Chapter 9: Investment

Question 1

What is investment?

Answer 1

National income accounting definition: Accumulation of physcial capital, which chnages the production potential of the future

(E.g. Building of roads)

Question 2

When should a business keep investing till?

Answer 2

MPK=r

Question 3

What is MPK??

Answer 3

Marginal product of capital

Question 4

What does the rental rate of capital (dneoted as r) equal to?

Answer 4

Real interest rate, as we use savings to buy capital as the economy is closed

Question 5

How do firms makes investment decisions?

Answer 5

• Firms should keep investing in physical capital until MPK falls to equal the rental price
• Capital has diminishing returns

Question 6

Arbitrage equation

Answer 6

• If investment is maximising profits, then the two investment yield the same results.
• p_k: 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

Question 7

What is the situation for capital gain?

Answer 7

Growth rate in price is positive

Question 8

What is the situation for capital loss?

Answer 8

Price change is negative

Question 9

Why do prices of capital change?

Answer 9

• Depreciation, wear and tear, therefore means a price decrease
• Technological change
  
  • Particulalry in electronics
• Scarce resources

Question 10

Equation that includes depreciation

Answer 10

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

Question 11

What is the user cost of capital?

Answer 11

Total cost to the firm of using one more unit of capital

Question 12

Diagram to show production marginal product of capital, with the user cost

Answer 12

Question 13

Answer 13

MPK is the additional benefit of adding one extra unit of capital

Where they intercept is the optimal decision

MPK = Unit cost of capital

Question 14

Investment and the corporate income tax

Answer 14

• 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

Question 15

Increase in corporate income tax diagram

Answer 15

User cost is higher, because of tax

Question 16

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

Answer 16

Equilibrium: MPK=user cost

The number 3 depends upon alpha

Question 17

What does the investment rate depend upon?

Answer 17

Question 18

Key endogenous variables in the macroeconomy:

Answer 18

Given that this is a closed economy, once we find the investment share, we can find the consumption share

Question 19

What connects capital and investment?

Answer 19

Arbitrage equation

Question 20

What are the finance investment options?

Answer 20

• 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

Question 21

What are dividends?

Answer 21

Proportion of profits of a firm

Question 22

What is the arbitrage equation with relation to the price of a stock?

Answer 22

• p_s: 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.

Question 23

Price earning ratio

Answer 23

• 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

Question 24

What is the accounting measure of profits?

Answer 24

Earnings

Question 25

Answer 25

* 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

Question 26

Informational efficiency

Answer 26

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

Question 27

Random walk

Answer 27

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.

Question 28

Mutual funds

Answer 28

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.

Question 29

One form of mutual funds Actively managed

Answer 29

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

Question 30

Efficient-markets benchmark is not the final word on understanding financial markets.

Answer 30

* 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

Question 31

Tobin's q

Answer 31

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.)

Question 32

What are the predictions of tobins q?

Answer 32

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.

Question 33

What are the issues with tobins q?

Answer 33

* 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

Question 34

What is investment broken down into?

Answer 34

Nonresidental fixed investment Residental fixed investment Inventory invesment

Question 35

Nonresidental fixed investment

Answer 35

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.

Question 36

Residental fixed investment

Answer 36

new housing purchased by households.

Question 37

Inventory investment

Answer 37

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.

Question 38

Production smoothing

Answer 38

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

Question 39

Pipeline theory

Answer 39

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.

Question 40

Stockout avoidance

Answer 40

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.