FINANCIAL ECONOMICS

Objectives of the Paper

• The course focuses equally on the theoretical framework as well as
the practical aspects of the functioning financial markets.
• The course is intended to provide an in-depth understanding of
the operational issues of capital an money market network along
with its regulatory framework.
• This course provides a thorough conceptual and practice
operations of the financial markets, institutions and instruments
network in Indian context.
Module 1
• Module 1-Introduction to Financial Markets-
Capital markets, consumption and investments
with and without capital markets, market places
and transaction costs and the breakdown of
separation; Fisher separation theorem; the agency
problem; maximization of shareholder's wealth.
Introduction
Indian Financial System
• The Indian financial system is a complex and structured network
of financial institutions, markets, instruments, and services that
facilitate the transfer of funds between savers and borrowers.
• It plays a crucial role in the economic development of the country
by mobilizing savings and directing them into productive
investments.
Capital Market
What is a Capital Market?
• A capital market is a financial market where buyers and
sellers engage in the trade of financial securities like stocks,
bonds, and other long-term investments.
• These markets facilitate the raising of capital by companies
and governments, providing them with access to funds for
expansion, operations, and other activities.
• Capital markets are crucial for economic growth as they
channel savings and investments into productive uses.
Types of Capital Market
Primary Market
• Otherwise called as New Issues Market, it is the market for the
trading of new securities, for the first time.
• It embraces both initial public offering and further public offering.
• Companies and governments raise new capital through Initial
Public Offerings (IPOs), bonds, and other instruments.
• Investors purchase these new issues directly from the issuer.
• https://www.business-standard.com/companies/news/ratlam-based-
kataria-industries-to-float-rs-54-5-cr-ipo-on-july-16-
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Types of Issue of Securities in Primary
Market
 Types of Issue of Securities in the Primary
Market
1. Public Issue:
• Initial Public Offering (IPO): When a company issues shares to the public for the first time.
• Follow-on Public Offering (FPO): When an already listed company issues additional shares to the public.
2. Rights Issue:
• Existing shareholders are given the right to buy additional shares at a discount on a pro-rata basis.
3. Preferential Issue:
• Shares are issued to a select group of investors, usually at a discount, without offering them to the general
public.
4. Qualified Institutional Placement (QIP):
• A way for listed companies to raise funds by issuing securities to qualified institutional buyers (QIBs) without
going through standard regulatory processes.
5. Private Placement:
• Securities are sold to a small group of investors, such as institutional investors or high-net-worth individuals,
rather than the general public.
6. Bonus Issue:
• Additional shares are given to existing shareholders without any extra cost, based on the number of shares
already held.
Secondary Market

• The secondary market is a part of the financial market where

previously issued financial instruments such as stocks, bonds,
options, and futures are bought and sold.
• Unlike the primary market, where securities are created and sold
for the first time, the secondary market involves the trading of
existing securities.
• The trading takes place between investors, that follows the original
issue in the primary market.
Key Features of the Secondary Market
1.Liquidity : It allows investors to buy and sell securities quickly and easily.
2.Price Discovery : The secondary market helps in determining the fair market
price of securities through the forces of supply and demand.
3.Investor Accessibility: It provides a platform for a wide range of investors,
from individual retail investors to large institutional investors, to trade
securities.
4.Regulation: Secondary markets are usually well-regulated to ensure fair
trading practices, protect investors, and maintain market integrity. In the
United States, the Securities and Exchange Commission (SEC) is responsible
for regulating secondary markets.
Types of Secondary Markets
1.Stock Exchanges: These are centralized platforms where
securities are listed and traded.
2.Over-the-Counter (OTC) Markets:
These are decentralized markets where trading is done directly
between parties without a centralized exchange.
The OTC market often deals with securities not listed on formal
exchanges. Trading is facilitated through networks of dealers and
brokers.
Instruments Traded:
•Stocks not listed on major exchanges.
•Corporate bonds.
•Government securities.
•Derivatives, such as forwards, options, and swaps.
•Foreign exchange.
Participants:
•Financial institutions.
•Banks.
•Corporations.
•Hedge funds.
•Individual investors.
Regulation:
• While OTC markets are less regulated than exchange markets, they are still subject to
oversight by regulatory bodies such as the Securities and Exchange Board of India (SEBI)
and the Reserve Bank of India (RBI).
3. Electronic Trading Platforms: With advancements in technology, many secondary market transactions now
occur on electronic trading platforms which facilitate the trading process more efficiently. Major Electronic Trading
Platforms
National Stock Exchange (NSE)
• Platform: NSE operates the NEAT (National Exchange for Automated Trading) system.
• Features: High-speed trading, advanced technology, and a wide range of products including equities,
derivatives, and debt.
Bombay Stock Exchange (BSE)
• Platform: BSE operates the BOLT (BSE On-Line Trading) system.
• Features: Fast execution, diverse product offerings including equities, mutual funds, and fixed income
securities.
• https://www.bseindia.com/markets.html
Multi Commodity Exchange (MCX)
• Platform: MCX operates an electronic trading platform for commodity derivatives.
• Features: Trading in metals, energy, and agricultural commodities.
National Commodity & Derivatives Exchange (NCDEX)
• Platform: NCDEX provides an electronic platform for commodity derivatives.
• Features: Trading in agricultural commodities, metals, and energy products.
Key Participants in
Capital market
1. Securities and Exchange Board of
India (SEBI):
• SEBI was established in 1988 and given statutory powers on January 30,
1992, through the SEBI Act, 1992.
• It is the regulator for the securities market in India.

