5. The Market of the Factors of Production
5.3. The Market of Capital Goods
Capital is considered to be a secondary factor of production, and its two main forms are real capital and nominal capital. Real capital comprises machinery, buildings, tools, equipments, and material to be used in the production process, while nominal capital means the financial funds used for production, either in the form of money or as stocks and bonds.
The market of real capital is called the market of capital assets, while the market for nominal capital is made up of two markets: the financial market (market of money and loanable funds19), and the securities market (or stock market, the market of stocks and bonds).
5.3.1. The Market of Real Capital
The market of real capital, that is, the market of capital assets deals with the sale of machinery, equipment, raw materials, fuels. For materials used up completely during one production cycle, the firm making a purchase decision, will simply compare the costs of buying these factors and the total revenue received after selling the resulting output. The situation is more complicated when capital assets are used for more than one year, during several production cycles, contributing to the total sales revenues of many years, but the cost of buying them occurs now. Such long-term assets are e.g. buildings, expensive machinery, and vehicles. The decision-maker must consider the impact of the time factor: it is important to know whether the revenue generated by the asset is earned now or one year later. Assume that this year the revenue earned was 100000 HUF, and we decide to deposit this revenue in the bank for a year at 5% interest rate, therefore next year we will own 105000 HUF. If, however, the revenue of 100000 HUF will be earned only next year, but we need money now, we have to take out a loan from a bank, and, of course, as next year we can pay back only the 100000 HUF including the interest, the bank would now offer a loan less than this amount.
Therefore any costs and revenues earned or paid in different times have to be re-valued to current money, using the notions of present value and future value.
The future value (FV) of a cash flow received today is calculated using the formula for compound interest. The future value of a present cash amount C in t years time, at annual rate of interest r is calculated by the following formula: FVt = C × (1+r)t. Assume, for example that we receive 1000000 HUF today, and in 5 years time, at an annual interest rate 10 %, this amount of money is worth: FV5 = 1000 000 × (1+0,1)5 = 1000 000 ×1,61051 = 1610510 HUF.
19 The money market handles short-term loans to be paid back within a year, while the market of loanable funds handle long-term loans to be paid back later than a year (or with no specified maturity date) (Farkasné Fekete – Molnár, 2007).
The opposite logic gives us the present value (PV) of a cash flow to be received in the future, in t years time, and it is calculated by the method of discounting. The present value of a cash amount of C due in t years time, at an annual interest rate of r is given by the following formula: PVt = C / (1+r)t. For example, we are going to receive the sum 1000000 HUF in 5 years from now, and the annual rate of interest is 10 %, so the present value of this future sum is: PV5 = 1000000/(1+0,1)5 = 1000000/ 1,61051 = 620 921 HUF.
The notions of present value and future value are used in investment decisions, when the firm decides whether to purchase a valuable piece of machinery. The valuation of the asset is done by the logic of business management: the capacity of the asset to generate income is assessed, and the capitalised value of the machinery is calculated as the discounted sum of the successive revenues or profits that the machine will earn. Assume, for example, that the machine will earn a profit of 1000000 HUF each year of its life span, and it will operate for 5 years. Assuming 10 % interest rate per year, the sum of the present values of the annual earnings is: PV=1000000/1,1+ +1000000/1,12 +1000000/1,13 + 1000000/1,14 + 1000 000/1,15 = 909091 + 826446 +751315+ + 683014 + 620921 = 3790787 HUF.
Should the firm buy the machine, if the price payable today is 3600000 HUF? The decision is made by calculating the net present value of the investment. Net present value (NPV) is the difference of the present value of the yield of investment and the cost of establishing the investment. In the former example NPV= 3790787 HUF – 3600000 HUF = 90787 HUF. A general rule is that investments of positive net present value may be established, but naturally the investor must consider the risks of future cash flows and the risk of changing interest rates, therefore an expected small positive NPV may easily turn negative in the future.
Economic decisions about the future involve double uncertainties or risks. One is about the expected earnings, that are predicted with great uncertainty. The other is about the expected interest rates, which are also difficult to forecast. The business agents differ in their expectations about the future, and that is the explanation why some agents exit a business negotiation earlier than others, as they are more pessimistic about the earnings or interest rates than others.
