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Transcript
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 2 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 10 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 18 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 19 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 21 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 22 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 25 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 26 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 27 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 28 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 29 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 30 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 31 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 33