1. Capital and Financial Markets © 2003 South-Western/Thomson Learning

2. Physical Capital and the Firm’s Investment Decision Marginal Revenue Product of Capital Increase in revenue due to a one-unit increase in the capital input

3. The Value of Future Dollars A dollar received now is worth more than a dollar received in the future Present dollars can earn interest Present dollars can earn interest Interest must be paid to borrow present dollars Interest must be paid to borrow present dollars

4. The Value of Future Dollars Present Value The value, in today’s dollars, of a sum of money to be received or paid at a specific date in the future

5. The Value of Future Dollars Present value of $Y to be received in n years in the future is

6. The Value of Future Dollars Discounting The act of converting a future value into its present-day equivalent Discount Rate The interest rate used in computing present value

7. The Value of Future Dollars The present value of a future payment is smaller if the size of the payment is smallerthe size of the payment is smaller the interest rate is largerthe interest rate is larger the payment is received laterthe payment is received later

8. The Firm’s Demand for Capital Principle of Asset Valuation The value of any asset is equal to the total of the present value of all the future benefits it generates

9. The Investment Curve Investment Firms’ purchases of new capital over some period of time

10. The Investment Curve Investment Spending Interest Rate 10% 5% D $1 trillion $1.5 trillion B A

11. The Investment Curve As the interest rate rises, each business firm places a lower value on additional capital, and purchases less of it.As the interest rate rises, each business firm places a lower value on additional capital, and purchases less of it. In the economy as a whole, a rise in the interest rate causes a decrease in investment expenditures.In the economy as a whole, a rise in the interest rate causes a decrease in investment expenditures.

12. The Investment Curve Lower interest rate increase firms’ investment in physical capital –causing capital stock to be larger, and –causing our overall standard of living to be higher.

13. Investment in Human Capital General Human Capital Knowledge, education, or training valuable to many different firmsKnowledge, education, or training valuable to many different firms Specific Human Capital Knowledge, education, or training valuable only at a specific firm.Knowledge, education, or training valuable only at a specific firm.

14. Investment in Human Capital Employers have limited incentives to provide general human capital it increases worker’s value to many firmsit increases worker’s value to many firms worker will capture benefits of higher wagesworker will capture benefits of higher wages Therefore, workers must acquire general human capital on their own, or though government subsidies.

15. Investment in Human Capital Individuals have little incentive to pay for specific human capital it increases their value to only one firmit increases their value to only one firm that one firm will capture the benefitsthat one firm will capture the benefits Therefore, firms provide their workers with specific human capital at the firm’s expense.

16. The Decision to Invest in General Human Capital Human capital is an asset that generates higher income in the future. Therefore, the benefit of any given human capital investment is equal to the total present value of the additional future income.

17. The Decision to Invest in General Human Capital Investment in human capital is inversely related to the interest rate. The lower the interest rate, the higher the investment in general human capital, and the higher our overall standard of living.

18. Financial Markets The Bond MarketThe Bond Market The Stock MarketThe Stock Market The Economic Role of Financial MarketsThe Economic Role of Financial Markets

19. Financial Markets Financial Asset A promise to pay future income in some form such as future dividends or future interest payments

20. The Bond Market Bond: A promise to pay a specific sum of money at some future dateBond: A promise to pay a specific sum of money at some future date Principal: The amount of money a bond promises to pay when it matures.Principal: The amount of money a bond promises to pay when it matures. Maturity Date: The date at which a bond’s principal amount will be paid to the bond’s owner.Maturity Date: The date at which a bond’s principal amount will be paid to the bond’s owner.

21. The Bond Market Pure Discount Bond: A bond that promises no payments except for the principal.Pure Discount Bond: A bond that promises no payments except for the principal. Coupon Payments: A series of periodic payments that a bond promises before maturity.Coupon Payments: A series of periodic payments that a bond promises before maturity. Yield: The rate of return a bond earns for its owner.Yield: The rate of return a bond earns for its owner.

22. The Bond Market Bond Prices and Bond Yields Inverse relationship:Inverse relationship: –the higher the price of any given bond –the lower the yield on that bond

23. Primary and Secondary Bond Markets Primary Market market in which newly issued financial assets are sold for the first timemarket in which newly issued financial assets are sold for the first time Secondary Market market in which previously issued financial assets are soldmarket in which previously issued financial assets are sold

24. Primary and Secondary Bond Markets Secondary Market Bond issuers are not direct participants in trading, but are affected Bond issuers are not direct participants in trading, but are affected –if a bond’s price rises in the secondary market, the price charged for similar newly issued bonds in the primary market will fall as well

25. Why Do Bond Prices and Yields Differ? To put a value on riskier bonds, market participants use a higher discount rate.To put a value on riskier bonds, market participants use a higher discount rate. This leads to lower total present values and lower prices for riskier bonds.This leads to lower total present values and lower prices for riskier bonds. With lower prices, riskier bonds have higher yields.With lower prices, riskier bonds have higher yields.

26. Stock Markets Share of Stock: A share of corporate ownership.Share of Stock: A share of corporate ownership. Dividends: Part of a firm’s current profit that is distributed to shareholders.Dividends: Part of a firm’s current profit that is distributed to shareholders. Capital Gain: The return someone gets by selling a financial asset at a price higher than paid for it.Capital Gain: The return someone gets by selling a financial asset at a price higher than paid for it.

27. Explaining Stock Prices aaa a Shares in The Gap Price per Share $18 15 D S A 12 863 million

28. Explaining Stock Prices aaa a Shares in The Gap Price per Share $20 15 D 1 D 2 S 863 million

29. The Economic Role of Financial Markets Facilitating Large-Scale ProductionFacilitating Large-Scale Production Reallocating Spending Across TimeReallocating Spending Across Time Reducing RiskReducing Risk Disciplining ManagementDisciplining Management

30. Predicting Stock Prices Fundamental AnalysisFundamental Analysis –A method based on the fundamental forces driving a firm’s future earnings Technical AnalysisTechnical Analysis –A method based on a stock’s past behavior

31. Efficient Market Theory A market that instantaneously incorporates all available information relevant to a stock’s price

32. Efficient Market Theory 1.Any information that can be used to predict a stock’s future earnings will be incorporated into its price as soon as it becomes publicly available. By the time a fundamental analyst predicts a rise or fall in price, it has already risen or fallen.

33. Efficient Market Theory 2.Any patterns in stock price movements will be incorporated as soon as they are discernable. Therefore, stock market patterns disappear as soon as they are discovered.