Investment and the employment of capital
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Transcript of Investment and the employment of capital
Investment and the Employment of Capital
The Pricing of Capital andCapital 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
O Q of factor
£
MRPf
Pf1
O Q of factor
£
MRPf
Qf1
Pf1
Perfectly competitive factor market
The Pricing of Capital andCapital 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
O Q of factor
£
MRPf
ACf = S
MCf
O Q of factor
£
MRPf
ACf = S
Qf2
Pf2
MCf
Firm with monopsony power in factor market
The Demand for and Supply ofCapital 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
S
D
O
Re
Qe
Ren
tal r
ate
(£)
Quantity per period
Long-run equilibrium rental rate in the market for capital services
O
MRPK
Re
MCK = S
Q1
Ren
tal r
ate
(£)
Quantity per period
An individual user of capital services
O
Re
Quantity per periodQ2
D
S
An individual supplier of capital servicesR
enta
l rat
e (£
)
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
O
% ra
te p
er y
ear
Quantity of loanable funds
D
S
O
D
% ra
te p
er y
ear
Quantity of loanable funds£e
ie
S
The market for 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
O
Cos
t of c
apita
l (%
)
Ratio of debt to equity
Cost of equity
Cost of debt
O
Cos
t of c
apita
l (%
)
Ratio of debt to equity
Cost of equity
Cost of debt
Weighted average costof capital
The debt / equity ratio
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')