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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 percentage.

The 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 inversely proportional.

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)
c)    The government (subsidies and share-holdings)
d)   Trade credit - delaying payments

          Debentures - redeemable or irredeemable. Interest can be paid out of capital.

          Shares - give voting right. Types:

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)

      Increased growth

Calculating the return

Interest 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

1.     Dual capacity dealing - no more differentials between jobbers (issue co. shares) and brokers (sell shares to public).
2.     Abolition of fixed commissions
3.     The ownership of stock-brooking firms was allowed to non-members of exchange (banks).
4.     Computers were introduced even further.
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