McEachern, Economics 11e, Ch. 13
3
Capital, Interest, Entrepreneurship,
and Corporate Finance
Prepared by: V. Andreea Chiritescu, Eastern Illinois University
Reviewed by: William A. McEachern, University of Connecticut
Production, Saving, and Time
• Production cannot occur without prior
saving
– Because production takes time
• During which goods and services are not
available from current production
– Production needs capital
– Producers can also borrow funds
McEachern, Economics 11e, Ch. 13
Consumption, Saving, and Time
• Consumers
– Have a positive rate of time preference
– Willing to pay more to consume now
• Impatience
• Uncertainty
– Interest
• Reward for postponing consumption
McEachern, Economics 11e, Ch. 13
Consumption, Saving, and Time
• Positive rate of time preference
– Consumers value present consumption
more than future consumption
– People must be rewarded to postpone
consumption
– Explained by impatience and uncertainty
• Interest rate
– Interest per year as a percentage of the
amount saved or borrowed
McEachern, Economics 11e, Ch. 13
Optimal Investment
• Market economy: specialization and
exchange
– Purchase capital with borrowed funds
• Firms buy new capital goods
– If they expect this investment to yield a
higher return than other possible uses of
their funds
McEachern, Economics 11e, Ch. 13
Optimal Investment
• Expected rate of return on capital
– Expected annual earnings divided by
capital’s purchase price
• Market interest rate
– Opportunity cost of investing in capital
– The marginal cost of investing in capital
• Maximize profit
– Increase investment as long as expected
rate of return > market interest rate
McEachern, Economics 11e, Ch. 13
Exhibit 1
Expected Rate of Return on Golf Carts and the
Opportunity Cost of Funds
Interest rate (percent)
25
Expected rate
of return
20
15
10
8
5
Market rate
of interest
Investment
0
$5,000
$10,000 $15,000 $20,000 $25,000
An individual firm invests in any project with an expected rate of return that exceeds
the market interest rate. At an interest rate of 8 percent, Hacker Haven invests $15,000
in three golf carts.
McEachern, Economics 11e, Ch. 13
Optimal Investment
• Downward-sloping demand curve for
investment (individual industries)
– More is invested when the opportunity cost
of borrowing is lower
• Investment demand curve for the entire
economy
– Downward sloping
McEachern, Economics 11e, Ch. 13
The Value of a Good Idea: Intellectual Property
• Intellectual property
– Intangible assets created by human
knowledge and ideas
– Costly to create
– Once created, can be reproduced at low
cost
• Patent
– Establishes property rights to an invention
or other technical advances
McEachern, Economics 11e, Ch. 13
The Value of a Good Idea: Intellectual Property
• Copyright
– Confers property rights to an original
expression of an author, artist, composer,
or computer programmer
• Trademark
– Establishes property rights in unique
commercial marks and symbols
McEachern, Economics 11e, Ch. 13
The Value of a Good Idea: Intellectual Property
• Enforcing property rights is costly
– Diminished incentive to create new
products
• Pirated videos, music, computer games,
software
– No royalties to artists
– No wages to industry workers
– No profits to producers, programmers
– No taxes to government
McEachern, Economics 11e, Ch. 13
The Value of a Good Idea: Intellectual Property
• Between 2000 and 2014,
– Music-industry revenue dropped 50%
• Sharing music files: not a victimless crime
– Since 2000, more than one-fourth of music
industry workers lost their jobs
• Most musicians
– Earn more from touring than from
recordings
McEachern, Economics 11e, Ch. 13
The Value of a Good Idea: Intellectual Property
• Intellectual property
– Intangible asset that fuels the digital
economy
• Economic development across the globe
– Affected by the way society nurtures
• Incentives to create new ideas
• Inventions
• Artistic creations
McEachern, Economics 11e, Ch. 13
The Market for Loanable Funds
• Demanders of loans
– Entrepreneurs borrow to:
• Start firms
• Invest in physical and intellectual capital
• Increase investment until expected marginal
rate of return = market interest rate
– Households borrow to:
