In finance, everything comes down to promises. When you invest money, questions arise: how profitable will it be down the line, and is it worth investing today? Determining the exact amount of those returns and whether investing is worthwhile can be challenging.
This lecture will introduce the concept of Net Present Value. It will discuss how NPV helps managers satisfy shareholders without direct interaction, and how it can evaluate uncertain future payoffs in order to meet investor expectations.
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A lecture by Raghavendra Rau recorded on 2 October 2023 at Barnard's Inn Hall, London
The transcript and downloadable versions of the lecture are available from the Gresham College website: https://www.gresham.ac.uk/watch-now/net-present-value
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Now, uh, last year, my series of lectures were covering the area of how technology affects the world of finance. This year, I'm going to step back, right? What is finance all about? So I'm gonna talk about the six big ideas of finance. In fact, that's all finance consists of six ideas. So this lecture coincides with the Nobel Prize announcement next Monday for economics. I can pretty sure it'll probably not be given to a finance professor because we really haven't come up with a new idea in nine since 1980. So it's about time we did something. But all these ideas go back to the 1980s, right? So what are these ideas? How do these ideas come about? To set the stage a little bit, let me start by asking ourselves, what are any concern with with finance? Whose perspectives do we care about? So the first one of course, is we focus on firms. We focus also on investors. We focus on financial intermediaries, people who connect the investors with the firms. And finally, we focus on governments, right? So these are the players we focus on when we talk about finance. Now, when we actually talk about these players, what do they care about? Well, let's start with firms. If you're a manager at a firm, what do you care about? Right? It's pretty much the same things we care about as individuals. If I ask you, what are your two most important financial questions, many of you will probably say, how do I make money? Or how do I spend my money? Right? These are the same questions that the firm has. The question number one would be, how do I spend my money? That's called the investment decision of the firm. The question on where do I get the money from? That's called the financing decision of the firm. Right? Now, notice the order of these questions. When we talk about ourselves, our first question is, how do we make money? Then we decide how do we spend the money? The firms go about it the other way. They start by saying, how should we spend our money? Then they go back and say, where do we get the money from right now? Why is that? The reason is because the money is coming from investors, right? So if you go to an investor and say, look, guys, I need money. The investors first question, they're gonna wanna ask us, why? What are you, what are you gonna give me in exchange? Right? What is it that you'll give me in order for me to part with my money? So you have to start with a business plan. You have to start with an investment plan to tell the investor how you're going to invest the money in order for them to give you the money to start with. So that's why firms start with an investing decision, and then they decide on a financing decision. But as an investor, you are not the only firm who's approaching the investors. There are hundreds of them. So the investors care about two things. One thing they care about is how do I get the maximum amount of returns for the minimum amount of risk, right? If there's anyone in the audience who prefers the minimum amount of returns for the maximum amount of risk, please see me after the lecture. Okay? But that's one. The second thing with these guys care about is the question of how do I ensure? How do I know that these people are telling me the truth? Anyone can promise me returns, but sometimes the Ponzi schemes, Bernie Madoff, for example, right? So how do I know that what these people are promising really is the truth? How do I know they're not gonna steal my money and run away? Okay? But the third problem is how do these people know each other, right? We don't get messages on our phone every morning from the c e o of a company saying, I need money. Well, Elon Musk, possibly, but that's a general tweet or an ex, right? He just sends out random tweets all the time, but he doesn't address it to you personally because he doesn't know who you are. So who are the people there that your financial intermediaries, they do the job of connecting the suppliers of capital with the people who require capital, the firms, and of course, they charge a fee for the service, right? Governments care about the issue of, can I just make sure that nobody complains about this whole process? I invested all my money in this company. It went bankrupt. I've lost everything. What were you doing as a regulator? You're asleep on the job. Or, I care about the fact that maybe I allow one firm to do something. Everybody does it. It causes the whole system to blow up has happened in the 2008 financial crisis, right? So these are some of the major questions which each of these parties is dealing with. How do we address these questions? As I said, it turns out there are only six ideas in finance, right? And these six ideas address every single one of these questions. So what are the ideas? The first one, and that's the one we are gonna talk about today, is that concept of net present value, right? So we'll spend some time talking about this, but make present value requires a discount rate, requires an interest rate. How do we get that interest rate? That's called the second big idea of finance portfolio theory and the capital Asset pricing model. And the people who came up with this idea, Markovitz and Sharp, got Nobel Prize for that in 1990. The third idea involves the financing decision of the firm. How do I raise money? And the people who came up with that idea, capital Structure theory, Lanier and Miller got Nobel prizes for that as well. Okay? The fourth idea involves how do I change my mind once I made a decision that is an option, I have the right to change my mind after I sign a contract. That's called option pricing. And the people who decided how to value an option s Schulz and Merton got a Nobel Prize for it. Three people, Fisher Black came up with the idea as well. But Fisher Black had died. And so the Nobel Prize is not awarded posthumously. The fifth idea is asymetic information. So Asymetic information is about the concept that every time we deal make any deal, somebody on the other side has more or less information than you do. We don't have the same amount of information as the person on the other side, and that might affect our willingness to actually do the deal. And three people, Olof spends and STIGs got a Nobel Prize for that idea. The final idea of market efficiency is so controversial that you have lots of people who got Nobel Prizes for this, all of whom disagree with each other, right? So