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Econ 10 - 951

Econ 10 - 951. UNC-Chapel Hill Spring 2001. Lecture 14 Capital Investments 02/27/2000. 1. Why People Invest. Capital and Investment. Physical capital Human capital Investment : purchase or development of a capital resource Saving is income not spent on current consumption.

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Econ 10 - 951

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  1. Econ 10 - 951 UNC-Chapel Hill Spring 2001 Lecture 14 Capital Investments 02/27/2000

  2. 1. Why People Invest

  3. Capital and Investment • Physical capital • Human capital • Investment: purchase or development of a capital resource • Saving is income not spent on current consumption. • Types of capital:

  4. Savings and Investment • Investment and saving are closely linked: • Savings is income minus consumption. • Investment is the use of unconsumed income to produce a capital resource. • Saving is required for investment - somebody must save in order to free resources for investment.

  5. Investment and Consumption • One can often produce more consumption goods in future by: • Using resources to produce more physical and human capital, and, • Then using the capital to produce more consumption goods in future. • Consumption in the future is less desirable than consumption now because people have a positive rate of time preference -- they prefer goods sooner rather than later.

  6. 2. Interest Rates

  7. Interest Rate • The interest rate is the price of earlier availability. • It is the premium that borrowers must pay lenders in order to acquire purchasing power now rather than later. • These funds may be used for either consumption or investment.

  8. Determination of Interest Rates • Interest rates are determined by the supply and demand for loanable funds. • The demand for loanable funds comes from two sources: • Productivity of capital resources -- investment demand • Positive rate of time preference -- desire by consumers for earlier availability.

  9. Determination of Interest Rates • Interest rewards lenders who curtail current consumption (supply loanable funds) so that others can buy now rather than later. • The market interest rate will bring the quantity of funds demanded by borrowers into balance with the quantity supplied by lenders.

  10. Supply Demand Determination of Interest Rate InterestRates • The demand for loanable funds stems from the consumer’s desire for earlier availability and the productivity of capital. • As the interest rate rises, current goods become more expensive in comparison with future goods. Therefore, borrowers will demand less loanable funds. i • On the other hand, higher interest rates will stimulate lenders to supply additional funds to the market. • In Equilibrium, the quantity of loanable funds demanded equals the quantity supplied. The “price” of loanable funds is the interest rate (i). Q LoanableFunds

  11. Money Rate vs. Real Rate • During inflation, the nominal interest rate (money interest rate)is a misleading indicator of the true cost of borrowing. • The money interest rate will include an inflationary premium reflecting the expected rate of inflation. • The real rate of interest (money interest rate minus the inflationary premium)is a better measure of the true cost of borrowing.

  12. Interest Rates and Risk • More than one interest exists in loanable funds market. • Ex: mortgage rate, credit card rate. • Riskier loans will have higher money interest rates. • Long-term loans are generally riskier.

  13. Components of Money Interest Rate • Pure rate of interest • Price of earlier availability • Inflationary premium • Reflects expectations that the loan will be paid with dollars of less purchasing power. • Risk premium • Reflects probability of default.

  14. Components of Money Interest Rate Risk Premium • The money interest rate reflects three components: • Risk Premiumis large when the probability of default by the borrower is substantial. InflationaryPremium • Inflationary Premiumis large when decision makers expect a high rate of inflation during the period in which the loan is outstanding. PureInterest • Pure Interest

  15. 3. Present Value of Future Income and Costs

  16. PV = $ 100 Receipts 1 year from now PV = 1.06 Interest rate • Def: where i = 6 % • Ex: = Present Value • The interest rate connects the value of dollars today with the value of dollars in the future. • The present value (PV) of a payment received one year from now is: $ 94.34

  17. R1 R2 R3 Rn PV . . . . . + + + + = (1 + i) (1 + i)2 (1 + i)3 (1 + i)n Present Value • The present value of a future stream of revenue (R) or costs: • The present value of a future dollar payment is inversely related to: • The interest rate • How far in the future the payment will be received.

