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

2 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

3 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

4 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

5 Exhibit 1a: Marginal Rate of Return on Investment

6 Exhibit 1b: Marginal Rate of Return on Investment

7 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

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

9 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

10 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

11 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

12 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.

13 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

14 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 Interest rate (percent) 100 Loanable funds per year (billions of dollars)

15 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 D Interest rate (percent) D' 115

16 Why Interest Rates Differ  Risk  Duration of the loan  Cost of administration  Tax treatment

17 Exhibit 3 Interest Rates Charged for Different Types of Loans

18 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

19 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

20 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

21 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 rate  The 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

22 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

23 Present Value in Later Years  Present value x 1.05 x 1.05 = present value x (1.05) 2 = $100

24 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

25 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

26 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

27 Corporate Stock and Retained Earnings  The initial sale of stock to the public is an initial public offering, or IPO  A share of corporate stock  Represents a claim on the net income and assets of a corporation, and  The right to vote on corporate directors and on other important matters  One share of stock leads to one vote

28 Corporate Stock and Retained Earnings  Corporations must pay corporate income taxes on any profit  After-tax profit is either paid as  Dividends to shareholders  Reinvested profit is called retained earnings and allows the firm to finance expansion

29 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

30 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

31 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

32 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

33 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