Case Econ08 Ab - Az.ppt 11

Chapter
11
Input Demand:
The Capital Market
and the Investment Decision
Prepared by:
Fernando & Yvonn

Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 11: Input Demand: The Capital Market
Input Demand:
The Capital Market 11
Chapter Outline
and the Investment Decision Capital, Investment, and
Depreciation
Capital
Investment and Depreciation
The Capital Market

Capital Income: Interest and
Profits
Financial Markets in Action

Capital Accumulation and
Allocation
The Demand for New Capital

Forming Expectations
Comparing Costs and Expected
Return
A Final Word on Capital

CAPITAL, INVESTMENT, AND
DEPRECIATION
CAPITAL
capital Those goods produced by

the economic system that are
used as inputs to produce other
goods and services in the future.
Capital goods are those goods produced by the economic system that are used as inputs to
produce other goods and services in the future. Capital goods thus yield valuable productive
services over time.
DEPRECIATION
Tangible Capital
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.
DEPRECIATION
Social Capital: 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).
DEPRECIATION
Intangible Capital
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.
DEPRECIATION
The Time Dimension

The value of capital is only as great as the value of the services it will render
over time.
Measuring Capital
capital stock For a single firm, the current

market value of the firm’s plant, equipment,
inventories, and intangible assets.
When we speak of capital, we refer not to money or to financial assets such as bonds and
stocks, but instead to the firm’s physical plant, equipment, inventory, and intangible assets.
DEPRECIATION
INVESTMENT AND DEPRECIATION

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
TABLE 11.1 Private Investment in the U.S. Economy, 2004

GDP = 11,734.3
Gross private domestic investment

= 1,928.1
BILLIONS OF AS A PERCENTAGE AS A
CURRENT OF TOTAL GROSS PERCENTAGE OF
DOLLARS INVESTMENT GDP
Nonresidential structures 298.4 15.5 2.5

Equipment and software 900.4 46.7 7.7
Change in inventories 55.4 2.9 0.5
Residential structures and equipment 673.8 34.9 5.7
Total gross private investment 1928.1 100.0 21.0
 depreciation  1206.2  62.6  10.3
Net investment =
gross investment  depreciation 721.9 37.4 6.2
depreciation The decline in an asset’s

economic value over time.
THE CAPITAL MARKET
capital market The market in which

households supply their savings to firms
that demand funds to buy capital goods.
The funds that firms use to buy capital goods come, directly or indirectly, from
households. When a household decides not to consume a portion of its income,
it saves. Investment by firms is the demand for capital. Saving by households
is the supply of capital. Various financial institutions facilitate the transfer of
households’ savings to firms that use them for capital investment.
THE CAPITAL MARKET
FIGURE 11.1 $1,000 in Savings Becomes $1,000 of Investment
In general, projects are undertaken as long as the revenues likely to be realized from
the investment are sufficient to cover the interest payments to the household.
THE CAPITAL MARKET
interest rate A fee paid annually expressed

as a percentage of the loan or deposit.
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.
financial capital market The part of the

capital market in which savers and investors
interact through intermediaries.
THE CAPITAL MARKET
CAPITAL INCOME: INTEREST AND PROFITS

capital income Income earned on savings

that have been put to use through financial
capital markets.
Interest
interest The payments made for

the use of money.
THE CAPITAL MARKET
Profits
share of common stock A certificate that

represents the ownership of a share of
a business, almost always a corporation.
dividend Profits that are paid

directly to shareholders.
profit The excess of revenues over

cost in a given period.
THE CAPITAL MARKET
Functions of Interest and Profit

A business that cannot cover

the interest payments on its
loans or a firm that does not
generate a normal rate of
return to its owners will
likely
exit the industry in the long
run.
THE CAPITAL MARKET
FINANCIAL MARKETS IN ACTION

FIGURE 11.2 Financial Markets Link Household Saving and Investment by Firms
THE CAPITAL MARKET
CAPITAL ACCUMULATION AND ALLOCATION

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 saving imposes a limit, or constraint, on the
amount of investment that firms can undertake. The capital market exists
to direct savings into profitable investment projects.
THE DEMAND FOR NEW CAPITAL
AND THE INVESTMENT DECISION
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.
FORMING EXPECTATIONS
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.
COMPARING 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.
TABLE 11.2 Potential Investment Projects and Expected Rates of Return for a
Hypothetical Firm, Based on Forecasts of Future Profits Attributable

to the Investment
(1) (2)
TOTAL EXPECTED RATE
INVESTMENT OF RETURN
PROJECT (DOLLARS) (PERCENT)
A. New computer network 400,000 25