  18. Present Value of $100 to be ReceivedA Designated Number of YearsIn the Future for Alternative Interest Rates YearsIn TheFuture 1 2 3 4 5 90.57 6 $90.57. 7 8 9 10 15 20 30 50 Present Value • The columns indicate the present value of $100 to be received a designated number of years in the future for alternate interest rates. 2Percent 6Percent 12Percent 20Percent 98.04 94.34 89.29 83.33 96.12 89.00 69.44 79.72 • For example, at a discount rate of 2%, the present value of $100 to be received five years from now is . . . 94.23 83.96 57.87 71.18 92.39 79.21 48.23 63.55 74.73 40.19 56.74 88.80 70.50 33.49 50.66 87.06 66.51 27.08 45.23 85.35 62.74 • Note that the present value of $100 declines as either the interest rate or the number of years in the future increases. 23.26 40.39 83.68 59.19 19.38 36.06 82.03 55.84 16.15 32.20 74.30 41.73 6.49 18.27 67.30 31.18 2.61 10.37 55.21 17.41 0.42 3.34 37.15 5.43 0.01 0.35

  19. 1. Why are investors willing to pay interest to acquire loanable funds? Why are lenders willing to loan funds? Questions for Thought: 2. If the current interest rate is 8%, what is the present value of three $1,000 payments to be received at the end of each of the next three years? Would the present value increase or decrease if the interest rate were higher, say 10%? 3. A lender made the following statement to a borrower, "You are borrowing $1,000, which is to be repaid in 12 monthly installments of $100 each. Your total interest charge is $200, which means your interest rate is 20 percent." Is the effective interest rate on the loan really 20 percent? Explain.

  20. 4. Present Value, Profitability, and Investment

  21. Discounted PV of $12,000 of Truck Rental for Four Years(Interest Rate = 8 Percent) Expected FutureIncome ReceivedAt Year-End(2) Discounted Value(8 Percent Rate)(3) Present Valueof Income(4) Year(1) Discounted Present Value 1 $ 12,000 0.926 $ 11,112 2 $ 12,000 0.857 $ 10,284 3 $ 12,000 0.794 $ 9,528 4 $ 12,000 0.735 $ 8,820 $ 39,744 • Suppose a truck rental firm is contemplating the purchase of a new $40,000 truck where past experience dictates that the firm can rent out the truck for net revenues of $12,000 per year for the 4 years of the truck’s expected life (assume the truck has 0 value after 4 yrs). • Because the firm can borrow and lend the funds at an interest rate of 8 %, we will discount the future expected income at an 8% rate. • How much is this 4 year stream of income worth today? We calculate its present value (PV)above. • The PV of the future income is less than the cost of the endeavor, $39,744 < $40,000, the project should not be undertaken.

  22. Expected Future Earnings and Asset Value • The current value of an asset will be determined by the present value of its expected future net earnings. • An increase (decline) in the expected future earnings derived from an asset will increase (reduce) the market value of the asset.

  23. 5. Investing in Human Capital

  24. Earningsw/ College Annual Earningsor Costs ($) B Earningsw/o College Co 0 Cd Age 65 18 22 Investing Human Capital • Consider here a simplified example of a human-capital investment decision confronting Juanita, an 18-year old who just finished high-school. and without college. • Above, we graph Juanita’s expected earnings with • If Juanita chooses to attend college, she will incur the direct cost (Cd) of the college education (tuition, books, etc) . . . plus the opportunity cost (Co) of earnings forgone while in college. • With a college education, though, Juanita can expect higher future earnings (B) during her career (even though they may begin lower, they end higher). • If the discounted present value of the additional future earnings exceeds the discounted value of the direct and indirect costs of a college education, then the college degree will be a profitable investment for Juanita.

  25. 6. Profit and Prosperity

  26. Economic Profit • Economic profit plays a central role in the allocation of capital and the determination of which investment projects will be undertaken. • In a competitive environment, profit reflects: • Uncertainty • Entrepreneurship • The ability to recognize and undertake profitable projects that have gone unnoticed by others.

  27. 7. The Capital Market and the Wealth of Nations

  28. Capital Market and Wealth of Nations • To grow and prosper, a nation must have a mechanism that will attract saving and channel it into investment projects that create wealth. • The capital market performs this function in a market economy. • When property rights are defined and securely enforced, productive investments will also be profitable.

  29. Capital Market and Wealth of Nations • Investment in both physical and human capital is an important source of growth in productivity (and income). • Economies that invest more and channel their investment funds into more productive projects generally grow more rapidly.

  30. 1. How are human‑ and physical‑capital investment decisions similar? How do they differ? Do human‑capital investors make profits? If so, what is the source of the profit? Explain. Questions for Thought: 2.In a market economy, investors have a strong incentive to undertake profitable investments. What makes an investment profitable? Do profitable investments create wealth? Why or why not? Do all investments create wealth? Explain. 3.Some countries with very low incomes per capita are unable to save very much. Are people in these countries helped or hurt by people in high‑income countries with much higher rates of saving?

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