Input Demand: The Capital Market and the Investment Decision

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Input Demand:Input Demand:The Capital Market and the The Capital Market and the

Investment DecisionInvestment Decision


The Capital MarketThe Capital Market


CapitalCapital

• One of the most important concepts in all One of the most important concepts in all of economics is the concept of of economics is the concept of capitalcapital..

• Capital goodsCapital goods are those goods produced are those goods produced by the economic system that are used as by the economic system that are used as inputs to produce other goods and inputs to produce other goods and services in the future.services in the future.


Physical CapitalPhysical Capital

• PhysicalPhysical, or , or tangibletangible, , capitalcapital refers to the refers to the material things used as inputs in the material things used as inputs in the production of future goods and services.production of future goods and services.

• Major categories of physical capital:Major categories of physical capital:

• Nonresidential structuresNonresidential structures

• Durable equipmentDurable equipment

• Residential structuresResidential structures

• InventoriesInventories


Social CapitalSocial Capital

• Social capitalSocial capital is capital that provides is capital that provides services to the public.services to the public.

• Major categories of social capital:Major categories of social capital:

• Public works (roads and bridges)Public works (roads and bridges)

• Public services (police and fire protection)Public services (police and fire protection)


Intangible CapitalIntangible Capital

• Nonmaterial things that contribute to the Nonmaterial things that contribute to the output of future goods and services are output of future goods and services are known as known as intangible capitalintangible capital..

• For example, an advertising campaign to For example, an advertising campaign to establish a brand name produces establish a brand name produces intangible capital called goodwill.intangible capital called goodwill.


Human CapitalHuman Capital

• Human capitalHuman capital is a form of intangible is a form of intangible capital that includes the skills and other capital that includes the skills and other knowledge that workers have or acquire knowledge that workers have or acquire through education and training.through education and training.

• Human capital yields valuable services to a Human capital yields valuable services to a firm over time.firm over time.


Measuring CapitalMeasuring Capital

• The measure of a firm’s The measure of a firm’s capital stockcapital stock is is the current market value of its plant, the current market value of its plant, equipment, inventories, and intangible equipment, inventories, and intangible assets.assets.

• When we speak of capital, we refer not to When we speak of capital, we refer not to money or financial assets such as bonds money or financial assets such as bonds or stocks, but to the firm’s physical plant, or stocks, but to the firm’s physical plant, equipment, inventory, and intangible equipment, inventory, and intangible assets.assets.


InvestmentInvestment

• InvestmentInvestment refers to new capital additions refers to new capital additions to a firm’s capital stock.to a firm’s capital stock.

• Although capital is measured at a given Although capital is measured at a given point in time (a stock), investment is point in time (a stock), investment is measured over a period of time (a flow).measured over a period of time (a flow).

• The flow of investment increases the The flow of investment increases the capital stock.capital stock.


Private Investment in the U.S. Private Investment in the U.S. Economy, 1999Economy, 1999

Private Investment in the U.S. Economy, 1999Private Investment in the U.S. Economy, 1999

BILLIONS OFBILLIONS OFCURRENTCURRENTDOLLARSDOLLARS

AS A PERCENTAGE AS A PERCENTAGE OF TOTAL GROSS OF TOTAL GROSS

INVESTMENTINVESTMENT

AS A AS A PERCENTAGE PERCENTAGE

OF GDPOF GDP

Nonresidential structuresNonresidential structures 285.6285.6 17.317.3 3.13.1

Equipment and softwareEquipment and software 917.4917.4 55.655.6 9.99.9

Change in inventoriesChange in inventories 43.343.3 2.62.6 0.50.5

Residential structuresResidential structures 403.8403.8 24.524.5 4.34.3

Total gross private investmentTotal gross private investment 1,650.11,650.1 100.0100.0 17.817.8

depreciationdepreciation 961.4961.4 58.358.3 10.310.3

Net investment =Net investment = 688.7688.7 41.741.7 7.57.5

gross investment minus depreciationgross investment minus depreciation

• DepreciationDepreciation is a decline in an asset’s economic value is a decline in an asset’s economic value over time.over time.


The Capital MarketThe Capital Market

• The The capital marketcapital market is a is a market in which market in which households supply their households supply their savings to firms that savings to firms that demand funds to buy demand funds to buy capital goods.capital goods.


$1,000 in Savings Becomes $1,000 of Investment$1,000 in Savings Becomes $1,000 of Investment


Bond LendingBond Lending

• A A bondbond is a contract between a borrower is a contract between a borrower and a lender, in which the borrower agrees and a lender, in which the borrower agrees to pay the loan at some time in the future, to pay the loan at some time in the future, along with interest payments along the along with interest payments along the way.way.

• In essence, households supply the capital In essence, households supply the capital demanded by a business firm. demanded by a business firm. Presumably, the investment will generate Presumably, the investment will generate added revenues that will facilitate the added revenues that will facilitate the payment of interest to the household.payment of interest to the household.


The Financial Capital MarketThe Financial Capital Market

• The The financial capital marketfinancial capital market is the part of is the part of the capital market in which savers and the capital market in which savers and investors interact through intermediaries.investors interact through intermediaries.

• Capital incomeCapital income is income earned on is income earned on savings that have been put to use through savings that have been put to use through financial capital markets.financial capital markets.


Capital Income: Interest and ProfitCapital Income: Interest and Profit

• InterestInterest is the payment made for the is the payment made for the use of money. Interest is a reward for use of money. Interest is a reward for postponing consumption.postponing consumption.

• ProfitProfit is the excess of revenues over is the excess of revenues over cost in a given period. Profit is a reward cost in a given period. Profit is a reward for innovation and risk taking.for innovation and risk taking.


