1 Capital, Interest, and Corporate Finance Chapter 13 © 2006 Thomson/South-Western.

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Capital, Interest, and Corporate Finance

Chapter 13

© 2006 Thomson/South-Western

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Production, Saving, and Time

An increased amount of roundabout production in an economy means that more capital accumulates so more goods can be produced in the future

Advanced industrial economies are characterized by roundabout production, thus capital accumulation

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Production, Saving, and Time

Production requires saving because both direct and roundabout production requires time

Time during which goods and services are not available from current production

In modern economies, producers need not rely exclusively on their own prior saving by relying on financial intermediaries for funds

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Consumption, Saving, and Time

Most consumers value present consumption more than future consumption, called the positive rate of time preference: Impatience Uncertainty

Because present consumption is valued more than future consumption, households must be rewarded to postpone consumption: Interest

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Exhibit 1a: Marginal Rate of Return on Investment

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Exhibit 1b: Marginal Rate of Return on Investment

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Optimal Investment

The farm equipment will increase revenue not only in the first year, but every year into the future

The optimal investment requires taking time into consideration

The marginal cost is an outlay this year, whereas the marginal product is an annual amount this year and each year into the future

Markets bridge this time discrepancy with the interest rate

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Optimal Investment

The marginal rate of return on investment is capital’s marginal revenue product as a percentage of its marginal resource cost

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Market for Loanable Funds

The major demanders of loans are firms that borrow to invest in physical capital

At any time, each firm has a variety of investment opportunities they rank their opportunities from highest to lowest, based on their expected marginal rates of return

Firms will increase their investment until their expected marginal rate of return just equals the market interest rate

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Market for Loanable Funds

Households are often willing to pay extra to consume now rather than later one way to ensure that these goods and services are

available now is to borrow for present consumption

Household demand curve for loans also slopes reflecting consumers’ greater willingness and ability to borrow at lower interest rates, other things constant

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Market for Loanable Funds

Banks play the role of financial intermediaries in the market for loanable funds

The loanable funds market brings together savers, or suppliers of loanable funds, and borrowers, or demanders of loanable funds, to determine the market rate of interest The higher the interest rate, other things constant,

the greater the reward for saving the larger the quantity of loanable funds

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Exhibit 2: Supply for Loanable Funds The supply of loanable funds curve shows the positive relationship between the market interest rate and the quantity of savings supplied, other things constant the upward sloping supply curve is shown as S.

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Demand for Loanable Funds

Diminishing marginal productivity causes the marginal rate of return curve – which is the demand curve for investment – to slope downward

The demand for loanable funds is based on the expected marginal rate of return these borrowed funds yield when invested in capital

Demand for loanable funds by each firm can be summed horizontally to yield the demand for loanable funds by all firms

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Exhibit 2: Demand for Loanable Funds The demand for loanable funds by all firms is shown as D. Factors assumed constant along the demand curve include the prices of resources, the level of technology, and the tax laws

S

0

8

D

Inte

rest

rat

e (p

erce

nt)

100 Loanable funds per year (billions of dollars)

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Exhibit 2: Market for Loanable Funds Any change in the demand or supply for loanable funds will change the market interest rate. For example a major technological breakthrough that increases the productivity of capital will increase its marginal rate of return – demand for loanable funds shifts from D to D' – a higher interest rate and an increase in the quantity of loanable funds

S

Loanable funds per year (billions of dollars)

0

8

DInte

rest

rat

e (p

erce

nt)

100

9

D'

115

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Why Interest Rates Differ

Risk Duration of the loanCost of administrationTax treatment

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Exhibit 3 Interest Rates Charged for Different Types of Loans

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Present Value and Discounting

Because present consumption is valued more than future consumption, present and future consumption can’t be directly compared

A way of standardizing the discussion is to measure all consumption in terms of its present value

Present value is the current value of a payment or payments that will be received in the future

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Present Value One Year Hence

The procedure of dividing the future payment by 1 plus the prevailing interest rate in order to express it in today’s dollars is called discounting

The interest rate used to discount future payments is called the discount rate

The present value of $100 to be received one year from now depends on the interest or discount rate

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Present Value One Year Hence

The more that present consumption is preferred to future consumption, the higher the interest rate that must be offered savers to defer consumption

That is, the higher the interest rate, or discount rate, the more the future payment is discounted and the lower its present value Alternatively, the higher the interest rate, the less

you need to save now to yield a given amount in the future

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Present Value One Year Hence

Conversely, the less present consumption is preferred to future consumption, the less savers need to be paid to defer consumption and the lower the interest rateThe lower the interest rate, or discount rate, the

less the future income is discounted and the greater its present value

A lower interest rate means that individuals must save more now to yield a given amount in the future

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Present Value One Year Hence

As a general rule, the present value of receiving an amount one year from now is:

Example: when the interest rate is 5%, the present value of receiving $100 one year from now is: $100/ 1.05 = $95.24

rateinterest 1now fromyear one receivedamount PV

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Present Value in Later Years

Present value x 1.05 x 1.05 =

present value x (1.05)2 = $100

70.90$1025.1100$

(1.05)$100 PV

2

tiMPV

)1(

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Present Value in Later Years

Because (1 + i) is greater than 1, the more times it is multiplied by itself (as determined by t), the smaller the present value

Thus, the present value of a given payment will be smaller the further into the future that payment is to be received

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Present Value of an Annuity

Annuity: a given sum of money received each year for a specified number of years

It is called a perpetuity if it continues indefinitely into the future

As a practical matter, the present value of receiving a particular amount forever is not much more than that of receiving it for, say 20 years, because of discounting

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Corporate Stock and Retained Earnings

Corporations acquire funds for investment in three ways Issuing stock Retaining some of their profits borrowing

An entrepreneur is a profit-seeking decision-maker who organizes an enterprise and assumes the risk of operation Pays resource owners for the opportunity to use

those resources in the firm

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Corporate Stock and Retained Earnings

The initial sale of stock to the public is an initial public offering, or IPO

A share of corporate stockRepresents a claim on the net income and

assets of a corporation, andThe right to vote on corporate directors and

on other important mattersOne share of stock leads to one vote

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Corporate Stock and Retained Earnings

Corporations must pay corporate income taxes on any profit

After-tax profit is either paid as Dividends to shareholdersReinvested profit is called retained earnings

and allows the firm to finance expansion

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Corporate Bonds

A bond is the corporation’s promise to pay back the holder a fixed sum of money on the designated maturity date plus make annual interest payments until that date

The payment stream for bonds is more predictable than that for stocks

Unless the corporation goes bankrupt, it is obliged to pay bondholders the promised amounts, making bonds less risky

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Securities Exchanges

After stocks and bonds have been issued and sold, owners are free to resell them on security exchanges

There are seven security exchanges in the U.S., with the two largest being the New York Stock Exchange and the Nasdaq

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Securities Exchanges

Institutional investors, such as banks, insurance companies and mutual funds account for over half the trading volume on major exchanges

By providing a secondary market for securities, exchanges enhance the liquidity of these securities

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Securities Exchanges

Share price reflects the present value of the discounted stream of expected profit

Security prices give the firm’s management some indication of the wisdom of raising investment funds through retained earnings, new stock issues, or new bond issues

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Securities Exchanges

The greater a corporation’s expected profit, other things constant: the higher the value of shares on the

stock market and the lower the interest rate that would

have to be paid on new bond issues