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11
Input Demand:
The Capital Market
and the Investment Decision
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© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Input Demand:
The Capital Market 11
and the Investment Decision
Chapter Outline
Capital, Investment, and Depreciation
Capital
Investment and Depreciation
Forming Expectations
Comparing Costs and Expected Return
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CAPITAL, INVESTMENT, AND DEPRECIATION
CAPITAL
Capital goods are those goods produced by the economic system that are used as inputs to
produce other goods and services in the future. Capital goods thus yield valuable productive
services over time.
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CAPITAL, INVESTMENT, AND DEPRECIATION
Tangible Capital
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CAPITAL, INVESTMENT, AND DEPRECIATION
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CAPITAL, INVESTMENT, AND DEPRECIATION
Intangible Capital
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CAPITAL, INVESTMENT, AND DEPRECIATION
Measuring Capital
When we speak of capital, we refer not to money or to financial assets such as bonds and
stocks, but instead to the firm’s physical plant, equipment, inventory, and intangible assets.
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CAPITAL, INVESTMENT, AND DEPRECIATION
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CAPITAL, INVESTMENT, AND DEPRECIATION
TABLE 11.1 Private Investment in the U.S. Economy, 2004
GDP = 11,734.3
Gross private domestic investment = 1,928.1
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THE CAPITAL MARKET
The funds that firms use to buy capital goods come, directly or indirectly, from
households. When a household decides not to consume a portion of its income,
it saves. Investment by firms is the demand for capital. Saving by households
is the supply of capital. Various financial institutions facilitate the transfer of
households’ savings to firms that use them for capital investment.
mt s e v nI e ht dna
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mt s e v nI e ht dna
THE CAPITAL MARKET
In general, projects are undertaken as long as the revenues likely to be realized from
the investment are sufficient to cover the interest payments to the household.
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THE CAPITAL MARKET
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THE CAPITAL MARKET
Interest
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THE CAPITAL MARKET
Profits
a given period.
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THE CAPITAL MARKET
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THE CAPITAL MARKET
FINANCIAL MARKETS IN ACTION
mt s e v nI e ht dna
FIGURE 11.2 Financial Markets Link Household Saving and Investment by Firms
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THE CAPITAL MARKET
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THE DEMAND FOR NEW CAPITAL
AND THE INVESTMENT DECISION
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THE DEMAND FOR NEW CAPITAL
AND THE INVESTMENT DECISION
FORMING EXPECTATIONS
The Expected Benefits of Investments
The investment process requires that the potential investor evaluate the expected
flow of future productive services that an investment project will yield.
The ability to lend at the market rate of interest means that there is an opportunity
cost associated with every investment project. The evaluation process thus
involves not only estimating future benefits but also comparing them with the
mt s e v nI e ht dna
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THE DEMAND FOR NEW CAPITAL
AND THE INVESTMENT DECISION
The expected rate of return on an investment project depends on the price of the investment,
the expected length of time the project provides additional cost savings or revenue, and the
expected amount of revenue attributable each year to the project.
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THE DEMAND FOR NEW CAPITAL
AND THE INVESTMENT DECISION
TABLE 11.2 Potential Investment Projects and Expected Rates of Return for a Hypothetical
Firm, Based on Forecasts of Future Profits Attributable to the Investment
(1) (2)
TOTAL EXPECTED RATE
INVESTMENT OF RETURN
PROJECT (DOLLARS) (PERCENT)
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THE DEMAND FOR NEW CAPITAL
mt s e v nI e ht dna
AND THE INVESTMENT DECISION
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THE DEMAND FOR NEW CAPITAL
mt s e v nI e ht dna
AND THE INVESTMENT DECISION
Only those investment projects in the economy that are expected to yield a rate of return
higher than the market interest rate will be funded. At lower market interest rates, more
investment projects are undertaken.
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THE DEMAND FOR NEW CAPITAL
AND THE INVESTMENT DECISION
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A FINAL WORD ON CAPITAL
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REVIEW TERMS AND CONCEPTS
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Appendix
PRESENT VALUE
Year 5 500
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Appendix
R
PV =
mt s e v nI e ht dna
(1 + r ) t
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Appendix
PRESENT VALUE
TABLE 11A.2 Calculation of Total Present Value of a Hypothetical Investment
Project (Assuming r = 10 Percent)
DIVIDED BY PRESENT
END OF… $(r) (1 + r)t = VALUE ($)
If the present value of the income stream associated with an investment is less than the full
cost of the investment project, the investment should not be undertaken.
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Appendix
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Appendix
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Appendix
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