FINANCIAL MARKETS AND NPV –
FIRST PRINCIPLES OF FINANCE
THE FINANCIAL MARKET ECONOMY
Individuals and institutions have different income streams and
different intertemporal consumption preferences.
This has led to the creation of financial markets. Financial
markets intermediate between agents with different
intertemporal consumption preferences.
THE FINANCIAL MARKET ECONOMY: EXAMPLE
Consider a dentist who earns $200,000 per year and chooses to consume
$80,000 per year. She has $120,000 in surplus money to invest.
She could loan $30,000 to each of 4 college seniors. They each promise to pay
her back with interest after they graduate in one year.
$30,000×(1+r)
$30,000
Student #1
$30,000
Student #2
$30,000
Student #3
$30,000
Student #4
$30,000×(1+r)
Dentist
$30,000×(1+r)
$30,000×(1+r)
THE FINANCIAL MARKET ECONOMY: EXAMPLE
Rather than performing the credit analysis 4 times, she could loan the
whole $120,000 to a financial intermediary in return for a promise to
repay the $120,000 in one year with interest.
The intermediary in turn loans $30,000 to each of the 4 college seniors.
$30,000×(1+r)
$120,000
$30,000
Student #1
$30,000
Student #2
$30,000
Student #3
$30,000
Student #4
$30,000×(1+r)
Dentist
Bank
$30,000×(1+r)
$120,000×(1+r)
$30,000×(1+r)
THE FINANCIAL MARKET ECONOMY
Financial intermediation can take three forms:
 Size intermediation
 In the example above, the bank took a large loan from the dentist and
made small loans to the students.
 Term intermediation
 Commercial banks finance long-term mortgages with short-term
deposits.
 Risk intermediation
 Financial intermediaries can tailor the risk characteristics of securities
for borrowers and lenders with different degrees of risk tolerance.
MARKET CLEARING
The job of balancing the supply of and demand for loanable
funds is taken by the money market.
When the quantity supplied equals, the quantity demanded,
the market is in equilibrium at the equilibrium price.
The price of money is the interest rate.
Consumption at t+1
INTERTEMPORAL CONSUMPTION OPPORTUNITY SET
A person with $95,000 who faces a 10% interest rate has
the following opportunity set.
$120,000
$104,500
One choice available is to consume $40,000 now;
invest the remaining $55,000; consume $60,000
next year.
$100,000
$80,000
move consumption from one period to another
$60,000 = $55,000  (1.10)1
$60,000
$40,000
$20,000
$95,000
$0
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
TAKING ADVANTAGE OF OPPORTUNITIES
$120,000
$100,000
A person’s preferences will tend to decide where on the opportunity
set, they will choose to be.
Patience
slope=0, perfect competitive
$80,000
Slope = - (1+r)
$60,000
$40,000
Impatience
$20,000
$0
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
Consumption today
Consumption at t+1
CHANGING OPPORTUNITIES
$120,000
$100,000
Consider an investor who has chosen to consume
$40,000 now and to consume $60,000 next year.
slope steeper, one more dollar today= more tomorrow
A rise in interest rates will make
saving more attractive …
$80,000
$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
THE COMPETITIVE MARKET
Three things characterize the competitive market
 Costless trading - Access to financial markets is free
 Information is readily available –No information asymmetry
 All participants are price takers – No market power
There can be only one equilibrium interest rate in a
competitive market —otherwise arbitrage opportunities
would arise.
D=P=MR=MC=AR=AC
slope =0
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.
HOW TO COMPARE?use
market rate to calculate MPV
PRACTICING THE PRINCIPLE: A LENDING EXAMPLE
Consider an investment opportunity that costs $50,000 this year and
provides a certain cash flow of $54,000 next year.
$54,000
Cash inflows
Time
0
Cash outflows
1
-$50,000
Is this a good deal?
It depends on the interest rate available in the financial markets.
The investment has an 8% return, if the interest rate available elsewhere is
less than this, invest here.
ILLUSTRATING THE INVESTMENT DECISION
Consider an investor who has an initial endowment of income of
$40,000 this year and $55,000 next year.
