Chapter 13 pp notes

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Eastern Illinois University

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Capital, Interest,

Entrepreneurship,

and Corporate Finance

1


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


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


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


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


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


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

25

20

15

10

5

Inte

rest

rat

e (p

erce

nt)

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 interest8


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


The value of a good idea

• Intellectual property– Intangible assets created by human

knowledge and ideas

– Costly to produce

– Once produced, can be supplied at low cost

• Patent– Establishes property rights to an

invention or other technical advances

9



• Copyright– Confers property rights to an original

expression of an author, artist, composer, or computer programmer

• Trademark – Establishes property rights in unique

commercial marks and symbols

10



• Enforcing property rights is costly– Diminished incentive to create new

products

• Pirated videos, music, computer games, software– No royalties to artists

– No wages to industry workers

– No profits to producers, programmers

– No taxes to government

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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

12



• 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

13



• Supply of loanable funds– Banks = financial intermediaries

– Positive relationship between • Market interest rate• Quantity of savings supplied

– Interest rate = Reward for saving

14



• 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

15


Exhibit 2

16

Market for Loanable Funds

1.0 1.10

Loanable funds per year

(trillions of dollars)

8

9

Inte

rest

rat

e (p

erce

nt)

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


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

17


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 treatment18


Exhibit 3

19

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.


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

20



• 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

21



• Present value (PV) for payments in later years– Receive M dollars

– t years from now

– Interest rate i

– Smaller for higher t22

ti

MPV

)1(



• Present value of an income stream– Receive $100 next year

– And $150 year after next

– i=5%

23

29.231$)05.1(

150$

05.1

100$2PV



• 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

24

i

M


The million-dollar lottery?

• Win $1 million– Paid in annuities

• $33,333 a year for 30 years, i=8%• Present value of the 30th annuity of $33,333

is $3,313• Present value: $375,256

– Lump sum• Less than half• After taxes: only 26% of winnings

25


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)

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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

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Entrepreneurship

• Not entrepreneurs– Corporate inventors

– Managers

– Stockholders

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Exhibit 4

29

Source of U.S. Patents


Corporate Finance

• Corporation– Owned by stockholders

– Owns property

– Earns profit

– Sue or get sued

– Incur debt

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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

corporation31


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

32


Retained Earnings

• Retained earnings– After-tax corporate profit reinvested in

the firm

– Rather than paid to stockholders as dividends

– Help the firm grow

33


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

34


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

35

Chapter 13 pp notes

Economy & Finance

Transcript of Chapter 13 pp notes