Deck 11: Input Demand: the Capital Market and the Investment Decision

Question 1

Before investing what should investors evaluate first?

Answer 1

Before investing, investors must evaluate the expected flow of future productive services that an investment project will yield.

Question 2

Comment on the following statement: "In economics, investment means a wide variety of things including purchases of stocks, bonds, and other financial assets."

Answer 2

The statement is false. In economics, investment refers only to an increase in capital. Purchasing stocks or bonds is a form of saving.

Question 3

Explain why a computer might depreciate rapidly just in one year even if it is in just as good of a condition as the day it was purchased?

Answer 3

The reason is that newer, faster and more capable computers are being manufactured at a fairly rapid pace. This serves to make older computers more obsolete even more quickly than they otherwise would.

Question 4

Typically when firms talk about depreciation they are usually referring to the deprecation of physical capital assets. However, how any why might it be possible for there to be deprecation in human capital?

Question 5

How can lack of investment in social capital affect private firms' profits?

Question 6

What is depreciation?

Question 7

In economics, what is meant by investment?

Question 8

What is the difference between stock and flow measures?

Question 9

Why does capital depreciate?

Question 10

What is meant by capital stock?

Question 11

Assume an attorney who has worked with a large law firm decides to leave to establish his own practice. Even though he is not leaving the company with any physical assets what might be his most important asset? What factors might impede his ability to use this asset and why?

Question 12

What is human capital?

Question 13

Explain what is meant by capital.

Question 14

What is social capital? Give an example.

Question 15

Define capital. Explain the relationship between investment and capital.

Question 16

Comment on the following statement: "Capital investment decisions always involve risk."

Question 17

What is the most important dimension of capital and how does that relate to its value?

Question 18

Why is knowledge considered a type of capital?

Question 19

How is capital valued?

Question 20

List the major categories of tangible capital.

Question 21

What is a bond?

Question 22

What is capital income?

Question 23

What is the financial capital market? Who are the suppliers in the market? Who are the demanders?

Question 24

When economists say that mortgages are "securitized" what do they mean by this description?

Question 25

Why is the manager of a company typically not the same person as an entrepreneur?

Question 26

Why might two Fortune 500 companies borrow the same amount of money for the same term at the same time yet both pay a very different interest rate even when the same banks makes both loans?

Question 27

Name two conditions that can cause a capital asset to depreciate.

Question 28

Why do mortgage companies begin to require larger down payments from their borrowers when housing prices begin to fall?

Question 29

Why do school districts sell bonds to the public when they are financing a new school building program rather than sell stock?

Question 30

What is the primary source for capital available to businesses? Name four methods of channeling these funds.

Question 31

Why does it seem to be more difficult for investors to measure the capital stock of a firm like eBay rather than a firm like Ford Motor Company? Explain.

Question 32

Is each of the following situations an example of savings, investment, or neither? In each case explain your choice.
(a) A savings and loan association lends money for the purchase of "junk" (not backed) bonds.
(b) John's income is $25,000 per year; $22,000 is spent on consumer goods and the remaining money is used purchase stock in the local electric company.
(c) Just before retirement a couple sells their shares of Pacific Bell stock and puts the proceeds in a bank savings account.
(d) The city of Los Angeles rebuilds highways after an earthquake.
(e) In order to improve the income earning potential of current welfare recipients, the federal government increases the size of income transfers.

Question 33

What is an entrepreneur?

Question 34

Explain what occurs in the capital market.

Question 35

What role do households play in the capital market? What role do firms play?

Question 36

List and define two types of capital income.

Question 37

Suppose a firm is considering locating a manufacturing facility in a poorer country where wage rates are much lower than in the United States. Why would social capital be a factor in their decision to relocate? Explain in terms of the impact that a lack of social capital may have on the marginal revenue product

Question 38

A government wants to build a hydroelectric dam to reduce flooding in a region and provide electricity to its people. What type of investment is this? In order to make a decision about whether or not to make the investment, how should the government evaluate this project?

Question 39

An Internet start-up company consists of three people with an idea that they wish to use in pursuing a patent for a product. What type of capital does this company have and what is its value?