for example, Kahneman was a behavioral psychologist, got in 2002, and Pharma and Shila got it in the same year, 2013 pharma, for saying that markets are perfectly efficient and irrational. Investors do not play a role in markets. And shila for saying invest irrational investors do play a role in markets, and they do influence the prices. Two people saying completely opposite things in the same year, got the Nobel Prize at the simultaneously, right? How the Nobel Committees squared, that circle is a story in itself. But Taylor got the Nobel Prize in 2017 for showing they were actually siding with Schiller, not with pharma. Which is kind of ironic because pharma and Taylor have offices right next to each other in the University of Chicago, right? Anyway, these are the big ideas, right? How could they actually fit in? Where do these ideas fit in to understand that? Let's look at the cycle of finance. What I have here on the right hand side is the financial market, right? On the left hand side, I've got the firm. Now, the firm has to, was trying to invest in something, some short-term assets called current assets or long-term assets called fixed assets. A short-term asset for, if you take that kind of looks like a restaurant. So if you think of a restaurant, it might be the food, right? So food is short term. You don't sell the same food for two years, right? I mean, presumably you cook it every day. But fixed assets would be the decor of the restaurant, would be the refrigerator in the kitchen would be some things that last for a long period of time. And different forms, different restaurants make different decisions. For example, we've all seen examples of hole in the wall places, but with amazing food, right? Why is that? Because they have put more emphasis on the current assets part of their business. We've also seen restaurants, which look amazing, but the food is absolutely awful, right? That those are people who put their decision onto the fixed assets side of the business. But it's a choice the restaurant makes, right? Some people go for current assets, some people go for fixed assets. How you choose to invest is part of your investment plan. But anyway, you have this investment plan and you have the financial markets over there. So you go with your investment plan to the financial market, and you say, I need money. Okay? So the firm issues securities. So what are these securities? It's basically pieces of paper. So one piece of paper might be a bond. So the bond basically says, look, I'll guarantee paying you an interest payment every six months, every three months, every year, whatever. And, and the end, I'll give you your money back. But if you make a lot of money, you won't get any more. If you lose a lot of money, you'll still get your payment. It's very safe. In contrast, I can issue a share. The share would be, if I make a lot of money, you make a lot of money. If I lose a lot of money, you lose a lot of money, right? So the investors basically decide which, how much these pieces of paper are worth, and they bid for the pieces of paper. Once they buy those pieces of paper, the money will then go from the firm or from the investors to the firm. The firm investors, and generates cash flows. Part of those cash flows go to the government in the form of taxes. Part of that is retained by the firm, right? To grow faster. And part of that is returned to the financial markets in the form of dividend and debt payment. So this is a basic, basic cycle of finance. So where do these six ideas fit into this picture? Well, if you think about this, the first idea is that a market efficiency, it basically says investors aren't stupid, right? You can, if you promise them things, but they don't actually see this return coming back, they're not going to pay you money to start with. They'll pay you exactly what they think they're gonna get back from you, right? We'll go more details about that later. The second idea is what we're gonna talk about today, which is what do you invest in? Firms use net present value. And the idea is you wanna maximize the net present value of this particular company. But to get the net present value, you need a discount rate. The discount rate comes from investors, and that's a capital asset pricing model, which we'll talk about next time. The fourth idea, capital structure, which determines the exact mix of debt and equity in the firm. So how much debt to have, how much equity to have. That's what you decide at that point, right? It also determines how much dividends and debt payments you need to pay back. It determines the amount of taxes you need to pay, because debt is tax deductible. You pay your interest before you pay your taxes. Okay? Alright. The fifth idea, asymetic information happens because if you ask a firm manager, are you a good manager? What will they say? They're wonderful, right? No manager is gonna say, really, I don't have any ideas, but I've got a wife and three kids gimme money to keep them. My family, nobody caress, right? So the, some managers are lying, some managers are telling you the truth. But every manager is saying that they're wonderful. They have asymmetric information, they know their quality. You don't. How do you adjust for that when you're deciding how much to pay for those pieces of paper? Okay? The final idea is that of option pricing theory, right? That is both for the firm level and the investor level. The firm can make a choice and change its mind if something else happens. For example, it can build a small factory just to test the waters. And if the product is successful, it can scale up. The factory product is not successful. It shuts the factory and walks away, right? So that's a choice which you're making at the firm level. So all of these are different ways of fitting in these ideas. Okay? Now let's talk about N P V. Why do we need N P V? This is the only idea which does not have a Nobel Prize associated with it, possibly because the guy who came up with it, um, you're talking about fishery and separation, came up with the idea in the 1930s, well before the Nobel Prize for economics was instituted in the 1960s, right? So, but we will talk about a Nobel Prize winner in a little bit, okay? But not for the idea we have. So when you think about finance, what exactly is finance all about? The answer is it's about promises, right? Everything in finance is a promise. What is a promise? Basically, it is, I'm going to give you some amazingly large, some amazing amount of money if only you gimme some money today. That's literally the essence of finance, right? If it sound, if it sounds like that, it sounds kind of, you know, like somebody begging you for money, right? I mean, but seriously, that's exactly what finance is all about, right? Promises, I promise you pay you something. If you give me something today, the question for you is what's that promise worth, right? Sometimes this is easy to do. So let's see when it's easy to do. But before I do this, as you pointed out, most people do the lectures and write a book. I wrote a book on these lectures and that then I'm giving the lectures. So the book is actually available on Amazon. It's actually for some reason