Capital and Financial

Markets

Lecture by: Jacinto F. Fabiosa

Fall 2005
 Capital and Financial Markets

• Almost every weekday, each of the following is almost

guaranteed to occur in United States
– Managers at some corporation launch a new product
• Covering costs with firm’s past profits, or raising funds from outside
firm by issuing new shares of stock or new bonds
– Owner of an apartment or office building sells it to a real estate
developer, who plans to improve the property
– An experienced registered nurse—earning about $44,000 a year—
decides to apply for a costly two-year program to become a nurse
practitioner, with starting salaries of around $56,000
– A new Starbucks opens its doors
– A college professor goes online and buys a few hundred shares of
stock in Amazon.com
– A different college professor goes online and sells a few hundred
shares of stock in Amazon.com

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Capital and Financial Markets

• In each case, a decision maker—

consciously or unconsciously—is putting a
value on money to be received in the future
• This chapter focuses on decisions about
– Investing in productive capital, such as factory
buildings, equipment, or skills and training
– Purchasing financial assets, such as stocks and
bonds

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Physical Capital and the Firm’s
Investment Decision

• How does a business firm decide how much

physical capital to use?
– Firm’s goal is to maximize its profit
• Not just this year, but over many years into the future
• Are there guidelines the firm should use?
– Yes, but depends on conditions under which
firm obtains and uses its capital

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 A First, Simple Approach

• In this section, assume that one of two special conditions

holds
– Firms rent their capital at a constant price
– Firms buy their capital, but it lasts forever
• Marginal approach to profit states that a firm should take
any action that adds more to its revenue per period than it
adds to its cost per period
• When firms rent capital, or the capital they buy lasts
forever, we can apply marginal approach to profits just as
we apply it for firm’s labor decision
– Firm should buy another unit of capital whenever marginal revenue
product > its marginal factor cost

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Why the Simple Approach Usually Fails

• The simple approach will not help us

understand investment decisions, because
assumptions are problematic
– Our assumption that capital can be rented
• Does not work for economy in general
– Capital does not last forever
• Length of time that capital lasts matters
when deciding whether to buy it
• Value of a future payment depends on when
that payment is received
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The Value of Future Dollars

• Always preferable to receive a given sum of money

earlier rather than later
– Because present dollars can earn interest and
– Because borrowing dollars requires payment of interest
• Therefore, a dollar received later is worth less than a dollar
received now
• Present value (PV) of a future payment is the value of
that future payment in today’s dollars
– Alternatively, it is the most anyone would pay today for the right
to receive the future payment
• Present value of $Y to be received n years in the future
is equal to
Y
PV 
1  i
n

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 The Value of Future Dollars

• Discounting
– Converting a future value into its present-day equivalent
• Discount rate
– Interest rate used in computing present values
• Present value of a future payment is smaller if
– Size of the payment is smaller
– Interest rate is larger
– Payment is received later
• Logic of present value shows why anyone who expects to
receive a stream of future payments must discount each of
those payments before adding them together

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The Firm’s Demand for Capital

• First step in making a decision about a

capital purchase
– Put a value on an additional unit of capital
• Value is total present value of future revenue
generated by the capital
• Principle of asset valuation says that value
of any asset is
– Sum of present values of all future benefits it
generates

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 What Happens When Things Change:
The Investment Curve
• Investment—firms’ purchases of new capital over some
period of time
• At high interest rates, U.S. firms end up buying less of all
different kinds of capital
• Thus, as interest rate rises, each firm will place a lower
value on additional capital and decide to purchase less of
it
– In economy as a whole, a rise in interest rate causes a decrease in
investment expenditures
• Lower interest rates increase firms’ investment in physical
capital
– Causing capital stock to be larger, and overall standard of living to
be higher

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Figure 1: The Investment Curve

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Investment in Human Capital

• Economists are very interested in human

capital investment
– Who pays for workers to acquire human
capital—the workers themselves, or the firms
that employ them?
– When an individual must pay to acquire human
capital on his own, how does he make the
decision?

