Finance Theory under Certainty (CWS Chapter 1) How do capital markets benefit society? Consider a one-period economy.

. Without capital markets and without production, individuals are constrained to either: 1) Consume their particular initial endowments, y0, y1 2) Store all of, or a portion of, their time 0 endowment (at a zero interest rate) for consumption at time 1 When does this create a problem for individuals? Capital markets allow individuals to borrow against their anticipated future income (endowments). They borrow from other individuals who lend excess current income (endowments) at positive interest rates. Why does the interest rate have to be positive? The investment/consumption decision depends on the individual's subjective preference for consumption across the different time periods, opportunities for investment in productive opportunities, and the market interest rate, r. To analyze this decision, we consider Irving Fisher's Theory of the Real Interest Rate (1930). What we get from the analysis: 1) How capital markets lead to an efficient allocation of resources to investment projects 2) A foundation for net present value (NPV) rule 3) Fisher Separation Theorem

Fishers Theory of the Real Interest Rate - Assumptions Assumptions: 1) One period world (today and end of the period) 2) Certainty 3) Perfect capital markets (i.e., no taxes, transaction costs, etc.) 4) Initial wealth endowment (y0 and y1) 5) Individual preferences for consumption today (t = 0) vs. consumption at the end of the period (t = 1) are a function of their utility function, U(C0, C1) and associated indifference curves a. b.
U (C0 , C1 ) U (C0 , C1 ) > 0 and >0 C0 C1

2U (C 0 , C1 ) C 0
2

< 0 and

2U (C0 , C1 ) C1
2

<0

c. What is the interpretation of the above conditions? What do these utility functions look like graphically?
C d. The slope of an individuals indifference curve at a particular point (C0, C1) is denoted as M RSC and reflects the rate at which they are indifferent to exchanging time 0 and time 1 dollars.
0 1

e. We will see later that

U (C0 , C1 ) U (C0 , C1 ) C0 M RSC = 1 C0 C1

Fishers Theory of the Real Interest Rate Assumptions (continued) 6) Capital markets that allow for borrowing and lending at interest rate r a. Let T(C0,C1) be the transformation function relating t = 0 and t = +1 consumption opportunities
0 b. The marginal rate of transformation at a particular point, for example at (C0, C1), is denoted as MRTC C1

C c. With borrowing and lending at interest rate r, MRTC = (1 + r ) , for all possible C0,C1
0 1

d. The lower the consumption this period, the higher the investment (at interest rate r) and, therefore, the higher the consumption next period 7) Firms with productive capacity, defined by the marginal rate of transformation and initial capital. a. Let T(P0,P1) be the transformation function that relates dividend payments (production) today with dividend payments (production) next period b. The lower the dividend this period, the higher the t = 0 investment. This results in a higher dividend payment (production) next period.

Fishers Theory of the Real Interest Rate Graphical examples Case 1: Individual endowed y0, y1, no storage, no capital markets, no production. Note the amount of utility the individual has at this point. Case 2: Individual endowed y0, y1, storage, no capital markets, no production. The tangency point of the individuals indifference curve with the storage line indicates preferred location for individual. 1) Does the ability to store benefit all individuals (i.e., would everyone want to store)? 2) Movement to a higher indifference curve indicates higher utility Case 3: Individual endowed y0, y1, capital markets with a positive interest rate r, no production 1) What do the X and Y intercepts signify? 2) Consider two individuals one prefers time 0 dollars and the other prefers time 1 dollars a. Where would these two individuals locate on the capital market line b. At what rate are these two individuals indifferent to exchanging time 0 and time 1 dollars? c. What is the amount of lending / borrowing at time 0 for these two individuals? 3) How does the existence of capital markets (i.e., the ability to borrow / lend at some positive interest rate r) benefit individuals? Is anyone worse off with the introduction of capital markets? Is everyone better off?

