448_01Introduction

448_01Introduction - Lecture Notes 1 What is Corporate...

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1 Lecture Notes 1 What is Corporate Finance and why is it important? • Corporate finance is the study of the investment decisions made by corporations and the way that investment is financed . An overview of the economic analysis of investment • Investment involves giving up some consumption today in return for obtaining additional con- sumption in the future. • Simplest model of the investment process – a farmer has a quantity of grain. Either it can be con- sumed today or some of it can be kept as seed grain for next year’s crop: Figure 1: Consumption and investment opportunities of a sole proprietor • Initially, one seed held over for planting will yield much more than one grain in return. The slope of the intertemporal production possibilities frontier will be much steeper than -1. Eventually, the farmer will run out of land to plant. A seed retained can then only be stored for future con- sumption. If there is no loss in storage, the slope of the frontier will decline to -1. More generally, consumption today consumption next period investment
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2 if there is depreciation of the asset (deterioration of the grain) the slope of the frontier will flatten to (1 −δ ) • In general, consumers would like to consume both today and tomorrow – although they will get decreasing marginal utility from consumption in any one period and they will prefer to consume sooner rather than later, other things equal. • Specifically, we can represent a consumer’s indifference curves as in the following diagram. These are all possible different combinations of consumptions in the two periods that neverthless yield the same total level of utility. Figure 2: Intertemporal indifference curves • The indifference curves drawn in Figure 2 reflect an assumption that the individual experiences decreasing marginal utility of consumption in each period. As current consumption increases, larger increases in current consumption are required to compensate the individual for a given- sized decrease in future consumption. Conversely, as future consumption increases, larger in- creases in future consumption are required to compensate the individual for a given sized de- crease in current consumption. consumption today consumption next period
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3 • The slope of their indifference curves along the 45 line where c t and c t +1 are equal will in general be steeper (more negative) than -1. When they are consuming equal amounts in the two periods, the consumers will need to receive more than one unit of consumption next period for each unit of consumption they give up this period. They will discount future consumption. The time rate of discounting is given by the extent to which the slope of their indifference curves along the 45 line is more negative than -1. • With preferences such as these, the consumer will generally be better off when an investment op-
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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448_01Introduction - Lecture Notes 1 What is Corporate...

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