High Finance : Capital Values

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C16CapVal March 20, 1998 November 3, 2018

©ArmenAlchian 1999

Chapter 16

"HIGH FINANCE": CAPITAL VALUES

This and the next nine chapters form a core set on Capital Values. For non-majors, only this and the next four are strongly recommended. For students majoring in Economics, all ten are “necessary.”

Big Brothers Are Watching You! Though your actions are your own business, that's not the case for your privately owned resources. People are watching your actions and will punish you if you ignore their opinions about the decisions you make for your privately owned resources. They'll do it not by laws, but by a far more powerful force. If you make a "wasteful” decision about your resource – in the opinion of other people – it’s market value will fall. Whether or not you look far ahead into the future, other people do. Their opinions are revealed by the market value they offer for your privately owned resources. Your wealth is immediately affected by the public’s opinion of the future effects of what you do now to what you own. You’ll be comparing salaries of different job offers, or savings plans, and whether to rent or buy a house, and whether to purchase or lease a car, and you’ll consider various types of insurance – the list is long. We affirm, “If you don’t learn capital values, you won’t have learned Economics.” Furthermore, you're very likely going to have to make personal investments for your own “social security.” You'll be making personal decisions about investments. That’s why this and the following chapters on the interest rate and capital values are presented early in this text. Immature “minors” can ignore these concepts, but any “major” or adult who doesn’t understand and use them will be inexcusably handicapped. Fortunately, we can assure you the basic ideas in capital values and interest rates are simple and are easy to apply— despite appearing strange initially. Also, though we'll have to do some arithmetic, modern cheap hand-held computers can do all the calculations for you. The principles and applications are easy if we start with the basic concepts, “yields” and “interest”, as we now do.

A RESOURCE'S OWN SERVICE YIELDS

You know the demand for goods like candy, eggs, and milk is based on the worth of the service yielded now. However, most goods are durable and yield a stream of valued services into the distant future. Shoes, houses, automobiles, computers, tennis rackets , to name a few, are durable goods. They are also called “capital goods.” Your demand for a capital good reflects the worths of all the anticipated future services of the good. Hence, goods that will yield more future services are worth more now. That’s obvious. But what’s not obvious is why the worth of a service is increasingly smaller at present, the farther that service is in the future. If a TV set lasts 10 years, and in each year yields services worth $600, it’s tempting, but wrong, to think the TV’s value is $6,000, the sum of the future ten annual $600 services. We’ll see that the value of the TV set now is worth less than $6,000. In other words, the value of a durable good will be less than the sum of future values of its future services. The market value of a durable good, i.e., of a capital good, is called its “capital value.” Capital values apply to a much broader range of items than bonds, or common stocks of a corporation, or borrowed money for a house and your college education. Capital values cover all durable goods. That’s a reason why the capital values of capital goods are an important topic for you in your earning, saving, spending, and investing – probably the most important topic for you personally in all of economics.

Resources – capital goods – buildings, machinery, land, books, computers, CDs, paintings, and pencils, to name a few, have service streams -- called, "yields." The time pattern of these services, the yield, can be described in various ways. An apple tree may yield all its apples in one month, say 300 apples in October. Instead of saying the yield from the apple tree is zero for 11 months and 300 in one month, it's conventional to measure the sequence as a flow per year. Here, it could be expressed as 300 apples per year, or 25 apples per month (=300 apples/12 months), even though all the apples were ripe and picked in one month.

Take another example with a different pattern of yields. A deciduous tree yields shade during six summer months, and none during the other six months. Suppose that shade is worth $100 per month during the summer. A more detailed description of the situation would state that the tree's "short-term" (monthly) yields are $100 in each summer month, and zero in each winter month. It's yield, averaged over a year, is $50 per month (=$600/12). You could , no matter how the flow is described, rent that shade by paying the $100 a month during the six summer months -- called a short-term rental. Or you could pay a longer term rate of $50 a month over the whole year. The conventional method of expressing yields is "per year."

For resources used in a business, the yield is usually measurable in terms of dollars. For others, like cars, clothing, pictures, furniture, and other consumption goods, the yields aren't sold and measured in monetary terms. But the yields do have personal worths to the owner, and those worths can be valued in terms of dollars.

