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CHAPTER 13
CAPITAL, INTEREST, ENTREPRENEURSHIP, AND CORPORATE
FINANCE
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
This chapter adds investment and corporate finance considerations to the theory of firm behavior and resource
allocation. The first two thirds of the chapter describes in considerable detail the process of determining the
LEARNING OUTCOMES
13-1 Derive a firm’s demand curve for investment, and determine its marginal cost of investing.
Choosing the profit-maximizing level of capital is complicated because capital purchased today usu-
ally yields a stream of benefits for years into the future. The expected rate of return on capital equals
13-2 Explain what determines the interest rate for loanable funds.
The demand and supply of loanable funds determine the market interest rate as illustrated in a graph.
13-3 Describe four reasons why interest rates differ across markets.
13-4 Articulate how to convert future dollars into their present value.
The current value of future payments is the present value. The process of translating future payments
into present value is called discounting. The present value of a given payment is smaller the further
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 186
13-5 Summarize how entrepreneurs drive the economy forward.
An entrepreneur is a profit-seeker who comes up with an idea, tries to turn that idea into a marketable
product, and accepts the risk of success or failure. The entrepreneur need not supply any resource
13-6 Distinguish between stocks and bonds, and explain which involves more risk and why.
Corporations fund new investment from three main sources: new stock issues, retained earnings, and
borrowing (either directly from a bank or by issuing bonds). Once new stocks and bonds are issued,
they can then be bought and sold on securities markets. The value of corporate stocks and bonds tends
to vary directly with the firm’s profit prospects. More profitable firms have more ready access to
CHAPTER OUTLINE WITH POWERPOINT SCRIPTS
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
Production, Saving, and Time: Production cannot occur without prior saving because both direct and
roundabout production take time—time during which goods and services are not available from current
production.
USE POWERPOINT SLIDES 3-4 FOR THE FOLLOWING SECTION
Consumption, Saving, and Time: If you are willing to pay more to consume something now rather than
USE POWERPOINT SLIDES 5-8 FOR THE FOLLOWING SECTION
Optimal Investment: Firms invest in any project whose rate of return exceeds the market interest
rate.
USE POWERPOINT SLIDES 9-13 FOR THE FOLLOWING SECTION
The Market for Loanable Funds: This market brings together borrowers, or demanders of loanable
funds, and savers, or the suppliers of loanable funds, to determine the market interest rate.
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 187
• Demand for loanable funds: The relationship between the market interest rate and the quantity of
loanable funds demanded, other things constant. Based on the expected marginal rate of return the
USE POWERPOINT SLIDES 14-16 FOR THE FOLLOWING SECTION
Why Interest Rates Differ
• Risk: Differences in the risk of loans. The more valuable the collateral that backs up a loan, the lower
the interest rate charged.
• Duration of the Loan: As the duration of the loan increases, so does the risk. The term structure of
USE POWERPOINT SLIDES 17-21 FOR THE FOLLOWING SECTION
Present Value and Discounting: Present value is the current value of a payment or payments to be
received in the future. Discounting is the process of dividing the future payment by 1 plus the prevailing
interest rate to express in today’s dollars.
USE POWERPOINT SLIDES 22-25 FOR THE FOLLOWING SECTION
Entrepreneurship
• Entrepreneur: Comes up with an idea, turns that idea into a marketable product, accepts the risk of
success or failure, and claims any resulting profit or loss (residual claimant).
USE POWERPOINT SLIDES 26-29 FOR THE FOLLOWING SECTION
Corporate Finance
Corporate Stock and Retained Earnings: Corporations fund investment by issuing stock, by retaining
some of their profits, and by borrowing.
• Entrepreneur: A profit-seeking decision maker who organizes an enterprise and assumes the risk of
operation.
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 188
USE POWERPOINT SLIDES 30-31 FOR THE FOLLOWING SECTION
Corporate Bonds: Certificates reflecting a corporation’s promise to pay the holder a fixed sum of money
on the designated maturity date, plus make interest payments until that date.
Securities Exchanges: Places where stocks and bonds are traded.
CHAPTER SUMMARY
Production cannot occur without savings because both direct production and roundabout production
require time—time during which the resources required for production must be paid. Because people value
present consumption more than future consumption, they must be rewarded to defer consumption. Interest
is the reward to savers for forgoing present consumption and the cost to borrowers for being able to spend
now.
The current value of future payments is the present value. The process of translating future payments into
present value is called discounting. The present value of a given payment is smaller the further into the
future that payment is to be received. A given sum of money received each year for a specified number of
years is called an annuity. The present value of receiving a sum each year forever is the amount received
each year divided by the market interest rate.
An entrepreneur is a profit-seeker who comes up with an idea, tries to turn that idea into a marketable
product, and accepts the risk of success or failure. The entrepreneur need not supply any resource other
TEACHING POINTS
1. The decision of whether to borrow to invest in capital formation is complicated by the element of
time. When the benefits and costs of such a decision are spread over time, the manner in which time
is discounted and the opportunity cost of time become important.