B. New branch plant 2,600,000 20
C. Sales office in another state 1,500,000 15
D. New automated billing system 100,000 12
E. Ten new delivery trucks 400,000 10
F. Advertising campaign 1,000,000 7
G. Employee cafeteria 100,000 5
FIGURE 11.3 Total Investment as a Function of the Market Interest Rate
FIGURE 11.4 Investment Demand
Only those investment projects in the economy that are expected to yield a rate of return
higher than the market interest rate will be funded. At lower market interest rates, more
investment projects are undertaken.
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, which is what we learned in Chapter 10.
A FINAL WORD ON CAPITAL
The concept of capital is one of the central

ideas in economics. Capital is produced by

the economic system itself. Capital generates
services over time, and it is used as an input
in the production of goods and services.
REVIEW TERMS AND CONCEPTS
bond human capital

capital intangible capital

capital income interest
capital market interest rate
capital stock
investment
depreciation
physical, or tangible,
dividend
capital
expected rate of
profit
return
financial capital
share of common
stock
market
social capital,
infrastructure
Appendix
CALCULATING PRESENT VALUE

PRESENT VALUE
TABLE 11A.1 Expected Profits from a

$1,200
Investment Project
The discount rate used to
Year 1 $10 evaluate an investment
0
project is the interest rate
Year 2 100
that you could earn by
Year 3 400
investing a similar amount
Year 4 500
of money in an alternative
Year 5 500
investment of comparable
All later years 0
risk.
Total 1,60
0
Appendix
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.
R
PV =
(1 + r ) t
Appendix
PRESENT VALUE
TABLE 11A.2 Calculation of Total Present Value of a Hypothetical

Investment Project (Assuming r = 10 Percent)
DIVIDED BY PRESENT
END OF… $(r) (1 + r)t = VALUE ($)
Year 1 100 (1.1) 90.91

Year 2 100 (1.1)2 82.65
Year 3 400 (1.1)3 300.53
Year 4 500 (1.1)4 341.51
Year 5 500 (1.1)5 310.46
Total Present 1,126.06
Value
If the present value of the income stream associated with an investment is less than the full
cost of the investment project, the investment should not be undertaken.
Appendix
FIGURE 11A.1 Investment Project:

Go or No?
A Thinking Map
Appendix
LOWER INTEREST RATES, HIGHER

PRESENT VALUES
TABLE 11A.3 Calculation of Total Present Value of a Hypothetical

Investment Project (Assuming r = 5 Percent)
DIVIDED BY PRESENT
END OF… $ (1 + r)t = VALUE ($)
Year 1 100 (1.05) 95.24

Year 2 100 (1.05)2 90.70
Year 3 400 (1.05)3 345.54
Year 4 500 (1.05)4 411.35
Year 5 500 (1.05)5 391.76
Total Present 1,334.59
Value
Appendix
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.

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Chapter

Fernando & Yvonn

The Capital Market

Financial Markets in Action

The Demand for New Capital

A Final Word on Capital

capital Those goods produced by

physical, or tangible, capital Material

Social Capital: Infrastructure

social capital, or infrastructure Capital

intangible capital Nonmaterial things that

human capital A form of intangible

The Time Dimension

capital stock For a single firm, the current

INVESTMENT AND DEPRECIATION

investment New capital additions to a

TABLE 11.1 Private Investment in the U.S. Economy, 2004

Gross private domestic investment

Nonresidential structures 298.4 15.5 2.5

depreciation The decline in an asset’s

capital market The market in which

FIGURE 11.1 $1,000 in Savings Becomes $1,000 of Investment

interest rate A fee paid annually expressed

bond A contract between a borrower and a

financial capital market The part of the

CAPITAL INCOME: INTEREST AND PROFITS

capital income Income earned on savings

interest The payments made for

share of common stock A certificate that

dividend Profits that are paid

profit The excess of revenues over

Functions of Interest and Profit

A business that cannot cover

FINANCIAL MARKETS IN ACTION

CAPITAL ACCUMULATION AND ALLOCATION

In modern industrial societies, investment decisions (capital production

Firms have an incentive to expand in industries

that earn positive profits—that is, a rate of return

The Expected Benefits of Investments

The Expected Costs of Investments

COMPARING COSTS AND EXPECTED RETURN

expected rate of return The annual

Hypothetical Firm, Based on Forecasts of Future Profits Attributable

A. New computer network 400,000 25

FIGURE 11.3 Total Investment as a Function of the Market Interest Rate

FIGURE 11.4 Investment Demand

The Expected Rate of Return and the

A perfectly competitive profit-maximizing firm will keep investing in new capital

The concept of capital is one of the central

ideas in economics. Capital is produced by

bond human capital

capital intangible capital

CALCULATING PRESENT VALUE

TABLE 11A.1 Expected Profits from a

present discounted value (PDV), or

present value (PV) The present

TABLE 11A.2 Calculation of Total Present Value of a Hypothetical

Year 1 100 (1.1) 90.91

FIGURE 11A.1 Investment Project: