1. 1 Capital, Interest, and Corporate Finance CHAPTER 13 © 2003 South-Western/Thomson Learning

2. 2 Production, Saving, and Time Since production takes time, it cannot occur without prior saving For example, while Jones is waiting for his current crop to grow, he must rely on food saved from prior production Jones could take some of his time to make a plow which would increase his productivity However, making the plow is time consuming

3. 3 Production, Saving, and Time In making the plow, Jones engages in roundabout production That is, when Jones produces capital he hopes to increase his future productivity An increased amount of roundabout production in an economy means that more capital accumulates  more goods can be produced in the future Advanced industrial economies are characterized by much roundabout production  capital accumulation

4. 4 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

5. 5 Consumption, Saving, and Time Most consumers value present consumption more than future consumption  they have a positive rate of time preference Another explanation for this positive rate of time preference is uncertainty Because present consumption is valued more than future consumption, households must be rewarded to postpone consumption  they must be rewarded

6. 6 Consumption, Saving, and Time By saving a portion of their income in financial institutions, households forgo present consumption for a greater ability to consumer in the future Interest is the reward offered households for forgoing present consumption The interest rate is the annual interest as a percentage of the amount saved

7. 7 Consumption, Saving, and Time The higher the interest rate, other things constant, the more consumers are rewarded for saving  the more willing they are to save

8. 8 Optimal Investment In a market economy characterized by specialization and exchange, firms need not produce their own capital, nor must they rely upon their own saving They can purchase capital using borrowed funds

9. 9 Optimal Investment Suppose that the equipment is so durable that it lasts indefinitely, and that the price is expected to remain the same in the future Thus, the farm equipment will increase revenue not only in the first year but every year into the future The optimal investment requires that Jones take time into consideration

10. 10 Optimal Investment Jones can’t simply equate the marginal resource cost with marginal revenue product 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

11. 11 Optimal Investment Jones must decide how much to invest The first task is to compute the marginal rate of return he would earn each year by investing in farm machinery The marginal rate of return on investment is capital’s marginal revenue product as a percentage of its marginal resource cost

12. 12 Optimal Investment For example, the Tractor-Tiller yields a marginal revenue product of $4,000 per year and has a marginal resource cost of $10,000 The rate of return Jones could earn on this investment is $4,000 / $10,000 is 40% The rates of return for all the pieces of farm equipment are shown in column (6)

13. 13 Optimal Investment Given the marginal rates of return on each piece of equipment, how much should Jones invest in order to maximize profits? Suppose he borrows the money, paying the market interest rate  Jones will buy more capital as long as its marginal rate of return exceeds the market interest rate  he will stop before capital’s marginal rate of return falls below the market rate of interest

14. 14 Optimal Investment If the market rate of interest is 20%, Jones would invest in the first three pieces of equipment  $30,000 Conversely, if the market rate of interest falls to 10%, he will invest in the Harrow as well and at 6% he will invest in the Crop Sprayer

15. 15 Optimal Investment The results would not change if Jones used his own funds so long as he could save at the market interest rate That is, whether Jones borrows the money or uses savings on hand, the market interest rate represents his opportunity cost of investing

16. 16 Summary of Steps First, compute the marginal revenue product of capital Next divide the marginal revenue product by the marginal resource cost to determine the marginal rate of return  the firm’s demand curve for investment The market interest rate is the opportunity cost of investing Firm should invest more as long as the marginal rate of return on capital exceeds the market interest rate

17. 17 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

18. 18 Market for Loanable Funds Firms are not the only demanders of loans Households are often willing to pay extra to consume now rather than later and 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

19. 19 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

20. 20 Demand for Loanable Funds For the economy as a whole, if the amount of other resources and the level of technology are fixed, 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

21. 21 Demand for Loanable Funds Each firm has a downward-sloping demand curve for loanable funds, reflecting a declining marginal rate of return on investment With some qualifications, the demand for loanable funds by each firm can be summed horizontally to yield the demand for loanable funds by all firms

22. 22 Why Interest Rates Differ Thus far, we have been talking about the market rate of interest, implying that only one interest rate prevails in the loanable funds market At any particular time, however, a range of interest rates coexist in the economy Why do interest rates differ? Risk  some borrowers are more likely than others to default

23. 23 Why Interest Rates Differ Duration of the loan Since the future is uncertain, and the further into the future a loan is to be repaid, the more uncertain that repayment becomes  lenders require a higher interest rate Term structure of interest rates is the relationship between the duration of the loan and the interest rate charge Cost of administration Costs of executing the loan agreement, monitoring the loan, and collecting the payments These costs, as a proportion of the total amount of the loan, decrease as the size of the loan increases Tax treatment Lower the tax rate, the lower the interest rate

24. 24 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

25. 25 Present Value One Year Hence Suppose the market interest rate is 10%, so you can either lend or borrow at that rate One way to determine how much you would pay for the opportunity to receive $100 one year from now is to ask how much you would have to save now, at the market interest rate, to end up with $100 one year from now

26. 26 Present Value One Year Hence That is, what amount of money, if saved at a rate of interest of 10%, will accumulate to $100 one year from now We can calculate the answer with the following formula present value x 1.10 = $100, or present value = ($100/1.10) = $90.91 That is, if the interest rate is 10%, $90.91 is the present value of receiving $100 one year from now

27. 27 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 Thus, the present value of $100 to be received one year from now depends on the interest or discount rate

28. 28 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

29. 29 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

30. 30 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

31. 31 Present Value in Later Years Now consider the present value of receiving $100 two years from now  what amount of money, if deposited at the market rate of interest of 5%, would yield $100 two years from now? At the end of the first year, the value would be the present value x 1.05, which would then earn the market interest rate during the second year  the following equation

32. 32 Present Value in Later Years Present value x 1.05 x 1.05 = present value x (1.05) 2 = $100

33. 33 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

34. 34 Present Value of an Income Stream The previous method is used to compute the present value of a single sum to be paid at some point in the future More investments, however, yield a stream of income over time In cases where the income is received over a period of years, the present value of each receipt can be computed individually and the results summed to yield the present value of the entire income stream

35. 35 Present Value of an Annuity A given sum of money received each year for a specified number of years is called an annuity Such an income stream 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

36. 36 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

37. 37 Corporate Stock and Retained Earnings The initial sale of stock to the public is called an initial public offering, or an 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

38. 38 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 Corporations are not required to pay dividends

39. 39 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  less risky

40. 40 Securities Exchanges Once stocks and bonds have been issued and sold, owners of these securities 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

41. 41 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 The secondary markets for stocks also determine the current market value of the corporation

42. 42 Securities Exchanges The 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

43. 43 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 Thus, securities markets allocate funds more readily to successful firms than to firms in financial difficulty