• Objectives:
• To protect the interests of investors in securities.
• To promote the development of the securities market.
• To regulate the securities market.
 Functions and Responsibilities of SEBI
Regulatory Functions:
• Regulating business in stock exchanges and other securities markets.
• Registering and regulating stock brokers, sub-brokers, share transfer agents, and other
market intermediaries.
• Registering and regulating collective investment schemes, including mutual funds.
• Promoting and regulating self-regulatory organizations.
• Prohibiting fraudulent and unfair trade practices in securities markets.
• Promoting investor education and training intermediaries.
• Prohibiting insider trading.
• Regulating substantial acquisition of shares and takeovers.
• Inspecting, inquiring, and auditing stock exchanges, intermediaries, and self-regulatory
organizations.
• Exercising powers under the Securities Contracts (Regulation) Act, 1956, as delegated
by the Central Government.
Development Functions:
• Promoting fair practices and a code of conduct for market
intermediaries.
• Encouraging self-regulatory organizations.
• Promoting research and investigation.
• Promoting investor education and training intermediaries.
• Training intermediaries of the securities market.
Protective Functions:
• Prohibiting fraudulent and unfair trade practices.
• Prohibiting insider trading.
• Imposing penalties for securities law violations.
• Monitoring substantial acquisitions of shares and takeovers
2. Stock Exchanges
• Stock exchanges are marketplaces where securities,
such as stocks and bonds, are bought and sold.
•They facilitate trading, price discovery, and liquidity
for financial instruments.
Major Stock Exchanges in
India
Bombay Stock Exchange (BSE):
• Establishment: The BSE was established in 1875 as the Native
Share and Stock Brokers' Association. It is the first stock exchange
in Asia.
• Location: BSE is located on Dalal Street in Mumbai, Maharashtra,
India.
• Regulation: The BSE is regulated by the Securities and Exchange
Board of India (SEBI).
Trading Platform
• BOLT (BSE On-Line Trading): Introduced in 1995, BOLT is BSE's
electronic trading system that allows for efficient and transparent
trading.
• BSE Star MF: A platform for mutual fund transactions, providing
convenience and efficiency for investors and distributors.
• BSE SME: A platform for small and medium-sized enterprises to
raise capital and get listed
Key Indices
1. S&P BSE SENSEX
The S&P BSE SENSEX is BSE’s flagship index, representing 30 of the largest and most
actively traded stocks on the exchange. Covers various sectors including finance, IT,
consumer goods, healthcare, and energy.
2. S&P BSE 100-Comprises 100 of the largest and most liquid stocks.
3. S&P BSE 200
4. S&P BSE MidCap
5. S&P BSE SmallCap
6. Sectoral Indices
• Examples: S&P BSE Bankex, S&P BSE IT, S&P BSE Healthcare, S&P BSE FMCG, etc.
• These indices focus on specific sectors of the economy, providing a snapshot of the
performance of companies within those sectors.
National Stock Exchange (NSE):
• National Stock Exchange of India (NSE)
• Established: 1992
• Location: Mumbai, India
• Main Functions:
• Facilitates trading in equities, bonds, and derivatives.
• Provides a transparent and efficient trading platform.
• Introduces innovative financial products.
• Sets standards for market practices.
Key Indices of NSE
1. NIFTY 50- The NIFTY 50 is NSE’s flagship index and represents the
weighted average of 50 of the largest and most liquid Indian securities
listed on the NSE.-Covers various sectors such as financial services,
energy, information technology, consumer goods, and more.
2. NIFTY Next 50-Tracks the performance of the 50 companies that rank
after the NIFTY 50 companies.
3. NIFTY Midcap 150
4. NIFTY Smallcap 250
5. Sectoral Indices
Examples: NIFTY Bank, NIFTY IT, NIFTY Pharma, NIFTY FMCG, etc.
Major Stock Exchanges Around the World
1. New York Stock Exchange (NYSE)
• Location: New York, USA
• Established: 1792
• Description: The largest stock exchange in the world by market capitalization, offering trading in a wide range of financial instruments including
equities, bonds, and exchange-traded funds (ETFs).
2. NASDAQ
• Location: New York, USA
• Established: 1971
• Description: Known for its high-tech and biotech listings, NASDAQ is the second-largest stock exchange by market capitalization and is fully
electronic.
3. Tokyo Stock Exchange (TSE)
• Location: Tokyo, Japan
• Established: 1878
• Description: The largest stock exchange in Japan and one of the largest in Asia, known for listing major Japanese companies like Toyota and Sony.
4. Shanghai Stock Exchange (SSE)
• Location: Shanghai, China
• Established: 1990
• Description: One of the two major stock exchanges in mainland China, focusing on Chinese companies, including state-owned enterprises.
5. Hong Kong Stock Exchange (HKEX)
• Location: Hong Kong
• Established: 1891
• Description: A major global financial hub with a significant number of Chinese company listings and a key player in connecting international
investors with Chinese markets.
6. London Stock Exchange (LSE)
• Location: London, United Kingdom
• Description: One of the oldest stock exchanges in the world, known for its global reach and listings of international
companies.
7. Euronext
• Location: Amsterdam, Brussels, Dublin, Lisbon, Milan, Oslo, and Paris
• Established: 2000 (merger of multiple European exchanges)
• Description: A pan-European stock exchange offering trading across multiple European countries, known for its diversified
listings.
8. Shenzhen Stock Exchange (SZSE)
• Location: Shenzhen, China
• Established: 1990
• Description: The second major stock exchange in mainland China, focusing on technology and growth-oriented companies.
9. Toronto Stock Exchange (TSX)
• Location: Toronto, Canada
• Established: 1852
• Description: The largest stock exchange in Canada, known for its listings of natural resources, mining, and energy companies.
10. Frankfurt Stock Exchange
• Location: Frankfurt, Germany
• Description: The largest stock exchange in Germany, offering trading in a wide range of financial products and known for its
DAX index, which tracks major German companies.
Depositories
Depositories