also printed in China. So it's in Chinese as well, if you prefer that version. But it's a very slim book. As you can see, it's 180 pages. That's all you need to know about finance 180 pages for everything you need to know. Okay? So let's start with a very, very simple question, right? So now I want you to take out your phones and go to a different website. Go to menti.com and enter this code. 1, 4, 1 6, 8, 0, 5, 0. Or as usual, just scan your QR code. I'm going to try to make this as interactive as possible. So we'll just go with that one, right? So the code is 1, 4, 1, 6, 8, 0, 5, 0. And by the way, this is available for everybody even online. So if you're online, go ahead and try that as well, one, okay? So you can see it works quite well, okay? Alright. So, okay, should be straightforward to use. So keep that open and I'm gonna ask questions and get your opinion in the room as well as people online, anywhere in the world. Alright? Sounds good. So now let me ask my first question. How do you figure out the worth of a promise? Okay? So the first question Is straightforward. Suppose you'll have three promises. The first promise says you gimme a hundred pounds, and I give you back a hundred and ten one year from now. The second one says, you gimme a hundred and I give you back 110, 2 years from now, a hundred and I give you back a hundred ten three years from now, which is the best? Like this is almost a no brainer, right? Except for, oh, okay, these two people please see me after the lecture, right? I mean, unless you're doing this online <laugh>, okay? For almost a no brainer, okay? But now let's go to a slightly more complicated question, right? You can see there's a lot of people who are going for that one. That's easy. But now let's try this question. You gimme a hundred dollars and I give back 121 year from now, or 1 45, 2 years from now, 172 years from now. Which one is better stable process? Well, that's an interesting question, right? The part which I'm trying to make here is, this is a much, much more complicated question than the previous one, right? Previous one was easy, it's the same amount and it's always better to get money back early than get money back late, right? So in that case, the answer number one was UNE unequivocally, correct? In this one, it depends on the interest rates. If you think that interest rates are gonna be high, you might want to take that one. If you want, interest rates are going to go down, you might want to take that one, but it, there is no right answer here, right? Because it all depends on a second number, which I have not given you. That's something which we will try to determine next time. What is that discount rate? So let's hold off on the answer to the question, but see how you might try to address a question like this in finance, right? The essence of net present value. So to address a question like this, we are asking ourselves a basic question. You deposit a hundred pounds in your bank account, the bank tells you the interest rate is 10% at the end of one year. How much is in your bank account? Pretty straightforward, right? So the answer would be 110. So how did you get that answer? Well, a hundred times one plus the interest rate gives you 110, not difficult, but if you say, what about if you left the money there for another, another year? Well, you get 10% on the original a hundred, but you get 10% on the $10 as well interest as well. So you get $11 a second year. So the total would be 121, right? If you could do this in one step, which is a hundred times one plus 10% times one plus 10% is 1 21. And that's the essential formula of finance, which just basically says that the present value multiplied by one plus R ratio, the power T is in fact the future value, right? So that's a fundamental formula. The things in the fundamental in there. What is the present value? What is the R? What is the T? What's what the R of finance. But the formula itself is very, very straightforward. In reality, of course, we don't know this, right? Remember, it's all about promises. So when we have promises, what do we do? What we do is we invert the formula. So essentially this becomes, you take one plus out of the power T to this side. So present values, future value divided by one plus R of the power T. In effect, what we are saying is, if someone is promising you a hundred twenty one two years from now and the interest rate is 10%, that's worth a hundred dollars today. Okay? So we've just gone backwards. So the promise is about 121. The present value is a hundred. If the interest rate is 10%, but you can compare those numbers, you cannot compare $120 one year from now with $145 two years from now with $170 three years from now, three different time periods, you cannot compare them. Net present value is about bringing all those numbers into one point in time today, right? So literally everything in finance, it consists of moving money back and forth through time, right? So you have money which is being promised to you in the future. You want to know what's the value of that money today? Okay, fine. So this formula is the most important formula in finance. We use this everywhere. We teach our M B A students this on day one, when they arrive in their first finance clause, and we call it discounted cash flow. Every finance textbook talks about this and we use it literally everywhere. Okay, I'll come, but why is that formula so important? That's a different question. So I'm gonna get to that question in a couple of minutes. But let's start by asking ourselves a different question right now to motivate why this formula is so important. Let's look at a different question, right? This is a question which all of us might be wondering today especially, right? What is the purpose of a firm? In whose interest do you think a firm should be managed? So you can have workers, these are all the stakeholders in the company, workers, creditors, suppliers, managers, customers, government, bond holders, shareholders, or all of the above. So let's go back and see what you think is the answer. So, customers, workers, creditors, suppliers, shareholders only society, or all of the above. Interesting. Okay. So we can see that the dominant, by far the most dominant answer is all of the above. The reason I think this is an interesting question is that if you ask it for managers in different countries, you get very different responses. Let me show you, right? So I'm gonna move away from the slide. It turns out, if you ask, let's, actually, let me go back and ask a more specific question and then come to this slide. Uh, the more specific question is, suppose your firm has made a major loss on an investment to meet its quarterly earnings target. It can either fire 300 workers or cut its dividends next quarter. What do you think it should do? Should do or will? Sorry, should Do or will do? Well, what will you want? What do you, what do you think is the best alternative if you are a manager in the company? I'm making it. There's not enough information. You're absolutely right. But in, in this, on this information, what would you, what would you prefer to do? Is what the question is. Yeah. There Was a recall in the Sunday Times magazine about this manager who was faced with this problem. Mm-hmm.