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Chapter Three

Financial Markets
and
Corporate
Finance
Ross Westerfield Jaffe
Net Present Value

Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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2003 McGrawHill Ryerson Limited

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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

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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.

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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.
$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)

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$30,000(1+r)

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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.
$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)
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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.
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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.

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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.

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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

One choice available is to consume

$40,000 now; invest the remaining
$55,000; consume $60,000 next year.

$100,000

$80,000

$60,000 $55,000 (1.10)1

$60,000

$40,000

$20,000

$0
$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Consumption today
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Consumption at t+1

Intertemporal Consumption Opportunity Set

Another choice available

is to consume $60,000
now; invest the remaining
$35,000; consume
$38,500 next year.

$120,000

$100,000

$80,000

$60,000

$40,000

$38,500 $35,000 (1.10)1

$20,000

$0
$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Consumption today
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Consumption at t+1

Taking Advantage of Our Opportunities

A persons preferences will tend
to decide where on the
opportunity set they will choose
Ms. Patience
to be.

$120,000

$100,000

$80,000

$60,000

$40,000

Ms. Impatience

$20,000

$0
$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Consumption today
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Consumption at t+1

Changing Our Opportunities

Consider an investor who has chosen
to consume $40,000 now and to
consume $60,000 next year.

$120,000

$100,000

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
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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 marketotherwise
arbitrage opportunities would arise.
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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.

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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.
$54,000

Cash inflows
Time

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.
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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.
$30,000

Cash inflows
Time
Cash outflows

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1
-$25,000
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Consumption at t+1

3.6 Illustrating the Investment Decision

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.
Our investor begins with the
following opportunity set:
endowment of $40,000
today, $55,000 next year
and a 10% interest rate.

$99,000
$82,500

$55,000

$0
$0

$15,000

$40,000

$90,000

Consumption today
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Consumption at t+1

3.6 Illustrating the Investment Decision

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.
With borrowing or lending in
the financial markets, he can
achieve any pattern of cash
flows he wantsany of
which is better
than his original
opportunities.

$99,000
$85,000
$82,500

$55,000

$0
$0

$15,000

$40,000

$90,000

Consumption today
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Consumption at t+1

3.6 Illustrating the Investment Decision

Note that we are better off in that we can
command more consumption today or next year.
$101,500 = $15,000(1.10) + $85,000

$101,500
$99,000
$85,000
$82,500

$92,273 = $15,000 + $85,000(1.10)

$55,000

$0
$0

$15,000

$40,000

$90,000 $92,273

Consumption today
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Net Present Value

We can calculate how much better off in
todays dollar the investment makes us by
calculating the Net Present Value:.
$30,000

Cash inflows

Time
Cash outflows

0
1
-$25,000

$30,000
NPV 25,000
$2,272.73
1.10
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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.

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Consumption at t+1

Corporate Investment Decision-Making

Positive NPV projects shift the
shareholders 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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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.

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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 decisionmaking from the shareholders is a basic
requirement of the modern corporation.

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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.

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