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

Re

nta

l ra

te (

£)

Quantity per period

Long-run equilibrium rental rate in the market for capital services

O

MRPK

Re

MCK = S

Q1

Re

nta

l ra

te (

£)

Quantity per period

An individual user of capital services

O

Re

Quantity per periodQ2

D

S

An individual supplier of capital servicesR

ent

al r

ate

(£)

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

% r

ate

per

yea

r

Quantity of loanable funds

D

S

O

D

% r

ate

per

yea

r

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

Co

st o

f ca

pita

l (%

)

Ratio of debt to equity

Cost of equity

Cost of debt

O

Co

st o

f ca

pita

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')