• A depository is a facility, organization, or institution that holds and

manages securities in electronic form for its clients, typically facilitating
the trading and settlement processes in financial markets.
• The primary function of a depository is to enable the holding and transfer
of securities without the need for physical certificates, thus ensuring the
safety, efficiency, and reliability of the securities transactions.
1. National Securities Depository
Limited (NSDL)
• Establishment: NSDL was established in 1996 and is the first
depository in India.
• Ownership: It is promoted by institutions such as IDBI, UTI, and
NSE.
• Functions:
• Holds securities in dematerialized form.
• Facilitates electronic settlement of trades.
• Provides services like account maintenance, dematerialization,
rematerialization, transfer and pledge of securities.
• Offers corporate actions such as dividends, interest, and bonus shares
distribution.
2. Central Depository Services (India)
Limited (CDSL)
• Establishment: CDSL was established in 1999.
• Ownership: Promoted by the Bombay Stock Exchange (BSE) along
with other banks and financial institutions.
• Functions:
• Similar to NSDL, it holds and maintains securities in electronic form.
• Facilitates dematerialization and rematerialization.
• Manages electronic transfer of securities.
• Provides services related to corporate actions, account maintenance, and
settlement of trades.
Functions
1.Dematerialization (Demat): Converting physical securities into
electronic form.
2.Rematerialization (Remat): Converting electronic securities
back to physical form.
3.Settlement of Trades: Facilitates the transfer of ownership of
securities in the electronic form.
4.Pledge and Hypothecation: Allows for pledging of
dematerialized securities as collateral for loans.
5.Corporate Actions: Efficient management of corporate actions
like dividends, interest, and bonuses.
Benefits of Depositories
• Safety: Reduced risk of theft, loss, or damage to physical
certificates.
• Efficiency: Faster settlement and transfer of securities.
• Cost-Effective: Lower costs associated with the transfer and
maintenance of securities.
• Transparency: Enhanced transparency and accuracy in the
recording and transfer of ownership.
Derivatives
Derivatives
• Derivatives are financial instruments whose value is derived from
the value of an underlying asset.
• These underlying assets can be stocks, bonds, commodities,
currencies, interest rates, or market indexes.
• The primary derivative instruments traded in India are futures
and options, available on the National Stock Exchange (NSE) and
the Bombay Stock Exchange (BSE).
Types of Derivatives
1.Futures Contracts:
• Definition: A futures contract is an agreement to buy or sell an asset at a
predetermined price at a specified time in the future.
• Example:
• Suppose an investor expects the price of gold to rise in the next three months. They
can buy a gold futures contract at the current price (let's say 8 grams- 50,000 ). If the
price of gold rises to 58,000 in three months, the investor can sell the contract at the
higher price, making a profit of 8000 (minus any fees).
•
Options Contracts:
• Definition: An option gives the holder the right, but not the obligation,
to buy or sell an asset at a specified price before or on a specified date.
• Types:
• Call Option: The right to buy an asset at a specified price.
• Put Option: The right to sell an asset at a specified price.
• Example:
• Call Option: An investor buys a call option on a stock with a strike price of 50,
expiring in one month. If the stock price rises to 60, the investor can exercise the
option to buy the stock at 50, then sell it at the market price of 60, making a
profit of 10 per share
• Put Option: An investor buys a put option on a stock with a strike price of 50. If
the stock price falls to 40, the investor can exercise the option to sell the stock at
50, making a profit of 10 per share (minus the premium paid for the option).
• Currency Derivatives:
• Definition: Contracts that derive their value from the exchange
rates of two or more currencies.
• Example:
• A company expecting to receive payment in a foreign currency in the
future might use a currency futures contract to lock in the exchange rate.
For instance, if an Indian company expects to receive $100,000 in three
months and wants to hedge against the rupee weakening against the
dollar, it can enter a futures contract to sell $100,000 at a predetermined
rate.
• Commodity Derivatives:
• Definition: Contracts that derive their value from the price of a
commodity such as oil, gold, or agricultural products.
• Example:
• An agricultural producer might use futures contracts to hedge against the
risk of falling prices. For example, a wheat farmer expecting to harvest
1,000 stacks in six months can sell wheat futures contracts at the current
price. If the price of wheat falls by the time of harvest, the farmer is
protected by the locked-in higher price from the futures contract.
Hedging and Speculation Using Derivatives
Hedging Using Derivatives
• Hedging involves taking a position in the derivatives market to
offset potential losses in the spot market. This is a risk
management strategy used by investors and companies to protect
themselves against adverse price movements.
• Suppose an investor holds shares of Reliance Industries. To protect
against a potential decline in the stock's price, the investor can buy
put options on Reliance Industries. If the stock price falls, the gains
from the put options will offset the losses in the stock holdings.
Speculation Using Derivatives
• Speculation involves taking a position in the derivatives market to
profit from expected price movements. Speculators assume risk in
the hope of making gains, without having any underlying exposure
• Example: A trader expects the price of Tata Motors to rise. Instead
of buying the stock, the trader can buy call options on Tata Motors.
If the stock price rises, the call options will become profitable,
providing leveraged returns.
Bond
Bond
• A bond is a fixed-income instrument that represents a loan made by an
investor to a borrower (typically corporate or governmental).
• Bonds are used by companies, municipalities, states, and governments
to finance projects and operations.
• Owners of bonds are debtholders, or creditors, of the issuer
• A bond is referred to as a fixed-income instrument since bonds
traditionally paid a fixed interest rate (coupon) to debtholders.
• Variable or floating interest rates are there
• Bonds have maturity dates at which point the principal amount must be
paid back in full or risk default
Who Issues Bonds?
• Bonds are debt instruments representing loans to the issuer, commonly
used by governments and corporations.
• Governments use bonds to fund infrastructure projects like roads,
schools, or during emergencies like war.
• Corporations borrow through bonds for expansion, purchasing assets,
funding projects, research, or hiring.
• Bonds provide access to large sums of money beyond what banks can
offer.
• Bond markets allow individual investors to act as lenders, enabling
them to buy, sell, or trade bonds among themselves, even after the
initial issuance by the organization.
How Bonds Work?
• The borrower (issuer) issues a bond that includes the terms of the
loan, interest payments that will be made, and the time at which
the loaned funds (bond principal) must be paid back (maturity
date).
• The interest payment (the coupon) is part of the return that
bondholders earn for loaning their funds to the issuer.
• The interest rate that determines the payment is called
the coupon rate
• The initial price of most bonds is typically set at at par, or face
value per individual bond.
• Most bonds can be sold by the initial bondholder to other
investors after they have been issued.
• In other words, a bond investor does not have to hold a bond all
the way through to its maturity date.
• It is also common for bonds to be repurchased by the borrower if
interest rates decline, or if the borrower’s credit has improved,
and it can reissue new bonds at a lower cost.
Types of Bonds
Government Bonds
• A debt security issued by a government to support government
spending, most often issued in the country's domestic currency.
• Government debt is money owed by any level of government and
is backed by the full faith of the government. Central and state
government issue the bonds through the RBI.
• The entire category of bonds issued by a government treasury is
often collectively referred to as "treasuries."
Corporate Bonds
• Companies borrow money by issuing bonds called corporate
debenture. These are riskier than the government bonds so
interest rate is also high.
Municipal bonds are issued by states and municipalities. Some
municipal bonds offer tax-free coupon income for investors.
Varieties of Bonds
Zero-Coupon Bonds
• Zero-coupon bonds (Z-bonds) do not pay coupon payments and
instead are issued at a discount to their par value that will
generate a return once the bondholder is paid the full face value
when the bond matures
Convertible Bonds
• Convertible bonds are debt instruments with an embedded option
that allows bondholders to convert their debt into stock (equity)
at some point, depending on certain conditions like the share
price.
Callable Bonds
• Callable bonds also have an embedded option, but it is different
than what is found in a convertible bond. A callable bond is one
that can be “called” back by the company before it matures.
Puttable Bond
• A puttable bond allows the bondholders to put or sell the bond
back to the company before it has matured. This is valuable for
investors who are worried that a bond may fall in value or if they
think interest rates will rise and they want to get their principal
back before the bond falls in value.
•Samurai Bonds: These are yen-denominated bonds issued in Japan by foreign entities. They offer a way
for foreign issuers to access Japanese capital markets and Japanese investors.
•Bulldog Bonds: These are pound -denominated bonds issued in the UK by foreign entities. They provide
a means for foreign issuers to raise capital from UK investors.
•Dim Sum Bonds: These are Chinese yuan-denominated bonds issued outside mainland China, typically
in Hong Kong. They allow foreign investors to invest in Chinese currency and help issuers diversify their
funding sources.
•Kangaroo Bonds: These are Australian dollar-denominated bonds issued in Australia by foreign entities.
They allow foreign issuers to tap into the Australian investor base.
•Maple Bonds: These are Canadian dollar-denominated bonds issued in Canada by foreign entities. They
give foreign issuers access to the Canadian market and investors.
•Panda Bonds: These are renminbi-denominated bonds issued in China by foreign entities. They offer a
way for foreign issuers to raise capital in China and attract Chinese investors.
•Matador Bonds: These are euro-denominated bonds issued in Spain by foreign entities. They allow
foreign issuers to access the Spanish market and its investors.
•Dragon Bonds: These are US dollar-denominated bonds issued in Asian markets by Asian entities. They
offer a way for Asian issuers to raise funds in US dollars and access a wider investor base.
• Case Study: The Demonetization Impact on Indian Stock Markets
• On November 8, 2016, the Government of India announced the demonetization of ₹500 and
₹1,000 currency notes to combat black money, counterfeit currency, and corruption. This
sudden move had immediate and profound effects on the Indian stock markets. The
following day, the Bombay Stock Exchange (BSE) Sensex and the National Stock Exchange
(NSE) Nifty 50 experienced significant volatility, with the Sensex dropping over 1,600 points
intraday before closing down by 338 points, and the Nifty 50 falling by approximately 541
points intraday, closing down by 111 points. Trading volumes surged as investors hurried to
adjust their positions. The BSE’s BOLT and NSE’s NEAT electronic trading systems efficiently
managed the increased volume, ensuring smooth operation despite high volatility. Clearing
corporations (NSCCL for NSE and ICCL for BSE) handled the heightened settlement load, and
SEBI’s regulatory oversight prevented market manipulation. Sectoral impacts varied, with
banks initially facing liquidity issues but later benefiting from increased deposits, while real
estate and consumer goods sectors were hit hard due to reduced cash transactions. IT and
export-oriented companies were less affected. The stock markets gradually recovered over
the following months, and by January 2017, the Sensex and Nifty had regained most of their
losses. Demonetization also spurred a significant increase in digital transactions, boosting
fintech companies. This event highlighted the resilience of India’s trading mechanisms and
the critical role of SEBI in maintaining market stability.
• Question: How did the electronic trading platforms and regulatory frameworks in India
contribute to maintaining market stability during the demonetization period, and what
lessons can be learned from this event to prepare for future economic disruptions?
Consumption and investments
with and without capital
markets
Consumption
• Consumption: The act of using goods and services to satisfy needs and
wants. In economic terms, it refers to the spending by individuals or
households on goods and services that are consumed immediately or over a
short period.
• Current Consumption: The use of goods and services in the present period.
• Future Consumption: The use of goods and services in a future period,
which can be facilitated by saving and investing current resources.
• Utility: Consumption is driven by the desire to achieve utility (satisfaction or
happiness) from the goods and services used.
• Examples:
• Food and Groceries: Buying and consuming food.
• Housing: Paying rent or mortgage for a place to live.
• Entertainment: Spending on movies, games, or vacations.
Investment
• Investment: The act of using resources (such as money, time, or effort) to create future
benefits. In economic terms, it refers to the allocation of resources to produce goods and
services that will be used in the future, aiming to generate returns or profits.
• Current Investment: The use of resources in the present to create future outputs or returns.
• Types of Investment:
• Physical Capital: Purchasing machinery, buildings, or infrastructure.
• Human Capital: Spending on education or training to improve skills and productivity.
• Financial Investment: Buying stocks, bonds, or other financial instruments to earn
returns.
• Examples:
• Business Investment: A company purchasing new equipment to increase production
capacity.
• Personal Investment: An individual saving money in a bank account or investing in the
stock market.
• Education: Spending on schooling or training programs to enhance future earning
potential.
Relationship Between Consumption and
Investment
• Trade-Off: Trade-off between consumption and investment.
(Resources used for consumption cannot be used for investment
and vice versa.)
• Current vs. Future: Choosing to consume more today means fewer
resources available for investment, which could reduce future
consumption possibilities. Conversely, investing more today can lead
to greater consumption in the future due to the returns generated
by the investment.
• Individual Decisions: Each individual's decision on how much to
consume now versus how much to invest for the future depends on
their preferences, needs, and expectations about future returns.
Consumption and investments
without capital markets
Example: Robinson Crusoe Economy
Scenario
• Robinson Crusoe has an initial endowment of resources (e.g., food,
tools) that he can use for current consumption or invest to improve his
future living conditions.
• Decision-Making
1.Consumption:
• Crusoe decides to consume part of his resources to meet his immediate needs
(e.g., eating some of his food).
• This provides him with immediate utility (satisfaction from not being hungry).
2.Investment:
• Crusoe invests some of his resources in productive activities (e.g., planting crops,
building a shelter).
• This reduces his current consumption but is expected to yield returns in the
future (e.g., more food from the crops, better living conditions from the shelter).
Assumptions
• All outcomes from investment are known with certainty
• No transaction costs or taxes
• Decisions are made on the basis of one-period
• Individuals are endowed with income at the beginning of the period
(today), yo, and at the end of period (tomorrow), y1.
• They must decide how much to actually consume now (today), Co, and
how much to invest in productive opportunities in order to provide
end-of-period (tomorrow) consumption, C1
• Every individuals prefer more consumption to less. The marginal utility
of consumption is always positive.
• The marginal utility of consumption is decreasing
Total utility of consumption