• Increase present consumption
• Invest in human capital
McEachern, Economics 11e, Ch. 13
Demand for Loanable Funds
• Demand for loanable funds
– Negative relationship between market
interest rate and quantity of loans
demanded
– Declining marginal rate of return
– Other things constant
• Prices of other resources; Technology
• Expected rate of inflation; Tax laws
• Customs and conventions of the market
McEachern, Economics 11e, Ch. 13
Supply of Loanable Funds
• Supply of loanable funds
– Banks and other financial institutions are
financial intermediaries
– Positive relationship between market
interest rate and quantity of savings
supplied
– Other things constant
• Expected rate of inflation
• People’s retirement plans
McEachern, Economics 11e, Ch. 13
Market Interest Rate
• Loanable funds market
– Savers (suppliers of loanable funds)
– And borrowers (demanders of loanable
funds)
– Come together to determine
• Market interest rate
• Quantity of loanable funds exchanged
McEachern, Economics 11e, Ch. 13
Exhibit 2
Market for Loanable Funds
Interest rate (percent)
S
9
8
D′
D
0
1.0 1.1
Loanable funds per year
(trillions of dollars)
Because of the declining expected
rate of return on capital, the
quantity of loanable funds
demanded is inversely related to
the interest rate. The market rate of
interest, 8 percent, is found where
the demand curve for loanable
funds intersects the supply curve of
loanable funds. An increase in the
demand for loanable funds from D
to D′ raises the market interest rate
from 8 percent to 9 percent and
increases the equilibrium quantity
of loanable funds from $1.0 to $1.1
trillion.
McEachern, Economics 11e, Ch. 13
Why Interest Rates Differ
• Prime rate
– Interest rate lenders charge their most
trustworthy business borrowers
• Collateral
– Asset pledged by the borrower
• Can be sold to pay off the loan in the event the
borrower defaults
• Term structure of interest rates
– Relationship between the duration of a loan
and the interest rate charged
McEachern, Economics 11e, Ch. 13
Why Interest Rates Differ
• Risk
– The more valuable the collateral, the lower
the interest rate
• Duration of the loan
– Interest rate increases with the duration of
the loan
• Administration costs as percent of loan
– Decrease as size of the loan increases
• Tax treatment
McEachern, Economics 11e, Ch. 13
Exhibit 3
Interest Rates Charged for Different Types of Loans
Interest rates are
higher for riskier
loans. Rates for
home mortgages
and new cars are
relatively low
because these
loans are backed up
by the home or car
as collateral.
Personal loans and
credit card balances
face the highest
rates, because
these loans are
riskier—that is, the
likelihood borrowers
fail to repay the
loans is greater and
the borrower offers
no collateral.
McEachern, Economics 11e, Ch. 13
Present Value and Discounting
• Present value
– The value today of income to be received in
the future
• Discounting
– Converting future dollar amounts into
present value
McEachern, Economics 11e, Ch. 13
Present Value and Discounting
• Present value of payment one year hence
– Amount received one year from now
divided by (1 + interest rate)
– The higher the interest rate
• The more any future payment is discounted
• The lower its present value
McEachern, Economics 11e, Ch. 13
Present Value and Discounting
• Present value, PV, for payments in later
years
– Present value of M dollars received t years
from now is M divided by (1+ interest rate)t
• Receive M dollars
• t years from now
• Interest rate i
– PV smaller for higher t
M
PV =
t
(1 + i )
McEachern, Economics 11e, Ch. 13
Present Value and Discounting
• Present value of an income stream
– Is the sum of present value of each receipt
– Example: to receive $100 next year and
$150 year after next, for i = 5%
• Present value is $100 divided by (1 + interest
rate) + $150 divided by (1 + interest rate)2
$100 $150
PV =
+
= $231.29
2
1.05 (1.05)
McEachern, Economics 11e, Ch. 13
Present Value and Discounting
• Annuity
– A given sum of money received each year
for a specified number of years
• Present value of an annuity
– Perpetuity – if continues indefinitely
– Present value of receiving M dollars each
year forever is M divided by the interest rate