Gross and Net Income

A pair of concepts that tend to be confused are (a) “gross" and (b) “net" yields, or incomes.. They can cause you trouble later if you don’t understand the distinction. If some of the current gross yield (or gross income) is used to replace wear and tear (the depreciation) of the productive resources that generate that gross yield, the remainder of that gross yield is called net yield, or more commonly "'net income." Of course, if none of the gross income were used to replace depreciation, in time no resources would remain to generate future income. So, we can think of the net income as the rate of flow of services that could be sustained forever, after using some of the gross income to repair, replace and maintain resources to obtain the same gross and net income flow in the future. In other words, net income is the maintainable flow of services that can be consumed while also maintaining the productive ability to yield that flow gross income. The one word "income", without the adjectives “gross” or “net”, usually (but unfortunately not always) means the “net income.” However, you should be able to deduce from the context what is meant when just the one word "income" is used.

In terms of the market values of the resources, if you have resources worth $100,000 (your total wealth) and if the interest rate is 10% you would receive $10,000 a year in interest, that is, strictly speaking, your net income. In other words, "interest" from investments or wealth is often a name for the net income. Each year you (and your heirs) could spend at the rate of $10,000 per year for consumption without reducing the $100,000 of wealth. However, retired people who might decide to leave no wealth for heirs can consume more than their net income by consuming some of their wealth They may have a small “net” income, but a larger gross income by consuming some of their wealth for a while – until the wealth is all consumed. They use all their gross income for consumption , instead of using some for maintenance of the wealth that was yielding the income. This is also expressed as “consuming one’s capital:” (That’s one reason some old people appear to be in poverty during their last years. Their net income is small but their consumption is high until that final moment – at which they may luckily have just consumed the last bit of wealth.) If enough people do that, the society-wide stock of resources (wealth) will decrease. That would be an aggregate "negative" rate of investment. The language in ordinary usage is not precise. You’ll have to be alert to detect exactly what is meant.

THE “OWN YIELD” and the "OWN RATE of INTEREST" and “CAPITAL VALUE”

Financial terminology calls the market price of a durable good its "capital value." In the example of our shade tree, suppose its market value were $6,000. The tree's “own yield” of $600 of shade would be equivalent to a percentage yield of 10% per year of the market value of the tree (=$600/$6,000). When expressed as a percentage of the resource's market value, the own yield is called the "own rate of interest", or the “own interest rate.” Here, 10% is the tree's own interest rate.

Own Interest Rate = Annual Yield of the Resource = $600 = 0.10 (or 10%)

Market Price of the Resource $6,000

To repeat, the tree's own interest rate is 10% per year, because the value of the annual shade yield is $600 and the market price, the capital value, of the tree is $6,000. In summary: the tree's annual yield is $600; its own rate of interest is 10% of its $6,000 capital value. Later, we'll look at the market rate of interest.

THREE FORMS OF YIELDS

The “full yield” from a resource consists of three component forms; non-monetary, monetary, and growth in the resource’s market value.

(a) Non-monetary services

Some yields are direct services received by the owner, like the warmth and comfort of your clothes and shoes, the shade from a tree, the safety provided by a fire-extinguisher, or an eraser's services in correcting written errors. Think for a moment of a $50 picture you'd like to hang in your room. If you choose to buy it when the interest rate you could otherwise earn by investing or lending your money is 10% per year, the picture’s yearly services to you must be worth more than $5 a year (=.10x$50), else why did you buy it or why don't you sell it to someone else? Discovering a monetary equivalent value, or a market value, is not always easy.

(b) Monetary Yields

The most commonly recognized form of the yield is money – such as money received for the rent of a house or land. The resource's services are sold for money, bringing a monetary yield. The yield on savings accounts, bonds and other financial instruments is often called "interest."

Incidentally, you can now see a reason why you must pay interest when you borrow. If you were to buy a $1,000 computer, you could pay $1000 now and take delivery now. Or, you could take delivery now and buy on credit, paying $1,100 one year later -- $100 more. Notice that in both situations you get the computer now. The difference is in when you pay for the computer. In the first situation you pay now, and in the second you pay one year from now. (There's no inflation in this problem. The price level is unchanged.) That extra $100 paid later is interest of 10% (=$100/$1,000) for one year. That interest must be paid because, in the intervening year, the seller will lose services from what the seller could have obtained if the payment had been made at the time of delivery of the item.

(c) Growth of Relative Market Value

Another form in which the yield accrues is in the accumulating rise in the current market value of a resource. Suppose you have a share of common stock in some corporation, and the stock is worth $80 a share. Suppose you receive $5 in dividends (earnings of the corporation paid to you) during the year, while the value of the stock rises $3, to $83. That's a return of $8, consisting of the $3 rise in value plus the $5 dividend received. That's a 10% rate of return on the $80 initial stock value. Whether the return is in the form of cash receipts or a rise in the market value of the stock makes no difference in your wealth (except for income tax considerations).

