Financial Theory and Corporate Policy Decisions (MGT 602)

Spring: 2012 Semester

3 Credit Hours
Timings: 1800 – 2100 Hrs (Monday)
Room: LR-5

Dr. Khurrum S. Mughal

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Introduction

 B.Sc (Mathematics, Statistics, & Economics) 1999

Punjab University, Pakistan

 MBA (Finance & Investment)2002

NUST Business School, Islamabad, Pakistan

 PhD (Public Policy) 2010

Johannes Kepler University, Linz, Austria

 Working in a Public Sector Department since 2002

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Course Material

Required Texts & Readings:

 Financial Theory and Corporate Policy, 4th Edition by
Copeland, Weston, & Shastri

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Grading Criteria

Class Participation/Attendance 05

13 Quizzes (One after each lecture) 10

Paper Presentation/Discussion 10

Project/Term Paper (10 + 5) 15

2 x Mid Term Examinations 30

Final Exam (in class, close book) 30

100

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Class Decorum

 Switch off Mobile Phones

 Late arrival will result in absence on the record

 15 minutes brake at 1930 Hrs

 Mandatory second attendance after brake

 Formal dressing for first two days of every week

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Term Paper

Proposal for Term Paper to be submitted on/before Feb 13, 2012

(Week 3)

The final term paper must be submitted by the students on/before

Monday Week 19.

 Written report must be maximum of 15 pages, written in the

following format:
MS WORD,
12 FONT SIZE,
1.5 LINE SPACING
Font: TIMES NEW ROMAN,
WITH PLAGIARISM REPORT AT THE END IN THE APPENDICES.

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Theme of Lectures

Financial Theory

Corporate Policy

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Introduction

 Understand the Consumption and Investment decisions

 Role of Interest rates

 Importance of Capital Markets 

 A Robinson Crusoe Economy

 One Person, One Good Economy with no uncertainty
 Choice of Consumption now or in future
 Consumption in future is Investment

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Without Capital Markets

Consumption and Investment without Capital Markets

Assumptions

No Uncertainty

No transaction Costs or Taxes

Decisions are made in one period context

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Without Capital Markets

 Assumptions (contd…)
 The individuals are Endowed
with income at y0 & y1

 Current Consumption C0 and

future consumption C1

 Marginal Utility of Consumption

is Positive and decreasing

 Decision to consume now or later Beginning period utility where C1

is held constant

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Without Capital Markets

 Trade off

 Dashed line represent the

contours along total utility

surface

 Indifference between point

A&B

 The curves can be projected Trade-offs: Beginning and end

period consumption
to another plane

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Without Capital Markets

 Combinations of C0 & C1 on an
IC have same total utility

 Point A has more end period

consumption

 Point B has more beginning

period consumption

Indifference Curves with time

preference of consumption

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Without Capital Markets

 Rate of Trade-off between C0 & C1

 Marginal Rate of Substitution

 Subjective Rate of Time Preference

Indifference Curves with time

preference of consumption

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Without Capital Markets

 Subjective Rate of Time Preference

is higher at A than B, owing to
convexity of the IC

 At point A the individual will

demand more consumption in end
period

Indifference Curves with time

preference of consumption

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Without Capital Markets

 Introducing Productive
Opportunities

 Investment opportunities from

highest to lowest rate of return

 Diminishing marginal rate of

Investment

 Assuming independent and

perfectly divisible investments Individual’s schedule of productive
investment opportunities

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Without Capital Markets

 Individual will make investment

opportunities where return is higher than
his subjective rate of time preference

 Tangent to ABX is the marginal rate of

transformation

 Highest rate of return at point A

 Initial Endowment y0 & y1 at U1

 y0-C0 is to be invested
The Production Opportunity Set

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Without Capital Markets

 With Initial Endowment of y0 & y1

 The individual will invest till

MRS < MRT

 At point B MRS = MRT

 Production equals consumption

The Production Opportunity Set

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Without Capital Markets

 In the absence of Capital markets

 Individual 2 will choose to invest

more than individual 1

Difference in ICs

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With Capital Markets

 Intertemporal Exchange of
Consumption Bundles

 Opportunity to borrow and

lend at market determined
rate of interest “r”

