Topic 2 - Investment Flashcards
How do we calculate Future Value (F.V)?
PV(1+I)n
Where:
P.V present value
I: Interest Rate
N: No of years which compounding takes place
E.G:
£100 deposit 6% annum after 4 years
100(1+0.05)4 = 126.25
How do we calculate Present Value (P.V)?
P.V= FV/(1+I)N
OR
P.V= FV x 1/(1+I)N (To the power of N)
E.g:
6% annum. How much do i need to deposit to get 126.25 after 4 years?
126.25/(1+0.06)4 = 100
What is NPV used for?
To see if an investment will be profitable
How do we calculate NPV?
NPV= CF0 + CF1/(1+K)N (to the power of N)
Where;
CF0= Cash flow at time 0 (t0)
CF1= Cash flow at time 1 (t1)
K= Generally means interest
E.G. CF0= -3000 CF1= 900
Over 4 years 10% Interest
NPV= -3000 + 900/(1+0.1)4
When do we accept and reject an investment based on NPV?
If NPV is equal to or greater than 0: ACCEPT
If NPV is less then 0: REJECT
What does the Neoclassical Model believe investment depends on?
1) MPK= F(L,(K+1)) - F(L,K) for Y=F(L,K)
2) Interest rate
3) Tax rule affecting firms
What does the denotations of MPK represent?
MPK= F(L,(K+1)) - F(L,K) for Y=(L,K)
(CURRENT) (PREVIOUS)
Where:
L= Labour Capital
(K+1) = Extra unit of capital
K= CapitalWhat does the formula of MPK represent?
Represent the change in output from getting an extra unit of capital
Why is there diminishing marginal product with capital?
(Yk> 0, Ykk<0)
As capital increases it gets to a point where capital becomes idle so productivity decreases
For the sake of simplicity behind the Neoclassical model what do we assume?
Assume only 2 types of firms:
1) Production Firms:
Don’t own the capital but rent from a rental firm to produce goods and services
2) Rental Firms:
Own capital and rent it to production firms
What does the capital rental market look like?
SEE GRAPH IN NOTES
How do we calculate the change in profit from 1 more unit of capital?
Δ PROFITS= Δ REVENUE - ΔCOST= P x MPK - R
Where R is the rental rate (cost)
How does a production firm maximise profits?
Firm must increase capital to the point where MPK= R/P
R/P is the real cost of capital
How can we accurately see the factors that affect rental price?
We can see this via the Cobb-Douglas production function
How do we calculate the Cobb-Douglas Production function?
Y= AKα L (1-α)
Where:
α and (1-α) is to the power of
A= Technology K = Capital α = Amount of income devoted to capital L = Labour (1-α) = Amount of income devoted to labour
SEE NOTES FOR BETTER VIEW
How can we rewrite the Cobb-Douglas function to work for the MPK?
R/P = MPK = αA(L/K) (1-α)
Where 1-α is to the power of
SEE NOTES FOR CLEARER VIEW
When will equilibrium R/P increase?
K goes down (e.g. Earthquake or War)
L goes up (e.g. Pop. growth or immigration)
A goes up (e.g. Tech improvement or deregulation)
How will rental firms make investment decisions?
Rental firms invest in new capital when benefit of doing so outweighs the cost
The benefit of purchasing (per unit capital): R/P (Income that rental firms earn from renting the unit of capital to production firms)
What are the three costs of capital to rental firms?
Interest rate= 1 x Pk (denoted usually as iPk)
Where Pk is nominal price of capital
Depreciation Cost = δ x Pk
Where δ is rate of depreciation
Capital Loss = -ΔPk
How do we get the nominal cost of capital (Total cost)?
iPk + δPk - ΔPk = Pk(i + δPk - ΔPk/Pk)
Either way works
e.g. Cost of Cars
Pk = 10,000 ΔPk/Pk = 0.06
i = 0.10 δ = 0.20
interest rate cost: 1,000
depreciation cost: 2,000
Capital Loss: -600 (Minus cus ΔPk/Pk = 0.06 repping capital gain) = 2,400
