I.

INTRODUCTION

Output
Product Markets
Consumption
Manufacturing
Labor Markets or Business
Firms

Investment
Capital Markets Capital
Households
• Stock
Savings • Bond
• Money
• Futures

Savings
Financial Intermediaries
(Borrowings)

Domain of Finance

This course is an introduction to the theory of optimal financial management of households,

business firms, and financial intermediaries. For the term "optimal" to have meaning, a criterion for
measuring performance must be established. For households, it is assumed that each consumer has
a criterion or "utility" function representing his preferences among alternatives, and this set of
preferences is taken as "given" (i.e., as exogenous to the theory). This traditional approach to
households and their tastes does not extend to economic organizations and institutions. That is,
they are regarded as existing primarily because of the functions they serve instead of functioning
primarily because they exist. Economic organizations and institutions, unlike households and their
tastes, are endogenous to the theory. Hence, in the theory of the firm, it is not a fruitful approach to
treat the firm as an "individual" with exogenous preferences. Rather, it is assumed that firms are
created as means to the ends of consumer-investor welfare, and therefore, the criterion function for
judging optimal management of the firm will be endogenous.
In a modern large-scale economy, it is neither practical nor necessary for management to
"poll" the owners of the firm to make decisions. Instead certain data gathered from the capital
markets can be used as "indirect" signals for the determination of the optimal investment and
financing decisions. What the labor and product markets are to the marketing, production and

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 Robert C. Merton

product-pricing managers, the capital markets are to the financial manager. Hence, a good financial
manager must understand how capital markets work.
Since the capital markets are central, it is quite natural to begin the study of Finance with
the theory of capital markets. To derive the functions of financial markets and institutions, we
investigate the behavior of individual households. Using portfolio selection theory, the households'
demand functions for assets and financial securities are derived to develop the demand side of
capital markets. Taking as given the supply of available assets (i.e., the investment and financing
decisions of business firms), the demands of households are aggregated and equated to aggregate
supplies to determine the equilibrium structure of returns of assets traded in the capital market.
Inspection of the structure of these demand functions leads in a natural way to an introductory
theory for the existence and optimal management of financial intermediaries.
In the second part of the course, the supply side of the capital markets is developed by
studying the optimal management of business firms (given the demand functions of households).
The two elements which make Finance a nontrivial subject are time and uncertainty.
Capital investments often require substantial commitments of resources to earn uncertain cash
flows which may not be generated before some distant future date. It is the financial manager's
responsibility to determine under what conditions such investments should be taken and to ensure
that sufficient funds will be available to take the investments. Because future flows and rates of
return are not known with certainty, to make good decisions, the financial manager must have a
thorough understanding of the tradeoff between risk and return.
While the basic mode of approach has universal application, it should be understood that
the assumed environment is the (reasonably) large corporation in a large-scale economy with well-
developed capital markets and institutions similar to those in the United States. Although the
emphasis is on the private sector, most of the analysis can be applied directly to public sector
financing and investment decisions. However, certain assumptions made in developing the theory
(which are quite reasonable in the assumed environment) will require modification before being
applied to small businesses with limited access to the capital markets or to foreign countries with
significantly different institutional and social structures.

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Summary of Different Parts of Finance

Households (Personal Finance)

Taken as Given: 1. A criterion function for choice among alternative consumption
programs
2. Initial endowments

To be Determined: 1. Optimal consumption-saving decision

2. Optimal allocation of savings (portfolio selection)

Manufacturing or Business Firms (Corporate Finance)

Taken as Given: 1. Owners of the firm are households [either directly or through
financial intermediaries]
2. Proper management is to operate the firm in the best interests of the
owners or shareholders
3. The technology or "blueprints" of available projects (including cost
and revenue forecasts) are known either as point values (certainty) or
as probability distributions.

To be Determined: 1. An operation criterion for measuring good management

2. Investment decision in physical assets (capital budgeting)
a. Which assets to invest in
b. How much to invest in total
3. The long-term financing decision
a. Dividend policy
b. Capital structure decisions and the cost of capital
4. The short-term financing decision
a. Management of working capital and cash

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 Robert C. Merton

5. Mergers and Acquisitions: Firm diversification

6. Taxation and its impact on 2-5 (above)

Financial Intermediaries (Financial Institutions)

Taken as Given: 1. Owners of the intermediary are households [either directly or
through other financial intermediaries]
2. Proper management is to operate the intermediary in the best
interests of the owners or shareholders
To be Determined: 1. Why they exist and what services they provide
2. How the management of financial intermediaries differs from the
management of business firms
3. Efficient management and measurement of performance
4. The role of market makers

Capital Markets and Financial Instruments (Capital Market Finance)

To be Determined: 1. Why they exist and what services they provide
2. The characteristics of an "efficient" capital market
3. How an efficient capital market permits decentralization of decision
making
4. The role of capital markets as a source of information (or "signals")
for efficient decision making by households and managers of
business firms and financial intermediaries
5. The empirical testing of finance theories using capital market
data

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Basic Methodology and Approach of the Course

1. How should the system work?

2. Does it work that way?
3. If not, is there an opportunity for improvement (and hence, a profit opportunity)?
4. If you and the market "disagree," then who is right?

Frequently-Used Concepts

Equilibrium: To understand each element of the system, one must frequently analyze the whole
system. To do so, we look at the aggregated resultant of the actions of each unit. If each unit is
choosing the "best" plan possible and the aggregation of the actions implied by these plans are such
that the market clears (i.e., supply equals demand for every item), then these "best" plans can be
realized, and the market is said to be in equilibrium. In general, it will be assumed that the markets
are in or tending toward equilibrium.

Competition: The basic paradigm adopted is that markets operate such that the very best at their
"job" will earn a "fair" return and those that are not will earn a less-than-fair return. This is in
contrast to the view that anyone can earn a "fair" return and the "smart" people will earn a "super"
return. In certain situations, it will be assumed that the capital markets satisfy the technical
conditions of pure competition.

"Perfect" or "Frictionless" Markets: At times, we will use the abstract concept of a perfect market.
That is, there are no transactions costs or other frictions; that there are no institutional restrictions
against market transactions of any sort; there are no divisibility problems with respect to the scale of
transactions; that equal information is available to all market participants. In some cases, actual
markets will be sufficiently "close" to this abstraction to use the resulting analysis directly. In other
cases, it provides a "benchmark" for the study of imperfections.

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 Robert C. Merton

Summary 53-Year Return Experience: Stocks and Bonds (1926–1978)

Source: “Stocks, Bonds, Bills, and Inflation: Historical Returns (1926–1978),”

R.G. Ibbotson and R.A. Sinquefield, Financial Analysts Foundation (1979).

Average Annual Standard Growth of $1000

Type Return Deviation (Average Compound Return)

Common Stocks (S&P 500) 11.2% 22.2% $89,592

(8.9%)

Long-Term Corporate Bonds 4.1% 5.6% $ 7,807

(4.0%)

Long-Term Government Bonds 3.4% 5.7% $ 5,342

(3.2%)

U.S. Treasury Bills 2.5% 2.2% $ 3,728

(2.5%)

“Inflation-Adjusted” (Consumers Price Index) (“Real”) Returns

Average Annual Standard Growth of $1000

Type Return Deviation (Average Compound Return)

Common Stocks (S&P 500) 8.7% 22.3% $23,399

(6.1%)

Long-Term Corporate Bonds 1.6% NA $ 2,018

(1.3%)

Long-Term Government Bonds 0.9% NA $ 1,377

(0.6%)

U.S. Treasury Bills 0.0% 4.6% $ 965

(0.0%)

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