NEW YORK UNIVERSITY FINANCIAL ECONOMICS Spring 2003 Franklin Allen and Douglas gale Topic 1: What is Corporate Finance? Readings A Ph. D. textbook that provides basic coverage of some of the main topics is J. A. de Matos. Theoretical Foundations of Corporate Finance, Princeton: Princeton University Press, 2002) There are many MBa textbooks. A very good one is R.A. Brealey and S.C. Myers, Principles of Corporate Finance, 7th edition(New York McGraw Hill, 2002) 1.0 Introduction Corporate finance is concerned with how firms should make investment and financing decisions. It is at the heart of most MBA programs. In recent years it has also become an important part of financial economics. In this course we will cover the subject at an advanced level by first developing the economic tools that are used in the subject and ther applying them. In this first part of the course we will start by briefly outlining what corporate finance focuses on. We will do this by outlining the coverage of a typical MBA course. As a comparison of the two books above will show this is somewhat different from what is usually studied in Ph. D courses. These usually cover a subset of what MBA courses
1 NEW YORK UNIVERSITY FINANCIAL ECONOMICS II Spring 2003 Franklin Allen and Douglas Gale Topic 1: What is Corporate Finance? Readings: A Ph. D. textbook that provides basic coverage of some of the main topics is: J. A. de Matos. Theoretical Foundations of Corporate Finance, Princeton: Princeton University Press, 2002). There are many MBA textbooks. A very good one is R.A. Brealey and S.C. Myers, Principles of Corporate Finance, 7th edition (New York: McGraw Hill, 2002). 1.0 Introduction Corporate finance is concerned with how firms should make investment and financing decisions. It is at the heart of most MBA programs. In recent years it has also become an important part of financial economics. In this course we will cover the subject at an advanced level by first developing the economic tools that are used in the subject and then applying them. In this first part of the course we will start by briefly outlining what corporate finance focuses on. We will do this by outlining the coverage of a typical MBA course. As a comparison of the two books above will show, this is somewhat different from what is usually studied in Ph. D. courses. These usually cover a subset of what MBA courses
cover. This is unfortunate as many interesting topics with important research questions are left out It is important that you read an MBa textbook. I would suggest Brealey and myer as it introduced the current way in which mba courses are taught. It is quite readable and should take only two or three days to finish It is perhaps helpful to start with a brief historical account of where corporate fina comes from. The railroad companies in the US began to use discounting techniques to make investment decisions. Irving Fisher's book on the Theory of Interest was quite influential However, the corporate finance that was taught in business schools before the Second world War was still very much based on the law. Arthur Stone Dewing's classic book on Corporate Finance which was originally written in the 1920s essentially described various financing instruments and legal precedents. After the war books began to move more towards an accounting and economics based approach. Jack Hirshleifer's 1970 book was q influential in making the subject more economics based. Brealey and Myers was the first book when it was published in the late 1970's was the first to properly incorporate the modern foundations of corporate finance which are Fishers separation theory, the Gordon Growth model, the Modigliani-Miller theorems, the Capital Asset Pricing Model and efficient markets In what follows we will start with firm's investment decisions and then consider the financing aspects
2 cover. This is unfortunate as many interesting topics with important research questions are left out. It is important that you read an MBA textbook. I would suggest Brealey and Myers as it introduced the current way in which MBA courses are taught. It is quite readable and should take only two or three days to finish. It is perhaps helpful to start with a brief historical account of where corporate finance comes from. The railroad companies in the US began to use discounting techniques to make investment decisions. Irving Fisherís book on the Theory of Interest was quite influential. However, the corporate finance that was taught in business schools before the Second World War was still very much based on the law. Arthur Stone Dewingís classic book on Corporate Finance which was originally written in the 1920ís essentially described various financing instruments and legal precedents. After the war books began to move more towards an accounting and economics based approach. Jack Hirshleiferís 1970 book was quite influential in making the subject more economics based. Brealey and Myers was the first book when it was published in the late 1970ís was the first to properly incorporate the modern foundations of corporate finance which are Fisherís separation theory, the Gordon Growth model, the Modigliani-Miller theorems, the Capital Asset Pricing Model and efficient markets. In what follows we will start with firmís investment decisions and then consider the financing aspects
1.1 Investment decisions Objective Function of the Corporation Motivation Example 1 Suppose you are at a gm shareholders'meeting. Three of the shareholders there have very different ideas about what the firm should do Old lady Wants money now. Wants gm to invest in large cars since this would yield a quick profit Little boy's trust Wants money a long way in the future. Wants gm to invest in fund representative building electric cars Pension fund Wants money in the medium term. Thinks there will be a very serious oil crisis some time in that period. Recommends that GM build small cars What should gm do? We will see how to answer this question by looking at how an individual should make investment decisions. Once we see that we can see how a corporation should make investment decisions Example Bill ross has inherited $1M. He grew up in Europe and has developed a real aversion to work, which he completely detests. He therefore plans to use his inheritance to finance himself for the rest of his life. For simplicity we'll divide his life into two periods youth and old age. Also, we're going to assume that there is only one financial institution, a bank, which lends and borrows at a rate of 20%, so that for every dollar deposited in youth S1.20 is received in old age 3