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 189
2. The idea that present consumption is more highly valued than future consumption is one with
which most students will readily agree. However, connecting future income to present value by
means of the interest, or discount, rate is more challenging. One way to foster such understanding is
3. An important distinction (not yet brought up in the text) should be made between the rate of inter-
est that is figured in nominal terms and the real rate of interest—the rate calculated from real sums
4. You may wish to introduce the concept of risk into the present value calculations. This is one of the
most poorly understood ideas in security valuation, and grasping this concept will help students in
5. Ask student volunteers to describe ideas for new products or production methods. Then ask others
in the class to provide off-the-cuff economic analyses of the viability of the ideas.
SOLUTIONS TO PROBLEMS APPENDIX
1. (Role of Time) Complete the following sentences with a word or phrase:
a. If Bryan values current consumption more than future consumption, he has a _________
___________________________________________.
b. The reward to households for forgoing current consumption is _____________________
________________________.
2. (Investment) What is the firm's marginal cost of investing?
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 190
3. (Optimal Investment) Look at the exhibit above (Exhibit 1). If the operators of the golf course
revised their revenue estimates so that each cart is expected to earn 5 percent less, how many
carts would they buy at an interest rate of 8 percent? How many would they buy if the interest
rate is 3 percent?
The lower expected revenues reduce the expected rate of return for each golf cart to 15 percent
4. (Supply of Loanable Funds) Explain why the supply of loanable funds curve slopes upward to the
right.
Higher interest rates are required to compensate lenders for the greater quantities of foregone
5. (Demand for Loanable Funds) Explain why the demand for loanable funds curve slopes
downward to the right.
6. (Market for Loanable Funds) Using the demand-supply for loanable funds diagram, show the
effect on the market interest rate of each of the following:
a. An increase in the purchase price of capital
b. An increase in the productivity of capital
c. A shift in preferences toward present consumption and away from future consumption
a. An increase in the purchase price of capital reduces the marginal rates of return on invest-
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 191
c. A shift in preferences toward present consumption decreases the supply of loanable funds as
rises.
7. (Why Interest Rates Differ) At any given time, a range of interest rates prevails in the economy.
What four factors contribute to differences in interest rates across consumers?
8. (Present Value) Calculate the present value of each of the following future payments. (For some
of these problems you may wish to use the online calculator available at
http://www.moneychimp.com/ articles/finworks/fmpresval.htm.)
a. A $10,000 lump sum received 1 year from now if the market interest rate is 8 percent
b. A $10,000 lump sum received 2 years from now if the market interest rate is 10 percent
c. A $1,000 lump sum received 3 years from now if the market interest rate is 5 percent
d. A $25,000 lump sum received 1 year from now if the market interest rate is 12 percent
e. A $25,000 lump sum received 1 year from now if the market interest rate is 10 percent
f. A perpetuity of $500 per year if the market rate of interest is 6 percent
a. $9,259.26 = [10,000/(1+.08)]
9. (Present Value of an Income Stream) Suppose the market interest rate is 10 percent. Would you
be willing to lend $10,000 if you were guaranteed to receive $1,000 at the end of each of the
next 12 years plus a $5,000 payment 15 years from now? Why or why not?
At a 10 percent interest rate, it takes only about an $8,010 investment to meet the proposed re-
10. (Role of Entrepreneurs) Describe four ways that entrepreneurs affect the economy.
Entrepreneurs affect the economy by creating new products, improving existing
11. (Entrepreneurship) What entrepreneurial idea do you have? How would your idea contribute
to the economy?
Chapter 13 Capital, Interest, Entrepreneurship, and Corporate Finance 192
Student answers will vary, but ideas should be a new product, a better version of an existing
12. (Corporate Finance) Describe the three ways in which corporations acquire funds for invest-
ment.
Corporations fund new investment from three main sources: new stock issues, retained earn-
13. (Stocks and Bonds) What's the difference between stocks and bonds. Which is more risky to
own and why?
The value of corporate stocks and bonds tends to vary directly with the firm’s profit prospects.
14. (Securities Exchanges) What role do securities exchanges play in financing corporations?
Securities exchanges provide a venue for selling newly issued stocks and bonds. However, the
bulk of transactions on these exchanges is for the secondary market—the buying and selling of
Experiential Assignments
1. Although the article is dated, have students read Jane Katz, “Who Should Be in Charge,” in the
Federal Reserve Bank of Boston’s Regional Review at
corporate finance as outlined by Katz? Do they hold true today?
2. Each day, the Wall Street Journal highlights a key interest rate in a graph on the first page of the
Money and Investing section. Have students compare the graphs over several days to see the move-
ments in rates for different securities. How have interest rates changed over the past year? Ask stu-
