Teaching Note 3A

Valuation under certainty

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University of Delaware Lerner College of Business and Economics

FINC871 Workshop in Financial Economics: Seminar

Dr. Paul A. Laux nc871prof@TheFinanceWorks.net Teaching Note 3A Spring 2010

Foundations of valuation theory: Valuation under certainty

Main Reference: Matos, J., 2001, Introduction and Section 1, Valuation under certainty of Chapter 1, Valuation in Theoretical Foundations of Corporate Finance, Princeton University Press. I hope that while so many people are out smelling the owers, someone is taking the time to plant some. Herbert Rappaport. Dont fret. People will plant for the future, even if they really enjoy smelling owers today, so long as the marginal return is high enough. The theory of nance. What is high enough? Answered in this Teaching Note

Introduction

Valuation is fundamental to both the theory of investments and the theory of corporate nance. The Matos chapter that is the main reference to which this note corresponds is taken from a graduate level textbook on the theory of nance. Our course will often has a more empirical feel to it, but, to give you a full perspective, we need to include the starting pointand these are the fundamentals. In his Chapter 1, Matos provides an overview of: valuation under certainty in one period, demonstrating the usefulness of the present value and net present value concepts, and the crucial role of capital markets in allowing the separation of corporate ownership and management. This is traditionally called Fisher separation in the literature. This topc is the subject of this Note.

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valuation under uncertainty in one period, reminding you of ArrowDebreu state pricing and the implications of market completeness.1 I discuss the pricing kernel, stochastic discount rate, and risk neutral probabilities. This section of Matos chapter provides the rigorous underpinnings for the Binomial Option Pricing Model (OPM) that we have already seen in an earlier Teaching Note. This topic will be covered in a later Note and in class. In this Note, I provide some exposition on the rst bullet point above Section 1 of Matos Chapter 1 (pages 5-17). I intend to be informal and to provide intuition in this note. Even so, I stick very closely to Matos notation (though I think it is perhaps just a little fussy for the job at hand) because this topic should be review for you and I want you to be able to link this discussion to the standard drawings that are used for this topic in high-level sources. That said, I do NOT expect you to read the Matos chapter. If you want to dig deeper, that is always encouragedbut this is foundation rather than on-the-table for our course. If youd like to see most of these same points developed with a graphical example, please ask me for my MBA Teaching Note on the topic. If youd like to see the analysis under certainty really fully extended to consider investment, valuation and capital budgeting problems, the classic textbook treatment is (Fama & Miller 1972). The Main Reference chapter also discusses valuation under uncertainty in multiple periods. We have already gotten a avor for this extension in our consideration of the Binomial OPM (see Teaching Note 1A), and we wont have time to dig more into this right now. Finally, I refer you to the note in the Course Description on this topic. As stated explicitly in the Reading List, this is a review topic, which will be covered very littleif at all in class. Please read this and be sure you recall the main economic points and main analytical reasoning. Keep these things in mind as we move on (quickly) to study valuation under UNcertainty very soon.
I hope you have seen a little of Arrow-Debreu pricing in your earlier classes. If not, pay especially close attention, for this material is also at the foundations of economics. Both Arrow and Debreau were awarded Nobel Prizes, in part for this thinking.
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Valuation under certainty: The Fisher analysis

Valuation theory always ows from the solution to investment problems. We begin with a simple but useful one. What are the implications of utility maximization for the properties of the solution to the problem of a single investor allocating resources across two dates? There are several cases considered: storage only, productive investment, and productive investment in the presence of a capital market (i.e., an interest rate). My discussion builds systematically from the simplest case toward increasingly complex ones.

2.1

Storage

Consider Robinson Crusoes storage problem: how much of his xed stores to eat today, and how much tomorrow. With standard assumptions on utility functions, he shows that the solution for todays consumption x satises the o 0 U1 (0, Y + X) U2 (0, Y + X) X U1 (X, Y ) U2 (X, Y ) xo = arg max U (x, yo (x)) = x otherwise.

For details on the notation, check Matos. Perhaps even better, think about his gure reproduced below.