<affirmative>. And he did everything he said, we ack a load of workers. When things turned round, we weren't able to get them back 'cause our competitors Were tight. These are all absolute points. I'm just asking, um, avoiding all the other issues which might accompany with, get them back, what the tightness of the labor market. All these questions, I'm just going in here and showing that most people would typically say cut the dividend, interestingly only in Europe. So in Japan, the same question, which is more important, dividends or job security. The people who say job security is more important would cut dividends. The people who say, um, dividends are more important would fire the workers. Man, Japan, 97% of the managers think the job security is more important than dividends, right? Germany, France, similar. They're actually only two countries in the world, which are exactly the opposite. Britain, the UK and the us where you have almost 90% of managers who would ask that same question would say, I would rather keep the dividend and file the workers. So what is it about the UK and the US that makes them stick out from everywhere else in the world? Everybody else is like, you know, this are human beings, but somehow in the UK and the US they're very different. Okay? So to get that question, what do you ask? One part of the problem may be people like me, right? When you ask me what's the right thing to do, I would say maximize shareholder value, maximize share price, maximize firm value, right? So we teach our managers focus on the shareholders, and those guys listen to us, right? Maybe they shouldn't be listening to us, but you know, they paid a lot of money to get their MBAs. So presumably, you know, they want to do what? They want to be sure that the education has got them something. So that's why they do it, right? Maybe that's one answer, but no, we actually go back to another Nobel prize winning guy, Milton Friedman, who in 1970 wrote an article in the New York Times, which said the social responsibility of business is to increase its profits, right? And he wrote a long article as one of the most influential articles in finance. And so we talk about this thing, we talk about shareholder value based on Friedman's arguments. So I'm gonna talk about why those arguments are important, right? Why did he make that question? And based on that one, we say they focus on the shareholders. But to get there, let me ask you a different question, right? Let's suppose, you know, COVID is over, everybody's coming back to work, but not all people are happy to come back to work, right? Some of us prefer to work from home. So your manager has noticed that all the people in your team is very quiet and unsocial. They don't like being back at work. They sit down in front of their computers, they never talk to each other, they always glued to their computers and they always look depressed. But looking at you guys, your manager notices that you're the only outgoing, happy, friendly worker, right? Sounds like you. Yeah, I can see a lot of happy faces. Excellent. And your manager says, look, I wanna get people together. People are, you know, uh, what is better to get people together than to bond them through a meal. So he says, good food will bring people together into a happy team. So you ask to find a restaurant where everyone can go to, which will make everyone happy, okay? Good news. The budget is unlimited.<laugh> Bad news. You can only pick one type of food. Can't pick a buffet or food from around the world. And remember, your team can consist of people from all over the world. It's not just, you know, people from England. You can have Africans, you can have Indians, you can have vegetarians, you can have any kind of, you know, gluten allergies. You can be anything. So the question for you is, how do you find out from your coworkers what restaurant will make them happy? So this one is actually a wordy question. So you can type in what you think, which restaurant will make them happy. So go ahead and type in what you think will make people happy. How do you find out which your coworkers will think is a good restaurant for them to go? That's your job, right? I'm not going to show you the responses yet, I just want to collect the responses first. Okay? Let's take a look, right? A lot of answers here. Okay, let's see what the common answers are. Let, right, so the predominant answer is ask them, conduct a survey. Conduct a survey, um, you know, multiple choice, what you know, form, uh, questionnaire, um, buffet, no buffets. So, you know, things like that, right? So a lot of answers, but the dominant answer is ask them or conduct a survey. Alright? Now let's assume that's exactly what I'm gonna do, Right? So I have survey. Now I'm going to suggest an alternative method. And this is why Friedman said, focus on the shareholders, right? So the alternative method is, I'm not going to have a survey. I'm not going to have a questionnaire. I'm not going to ask anybody. Instead I'm going to take them to the kind of restaurant I want to go to. What is that restaurant? Well, it turns out this is an interesting restaurant which serves that kind of food, right? I haven't asked anybody, okay? So how would you feel if I took you to this restaurant? Very bad. Very bad, right? So what would you say? I don't want, want that food.<laugh>, one thing you might say is, this is horrible. Why the hell did we pick this restaurant? What do I say? I say, I feel for you. I know how you feel. I don't want this restaurant either, but I sent out a questionnaire. This is what the majority wanted. You know, I I couldn't help it. And she says, but I never got the questionnaire. And he said, well, you know what? Spam folder, please check your junk mail. Next time it must be there somewhere. Be more careful. So to translate that into something managers do, this is what the manager do does, right? So you go back to the case here. The key point is that bit they never talk to each other, which means essentially the manager, you're talking to everybody. So what happens? So let's say you go to a worker, right? And you say, would you deserve, would you like a bonus as a worker? What do you think the answer, by the way, yes, <laugh>, okay, so she wants a bonus, right? So I say, of course you deserve a bonus. You obviously work very hard. I want to give you a bonus, but you know what, I have other people like the bond holders who are asking for their interest. If I pay you the bonus, I don't have enough money to pay them. So I lose, the company goes bankrupt. Can I pay you a bonus next year? Maybe? What do you think? Everybody loses their job. So that's the point. You can persuade the workers that you would like to give them a bonus, but you can't because of constraints. And then you go to the bond holders, say, you know, I have to pay your interest, but I problem is workers are asking for a bonus. If I don't give them a bonus, they'll go on strike. If they go on strike, I, you know, the company goes down, can I pay you more interest next year? Maybe put off the paying the interest. So I negotiate with anybody, do not