Investment and the Employment

of Capital

Investment and the Employment

of Capital

The Pricing of Capital and Capital Services

• Factor prices versus the price of factor services • factor prices and factor rental rates

• stocks and flows

• Profit-maximising employment of capital

Q Capital as a factor or production refers to

A. the money a firm uses to hire resources.

B. the market value of the firm’s shares.

C. the process by which resources are transformed into other products.

D. things that have already been produced and are used to produce other things. A. B. C. D.

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The Pricing of Capital and Capital Services

• Factor prices versus the price of factor services • factor prices and factor rental rates

• stocks and flows

• Profit-maximising employment of capital

– marginal cost of capital (MCK) – marginal revenue product of capital (MRPK) – profit maximising in perfect capital markets

Perfectly competitive factor market

O Q of factor

£

MRPf

Pf1

O Q of factor

£

MRPf

Qf1

Pf1

Perfectly competitive factor market

Q In a perfectly competitive market for capital services, an individual firm’s

A. marginal cost of capital increases as more capital is used.

B. marginal cost of capital is constant with respect to the quantity of capital used.

C. marginal revenue product of capital increases as more capital used.

D. marginal revenue product of capital is constant with respect to the quantity of capital used. A. B. C. D.

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The Pricing of Capital and Capital Services

• Factor prices versus the price of factor services • factor prices and factor rental rates • stocks and flows

• Profit maximising employment of capital • marginal cost of capital (MCK) • marginal revenue product of capital (MRPK) • profit maximising in perfect capital markets • profit maximising given monopsony power in capital markets

Firm with monopsony power in factor market

O Q of factor

£

MRPf

ACf = S

MCf

O Q of factor

£

MRPf

ACf = S

Qf2

Pf2

MCf

Firm with monopsony power in factor market

The Demand for and Supply of Capital Services

• The demand for capital services • individual firm’s demand • market demand

• The supply of capital services • supply to a single firm • supply by a single firm

• short-run MC • long-run MC

• market supply

• The price of capital services

S

D

O

Re

Qe

Ren

tal r

ate

(£)

Quantity per period

Long-run equilibrium rental rate in the market for capital services Long-run equilibrium rental rate in the market for capital services

O

MRPK

Re MCK = S

Q1

Ren

tal r

ate

(£)

Quantity per period

An individual user of capital services An individual user of capital services

O

Re

Quantity per period Q2

D

S

An individual supplier of capital services An individual supplier of capital services

Ren

tal r

ate

(£)

Investment Appraisal • Capital for purchase: investment • Investment demand

• calculating the benefits of investment • discounting

• present value approach – project is profitable if

NPV > 0 • rate of return approach

– project is profitable if the value of r to make project break even (NPV = 0) is > interest rate

– the risks of investment

cost minusbenefit )1( t

t

Πr

ΠNPV

cost minusbenefit )1( t

t

Πr

ΠNPV

Q If we calculate the value now of a future stream of costs and benefits from an investment, the result is

called the

A. compounding approach.

B. internal rate of return.

C. present value.

D. rate of discount.

E. rate of interest.

A. B. C. D. E.

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Q If a firm invests in a 2-year project that incurs a single initial cost of £10,000 and earns a revenue of £6000 after

one year and another £6000 after the second year, what is the NPV of the project?

A. £11,455

B. £10,413

C. £2000.

D. £1455.

E. £413.

A. B. C. D. E.

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Investment Appraisal • Capital for purchase: investment • Investment demand

• calculating the benefits of investment • discounting

• present value approach – project is profitable if

NPV > 0 • rate of return approach

– project is profitable if the value of r to make project break even (NPV = 0) is > interest rate

– the risks of investment • The supply of capital

– supply of physical capital – supply of finance

Investment Appraisal • Determination of the rate of interest

The market for loanable funds

O

% ra

te p

er y

ear

Quantity of loanable funds

D

S

O

D

% ra

te p

er y

ear

Quantity of loanable funds £e

ie

S

The market for loanable funds

Investment Appraisal • Calculating the costs of capital

• sources of investment finance • retained profits

• borrowing from the banking sector

• share issue

• leverage and the cost of capital • leverage and the risks to suppliers

• measures of leverage • gearing ratio

• debt / equity ratio

The debt / equity ratio The debt / equity ratio

O

Cos

t of c

apita

l (%

)

Ratio of debt to equity

Cost of equity

Cost of debt

O

Cos

t of c

apita

l (%

)

Ratio of debt to equity

Cost of equity

Cost of debt

Weighted average cost of capital

The debt / equity ratio The debt / equity ratio

Q As a company’s leverage increases, so

A. Risk will increase and so will both the cost of equity and the cost of debt, but up to a certain gearing ratio, the weighted average cost of debt will fall.

B. Risk will increase and so will the cost of debt but the cost of equity will decrease as will the weighted average cost of debt.

C. Risk will decrease and so will both the cost of equity and the cost of debt, but up to a certain gearing ratio, the weighted average cost of debt will rise.

D. Risk will decrease and so will the cost of debt, but the cost of equity will increase as will the weighted average cost of debt .

A. B. C. D.

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Investment Appraisal • Calculating the costs of capital

• sources of investment finance • retained profits • borrowing from the banking sector • share issue

• leverage and the cost of capital • leverage and the risks to suppliers • measures of leverage

• gearing ratio • debt / equity ratio

• risk premia

Financing Investment • Sources of business finance

• internal sources

• external sources

• short-term finance

• medium-term finance

• long-term finance • international sources

• comparison of the UK with other EU countries

Financing Investment • The role of the financial sector

• expert advice • expertise in channelling funds • maturity transformation • risk transformation

• Financial institutions in the UK • retail banks • investment banks (wholesale banks)

• merchant banks • overseas banks

• finance houses

The Stock Market • The role of the Stock Exchange

• primary market • secondary market • advantages

• brings together savers & firms seeking investment • regulates firms & helps instil confidence • facilitates mergers and takeovers • reduces transaction costs of investment finance

• disadvantages • cost of getting listed • possible short-termism and instability

The Stock Market • Is the stock market efficient?

• the efficient market hypothesis • weak form of efficiency

• where share dealing prevents cyclical fluctuations in share prices • semi-strong form of efficiency

• where share prices adjust fully to publicly available information • chances, however, of 'insiders' gaining

• strong form of efficiency • where share prices adjust fully to all relevant information (including

'inside information')

Q If share prices respond fully and perfectly to ALL publicly available information, then the stock market is

efficient in the

A. weak sense.

B. semi-strong sense.

C. strong sense.

D. perfectly competitive sense.

E. public sense

A. B. C. D. E.

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Q If stock markets were perfectly efficient in the strong sense, then

A. there would be no insider dealing.

B. share prices would be constant.

C. share prices would reflect speculative pressure.

D. the expected yield on shares would depend on the profitability of the company.

E. share prices would deviate only randomly from their expected value. A. B. C. D. E.

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