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Problem 1 With standard indierence curves, where will be the optimum bundle of x and yo (x )? o o The marginal rate of substitution at any consumption bundle (x, y) is dened as the rate of trade-o of todays consumption for tomorrows that would leave utility unchanged: dy U1 (x, y) (1 + (x, y)) < 0, dx U2 (x, y) where Ut is marginal utility for date t consumption and (x, y) measures the (positive) strength of psychological time preference for rst-date consumption. Keep this quantity in mind: it will bear a resemblance to the pricing kernel for valuing investments under uncertainty.2 With , we can meaningfully discuss the price of later consumption in terms of earlier consumption:
Matos writes , not (x, y). His convention does not emphasize that the marginal strength of the preference for current consumption over future consumption diers depending on the bundlebut it does. This will be important for the the optimum in other cases considered. In presenting this same material, other authors might separate out a parameter for the fundamental, unchanging psychological strength of preference for consuming sooner from the part the the marginal rate of substitution that depends on the dy (x, y) bundle. Something like dx = V1 (x,y) , where is a parameter and Vt () is the part V2 (x,y) of the utility function that does not depend on .
2

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1 a unit of later consumption is worth 1+ units of earlier consumption. We have dened a psychological version of present value. We will also encounter marginal rates of substitution when we study valuation under uncertainty. It is important to remember that a rate of time preference is simplicity buried inside any marginal rate of substitution.

2.2

Investment

Now lets allow for the additional possibility of productive investment. This is represented by a function , whose argument is the amount of consumption deferred, which we might generically call I, for investment. (I) is then the marginal second-date consumption produced by the nal unit of investment i.e., is the marginal productivity of investment in real terms. Well often call this the (real) marginal return on investment. We assume (I) 0. The total product of investment function is presumed to be concave (no techbubble increasing returns to scale here), so 0 (I) < 0the marginal return is declining. Graphically, the new situation looks like this, where yp (x) traces out the new set of possibilities for second date consumption. Robinson is now better o than before. For any given x, yp (x) > yo (x).

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Problem 2 With standard indierence curves, can you depict the optimal allocation? What would be the interpretation of the marginal rate of substitution at a point along the yp (x) curve, as compared to the interpretation at a point along the yo (x) curve? Problem 3 As an thought experiment, you might consider what would be the outcome if Robinson and Friday shared ownership of the production process. Suppose Friday does the work, reports to Robinson on the productivity, and brings back the output to be divided up. What are Fridays incentives? What aect will Fridays actions have on Robinsons willingness to invest (i.e., if Friday responds to those incentives and Robinson cannot stop him)? This principalagent problem lies at the core of corporate nance and corporate governance. Information ow and enforcement mechanisms are key to obtaining the anything close to rst-best outcomes for the principal.

2.3

Capital market opportunities

Next, a capital market opportunity is added to the analysisthat is, an interest rate based on the time preferences (and perhaps production opportunities) of other people besides Robinson. Impatient people borrow from patient people, and people with a lot of date 2 endowment borrow from those with a lot of time 2. Dierent people may also own dierent investment opportunities, and these aect their desires to borrow and lend. Trading of claims on future consumption results in an equilibrium real interest rate r, so that one can trade units of todays consumption for (1 + r) units of tomorrows. We will take r as given for this discussion. The underlying assumption is that Robinsons decisions are small relative to the size of the competitive capital market, and so do not aect its outcomes.3 Finance is, of course, partly about the determination of r. Later, I will ask you to consider this in a problem set. Macroeconomics is also partly about the determination of r, though with a dierent focus. You might want to look at (Gibbons 1987) on that point. Matos rst introduces capital markets without allowing the possibility productive investment. Assuming only that r > 0, the capital market
3 Other considerations can be important in specic settings. In corporate governance, we might consider whether Robinson is an insider with special access to the market. In setting policy, we might consider whether Robinson is descriminated against on account of his race. And so on.

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presents Robinson with an improvement over storage as a way to move consumption to the future. It should not surprise you, as economists, that trading makes Robinson better o. By considering rst the comparison to storage only, Matos has a simple setting in which to introduce the idea of present value. The present value of any consumption bundle is dened as the amount of total current consumption for which it could be exchanged: P V (y, x) x + y(x) . 1+r

Robinsons optimal consumption bundle for this situation, (yr , x ), satisr es the condition that (1 + (yr , x )) = (1 + r). Robinson saves at the r real interest rate up to the point where the psychological rate of trade-o of present for future consumption equals the market rate of trade-o. At this bundle, the present value is yr (x ) r . 1+r This present value denes the market value of Robinsons wealth Wo . Note that, in the absence of any other investment opportunity, this is the same as the present value of his endowment (X, Y ), but yields a higher level of satisfaction. P V (yr , x ) = x + r r

