Weeks 5 & 6 review

We looked at definitions of Capital. While some definitions make it a synonym of money or

wealth, the economic definition is something that helps turn labor and/or materials into valuable
product.

Tangible Capital includes equipment, buildings, and vehicles. Tangible (private) capital can be
bought and sold.

Intangible Capital includes sklls, reputation (goodwill), connections, and credentials.

Intangible capital can be acquired, but it typically isnt as simple as a financial transaction to
acquire it.

Tangible Social Capital, a.k.a. infrastructure includes the electric grid and other utilities,
transportation systems, and communication systems.

Intangible Social Capital is our legal system (including property and political rights) and
culture, which make it safe and beneficial to do business successfully without worrying about
being killed by a rival or having everything seized by the political ruler.

We measure investments based on their (annual) Rate of Return, which typically is expressed as
a %. Rate of Return and yield are synonyms.

(annual) Rate of Return = (annual profit or savings) / (one-time cost)

Example: a business has an annual TR of 500K and an annual cost of 400K. It is purchased for
$
2,000,000 The rate of return = (500K 400K) / (2M) = 5%

Example 2: paying down debt on which you are charged an annual yield of 11.5% has a Rate of
Return of 11.5%, regardless of how much of it is paid down. (Limited by the total size of the
debt, of course.)

Payback Time = 1 / (Rate of Return) = (one-time cost) / (annual profit or savings). It is

measured in terms of years, and represents how long it takes for an investment to pay for itself.

Example: if it costs $3000 to insulate a home, and it saves an average of $100/month on energy
bills, the payback time = 3000 / (100 * 12) = 2.5 years.

Depreciation represents a piece of (tangible) capital wearing out. Depreciation counts as a

cost.
Annual depreciation of an item = (cost / expected number of years it lasts). (For more
information on depreciation, speak with your accountant. )

Example: A 3-D printer costs $6000, and is expected to last 4 years. Its annual depreciation is
$
6000 / 4 = $1500.

Asset value = (Annual Profit or Savings) / ysafe

ysafe is the safe yield. This is the highest rate of return that people predictably can get on a 99.9+
% safe investment. Typically it reflect the rate paid on long-term treasury bills, or the Prime
interest rate.

This formula is used to determine the value of stocks, companies, real estate, bonds, and other
income-producing (or money-saving) investments. If value > price, its a good thing to buy. If
value < price, its a good thing to sell.

Example: a share of stock pays a $6 dividend each year. If the safe yield is 5%, the value of this
share is 6 / .05 = $120.

The formula looks simple, but it assumes that both (Annual Profit or Savings) and ysafe will stay
the same into the indefinite future. This is almost never the case. For example, a company may
be paying no dividends today, but you expect it to be very profitable (and pay large dividends) in
the future. This will make people willing to pay a large amount for the companys stock.
Similarly, a house or condo may sell for more than the equation indicates if we expect the
neighborhood to improveleading to rent increases (or ysafe to be lower).

Another way that assets can be valued is momentum pricing the belief that rising prices will
continue to rise, and falling prices will continue to fall. This belief leads to asset price bubbles,
in which assets become overvalued (according to the formula above), then at some point the
bubble pops (= the asset price quickly crashes). People who believe in momentum pricing
inevitably lose their money; those who keep their eyes on the fundamentals (and use the equation
above) often can make lots of money when there is a bubble.

Examples of bubbles include tulips in 17th Century Holland, Stocks in the late 1920s (and dot
com stocks in the late 1990s), silver in 1979, and housing in the middle of the last decade.
(That bubble popped in 2008).

The 1920s stock bubble and the 2008 housing bubble both were made worse by financial
derivatives, which can be used to greatly magnify the risk.
We looked at one of the simpler financial derivatives: stock options, where you pay money for
the option to buy a share at a given price within a certain time window.

For example, if the price of a share is $50, you might pay $4 to get the option to buy a share at $55
anytime that year. If the share prices rises to $65, each option is now worth 65 50 = $15. So
you increased your money by 275%, while the person who held stock only increased their money
by 30%. Of course, if the share price stays below $55, your stock option is worthless and one
day it expires.

The 2008 bank crisis, caused by the housing market bubble deflating, involved more complicated
financial derivatives, but the principle was the same: these turned a $700 billion potential loss
into a $10 trillion loss, or magnified the bad new roughly 14-fold.

Another contributing factor was IBGYBG Ill be gone. Youll be gone. The concept that,
since individuals on Wall St. could make enough money to retire in a couple of years, many were
willing to gamble that an asset they knew would collapse in the future would do so after they
left, so many risk assessors marked these poor investments as AAA safe.

The 2008 housing bubble deflation was particularly painful to homeowners with mortgages, as
losses to home equity were well beyond the % drop in housing prices.

Home Equity = (the market price of your home) (how much your owe the bank based on your
mortgage(s) and possible home equity loan)

For example, if your home is worth $250,000, and you have a $200,000 mortgage, you have
$
50,000 of home equity. If the market price of your home falls to $180,000 while the debt
remains the same, your equity is negative $20,000. Negative equity also is called having an
underwater mortgage. The financially rational thing to do in this case is move and let the
bank foreclose on the housethey get the house, but nothing elseat least if there is too much
negative equity.

Home equity is a very good thing to have. Not only does it mean you eventually get money
when you sell a home, but in the meantime many people get a home equity line of credit, or
home equity loan, in which the loan is secured by the home. (in other words, like a mortgage,
the bank can take the home if the borrower defaults). Home equity lines typically have very low
interest, because the risk to the bank should be minimal.

On a tangent, we saw that the existence of the corporation as a legal entity enabled greater
economic activity and growth. The primary befit is the ability for people to pool their money
and finance a larger enterprise than any one of them can afford. A second thing what
corporations provide is limited liability: investors can have their holdings fall to zero, but the
value cant go negative. For example, stockholders can not be sued for the actions of a company,
however negligent. (This is most definitely a double-edged sword.)