Determination of the Optimal Capital Investment

The desired/optimal amount of capital for the firm to own occurs at

the intersection of the marginal product with the user cost of capital:
= . At this point, the extra output produced by one
additional unit of capital is precisely enough to cover the extra cost of
owning a unit of capital, the user cost.
When the capital stock reaches a steady-state level
= ( + ). Thus, in the long run, the marginal product of
capital equals the real cost of capital.

Determination of the Optimal Capital Investment

The speed of adjustment toward the steady state depends on how
quickly firms adjust their capital stock which in turn depends on how
costly it is to build, deliver, and instill new capital.

Changes in the Optimal/Desired Capital Stock

Factors that shifts the curve or change the user cost of capital
cause the optimal/desired capital stock to change.
An increase (or a decrease) in interest rate leads to a decrease
(or an increase) in the optimal capital stock.

Figure 5.2: An Increase in Interest Rate

An Increase in Interest Rate

The interest rate rises from to
The rise in the user cost leads to an upward shift of the user cost
line, from 1 to 2
After that shift, the at the initial optimal capital is less than
the user cost of capital: < < .
The optimal capital stock decreases from to .
Summary: Any other change that increases (or decrease) the user
cost of capital decrease (or increases) the optimal capital stock.

Changes in the Optimal Capital Stock

An increase in future total factor productivity (TFP) or technology
leads to an increase in optimal capital stock.
Figure 5.3: An increase in Technology

An increase in Technology
Technological changes affect the
A technological advance causes the to shift upward from

to

2 .

After that shift, the at the initial optimal capital is more

than the user cost of capital: > > .
If the user cost remains unchanged, the technological advance
causes the optimal capital stock to rise from to .
Summary: With the user cost of capital held constant, an increase in
the at any level of capital raises the optimal capitals stock.

Changes in the Optimal Capital Stock

Taxes and the Optimal Capital Stock
So far we have ignored the role of taxes in the investment decision.
But a firm must take into account taxes in evaluating the desirability
of an additional unit of capital.
Suppose that = the tax rate on firm revenue.
Then the optimal capital stock is the one at which the after-tax future
marginal product of capital equals the user cost:
5.10 : =

Taxes and the Optimal Capital Stock

In 5.10 , the term

is called the tax-adjusted user cost of

capital, which shows how large the before-tax future marginal

product of capital must be for a firm to willingly add another unit of
capital.
An increase in tax rate raises the tax-adjusted user cost and thus
reduces the optimal capital stock.

Figure 5.4: An Increase in Tax on a Firms Revenue

Changes in Taxes
The tax rate rises from = 0 to > 0
The rise in the user cost leads to an upward shift of the user cost
line, from 1 to 2
After that shift, the at the initial optimal capital is less than
the user cost of capital: < < .
The optimal capital stock decreases from to .
Summary: Any other change that increases (or decrease) the user
cost of capital decrease (or increases) the optimal capital stock.

Some caveats on the tax-adjusted user cost of capital:

In reality, profits are taxed even though we assumed that firm revenues
were taxed. The corporate income tax is a tax on corporate profits.
Depreciation allowances reduce the tax paid by firms, because they
reduce profits.

Depreciation allowances
Tax deductions that allow firms to reduce its total tax payment by
deducting the purchase price of capital from its taxable profit in both the
year of purchase and in subsequent years
Investment tax credits reduce taxes when firms make new investments.

Some caveats on the tax-adjusted user cost of capital:

Investment tax credits
Tax provision in which a firm is permitted to subtract a certain
percentage of the purchase price of new capital directly from its tax
bill
Economists summarizes the many provisions of the tax code
affecting investment by a single measure of the tax burden on capital
called the effective tax rate.
Effective tax rate
The tax rate on firm revenue that would have the same effect on
the optimal capital stock as do the actual provisions of the tax code.

Some caveats on the tax-adjusted user cost of capital:

Changes in the tax law that raise the effective tax rate are equivalent
to an increase in tax on firm revenue and a rise in the tax-adjusted
user cost of capital. Thus, all else being equal, an increase in the
effective tax lowers the optimal capital stock.

Example (5.3): Optimal Capital Stock

Hula hoop fabricator cost $100 each. The Hi-Ho Hula Hoop
Company (HHHHC) is trying to decide how many of these machines to
buy. HHHHC expects to produce the following number of hoops
each year for each level of capital stock shown in the table.
Hula hoops have a price of $1 each. HHHHC has no
other costs besides the cost of fabricators.

Example (5.3): Optimal Capital Stock

100

150

180

195

205

210

=
+

$0

1
$0

Example (5.3): Optimal Capital Stock

a) If = 12% ( 0.12) per year and = 20%(0.20) per year, find
the user cost of capital (in dollars per fabricator per year). How many
fabricator should HHHHC buy?
(Ans.)
HHHHC should buy two fabricators, since at two fabricators,
= $ > = $.
But at the third fabricator, = $ < = $.
You want to add capital only if > .
Since < for the third fabricator, so it should not be added.