• As the consumption increases

in equal proportions, utility
increases but in a lesser
proportion.
• i.e. Marginal Utility
decreases.
• Each extra unit of
consumption adds less utility.
Consumption today (C0) & Consumption
tomorrow (C1)

Along the curves between U(C1) and

U(Co), there is same total utility.
i.e. Points A and B have
same utility.
So these are indifference
curves.
Indifference curves representing the time
preference of consumption
❖ Pt A - More consumption (tomorrow) end of the
period and less consumption at the beginning (today)

❖ Pt B - Less consumption at end of the period and more

consumption at the beginning

❖ Pt D - More consumption at both period than A and B.

D is also on a higher utility curve.

❖ The trade-off between Co and C1 is called as the

Marginal Rate of Substitution (MRS)
MRS = SUBJECTIVE RATE OF TIME PREFERENCE
Decisions on whether to consume now (Co) or invest
(C1) can be made by looking at: r (subjective rate of
time preference) MRS = (1+r)
Marginal Rate of Substitution (MRS) and
Subjective Rate of Time Preference
• Marginal Rate of Substitution (MRS): The rate at which an individual
is willing to trade current consumption (C0)for future consumption
(C1​) while maintaining the same level of total utility.
• Subjective Rate of Time Preference: An individual's personal interest
rate that reflects their preference for current consumption over future
consumption.
Understanding MRS
• MRS is the slope of the indifference curve at a given point.
• It measures how much future consumption an individual requires to
give up one unit of current consumption without changing their overall
satisfaction.
An individual's schedule of investment
opportunities.

