Deck 14: Investment, the Capital Market, and the Wealth of Nations

Question 1

*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 1

According to the given situation, the following changes in interest rates in the United States will be implemented.
a) If there is an increase in positive time preference of lenders then the rate of interest will also increase. As this is a motivating factor.
b) Interest rate will increase in the case of positive time preference increments of borrowers.
c) An increase in domestic inflation will lead to an increase in interest rates.
d) Uncertainty about a nuclear war also increases the rate of interest.
e) Improved investment opportunities in Europe will also increase the rate of interest in the United States.

Question 2

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

Answer 2

Capital investment refers to money spent in a business with the intention to use that money to buy fixed assets, rather than to cover the daily expenses of the business.
If a firm purchases fixed assets or capital assets, like land, buildings, manufacturing plants, and machinery, which are likely to be productive over a numbers of years, it is known as capital investment.
Firms regularly use machinery and other capital assets to produce goods and services, as the capital assets can produce much higher quantity in a limited period of time and bring down the per unit cost of production as compared to human capital.
Also, capital investments are the effective ways of investment that are safe and could earn good returns even if they are sold. But, here the reason is they improve the productivity.

Question 3

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.

Answer 3

As we know that capital is something which is responsible for continuing services to business firms. There are two types of capital. One is physical capital which includes land, building, tools, machinery, and other natural resources. And the second is human capital which includes skills and knowledge of firm's human resource.
Since the capital investment refers to money spent in the business with the thought that the money will be used to buy fixed assets, rather than used to cover the daily expenses of business. Investment is the purchase and development of capital resources including human and physical capital.
Return on physical and human capital makes the decision of an investor similar. Profit provides incentives on both physical and human capital decision to start investment yielding an indefinite profit, determine and start profitable investment opportunities.
Human capital investment refers to the investment on skills, knowledge, or education of human resource of a company, while the physical capital investment refers to the investment on physical productive plants, tools, and machinery.
If the rate of return on physical capital investment is higher than the supply price of capital, then the investment is profitable.
Yes , human capital investors do earn profit by enhancing the skills of their workers, which increase the productivity and provide greater amount of return. But the profit in human capital investment cannot be determined.

Question 4

*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 5

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 6

*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 7

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 8

*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 9

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 10

*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 11

*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 12

*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 13

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 14

*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?

Question 15

"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.

Question 16

*Will political officials be more likely to channel funds into wealth-creating projects than private investors and entrepreneurs? Why or why not? Discuss.
*Asterisk denotes questions for which answers appear in Appendix B.