Investment

Question 1

3 things that investment comprises

Answer 1

Business fixed investment (firms purchasing new capital for use) residential investment, inventory investment (changes in the value of the stock of finished goods)

Question 2

Two Period Model of Investment

Answer 2

purchases of new capital by firms
Neoclassical production function: F (K,N) dealing with present and future TFP (z)
Current investment I affects future capital

K^1 = I + (1-d)K
Capital depreciates at rate d over time
current Cap stock determined by past decisions

Question 3

Two Period Model of Investment:

Profits made by firm in current and future periods

Answer 3

Pi = Y - wN

same with future symbols

Question 4

How can you finance investment in the 2 period model? (3)

Answer 4

1) Borrowing
2) Retained earnings (undistributed profits used for investment)
3) Issuance of new equity (negative dividend)

Question 5

Condition for the optimal investment decision

Answer 5

MPk(^1) - d = r(subscript l)

Question 6

Optimal Investment Decision in 2 period model?

Answer 6

MB = MC

Question 7

When can firms borrow at interest rate r

Answer 7

When there are no credit market imperfections (same rate received by savers)

Question 8

What’s the ideal source of financing for firms?

Answer 8

Depends on whether there are credit market imperfections

if rl = r, then direct cost of borrowing = opportunity costs to shareholders of delaying the dist. of profits
- condition for optimal investment is MPk(^1) - d = r in both cases

NOT TRUE IF IMPERFECTIONS

Question 9

Investment Demand Curve Characteristics

Answer 9

Neoclass Prod. Function has Dimin. Returns to Cap. so MPk(^1) decreases with investment I

MPk(^1) - d = r implies downward slowing investment demand curve

Question 10

Share price p is :

Answer 10

present discounted value of dividends V

Question 11

TOBIN’S Q DEF?

Answer 11

Firms should increase investment until Tobin’s Q ratio is = 1

Tobin’s Q = market value of firm / Replacement cost of capital

Question 12

TOBIN’S Q IN PRACTISE?

Answer 12

TQ is >1 when MPk(^1) + 1 - d > 1 + r which is the same as MPk(^1) - d > r (investment is too low)

Invest up to a point where MPk(^1) - d = r, equivalent to investing until Tobin’s Q has declined to 1

Question 13

Asymmetric Information

Answer 13

Firms can only borrow at interest rate rl > r