❖ Diminishing rate of returns because the more the

individual invests, the lower the rate of return.

❖ Rate at which a unit of consumption today (Co) is

given up in order to have productive investment
and consumption tomorrow (C1).
MRS and MRT
MRS MRT

The Marginal Rate of Substitution It shows how many units of future

(MRS) is the rate at which a consumer consumption can be produced by
is willing to trade one good for another sacrificing one unit of current
while maintaining the same level of consumption through investment.
utility.
Consumer theory (trade-off between Production theory (trade-off between
goods or consumption over time) outputs or investment over time)
If his MRS is 2, it means he is willing to If his MRT is 3, it means that by giving
give up 2 units of future consumption up 1 unit of current consumption
to gain 1 additional unit of current (saving it), he can produce 3 additional
consumption while maintaining the units of future consumption.
same level of utility.
Productive investment opportunity set
• Combining the indifference curves and investment
opportunity schedule to decide between C1 and Co with
the given Investment opportunities.

• Without capital markets, the individual decision maker

starts with an initial endowment (yo,y1) and compares
the marginal rate of return on productive investment
with the subjective time preference r.

• If the rate on return is greater, he will invest and gain

utility. This will continue till the individual's rate on
return is equal to the subjective time preference i.e.
MRT=MRS.
Below U1
Point Z→ MRS<MRT → invest more
Point L→ MRS>MRT → invest less
U2- Point B → MRS=MRT
Optimal consumption at (Co, C1)
Productive investment opportunity set for
two individuals
• Without the existence of capital
markets, two individuals with
same endowments and same
productive investment
opportunities will choose different
investments because they have
different indifference curves.
• Individual 2 has a lower rate of
time preference MRT>MRS
• So he will choose to invest more
than individual 1.
Production/Consumption
with Capital Markets
 Production/Consumption with Capital
Markets
Assumptions:
• Frictionless Capital Markets
• No taxes, transactions costs or constraining regulations. Assets are perfectly divisible.
• Two period model
• Perfect competition in product and securities markets
• Markets are informationally efficient
• Agents are rational, expected utility maximisers
• Assume there are a lot of consumers in the market
• Some of them would like to borrow funds to consume more today and some would be
interested in lending funds to consume more tomorrow
• The capital market facilitates the transfer of funds between lenders and borrowers
• Every consumer can borrow or lend unlimited amount at the market determined rate of
interest r.
Introduction of Financial Markets
❖When financial markets are introduced, individuals have the
opportunity to exchange intertemporal consumption. They can
borrow or lend at a market-determined interest rate r.
Financial Markets and Capital Market Line
❖Financial markets facilitate the transfer of funds between lenders
and borrowers.
❖Assuming positive interest rates, any amount of funds lent today
will return the principal plus interest at the end of the period.
❖This can be represented on a graph where the x-axis is current
consumption (C0) and the y-axis is future consumption (C1).
 Case 1: No production
opportunity. But individuals
can lend/borrow at r.
•Starting from the initial endowment
point (y0,y1) an individual can choose
to move to any point on the capital
market line by borrowing or lending.

•With an initial endowment of (yo, y1)

that has utility equal to U1, we can
reach any point along the market line
by borrowing or lending at the market
interest rate plus repaying the
principal amount, X
• When an individual borrows or lends at the market interest rate r, the
future value of the amount X0​ he borrows or lends can be calculated as:

• Simplified :

➢Xo​ is the principal amount (the initial amount borrowed or lent).

➢r is the market interest rate.
➢𝑋1 is the future value including the interest.
 Present Value Calculation
• Present Value (Wo): The present value of the initial endowment is the sum
of current income Yo and the present value of future income Y1. The
formula for present value is

where:
• Wo is the present value of the endowment.
• Yo is the current income.
• Yi is the end-of-period income.
• r is the market interest rate.
This formula reflects the idea that future income yi needs to be discounted to
present value terms to account for the time value of money.
Subjective vs. Market Rate:
• If your subjective time preference (the rate at which you discount
future consumption) is less than the market interest rate r, you will
prefer to lend (save) because the market offers a return higher than
what you subjectively require.
• Moving along the market line, you will seek to maximize utility by
choosing a consumption bundle where your subjective rate of time
preference equals the market rate.
Optimal Consumption Bundle (Point B):
• Point B: This point represents the
optimal consumption bundle
(Co,C1) where your utility is
maximized, and you are on the
highest attainable indifference
curve U2
Case 2: Individuals can now
borrow/lend at r & invest in
production opportunities.
Combines production possibilities with market
exchange possibilities

• With only production opportunity, the

individual achieve U2 only. But if capital
market is introduced, he can do better.
• At point D, the individual can borrow
more money at rate r from the capital
market, and be able to invest more and
get return higher than r.
• Until in equilibrium, he reaches B, where
the return on the marginal investment is
equal to the market interest rate r. At this
point, his wealth is maximized.
• With his wealth maximized, he chooses to
consume C and yield him U3 .
•Investor 1: This investor prefers to consume more today than their
share of current production allows. They can borrow from the capital
market today and repay in the future from their share of future
production.
•Investor 2: This investor prefers to consume less today. They can
lend in the capital market and save their share of current production
to consume more in the future.

Enhanced Utility:
•With Capital Markets: Both investors can achieve higher utility by
borrowing or lending according to their preferences. Without capital
markets, Investor 1 and Investor 2 would be constrained and
potentially less satisfied with their consumption choices.
•Without Capital Markets: Investor 1 would face lower utility by
producing at point Y, and Investor 2 would face lower utility at point
X.

Equilibrium:
•Marginal Rates Equality: In equilibrium, the Marginal Rate of
Substitution (MRS) for all investors = the market interest rate, which
also equals the MRT for productive investment.
Importance of Capital Markets
•Efficient Fund Transfer: Capital markets facilitate the efficient allocation of
funds between those who have surplus funds and few investment opportunities
(lenders) and those with many investment opportunities but insufficient funds
(borrowers).

•Borrowers and Lenders: Capital markets enable individuals with less wealth
but good investment opportunities to access additional funds, while those with
excess wealth but fewer opportunities can invest their funds elsewhere.

•Enhanced Allocation By enabling borrowing and lending, capital markets

help ensure that funds are used more efficiently, leading to higher overall
returns and better economic outcomes for all parties involved.
Without Capital Markets
• Production: Limited by the available wealth and resources, with decisions
potentially constrained by personal consumption preferences.
• Consumption: Fixed by current income and wealth, with no ability to borrow
or lend to adjust consumption preferences between present and future.

