Ch 13 capital, interest, entrepreneurship,and corporate finance micro econ4

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Chapter 13 ECON4 William A. McEachern

1

Capital, Interest,

Entrepreneurship,

and

Corporate

Finance





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

rate

(perc

ent)

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 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






• Demand for loanable funds

– Negative relationship between


• 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






• Supply of loanable funds

– Banks = financial intermediaries

– Positive relationship between


• Quantity of savings supplied

– Interest rate = Reward for saving

11






• Loanable funds market

– Savers (suppliers of loanable funds)

– And borrowers (demanders of loanable

funds)

– Come together to determine


• Quantity of loanable funds

12



Exhibit 2

13

Market for Loanable Funds

1.0 1.10

Loanable funds per year

(trillions of dollars)

8

9

Inte

rest

rate

(perc

ent)

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

14





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 treatment15



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.





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






• 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






• Present value (PV) for payments in later

years

– Receive M dollars

– t years from now

– Interest rate i

– Smaller for higher t19

ti

MPV

)1(






• Present value of an income stream

– Receive $100 next year

– And $150 year after next

– i=5%

20

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

21

i

M





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





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





Entrepreneurship

• Not entrepreneurs

– Corporate inventors

– Managers

– Stockholders

24



Exhibit 4

25

Source of U.S. Patents





Corporate Finance

• Corporation

– Owned by stockholders

– Owns property

– Earns profit

– Sue or get sued

– Incur debt

26





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

corporation27





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





Retained Earnings

• Retained earnings

– After-tax corporate profit reinvested in

the firm

– Rather than paid to stockholders as

dividends

– Help the firm grow

29





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





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

Economy & Finance

Ch 13 capital, interest, entrepreneurship,and corporate finance micro econ4