Investment And The Employment Of Capital
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Investment and the Employment of Capital
The Pricing of Capital and Capital Services • Factor prices versus the price of factor services – factor prices and factor rental rates – stocks and flows
• Profit maximising employment of capital – marginal cost of capital (MCK) – marginal revenue product of capital (MRPK) – profit maximising in perfect capital markets
Perfectly competitive factor market £
Pf1
MRPf O
Q of factor
Perfectly competitive factor market £
Pf1
MRPf O
Qf1
Q of factor
The Pricing of Capital and Capital Services • Factor prices versus the price of factor services – factor prices and factor rental rates – stocks and flows
• Profit maximising employment of capital – marginal cost of capital (MCK) – marginal revenue product of capital (MRPK) – profit maximising in perfect capital markets – profit maximising given monopsony power in capital markets
Firm with monopsony power in factor market £
MCf ACf = S
MRPf O
Q of factor
Firm with monopsony power in factor market £
MCf ACf = S
Pf2
MRPf O
Qf2
Q of factor
The Demand for and Supply of Capital Services • The demand for capital services – individual firm’s demand – market demand
• The supply of capital services – supply to a single firm – supply by a single firm • short-run MC • long-run MC
– market supply
• The price of capital services
Long-run equilibrium rental rate in the market for capital services
Rental rate (£)
S
Re
D
O
Qe
Quantity per period
Rental rate (£)
An individual user of capital services
MCK = S
Re
MRPK
O
Q1
Quantity per period
An individual supplier of capital services
Rental rate (£)
S Re
D
O
Quantity per period
Q2
Investment Appraisal • Capital for purchase: investment • Investment demand – calculating the benefits of investment – discounting • present value approach • rate of return approach
– the risks of investment
• The supply of capital – supply of physical capital – supply of finance
Investment Appraisal • Determination of the rate of interest
The market for loanable funds
% rate per year
S
D
O
Quantity of loanable funds
The market for loanable funds
% rate per year
S
ie
D
O
£e
Quantity of loanable funds
Investment Appraisal • Calculating the costs of capital – sources of investment finance • retained profits • borrowing from the banking sector • share issue
– leverage and the cost of capital • leverage and the risks to suppliers • measures of leverage – gearing ratio – debt / equity ratio
The debt / equity ratio
Cost of capital (%)
Cost of equity
Cost of debt
O
Ratio of debt to equity
The debt / equity ratio
Cost of capital (%)
Cost of equity
Weighted average cost of capital Cost of debt
O
Ratio of debt to equity
Investment Appraisal • Calculating the costs of capital – sources of investment finance • retained profits • borrowing from the banking sector • share issue
– leverage and the cost of capital • leverage and the risks to suppliers • measures of leverage – gearing ratio – debt / equity ratio
– risk premia
Financing Investment • Sources of business finance – internal sources – external sources • short-term finance • medium-term finance • long-term finance
– international sources – comparison of the UK with other EU countries
Financing Investment • The role of the financial sector – expert advice – expertise in channelling funds – maturity transformation – risk transformation
• Financial institutions in the UK – retail banks – investment banks (wholesale banks) • merchant banks • overseas banks
– finance houses
The Stock Market • The role of the Stock Exchange – primary market – secondary market – advantages • brings together savers & firms seeking investment • regulates firms & helps instil confidence • facilitates mergers and takeovers • reduces transaction costs of investment finance
– disadvantages • cost of getting listed • possible short-termism and instability
The Stock Market • Is the stock market efficient? – the efficient market hypothesis – weak form of efficiency • where share dealing prevents cyclical fluctuations in share prices
– semi-strong form of efficiency • where share prices adjust fully to publicly available information • chances, however, of 'insiders' gaining
– strong form of efficiency • where share prices adjust fully to all relevant information (including 'inside information')
The Pricing of Capital and Capital Services • Factor prices versus the price of factor services – factor prices and factor rental rates – stocks and flows
• Profit maximising employment of capital – marginal cost of capital (MCK) – marginal revenue product of capital (MRPK) – profit maximising in perfect capital markets
Perfectly competitive factor market £
Pf1
MRPf O
Q of factor
Perfectly competitive factor market £
Pf1
MRPf O
Qf1
Q of factor
The Pricing of Capital and Capital Services • Factor prices versus the price of factor services – factor prices and factor rental rates – stocks and flows
• Profit maximising employment of capital – marginal cost of capital (MCK) – marginal revenue product of capital (MRPK) – profit maximising in perfect capital markets – profit maximising given monopsony power in capital markets
Firm with monopsony power in factor market £
MCf ACf = S
MRPf O
Q of factor
Firm with monopsony power in factor market £
MCf ACf = S
Pf2
MRPf O
Qf2
Q of factor
The Demand for and Supply of Capital Services • The demand for capital services – individual firm’s demand – market demand
• The supply of capital services – supply to a single firm – supply by a single firm • short-run MC • long-run MC
– market supply
• The price of capital services
Long-run equilibrium rental rate in the market for capital services
Rental rate (£)
S
Re
D
O
Qe
Quantity per period
Rental rate (£)
An individual user of capital services
MCK = S
Re
MRPK
O
Q1
Quantity per period
An individual supplier of capital services
Rental rate (£)
S Re
D
O
Quantity per period
Q2
Investment Appraisal • Capital for purchase: investment • Investment demand – calculating the benefits of investment – discounting • present value approach • rate of return approach
– the risks of investment
• The supply of capital – supply of physical capital – supply of finance
Investment Appraisal • Determination of the rate of interest
The market for loanable funds
% rate per year
S
D
O
Quantity of loanable funds
The market for loanable funds
% rate per year
S
ie
D
O
£e
Quantity of loanable funds
Investment Appraisal • Calculating the costs of capital – sources of investment finance • retained profits • borrowing from the banking sector • share issue
– leverage and the cost of capital • leverage and the risks to suppliers • measures of leverage – gearing ratio – debt / equity ratio
The debt / equity ratio
Cost of capital (%)
Cost of equity
Cost of debt
O
Ratio of debt to equity
The debt / equity ratio
Cost of capital (%)
Cost of equity
Weighted average cost of capital Cost of debt
O
Ratio of debt to equity
Investment Appraisal • Calculating the costs of capital – sources of investment finance • retained profits • borrowing from the banking sector • share issue
– leverage and the cost of capital • leverage and the risks to suppliers • measures of leverage – gearing ratio – debt / equity ratio
– risk premia
Financing Investment • Sources of business finance – internal sources – external sources • short-term finance • medium-term finance • long-term finance
– international sources – comparison of the UK with other EU countries
Financing Investment • The role of the financial sector – expert advice – expertise in channelling funds – maturity transformation – risk transformation
• Financial institutions in the UK – retail banks – investment banks (wholesale banks) • merchant banks • overseas banks
– finance houses
The Stock Market • The role of the Stock Exchange – primary market – secondary market – advantages • brings together savers & firms seeking investment • regulates firms & helps instil confidence • facilitates mergers and takeovers • reduces transaction costs of investment finance
– disadvantages • cost of getting listed • possible short-termism and instability
The Stock Market • Is the stock market efficient? – the efficient market hypothesis – weak form of efficiency • where share dealing prevents cyclical fluctuations in share prices
– semi-strong form of efficiency • where share prices adjust fully to publicly available information • chances, however, of 'insiders' gaining
– strong form of efficiency • where share prices adjust fully to all relevant information (including 'inside information')
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