5.3.2. The Financial Markets
The market of money and loanable funds handles transactions about the right of using money (Farkasné Fekete - Molnár, 2007). In the supply side we find all the agents having excess money, or savings, while borrowers represent the demand side. Interest is the fee for the use of borrowed money, savers earn interest by their deposited funds, borrowers pay interest for the loan they take, the latter being usually higher than the former. The banks are financial intermediaries acting between savers and borrowers, they pay the interest payable on deposits from the interest taken from borrowers. The difference between the loan interest rate (the interest income of the bank) and the deposit interest rate (the interest expense of the bank) is interest margin which covers the expenses of the bank’s operations and contributes to the profits of the bank. The interest rate is simply the annual interest payment divided by the principal (the amount of the loan or the deposit), expressed in percentages. The demand for loanable funds is determined by the market value of the goods produced using these funds, which the borrower compares to the costs of the loan, that is, the interest payable.
A firm may take a bank loan to raise funds, but it might do so by exchanging securities (stocks or bonds) as well. A security (also called a financial instrument) is a tradable claim on the issuer’s future income or property that is subject to ownership. The main types of securities are discussed below.
A promissory note is a legal promise in written form of paying a specified sum of money to a specified payee at a specified time in the future. A promissory note is usually issued when a firm may need some resource, e.g. raw materials for production, but it does not have money to pay for it. The firm expects to sell the product within a fixed time in the future, e.g. within 3 months, for a price that covers the firm’s costs as well as some profit. Therefore the firm would be able to pay for the raw materials after the sale of the output. The firm wanting the raw material, but lacking money promises to the owner of the raw material to pay the price of the resource after the sale of the output – paying not only the current price but an interest as well. The transaction can be understood as if the firm borrowed the price of the input from its owner for the specified time (three months in the example). Naturally, our firm cannot force the input provider to accept a promissory note instead of the actual payment. The input provider will do that only if he/she considers the borrower a trustworthy partner, and believes that it will repay the borrowed sum and its interest by the specified deadline. The promissory note can be transferred to other parties as a form of payment instead of money (assuming that the other party accepts it), and it can be discounted in a bank, that is, sold to the bank for cash before its expiry date, for which the bank charges interest.
A bond is a debt security that promises to pay a fixed yield to maturity, making pre-defined payments periodically for a specified period of time. Firms or institutions issue bonds when they need a loan, and savers will purchase these bonds. The face value (also called the principal) of the bond is the nominal value written on the bond, and the fixed interest is paid on this face value. The issue price of the bond is the price at which the first bondholder can buy the bond (this may be equal to the face value of the bond, or lower than that). The price of the bond between the date of its issuing and its maturity is determined by its demand and supply. Government bonds are long-term debt instruments issued by the government to finance the deficits of government budget. They are issued at larger units than the private (corporate) bonds, and their maturity is longer than those. Treasury bills are issued in smaller units and for shorter maturity with the same purpose of financing budget deficits.
The common stock (typically just called a stock) represents a share of ownership in a corporation. It is a security with no maturity date, that is a claim on the earnings and assets of the corporation. Stocks also have face value, issue value and market price. The meanings of these are similar to those of the bond, but the issue value of the stock cannot be lower than its face value. The stockholder is the owner of the stock, who, by purchasing the stock, gives his/her funds to the corporation for good, the stockholders cannot return their stock for money, but they can sell it to someone else interested in buying it. The stockholder is entitled to a share of the corporate profit, called dividend, in proportion to his/her share, and has a right to vote about the decisions of the corporation. The yield of the stock is either the dividend, or capital gains collected when selling the stock at a price higher than the price at which it was purchased. Naturally, the stockholders must bear the risk of capital losses as well. Stocks are usually classified by their tradability and ownership rights, some stocks may restrain the stockholder’s interference to managerial decisions, others may restrain the tradability of stocks.
The primary market of securities deals with the trade of newly issued securities, here the securities are sold to the first owner, the capital saved by the first owner is transferred to the issuer of the security. The secondary market of securities deals with the trade of securities that had been issued earlier and that are owned by their holders. Transactions in the secondary market do not have any direct impact on the corporation that issued the security, there transactions take place among savers. The top institution of secondary security markets is the stock exchange. The main role of the stock exchange is the trading of securities, although the stock exchange prices also provide valuable information for the economic agents about the market processes and market value of corporations, too. Some of the
stock-exchange transactions – purchases or securities – take place with the objective of long-term investment, others are done with the aim of speculation, for capital gains. Hausse speculants expect a bull market in stocks (that is, they expect stock prices to rise), so they buy stocks today at lower prices to sell them later at higher prices, earning gains by the price difference.
Baisse speculants expect a bear market in stocks (that is, declining stock prices), so they sell stocks today at higher prices to buy them back at lower prices, earning gains by the price difference. Speculation in the stock exchange plays an important role vitalising the market, therefore the normal forms of speculation are not prohibited, but regulated. However, incorrect behaviour, such as collusion, fake transactions, misinformation, and the abuse of information is heavily penalised (Farkasné Fekete –Molnár, 2007).