pay anybody, eventually end up with a big chunk of money. What do I do with a big chunk of money? I pay myself a big bonus. Absolutely. Right? Right. Because I've saved so much money for the company. That's what we call agency problems, right? And that's what you say here. You say, well, in whose interest do you think a form should be managed? If you say all of the above, the manager has too much discretion, the manager can, will basically use it to play off everybody into each other because the problem isn't defined. But if you focus on one group of people, the shareholders, the beauty of the shareholders is they are paid at the end after everybody else. So in other words, if you treat your workers badly, they go on strike. Your share price is affected. If you treat your, um, customers badly, they don't buy your products. The share price is affected. So ultimately everything depends on the share price because they get paid after everybody else, right? They're what we call the residual income holders of the company, right? They get the money at the end. So that's why we focus on shareholder value. Nothing special about shareholders. It's just like a, like almost a leading indicator of how everybody in the company is feeling. Okay? So, but that whole idea of Friedman wants to say, you let managers do whatever they want to make everybody happy. The only people they're gonna make happy is themselves. That's the principle agent problem, right? The principle is someone who's hiring an agent to do work for them. Here the agent is the manager, the principle is the shareholder. So the shareholder says, I want you to work hard for me. So will you the shareholder, will the managers work in the shareholder's best interests? And Friedman's answer was, no, they won't. Because if you let them do whatever they want, they will maximize their own interest. How come? If that's the case, uh, managers are paid far higher wages, salaries in U s A, uh, and Britain than they are in Germany and many other continental countries where they put more of an emphasis on other stakeholders. That's a very good question. That's a very good question. And it depends on how the finance system has evolved in the two countries. In those countries, shareholders don't participate in the market because they know that the managers are putting emphasis on the rights of the workers. And the law is on the rights of the workers. So that those markets are usually debt financed. They're not equity financed. In an equity finance market, the government protects the right to the shareholders. So the shareholders are more confident and they buy more shares. In a debt finance market, the shareholders say, I can get expropriate at any time. I'm not gonna participate. So the firm has a different way of financing, but different markets make different choices, not the one better than the other. This is a market which is a public market. And that's the reason why Friedman said, let's focus on shareholders, right? Okay. And that's the whole article. He wrote this whole article about what are the social responsibilities? We are not doing this stuff, right? Social responsibilities means you're doing your own thing and claiming it's for the shareholders, but that's not true. So it's a long article, incredibly influential. Now, agency costs can arise everywhere between shareholders and managers, between bond holders and shareholders, and between different types of shareholders. Let me just give you a couple of examples. The first example says, imagine you're the c e o of a large multinational. You are weighing the purchase of a corporate jet for $200 million to fly you to New York, to Wall Street, to Berlin and Paris, to deal with Brexit in the eu to Shanghai to explore opportunities in India and Gally, because you want to expand to India. Should you buy the jet? What do you think it costs?$200 million S Sorry. We dunno what percentage of profit that jet represents. Well, just based on the information you have, right? I'm just getting a sense of it, right? So a large number of people are voting and saying, no, it's totally unnecessary. Not a problem. Let me try and convince you. That's the living room on the jet <laugh>, okay? That's the bedroom, right? So that sheet there covers what's called a gust belt, which keeps you in thing doing turbulence, right? That's the bathroom, separate sinks for his and hers, right? Does anybody wanna change their mind?<laugh>? Well, the point about this is asymetic information we'll talk about later, but the idea is, as a C E O, I would say, uh, to the board of directors, I want to buy this jet it, it's costing me 1% of 200 million. That's pretty good for a jet, right? The board of director's job is not to let me do anything that the shareholders don't want me to do. So how do I convince the shareholders? Well, I'll tell them, look, I'm happy. You know what? I'm happy to go by train to Heathrow train strikes fine. Not a problem. I'm all about shareholder value. I get to Heathrow and then I go in flying economy, okay? Still not a problem. And then I'm cramped up in British Airways. You know, there's horrible seats in the economy. And then, ah, the food is awful. I don't know who's sitting next to me. I get off in New York, I'm so exhausted. Did you ask me sign this contract, giving away your product for free? And I say, okay, just, I, I'm too tired. I can't do it. But If you let me buy the check, even when I'm sleeping, I'm thinking of shareholders. I'm dreaming of shareholders. I'll make so much money for you. That 200 million, nothing. How do you know? I said, I telling the truth. Is he lying? Right? That's the problem we have. However, oh, by the way, this is actually a convincing argument. When Goldman Sachs, um, their CEOs never had private jets. When David Solomon took over CEOs, Goldman Sachs, he said, I want a private jet. I'm not gonna waste my time renting a jet. I want my own private jet. And he gave all these arguments. They did a cost benefit analysis, and they ended up buying two jets, not one, right? So anyway, that's his question is essentially, how do you know what the, that's called an agency problem. How do you know that your c e o is telling the truth or not? Okay? Let's talk about another agency cost between shareholders and bond holders, right? Simple everyday example, borrow from the mafiaa. Okay? So you borrowed 10,000 pounds from your friendly neighborhood, MAFIAA don, the due rate is tomorrow, but you only have 500 pounds left. Okay? And you know that the dawn will have your leg broken if you come. Don't come back with a 10,000 pounds tomorrow. What do you do? Oh, a lot of people. Like we really know what to do with the mafiaa. Okay, let's see what the answers look like. Okay? The dominant answer is run, hide, leave the country, and so on, right? These are good stuff, right? Panic, okay? Yeah. Well, a big answer is run, right? And that's okay, but this is the mafiaa guys. So, you know, 20 years from now you're on this remote island in the Pacific and you know, you think you're safe, but they've tracked you down and now interest a bullet to the head, right? Or if you have things like, you know, leave the country run hide, same thing. Or if it's called witness protection, that's fine, but how long, right? I mean, sooner or later they find you or borrow money. I mean, you don't actually borrow money from the mafiaa to start as a first choice, right? You borrow from your friends, from your family, from the bank, only at the end you borrow from the mafiaa. So how, where do you borrow money from if you're already exhausted all the other opportunities you have? So most of these answers are kind of tough, right? But let me give you an alternative answer. Uh, join the Yakuza is kind of an interesting answer there, right? But let me give you an alternative answer over here. The alternative answer is take the 500 pound, go to casino and gamble. What's going to happen? Most of the time you're gonna lose everything, right? 