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General Versus Specific Human Capital

• Economists classify human capital into

– General human capital
• Knowledge, education, or training that is valuable at many
different firms
– Specific human capital
• Knowledge, education, or training that is valuable only at a
specific firm
• Reason for distinguishing between general and
specific human capital
– Firms have limited incentive to invest in general human
capital because they cannot be sure of capturing all the
benefits

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 General Versus Specific Human Capital

• Employers have limited incentive to provide

general human capital,
– Since it increases worker’s value to many firms
– Worker will capture benefits in the form of a higher
wage
• Therefore, workers must acquire general human capital on their
own—or with help of government subsidies
• Individuals have little incentive to pay for specific
human capital
– Since it increases their value to only one firm, and that
firm will capture the benefits
• Therefore, firms provide their workers with specific human
capital at the firms’ expense

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 The Decision to Invest in General Human
Capital
• How do individuals make decision to acquire their own general human
capital?
• To the worker that possesses it, human capital is an asset that
generates higher income in the future
– Therefore, benefit of any given human capital investment is equal to total
present value of additional future income
• Investment in human capital is inversely related to interest rate
– The lower the interest rate, the greater the benefits of any human capital
investment, and the more human capital workers will want to acquire
• Lower interest rates encourage individuals to invest in general human
capital
– Total amount of human capital—and overall standard of living—will be
higher if interest rates are lower

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 Financial Markets

• The pieces of paper being traded in financial markets are

financial assets
– Promises to pay future income to their owners
– Because capital lasts for many years, most firms fund their capital
purchases by issuing and selling financial assets
• Close economic connection between a firm’s decision to
be a demander in a capital market and
– Its decision to be a supplier in financial markets
• Because a financial asset gives holder a stream of future
payments
– Value of a financial asset is calculated in the same way as value of
any other asset
• Find total present value of future payments asset is expected to
generate

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The Bond Market

• If a firm wants to buy a new fleet of trucks,

build a new factory, or upgrade its computer
system
– Must decide how to finance the purchase
• Perhaps by selling bonds
• Bonds
– Promise to pay a specific sum of money at
some future date
• Principal (face value)
– Amount of money a bond promises to pay when
it matures
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The Bond Market

• Maturity date
– Date at which a bond’s principal amount will be paid to
bond’s owner
• Pure discount bond
– Promises no payments except for principal it pays at
maturity
• Coupon payments
– Series of periodic payments that a bond promises
before maturity
• Yield
– Rate of return a bond earns for its owner

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 How Much is a Bond Worth?

• Can determine present value of a bond with a

face value of $10,000 which matures in exactly
one year and has an interest rate of 10%
$Y $10,000
PV    $9,091
(1  i ) 1.10
Bond will sell for $9,091
Same principle applies to more complicated types of bonds
Such as discount bonds that don’t pay off for many years, or coupon bonds

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 How Much Is A Bond Worth?

• Bond with a principal of $10,000, a five-year

maturity and an annual coupon payment of $500
has a present value of
$600 $600 $600 $600 $600 $10,000
PV        $8,483.69
(1.10) (1.10)2 (1.10)3 (1.10)4 (1.10)5 (1.10)5

Total present value is what bond is worth

Price at which it will trade
As long as buyers and sellers use the same discount rate of 10% in their
calculations

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Bond Prices and Bond Yields

• Inverse relationship between bond price

and bond yields
– The higher the price of any given bond the
lower the yield on that bond

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 Primary and Secondary Bond Markets

• Every type of financial asset is traded in two

different types of markets
– Primary market
• Market in which newly issued financial assets are sold for first
time
– Secondary market
• Market in which previously issued financial assets are sold
• Applying this distinction to bonds
– Primary bond market is where newly issued bonds are
sold to their original buyers
– Secondary bond market is where previously issued
bonds change hands

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Primary and Secondary Bond Markets

• While bond issuers are not directly

participants in secondary market trading,
they are affected by what happens in
secondary market
– If a bond’s price rises in secondary market
• Price one can charge for similar, newly issued bonds
in the primary market will rise as well, or
• If a bond’s yield falls in secondary market, yield of
similar newly issued bonds in the primary market will
fall as well

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Why Do Bond Prices (and Bond Yields)
Differ?

