Deck 27: Investment, the Capital Market, and the Wealth of Nations   

Question 1

"In a world of uncertainty, it is important that entrepreneurs be able to introduce new products and try out innovative ideas. But it is also important that unproductive projects be brought to a halt." Evaluate this statement.

Answer 1

In a world of uncertainty diversified business portfolios are preferred over doing business narrowly. So in this uncertainty environment with lots of competition only those businesses can survive who come up with new products within regular time intervals and as per market demand and also bring innovative ideas which satisfy the customer demand and help to grow themselves. In today's competitive environment only those firms can survive which come up with innovative ideas on a regular basis and believe in diversified business and if they feel that some department is not productive or its unproductive then despite of investing in that it's better to close it and focus on other departments which are growing and where they have strong market share.

Question 2

Will political officials be more likely to channel funds into wealth-creating projects than private investors and entrepreneurs? Why or why not? Discuss.

Answer 2

Political investors basically work for the society not for their own benefit. So for them the main aim is to maximize the benefits to consumers living in the society and not to maximize their own wealth (which is the aim for private firms). So, government political officials will not engage into projects which will give more wealth returns, instead they would invest in projects which would benefit the consumers and the society as a whole.

Question 3

How would the following changes influence the rate of interest in the United States?
a. an increase in the positive time preference of lenders
b. an increase in the positive time preference of borrowers
c. an increase in domestic inflation
d. increased uncertainty about a nuclear war
e. improved investment opportunities in Europe

Answer 3

a) An increase in the positive time preference will influence interest rates in the economy. If lenders lend for longer time periods then the interest rates which they charge will also be high as compared to lending money for shorter durations. Time has a direct impact on interest rates such that if the time period is longer then interest rates charged on that will be high.
b) An increase in positive time preference of borrowers will have the same effect as that of lenders i.e. the increase rates would increase. Borrowers would demand money for a longer time period and thus would have to pay higher interest rates to lend from lenders.
c) Inflation indicates an increase in the supply of money in an economy which leads to increase in the price and cost of goods. In such a case lenders try to increase their interest rates so as to achieve a better return from the money lent, since an increase in inflation rates increases the time value of money.
d) An increase in uncertainty about nuclear war will increase interest rates because a risk of future war would make investors move out of the economy. In order to attract them back, the policymakers will have to increase interest rates in order to increase the returns from their investments.
e) If investment opportunity increases in Europe then investors will shift their money and investments from US to Europe. As a result policymakers will have to increase interest rates in the economy in order to increase the returns from their investments and thus attract more investment into the economy.

Question 4

What is capital investment? Why do business firms often use machinery and other capital assets to produce goods and services?

Question 5

How are human and physical capital investment decisions similar? How do they differ? What determines the profitability of a physical capital investment? Do human capital investors make profits? If so, what is the source of the profit? Explain.

Question 6

A lender made the following statement to a borrower: "You are borrowing $1,000, which is to be repaid in twelve monthly installments of $100 each. Your total interest charge is $200, which means your interest rate is 20 percent." Is the effective interest rate on the loan really 20 percent? Explain.

Question 7

In a market economy, investors have a strong incentive to undertake profitable investments. What makes an investment profitable? Do profitable investments create wealth? Why or why not? Do all investments create wealth? Discuss.

Question 8

Over long periods of time, the rate of return of an average investment in the stock market has exceeded the return on high-quality bonds. Is the higher return on stocks surprising? Why or why not?

Question 9

The interest rates charged on outstanding credit card balances are generally higher than the interest rate that banks charge customers with a good credit rating. Why do you think the credit card rate is so high? Should the government impose an interest rate ceiling of, say, 10 percent? If it did, who would be hurt and who would be helped? Discuss.

Question 10

If the money rate of interest on a low-risk government bond is 10 percent and the inflation rate for the last several years has been steady at 4 percent, what is the estimated real rate of interest?

Question 11

Suppose you are contemplating the purchase of a commercial lawn mower at a cost of $10,000. The expected lifetime of the machine is three years. You can lease the asset to a local business for $4,000 annually (payable at the end of each year) for three years. The lessee is responsible for the upkeep and maintenance of the machine during the three-year period. If you can borrow (and lend) money at an interest rate of 8 percent, will the investment be a profitable undertaking? Is the project profitable at an interest rate of 12 percent? Provide calculations in support of your answer.

Question 12

Alicia's philosophy of life is summed up by the proverb "A penny saved is a penny earned." She plans and saves for the future. In contrast, Mike's view is "Life is uncertain; eat dessert first." Mike wants as much as possible now.
a. Who has the highest rate of time preference?
b. Do people like Alicia benefit from the presence of people like Mike?
c. Do people like Mike benefit from the presence of people like Alicia? Explain.

Question 13

Some countries with very low incomes per capita are unable to save very much. Are people in these countries helped or hurt by people in high-income countries with much higher rates of saving?

Question 14

According to a news item, the owner of a lottery ticket paying $3 million over twenty years is offering to sell the ticket for $1.2 million cash now. "Who knows?" the ticket owner explained. "We might not even be here in 20 years, and I do not want to leave it to the dinosaurs."
a. If the ticket pays $150,000 per year at the end of each year for the next twenty years, what is the present value of the ticket when the appropriate rate for discounting the future income is thought to be 10 percent?
b. If the discount rate is in the 10 percent range, is the sale price of $1.2 million reasonable?
c. Can you think of any disadvantages of buying the lottery earnings rather than a bond?

Question 15

Suppose you are moving into a new apartment you expect to rent for five years. The owner of the apartment offers to provide you with a used refrigerator for free and promises to maintain and repair the refrigerator during the next five years. You also have the option of buying a new energy-efficient refrigerator (with a five-year free maintenance agreement) for $700. The new refrigerator will reduce your electric bill by $150 per year and will have a market value of $200 after five years. If necessary, you can borrow money from the bank at an 8 percent rate of interest. Which option should you choose?

Question 16

Suppose that you are considering whether to enroll in a summer computer-training program that costs $2,500. If you take the program, you will have to give up $1,500 of earnings from your summer job. You figure that the program will increase your earnings by $500 per year for each of the next ten years. Beyond that, it is not expected to affect your earnings. If you take the program, you will have to borrow the funds at an 8 percent rate of interest. From a strictly monetary viewpoint, should you enroll in the program?