Example (5.3): Optimal Capital Stock

b) If = 12% ( 0.12) per year, = 20%(0.20) per year and =
40% ( 0.4) on HHHHCs sales revenue, how many fabricator should
HHHHC buy?
(Ans.)
HHHHC should buy just one fabricator,
since = $ > = $.
It shouldnt buy the second one
since = $ < = $.

Example (5.3): Optimal Capital Stock

100

150

=
+

$0

$50

$100(0.12+0.2)
= $32
$32

(1 0.4)$100
= $60
0.6(50) = $30

180

$30

$32

0.6(30) = $18

195

$15

$32

0.6(15) = $9

205

$10

$32

0.6(10) = $6

210

$5

$32

0.6(5) = $3

$100

$0

Example (5.4): From Desired Capital to Investment

Cobb-Douglas production function: = 1/3 2/3
Show that the marginal product of capital declines as capital increases
this is the diminishing returns to capital or the diminishing
marginal product of capital.
(Ans.)
=

2/3
1
1

= 2/3 2/3 =
3
3

= =

< > .

From Desired Capital to Investment

From 5.1 : +1 =

From 5.9 : =

1
= 2/3 2/3 =
3

=
=
3

= 3 = 3

+ (in real terms)

1 / /

Dividing both sides of (5.1) by :

+1

From Desired Capital to Investment

Substitute for and solve for :

+
5.11 : ( ) =

Intuition: The investment rate inversely depends on the user cost:

a higher user cost of capital leads to a lower investment.
For example, higher taxes reduce the investment rate (via the user
cost of capital).

The Stock Market and Financial Investment

In macroeconomics, capital and investment usually refer to the
accumulation of physical capital. However, these words are used
frequently in finance while these are different uses.
The Arbitrage Equation and the Price of Stock
Suppose a (financial) investor has some extra money to invest.
Option 1: Put the money into a saving account that pays an interest
rate .
Option 2: Purchase a stock at price , hold the stock for a year, and
then sell it.

The Arbitrage Equation and the Price of Stock

Assumption: Both investments are perfectly safe. That is, the investor
knows what the dividend and capital gain will be; these are not
uncertain.
The arbitrage equation tells someone investing dollars in either
the bank account or the stock must get the same financial return.
= +

dividend+

The Arbitrage Equation and the Price of Stock

5.12 : =

()

()

Meaning: The only way there is no arbitrage opportunity is if these

two investments have the same return.
5.13 : =

dividend

dividend
capital gain

Example (5.5)
a) A stock may pay a dividend of $10 per share forever. If the capital
gain is zero and the interest rate is 5%, what is the price of the stock?
(Ans.)
=

$
.

$
..

= $

b) Suppose the initial dividend is $10, the interest rate is 5%, and the
growth rate of dividend (and, therefore, the stock price) is 2%. What
is the price of stock?
(Ans.)
$

Investment and the Stock Market

Many economists see a link between fluctuations in investment and
fluctuations in the stock market. Economic theory suggests that rises
and falls in the stock market should lead firms to change their rates of
capital investment in the same direction: Firms change investment in
the same direction as the stock market.
The relationship between stock prices and firms investment in
physical capital is captured by the q theory of investment, called
Tobins q, developed by James Tobin.

Investment and the Stock Market

5.11 : =

where is stock market value of firm (the value of the economys

capital as determined by the stock market = stock price x the number
of shares), is firms capital and is price of new capital.
The denominator is the price of that capital if it were purchased
today.
Tobin reasoned that net investment should depend on whether q is
greater or less than 1.

Investment and the Stock Market

> 1
>
Managers can raise the market value of firms stock by buying
more capital. Invest more!
< 1
<
Managers will not replace capital as it wears out. Dont invest!
Booming stock market raises V, causing q to rise, increasing
investment.

Figure 5.5: Investment and Tobins q, 1987 - 2012

Investment and the Stock Market

Tobins q and real private non-residential investment are closely
related; they rose together throughout the 1990s and then both fell
sharply in 2000 and 2008. But the relationship isnt strong in the 1987
stock market crash and the mid-2000s because many other things
change at the same time.
Relationship b/w the q theory of investment and neoclassical theory
of investment:
Higher
Higher future earnings
Increases V and so q.

Investment and the Stock Market

Relationship b/w the q theory of investment and neoclassical theory
of investment:
A falling real interest rate
raise stock prices and hence q as investors substitute away from
low-yielding bonds and bank deposits and buy stocks instead.
A decrease in the purchase price of capital
Lower replacement cost of installed capital
Raise q.
Because all three types of change increase Tobins q, they also
increase the optimal capital stock and investment.

Investment and the Stock Market

Q: What is the advantage of Tobins q as a measure of the incentive to
invest?
A: Tobins reflects the expected future profitability of capital as well
as the current profitability. For example, Congress legislates
a reduction in the corporate income tax beginning next year
Greater profits for the owners of capital
Higher expected profits raise the value of stock today
Increase Tobins q
Raise investment today.

Investment and the Stock Market

Tobins q theory of investment emphasizes that investment decisions
depend not only on current economic policies but also on policies
expected to prevail in the future.