Fishers Theory of the Real Interest Rate Graphical examples (continued) Case 4: Individual (100% owner of a firm) endowed with y0, y1, with productive investment opportunities (i.e., projects), but no capital markets Assume that projects are infinitely divisible and independent, ordered from best (highest return) to worst (lowest return), resulting in smooth curved line. The curved line is called the production possibility frontier or investment opportunity schedule. The initial endowment is the lower right point of the curve. Movement up and to the left is investment in the firms projects. How is this case different (the same as) case 3? 1) How would two different owners time preferences affect the investment decisions of their two firms? 2) What is the marginal rate of production at the owners preferred locations? What do we call the marginal rate of production in an undergraduate finance class? 3) At their respective tangency points, what rate are these individuals indifferent to exchanging time 0 and time 1 dollars?

Fishers Theory of the Real Interest Rate Graphical examples (continued) Case 5: Individual (100% owner of a firm) endowed y0, y1, with productive investment opportunities, and capital markets 1) How much better off is the consumer in case 5 than in case 4? 2) Examine the graph. Be able to point out: a. Initial endowment (y0, y1) b. Dividend payments by the firm (P0, P1) c. Investment by the firm d. Rate of return on the last dollar invested e. PV and FV of consumers wealth at initial endowment f. PV and FV of dividend payments g. NPV of investment h. Preferred location by consumer on the capital market line (and PV and FV of this preferred location) i. Amount of borrowing or lending at time 0 (difference between C0 and P0) and the associated adjustment to time 1 consumption (difference between C1 and P1) Some valuable finance concepts from Case 5 1) Fisher separation all investors can delegate investment decisions to firm managers who can ignore the composition / preferences of the owners (why?). The firms managers do this by: 2) Investing in all projects in which have an IRR > r (why r?), or, equivalently, investing in all projects with a positive NPV 3) Investment policy sets the amount of time 0 and time 1 dividends, which determines investor wealth 4) Is investor wealth affected by dividend policy? For instance, say the firm wants (for some reason) to pay more dividends at time 0. How should they do this?

Fishers Theory of the Real Interest Rate Mathematical Presentation and Examples Start with an initial endowment of y0, y1. Lets allow for borrowing and lending at interest rate r and no production (case 3 above). To determine the individual's choice between consumption this period versus next period, solve the following problem:
max U (C0 , C1 ) C0 , C1 s.t. T (C0 , C1 ) =0

1 To solve this constrained maximization problem, the following lagrangian function is formed:
L =U (C 0 , C1 ) + T (C 0 , C1 )

2 Taking the partial derivative of L w.r.t. C0, C1 and and setting each equation equal to 0 (to find the first order conditions for a maximum value) yields:
U (C0 , C1 ) T (C0 , C1 ) L = + =0 C0 C0 C0
U (C0 , C1 ) T (C0 , C1 ) L = + =0 C1 C1 C1
L = T (C0 , C1 ) = 0

3 4

Therefore, the solution to the consumers choice problem will be defined by equations (3) (5). From these equations:
7

U (C0 , C1 ) C0

U (C0 , C1 ) T (C0 , C1 ) = C1 C0

T (C0 , C1 ) C1

6 Fishers Theory of the Real Interest Rate Mathematical Presentation and Examples (continued) In the context of our problem, an indifference curve is the combination of consumption possibilities at time 0 and 1 for which a consumer is indifferent. Mathematically, it is defined by the collection of points satisfying the following differential equation:
dU(C0 , C1) = UC0 dC0 + UC1 dC1 = 0 7

U dC1 = - C0 d C0 UC1 8

So, the LHS of equation (6) is the equation for the slope of the individuals indifference curve. (Note, I will continue to use the short-hand designation of the partial from this point forward.) In a similar manner, the right hand side of equation (6) is the slope of the opportunity set. Equation (6) says that the consumer derives the maximum utility when he/she is at a point on his/her indifference curve that has a slope equal to the slope of the opportunity set (or budget constraint). Example (case 3): Assume that y0 and y1 are $500 and $1650 respectively. Let U(C0,C1) = ln[(C0)(C1)] = ln(C0) + ln(C1). Therefore, the consumer derives 13.6231 utiles from the endowed consumption pattern. Notice there is no time preference.