With Capital Markets

• Production: Made based on objective criteria (e.g., where the Marginal Rate of
Transformation (MRT) equals the market interest rate.
• Consumption: Adjusted according to individual preferences by borrowing or
lending at the market rate to match subjective time preferences.

Without Capital Markets: Production and consumption are intertwined, with

less flexibility and efficiency in resource allocation.
With Capital Markets: Production and consumption are separated, with
efficient allocation of resources and flexible consumption.
 Marketplace and
Transactions Costs
Transaction Cost
• Transaction cost refers to the costs associated with making an
economic exchange. These costs are incurred when buying or selling
goods or services and can impact the efficiency of markets and the
behavior of economic agents
Types
1. Search and Information Costs- Costs related to finding the right
products or services and obtaining relevant information about them.
Time and effort spent searching for the best price, evaluating product
quality, or comparing different options.
2. Bargaining and Decision Cost- Costs associated with negotiating
terms of exchange and making decisions. Time spent negotiating prices,
drafting contracts, or reaching an agreement.
3. Contracting Cost - Costs involved in drafting, enforcing, and
managing contracts.-: Legal fees for writing contracts, costs related
to monitoring compliance, and expenses from resolving disputes.
4. Monitoring and Enforcement Costs- Costs related to ensuring
that parties adhere to the agreed terms of exchange.
• Examples: Costs of auditing, inspecting, and enforcing contract
terms.
5. Administrative Costs- Costs associated with the overall
administrative processes of transactions.
• Examples: Costs of maintaining records, processing paperwork,
and handling regulatory requirements.
Situation 1: A primitive exchange economy
with no central marketplace.
• In a world without transaction costs, you don't need a central
marketplace because you can exchange goods directly between
producers.
Primitive Economy Example:
• Imagine a small economy with N producers, each making a
different product and needing to consume all N products. Without
a central marketplace, each producer must visit every other
producer to exchange goods.
• If there are 5 producers:
• Producer 1 needs to visit 4 others.
• Producer 2 visits 3 others, and so on.
• Total trips = For 5 producers,
that’s 10 trips.
Cost of Exchange:
• Each trip costs T Rupees.
• Total cost without a marketplace
Situation 2: The productivity of a central
marketplace.
Each producer only needs to make 1 trip to the
marketplace.
• For 5 producers, this is 5 trips.
• Total cost with a marketplace = N X T
Savings:
• By having a marketplace, you save trips and thus
transaction costs. The savings are

• For 5 producers, savings =

 Role of Financial Intermediaries
• When transaction costs are significant, financial
intermediaries (like banks) help by managing these costs.

• Borrowing and Lending Rates: Banks pay interest on

deposits (lending rate) and charge higher interest on loans
(borrowing rate).

• The difference is their fee for the service.

Impact of Transaction Costs
• When transaction costs are present, borrowing and lending rates
differ. This means:
• Individual 1: Might prefer investments based on the lower lending rate.
• Individual 2: Might prefer investments based on the higher borrowing
rate.
• Investment Choices: Without a single market rate, individuals will make
different investment choices based on their preferences and available
rates.
Scenario
• Imagine two individuals, Tom and Jerry, who are evaluating an
investment opportunity in India. Due to different transaction costs
and market conditions, they have different borrowing and lending
rates.

Tom Jerry

Lending Rate: 4% per annum Lending Rate: 6% per annum

Borrowing Rate: 10% per annum Borrowing Rate: 12% per annum
Investment Opportunity:
Project X: Requires an investment of ₹1,00,000
and offers an expected return of 15%.
Tom Jerry
Investment Using Own Funds: Investment Using Own Funds:
I₹1,00,000 using his own money, he earns a 15% return. Return on Investment (ROI) = ₹1,00,000 * 15% = ₹15,000.
Return on Investment (ROI) = ₹1,00,000 * 15% = ₹15,000. Opportunity Cost:If Jerry had lent the ₹1,00,000 at a 6%
Opportunity Cost:If Tom had instead lent the ₹1,00,000 at a lending rate, he would have earned ₹6,000.
4% lending rate, he would have earned ₹4,000.
Investment Using Borrowed Funds: Investment Using Borrowed Funds:
If borrows ₹1,00,000 at a 10% rate, the interest expense is If ₹1,00,000 at a 12% rate, the interest expense is ₹12,000.
₹10,000. Return on Investment (ROI) = ₹1,00,000 * 15% = ₹15,000.
Return on Investment (ROI) = ₹1,00,000 * 15% = ₹15,000. Net Return (after paying interest) = ₹15,000 - ₹12,000 =
Net Return (after paying interest) = ₹15,000 - ₹10,000 = ₹3,000.
₹5,000. Preference: would prefer using own funds
Preference:
Tom prefers using his own funds
Conclusion

•Tom : might prefer investments based on their lower lending rate, making it advantageous
for them to use their own funds rather than borrowing, as it maximizes their net return.
•Jerry faces higher costs of borrowing, which makes them cautious about using borrowed
funds and places more value on the use of their own money, though borrowing is less
favorable due to the higher rate.
Investment Decisions:
The Certainty Case
Key Assumptions in the Certainty Case
• Time Value of Money: Investment decisions are based on the
market-determined interest rate, which is assumed to be known
and constant over time. This means the future value of money is
predictable and does not involve uncertainty.
• Perfect Information: Future payoffs from investments are
assumed to be known with certainty, and there are no transaction
costs or market imperfections.
Investment Decision Basics

