Chapter 9: Investment Flashcards
What is investment?
National income accounting definition: Accumulation of physcial capital, which chnages the production potential of the future
(E.g. Building of roads)
When should a business keep investing till?
MPK=r
What is MPK??
Marginal product of capital
What does the rental rate of capital (dneoted as r) equal to?
Real interest rate, as we use savings to buy capital as the economy is closed
How do firms makes investment decisions?
- Firms should keep investing in physical capital until MPK falls to equal the rental price
- Capital has diminishing returns
Arbitrage equation
- If investment is maximising profits, then the two investment yield the same results.
- pk: Amount of cash
- r: real interest rate
- MPK: marginal product of capital
Left side: Gain from saving cash
Right side: Amount of additional output as a result of employing an extra unit of output + change in price, when we sell capital
Must be equal as we are maximising profits
Assume price in period 1 =1. Rearrange the equation to slide 2. Invest until MPK equals to the rental price minus the growth rate. If price change is constant, then the percentagre change is 0 so MPK =r
What is the situation for capital gain?
Growth rate in price is positive
What is the situation for capital loss?
Price change is negative
Why do prices of capital change?
- Depreciation, wear and tear, therefore means a price decrease
- Technological change
- Particulalry in electronics
- Scarce resources
Equation that includes depreciation
Right hand side is the user cost
Capital gain is a loss, as the cost is reduced through reselling
Capital loss is a addition, as the loss is an addition to the cost
This equation determines how much capital is in business
What is the user cost of capital?
Total cost to the firm of using one more unit of capital
Diagram to show production marginal product of capital, with the user cost
MPK is the additional benefit of adding one extra unit of capital
Where they intercept is the optimal decision
MPK = Unit cost of capital
Investment and the corporate income tax
- Profits are taxed and this needs to be incorporated
- (1- t): proportion that remains with the comapny. Increasing taxes, therefore denominator will be smaller, therefore the user cost increases
- t: fraction of profits that is given to the government every period
- r: cost of funds/ rental price
- Returns from saving: firms earning from installing an extra unit(amount left after tax is taken away) - capital lost due to depreciation + capital gains or loss
- Usually capital gains are 0 because firms use capital until the reselling value is equal to 0
- Rearrange to get MPK
Increase in corporate income tax diagram
User cost is higher, because of tax
Production function with the marginal product of capital (derivative with respect to capital)
Standard capital accumulation
Growth rate of capital
Steps to derive the investment rate
Equilibrium: MPK=user cost
The number 3 depends upon alpha
What does the investment rate depend upon?
Key endogenous variables in the macroeconomy:
Given that this is a closed economy, once we find the investment share, we can find the consumption share
What connects capital and investment?
Arbitrage equation
What are the finance investment options?
- Put money in a savings account
- Earn interest
- Purchase stock, sell a year later
- Own some future profit of the firm and we can resell ownership and either make a capital loss or gain
If they don’t give the same return, there is a preference
What are dividends?
Proportion of profits of a firm
What is the arbitrage equation with relation to the price of a stock?
- ps: price of a stock
- Right side: Multiplying price of stock by interest rate to show gain through saving
- Left shows: Dividends and the return from selling the stock
- Price of stock is equal to the present discounted value of dividends
- Notice that the dividend here plays the same role that the marginal product of capital played in the physical investment application: it is the key return if there is no change in the price of the asset.
Price earning ratio
- The ratio of a stock price to an earnings measure (a rough measure of profits) for a company or set of company
- Dividends/earnings = fraction of profit you get as a dividend. If this is stable, then the capital gains is irrelevant.
- Higher price earning ratio means a greater diversion between the valuation and what the comapny is actually traded at
What is the accounting measure of profits?
Earnings
- Possibility our model is wrong as the price earnings ratio should be stable
- Reason for deviation is bubbles in which there is a deviations of price of security from its value. Therefore valuation of stocks is incorrect, compared to the reality
Informational efficiency
A financial market is said to be informationally efficient if financial prices fully and correctly reflect all available information.
it is impossible to make economic profits by trading on the basis of that information.
Information about stock changes are included in the price given
Unexpected predicitions change the price
Random walk
An implication of the neoclassical consumption model: current consumption should reflect all available information, including expectations of future income. So the change in consumption should be unpredictable.
Mutual funds
Collections of stocks and other financial assets that are held together in a large portfolio, small pieces of which are sold off to individual investors.
One form of mutual funds
Actively managed
they are run by investment managers who are constantly buying and selling financial assets in an effort to deliver the highest possible return in the least risky way
Constant buying and selling
Deliever high retrun with low risk
Higher fees
Efficient-markets benchmark is not the final word on understanding financial markets.
- Some mutual funds beat the S&P index with more persistence than predicted.
- More volatility in markets than justified by fundamentals in model
- bubbles, for example
- may be explained by behavioral elements
Tobin’s q
Tobin’s approach, the only asset that a firm possesses is its capital; so, in the simplest case, the stock market value of the firm is the value of its capital stock.The ratio of the stock market value of a firm to the value of its capital stock.
- q<1 :the value of the firm is less than the value of its capital, and we would expect the firm to be “disinvesting.” (That is, the owners could sell off the pieces of the firm, if its capital is worth more than its market value.)
What are the predictions of tobins q?
the value of the firm is less than the value of its capital, and we would expect the firm to be “disinvesting.” (That is, the owners could sell off the pieces of the firm, if its capital is worth more than its market value.)
the value of q should be a useful predictor of firm-level investment.
What are the issues with tobins q?
- If capital were the only asset owned by firms, we would expect values of q to be close to 1. However, firms also own their brand names (often called “goodwill” capital) and the ideas they have created, some patented, some not. Because these assets also have values that are capitalized into the stock market price, values for q often exceed 1.
- other factors that are not included in the theory so far—such as a firm’s cash flow or access to financial markets and bank loans
What is investment broken down into?
Nonresidental fixed investment
Residental fixed investment
Inventory invesment
Nonresidental fixed investment
equipment and structures purchased by businesses as well as intellectual property products (IPP). In recent years, equipment and structures accounted for about half of investment, while IPP accounted for about one quarter of investment.
Residental fixed investment
new housing purchased by households.
Inventory investment
goods that have been produced by firms but that have not been sold. An auto dealer has an inventory of cars on hand to sell to new customers. Inventory investment is the change in this stock of goods on hand
In a booming economy, inventory investment is generally positive—firms are producing more goods than they are selling. In a recession, the opposite occurs: firms cut production sharply and run down their inventories.
Production smoothing
A theory of inventory behavior where firms maintain a stable level of production, producing more than they sell when business is booming and less than they sell when business is slumping
Pipeline theory
A theory of inventory behavior where firms hold components and materials are part of the production process itself. This theory helps us understand why inventories are often pro-cyclical.
Stockout avoidance
A theory of inventory behavior where firms hold extra supplies of the goods they produce to avoid being sold out of the goods when customers wish to buy them.
