BUS 290 Chapter 4 - Summary Notes of Corporate Finance
Financial Markets and the Economy People and institutions have various sources of income and
various intertemporal (time) consumption preferences, which has led to the emergence of a
market for money. Money price equals interest rate Financial markets emerge to enable
inter-individual borrowing and lending, according to The Anonymous Market. The role of
financial intermediaries is to connect borrowers and lenders/traders. For example, a bank
receives loans from its depositors and finances loans with the money it has in reserve. Three
types of financial intermediation exist: Small loans are made to students by banks that receive
substantial loans from businesses. Commercial banks also use short-term deposits to support
long-term mortgages.
Market Clearing: the total amount that people wish to lend to the market equals the total amount
that people wish to borrow When quantity supplied = quantity demanded, market = equilibrium
at the equilibrium price. Risk Intermediation: Financial intermediaries can tailor the risk
characteristics of securities for borrowers and lenders with different degrees of risk tolerance. If
the lenders want to lend more than the borrowers want to borrow, the interest rate is too high.
This must occur for the market to function. The interest rate that clears the market is known as
the equilibrium rate of interest. Lower interest rates indicate that borrowers need more loans than
lenders are prepared to provide. Financial instruments include loans, bonds, and exchanged
IOUs.
Choosing Consumption Over Time With borrowing and lending, a person might change his
consumption over time. The Competitive Market's graph illustrates options for intertemporal
consumption. Those who respond to rates and prices by acting as though they have no control
over them are known as "Price Takers" (price taking assumption) Financial Markets with Perfect
Competition: Trade is free of charge. Information regarding borrowing and lending possibilities
is easily accessible, and there are numerous traders. As a result, no single trader can significantly
affect market pricing. How many interest rates are there in a market when there is competition?
At any one time, the market can only quote one equilibrium interest rate. Arbitrage is the process
of agreeing to a contract in one market and an opposite agreement in a different market.
Arbitrageurs will take advantage of the scenario by borrowing at the low rate and lending at the
high rate as soon as various interest rates are given for essentially the same risk-free loans. The
Fundamental Concept An investment project is only worthwhile if it broadens the variety of
options available in the financial markets. The financial markets provide the person, the firm, or
even the government with a standard of comparison for economic decisions. Must at least match
the level of attractive options offered by the financial markets. governs all of our investment
choices and serves as the basis for all of our guidelines (first principle of investment decision
making).
Application of the Principle Should he invest in land for $70,000 if it would increase to $75,000
next year, generating a guaranteed $5,000 gain, with an estimated income of $100,000 this year
and $100,000 the next year? Rather, you should invest the same $70,000 in a loan on the
financial market. A 10% interest rate will result in his having $77,000 the following year. Should
he make the investment now that borrowing oLand is worth $80,000 rather than $75,000 future
year? Sure, borrow the $70,000 from the bank. He must pay it back within a year, at which point
he will owe $77,000. If the land subsequently sells for $80,000, he will have $3000 in extra
income.
According to the Separation Theorem, a person's investment worth is independent of their
consumption habits. asserts that, regardless of their individual tastes, all investors will desire to
accept or reject the same investment projects when applying the NPV criterion. "Fundamental
need of the contemporary corporation" - Providing Examples of Investing Decisions If an
investment has a positive NPV, it is worthwhile. Corporate Investment Decision Making states
that if an investment's NPV is negative, it should be rejected. The difference between a
corporation and an individual is that a firm has no endowment for consumption. Regardless of
their individual preferences for intertemporal consumption, shareholders will be unified in their
desire for the company to make actions that increase net present value. Our ownership of the
firm increases after it makes an investment with a positive NPV.
