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P. 23. Capital and interest, p316.
Capital is producer's goods. Capital is
formed by forgoing current consumption and diverting these resources to the
production of future wealth. The return on capital is expressed as a
capitalised value of an asset is which would be placed on it at its existing
level of earnings and current rates of interest. The value and interest are
The marginal efficiency of capital is the rate of return
on the last unit of capital employed. . MEC=i (interest). MEC is the demand for capital.
Capital deepening - if
firm places more capital per unit of other factor (new machines)
Capital widening - if more
capital is accumulated leaving proportions the same (new factory)
Interest rate is
the price of borrowing capital. Optimum MEC=i (interest rate). Change in
technology will shift the MEC curve.
Real rate of
interest is the difference between nominal rate and inflation.
Appraising investment techniques.
1. The pay-back method (ignores earnings after asset has paid back
and money worth after time).
2. The average rate of return (total yield / years, only for similar
life span projects).
3. Discounted cash flow
(money received in the future is converted to todays prices). It obtains
present discounted value (PDV)=().
4. Net present value = PDV - initial costs.
5. The internal rate of return. A discounting percentage by which
the discounted value is equal to original value. If percentage is bigger than
interest rate, the investment is profitable.
Sources of finance for the firm.
1. Internal finance - ploughed back profits.
2. External finance - obtained outside.
a) The capital
market - either London Stock exchange (individuals have declined, pension funds
increased) or Unlisted Securities Market (attracts indiv.).
b) Banks (UK
banks do not buy shares, but give loans & overdrafts)
government (subsidies and share-holdings)
credit - delaying payments
redeemable or irredeemable. Interest can be paid out of capital.
Shares - give voting
1. Preference shares - fixed dividend is received before others. Are
cumulative (interest is paid next year after a bad year). Only participating
pref. shares give voting right.
2. Ordinary shares - risky.
Capital gearing - the
proportion of loan capital to share capital in capital structure.
Advantages of some loan capital
Reduced tax burden
(interest paid on loan can be claimed)
Calculating the return
is the rate of lending when no risk is involved. Profit is reward for risk.
Dividend is how much co. pays out at the
end of the year whereas interest is how much it is from the market value.
1. Yield =
2. Price earnings ratio (P/E) =
3. Dividend cover =
The stock exchange changes in 27.10.86
capacity dealing - no more differentials between jobbers (issue co. shares) and
brokers (sell shares to public).
of fixed commissions
ownership of stock-brooking firms was allowed to non-members of exchange
were introduced even further.