in two equal halves and consume
$185000 now and $194250 (= 1.05 * $185000) one year from now.
• You can make as many combinations of consumption as possible.
 Theoretical Foundation of the NPV Rule
Example 1

• However, if you decide to invest in the project and earn a single cash
flow of $420000 at the end of the year, you can consume $400000 (=
$420000/1.05) today (and nothing in year 1).
• Borrow $400000 today and repay $420000 one year from today. By
varying the amount of borrowing, you can have any mixture of
consumption this year and the next year.
 Theoretical Foundation of the NPV Rule
Example 1

Dollars Next Year Invests $370000 now

and consume $420000
next year
420000
388500

Invests $370000 now

and borrow $400000 to
consumes now.

Dollars
370000 400000
Now
 Theoretical Foundation of the NPV Rule

• The key condition that allows two shareholders on agreeing to invest

is the “access to well-functioning competitive capital market”, in
which they can borrow and lend.
 Theoretical Foundation of the NPV Rule

• NPV rule will not work efficiently if we do not have well-

functioning and competitive capital markets. For example, suppose
that one of the shareholders is not able to borrow against future
consumption. In this case, he may prefer to spend his cash today
rather than investing. Investment does allow him to generate
higher cash flows in future, but in the absence of well-functioning
capital markets, he will be unable to borrow against high future
cash flows.
 Theoretical Foundation of the NPV Rule

• Therefore, in the absence of well functioning capital markets, two

investors that have different preferences regarding their
consumption may not accept a positive NPV project.
 Theoretical Foundation of the NPV Rule

• The arguments presented above leads us to argue that shareholders

can achieve any consumption pattern, as long as there are well
functioning and competitive capital markets in the economy.
 Theoretical Foundation of the NPV Rule

• If shareholders can achieve any consumption pattern themselves,

what should be the role of financial managers in this process? Do
shareholders need financial managers to realize their consumption
patterns?
 Theoretical Foundation of the NPV Rule

• Financial managers can help shareholders only in one way:

Increase the market value of each shareholder’s stocks. When
the current value of shareholder’s wealth is high, he can either
consume now or shift the wealth in future by investing.
 Theoretical Foundation of the NPV Rule
Example 1

• Mrs. X is retired and depends on her investments for her income. Mr.
Y is a young executive who wants to save for the future. Both are
stockholders in Incentives Corp., which is building SpaceShipOne to
take commercial passengers into space. This investment’s payoff is
many years away. Assume it has positive NPV for Mr. Y. Explain why
this investment also makes sense for Mrs. X.
 Theoretical Foundation of the NPV Rule
Example 1

• The investment’s positive NPV will be reflected in the price of stock of

Incentives Corp.
• In order to derive a cash flow from her investment that will allow her
to spend more today, Ms. X can sell some of her shares at the higher
price or she can borrow against the increased value of her holdings.
 Theoretical Foundation of the NPV Rule
Example 2

• Casper has $200000 available to support consumption in period 0

(now) and in period 1 (next year). He wants to consume exactly the
same amount in each period. The interest rate is 8%. There is no risk.
How much should he invest, and how much can he consume in each
period.
 Theoretical Foundation of the NPV Rule
Example 2

• Suppose Casper is given an opportunity to invest up to $200000 at

a return of 10% in a project. The interest rate stays at 8%. What
should he do, and how much can he consume in each period?
• What is the NPV of the opportunity in part (b)?
 Theoretical Foundation of the NPV Rule
Example 2

• Assume that X is the amount that Casper should invest now.

Therefore, ($200000 – X) is the amount he will consume now, and
(1.08*X) is the amount he will consume next year.
• Since Casper wants to consume exactly the same amount each
period, therefore:
• 200000 – X = 1.08*X
 Theoretical Foundation of the NPV Rule
Example 2

• Solving for X yields X = $96153.85. It implies that Casper should

invest $96153.85 now.
• Therefore, he should spend ($200000 – $96153.85) = $103846.15
now, and he should spend (1.08 * $96153.85) = $103846.15 next
year.
 Theoretical Foundation of the NPV Rule
Example 2

• Since Casper can invest $200000 at 10%, he can consume as much as

$220000 (= $200000 * 1.10) next year.
• The present value of this $220000 is $203703.70 (= $220000/1.08).
• Therefore Casper can consume as much as $203703.70 now by first
investing $200000 at 10% and then borrowing, at the 8% rate, against
the $220000 available next year.
 Theoretical Foundation of the NPV Rule
Example 2

• If we use the $203703.70 as the available consumption now, and

assume that X is the amount that Casper should invest now, we can
have the following:
• $203703.70 – X = 1.08*X
• Solve the above for X yields $97934.47.
 Theoretical Foundation of the NPV Rule
Example 2

• Therefore, Casper should invest $97934.47 now at 8%.

• He should spend $105769.23 (= $203703.70 – $97934.47) now, and
he should spend $105769.23 (= $97934.47 * 1.08) next year.
 Theoretical Foundation of the NPV Rule
Example 2

• The NPV of the opportunity in part (b) is $3703.70 (= $203703.70 –

$200000).
 Theoretical Foundation of the NPV Rule
Example 2
Dollars Next Year

220,000

216,000

203,704

200,000
Dollars Now
Optimal Intertemporal Allocation
References
 References

• Bradfield, J., (2007). Chapter 3 (The Fundamental Economics of

Intertemporal Allocation). Introduction to the Economics of
Financial Markets, Oxford University Press.
• Bradfield, J., (2007). Chapter 4 (The Fisher Diagram for Optimal
Intertemporal Allocation). Introduction to the Economics of
Financial Markets. Oxford University Press.
 References

• Nicholson, W. and Snyder, C., (2008). Chapter 17 (Capital and

Time). Microeconomic Theory: Basic Principles and Extensions,
10th Edition. Thomson-SouthWestern.
• Silberberg, E. and Suen W., (2001). Chapter 12 (Intertemporal
Choice). The Structure of Economics: A Mathematical Analysis, 3rd
Edition. McGraw-Hill.