The two-period model
Escuela de Negocios Universidad de Chile
Miscellaneous
• Quiz One 19/10
• WorkShops
• Project - Essay 3000 words top.
– Individual work.
– Use the Bloomberg commands
– Describe the firm.
Economic Theory
Financial Economics
Corporate Finance
Intro
The two-period model is an economic (macroeconomic)
model used to develop the principles on how market
participants allocate their income between the present
and the future.
Perfect Capital Markets
• Prices are formed freely. (supply and demand)
• Buyers or sellers can´t influence the prices of these.
• No asymmetries. Markets are transparent, i.e. information for intermediaries and
investors must be the same.
• Homogeneity. Traded goods are the same, i.e. their exchange is easier.
Summary
…..intertemporal choice, Decisions that
have consequences in multiple time
periods are intertemporal choices
Base Line
• Developing intuitions about equilibrium solutions for
consumption and the cost of consuming today or in
the future, and the same for investment, requires to
consider factors such as time preference, risk
tolerance, interest rates, and changes in income.
General Framework
The model involves variables like consumption and investment.
By simplicity it extends only to two periods. Today and the
future. (C0,C1,I0,I1, W0,W1,U0,U1, etc...)
• This model provides valuable information on how individuals
make intertemporal decisions about consumption and
investment.
Assumptions of the Model
Well-behaved decisions. The model allows to study
long-term decisions on the value of the company and
the wealth of the shareholder, in a context of perfect
certainty and a perfect capital market.
Assumptions:
The flows generated by the investment are known with certainty.
There are no transaction costs or taxes.
Individuals are rational.
Perfect competition in the financial instruments market.
• Markets are efficient from an informational point of view.
Important Concepts
In economics, the marginal rate of substitution (MRS)
measures consumer demand, while the marginal rate of
transformation (MRT) measures producer supply
Consumption & Investments (W/ CM)
Relationship (1) between Utility and Consumption
Consumption & Investments (W/ CM)
MRS= Marginal Rate of Substitution between present consumption and future
consumption.
It reveals the subjective rate of preference of the individual "ri".
• It reveals how many units of future extra consumption should be received for each unit of
present consumption that is sacrificed (keeping the level of utility constant). Also is a
measure of how much market participants think interest rates might change in the future
To make the investment decision, the available projects must be identified (sorted by
profitability).
The set of investment opportunities is an orderly representation of the profitability offered by
existing projects.
• Thus the TMT=Marginal Rate of Transformation. It defines the exchange rate by which a
present unit of consumption that is postponed is transformed by means of productive
investment into a unit of future consumption (slope at point A, maximum level of return).
Consumption & Investments (W/ CM)
Relationship (2) Consumption and Investment Opportunities
• We need to relate consumption, utility functions, marginal rate of returns and all
investments.
• Consider the ratio savings to invesments to understand productive opportunities.
Consumption & Investments (W/ CM)
Relationship (3) Utility , Consumption and Investment
Opportunities
• All together, investment productive opportunities for markets participants are
assessed at the rate to which one dollar of consumption today changes or is
transformed to one dollar of consumption tommorrow.
• That is MRT, marginal rate of transformation.
Consumption & Investments (W/ CM)
So why this condition holds, MRS=MRT?
• Because market participants have an initial wealth.
• They comparte the marginal rate of return with the subjective rate of interest.
• Hence, they invest or desinvest based on that set of information.
• i.e. Robinson Crusoe case.
Consumption & Investments (With Capital Markets)
In the presence of Capital Markets this can differ!!
“We need to understand the role of borrowing”
Consumption & Investments (With Capital Markets)
• Capital Markets provide the interest rate.
• Thus, we can rearrange previous definitions.
– W0= Y0 +
– W0= C0 +
Fisher's Principle of Separation
Optimal Decision and Capital Market Benefit...
A: Initial situation: TMS < (1+r)
B: Optimal investment decision: TMT = (1+r) (Po, P1)
C: Optimal Consumption Decision: TMS = (1+r) (Co*, C1*)
D: The capital market is not used (lower level of profit)
• Wo*-Wo= Increase in the wealth of the individual/maximize enterprise value (NPV)
Fisher's Principle of Separation: Separate and Independent Decisions...
• Choose the optimal production/investment through making projects until the
marginal rate of return of the last project equals the market interest rate.
Objective criterion and independent of subjective preferences.
• Choose the optimal pattern of consumption by lending or borrowing along the
capital market line until the TMS equals with (1+r).
