Chapter 1

Introduction: Capital Markets,

Consumption, and Investment
1. Assume the individual is initially endowed, at point A, with current income of y0 and end-of-period
income of y1. Using the market rate, the present value of his endowment is his current wealth, W0:
W0 = y0 +

y1
1 + rf

The individual will take on investment up to the point where the marginal rate of return on investment

Figure S1.1 Fisher separation for the lender case

equals the market rate of interest at point B. This determines the optimal investment in production (P0,
P1). Finally, in order to achieve his maximum utility (on indifference curve U1) the individual will lend
(i.e., consume less than P0) along the capital market line until he reaches point C. At this point his
optimal consumption is C0 , C1 which has a present value of
W0 = C0 +

C1
1 + rf

Copeland/Shastri/Weston Financial Theory and Corporate Policy, Fourth Edition

2.

Figure S1.2 An exogenous decline in the interest rate

(a) An exogenous decrease in the interest rate shifts the capital market line from the line through AW0
to the line through AW0. Borrowers originally chose levels of current consumption to the right of
A. After the decrease in interest rate, their utility has increased unambiguously from UB to UB .
The case for those who were originally lenders is ambiguous. Some individuals who were lenders
become borrowers under the new, lower, rate, and experience an increase in utility from U L 1 to

UB 1 . The remaining lenders experience a decrease in utility, from U L to U L .

2

(b) Because borrowers and lenders face the same investment opportunity set and choose the same
optimal investment (at A before the interest rate decreases and at A afterward), current wealth is
the intercept of the capital market line with the C0 axis. Originally it is at W0; then it increases
to W0 .
(c) The amount of investment increases from I to I.
3. Assuming that there are no opportunity costs or spoilage costs associated with storage, then the rate of
return from storage is zero. This implies a capital market line with a 45 slope (a slope of minus 1) as
shown in Figure S1.3.

Figure S1.3 Market rate cannot fall below net rate from storage

Chapter 1

Introduction: Capital Markets, Consumption, and Investment

Also shown is a line with lower absolute slope, which represents a negative borrowing and lending
rate. Any rational investor would choose to store forward from his initial endowment (at y0, y1) rather
than lending (to the left of y0). He would also prefer to borrow at a negative rate rather than storing
backward (i.e., consuming tomorrows endowment today). These dominant alternatives are
represented by the heavy lines in Figure S1.3. However, one of them is not feasible. In order to borrow
at a negative rate it is necessary that someone lend at a negative rate. Clearly, no one will be willing to
do so because storage at a zero rate of interest is better than lending at a negative rate. Consequently,
points along line segment YZ in Figure S1.3 are infeasible. The conclusion is that the market rate of
interest cannot fall below the storage rate.
4. Assume that Robinson Crusoe has an endowment of y0 coconuts now and y1 coconuts which will
mature at the end of the time period. If his time preference is such that he desires to save some of his
current consumption and store it, he will do so and move to point A in Figure S1.4. In this case he is
storing forward.

Figure S1.4 Storage as the only investment

On the other hand, if the individual wishes to consume more than his current supply of coconuts in
order to move to point B, it may not be possible. If next years coconut supply does not mature until
then, it may be impossible to store coconuts backward. If we were not assuming a Robinson Crusoe
economy, then exchange would make it possible to attain point B. An individual who wished to
consume more than his current allocation of wealth could contract with other individuals for some of
their wealth today in return for some of his future wealth.

Copeland/Shastri/Weston Financial Theory and Corporate Policy, Fourth Edition

*

5. Figure S1.5 shows a schedule of investments, all of which have the same rate of return, R .

Figure S1.5 All investment projects have the same rate of return
The resultant investment opportunity set is a straight line with slope (1 + R*) as shown in Figure S1.6.
The marginal rate of substitution between C0 and C1 is a constant.

Figure S1.6 Investment opportunity set

6. In order to graph the production opportunity set, first order the investments by their rate of return and
sum the total investment required to undertake the first through the ith project. This is done below.
Project
D
B
A
C

One Plus the

Rate of Return
1.30
1.20
1.08
1.04

Outlay for the

ith Project
$3,000,000
1,000,000
1,000,000
2,000,000

Sum of Outlays
$3,000,000
4,000,000
5,000,000
7,000,000

The production opportunity set plots the relationship between resources utilized today (i.e.,
consumption foregone along the C0 axis) and the extra consumption provided at the end of the
investment period. For example, if only project D were undertaken then $3 million in current

Chapter 1

Introduction: Capital Markets, Consumption, and Investment

consumption would be foregone in order to receive 1.3 ($3 million) = $3.9 million in end-of-period
consumption. This is graphed below in Figure S1.7.

Figure S1.7
If we aggregate all investment opportunities then $7 million in consumption could be foregone and the
production opportunity set looks like Figure S1.8. The answer to part b of the question is found by
drawing in a line with a slope of 1.1 and finding that it is tangent to point B. Hence the optimal
production decision is to undertake projects D and B. The present value of this decision is
W0 =

C1

+ C0
1+ r
5.1
=
+ 3 = $7.6364 million
1.1

Figure S1.8 Production opportunity set