Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 1 ECON Designed by Amy McGuire, B-books, Ltd. McEachern CHAPTER Capital, Interest, and Corporate Finance Micro

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 2 Production, Saving, and Time LO 1  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 3 Consumption, Saving, and Time LO 1  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 4 Exhibit 1(a) LO 1 Marginal Rate of Return per Year on Investment in Farm Equipment Marginal rate of return = MRP/MRC

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 5 Optimal Investment LO 2  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 6 Exhibit 1(b) LO 2 Marginal Rate of Return per Year on Investment in Farm Equipment $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 0 Investment Interest rate (percent) 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.

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 7 Optimal Investment LO 2  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 8 LO 2 Case Study 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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 9 LO 2 Case Study The Value of a Good Idea–Intellectual Property  Patent  Invention, technical advances  Copyright  Original expression of an author, artist, composer, computer programming  Trademark  Unique commercial marks and symbols

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 10 LO 2 Case Study The Value of a Good Idea–Intellectual Property  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 11 The Market for Loanable Funds LO 2  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 12 The Market for Loanable Funds LO 2  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 13 The Market for Loanable Funds LO 2  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 14 Exhibit 2 LO 2 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.

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 15 Why Interest Rates Differ LO 2  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 16 Exhibit 3 LO 2 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.

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 17 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 LO 3

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 18  Present value (PV) for payments in later years  Receive M dollars  t years from now  Interest rate i  Smaller for higher t LO 3 Present Value and Discounting

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 19  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 LO 3 Present Value and Discounting

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 20 LO 3 Case Study 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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 21 Corporate Finance LO 4  Corporation –Owned by stockholders –Owns property –Earns profit –Sue or get sued –Incur debt

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 22 Corporate Stock and Retained Earnings LO 4  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

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 23 Corporate Bonds LO 4  Corporations borrow –Bank loan –Issue and sell bonds  Bond –Pay back a fixed sum, on the maturity date; annual interest payment –Less risky

Chapter 13Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 24 Securities Exchange LO 4  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