99.9% priority, you lose everything. But what's the consequence? You're gonna have your leg broken next tomorrow when you don't come back with any money, but your leg would have been broken anyway. It doesn't matter whether you come back with 500 or zero, your leg ISS gone. But there's a small fraction of a possibility that you might come back with enough money to pay off the mafiaa, right? So before you say, this is a really fanciful example, this actually did happen with FedEx. So when FedEx first started out in the 1970s, it was an oil price shock. Price of oil went up dramatically. FedEx started losing money like crazy. So the C F O of the firm company, Fred Smith, took the last few hundred thousand dollars of the firm's money, went to Las Vegas, and he gambled. He came back with a million dollars, enough to pay off his creditors and say FedEx. But if the creditors had known he was going to Vegas, would they have let him? Probably not, right? So that's the story here of how all these things are agency problems. I do something which you don't want me to do, we'll talk more about this, but it also raised a bigger question. I'm focusing on my shareholders. Which shareholder do I focus on? For example, short-term shareholders. Somebody if, for example, somebody who needs to pay off the mafia tomorrow wants money tomorrow, somebody who's a young person not borrowing from the mafiaa may want money for in the future. So how do you focus on maximizing shareholder value when you do not know who your shareholders are? That's the biggest question we have as a manager. How many of us actually talk to our shareholders? Nobody. How do you make them happy? We've just seen you cannot make everybody happy. So how do you make them happy, right? That's the question which N P V is all about. That's why we go back to the formula in the beginning. So what I'm gonna do is introduce an island problem. Economists love islands because it's an isolated economy and you know, nobody coming in from the outside world. Very nice analyze. We focus on this. So in this island, there are two types of people. One I'm gonna call Skipper, who is, wants to consume everything today, leave nothing for tomorrow, somebody who lived for the moment, a short term shareholder. And we have Ginger who wants to leave something for tomorrow, wants to consume last today, you might recognize the names is actually taken from a 1960s TV series called Gilligan's Island, right? So if you watched it, I just took the names from there. So anyway, these two are on this island, right? What do they have to eat on the island? Answer is potatoes. Okay? Okay. But the choice is they have to choose how much potatoes to plant and how much potatoes to consume, right? And I'm gonna get a little technical here, but it'll give you the answers, um, in a very straightforward way. So what I have is a production function for potatoes. What that means is I have on the X axis, I have potatoes, which I'm have today. So P zero zero means today, okay? And P one on the Y axis means potatoes tomorrow. So if I plant potatoes today, I will get potatoes tomorrow. That's what a production function means. I'm converting potatoes today into potatoes tomorrow. I'm producing potatoes today by planting potatoes and harvesting them tomorrow. The question is, how much of my initial number of potatoes do I consume? And how much do I plant? That's the question I want to answer. Okay? So to answer that question, we come up with a production function. Now, let me explain this function to you intuitively. What the function is saying is this, zero to A is your initial endowment. You're given a potatoes, a may be a hundred, maybe 50, maybe 20. But zero to A is zero to 20 or zero to 50 or how many potatoes you have. So A represents all the potatoes you have today. If you consume everything, you get nothing tomorrow, okay? There's nothing to plant. So you get nothing. However, if you choose something first you decide how much you want to consume. So this is what you consume, the remaining amount you plant, okay? So now what you do is you take up appendicular and you connect it to the Y-axis over there. So what that means is the production function tells you that if you plant this amount, taking it to the production function will give you back something the next year, the next period, okay? It's a very straightforward, right? So if you double take the lineup, go over there, decreasing returns to scale mean if you double your input, you don't get double the output, you get less than double your output, right? That's true everywhere. If my students study for two hours, they get 80% in their exams. Maybe don't tell them I said that, but if they study for six hours, they don't get, you know, much more. They get them maybe a modular improvement. So the first hour gets them a lot, second hour gets them a little less and so on. Same idea here. Okay? So this is the production function. Now, the second thing I want to express is how do people decide how much to plant and how much to consume? So how much to consume, how much to plant, how do you decide that the answer is preferences. So preferences, economists model this. When I did my PhD, the big choice was cake and ice cream, right? Today, you know, as at my age, you can no longer eat either cake or ice cream. So this is a mood choice, right? But <laugh>, in the in, when I was growing up, it was like ice cream or cake, this standard question, right? There's also a choice between quiche and beer. So those are the two things which economists seem to be really concerned about. But anyway, the point here is if you have one slice of cake and two scoops of ice cream, how much ice cream are we willing to give up to get one more slice of cake? If you really, really like cake, you might say, I'll give up all my ice cream. If you don't like cake, you give up only a little bit of ice cream. So that's the question which you're trying to ask, right? And you represent that, right? How much cake would you be willing to give up to get one more scoop of ice cream? You represent that by a preference curve. So how does a preference curve work? Preference curve. Again, remember this is potatoes today, potatoes tomorrow. So what this one says is that if I have a choice between X and Y, they're both the same to me. So many potatoes today and so many potatoes tomorrow is exactly the same to me as so many X potatoes today and X