 ? What is UC and UC
0 0

Note these are also the first and second derivatives with respect to C1.

Fishers Theory of the Real Interest Rate Mathematical Presentation and Examples (continued) Let r = 10%. (What is the present value (PV) of the endowed consumption bundle?) This implies that the outer boundary of the opportunity set (i.e., the equation for the capital market line) is defined by the following equation:
C1 = 2200 1.1C0

9 Therefore, write T(C0,C1) as: 10

Equation (2) gives the form of the lagrangian function:

L =ln(C0 ) + ln(C1 ) + ( 2200 1.1C0 C1 )

11

Equations (3), (4), and (5) give the necessary first order conditions for a maximum.
L = C0 L = C1

12 13 14

L =

Now, lets solve for the maximum What is

10

What is

C1

11

Fishers Theory of the Real Interest Rate Mathematical Presentation and Examples (continued) The slope of the consumer's indifference curve at the optimum, MRSC C should be equal to the slope of the budget
0 constraint, MRT C C1 , i.e., capital market line (= -1.1). Using equation (6):
* 0 * 1

U dC1 = - C0 = d C0 UC1

15
C1
*

Also,

C0

= $1000 and

= $1100 results in 13.9108 utiles. Testing other possible combinations:

C0 = $990 and C1 = $1111 13.9107 utiles C0 = $1010 and C1 = $1089 13.9107 utiles What is the PV of the preferred consumption pattern? Compare to the PV of $990, $1111 and $1010, $1089? What are the implications? While ($1000, $1100) solves the maximization problem for the above individual, what about other individuals with different time preferences for consumption? For instance, assume two other individuals one with a preference for time 0 consumption and the other for time 1 consumption. Graph the three individuals difference curves at the initial endowment. What do the different slopes imply? Graph these three individuals difference curves at their optimal locations on the capital market line. Note that the slopes of all three individuals indifference curves are all equal to -1.1 at their optimal locations. So,

12

C0 0 * = MRT * = -1.1. What does this imply? MRSC C1 C1

13

Fishers Theory of the Real Interest Rate Mathematical Presentation and Examples (continued) Example (Case 4): 1) Same utility function as above: U(C0,C1) = ln(C0) + ln(C1) 2) PPF is given by the following equation: P1 = $5000 0.00004 (P0)3 + 1650 for value of P0 between $0 and $500 3) Dividend payments (and consumption, C0 and C1) at time 0 and time 1 equal cash flows from the production function (P0 and P1) 4) With no capital markets (and no storage, to makes things simple), the owner needs to consume dividend payments Find the optimum in same manner as above:
C0
*

= P* 0 = $346.391496 and

C1

* = P1 = $4987.50

The slope of PPF at this point is the slope of the indifference curve for the consumer/owner = ($4987.50/$346.391496) = -14.3984. Thus, the last dollar invested had an IRR of 1339.84% As mentioned above, owners with different time preferences for consumption would have different optimums. This implies that managers must direct investment/dividend policy based on the desires of its owners This could create a problem with multiple owners with different time preferences

14

Fishers Theory of the Real Interest Rate Mathematical Presentation and Examples (continued) Example (case 5): Now, the owner directs management to invest in all projects that earn at least the market interest rate (10%) To solve, first find the tangency point of capital market line with the PPF (i.e., where the slope of the PPF is -1.1). This fixes dividend payments and the capital market line. Then, find the consumers preferred location on * * * the capital market line. Solution: P* 0 = $95.7427 and P1 = $6614.8943, C 0 = $3054.6415 and C1 = $3360.1056 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) What is MRSC ? Current value (PV) of firm (no investment in projects) = $500 + 1650 /1.1 = $2000 Time one value of firm (maximum investment in capital markets, instead of projects) = $2200 Time one value of firm (maximum investment in projects) = $6650 Amount of optimal investment = PV of dividends (and PV of consumption) = FV of dividends (and FV of consumption) = NPV of total investment = Amount borrowed at time 0 and paid back at time 1= NPV of last dollar invested = IRR of last dollar invested = How does this relate to Fisher Separation?
* 1 * C0

