Investment and the

Employment of Capital
The Pricing of Capital and
Capital Services
• Factor prices versus the price of factor
services
– factor prices and factor rental rates
– stocks and flows
• Profit maximising employment of capital
– marginal cost of capital (MCK)
– marginal revenue product of capital (MRPK)
– profit maximising in perfect capital markets
 Perfectly competitive factor market
£

Pf1

MRPf

O Q of factor
 Perfectly competitive factor market
£

Pf1

MRPf

O Qf1 Q of factor
The Pricing of Capital and
Capital Services
• Factor prices versus the price of factor
services
– factor prices and factor rental rates
– stocks and flows
• Profit maximising employment of capital
– marginal cost of capital (MCK)
– marginal revenue product of capital (MRPK)
– profit maximising in perfect capital markets
– profit maximising given monopsony power
in capital markets
Firm with monopsony power in factor market
£
MCf

ACf = S

MRPf

O Q of factor
 Firm with monopsony power in factor market
£
MCf

ACf = S

Pf2

MRPf

O Qf2 Q of factor
The Demand for and Supply of
Capital Services
• The demand for capital services
– individual firm’s demand
– market demand
• The supply of capital services
– supply to a single firm
– supply by a single firm
• short-run MC
• long-run MC
– market supply
• The price of capital services
 Long-run equilibrium rental rate in the market for capital services

S
Rental rate (£)

Re

O Qe Quantity per period

Rental rate (£) An individual user of capital services

MCK = S
Re

MRPK

O Q1 Quantity per period

 An individual supplier of capital services

S
Rental rate (£)

Re D

O Q2
Quantity per period
Investment Appraisal
• Capital for purchase: investment
• Investment demand
– calculating the benefits of investment
– discounting
• present value approach
• rate of return approach
– the risks of investment
• The supply of capital
– supply of physical capital
– supply of finance
Investment Appraisal
• Determination of the rate of interest
 The market for loanable funds

S
% rate per year

O
Quantity of loanable funds
 The market for loanable funds

S
% rate per year

ie

O £e Quantity of loanable funds

Investment Appraisal
• Calculating the costs of capital
– sources of investment finance
• retained profits
• borrowing from the banking sector
• share issue
– leverage and the cost of capital
• leverage and the risks to suppliers
• measures of leverage
– gearing ratio
– debt / equity ratio
 The debt / equity ratio

Cost of equity
Cost of capital (%)

Cost of debt

O
Ratio of debt to equity
 The debt / equity ratio

Cost of equity
Cost of capital (%)

Weighted average cost

of capital

Cost of debt

O
Ratio of debt to equity
Investment Appraisal
• Calculating the costs of capital
– sources of investment finance
• retained profits
• borrowing from the banking sector
• share issue
– leverage and the cost of capital
• leverage and the risks to suppliers
• measures of leverage
– gearing ratio
– debt / equity ratio

– risk premia
Financing Investment
• Sources of business finance
– internal sources
– external sources
• short-term finance
• medium-term finance
• long-term finance
– international sources
– comparison of the UK with other EU
countries
Financing Investment
• The role of the financial sector
– expert advice
– expertise in channelling funds
– maturity transformation
– risk transformation
• Financial institutions in the UK
– retail banks
– investment banks (wholesale banks)
• merchant banks
• overseas banks
– finance houses
The Stock Market
• The role of the Stock Exchange
– primary market
– secondary market
– advantages
• brings together savers & firms seeking
investment
• regulates firms & helps instil confidence
• facilitates mergers and takeovers
• reduces transaction costs of investment
finance
– disadvantages
• cost of getting listed
• possible short-termism and instability
The Stock Market
• Is the stock market efficient?
– the efficient market hypothesis
– weak form of efficiency
• where share dealing prevents cyclical
fluctuations in share prices
– semi-strong form of efficiency
• where share prices adjust fully to publicly
available information
• chances, however, of 'insiders' gaining
– strong form of efficiency
• where share prices adjust fully to all relevant
information (including 'inside information')