Guest Lecturer from Dawson's Creek
Capital and Rental Cost

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Factors of Production: Land, Labor, and Capital

What is capital? Machinery, equipment

Movie theaters' capital: projectors; ticket machines; popcorn machines; seats; etc.

Consumer Goods and ServicesCapital Goods
Provide immediate, direct enjoymentUsed to produce other goods and services
Can only be used for a short period of timeCan be used for years
Bought primarily by consumersBought primarily by businesses

Capital is produced, land is not

Buildings are capital

Consumer-bought capital is called Consumer Durables (e.g. refrigerators, cars)

Physical Capital vs. Financial Capital

Cost of Capital and the Rent-or-Buy Formula

Profitability = Rental Rate + Appreciation - Interest Cost

You buy when profitability is greater than zero; you rent when profitability is less than zero

Example: Lease a car for one year for \$12,000; or borrow money at 5 percent to buy the car new for \$32,000 and sell it in one year for \$24,000?

rental rate = \$12,000/\$32,000 = 37.5 %

appreciation rate = (\$24,000 - \$32,000)/\$32,000 = - 25%. (the car depreciates)

interest cost = 5 %

profitability = 37.5 + (-25) - 5 = 7.5   since profitability is positive, you should buy rather than lease

What if you could only sell the car for \$20,000?

Appreciation = -37.5% and you're better off leasing

What if you didn't need to borrow the money, but you had the cash?

Opportunity Cost

Why should the profitability usually be close to zero?

Arbitrage

Are houses in my neighborhood overpriced? A few years ago, typical house cost \$350,000 and now sells for \$600,000. That same house rents for \$2000 a month; mortgage interest rate = 6 percent;

Need annual rental rate. \$2000 x 12 = \$24,000  Divide this by \$600,000 and the rental rate = 4 percent.

profitability = 4 % + ? - 6%

How much will house prices keep going up? If they go up at 2 percent per year, then rent-buy analysis is breakeven. If we expect faster appreciation, we should buy. If we expect slower appreciation, we should keep renting.

If you bought the house and rented it out, you would have negative cash flow: \$600,000 x 6 percent means \$36,000 in interest expense, but only \$24,000 in rental income. But if appreciation is 4 percent per year, it's a good investment.

Capital gain

Valuing Common Stock

Deciding whether to rent or buy a movie projector

What if your only choice is to buy?

Review: Factors of Production; Capital; ***Rent vs. Buy profitability formula***; Arbitrage; Opportunity Cost; Capital Gain