MODULE 3

CAPITAL, INTEREST, ENTREPRENEURSHIP, AND

CORPORATE FINANCE

PROVERBS 16:3

“COMMIT THY WORKS UNTO THE LORD, AND THY THOUGHTS SHALL BE
ESTABLISHED.”

INTRODUCTION
This chapter adds investment and corporate finance considerations to the theory of firm behavior and
resource allocation. The first two thirds of the chapter describe in considerable detail the process of
determining the desirability of capital investment by comparing the opportunity cost of investing with
the yield on the investment. Included in this discussion is information on how interest rates are deter-
mined in loanable funds markets as well as a discussion of nominal versus real interest rates and
sources of interest rate differentials. There is also a brief description of the present value calculation
and an examination of the role of the entrepreneur, who comes up with an idea, turns the idea into a
marketable product, accepts the risk of success or failure, and claims any resulting profit or loss. The
last part of the chapter describes aspects of corporate finance.

OUTLINE
I. The Role of Time in Production and Consumption

A. Production, Saving, and Time

Production requires savings because production takes time—time during which
goods and services are not available from current production. Producers need not rely
just on their own savings. Banks and other financial institutions serve as
intermediaries between savers and borrowers.

B. Consumption, Saving, and Time

If you are willing to pay more to consume something now rather than later, you have
a positive rate of time preference. Because you value present consumption more than
future consumption, you are willing to pay more to consume now rather than wait.
Because people value present consumption more than future consumption, they must
be rewarded to postpone consumption; interest is the reward for postponing
consumption.
• Interest rate: The annual reward for saving as a percentage of the amount saved.
The higher the interest rate, other things constant, the more consumers are
rewarded for saving, so the more they save, other things constant.

C. Optimal Investment: Firms buy new capital goods only if they expect this
investment to yield a higher return than other possible uses of their funds.
• Expected rate of return on capital: The expected annual earnings divided by
capital’s purchase price.
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• Market interest rate: The opportunity cost, and hence the marginal cost, of
investing in capital.
• Investment decisions of all industries: Individual industries have downward-
sloping demand curves for investment: more is invested when the opportunity
cost of borrowing is lower.
• A downward-sloping investment demand curve for the entire economy can be
derived.

II. The Market for Loanable Funds

This market brings together borrowers, or demanders of loanable funds, and savers, or
the suppliers of loanable funds, to determine the market interest rate. The firm
increases investment until the expected rate of return on that marginal investment just
equals the market interest rate.

A. Demand for loanable funds: The negative relationship between the market interest
rate and the quantity of loanable funds demanded, other things constant. Based on the
expected marginal rate of return the borrowed funds yield when invested in capital.

B. Supply of loanable funds: The positive relationship between the market interest rate
and the quantity of savings supplied, other things constant

C. Market Interest Rate: The loanable funds market brings together borrowers, or
demanders, and savers, or suppliers of loanable funds to determine the market interest
rate.

III. Why Interest Rates Differ

A. Risk: Differences in the risk of loan. The more valuable the collateral that backs up
a loan, the lower the interest rate charged.

B. Duration of the Loan: As the duration of the loan increases, so does the risk. The
term structure of interest rates is the relationship between the duration of a loan and
the interest rate charged. The interest rate usually increases with the duration of the
loan, other things constant.

C. Administration Costs: That portion of the interest charge reflecting administration

costs is smaller as the loan size increases, other things constant, thus reducing the
interest rate for larger loans.

D. Tax Treatment: Different tax treatments of different types of loans affect the interest
rate.

IV. Present Value and Discounting

Present value is the current value of a payment or payments to be received in the future.
Discounting is the process of dividing the future payment by 1 plus the prevailing interest rate
to express in today’s dollars.

A. Present Value of Payment One Year Hence: The higher the interest rate, or
discount rate, the more any future payment is discounted and the lower its present
value. Present value = amount received 1 year from now / 1 plus interest rate.
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B. Present Value for Payments in Later Years: The present value of a given payment
is smaller the further into the future that payment is to be received. PV = M/(1+i) 2
(PV = Present Value, M = present value of money dollars, i = interest rate).

C. Present Value of an Income Stream: The present value of each receipt can be
computed individually, and the results summed to yield present value of entire
income stream.

D. Present Value of an Annuity: An annuity is a given sum of money received each

year for a specified number of years; a perpetuity continues indefinitely. Present
value of receiving M dollars each year forever = M/i.

V. Entrepreneurship

A. Role of the Entrepreneur: An entrepreneur comes up with an idea, turns that idea
into a marketable product, accepts the risk of success or failure, and claims any
resulting profit or loss (residual claimant).
• An entrepreneur must have the authority to hire and fire managers.

B. Entrepreneurs Drive the Economy Forward: Entrepreneurs push forward with:

1. New Products
2. Improve Existing Products
3. New Production Methods
4. New Ways of Doing Business.

C. Who Are Not Entrepreneurs?

1. Corporate Inventors
2. Managers
3. Stockholders

VI. Corporate Finance

A. Corporate Stock and Retained Earnings: Corporations fund investment by issuing

stock, by retaining some of their profits, and by borrowing.
• Initial public offerings (IPOs): The initial sale of stock to the public.
• Corporate Stock: A claim on the net income and assets of a corporation, as well
as the right to vote on corporate directors and on other important matters.
• Dividends: After-tax corporate profits paid to stockholders rather than reinvested
in the firm.
• Retained earnings: After-tax corporate profits reinvested in the firm rather than
paid to stockholders as dividends.