Suppose that she faces a 10-percent interest rate and is offered the
following investment.
$30,000
Cash inflows
0
Time
Cash outflows
1
-$25,000
Consumption at t+1
ILLUSTRATING THE INVESTMENT DECISION
Our investor begins with the following opportunity set
endowment of $40,000 today, $55,000 next year and a
10% interest rate.
$99,000
One choice available is to consume $15,000 now;
invest the remaining $25,000 in the financial
markets at 10%; consume $82,500 next year.
$82,500
$55,000
$0
25000(1.1)=27500
55000(1.1)=60500
C1=88000
C0=(15000+88000)/1.1
$0
$15,000
$40,000
$90,000
Consumption today
Consumption at t+1
ILLUSTRATING THE INVESTMENT DECISION
A better alternative would be to invest in the project instead
of the financial markets.
She could consume $15,000 now; invest the remaining
$25,000 in the project at 20%; consume $85,000 next year.
$99,000
$85,000
$82,500
With borrowing or lending in the financial
markets, she can achieve any pattern of cash
flows she wants—any of which is better than
her original opportunities at time t
$55,000
25000(1.2)=30000
+ 60500
= 90500
90500-88000=2500
2500/1.1=2273
$0
$0
$15,000
$40,000
$90,000
Consumption today
Consumption at t+1
ILLUSTRATING THE INVESTMENT DECISION
Note that the investor is better off in that she can command
more consumption today or next year.
$15,000 + $85,000 ÷(1.10) = $92,273 Today
$101,500
$99,000
$85,000
$82,500
$15,000×(1.10) + $85,000 = $101,500 Next year
$55,000
$0
$0
$15,000
$40,000
$90,000 $92,273
Consumption today
TWO IMPORTANT QUESTIONS
How much more money we need to give our investor today
to make her just as well off as she is with the investment?
Or
How much more money we need to give our investor next
year to make her just as well off as she is with the
investment?
LET’S EVALUATE THIS INVESTMENT OPPORTUNITY
We can calculate how much better off in today’s dollars the
investment makes our investor by calculating the Net Present
Value:
$30,000
0
1
-$25,000
$30,000
NPV = −25,000 +
= $2,272.73
1.10
CORPORATE INVESTMENT DECISION-MAKING
Corporations that invest in positive NPV investments will
increase the value of the firm by the NPV.
 Negative NPV investments should be rejected
Shareholders will be united in their preference for the firm to
undertake positive net present value decisions, regardless of
their personal intertemporal consumption preferences.
 Financial markets allow for these personal differences
Consumption at t+1
CORPORATE INVESTMENT DECISION-MAKING
Positive NPV projects shift the 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
CORPORATE INVESTMENT DECISION-MAKING
We may view firms as means by which many investors pool
their resources to make large scale investment decisions.
Shareholders will be united in their preference for the firm to
undertake positive net present value decisions, regardless of
their personal intertemporal consumption preferences.
This is because the value of their investment in the firm
increases proportionally with the value of the firm.
CORPORATE INVESTMENT DECISION-MAKING
Unlike individuals, firms have no consumption endowment.
It starts at origin in our diagram.
Consumption next year (future value)
Slope = -(1+r)
B
$-25,000
$33,000
0
C
NPV=$5,000
Assume Investment Opportunity B, cost
$25,000 and has a future value of
$33,000. If the interest rates are 10%,
the NPV is $5,000.
Consumption this year (present value)
CORPORATE INVESTMENT DECISION-MAKING
Shareholders do not vote on every investment decision faced by
a firm and the managers of firms need decision rules to operate
by.
All shareholders of a firm will be made better off if managers
follow the NPV rule—undertake positive NPV projects and
reject negative NPV projects.
THE SEPARATION THEOREM
The separation theorem says that all investors will want to
accept or reject the same investment projects by using the
NPV rule, regardless of their personal preferences.
Why? Only because the financial markets exist!!
Separating investment decision-making from the
shareholders is a basic requirement of the modern
corporation.