Lecture+26 - Announcements HW due tonight (chs. 11-12) Ch...

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Announcements HW due tonight (chs. 11-12) Ch 13 due Thurs. Ch 14 due next Monday (maybe 16 too) We’ll get through ch 17 before break. 1 of 35
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THE FIRM’S INVESTMENT DECISION 2 of 32
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3 of 32 THE DEMAND FOR NEW CAPITAL AND THE INVESTMENT DECISION (BASIC) For a firm, the first unit of capital may provide a big return but each additional until might provide less and less return (holding all other inputs constant) – diminishing marginal product. A profit-maximizing firm will keep investing in new capital up to the point at which the expected rate of return is equal to the interest rate (or discount rate ). This is analogous to saying that the firm will continue investing up to the point at which the marginal revenue product of capital is equal to the price of capital, or MRP K = P K , which is what we learned in Chapter 11. But the time dimension adds a twist when we talk about capital.
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4 of 32 AND THE INVESTMENT DECISION (A BIT MORE DETAIL) The Expected Benefits of Investments The investment process requires that the potential investor (the firm) evaluate the expected flow of future productive services that an investment project will yield. This is also called the Marginal Revenue Product of capital. The Expected Costs of Investments If the firm needs to borrow the money for the investment, the cost is the interest they have to pay on the loan plus the cost of paying the loan back. If the firm has the money in hand, they still need to consider possible alternative uses of the funds required to undertake the project. At a minimum, those funds could earn interest in financial markets (they can put the money in a bank).
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5 of 32 THE DEMAND FOR NEW CAPITAL AND THE INVESTMENT DECISION COMPARING COSTS AND EXPECTED RETURN The expected rate of return on an investment project depends on: the price of the investment, the expected length of time the project provides additional cost savings or revenue, and the expected amount of revenue attributable each year to the project. expected rate of return (aka the marginal rate of return on investment) The rate of return that a firm expects to obtain through a capital investment. = the marginal revenue product/the cost of the investment.
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Marginal rate of return per year on investment in farm equipment that lasts forever (a simple example) 6 (1) Farm Equipment (2) Total Product (bushels) (3) Marginal Product (bushels) (4) Marginal Revenue Product (4)=(3)×$4 (5) Marginal Resource Cost (6) Marginal Rate of Return (6)=(4)/(5) No equipment Tractor-tiller Combine Irrigator Harrow Crop sprayer Post-hole digger 200 1,200 2,000 2,600 3,000 3,200 3,200 - 1,000 800 600 400 200 0 - $4,000 3,200 2,400 1,600 800 0 - $10,000 10,000 10,000 10,000 10,000 10,000 - 40% 32 24 16 8 0 Marginal rate of return = MRP/MRC In this example life is easy, if the MRR of an investment is greater than the interest rate that the farmer could get from a “bank” then the farmer should undertake the investment.
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This note was uploaded on 08/30/2011 for the course ART 3514 taught by Professor Dhbannan during the Summer '03 term at Virginia Tech.

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Lecture+26 - Announcements HW due tonight (chs. 11-12) Ch...

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