• Purpose: Investment decisions revolve around choosing how

much to save (or invest) now to increase future consumption. This
involves deciding whether to consume today or invest for future
benefits.
• Objective: The goal of investment decisions is to maximize overall
satisfaction or utility from consumption over time.
Investment :Application Across Sectors
• Individuals: For personal finance, individuals save money if they
believe the benefit of future consumption (from saving) outweighs the
benefit of immediate consumption.
• Corporations: Managers decide between paying dividends (which
shareholders can use now) or reinvesting profits into projects that will
provide future returns. The aim is to maximize the future value of the
company, which translates to shareholder wealth.
• Not-for-Profit Organizations: They aim to maximize the utility for
their contributors, often by effectively using donations to achieve their
missions.
• Public Sector: Government managers aim to maximize the utility for
the public through effective use of public funds.
 FISHER SEPARATION:
THE SEPARATION OF INDIVIDUAL UTILITY
PREFERENCES FROM THE
INVESTMENT DECISION
FISHER SEPARATION
• The Fisher Separation Theorem is a concept in finance that addresses
how a firm can maximize shareholder wealth despite individual
differences in preferences for consumption over time.
• a firm's choice of investment is separate from its owners' investment
preferences and therefore the firm should only be motivated to
maximize profits.
• Firms can maximize the present value of future returns by making
investment decisions independently of their shareholders’ consumption
preferences.
• Shareholders can adjust their personal consumption through
borrowing or lending in the perfect capital market, without affecting
the firm’s investment decisions.
Assumptions of the theory
• Perfect capital markets (no transaction costs or taxes).
• Equal borrowing and lending rates.
• Rational investors focused on maximizing utility.
• Perfect information for all market participants.
• Investment decisions based on maximizing Net Present Value
(NPV).
Example: The Widget Company
Scenario
Investment Opportunity: Widget Corp is considering a new
project that requires an initial investment of ₹10 crore and is
expected to generate ₹15 crore in returns after one year. The market
interest rate (the cost of capital) is 10%.
Shareholders’ Preferences: Widget Corp has two shareholders:
• Shareholder A prefers to consume most of their wealth now and
save less for the future.
• Shareholder B prefers to save more now and consume later.
Investment Decision
According to the Fisher Separation Theorem, Widget Corp should
evaluate the investment based on the market rate of return. If the
project’s return exceeds the market rate, it should be accepted.
1.Expected Return on Investment:
• Initial Investment: ₹10 crore
• Expected Return After One Year: ₹15 crore
2.Return on Investment (ROI) can be calculated as:
• Market Rate of Return: 10%
• Since 50% (ROI) is greater than 10%
(market rate), the project is worthwhile.
• Decision: Widget Corp should invest in
the project.
 Result of investment decision
• Maximizing Shareholder Wealth- By investing in the project, Widget Corp increases the overall value of
the firm. The increased value is reflected in the higher returns.
• Impact on Shareholders
➢ Shareholder A will receive a cash payout from the firm, which they can use for immediate consumption.
➢ Shareholder B will also receive a payout but might choose to save it for future consumption.
• Despite their different consumption preferences, both shareholders benefit from the increased value
created by the investment.
Managing Consumption Preferences
Each shareholder can adjust their personal consumption pattern by borrowing or lending at the market
rate:
➢ Shareholder A (prefers to consume now) can borrow against future dividends. For instance, if
Shareholder A needs extra funds now, they could borrow from a bank or financial institution using their
expected future returns as collateral.
➢ Shareholder B (prefers to save) can lend their share of the payouts at the market rate to earn interest.
For example, Shareholder B could deposit the payout in a savings account or invest in fixed deposits to
earn interest.
Separation Principle & Unanimity
Principle
• Separation Principle
The Fisher Separation Principle emphasizes that the firm’s investment
decision should focus solely on maximizing shareholder wealth,
irrespective of individual consumption preferences. The optimal
investment decision is to invest in projects that exceed the market rate of
return.
• Unanimity Principle
Even though Shareholder A and Shareholder B have different preferences
for consumption, they both benefit from the firm’s investment decision.
This is due to the ability of capital markets to allow individuals to adjust
their personal consumption preferences independently through
borrowing and lending.
Even though the two
individuals in Fig. 2.1 choose
different levels of current and
future consumption, they have
the same current wealth, Wo.

This follows from the

fact that they receive the same
income from productive
investments (Po, P1).
Conclusion of the theory
1.Optimal Investment: Widget Corp invests in projects with a
return higher than the market rate.
2.Shareholder Benefit: Both Shareholder A and Shareholder B
benefit from increased firm value, even though they have different
consumption preferences.
3.Capital Markets: Shareholders can adjust their consumption
through borrowing or lending at the market rate.
• The Fisher Separation Theorem thus shows that firms can focus on
wealth maximization while shareholders manage their individual
consumption preferences using capital markets.
Case Study: SolarTech Innovations Pvt. Ltd.
• SolarTech Innovations Pvt. Ltd. is evaluating an investment to expand its solar panel
manufacturing facility, requiring ₹20 crore and promising ₹30 crore in returns after
one year, with the market interest rate at 8%. According to the Fisher Separation
Theorem, the decision to invest should be based solely on whether the project's
return exceeds the market rate, which it does in this case with a 50% return
compared to 8%. Shareholder A, who prefers immediate consumption, will benefit
from the returns now and could borrow if needed, while Shareholder B, who prefers
saving, will reinvest their share for future gains. This approach allows the company
to focus on maximizing shareholder wealth regardless of individual consumption
preferences, demonstrating how capital markets enable shareholders to manage
their consumption preferences independently.
• Question: How does the Fisher Separation Theorem facilitate optimal investment
decisions for SolarTech Innovations Pvt. Ltd. while accommodating the differing
consumption preferences of its shareholders?
Breakdown of Fisher Separation
• In a world with transaction costs and differentiated borrowing and
lending rates, the Fisher Separation Theorem breaks down because
individuals will no longer make the same investment decisions.
Different Borrowing and Lending Rates
• Lending Rate: The interest rate an individual receives when they lend
money (deposit in a bank, for example).
• Borrowing Rate: The interest rate charged when they borrow money
(take a loan).
• The borrowing rate is typically higher than the lending rate, and this
difference represents the transaction costs or the fee charged by
financial intermediaries.
Effect on Investment Decisions:
Without Transaction Costs (Perfect Capital Markets):
• Individuals can borrow or lend at the same rate.
• Every individual, regardless of their risk preferences or
consumption choices, will direct the firm’s manager to invest at
the same point, optimizing wealth and maximizing present value
(Fisher Separation).
• The individual’s consumption decisions can then be separated
from the firm's investment decisions.
With Transaction Costs (Imperfect Capital
Markets):
• The difference between borrowing and lending
rates causes individuals to make different
investment decisions.
• Individual 1 (who prefers to lend) will use the
lower lending rate and choose a conservative
investment at point B on the production
opportunity set (lower risk, lower return).
• Individual 2 (who prefers to borrow) will use
the higher borrowing rate and choose an
aggressive investment at point A (higher risk,
higher return).
• A third individual may choose an investment
between these two points, reflecting their own
preferences and cost of capital.
Breakdown of Fisher Separation:
• The core of Fisher’s theorem assumes that all individuals face the
same interest rate in perfect markets, allowing them to separate
the investment decision from their consumption preferences.
• When transaction costs exist (i.e., borrowing and lending rates
differ), this no longer holds. Individuals have different effective
costs of capital, leading them to make different investment
choices.
• As a result:
• Investment decisions become subjective, depending on the individual's
unique borrowing/lending rate and personal preferences.
• This breaks the separation between consumption preferences and
investment decisions, as the firm’s optimal investment now depends on
the preferences of the shareholders.
Implications:
• In reality, capital markets are not frictionless, and transaction
costs are present.
• The breakdown of Fisher Separation means that financial theories
that assume perfect markets must be refined to account for taxes,
information asymmetries, and transaction costs.
THE AGENCY PROBLEM.
DO MANAGERS HAVE THE CORRECT
INCENTIVE TO MAXIMIZE
SHAREHOLDERS' WEALTH?
Agency Problem
• The agency problem arises in situations where there is a
separation between ownership and control of a firm.
• This problem concerns the potential conflicts of interest between
managers (agents) and shareholders (principals)
• a conflict of interest inherent in any relationship where one party
is expected to act in another's best interests.
Main Concepts in Agency Problem
1.Ownership vs. Control:
❑Owners (Shareholders): They provide capital to the firm and expect
returns on their investment.
❑Managers: They are hired to run the firm on behalf of the shareholders.
They make decisions about which projects to undertake and how to
manage the firm.
2.Conflict of Interest:
❑Principal-Agent Relationship: Shareholders (principals) want managers
(agents) to make decisions that maximize shareholder wealth. However,
managers might have their own interests, which could be different from
those of the shareholders.
Example: The Agency Problem
Tech Innovators Inc., with the following structure:
➢Shareholders: Own shares in the company and want to maximize
their returns.
➢Managers: Make day-to-day decisions about the company's
operations and investments.
Scenario 1: Aligning Interests
➢Shareholders’ Goal: Maximize the company's stock price and
overall shareholder wealth.
➢Managers’ Goal: Ideally, they would make decisions that align
with this goal.
However, managers might pursue personal interests:
• Perks: They might enjoy higher salaries, luxurious offices, or other
non-monetary benefits.
• Project Choices: Managers might prefer projects that increase
their personal prestige or job security rather than those that
maximize shareholder returns.
 Example Issue:
Project Selection: Suppose there are two projects:
• Project A: Has a high rate of return and aligns with
shareholders’ goal.
• Project B: Offers moderate returns but involves significant
personal benefits for managers, such as public recognition or
more resources.