• Thousands of different kinds of bonds are

traded in financial markets every day
• Each bond has its own unique yield
• Why doesn’t each bond sell at a price that
makes its yield identical to the yield on any
other bond?
– A bond—like any asset—is worth the total
present value of its future payments

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Why Do Bond Prices (and Bond Yields)
Differ?
• To put a value on riskier bonds, markets
participants use a higher discount rate than on
safe bonds
– Leads to lower total present values and lower prices for
riskier bonds
– With lower prices, riskier bonds have higher yields
• Riskiness is only one reason that bond prices and
bond yields differ
– Other reasons include
• Differences in maturity dates
• Differences in frequency of coupon payments
• Because one bond is more widely traded (and therefore easier
to sell on short notice) than another

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 The Stock Market

• A share of stock, like a bond, is a financial asset

that promises its owner future payments
– But nature of promise is very different
– When a corporation issues a bond, it is borrowing funds
and promising to pay them back
– But when a corporation issues a share of stock, it
brings in new ownership of the firm itself
• When a firm wishes to raise money in the stock
market, it gets in touch with an investment bank

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 The Stock Market

• The purpose of the prospectus is to inform

potential investors of risks involved
– Must be reviewed by Securities and Exchange
Commission
• Principal regulatory agency that oversees financial markets
• If it is the first-ever offering of shares by this firm,
sale will be called an initial public offering (IPO)
• In practice, it’s usually large institutional investors,
such as mutual funds, who first purchase new
shares

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 Primary and Secondary Stock Markets

• When a corporation issues new shares—as part of an IPO

or a secondary offering—they are sold in a primary stock
market
– Only time a corporation receives any income from a trade in its
stock is when the corporation itself sells the stock in the primary
stock market
– Thereafter, stock is traded in secondary market
• Market in which previously issued shares are sold and resold
• Secondary market is very important to firms that raise
funds in primary market
– Because of secondary market, people who buy shares know they
can easily sell them when they want
– Price changes in secondary market affect price a firm can get from
selling shares in primary market

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 Direct and Indirect Ownership of Stock

• Many people own shares of stock directly

• Can also own stock indirectly
– By purchasing shares of a mutual fund
• Corporation that specializes in owning shares of stock in other corporations
• A final way that households can—indirectly—own stock is through
retirement accounts that are managed by their employers
– These accounts should not be confused with 401(k) and 403(b) accounts
that employees manage for themselves, in which the stock is owned
directly or indirectly through mutual fund shares
• Stock ownership in United States is growing rapidly
– In 2002, about half of all American households owned shares of stock or
mutual fund shares that they managed themselves
• Up from about 19% of households in 1983

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 Why Do People Hold Stock?

• Why do so many individuals and fund managers choose to put their

money into stocks?
– When you own a share of stock, you own part of the corporation
• Most firms do not pay out all of profit to shareholders
– Some of profit is kept as retained earnings, for later use by firm
– Part of profit that is distributed to shareholders is called dividends
• Another important reason people hold stocks
– Hope to enjoy capital gains
• Returns someone gets when they sell an asset at a higher price than they paid
for it
• Some stocks pay no dividends at all
– Because management believes that stockholders are best served by
reinvesting all profits so that future profits will be even higher
• Over past century, corporate stocks have generally been a good
investment

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 Valuing a Share of Stock

• Value of a share of stock

– Total present value of its future payments
• But over what time horizon should stocks be valued?
• Formulas to measure total present value of a firm’s future
profits under a variety of different assumptions
– For example, the simplest formula says
• If a firm will earn a constant $Y in profit after taxes each year forever
– Then total present value of these future profits is $Y ÷ і, where і is the
discount rate
• Value of a share in a firm is equal to
– Total present value of firm’s after tax profits divided by number of
shares outstanding
– Note that we are valuing a share of stock by future profits, not by
dividends
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Valuing a Share of Stock

• Important conclusions about factors that can

affect a stock’s value
– An increase in current profits increases value of a share
of stock
– An increase in anticipated growth rate of profits
increases value of a share of stock
– A rise in interest rates—or even an anticipated rise in
interest rates—decreases value of a share of stock
– An increase in perceived riskiness of future profits
decreases value of a share of stock

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Reading the Stock Pages

• In United States, financial markets are so

important that stock and bond prices are
monitored on a continuous basis
– If you wish to know value of a stock, you can find out
instantly by checking with a broker or logging on to a
Web site that reports such information
• To some people, the pages that cover the stock
market look as impenetrable as Egyptian
hieroglyphics
– But information on the stock pages is very easy to
understand, once you decide to learn it

