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Input Demand: The Capital Market and the Investment Decision

Input Demand: The Capital Market and the Investment Decision. 11. CHAPTER OUTLINE. Capital, Investment, and Depreciation Capital Investment and Depreciation The Capital Market Capital Income: Interest and Profits Financial Markets in Action Capital Accumulation and Allocation

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Input Demand: The Capital Market and the Investment Decision

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  1. Input Demand:The Capital Market andthe Investment Decision 11

  2. CHAPTER OUTLINE Capital, Investment, and DepreciationCapital Investment and Depreciation The Capital MarketCapital Income: Interest and Profits Financial Markets in Action Capital Accumulation and Allocation The Demand for New Capital and the Investment Decision Forming Expectations Comparing Costs and Expected Return Appendix: Calculating Present Value

  3. CAPİTAL, INVESTMENT, AND DEPRECİATİON capital Those goods produced by the economic system that are used as inputs to produce other goods and services in the future. physical, or tangible, capital Material things used as inputs in the production of future goods and services. The major categories of physical capital are : nonresidential structures, durable equipment, residential structures, and inventories.

  4. SOCİAL CAPİTAL: INFRASTRUCTURE social capital, or infrastructure Capital that provides services to the public. Most social capital takes the form of public works (roads and bridges) and public services (police and fire protection).

  5. INTANGİBLE CAPİTAL intangible capital Nonmaterial things that contribute to the output of future goods and services. human capital A form of intangible capital that includes the skills and other knowledge that workers have or acquire through education and training and that yields valuable services to a firm over time.

  6. MEASURİNG CAPİTAL the time dimension The value of capital is only as great as the value of the services it will render over time. capital stock For a single firm, the current market value of the firm’s plant, equipment, inventories, and intangible assets. Capital stocks are affected over time by two flows: investment and depreciation.

  7. INVESTMENT AND DEPRECİATİON investment New capital additions to a firm’s capital stock. Although capital is measured at a given point in time (a stock), investment is measured over a period of time (a flow). The flow of investment increases the capital stock. depreciation The decline in an asset’s economic value over time.

  8. THE CAPİTAL MARKET capital market The market in which households supply their savings to firms that demand funds to buy capital goods. financial capital market The part of the capital market in which savers and investors interact through intermediaries

  9. THE CAPİTAL MARKET bond A contract between a borrower and a lender, in which the borrower agrees to pay the loan at some time in the future, along with interest payments along the way.

  10. THE CAPİTAL MARKET

  11. CAPİTAL INCOME: INTEREST AND PROFİTS • capital income • Income earned on savings that have been put to use through financial capital markets. • Interest • The payments made for the use of money. • profit • The excess of revenues over cost in a given period. • interest rate • A fee paid annually expressed as a percentage of the loan or deposit.

  12. CAPİTAL INCOME: INTEREST AND PROFİTS • stock • A share of stock is an ownership claim on a firm, entitling its owner to a profit share. • Functions of Interest and Profit • Interest may function as an incentive to postpone gratification. • Profit serves as a reward for innovation and risk taking.

  13. FİNANCİAL MARKETS İN ACTİON

  14. CAPİTAL ACCUMULATİON AND ALLOCATİON In modern industrial societies, investment decisions (capital production decisions) are made primarily by firms. Households decide how much to save; and in the long run, savings limit or constrain the amount of investment that firms can undertake. The capital market exists to direct savings into profitable investment projects.

  15. THE DEMAND FOR NEW CAPİTAL Firms have an incentive to expand in industries that earn positive profits—that is, a rate of return above normal—and in industries in which economies of scale lead to lower average costs at higher levels of output. Positive profits in an industry stimulate the entry of new firms. The expansion of existing firms and the creation of new firms both involve investment in new capital.

  16. THE DEMAND FOR NEW CAPİTAL The Expected Benefits of Investments The investment process requires that the potential investor evaluate the expected flow of future productive services that an investment project will yield. The Expected Costs of Investments The ability to lend at the market rate of interest means that there is an opportunity cost associated with every investment project. The evaluation process thus involves not only estimating future benefits but also comparing them with the possible alternative uses of the funds required to undertake the project. At a minimum, those funds could earn interest in financial markets.