Similarly, if you own some land now worth $1,000 from which you receive a rent of $50 in the year, and if the land value rises by $30 to $1,030 during the year, you have received returns of $50 plus $30, for a total of $80. That's 8% of the initial value ($80/$1,000). The interest is in the form of a combination of a flow of money and non-money rents plus a rise in the value of the land. In general, whenever assessing the interest and the rate of interest, remember that there are three potential components.

Let’s consider one more example of the effect of a growth in value – how that growth affects the decision to conserve or to use a resource. Imagine you own some oil in the ground. Suppose you can leave (store, conserve) the oil underground as long as you like and then extract it at zero expenditure. The current price of oil is $90 per barrel. Should you pump the oil now and sell it at the $90 or continue to hold the oil underground? (Assume the cost of pumping the oil is zero, to simplify the arithmetic.) If you extract and sell the oil, you can invest the proceeds of the sale and receive interest income. But you could instead let the oil stay underground, because the price of oil may rise over time. Here's why. Suppose the market rate of interest is 10 percent. (Later, we'll examine in detail what is meant by the interest rate.) Here, all we have to know is that a 10% interest rate means if you sell a barrel of oil today for $90 and invest the money at 10%, the $90 will grow to $99 (=$90 x1.10) in one year. That's just like the growth of a savings account that pays 10% interest per year. The tricky part is in grasping this next idea.

If you expect the price of a barrel of oil to rise by more than the rate of interest, to any amount over $99, say $105, it will pay keep to the oil underground until next year and then extract and sell the oil for that price of $105. You will have obtained a profit of $6 (=$105-99) – $6 more than if you had sold it earlier for $90 and earned only 10% on the $90 during the year, ending up with only $99.

If, however, you expect that the price of oil next year will be less than $99, say only $95 – an increase of less than the rate of interest, you would sell the oil now for $90 and invest the proceeds at 10% for a year at end up with $99, which is more than the $95 you expected to receive for the oil at that later time. In general, if you don’t expect the future price to be higher than the present price by at least the rate of interest, there's no point in conserving the oil rather than selling it now. You would extract the oil, sell it and invest the proceeds elsewhere to earn the 10% rate of interest, which would be more than you expect the value of the oil to increase. This, incidentally, is how the rate of interest enters into decisions about the rate at which resources should be used or conserved for the future.

The preceding also outlines how and why interest rates are so crucial in every business. Unless the business can produce goods that cover costs and the interest on the costs, it will not survive. It will not survive because it earned less than could be earned elsewhere. What could be earned elsewhere per dollar of what was invested here is indicated by the rate of interest. If that alterrnative isn’t earned “here”, that business won’t be able to continue to get the resources from compeititors for the resources, where more can be earned. The rate of interset is a generalized measure of best alterantive return from use of resources. It’s the acid test of survival, or growth.

COMPETITIVE EQUALIZATION of RATES of OWN INTEREST

Through competition, the percentage rate of return on all resources tends toward the same rate. Two types of adjustments equalize the yields on all resources – (1) adjustments in the market price (capital value) of resources and (2) adjustments in the amount of the resources. Using some economics from preceding chapters, you can quickly figure out that the own rates of interest on all resources would tend to be the same percentage interest. That happens as a result of the inevitable competition for higher yielding resources. We all prefer resources that have higher yields. We compete to get higher yielding resources. That competition equalizes the percentage rates of return on resources, and does it in two ways.

(1) Adjustments in the Market Prices - the Capital Values - of Resources

One way of equalizing the rates of own interest is very fast. As soon as anyone perceives a difference in the own rates of interest between resources, the higher yielding one will be demanded and the lower will not. A higher price in the denominator of the ratio of the annual dollar yield divided by the price, lowers the percentage yield. An annual yield of $10 is a 10% yield if the price of the resource is $100. But if its price is bid up to $200, the percentage yield is only 5% . With competition for higher yields, no resource will have a higher own percentage yield – own rate of interest – than any other. The rate – the rate at which all the own rates happen to become equalized -- is called the market rate of interest. In brief, the own percentage rate of yield (or own rate of interest) on any resource tends to be competed immediately to where none is higher nor lower than expected on any other resource, and is competed to the market rate of interest. Again, there is no charity in the market.