 Ignoring production
individuals can borrow and
lend along capital market line

 With Initial endowment of y0

& y1 and U1 , X0 can be
borrowed
The Capital Market Line
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With Capital Markets

 At point A:
 Slope of Subjective rate is
less than the market rate
of return
 Individual desires to lend

 The individual reaches

point B and maximizes his
utility to U2

The Capital Market Line

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With Capital Markets

 Assuming production along

with exchange of funds at
market rate

 At point A with y0 & y1 ,

production opportunity set
offers higher return than
capital market line and
production opportunity set

 The individual moves to

point D (result same as in
case of without capital
market) Production and Consumption with Capital
Markets
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With Capital Markets

 At D, returns from
investment are higher than
borrowing so the individual
continues to invest and
reaches B
 where production is (P0, P1)
 Wealth is “W*o”
 At point B we can move
along the capital market line

 From borrowing the

individual can reach C with
total utility U3 Production and Consumption with Capital
Markets
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With Capital Markets

 Therefore the individual is

better off with the existence
of capital market

 The individual moved from:

 Point A(Initial endowment)
 To Point D (Robinson
Crusoe Solution)
 To Point C (exchange
economy solution)

Production and Consumption with Capital

Markets
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Fisher Separation Theorem

 Two step decision process in the presence of production and

capital market exchange opportunities:
1. Choosing optimal production decisions until marginal rate of return
on investment equals objective market rate.
2. Choosing consumption pattern by borrowing or lending along
capital market line to equate subjective time preference rate and
market rate of return.

 Fisher Separation Theorem: Separation of Investment and

consumption decisions given perfect and complete capital
markets

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Implication for Corporate Policy

 Investment decisions can be

delegated to managers

 Every investor will choose the

same production set (P0, P1)

 They can take output and

borrow or lend to adopt to their
subjective time preference rate

 Investor 1 will borrow and

Investor 2 will lend in the
capital market

 Both are better off than their

optimal production decisions
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Market Places and Transaction Costs

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Implication for Corporate Policy

 Difference in Borrowing and

lending rates

 Investment decisions cannot

be delegated to managers

 Investor one will target

point B

 Investor 2 will target point A

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Investment Decisions: Certainty Case

 Fisher Separation
 Individual Utility
Vs
Investment Decision

 Goal: Maximization of
Shareholder’s Wealth

 Shareholder’s Individual Utility

is not Comparable

 How will manager decide?

 The Agency Costs

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Shareholder’s Wealth Maximization
(Dividends Vs. Capital Gain)

 Shareholder’s Wealth: Discounted value of after tax cash flows

S0 = ∑ Divt/(1+ks)t

 Formula assumes:
 All future cash flows are known
 Market determined discount rate is non-stochastic and constant

 Capital Gains Divt = Div1(1+g)t-1

 Gordon Growth Model, where g<k

S0 = Divt/(ks-g)t
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Shareholder’s Wealth Maximization
Economic Profits

Rate of return in excess of opportunity cost of funds

Exact time pattern of cash flows is required

Discounted stream of dividends

Difference between accounting and economic

definition of profits

Model……

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Capital Budgeting Techniques

The best technique will maximize shareholder’s wealth

 All cash flows should be considered

 Cash flows to be discounted at opportunity cost
 Selection from mutually exclusive projects
 Each project can be considered independently

Mutually Exclusive projects

Independent Projects
Contingent Projects

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Capital Budgeting Techniques

Payback Method
Accounting Rate of Return
Net Present Value
Internal Rate of Return

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References

 Financial Theory and Corporate Policy, 4th Edition by

Copeland, Weston, & Shastri

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Short Quiz

Graphically Demonstrate the Fisher Separation

Theorem where an individual ends up lending in the
market

Following labels are required:

 Initial wealth W0
 Optimal Production/Investment (P , P )
o 1

 Optimal Consumption (C0, C1)

 Present Value of Final Wealth W0*

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Solution

Graphically Demonstrate the

Fisher Separation Theorem
where an individual ends up
lending in the market

Following labels are required:

 Initial wealth W0
 Optimal

Production/Investment (Po,
P1)
 Optimal Consumption (C0,
C 1)
 Present Value of Final
Wealth W0*
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