3 1.1 Investment Decisions Objective Function of the Corporation Motivation Example 1 Suppose you are at a GM shareholders' meeting. Three of the shareholders there have very different ideas about what the firm should do. Old lady: Wants money now. Wants GM to invest in large cars since this would yield a quick profit. Little Boy's trust Wants money a long way in the future. Wants GM to invest in fund representative building electric cars. Pension fund Wants money in the medium term. Thinks there will be a very representative serious oil crisis some time in that period. Recommends that GM build small cars. What should GM do? We will see how to answer this question by looking at how an individual should make investment decisions. Once we see that we can see how a corporation should make investment decisions. Example Bill Ross has inherited $1M. He grew up in Europe and has developed a real aversion to work, which he completely detests. He therefore plans to use his inheritance to finance himself for the rest of his life. For simplicity we'll divide his life into two periods, youth and old age. Also, we're going to assume that there is only one financial institution, a bank, which lends and borrows at a rate of 20%, so that for every dollar deposited in youth $1.20 is received in old age
Bank alone Assuming this bank is the only opportunity open to Bill, what can he do? 12M ope=-1+r)=-12 S spent in youth (i He could go on a fantastic trip around the world, spend the whole $IM, and then live in poverty with nothing for his old age (i) He could spend $O5M in his youth, have a moderate lifestyle, put $O.5M in the bank, and still have $0. 6M for his old age (iii He could put all his money in the bank for his old age and spend nothing in his youth, so that he can take an even better trip around the world in his old age. In this case he gets(0, $1. 2M) (iv) If we consider all the other possibilities, we get a straight line between(i)and He can thus consume anywhere on the straight line between SIM in youth and $1. 2M in old age. Analytically we have CoA =1.2M-1.2 CY
4 Bank Alone Assuming this bank is the only opportunity open to Bill, what can he do? (i) He could go on a fantastic trip around the world, spend the whole $1M, and then live in poverty with nothing for his old age. (ii) He could spend $0.5M in his youth, have a moderate lifestyle, put $0.5M in the bank, and still have $0.6M for his old age. (iii) He could put all his money in the bank for his old age and spend nothing in his youth, so that he can take an even better trip around the world in his old age. In this case he gets (0, $1.2M). (iv) If we consider all the other possibilities, we get a straight line between (i) and (iii). He can thus consume anywhere on the straight line between $1M in youth and $1.2M in old age. Analytically we have COA = 1.2M - 1.2 CY
Projects Alone Were next going to look at the case where there is no bank and there are only productive opportunities or projects that allow him to transfer wealth from his youth to hi Bill fancies himself as an entrepreneur and sits down to work out what investments he can make. He ranks them in terms of profitability with the most profitable being first and the least profitable last C OA Production Possibility urve 34M A+B 2M A 86.MC Project A Bill is a wine lover. He estimates that a small vineyard that has recently come on the market will cost him $50,000 now and will yield him $200, 000 for his old age. This is the best project he can think of. Hence, if he invests just $50,000 in this project and consumes $950.000 now. he can still consume $200.000 in his old age Proiect B Bill is also a gourmet. The next best project he can think of is to run a restaurant in the town he lives in. He reckons for a $100,000 outlay now he can get $140,000 in his old
5 Projects Alone We're next going to look at the case where there is no bank and there are only productive opportunities or projects that allow him to transfer wealth from his youth to his old age. Bill fancies himself as an entrepreneur and sits down to work out what investments he can make. He ranks them in terms of profitability with the most profitable being first and the least profitable last. Project A Bill is a wine lover. He estimates that a small vineyard that has recently come on the market will cost him $50,000 now and will yield him $200,000 for his old age. This is the best project he can think of. Hence, if he invests just $50,000 in this project and consumes $950,000 now, he can still consume $200,000 in his old age. Project B Bill is also a gourmet. The next best project he can think of is to run a restaurant in the town he lives in. He reckons for a $100,000 outlay now he can get $140,000 in his old
age. If he just undertakes this and project A, then he can consume $850,000 now and S340.000 later on Project c and so on There are a number of other projects he thinks of. We can trace out a curve to approximate these, e.g., see above With projects alone he can consume anywhere along the curve Proiects and the bank We now consider what he can do if we take account of both his projects and the ossibility of borrowing and lending at the bank Project A Suppose he just undertakes the first project, A. He has $950,000 now and $200,000 later on--what can he do? (i He could simply consume $950,000 now and $200,000 later on without going to the bank (i) Alternatively, he can use all the money he receives to have a marvelous time He has $950,000 now and $200,000 later on, which he can use to repay a loan that he spends now. How much can he borrow to repay with the $200,000 later on; i.e., what is the present value of $200,000 at 20%? PV(200,0000at20%)=200.000=166666 Total possible in consumption youth= 950,000+ 166, 666 $1.1167M 6
