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')