M
=
i
McEachern, Economics 11e, Ch. 13
Entrepreneurship
• Entrepreneur
– Comes up with an idea
– Turns that idea into a marketable product
• Obtains the financial capital needed to start or
expand the business
• Brings together the necessary resources to
produce and market the product
– Accepts the risk of success or failure
– Residual claimant: claims any resulting
profit or loss
McEachern, Economics 11e, Ch. 13
Entrepreneurship
• Entrepreneur
– Must have the authority to hire and fire the
manager
– Drives the economy forward
• New products, improve existing products
• New production methods
• New ways of doing business
• Not entrepreneurs
– Corporate inventors; managers; stockholders
McEachern, Economics 11e, Ch. 13
Corporate Finance
• Corporation is a legal entity
– Owned by stockholders
• Liable only to the extent of their investment in
the firm
– May own property
– May earn profit
– May sue or be sued
– May incur debt
– May be found guilty of a crime
McEachern, Economics 11e, Ch. 13
Corporate Stock
• Corporations fund investment
– Issue and sell stock
– Retain some of their profits
– Borrow
• Initial public offering, IPO
– Initial sale of corporate stock to the public
• Corporate stock
– Certificate reflecting part ownership of a
corporation
McEachern, Economics 11e, Ch. 13
Corporate Stock
• Corporations pay
– Corporate income taxes on any profit
– Dividends to shareholders
• Dividends
– After-tax corporate profit paid to
stockholders
– Rather than retained by the firm and
reinvested
McEachern, Economics 11e, Ch. 13
Retained Earnings
• Retained earnings
– After-tax corporate profit reinvested in the
firm
– Rather than paid to stockholders as
dividends
– Help the firm grow
McEachern, Economics 11e, Ch. 13
Corporate Bonds
• Corporations acquire funds by
– Issuing stock
– Retaining earnings
– Borrowing
• Bond
– Certificate reflecting a firm’s promise
• To pay the lender periodic interest
• And to repay the borrowed sum of money on
the designated maturity date
McEachern, Economics 11e, Ch. 13
Corporate Bonds
• Bond
– Less risky to own than are stocks
– Risks
• Corporate bankruptcy
• Higher market interest rate
• Corporations
– Issue more bonds when interest rates are
low
• Because their interest payments on those
bonds will be low
McEachern, Economics 11e, Ch. 13
Securities Exchange
• Securities exchange
– Secondary market for securities
– Regulated by SEC, Securities and
Exchange Commission
• New York Stock Exchange
– Largest securities market in the world
– Trades the securities of about 2,800 major
corporations
• Including about 500 non-U.S. companies
McEachern, Economics 11e, Ch. 13
Securities Exchange
• Major U.S. exchanges
– More than 5,000 corporations
• Network of brokers, over-the-countermarket
– Another 10,000 corporations
• Publicly traded corporations
– Traded on major exchanges and over the
counter
McEachern, Economics 11e, Ch. 13
Securities Exchange
• 6 million much smaller corporations
– Not publicly traded
– Shares are individually owned by families or
just a few stockholders
• 21 million sole proprietorships
• 3 million partnerships
McEachern, Economics 11e, Ch. 13
Securities Exchange
• The 15,000 publicly traded corporations
– Are just a fraction of 1 percent of all
businesses
– Account for the overwhelming share of
employment and sales in the U.S.
• Institutional investors
– Banks, insurance companies, and mutual
funds
– Account for most of the trading volume on
major exchanges
McEachern, Economics 11e, Ch. 13
Securities Exchange
• Exchanges
– Enhance the liquidity of securities
– Hedge funds
• Complex strategies to invest for institutions and
for wealthy clients
– Determine the current market value of the
corporation
• Share price times the number of shares issued
• The share price reflects the present value of
the discounted stream of expected profit
McEachern, Economics 11e, Ch. 13
Securities Exchange
• Crowdfunding
– Raising money from many people through
an online platform
– Kickstarter
• Economists talk about investing
– Purchases of new capital
• New machines and new buildings
• When the media talk about investing
– Usually mean buying stocks and bonds
McEachern, Economics 11e, Ch. 13