The Capital Market and the Investment Decision

1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 1010
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
Input Demand:Input Demand:
The Capital Market and theThe Capital Market and the
Investment DecisionInvestment Decision

2. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Capital MarketThe Capital Market

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CapitalCapital
• One of the most important concepts in allOne of the most important concepts in all
of economics is the concept ofof economics is the concept of capitalcapital..
• Capital goodsCapital goods are those goods producedare those goods produced
by the economic system that are used asby the economic system that are used as
inputs to produce other goods andinputs to produce other goods and
services in the future.services in the future.

4. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Physical CapitalPhysical Capital
• PhysicalPhysical, or, or tangibletangible,, capitalcapital refers to therefers to the
material things used as inputs in thematerial things used as inputs in the
production of future goods and services.production of future goods and services.
• Major categories of physical capital:Major categories of physical capital:
• Nonresidential structuresNonresidential structures
• Durable equipmentDurable equipment
• Residential structuresResidential structures
• InventoriesInventories

5. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Social CapitalSocial Capital
• Social capitalSocial capital is capital that providesis capital that provides
services to the public.services to the public.
• Major categories of social capital:Major categories of social capital:
• Public works (roads and bridges)Public works (roads and bridges)
• Public services (police and fire protection)Public services (police and fire protection)

6. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Intangible CapitalIntangible Capital
• Nonmaterial things that contribute to theNonmaterial things that contribute to the
output of future goods and services areoutput of future goods and services are
known asknown as intangible capitalintangible capital..
• For example, an advertising campaign toFor example, an advertising campaign to
establish a brand name producesestablish a brand name produces
intangible capital called goodwill.intangible capital called goodwill.

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Human CapitalHuman Capital
• Human capitalHuman capital is a form of intangibleis a form of intangible
capital that includes the skills and othercapital that includes the skills and other
knowledge that workers have or acquireknowledge that workers have or acquire
through education and training.through education and training.
• Human capital yields valuable services to aHuman capital yields valuable services to a
firm over time.firm over time.

8. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Measuring CapitalMeasuring Capital
• The measure of a firm’sThe measure of a firm’s capital stockcapital stock isis
the current market value of its plant,the current market value of its plant,
equipment, inventories, and intangibleequipment, inventories, and intangible
assets.assets.
• When we speak of capital, we refer not toWhen we speak of capital, we refer not to
money or financial assets such as bondsmoney or financial assets such as bonds
or stocks, but to the firm’s physical plant,or stocks, but to the firm’s physical plant,
equipment, inventory, and intangibleequipment, inventory, and intangible
assets.assets.

9. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
InvestmentInvestment
• InvestmentInvestment refers to new capital additionsrefers to new capital additions
to a firm’s capital stock.to a firm’s capital stock.
• Although capital is measured at a givenAlthough capital is measured at a given
point in time (a stock), investment ispoint in time (a stock), investment is
measured over a period of time (a flow).measured over a period of time (a flow).
• The flow of investment increases theThe flow of investment increases the
capital stock.capital stock.

10. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Capital MarketThe Capital Market
• TheThe capital marketcapital market is ais a
market in whichmarket in which
households supply theirhouseholds supply their
savings to firms thatsavings to firms that
demand funds to buydemand funds to buy
capital goods.capital goods.

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Bond LendingBond Lending
• AA bondbond is a contract between a borroweris a contract between a borrower
and a lender, in which the borrower agreesand a lender, in which the borrower agrees
to pay the loan at some time in the future,to pay the loan at some time in the future,
along with interest payments along thealong with interest payments along the
way.way.
• In essence, households supply the capitalIn essence, households supply the capital
demanded by a business firm.demanded by a business firm.
Presumably, the investment will generatePresumably, the investment will generate
added revenues that will facilitate theadded revenues that will facilitate the
payment of interest to the household.payment of interest to the household.

12. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Financial Capital MarketThe Financial Capital Market
• TheThe financial capital marketfinancial capital market is the part ofis the part of
the capital market in which savers andthe capital market in which savers and
investors interact through intermediaries.investors interact through intermediaries.
• Capital incomeCapital income is income earned onis income earned on
savings that have been put to use throughsavings that have been put to use through
financial capital markets.financial capital markets.

13. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Capital Income: Interest and ProfitCapital Income: Interest and Profit
• InterestInterest is the payment made for theis the payment made for the
use of money. Interest is a reward foruse of money. Interest is a reward for
postponing consumption.postponing consumption.
• ProfitProfit is the excess of revenues overis the excess of revenues over
cost in a given period. Profit is a rewardcost in a given period. Profit is a reward
for innovation and risk taking.for innovation and risk taking.

14. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Capital Accumulation and AllocationCapital Accumulation and Allocation
• In modern industrial societies, investmentIn modern industrial societies, investment
decisions (capital production decisions)decisions (capital production decisions)
are made primarily by firms.are made primarily by firms.
• Households decide how much to save,Households decide how much to save,
and in the long-run saving limits orand in the long-run saving limits or
constrains the amount of investment thatconstrains the amount of investment that
firms can undertake.firms can undertake.
• The capital market exists to direct savingsThe capital market exists to direct savings
into profitable investment projects.into profitable investment projects.

15. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Forming ExpectationsForming Expectations
• Decision makers must haveDecision makers must have expectationsexpectations
about what is going to happen in theabout what is going to happen in the
future.future.
• The investment process requires that theThe investment process requires that the
potential investor evaluate the expectedpotential investor evaluate the expected
flow of future productive services that anflow of future productive services that an
investment project will yield.investment project will yield.

16. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Demand for New Capital and theThe Demand for New Capital and the
Investment DecisionInvestment Decision
• The ability to lend at the market rate of interestThe ability to lend at the market rate of interest
means that there is anmeans that there is an opportunity costopportunity cost
associated with every investment project.associated with every investment project.
• The evaluation process thus involves not onlyThe evaluation process thus involves not only
estimatingestimating future benefitsfuture benefits, but also comparing the, but also comparing the
possiblepossible alternative usesalternative uses of the funds required toof the funds required to
undertake the project.undertake the project.
• At a minimum, those funds earn interest inAt a minimum, those funds earn interest in
financial markets.financial markets.

17. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Comparing Costs and Expected ReturnComparing Costs and Expected Return
• TheThe expected rate of returnexpected rate of return isis
the annual rate of return that athe annual rate of return that a
firm expects to obtain throughfirm expects to obtain through
a capital investment.a capital investment.

18. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Determinants of theDeterminants of the
Expected Rate of ReturnExpected Rate of Return
• The expected rate of return on anThe expected rate of return on an
investment project depends on:investment project depends on:
• the price of the investment,the price of the investment,
• the expected length of time the projectthe expected length of time the project
provides additional cost savings or revenue,provides additional cost savings or revenue,
andand
• the expected amount of revenue attributablethe expected amount of revenue attributable
each year to the project.each year to the project.

19. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
A Menu of Investment Choices andA Menu of Investment Choices and
Expected Rates of ReturnExpected Rates of Return
Potential Investment Projects and Expected Rates of Return for a Hypothetical Firm,Potential Investment Projects and Expected Rates of Return for a Hypothetical Firm,
Based on Forecasts of Future Profits Attributable to the InvestmentBased on Forecasts of Future Profits Attributable to the Investment
PROJECTPROJECT
(1)(1)
TOTALTOTAL
INVESTMENTINVESTMENT
(DOLLARS)(DOLLARS)
(2)(2)
EXPECTED RATEEXPECTED RATE
OF RETURNOF RETURN
(PERCENT)(PERCENT)
A. New computer networkA. New computer network 400,000400,000 2525
B. New branch plantB. New branch plant 2,600,0002,600,000 2020
C. Sales office in another stateC. Sales office in another state 1,500,0001,500,000 1515
D. New automated billing systemD. New automated billing system 100,000100,000 1212
E. Ten new delivery trucksE. Ten new delivery trucks 400,000400,000 1010
F. Advertising campaignF. Advertising campaign 1,000,0001,000,000 77
G. Employee cafeteriaG. Employee cafeteria 100,000100,000 55

20. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
A Menu of Investment Choices andA Menu of Investment Choices and
Expected Rates of ReturnExpected Rates of Return
• When the interest rate isWhen the interest rate is
low, firms are more likely tolow, firms are more likely to
invest in new plant andinvest in new plant and
equipment than when theequipment than when the
interest rate is high.interest rate is high.
• The interest rate determinesThe interest rate determines
the opportunity costthe opportunity cost
(alternative investment) of(alternative investment) of
each project.each project.

21. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Investment DemandInvestment Demand
• The market demand curveThe market demand curve
for new capital is the sumfor new capital is the sum
of all the individual demandof all the individual demand
curves for new capital incurves for new capital in
the economy.the economy.
• In a sense, the investmentIn a sense, the investment
demand schedule is ademand schedule is a
ranking of all theranking of all the
investment opportunities ininvestment opportunities in
the economy in order ofthe economy in order of
expected yield.expected yield.

22. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Profit-MaximizingThe Profit-Maximizing
Investment DecisionInvestment Decision
• A perfectly competitive profit-maximizingA perfectly competitive profit-maximizing
firm will keep investing in new capital up tofirm will keep investing in new capital up to
the point at which the expected rate ofthe point at which the expected rate of
return is equal to the interest rate.return is equal to the interest rate.
• This is analogous to saying that the firmThis is analogous to saying that the firm
will continue investing up to the point atwill continue investing up to the point at
which the marginal revenue product ofwhich the marginal revenue product of
capital is equal to the price of capital.capital is equal to the price of capital.
MRPK = PK