Financial Capital Markets in ActionFinancial Capital Markets in Action

• Four mechanisms for channeling Four mechanisms for channeling household savings into investment household savings into investment projects include:projects include:

• Business loansBusiness loans

• Venture capitalVenture capital

• Retained earningsRetained earnings

• The stock marketThe stock market


Financial Markets Link Household Financial Markets Link Household Saving and Investment by FirmsSaving and Investment by Firms


Capital Accumulation and AllocationCapital Accumulation and Allocation

• In modern industrial societies, investment In modern industrial societies, investment decisions (capital production decisions) decisions (capital production decisions) are made primarily by firms.are made primarily by firms.

• Households decide how much to save, and Households decide how much to save, and in the long-run saving limits or constrains in the long-run saving limits or constrains the amount of investment that firms can the amount of investment that firms can undertake.undertake.

• The capital market exists to direct savings The capital market exists to direct savings into profitable investment projects.into profitable investment projects.


Forming ExpectationsForming Expectations

• Decision makers must have Decision makers must have expectationsexpectations about what is going to happen in the about what is going to happen in the future.future.

• The investment process requires that the The investment process requires that the potential investor evaluate the expected potential investor evaluate the expected flow of future productive services that an flow of future productive services that an investment project will yield.investment project will yield.


The Demand for New Capital and the The Demand for New Capital and the Investment DecisionInvestment Decision

• The ability to lend at the market rate of interest The ability to lend at the market rate of interest means that there is an means that there is an opportunity costopportunity cost associated with every investment project.associated with every investment project.

• The evaluation process thus involves not only The evaluation process thus involves not only estimating estimating future benefitsfuture benefits, but also comparing the , but also comparing the possible possible alternative usesalternative uses of the funds required to of the funds required to undertake the project.undertake the project.

• At a minimum, those funds earn interest in At a minimum, those funds earn interest in financial markets.financial markets.


Comparing Costs and Expected ReturnComparing Costs and Expected Return

• The The expected rate of returnexpected rate of return is is the annual rate of return that a the annual rate of return that a firm expects to obtain through firm expects to obtain through a capital investment.a capital investment.


Determinants of theDeterminants of theExpected Rate of ReturnExpected Rate of Return

• The expected rate of return on an The expected rate of return on an investment project depends on:investment project depends on:

• the price of the investment,the price of the investment,

• the expected length of time the project the expected length of time the project provides additional cost savings or revenue, provides additional cost savings or revenue, andand

• the expected amount of revenue attributable the expected amount of revenue attributable each year to the project.each year to the project.


A Menu of Investment Choices and A Menu of Investment Choices and Expected Rates of ReturnExpected Rates of Return

Potential Investment Projects and Expected Rates of Return for a Hypothetical Firm, Potential Investment Projects and Expected Rates of Return for a Hypothetical Firm, Based on Forecasts of Future Profits Attributable to the InvestmentBased on Forecasts of Future Profits Attributable to the Investment

PROJECTPROJECT

(1)(1)TOTALTOTAL

INVESTMENT INVESTMENT(DOLLARS)(DOLLARS)

(2)(2)EXPECTED RATEEXPECTED RATE

OF RETURNOF RETURN(PERCENT)(PERCENT)

A. New computer networkA. New computer network 400,000400,000 2525

B. New branch plantB. New branch plant 2,600,0002,600,000 2020

C. Sales office in another stateC. Sales office in another state 1,500,0001,500,000 1515

D. New automated billing systemD. New automated billing system 100,000100,000 1212

E. Ten new delivery trucksE. Ten new delivery trucks 400,000400,000 1010

F. Advertising campaignF. Advertising campaign 1,000,0001,000,000 77

G. Employee cafeteriaG. Employee cafeteria 100,000100,000 55


A Menu of Investment Choices and A Menu of Investment Choices and Expected Rates of ReturnExpected Rates of Return

• When the interest rate is When the interest rate is low, firms are more likely to low, firms are more likely to invest in new plant and invest in new plant and equipment than when the equipment than when the interest rate is high.interest rate is high.

• The interest rate determines The interest rate determines the opportunity cost the opportunity cost (alternative investment) of (alternative investment) of each project.each project.


Investment DemandInvestment Demand

• The market demand curve The market demand curve for new capital is the sum for new capital is the sum of all the individual demand of all the individual demand curves for new capital in curves for new capital in the economy.the economy.

• In a sense, the investment In a sense, the investment demand schedule is a demand schedule is a ranking of all the ranking of all the investment opportunities in investment opportunities in the economy in order of the economy in order of expected yield.expected yield.


The Profit-MaximizingThe Profit-MaximizingInvestment DecisionInvestment Decision

• A perfectly competitive profit-maximizing A perfectly competitive profit-maximizing firm will keep investing in new capital up to firm will keep investing in new capital up to the point at which the expected rate of the point at which the expected rate of return is equal to the interest rate.return is equal to the interest rate.

• This is analogous to saying that the firm This is analogous to saying that the firm will continue investing up to the point at will continue investing up to the point at which the marginal revenue product of which the marginal revenue product of capital is equal to the price of capital.capital is equal to the price of capital.

MRPK = PK


Present ValuePresent Value

• The present value (The present value (PVPV), or present ), or present discounted value, of discounted value, of RR dollars dollars tt years from years from now is:now is:

• Lower interest rates result in higher Lower interest rates result in higher present values. The firm has to present values. The firm has to pay morepay more nownow to purchase the same number of to purchase the same number of future dollars.future dollars.

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Input Demand: The Capital Market and the Investment Decision

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