© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Capital, Interest, Entrepreneurship, and Corporate Finance 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Production, Saving, and Time Production –Cannot occur without prior saving –Roundabout production Produce capital to increase productivity –Requires saving Takes time –Goods and services are not available from current production 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Consumption, Saving, and Time Consumers –Positive rate of time preference –Willing to pay more to consume now Impatience Uncertainty –Interest Reward for postponing consumption 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Consumption, Saving, and Time Positive rate of time preference –Consumers value present consumption more than future consumption –People must be rewarded to postpone consumption Interest rate –Interest per year as a percentage of the amount saved or borrowed 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Optimal Investment Specialization and exchange –Purchase capital –Borrow funds Firms buy new capital goods –If they expect this investment to yield a higher return than other possible uses of their funds 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Optimal Investment Expected rate of return on capital –Expected annual earnings divided by capital’s purchase price Market interest rate –Opportunity cost of investing Maximize profit –Increase investment as long as marginal rate of return > market interest rate 6

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 1 7 Expected Rate of Return on Golf Carts and the Opportunity Cost of Funds $25,000$20,000$15,000$10,000$5,0000 Investment Interest rate (percent) Expected rate of return An individual firm invests in any project with an expected rate of return that exceeds the market interest rate. At an interest rate of 8 percent, Hacker Haven invests $15,000 in three golf carts. Market rate of interest 8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Optimal Investment Downward-sloping demand curve for investment (individual industries) –More is invested when the opportunity cost of borrowing is lower Investment demand curve for the entire economy –Downward sloping 8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds Demanders of loans (borrow) –Entrepreneurs Start firms Invest in physical and intellectual capital Increase investment until –Expected marginal rate of return = market interest rate –Households Present consumption Invest in human capital 9

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds Demand for loanable funds –Negative relationship between Market interest rate Quantity of loans demanded –Declining marginal rate of return –Other things constant Prices of other resources, technology Expected rate of inflation, tax laws Customs and conventions of the market 10

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds Supply of loanable funds –Banks = financial intermediaries –Positive relationship between Market interest rate Quantity of savings supplied –Interest rate = Reward for saving 11

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Market for Loanable Funds Loanable funds market –Savers (suppliers of loanable funds) –And borrowers (demanders of loanable funds) –Come together to determine Market interest rate Quantity of loanable funds 12

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 2 13 Market for Loanable Funds Loanable funds per year (trillions of dollars) 8 9 Interest rate (percent) S D D’ Because of the declining expected rate of return on capital, the quantity of loanable funds demanded is inversely related to the interest rate. The market rate of interest, 8 percent, is found where the demand curve for loanable funds intersects the supply curve of loanable funds. An increase in the demand for loanable funds from D to D’ raises the market interest rate from 8 percent to 9 percent and increases the equilibrium quantity of loanable funds from $1.0 to $1.1 trillion

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why Interest Rates Differ Prime rate –Interest rate lenders charge their most trustworthy business borrowers Collateral –Asset pledged by the borrower –Can be sold to pay off the loan in the event the borrower defaults 14

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Why Interest Rates Differ Risk –The more valuable the collateral, the lower the interest rate Duration of the loan –Interest rate increases with the duration of the loan Administration costs –Decrease as size of the loan increases Tax treatment 15

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 3 16 Interest Rates Charged for Different Types of Loans Interest rates are higher for riskier loans. Rates for home mortgages and new cars are relatively low because these loans are backed up by the home or car as collateral. Personal loans and credit card balances face the highest rates, because these loans are riskier—that is, the likelihood borrowers fail to repay the loans is greater and the borrower offers no collateral.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Present Value and Discounting Present value –Current value of payment(s) to be received in the future Discounting –Converting future dollar amounts into present value 17

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Present Value and Discounting Present value one year hence –Amount received one year from now Divided by (1+interest rate) –The higher the interest rate The more any future payment is discounted The lower its present value 18

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Present Value and Discounting Present value (PV) for payments in later years –Receive M dollars –t years from now –Interest rate i –Smaller for higher t 19

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Present Value and Discounting Present value of an income stream –Receive $100 next year –And $150 year after next – i=5% 20

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Present Value and Discounting Annuity –A given sum of money received each year for a specified number of years Present value of an annuity –Perpetuity – if continues indefinitely –Present value of receiving M dollars each year forever 21

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Entrepreneurship Entrepreneur –Comes up with an idea –Turns that idea into a marketable product –Accepts the risk of success or failure –Claims any resulting profit or loss (residual claimant) 22

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Entrepreneurship Entrepreneur –Have the authority to hire and fire the manager –Drive the economy forward New products Improve existing products New production methods New ways of doing business 23

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Entrepreneurship Not entrepreneurs –Corporate inventors –Managers –Stockholders 24

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 4 25 Source of U.S. Patents

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Finance Corporation –Owned by stockholders –Owns property –Earns profit –Sue or get sued –Incur debt 26

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Stock Corporations fund investment –Issue and sell stock –Retain some of their profits –Borrow Initial public offering (IPO) –Initial sale of corporate stock to the public Corporate stock –Certificate reflecting part ownership of a corporation 27

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Stock Corporations pay –Corporate income taxes on any profit –Dividends to shareholders Dividends –After-tax corporate profit paid to stockholders –Rather than retained by the firm and reinvested 28

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Retained Earnings Retained earnings –After-tax corporate profit reinvested in the firm –Rather than paid to stockholders as dividends –Help the firm grow 29

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Bonds Corporations borrow –Bank loan –Issue and sell bonds Bond –Certificate reflecting a firm’s promise To pay the lender periodic interest And to repay the borrowed sum of money on the designated maturity date –Less risky than stocks 30

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Securities Exchange Securities market –Stocks and bonds –Secondary market for securities Enhance liquidity –Hedge funds –Determine the current value of a corporation –Allocate funds more readily to successful firms than to firms in financial difficulty 31