potatoes tomorrow, right? But I prefer Z, Z to either X or Y because I want more. I always want more. There's no such thing as satiation. More is always better, okay? And of course economists justify that by saying, if I have more, I can sell it to somebody else. I don't have to eat it myself. But we'll keep that in a moment. But anyway, let's take skipper. Skipper has a very steep curve, which means if I wanna give up even one potato today, I'll need a lot more potatoes tomorrow. You order to get that curve. So what does skipper do? He'll take his curve, move it out until it touches the curve at one point, right? That's his indifference curve. It moves it out, touches that point there, and then he says, okay, I'm gonna consume that much. I'm gonna plant very little. I'm gonna get that next period. Very simple. Okay? Okay, what about ginger? Ginger has a very flat curve because she values consumption tomorrow. I'm willing to give up a lot today to get very little more tomorrow. Okay? So she, what she does is take her indifference curve, moves it up until it hits that point. Again, same thing, drop the tangent, drop that perpendicular over there, and you say, I'm gonna consume this. I'm gonna plant a lot more, I'm gonna consume a lot more next period. Right? So of The red curve or the White curve, I'm sorry, the Tangent. Is it from the red curve or from the white Curve? The the red. The red curve. The red the the red curve is a tangent to the white curve at the point G. Alright? Okay. Alright. So now the problem with this is if you look at skipper and you look at ginger, skipper is over here, ginger is over here. So you put them into a company, they won't agree. Skipper will say, I want to consume a lot, I want to invest very little. Ginger will say, I want to consume very little, I want to invest a lot. They won't agree with each other, right? So you cannot have a company with both of them in the same company. The two shareholders will disagree with each other all the time. So in order to make them agree, you need a third person. And that is a banker, right? A financial market. So Robin Banks dec decides to start the island potato exchange. Okay? So what is the island potato exchange? He says, I'm, it's an interesting, if you have a hundred potatoes, if you borrow a hundred potatoes from me, you have to pay me back 110. If you lend a hundred potatoes to me, I will lend you, I will give you back 110. So that means, in other words, that's a perpendicular, that's a base, right? Angle, triangle, high school, chronometry, we know the slope of the line must be equal to 110 divided by a hundred, which is one plus R. The interest rate is 10%. Okay? The line, it works for anything. So 50 potatoes means 55 to be returned, 20 potatoes means 22 to be returned. 10%, that's the same in every case. Fine. So now let's put only these two things into the capital market. What do you get? Move. Now the interest rate line out. There's no preferences on this until it touches the curve at one point. That point there, okay, now let's go to Skipper. I've got that point. I haven't made Ss, I wanna move him to SS dash. Which does he prefer? Ss or S dash S? Well, S Dash gives him even more today and less tomorrow. He really wants S dash, right? But how does he get to S dash? That's what we want to get him. It's even beyond the production function, right? How do we get him there? Well, we start at the tangent point. We drop up a pendula and we drop the straight line and we say Plant in zero this much you can consume, but you harvest that amount next period, but you don't want it all. What you want is only this amount. What do you do with the remaining amount? Well, the remaining amount you promise it to Mr. Banks. You say, I'm going to return this to you. How much will he lend you? Well, it's a right angle triangle. So he will lend you the base if you give him the perpendicular. So the base will be borrowed and consumed. So you end up consuming a lot more today. Okay? It's a little complicated, but let's go to ginger. Ginger's a G, I wanna move her to d a s. She prefers G dash because it gets it even more tomorrow. How do you get her there? Go back to that line. So it s there, right? You wanna bring her all the way there. How do you get her there? Same thing, start with N, right? Drop the perpendicular straight line there and tell her to plant the same thing that Skipper wants to do. Both Ginger and Skipper will pick exactly the same amount. The zero to G zero she consumes. What about the rest with that N zero? She gets back N one, the res bit. She lends to Mr. Banks. How much does Mr. Bank? Does she give her back? Well, again, right angle triangle over there, you get back that amount, right? So eventually Ginger ends up consuming a lot more. But see the commonality between the two, both of them agree on the optimal amount we invest, right? That's the key over here, right? So to put that to perspective, the key takeaway is F, both the graphs have exactly the same thing. Same amount of consumption, same amount of harvesting regardless of your preferences. So if you want more borrow, if you want less land, but not, the manager doesn't care about that, all the manager cares about is the point where the interest rate line touches the production function. The tangent point. Okay? Now what's the absolute maximum skipper could consume today if he wants nothing tomorrow? Well, he starts out as usual with a point N drops those two plants, the same thing, he'll consume the rest. But now he gets this back and he says to Mr. Banks, I want to give it all to you. I don't want anything tomorrow. So how much will Mr. Banks give him? He borrows, he returned that amount. So Mr. Banks will give him the triangle, the bottom part of the triangle. So he ends up consuming all the way to J. He started out with a, he's ending up consuming much more. So AJ is additional value created by the financial market. It does not exist without the financial market. Without the financial market. The maximum you can get to is A with the financial market. You can get to aj. Okay, so what is that aj? Well, let's take a look. This is now a RightAngle triangle, right? So we know the slope of the right angle triangle is one plus R. So we know, for example, a slope is defined as a perpendicular divide by the base. Perpendicular is an N zero. The base is N zero A plus aj, right? So, and we know the slope must be one plus R. So let's take that, right? Simplify, bring this over to that site, take this back over here. And so the additional value created by the market is n n zero, which is the what you amount of potatoes you earn in period one, discounted at one, one plus R minus your initial investment. Basically this is the derivation of that same formula, which we started out in the beginning. We said the present value is the future value divided by one plus R to the power T. This is the same formula. And what we are saying over here is that the net present value is all the manager needs to care about. Right? Why? Because that solves the problem of talking to your shareholders. You don't have to talk to them. They can do whatever they want to get to where they want to be, not your problem as a