McGraw-Hill Ryerson 3-0 © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 3 Chapter Three Financial Markets and Net Present Value Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

McGraw-Hill Ryerson 3-1 © 2003 McGraw–Hill Ryerson Limited Chapter Outline 3.1 The Financial Market Economy 3.2 Making Consumption Choices Over Time 3.3 The Competitive Market 3.4 The Basic Principle 3.5 Practicing the Principle 3.6 Illustrating the Investment Decision 3.7 Corporate Investment Decision ‑ Making 3.8 Summary and Conclusions

McGraw-Hill Ryerson 3-2 © 2003 McGraw–Hill Ryerson Limited 3.1 The Financial Market Economy Individuals and institutions have different income streams and different intertemporal consumption preferences. Because of this, a market has arisen for money. The price of money is the interest rate.

McGraw-Hill Ryerson 3-3 © 2003 McGraw–Hill Ryerson Limited The Financial Market Economy: Example Consider a dentist who earns $200,000 per year and chooses to consume $80,000 per year. He has $120,000 in surplus money to invest. He could loan $30,000 to each of 4 college seniors. They each promise to pay him back with interest after they graduate in one year. Dentist Student #1 Student #2 Student #3 Student #4 $30,000 $30,000×(1+r)

McGraw-Hill Ryerson 3-4 © 2003 McGraw–Hill Ryerson Limited The Financial Market Economy: Example Rather than performing the credit analysis 4 times, he 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. Student #1 Student #2 Student #3 Student #4 $30,000 Bank $120,000 Dentist $30,000 $30,000×(1+r) $120,000×(1+r)

McGraw-Hill Ryerson 3-5 © 2003 McGraw–Hill Ryerson Limited The Financial Market Economy: Example 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.

McGraw-Hill Ryerson 3-6 © 2003 McGraw–Hill Ryerson Limited 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.

McGraw-Hill Ryerson 3-7 © 2003 McGraw–Hill Ryerson Limited 3.2 Making Consumption Choices over Time An individual can alter his consumption across time periods through borrowing and lending. We can illustrate this by graphing consumption today versus consumption in the future. This graph will show intertemporal consumption opportunities.

McGraw-Hill Ryerson 3-8 © 2003 McGraw–Hill Ryerson Limited Intertemporal Consumption Opportunity Set $0$20,000$40,000$60,000$80,000$100,000$120,000 Consumption today A person with $95,000 who faces a 10% interest rate has the following opportunity set. One choice available is to consume $40,000 now; invest the remaining $55,000; consume $60,000 next year. $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Consumption at t+1

McGraw-Hill Ryerson 3-9 © 2003 McGraw–Hill Ryerson Limited Intertemporal Consumption Opportunity Set $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $0$20,000$40,000$60,000$80,000$100,000$120,000 Consumption today Consumption at t+1 Another choice available is to consume $60,000 now; invest the remaining $35,000; consume $38,500 next year.

McGraw-Hill Ryerson 3-10 © 2003 McGraw–Hill Ryerson Limited Taking Advantage of Our Opportunities $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $0$20,000$40,000$60,000$80,000$100,000$120,000 Consumption today Consumption at t+1 A person’s preferences will tend to decide where on the opportunity set they will choose to be. Ms. Patience Ms. Impatience

McGraw-Hill Ryerson 3-11 © 2003 McGraw–Hill Ryerson Limited Changing Our Opportunities $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $0$20,000$40,000$60,000$80,000$100,000$120,000 Consumption today Consumption at t+1 A rise in interest rates will make saving more attractive … …and borrowing less attractive. Consider an investor who has chosen to consume $40,000 now and to consume $60,000 next year.

McGraw-Hill Ryerson 3-12 © 2003 McGraw–Hill Ryerson Limited 3.3 The Competitive Market In a competitive market: –Trading is costless. –Information about borrowing and lending is available –There are many traders; no individual can move market prices. There can be only one equilibrium interest rate in a competitive market—otherwise arbitrage opportunities would arise.

McGraw-Hill Ryerson 3-13 © 2003 McGraw–Hill Ryerson Limited 3.4 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.

McGraw-Hill Ryerson 3-14 © 2003 McGraw–Hill Ryerson Limited 3.5 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. 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. Cash inflows Time Cash outflows 0 1 -$50,000 $54,000

McGraw-Hill Ryerson 3-15 © 2003 McGraw–Hill Ryerson Limited 3.6 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 he faces a 10-percent interest rate and is offered the following investment. Cash inflows Time Cash outflows 0 1 -$25,000 $30,000

McGraw-Hill Ryerson 3-16 © 2003 McGraw–Hill Ryerson Limited 3.6 Illustrating the Investment Decision $0 Consumption today Our investor begins with the following opportunity set: endowment of $40,000 today, $55,000 next year and a 10% interest rate. 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. $0 $99,000 Consumption at t+1 $55,000 $82,500 $40,000 $15,000 $90,000

McGraw-Hill Ryerson 3-17 © 2003 McGraw–Hill Ryerson Limited 3.6 Illustrating the Investment Decision $0 Consumption today A better alternative would be to invest in the project instead of the financial markets. He could consume $15,000 now; invest the remaining $25,000 in the project at 20%; consume $85,000 next year. $0 $99,000 Consumption at t+1 $55,000 $82,500 $40,000 $85,000 $15,000 $90,000 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.

McGraw-Hill Ryerson 3-18 © 2003 McGraw–Hill Ryerson Limited 3.6 Illustrating the Investment Decision $0 Consumption today Note that we are better off in that we can command more consumption today or next year. $0 $99,000 Consumption at t+1 $55,000 $82,500 $40,000 $85,000 $15,000 $101,500 $101,500 = $15,000×(1.10) + $85,000 $92,273 = $15,000 + $85,000÷(1.10) $90,000$92,273

McGraw-Hill Ryerson 3-19 © 2003 McGraw–Hill Ryerson Limited Net Present Value We can calculate how much better off in today’s dollar the investment makes us by calculating the Net Present Value:. Cash inflows Time Cash outflows 0 1 -$25,000 $30,000

McGraw-Hill Ryerson 3-20 © 2003 McGraw–Hill Ryerson Limited 3.7 Corporate Investment Decision ‑ Making Shareholders will be united in their preference for the firm to undertake positive net present value decisions, regardless of their personal intertemporal consumption preferences.

McGraw-Hill Ryerson 3-21 © 2003 McGraw–Hill Ryerson Limited Corporate Investment Decision ‑ Making Consumption today Consumption at t+1 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.

McGraw-Hill Ryerson 3-22 © 2003 McGraw–Hill Ryerson Limited 3.7 Corporate Investment Decision ‑ Making In reality, 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.

McGraw-Hill Ryerson 3-23 © 2003 McGraw–Hill Ryerson Limited The Separation Theorem The separation theorem in financial markets says that all investors will want to accept or reject the same investment projects by using the NPV rule, regardless of their personal preferences. Logistically, separating investment decision making from the shareholders is a basic requirement of the modern corporation.

McGraw-Hill Ryerson 3-24 © 2003 McGraw–Hill Ryerson Limited 3.8 Summary and Conclusions Financial markets exist because people want to adjust their consumption over time. They do this by borrowing or lending. An investment should be rejected if a superior alternative exists in the financial markets. If no superior alternative exists in the financial markets, an investment has a positive net present value.