B. Corporate Bonds:
Certificates reflecting a corporation’s promise to pay the holder a fixed sum of money
on the designated maturity date, plus make interest payments until that date.

C. Securities Exchanges: Places where stocks and bonds are traded. Regulated by the
SEC, the Securities and Exchange Commission. Securities are traded on major U.S.
exchanges or on over-the-counter market. Majority of securities traded are
secondhand securities. Securities markets allocate funds more readily to successful
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firms than to firms in financial difficulty. Crowdfunding, a new source of business

financing, is raising money from many people through online platforms.

VII. Conclusion
Capital is a more complicated resource than this chapter has conveyed. For example, the
demand curve for investment is a moving target. An accurate depiction of the investment
demand curve calls for knowledge of the marginal product of capital and the price of output
in the future. But capital’s marginal productivity changes with breakthroughs in technology
and with changes in the employment of other resources. The future price of the product can
also vary widely.

CHAPTER SUMMARY
Production cannot occur without savings because production takes time—time during which the
resources required for production must be paid. Because people value present consumption more than
future consumption, they must be rewarded to defer consumption. Interest is the reward to savers for
forgoing present consumption and the cost to borrowers for being able to spend now.

Choosing the profit-maximizing level of capital is complicated because capital purchased today
usually yields a stream of benefits for years into the future. The expected rate of return on capital
equals the expected annual earnings of that capital divided by that capital's purchase price. The profit-
maximizing firm invests up to the point where the expected rate of return on capital equals the market
rate of interest. The market interest rate is the opportunity cost and the marginal cost of investing.

The demand and supply of loanable funds determine the market interest rate. At any given time,
interest rates may differ across borrowers because of differences in risk, maturity, administrative costs,
and tax treatment.

The current value of future payments is the present value. Translating future payments into present
value is called discounting. The present value of a given payment is smaller the higher the interest rate
and the further into the future that payment is to be received. A given sum of money received each
year for a specified number of years is called an annuity. The present value of receiving a sum each
year forever is the amount received cash each year divided by the market interest rate.

An entrepreneur is a profit-seeker who comes up with an idea, tries to turn that idea into a marketable
product, and accepts the risk of success or failure. The entrepreneur need not supply any resource
other than entrepreneurial ability, though many manage the firm and provide some start-up funds. By
developing new products, improving existing ones, employing better production methods, and finding
new ways of doing business, successful entrepreneurs earn a profit and, in doing so, drive the economy
forward.

Corporations fund new investment from three main sources: new stock issues, retained earnings, and
borrowing (either directly from financial institutions or by selling bonds). Once new stocks and bonds
are sold by the firm, they can then be bought and sold on securities markets or over the counter. The
value of corporate stocks and bond tends to vary directly with the firm’s profit prospects. More
profitable firms have better access to funds needed for expansion.
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QUESTIONS FOR REVIEW

1. Explain why the supply of loanable funds curve slopes upward to the right.

2. At any given time, a range of interest rates prevails in the economy. What factors contribute to
differences in interest rates across consumers?

3. Why is $10,000 a close approximation of the price of an annuity that pays $1,000 each year for
30 years at 10 percent annual interest?

4. In many states with lotteries, people can take their winnings in a single, discounted, lump-sum
payment or in a series of annual payments for 20 or 30 years. What factors should a winner
consider in determining how to take the money?

5. What entrepreneurial idea do you have? How would your idea contribute to the economy?

6. Describe the three ways in which corporations acquire funds for investment.

7. What role do securities exchanges play in financing corporations?

PROBLEMS AND EXERCISES

8. Suppose you are hired by your state government to determine the profitability of a lottery offering
a grand prize of $10 million paid out in equal annual installments over 20 years. Show how to
calculate the cost to the state of paying out such a prize. Assume payments are made at the end
of each year.

9. Using the demand-supply for loanable funds diagram, show the effect on the market interest rate
of each of the following:
a. An increase in the purchase price of capital
b. An increase in the productivity of capital
c. A shift in preferences toward present consumption and away from future consumption

10. Calculate the present value of each of the following future payments:

a. A $10,000 lump sum received 1 year from now if the market interest rate is 8 percent.
b. A $10,000 lump sum received 2 years from now if the market interest rate is 10 percent.
c. A $1,000 lump sum received 3 years from now if the market interest rate is 5 percent.
d. A $25,000 lump sum received 1 year from now if the market interest rate is 12 percent.
e. A $25,000 lump sum received 1 year from now if the market interest rate is 10 percent.
f. A perpetuity of $500 per year if the market rate of interest is 6 percent.

11. Suppose the market interest rate is 10 percent. Would you be willing to lend $10,000 if you were
guaranteed to receive $1,000 at the end of each of the next 12 years plus a $5,000 payment 15
years from now? Why or why not?
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References
McEachern, W. (2017). Microeconomics: A Contemporary Introduction Eleventh Edition. Cengage
Learning Asia Pte Ltd.