A word about the market interest rate: We have assumed that the market interest rate is given. However, the intuition behind the setting of the market interest rate can be determined by considering a world composed of two identical firms and two individuals with different time preferences for consumption. The market interest rate would be the interest rate that equates supply (money lent) with demand (money borrowed). Note that changes in the market rate affect investment in projects, and therefore dividend payment (so this is not a trivial problem).

15

Asset Valuation under Certainty In the simple one-period world described above, the current value (V0) of an asset that generates cash flow VT at time 1 (i.e., T = 1), is
V0 =VT (1 + r ) 1

16

More precisely, this is the time 0 value of the asset, compounded once per period. We will derive this later. But first, we will derive the general formula for asset valuation (at time t, where t < T), using continuous compounding. Derivation of the formula for the value at time t of a single payment paid at time T (continuous compounding). The change in value of an asset, over some interval, is equal to: dVt =Vt rdt 17
1 dVt = rdt Vt

18

Recall that d ln(x) / dx = 1/x. So, d ln(x) = 1/x dx.

19

d ln(Vt ) = rdt
ln(Vt ) = rt + k

20

Vt = e

rt +k

Vt = e rt e k

21 22 23

Write equation for VT and solve for e k

24
e = VT e rT
k

25
16

Asset Valuation under Certainty (continued) Substitute back into equation (23):
Vt =VT e rt e rT

Vt =VT e

r (T t )

26 27

So, equation (27) is the time t value of a single payment of VT, at interest rate r per period, continuous compounding. Example (1): What is the time 0 value of $1 received in five years (r = 10% per year)? Example (2): What is the time 2 value of $1 received in five years (r = 10% per year)? Derivation of the formula for the value at time t of an asset that continuously pays $C per period (continuous compounding)
dVt + Cdt = Vt rdt

28
dVt + C = Vt r dt dVt rVt = C dt

29 30

This is a first-order linear differential equation of the form:

31

To solve equation (31), use e p ( x ) dx as the integrating factor and multiply (31) by the integrating factor
e p ( x ) dx dy + p ( x )e p ( x ) dx y = e p ( x ) dx f ( x ) dx

32
17

Asset Valuation under Certainty (continued) The left hand side of (32) is the derivative of the product of the integrating factor and the dependent variable: e p ( x ) dx y . So, write (32) as
d e p ( x ) dx y =e p ( x ) dx f ( x ) d ( x)

33 To solve, integrate both sides. Now, back to our formula:

34

The integrating factor is e rdt = e rt . Multiply by this integrating factor

d (Vt e rt ) = Ce rt dt

35

36

Take an integral of both sides

37
1 Vt e rt = C e rt + k r

38
Vt = C + ke rt r

39

18

Asset Valuation under Certainty (continued) Evaluate at time = T. (Note that at this time, there are no more payments left, so VT = $0.)
VT = $0 = C + ke rT r

40 41 42

C = ke rT r

k=

C re rT

Substitute back into equation (39)

43

Rearranging gets us the final formula:

44

Example (3): What is the time 0 (time 2) value of $1 received (continuously) every year for five years (r = 10% per year)? Example (4): What is the time 0 (time 2) of a bond that pays continuous coupon interest payments of $50 a year (for 20 years) and $1000 at the end of the 20th year (r = 10% per year)? Notice, as T t approaches infinity, Vt converges to C/r Example (5): What is the time 0 (time 2) of a bond that pays continuous coupon interest payments of $50 a year in perpetuity (r = 10% per year)?

19

Asset Valuation under Certainty (continued) In discrete time

45

Note that t = 1, and Vt = Vt+1 - Vt.

Vt +1 + C = Vt (1 + r )

46

Vt =

Vt +1 + C 1+ r

47 48

20