6 age. If he just undertakes this and project A, then he can consume $850,000 now and $340,000 later on. Project C and so on There are a number of other projects he thinks of. We can trace out a curve to approximate these, e.g., see above. With projects alone he can consume anywhere along the curve. Projects and the Bank We now consider what he can do if we take account of both his projects and the possibility of borrowing and lending at the bank. Project A Suppose he just undertakes the first project, A. He has $950,000 now and $200,000 later on--what can he do? (i) He could simply consume $950,000 now and $200,000 later on without going to the bank. (ii) Alternatively, he can use all the money he receives to have a marvelous time. He has $950,000 now and $200,000 later on, which he can use to repay a loan that he spends now. How much can he borrow to repay with the $200,000 later on; i.e., what is the present value of $200,000 at 20%? PV(200,000OA at 20%) = 200,000 = 166,666 1.20 Hence, Total possible in consumption youth = 950,000 + 166,666 = $1.1167M
OA 1.34M 2M () 1.1167M (iii) Alternatively he can plan to spend it all next period Total in old age= 1.2x.000+200.000 $1,340,000 As before, we can go on doing this until we trace out a straight-line budget constraint as before. The equation for this line is COA=1.34M-1.2C￥ The slope is again.2 since the interest rate is 20%. You can see that this follows from the structure of the problem since all values in Old Age are multiplied by 1.20 compared to their values in youth Project B Now suppose he undertakes the first and second projects, A and B, so that he produces at A+B. We can go through the same calculations again and get another line representing his consumption possibilities
7 (iii) Alternatively he can plan to spend it all next period. Total in old age = 1.2 x 950,000 + 200,000 = $1,340,000 As before, we can go on doing this until we trace out a straight-line budget constraint as before. The equation for this line is COA = 1.34M - 1.2 CY The slope is again - 1.2 since the interest rate is 20%. You can see that this follows from the structure of the problem since all values in Old Age are multiplied by 1.20 compared to their values in Youth. Project B Now suppose he undertakes the first and second projects, A and B, so that he produces at A + B. We can go through the same calculations again and get another line representing his consumption possibilities
OA 136M 134M A+B A Y In this case, Intercept on COA axis=1.2 X 850,000+ 340,000=136 M Hence, analytically the budget constraint is given by CoA=1.36M-1.2C We can see that by undertaking the first project he can push out the line representing his possible consumption, similarly when he undertakes the second project, and so on. If he prefers more money to less, he is better off if his budget constraint is pushed out further since this allows him to consume more in both periods. Hence no matter what his preferences are, he is better off with a budget constraint that is farther out To see this we can represent preferences in this diagram by an indifference curve This is the locus of combinations of Coa and Cy such that he is indifferent 8
8 In this case, Intercept on COA axis = 1.2 x 850,000 + 340,000 = 1.36 M. Hence, analytically the budget constraint is given by COA = 1.36 M - 1.2 CY We can see that by undertaking the first project he can push out the line representing his possible consumption, similarly when he undertakes the second project, and so on. If he prefers more money to less, he is better off if his budget constraint is pushed out further since this allows him to consume more in both periods. Hence no matter what his preferences are, he is better off with a budget constraint that is farther out. To see this we can represent preferences in this diagram by an indifference curve. This is the locus of combinations of COA and CY such that he is indifferent
OA utility increasing We can represent differences in preferences for consumption in old age and youth by differences in the shape of the indifference curves. Suppose, for example, somebody has a strong preference for consumption in old age Then her indifference curves will look something like this OA Miser Her curves are flat for the following reason. Since she is a miser a small reduction in consumption in old age must be compensated for by a large increase in youth to make her indifferent
9 We can represent differences in preferences for consumption in old age and youth by differences in the shape of the indifference curves. Suppose, for example, somebody has a strong preference for consumption in old age. Then her indifference curves will look something like this: Her curves are flat for the following reason. Since she is a miser a small reduction in consumption in old age must be compensated for by a large increase in youth to make her indifferent
Somebody who prefers consumption in his youth, who we shall call a spender, will have the type of indifference curves below. They are steep because a large reduction in consumption in old age can be compensated for by a small increase in youth to make him indifferent OA Spender Now if we put budget constraints on these diagrams we can see that pushing a budget constraint out makes both better off OA 10
10 Somebody who prefers consumption in his youth, who we shall call a spender, will have the type of indifference curves below. They are steep because a large reduction in consumption in old age can be compensated for by a small increase in youth to make him indifferent. Now if we put budget constraints on these diagrams we can see that pushing a budget constraint out makes both better off