• If managers prioritize Project B due to personal benefits, they are

not acting in the best interest of shareholders.
 Solutions to the Agency Problem
1.Incentives:
• Equity Compensation: Shareholders can provide managers with stock options or
shares. This aligns managers’ interests with those of shareholders, as managers
would directly benefit from an increase in the company's stock price.
• Performance Bonuses: Tying bonuses to performance metrics related to
shareholder value, such as return on investment (ROI) or earnings per share
(EPS), can help align interests.
2.Monitoring and Governance:
• Board of Directors: A well-functioning board can oversee and evaluate
management decisions to ensure alignment with shareholder interests.
• Audits: Regular audits and financial reviews can help detect any deviations from
optimal decision-making.
3.Contracts:
• Management Contracts: Clear and specific contracts can define the goals and
incentives for managers, making their responsibilities and rewards closely aligned
with shareholder interests.
 Case Study
• GreenTech Solutions Ltd., a rapidly growing renewable energy company, faced a
challenge when its CEO, Mr. Sharma, began prioritizing expansion projects that
would increase the company's size and his personal prestige. He proposed
acquiring a smaller, unrelated business in a different sector, arguing that
diversification would benefit the company. However, many shareholders,
including Ms. Patel, a major investor, were concerned that this move would divert
resources from the core business of renewable energy, potentially lowering
overall profitability. They suspected that Mr. Sharma’s motivation was more
about enhancing his reputation than maximizing shareholder value.
• Despite shareholders' concerns, Mr. Sharma proceeded with the acquisition,
using the company's retained earnings and taking on new debt. Over time, it
became evident that the acquisition was not as profitable as anticipated, and
GreenTech's stock price declined. Shareholders were left questioning whether
their interests were being properly represented by the management.
• Question: How could GreenTech Solutions Ltd. have better aligned the interests
of management and shareholders to avoid the agency problem in this scenario?
 Maximization of
Shareholders' Wealth
1. Dividends vs. Capital Gains
1. Definition of Shareholders' Wealth
• Shareholders' wealth is defined as the discounted value of after-
tax cash flows paid out by the firm to its shareholders.
• These after-tax cash flows are typically represented as the stream
of dividends paid to shareholders.
• Present Value of Shareholders' Wealth
The present value of shareholders' wealth S0 can be calculated using
the following formula:
Example: Calculating the Present Value
The present value of the stock, whether you hold it forever or for a specific
period (like five years), is approximately the same—₹100.00. This shows how
the expected dividends and the final stock price contribute to the stock's current
value.

•The equation S0 ​ represents the discounted value of the stream of cash

payments (dividends) to shareholders and thus defines shareholders' wealth.
2. The Economic Definition of Profit
• 1. Economic vs. Accounting Profit
• Economic Profit: Economists define profit as the rate of return
that exceeds the opportunity cost of capital employed in projects
of equal risk.
• Accounting Profit: Often referred to as net income, it is the
difference between revenue and explicit costs like wages,
materials, and services. Unlike economic profit, it does not account
for the opportunity cost of capital.
Opportunity Cost and Cash Flows

• To estimate economic profit, you need to know:

• The exact time pattern of cash flows provided by a project.
• The opportunity cost of capital, which represents the return that could
have been earned on an investment of similar risk.
• The pattern of cash flows is equated with the stream of dividends
paid by the firm to its shareholders. These dividends include:
• Regular cash payouts.
• Capital gains.
• Other cash payouts like, payments in liquidation, share repurchases, and
others.
Economic Profit as Discounted Cash Flows
Difference Between Economic and
Accounting Profit
Adjusting Accounting Profit for Economic
Profit
Focus Maximum Wealth

• Focusing only on EPS can mislead managers. Shareholders value a

company based on its ability to generate cash flows in the future, not
just its current earnings.
• Therefore, maximizing cash flow (and thus stock value) should be the
primary goal, not just boosting EPS.

In this case, while FIFO makes the EPS look better,

LIFO generates more cash because of lower taxes.
Since shareholders care about cash flow (which
affects the stock price), they will prefer the
company using LIFO, as it maximizes their wealth.
Irving Fisher's Theory of Investment
• Irving Fisher, a prominent economist, introduced his theory of
investment in his works from the early 1900s.
• His most famous exposition of this theory is in his book The
Theory of Interest (1930).
• Fisher's theory views investment decisions as a problem of
allocating resources over time.
 Key Assumptions
• All Capital is Circulating Capital:
Fisher assumed that all capital is used up during the production process. This means that instead of
having a fixed "stock" of capital, the focus is on continuous investment.
• Investment and Output:
Fisher proposed a simple production function where output in the second period depends on the
investment made in the first period. For example, if you invest during period 1, the output will be
produced in period 2.
•Investment Frontier:
The relationship between investment in period 1 and output in period 2
can be shown as a curve, where increasing investment leads to higher
output, but at a diminishing rate (due to decreasing returns on
investment).
•Interest Rate:
The cost of investing includes the interest rate. The firm seeks to maximize
its profit, which happens when the additional return from investment
equals the cost of investment (including interest).
Profit Maximization Problem
• Fisher's theory considers how a firm decides the optimal amount
of investment I1​ in the first period, aiming to maximize profit.