chapter 13copyright ©2009 by south-western, a division of cengage learning. all rights reserved 1...

Chapter 13 Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 1

ECON

Designed byAmy McGuire, B-books, Ltd.

McEachern 2008-2009

13

CHAPTERCapital, Interest,and Corporate Finance

Micro


Production, Saving, and Time

LO1

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


Consumption, Saving, and Time

LO1

Consumers– Positive rate of time preference

• Value present consumption more than future consumption

– Willing to pay more to consume now• Impatience• Uncertainty

– Interest• Reward for postponing consumption

– Interest rate


Exhibit 1(a)LO1

Marginal Rate of Return per Year on Investment in Farm Equipment

Marginal rate of return = MRP/MRC


Optimal Investment

LO2

Specialization and exchange• Purchase capital• Borrow funds

Diminishing marginal returns from capital Marginal rate of return on investment

– Capital’s MRP as percentage of its MRC– Marginal benefit of investment

Market interest rate– Opportunity cost of investing


Exhibit 1(b)LO2

Marginal Rate of Return per Year on Investment in Farm Equipment

$60,000$50,000

$40,000$30,000

$20,000$10,0000

Investment

40

32

24

16

8

Inte

rest

rat

e (p

erce

nt)

Marginal rate

of return

Marginal rate of return curve: line segments showing the relationship between the market interest rate and the amount invested in farm equipment. This curve shows the farmer’s demand for investment.


Optimal Investment

LO2

Maximize profit– Increase investment as long as marginal

rate of return > market interest rate Demand for investment

– Derived demand– Marginal rate of return curve– Demand curve: steps down

• Diminishing marginal productivity of capital


LO2C

ase

Stu

dy

The Value of a Good Idea–Intellectual Property

Intellectual property Intangible assets

created by human knowledge and ideas

Costly to produce Once produced, can be

supplied at low cost


LO2C

ase

Stu

dy


Patent Invention, technical

advances Copyright

Original expression of an author, artist, composer, computer programming

Trademark Unique commercial

marks and symbols


LO2C

ase

Stu

dy


Enforcing property rights 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


The Market for Loanable Funds

LO2

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

Downward sloping D curve



LO2

Demand for loanable funds

– Negative relationship

• Market interest rate

• Quantity of loans demanded

– Declining marginal rate of return on investment

– Other things constant

• Prices of other resources

• Technology

• Tax laws



LO2

Supply of loanable funds

– Banks = financial intermediaries

– Positive relationship

• Market interest rate

• Quantity of savings supplied

– Interest rate

• Reward for saving Market interest rate

• Demand

• Supply


Exhibit 2LO2

Market for Loanable Funds

Because of the declining marginal rate of return on capital, the quantity of loanable funds demanded is inversely related to the interest rate. The equilibrium rate of interest, 8%, is found where D intersects the S.

An increase in demand from D to D’ raises the equilibrium interest rate from 8% to 9% and increases the market quantity of loanable funds from $100 billion to $115 billion.


Why Interest Rates Differ

LO2

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 treatment


Exhibit 3LO2

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 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

LO3


Present value (PV) for payments in later years Receive M dollars t years from now Interest rate i

Smaller for higher t

LO3

ti

MPV

)1(



Present value of an income stream Receive $100 next year, and $150 year after

next; i=5%

Present value of an annuity Perpetuity – if continues indefinitely Present value of receiving M dollars each

year forever

LO3

29.231$)05.1(

150$

05.1

100$2PV

i

M



LO3C

ase

Stu

dy

The Million-Dollar Lottery?

Win $1 million Paid in annuities

$50,000 a year for 20 years, i=10%

Present value: $425,700

Lump sum Less than half After taxes: only

27% of winnings


Corporate Finance

LO4

Corporation– Owned by stockholders– Owns property– Earns profit– Sue or get sued– Incur debt


Corporate Stock and Retained Earnings

LO4

Fund investment– Issue and sell stock– Retain some of their profits– Borrow

Pay– Corporate income taxes on any profit– Dividends to shareholders

Retained earnings– Reinvested profit


Corporate Bonds

LO4

Corporations borrow – Bank loan– Issue and sell bonds

Bond– Pay back a fixed sum, on

the maturity date; annual interest payment

– Less risky


Securities Exchange

LO4

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

chapter 13copyright ©2009 by south-western, a division of cengage learning. all rights reserved 1...

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