manager. Okay? So the overall conclusion, the capital market allows you to separate the investment decision of the firm from the consumption decision of the shareholder, right? You don't need to ask your shareholders. This is called fishery and separation after Irving Fisher, who should have gotten Nobel Prize for this but didn't right it, it's too late. Anyway, the point is, as a manager, I don't care about what my shareholders want. I just maximize the N P V. If the shareholders want more money than I give them in dividends, they can borrow. If they want less money than I give them, they can lend. I don't really care. Not my problem. Okay? So what happens if interest rate changes? If for example, the Bank of England raises interest rates, what will happen? This is what I have started with. Now the Bank of England has increased interest rates to the slope is higher. What happens? I invest less, right? That's exactly what the government is trying to do. Economies, overheating increases interest rates, people invest less because now that's a new point which they invest. What happens is there's too much asis asymetic information. That means borrowing and lending rates are different. So your one line for borrowers and one line for lenders, you don't come to an agreement. So there's too much asymetic information, the market collapses. Third possibility. What happens if markets are not complete? This entire thing depends on the fact that shareholders only care about money. But what happens if you care about something social? What happens? You care about the climate. You can't trade climate on these markets, right? So that means you can't actually do anything. If a shareholder says, I care about social responsibility, I can't say, as a manager, I'm gonna focus on N P V. You can get to where you want to be on social responsibility, but buying and selling shares is not gonna happen, right? So Friedman argued, PRI primarily on the basis of money doesn't actually hold in a complicated world where care about other things which are not traded on financial markets. But that basis story is why we focus only on net present value, right? From our perspective, N P V is our basic equation in finance. It's used everywhere where someone promises to give you something in the future, in return for money. Today, this is a general formula, right? But we don't know what that interest rate is. And that is a topic of my next lecture. Where is the discount rate coming from? Where is the interest rate coming from? And this one does involve a Nobel Prize <laugh>. Okay. Alright. Um, well thank you very much. That was very interesting. Fascinating, really. Um, a a question from, from, uh, a person online asking, um, or in person for that matter, uh, asking are governments, um, do governments use N P V for their investment? Is it, is it a formula that they use, uh, in order to assess investments? They should, but not necessarily. The problem is essentially going back to our issue here, it what do your taxpayers care about, right? If your taxpayers care about things like social justice or other things like that, how does that fit into the N P V formula? You cannot buy and sell social justice on the markets. So governments supposed to, they may use N P V and a lot of them do, but there are other factors. Mm-hmm. Which they also take into account when they're deciding what to do, right? Like HS two, there is no reason for HSS two to be there, uh, or not to be there on purely financial grounds. Right? But this is all about vote exercise. We have a bit of time to perhaps take a couple of questions. Let's push it a bit because it's so interesting <laugh> a couple of questions from, uh, the person here in the audience. Just my colleague will pass on the mic. Thank you. Are there, sorry. So you spoke about the two problems being incomplete markets and asymmetric information. Would the idea behind that then be maybe you commodify those incomplete or that that, like the, the environment, like social justice is the odds to that commodifying that so you can then form it part of your equation? So, sorry, can you repeat that? Sorry, say can you use, So you say that when you get those two, those two curves, yep. Because of incomplete information and asymmetric, asymmetric information, sorry, incomplete markets and asymmetric information, we don't have complete markets because we can't necessarily quantify the damage that's happening to the environment. Is the answer then to comm modify that and let that trade and get that information? Yes. So, um, as long as you have a functioning market, finance works, right? So if you think about economists, economists will say one way to address things like this. Like the climate change problem is that have a carbon market, right? So you're quantifying the amount of emissions in some way or the other. Obviously there are lots of problems here, right? People will fake carbon credits, they'll do all sorts of things. But if the market is done properly, the idea behind Friedman is that as long as the market will is complete, you don't need, you don't have a problem, right? So Friedman's assumption was the market is perfect, it's complete under all dimensions. You can buy and sell anything to get to your optimal decision. But that's not true in the real world. And there are lots of things happening now, which are further, for example, going back to the environment, you're looking at what we call the tragedy of the commons, right? Each of us individually does not have, uh, an incentive to do anything for the climate because you think we are individually very small. So, but together we are contributing a lot. How do you price this? How do you make everybody pay for their share or for data? Your individual data item is not very valuable, but together your data can be used to train in a large language model, which is incredibly valuable. How do you price that? These are big questions and we don't have answers to this in finance and I don't think anybody does. Alright. Um, perhaps one last question actually from someone online. It's a bit political, if you don't mind. It's about Milton Friedman's, uh, theory actually. Um, is the popularity of Friedman's, uh, theory of shareholder value down to, its providing a convenient ideological justification for rich, staying rich. It's a nice, it is an intellectually very satisfying, um, uh, you know, exercise that Friedman did. And it took away a lot of pressure from us as economists, right? We look at Friedman and we say, Hey, but we are making a lot of assumptions under the behind the scenes, which are not really warranted, right? We are making a lot of assumptions about markets, about market efficiency, all these issues here. But as we go through our series of lectures, I'll talk about the problems behind each of these ideas as well. So they all depend on assumptions, but we don't talk about these assumptions when we teach our MBAs. We don't wanna confuse them, right? So we just say, focus on N P v, focus on shareholder value maximization. But many of our MBAs still don't know why, right? So hopefully they'll listen to this lecture. Thank you very much everyone. Thank you very much Professor O. Fantastic lecture.