1. PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital, Interest,
Entrepreneurship,
and Corporate Finance
1

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Production, Saving, and Time
• Production
–Cannot occur without prior saving
–Roundabout production
• Produce capital to increase productivity
–Requires saving
• Takes time
– Goods and services are not available from
current production
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3. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Consumption, Saving, and Time
• Consumers
–Positive rate of time preference
–Willing to pay more to consume now
• Impatience
• Uncertainty
–Interest
• Reward for postponing consumption
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Consumption, Saving, and Time
• Positive rate of time preference
–Consumers value present consumption
more than future consumption
–People must be rewarded to postpone
consumption
• Interest rate
–Interest per year as a percentage of the
amount saved or borrowed
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Optimal Investment
• Specialization and exchange
–Purchase capital
–Borrow funds
• Firms buy new capital goods
–If they expect this investment to yield a
higher return than other possible uses of
their funds
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Optimal Investment
• Expected rate of return on capital
–Expected annual earnings divided by
capital’s purchase price
• Market interest rate
–Opportunity cost of investing
• Maximize profit
–Increase investment as long as marginal
rate of return > market interest rate
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1
7
Expected Rate of Return on Golf Carts and the Opportunity
Cost of Funds
$25,000$20,000$15,000$10,000$5,0000
Investment
25
20
15
10
5
Interestrate(percent)
Expected rate
of return
An individual firm invests in any project with an expected rate of return that exceeds
the market interest rate. At an interest rate of 8 percent, Hacker Haven invests $15,000
in three golf carts.
Market rate
of interest
8

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Optimal Investment
• Downward-sloping demand curve for
investment (individual industries)
–More is invested when the opportunity
cost of borrowing is lower
• Investment demand curve for the entire
economy
–Downward sloping
8

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The value of a good idea
• Intellectual property
–Intangible assets created by human
knowledge and ideas
–Costly to produce
–Once produced, can be supplied at low
cost
• Patent
–Establishes property rights to an
invention or other technical advances
9

10. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The value of a good idea
• Copyright
–Confers property rights to an original
expression of an author, artist, composer,
or computer programmer
• Trademark
–Establishes property rights in unique
commercial marks and symbols
10

11. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The value of a good idea
• Enforcing property rights is costly
–Diminished incentive to create new
products
• Pirated videos, music, computer games,
software
–No royalties to artists
–No wages to industry workers
–No profits to producers, programmers
–No taxes to government
11

12. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Market for Loanable Funds
• Demanders of loans (borrow)
–Entrepreneurs
• Start firms
• Invest in physical and intellectual capital
• Increase investment until
– Expected marginal rate of return = market
interest rate
–Households
• Present consumption
• Invest in human capital
12

13. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Market for Loanable Funds
• Demand for loanable funds
–Negative relationship between
• Market interest rate
• Quantity of loans demanded
–Declining marginal rate of return
–Other things constant
• Prices of other resources, technology
• Expected rate of inflation, tax laws
• Customs and conventions of the market
13

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Market for Loanable Funds
• Supply of loanable funds
–Banks = financial intermediaries
–Positive relationship between
• Market interest rate
• Quantity of savings supplied
–Interest rate = Reward for saving
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Market for Loanable Funds
• Loanable funds market
–Savers (suppliers of loanable funds)
–And borrowers (demanders of loanable
funds)
–Come together to determine
• Market interest rate
• Quantity of loanable funds
15

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 2
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Market for Loanable Funds
1.0 1.10
Loanable funds per year
(trillions of dollars)
8
9
Interestrate(percent)
S
D
D’
Because of the declining expected
rate of return on capital, the
quantity of loanable funds
demanded is inversely related to
the interest rate. The market rate of
interest, 8 percent, is found where
the demand curve for loanable
funds intersects the supply curve of
loanable funds. An increase in the
demand for loanable funds from D
to D’ raises the market interest rate
from 8 percent to 9 percent and
increases the equilibrium quantity of
loanable funds from $1.0 to $1.1
trillion

17. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Why Interest Rates Differ
• Prime rate
–Interest rate lenders charge their most
trustworthy business borrowers
• Collateral
–Asset pledged by the borrower
–Can be sold to pay off the loan in the
event the borrower defaults
17

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Why Interest Rates Differ
• Risk
–The more valuable the collateral, the
lower the interest rate
• Duration of the loan
–Interest rate increases with the duration
of the loan
• Administration costs
–Decrease as size of the loan increases
• Tax treatment
18

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 3
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Interest Rates Charged for Different Types of Loans
Interest rates are
higher for riskier loans.
Rates for home
mortgages and new
cars are relatively low
because these loans
are backed up by the
home or car as
collateral. Personal
loans and credit card
balances face the
highest rates, because
these loans are riskier
—that is, the likelihood
borrowers fail to repay
the loans is greater
and the borrower
offers no collateral.

20. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Present Value and Discounting
• Present value
–Current value of payment(s) to be
received in the future
• Discounting
–Converting future dollar amounts into
present value
20

21. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Present Value and Discounting
• Present value one year hence
–Amount received one year from now
• Divided by (1+interest rate)
–The higher the interest rate
• The more any future payment is discounted
• The lower its present value
21

22. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Present Value and Discounting
• Present value (PV) for payments in later
years
–Receive M dollars
–t years from now
–Interest rate i
–Smaller for higher t
22
t
i
M
PV
)1( +
=

23. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Present Value and Discounting
• Present value of an income stream
–Receive $100 next year
–And $150 year after next
– i=5%
23
29.231$
)05.1(
150$
05.1
100$
2
=+=PV

24. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Present Value and Discounting
• Annuity
–A given sum of money received each
year for a specified number of years
• Present value of an annuity
–Perpetuity – if continues indefinitely
–Present value of receiving M dollars each
year forever
24
i
M
=

25. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The million-dollar lottery?
• Win $1 million
–Paid in annuities
• $33,333 a year for 30 years, i=8%
• Present value of the 30th
annuity of $33,333
is $3,313
• Present value: $375,256
–Lump sum
• Less than half
• After taxes: only 26% of winnings
25

26. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Entrepreneurship
• Entrepreneur
–Comes up with an idea
–Turns that idea into a marketable product
–Accepts the risk of success or failure
–Claims any resulting profit or loss
(residual claimant)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Entrepreneurship
• Entrepreneur
–Have the authority to hire and fire the
manager
–Drive the economy forward
• New products
• Improve existing products
• New production methods
• New ways of doing business
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Entrepreneurship
• Not entrepreneurs
–Corporate inventors
–Managers
–Stockholders
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 4
29
Source of U.S. Patents

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Corporate Finance
• Corporation
–Owned by stockholders
–Owns property
–Earns profit
–Sue or get sued
–Incur debt
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Corporate Stock
• Corporations fund investment
–Issue and sell stock
–Retain some of their profits
–Borrow
• Initial public offering (IPO)
–Initial sale of corporate stock to the
public
• Corporate stock
–Certificate reflecting part ownership of a
corporation 31

32. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Corporate Stock
• Corporations pay
–Corporate income taxes on any profit
–Dividends to shareholders
• Dividends
–After-tax corporate profit paid to
stockholders
–Rather than retained by the firm and
reinvested
32

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Retained Earnings
• Retained earnings
–After-tax corporate profit reinvested in
the firm
–Rather than paid to stockholders as
dividends
–Help the firm grow
33

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Corporate Bonds
• Corporations borrow
–Bank loan
–Issue and sell bonds
• Bond
–Certificate reflecting a firm’s promise
• To pay the lender periodic interest
• And to repay the borrowed sum of money on
the designated maturity date
–Less risky than stocks
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Securities Exchange
• Securities market
–Stocks and bonds
–Secondary market for securities
• Enhance liquidity
–Hedge funds
–Determine the current value of a
corporation
–Allocate funds more readily to successful
firms than to firms in financial difficulty
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