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 Reading the Stock Pages

• Figure 2 shows an excerpt from the New York Stock Exchange

Composite Transactions reported in the July 9, 2003 Wall Street
Journal
– The data refer to the previous trading day—Wednesday, July 8, 2003
– Focus on stock of FedEx Corporation (listed as FedExCp)
– First columns show percentage change in the stock’s price from a year
ago, and highest and lowest prices paid during the past 52 weeks
– Next columns show the stock’s name—abbreviated to FedExCp—followed
by its stock symbol—FDX
– Next two columns report firm’s most recent cash dividend—in this case
.20, or 20¢ per share—and corresponding dividend yield, obtained by
dividing most recent year’s dividends by current stock price

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Figure 2: Stock Market Table for Trading
on July 8, 2003

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 Reading the Stock Pages

• Price-earnings (PE) ratio

– Stock’s current price divided by its after-tax profit per share during
previous 12 months
• In general, an unusually high or unusually low PE ratio does not tell people
whether the stock is relatively expensive or relatively cheap
– One must also consider the stock’s future prospects
• Remaining columns tell us about the most recent day’s transactions in
this stock—July 8, 2003, in this case
• Column headed Vol 100s indicates how many shares, in hundreds,
traded on that day
• Next column tells us last price at which FedExCp stock traded on that
day
• Final column—Net Chg—tells us that the price of a share of FedExCp
stock decreased by $1.36 per share, from its price at the end of the
pervious day’s trading

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 Reading the Stock Pages

• In addition to reporting on individual stocks, Wall

Street Journal and other newspapers also report
on changes in different stock market averages or
indexes
– The most popular average is Dow Jones Industrial
Average
• Tracks prices of 30 of largest companies in United States,
including Boeing, Microsoft, and Wal-Mart
– Another popular average is the much broader Standard
& Poor’s 500
• Tracks stock prices of 500 large corporations

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 Explaining Stock Prices

• In examining Figure 2, you can see that most stocks experience a

price change on any given day
– Why?
• Like all prices, stock prices are determined by supply and demand
• On any given day, the number of FedExCp shares in existence is just
the number that FedExCp has issued previously, up until that day
– Therefore, no matter what happens to the price today, the number of
shares remains unchanged
• Just because 298 million shares of FedExCp stock actually exist
– Does not mean that this is the number of shares that people want to hold
• Value of a share of stock to any owner is equal to total present value
of its future after-tax profits
• At any given moment, there is an array of estimates of a stock’s total
present value

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Figure 3: The Market for FedEx

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Figure 4: An Increase in Demand for
Shares of FedEx

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 Explaining Stock Prices

• Only at equilibrium price of $64 are people satisfied holding the

number of shares they are actually holding
– Where supply and demand curves intersect
• Stocks achieve their equilibrium price almost instantly
– Can have confidence that price of a share at any time is the equilibrium
price
• Cannot be caused by shifts in the supply curve
• Must be caused by shifts in demand
• What causes these sudden shifts in demand for a share of stock?
• Logic of present value provides the answer
– Anything that causes large groups of individuals to change their estimates
of total present value of future profits will shift demand curve
• When stock prices move dramatically, it is usually because new
information has become available

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 The Economic Role of Financial Markets

• What functions do financial markets play?

• In the absence of capital markets, we would all be
constrained to live as if there were literally no tomorrow
• Would be poorer if there were no financial markets
– Firms would have to grow solely via retained earnings
• Would limit their growth rate
• Would be constrained as individuals
– Could not earn interest on savings
• Economic functions that financial markets play
– Facilitating large-scale production
– Reallocating spending across time
– Reducing risk
– Disciplining management

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 Facilitating Large-Scale Production

• Large industrial enterprises that are so common today are

only about a century old
– Prior to the 20th century, it would have been extremely unusual to
find a business employing a hundred or more workers
• As firms grew, so did their need to accumulate large sums
of money
• To take just a single example, think about railroads
– New railroads turned to bond market for funding
• Just as today’s large enterprises look to both stock and bond markets
for cash to expand their operations
– Without smoothly functioning financial markets, little of the
remarkable economic growth of the past century could have
occurred

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 Reallocating Spending Across Time