  17. COMPARİNG COSTS AND EXPECTED RETURN expected rate of return The annual rate of return that a firm expects to obtain through a capital investment. The expected rate of return on an investment project depends on the price of the investment, the expected length of time the project provides additional cost savings or revenue, and the expected amount of revenue attributable each year to the project.

  18. COMPARİNG COSTS AND EXPECTED RETURN

  19. COMPARİNG COSTS AND EXPECTED RETURN The demand for new capital depends on the interest rate. When the interest rate is low, firms are more likely to invest in new plant and equipment than when the interest rate is high. This is so because the interest rate determines the direct cost (interest on a loan) or the opportunity cost (alternative investment) of each project.

  20. COMPARİNG COSTS AND EXPECTED RETURN Lower interest rates are likely to stimulate investment in the economy as a whole, whereas higher interest rates are likely to slow investment.

  21. COMPARİNG COSTS AND EXPECTED RETURN The Expected Rate of Return and the Marginal Revenue Product of Capital A perfectly competitive profit-maximizing firm will keep investing in new capital up to the point at which the expected rate of return is equal to the interest rate. This is analogous to saying that the firm will continue investing up to the point at which the marginal revenue product of capital is equal to the price of capital, or MRPK = PK .

  22. A P P E N D I X PRESENT VALUE Present value describes how much a future sum of money is worth today. 

  23. A P P E N D I X present discounted value (PDV), or present value (PV) The present discounting value of R dollars to be paid t years in the future is the amount you need to pay today, at current interest rates, to ensure that you end up with R dollars t years from now. It is the current market value of receiving R dollars in t years.

  24. MEASURİNG THE TİME VALUE OF MONEY Money today is more valuable than the same amount of money in the future. Question 1: If you put $100 in a bank account today, how much will it be worth in t years? That is, what will be the future value of this $100? Then the $100 will become: (1 + r) × $100 after 1 year, (1 + r) × (1 + r) × $100 = (1 + r)² × $100 after 2 years, (1 + r) × (1 + r) × (1 + r) × $100 = (1 + r) ³ × $100 after 3 years, . . . (1 + r)t × $100 after t years. For example, if we are investing at an interest rate of %5 for 10 years, then the future value of the $100 will be (1+0.05)¹⁰× $100, which is $163.

  25. MEASURİNG THE TİME VALUE OF MONEY Question 2: Now suppose you are going to be paid $200 in t years. What is the present value of this future payment? That is, how much would you have to deposit in a bank right now to yield $200 in t years? The present value of $200 in t years is $200/(1 + r)ͭ. If that amount is deposited in a bank today, after t years it would become (1 + r)ͭ× [$200/(1 + r)ͭ], which is $200. For instance, if the interest rate is 5 percent, the present value of $200 in 10 years is $200/(1.05)¹⁰, which is $123. This means that $123 deposited today in a bank account that earned 5 percent would produce $200 after 10 years.

  26. A P P E N D I X LOWER INTEREST RATES, HIGHER PRESENT VALUES If the present value of an expected stream of earnings from an investment exceeds the cost of the investment necessary to undertake it, then the investment should be undertaken. However, if the present value of an expected stream of earnings falls short of the cost of the investment, then the financial market can generate the same stream of income for a smaller initial investment, and the investment should not be undertaken.

  27. Present Value Example • Suppose you are depositing an amount today in an account that earns 5% interest, compounded annually. If your goal is to have $5,000 in the account at the end of six years, how much must you deposit in the account today? • Solution • The following information is given: • future value = $5,000 • interest rate = 5% • number of periods = 6 • present value = future value / (1 + interest rate)number of periods • or, using notation • PV = R / (1 + r)t • Inserting the known information, • PV = $5,000 / (1 + 0.05)6 • PV = $5,000 / (1.3401) • PV = $3,731

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