AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #3CORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #31FINANCIAL MARKETS AND NET PRESENT VALUEI) Financial Markets and Net Present Value:A) Introduction:Financial markets make it possible for individuals and firms to borrow or lend over time, thereby improving their intertemporal (across time periods) investment and consumption patterns. Think about it! Why do individuals invest? They invest because they are willing to forego present consumption for future, and hopefully larger, consumption. Why do people borrow or sell assets, e.g., common stocks? They want to increase present consumption (spend the money now) at the sacrifice of future consumption (e.g., repay the debt or not receive future dividends). In this context, consumption can include purchasing a new car, a new home, investing in their or their children's education, retirement, charitable contributions, or an inheritance for their heirs. Because of the financial markets, individuals can choose consumption and investment patterns, within the limits of their wealth constraint, so to maximize their utility of consumption over time.In addition, financial markets provide individuals and firms critical feedback regarding required rates of return on investment, i.e., benchmark rates of return. Accordingly, financial markets are indispensable in a well-functioning market based economy as in the U.S. Investment, particularly in "real assets," is critical in the creation of jobs and increasing the wealth of individuals and, in turn, society. Investment produces future goods and services for our society always at the cost ofcurrent consumption. The question is always, is the sacrifice worthwhile?B) Market Clearing:Financial intermediaries, for example banks and other financial institutions, perform an important function--they match up borrowers and lenders. This market "clears" when the quantity of money demanded by borrowers equals the amount of money supplied by investors. If a surplus ofborrowers exists, interest rates will rise, discouraging some borrowers, money will become too expensive, and encouraging new lenders, the return to lending is higher. If a surplus of lenders exists, interest rates will fall, discouraging lenders and encouraging borrowers. The interest rate that causes markets to clear is referred to as the equilibrium market rate of interest.2 Interest rates are quite dynamic as the supply and demand of funds varies over time.C) Preliminary Assumptions:1 This module is designed to complement Chapters 3 and 4 in B&D.2 In equilibrium, no pressure exists for interest rates to change.1In the subsequent discussion we will assume the following:(1) Perfect certainty. Outcomes are known with 100% probability. What does perfect certainty look like on a probability diagram? Without risk, only one interest rate will exist in the market for each maturity. Differential interest rates result from investments with different risk. We (temporarily) assume risk away.(2) Perfect Capital Markets (PCM).(a) Information is free and available to all participants that want it;(b) All participants have equal access to the financial markets, or rb (the borrowing rate) = rl (the lending rate) = r ;(c) All participants are price takers, no investor is large enough to impact the supply or demand for funds;(d) There are no transactions or contracting costs exist; and(e) No distorting taxes exist.(3) Investors are Rational in the following sense:(a) Investors prefer more wealth to less wealth.(b) Investors prefer cash sooner than cash later.(c) Investors prefer less risk to more risk.(4) We have a one-period world, t = 0 (today) and t = 1 (in one time period).Do you understand why only one interest rate per maturity can exist in the market if we assume away uncertainty, i.e., no risk exists? (In a one-period world there is then only one interest rate since there can only be one maturity.) If more than one rate existed, you could create a "money machine!" What do I mean by a money machine? Borrow low and lend high with the same risk! Buy low and sell high with the same risk! What is "arbitrage" in this context? Arbitrage opportunities exist when the same item (or more generally, perfect substitutes) sell for two different prices. You can buy at the low price and sell at the high price, earning a riskless profit. Interest rates represent the price of moving money across time. If money sells at more than one price, i.e., interest rate, you would borrow low (low price) and lend high (high price). In a well-functioning economy, arbitrage opportunities should not persist very long; traders will exploit them, driving the prices of the substitute items to equality.Don’t worry I know these are unrealistic assumptions. We will begin to relax these assumptions 2in the next and following lectures. However, using these assumptions provides us important insights without complicating factors. It is a common technique in economics and finance to start with the simplest possible world and then add complications one-by-one. This procedure allows us to identify the complications that matter the most and precisely what each one does.D) The Concept of Present Value: a fundamental business conceptEvery investor has a utility function defined with respect to consumption, consumption at t = 0 (again, t = 0 represents today) and at t = 1 (again, t = 1 represents one period away). The investor's objective is to maximize the utility of his/her consumption over these two time periods. Some of us would prefer to consume more now; others would prefer to consume more in one period. In other words, it is perfectly rational to have different tastes and preferences for consumption from different individuals or at different periods in our lives. Tastes and preferencesare individualistic, a personal choice. Consider examples of how your consumption preferences change over your own life-cycle.We need a way to relate cash flows that occur at different time periods, i.e., at t = 0 and t = 1, to solve our consumption preference problem. For example, which would you prefer?Case #1--$1.00 at t = 0, or C0 = 1, and zero dollars at t = 1, C1 = 0 orCase #2--Zero dollars at t = 0, or C0 = 0, and $1.00 at t = 1, C1 = 1?You can’t directly compare since the cash arrives at different times. Why might you prefer Case #1?Let "r" = the interest rate, e.g., the rate on T-Bills. (What is a