2.4

Capital market opportunities and investment

Following Matos, I next consider the case with investment and capital market opportunities. Robinsons problem can be stated in terms of choosing the amount to invest today. The (interior) solution is = 1 (r), where is simply Matos notation for the amount of consumption deferred, i.e., investment, in this situation.4 That is, the best amount to invest is the amount implied by requiring that investing the same amount in the capital market would give the same future consumption at the margin. More briey, set the marginal rate of return on the investment project equal to the rate of return in the capital market. As Ive mentioned, the latter is presumably
0 If the condition seems confusing, note that the marginal return function is yp (x) = (). Given the amount of investment, the function maps to the marginal return on the last unit invested. So 1 (r) is the mapping of the marginal return on the last unit invested to the total amount invested. 4

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unaected by the choice, assuming Robinsons investment is small relative to the size of the capital market. Importantly, notice that the expression = 1 (r) does not involve any parameters of Robinsons utility function. Further, this expression for the optimal amount to invest only involves the investment function to the extent that we need to know when the marginal return has declined to the point that investing another unit in the production process would be less protable than investing in the interest rate market.

Problem 4 Assume Robinson is very impatient. Show graphically the optimal investment plan and optimal consumption plan.

2.5

Separation of ownership from control decisions

Problem 5 Suppose the investment process were jointly owned by Robinson and several other investors. Assume that some means (perhaps laws, or corporate governance standards, or a board of monitors) has been devised to c 2010 Paul A. Laux

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resolve the Robinson-Friday agency problem considered in the earlier question. Explain what investment plan they will choose? What will happen if one of them is much more impatient than the others? What would happen (for the impatient person and for the others) if there is a tax on trading or if the capital market is very expensive to access due to transactions costs?

2.6

Net present value

On page 15, Matos compares the case with an investment opportunity that has (I) > r for at least part of its range and a capital market to the base case of storage and a capital market. He notes that the Net Present Value of the investment opportunity is 1+r where refers to the future-date consumption increase that would imply the same increase in utility as the investment opportunity (used optimally). is really just a short-hand way of referring to the net utility increase that investment brings to Robinson, measured in consumption terms rather than unobservable psychological terms. Then NPV measures, in present consumption terms, the improvement in Robinsons situation from taking the investment opportunity. Note that NPV is a more general measureit can be applied to the net eect of any new investment project that faces Robinson, not just the rst one. If NPV > 0, then an investment is worth taking. NP V = Problem 6 Show graphically the increase in NPV if the rm suddenly discovers a new and attractive investment opportunity.

2.7

Summing up

Problem 7 To practice with this reasoning and see how trading of claims among agents leads to an equilibrium interest rate in the capital market, work Matos Exercise 9 on page 17. (The problem and solution provided as an Appendix to this Teaching Note.)

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2.8

Multiple periods

At the end of his Section 1, Matos considers the properties of the solution to Robinsons investment problem in a multi-period context (still under certainty, with investment opportunities and a capital market). Because the future is known once a choice is made, this is not really a dynamic problem Robinson can plan everything at the beginning. Fisher separation and the NPV calculation extend directly into this context.

Conclusion

This Teaching Note provides an overview of nancial economics approach to real investment decision making, focusing on the implications for the market values of the investments. Contrast is one way to learn. Though nance is essentially about uncertainty, weve begun here by considering a the allocation of wealth across time in a riskless setting. Even without risk, several key ndings emerge. We see in the fact that the marginal rate of substitution depends on wealth the roots of investors pricing of risky investmentsa unit of consumption is valued dierently in dierent circumstances. By comparing the possibly-declining marginal rate of return on any physical investment with the constant rate of return represented by a competitive markets interest rate, we see the roots of the separation of ownership and control that empowers capitalist economies. By comparing the utility from future wealth with the market investment needed to obtain it, we see the essence of present value and net present value. Finally, though the analysis makes no mention of principalagent problems, transactions costs, or corporate governance, I propose that the roots of these things can also be seen by thinking about how consideration of these things would change the certainty models implications. The other major part of the Matos chapter from which the Main Reference reading is taken concerns valuation under uncertainty. That is our next topic. In covering that topic, we will see the link between the valuation approach discussed in this Teaching Note (valuation as the implication of agents solutions to their investment problems) and the risk neutral valuation approach discussed in an earlier Teaching Note.

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References
Fama, E., & M. Miller, 1972, The Theory of Finance (Dryden Press). Gibbons, M., 1987, The interrelations of nance and economics: Empirical perspectives, American Economic Review 77, 3541.

c 2010 Paul A. Laux