Transcript Ch.13

Chapter 13
Capital and Financial Markets
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
A First, Simple Approach
Trucks
Additional Annual
Revenue (MRP)
Additional Annual Cost
(MFC)
First Truck
$10,000
$5,000
Second Truck
$10,000
$5,000
Third Truck
$8,000
$5,000
Fourth Truck
$5,500
$5,000
Fifth Truck
$2,000
$5,000
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The Firm’s Investment Decision
•
The simple approach
– The assumption - one conditions holds
1. Firms rent their capital at a constant
price, just as they rent their labor, OR
2. Firms buy their capital, but it lasts
forever
– The firm should buy another unit of
capital whenever MRP>MFC
– Usually fails
3
The Value of Future Dollars
• $1 received later has less value than $1
received now
– Present dollars - earn interest
– Borrowing dollars - pay interest
• Present value (PV) of a future payment
– Value of that future payment in today’s
dollars
4
The Value of Future Dollars
• The present value of $Y to be received n
years in the future is
Y
PV 
n
(1  r )
• Discounting
– Converting a future value into its present
day equivalent
5
The Value of Future Dollars
•
Discount rate
– The interest rate used in computing
present values.
•
PV of a future payment is smaller if
1. Size of the payment - smaller
2. Interest rate – larger
3. Payment -received later
6
The Firm’s Demand for Capital
• Principle of asset valuation
– Value of any asset = sum of the present
values of all the future benefits it
generates
– Determine the marginal benefit from
buying another unit of capital
7
The Investment Curve
• Investment
– Firms’ purchases of new capital over
some period of time.
• Higher interest rates
– Firms - purchase less capital
– Decrease investment expenditures
8
The Investment Curve
• Lower interest rates
– Firms – increase investment in physical
capital
– Economy - higher standard of living
9
The Investment Curve
• Figure 1 The Investment Curve
Interest
Rate
10%
A
B
5%
Investment Curve
$1
trillion
$1.5
trillion
Investment
Spending
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Financial Markets
• Financial assets
– Promise to pay future income (profits,
interest) to their owners
– Shares of stock
– Bonds
• Principle of asset valuation
– Value of the asset = the sum of the
present values of the future benefits
11
The Bond Market
• Bond
– Promise to pay back borrowed funds
– Corporation, government agency
• Maturity date
– Date at which a bond’s principal amount
will be paid to the bond’s owner
• Principal (face value)
– Amount of money a bond promises to
pay when it matures
12
The Bond Market
• Pure discount bond
– Pays for the principal at maturity
• Coupon payments
– Series of periodic payments - before
maturity
• Yield
– Rate of return a bond earns for its owner
13
Primary and Secondary Bond Markets
• The higher the price of a bond, the lower
the yield
• Primary market
– Newly issued financial assets are sold
• Secondary market
– Previously issued financial assets are
sold
14
Primary and Secondary Bond Markets
• Price increases in secondary markets
– Rise in the price of newly issued bonds
(primary markets)
• Bond’s yield falls in secondary markets
– Yield of newly issued bonds (primary
market) falls
• Riskier bonds
– Lower prices
– Higher yields
15
The Bond Market
• Supply of bonds
– Quantity of a particular bond in existence
at a given moment
– Supply curve - vertical
• Value of a bond = Present value –
discount rate
16
The Bond Market
• Demand for bonds
– Bonds people want to hold, at a given
moment, at different hypothetical prices
– Demand curve - slopes downward
17
The Bond Market
• Figure 2 The Market for One-Year GM Bonds
Price
per
Bond
BS
$10,000
A
BD
6,000
Number of Bonds
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Changes in a Bond’s Price
• Bonds trade at their equilibrium price
• Supply curve shifts rarely
• Price of bonds - changes every day
– An increase in the (riskless) interest rate
– An increase in the attractiveness of other
assets
– An increase in the perceived riskiness of
the bond.
– Expectations of any of the above
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Changes in a Bond’s Price
• Figure 3 A Decrease in Demand for GM Bonds
Price
per
Bond
BS
$10,000
A
9,500
B
BD1
BD2
6,000
Number of Bonds
20
The Stock Market
• Share of stock
– A share of ownership in a corporation
• Primary stock market
– Newly issued shares
– Corporation - receives income
• Secondary stock market
– Previously issued shares are sold and
resold
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Direct and Indirect Ownership of Stock
• Direct ownership
– Buy stock - by calling a broker
• Indirect ownership
– Purchase shares of a mutual fund
• Mutual fund
– Corporation that specializes in owning
shares of stock in other corporations
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Why Do People Hold Stock?
• Dividends
– Part of a firm’s current profit that is
distributed to shareholders
• Capital gain - sell a financial asset at a
higher price
• The value of a share of stock
– Total present value of its future payments
– $Y/r
• $Y - profit after taxes
• r - the discount rate
23
Reading the Stock Pages
• Figure 4 Stock Market Table for Trading on August 1, 2006
24
The Stock Market
• Supply
– Quantity of shares in existence at any
moment in time
– Number of shares that people are
actually holding
– Supply curve - vertical
• Demand
– Shares people want to hold, at a given
moment, at different hypothetical prices
– Demand curve - slopes downward
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The Stock Market
• Figure 5 The Market for FedEx Shares
Price per
Share
1. The supply curve is vertical at 302 million – the
total number of shares FedEx has issued.
S
$122
100
A
2. The downward-sloping demand
curve shows how many shares the
public wants to hold at each price.
78
3. The equilibrium is at point A,
where people want to hold all
the shares in existence.
D
302 million
Shares in FedEx
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Changes in a Stock’s Price
• Stocks- sell at their equilibrium prices
• Demand curve to shifts
– Release of new information suggesting
greater profits than previously
anticipated.
– A decrease in interest rates.
– A decrease in the attractiveness of other
assets.
– Expectations of any of the above
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Changes in a Stock’s Price
• Figure 6 An Increase in Demand for Shares of FedEx
Price per
Share
S
B
$125
100
A
D1
302 million
D2
Shares in FedEx
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Efficient Markets Theory
• Efficient market
– Instantaneously incorporates all available
information relevant to a stock’s price
– Beneficiaries - those who are holding the
stock before the information became
available
• Common Objections
– Research on particular stocks
– Luck
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Efficient Markets Theory
• Trade as little as possible
• Diversified portfolio with different stocks
• Assemble a diversified set of stocks
– Hold on to them
– Buy and sell only when new cash comes
in or cash needs to be taken out
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The Economic Role of Financial Markets
• Savers and borrowers come together in
financial markets - both sides benefit.
– Consumers - save funds, earn a rate of
return
– Firms - invest and grow
– Help relax the economic constraints
imposed by scarcity
– High standard of living
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College as an Investment
• Costs of college
– Present value of the costs of college,
explicit and implicit
• Financial benefits of college
– Earnings generally increase with age
– Earnings increase with education for all
age groups
– Earnings rise with age more sharply for
those with more education.
32
College as an Investment
Average Annual Earnings
• Figure 7 Age-Earnings Profiles
$70,000
Bachelor’s Degree
60,000
50,000
40,000
Associate’s Degree
30,000
High School Graduate
20,000
10,000
0
18-24 25-34
35-44
45-54
Age Group
55-64
>65
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