• Financial markets allow firms to invest in new projects today rather than
waiting until the necessary funds accumulate from current operations
– Something similar is true for individual households
• Financial markets allow them to reallocate their consumption over time
• When you open a savings account, buy a bond, or invest in a mutual
fund
– You are reducing your consumption today in order to enjoy greater
consumption in the future
• Financial markets reallocate funds from
– Surplus units
• Mostly individuals who are not consuming their entire incomes today
– To deficit units
• Mostly firms that desire to spend more than their current income today
– Markets help individuals, firms, and even government, to achieve best
intertemporal utilization of resources

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 Reducing Risk

• Prices of stocks and bonds serve several important functions that are
not immediately obvious
– Provide instantaneous feedback that allows corporate managers to see
how they are doing
• If stock price increases, and there has been no change in the discount
rate
– Means thousands of investors are—collectively—giving a vote of
confidence in those policies
• If price decreases
– Means investors are voting with their dollars against the way firm is being
managed
• By checking prices of your competitors’ shares, you can form at least a
rough estimate of what market is willing to pay for your shares
– Once you begin to participate in the stock market
• Existing share price will give you an indication of how much money you can
raise by selling additional shares

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Using the Theory: Can Anyone Predict
Stock Prices?
• Economists as a rule, don’t believe that
anyone can do much better than you—an
introductory economics student—reading
this book and finding out about stock market
for first time
– No matter how smart
– No matter how much research they do

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Using the Theory—Predicting Stock
Prices: Fundamental Analysis

• One widely practiced method for predicting

stock prices is fundamental analysis
– Focuses on fundamental forces driving a firm’s
future earnings
• Value placed on those earnings by stock market
participants
– Fundamental analysts try to determine whether
a stock is undervalued or overvalued relative to
rest of the market

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Using the Theory—Predicting Stock
Prices: Technical Analysis
• Idea is that, by graphing recent behavior of a stock’s
price
– Can predict whether stock is going to increase or
decrease in value over the near future
– Based on certain patterns
• Technical analysts believe that stocks move in
trends
– Have numerous, colorful names for the patterns they claim
to see
– Each market participant has to determine what other
participants are going to do
• Daunting task that some people think can be handled by looking
for patterns in stock prices

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 Using the Theory—The Economist’s
View: Efficient Markets Theory
• While economists believe that fundamental and technical
analysis can often explain stock price movements in the
past, they are extremely skeptical about anyone’s ability to
predict stock price changes in the future
• Implications of the efficient markets view are startling
– You cannot, on average, beat the market by doing research and
finding and buying under priced (or selling over priced) stocks
• According to efficient markets view of stock market
– Any information that can be used to predict a stock’s future
earnings will be incorporated into stock’s price as soon as it
becomes publicly available
– By the time a fundamental analyst predicts that a stock’s price will
rise or fall, it has already risen or fallen
• Fundamental analysis cannot help you outperform market
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Using the Theory—The Economist’s
View: Efficient Markets Theory

• According to efficient markets view of the

stock market
– Any pattern in stock price movements that can
be observed by a good technical analyst will be
incorporated into stock prices as soon as they
are discernable
– Therefore, stock market patterns disappear as
soon as anyone can discover them
• Technical analysis cannot help you outperform
market

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 Using the Theory—The Economist’s
View: Efficient Markets Theory
• Efficient market theory tells us that the only information that affects the
stock market is surprise information
– New announcement of a major technological breakthrough, or even new
information that suggests a firm might achieve such a breakthrough
• Why do we spend so much effort learning how stock prices are
determined, only to then learn that their changes are random?
– It is because so much effort is put into figuring out what price stocks
should sell for that price changes are random
• Theory of efficient markets is one of most exhaustively tested theories
in all of economics
– Thousands of studies have confirmed efficiency of stock prices with
respect to all sorts of information
– You can’t beat the market—period!

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 Using the Theory—The Economist’s
View: Efficient Markets Theory
• Evidence shows that outperforming the market in one year makes an
analyst no more or less likely to outperform market the next year
• Although idea of efficient markets is sweeping and rules out a great
many investment strategies as worthless
– Implications for the investor who understands it can be quite valuable
• Just because you can’t outperform the market doesn’t mean you shouldn’t invest
in the market at all
– Average stock’s price, over long periods of time, tends to rise
• If someone asks you to pay for their stock-picking advice, don’t
– Can do just as well by picking stocks on your own
» Even if you pick them randomly
• Because you have to pay commissions when you trade stocks, you should trade
as little as possible
• Choose a diversified portfolio with different stocks that tend not to rise and fall
together

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