Question 40

Many reporters in the media were critical of the high interest rates that many banks charged to lenders in the so-called sub-prime market. Using economic reasoning what was the likely justification for these high interest rates.

Question 41

List and define the two categories of after-tax corporate profits.

Question 42

Explain why some small start-up companies choose not to pay dividends even though they make very large profits. Why might investors still be happy with this arrangement?

Question 43

An engineer with a major power company decides to leave his job because he believes he has found a way to deliver Internet service across the electrical grid and he wants to start up his own business. He doesn't have very much cash or collateral. Which method of financing do you believe he will most likely use and why?

Question 44

Who makes investment decisions in most modern industrial societies? Discuss the roles played by firms, households, and the capital market.

Question 45

Why might a country like Brazil have to offer a much higher interest rate on its government bonds than those offered by the Great Britain?

Question 46

Suppose that Fred's Bed Company was started in 1999 and 100 percent of the $500,000 needed to start up the company was raised by selling shares of stock. In 2000, the company distributed its entire profit of $35,000 to shareholders. If the market interest rate is 8 percent, what is the level of economic profit earned by the firm's stockholders?

Question 47

Oftentimes when a company's share price is very "high" it will choose to split the stock price and offer each shareholder one share for each they currently hold. Explain why companies might do this and what the effect is on shareholder wealth.

Question 48

Up to which point will a perfectly competitive firm continue to invest? Explain carefully.

Question 49

Suppose that Mighty Mike's Sandwich Shop was started in 1998 and 100 percent of the $250,000 needed to start up the company was raised by selling shares of stock. In 2000, the company distributed its entire profit of $15,000 to shareholders. If the market interest rate is 5 percent, what is the level of economic profit earned by the firm's stockholders?

Question 50

Explain why using a firm's profits to reinvest in the company is really not "free borrowing"?

Question 51

What does the investment demand curve show?

Question 52

Explain how a firm makes an investment decision.

Question 53

Why do U.S. government loans generally pay a low interest rate?

Question 54

You start your own business selling boating equipment. To start the business you sell 5,000 shares of stock at $50 each. This year the revenues from the business are $300,000, and total costs of operating the business are $200,000. All profits are paid out as dividends to the shareholders. If the current interest rate is 20%, what is the economic profit being earned by the shareholders? What will happen to the amount of economic profits earned if the interest rate decreases? Explain your answer.

Question 55

What functions does capital income serve in the economy?

Question 56

What is venture capital?

Question 57

Give three examples of ways in which financial markets channel household savings into investment projects.

Question 58

Suppose that you are an analyst working for a venture capital firm. An individual contacts you about backing his brand new Internet company. What information would you want before making this decision?

Question 59

Why might stockholders be upset to find out that their company's profits that otherwise would have been distributed as dividends are instead invested in U.S. Treasury bonds?

Question 60

Comment on the following statement: "When a firm retains earnings for investment purposes, it is actually saving on behalf of its shareholders."

Question 61

Explain why lower interest rates can stimulate investment by businesses. Show this on a graph.

Question 62

Suppose that you are the president of a small printing company and you are considering the purchase of new machinery. What factors must you consider in making this decision?

Question 63

Explain the difference between financing investment with a business loan versus with venture capital. What are the pros and cons of each?

Question 64

What is meant by the expected rate of return?

Question 65

Suppose that you and two friends have an opportunity to purchase a pizza restaurant. Each of you would put up $75,000. The revenue from the restaurant is expected to remain $200,000 per year for the next several years. The costs (not including the opportunity costs of your investment) of operating the restaurant are expected to remain steady at $185,000 for the next several years. The current market rate of interest is 7 percent per year. Should you go in on this deal? Explain.

Question 66

Suppose that you and your four siblings are given an opportunity to purchase a video rental store. Each of you would put up $50,000. The revenue from the store is expected to remain $350,000 per year for the next several years. The costs (not including the opportunity costs of your investment) of operating the store are expected to remain steady at $320,000 for the next several years. The current market rate of interest is 5 percent per year. Should you go in on this deal? Explain.