Relationship between capital stock and investment

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relationship between capital stock and investment

Capital stock is the total amount of shares a company is authorized Capital stock and treasury stock describe two different types of a company's shares. What is the difference between capital gains and investment income. The main distinction is between fixed investment, or fixed capital formation (the . The relationship between investment and the capital stock depends on which. Fluctuations in the stock market can affect investment of firms. The relationship between stock prices and firms' investment in physical capital is captured by the.

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Suppose the price per share is Rs and the purchase price of a machine is only Rs It is quite obvious that the firm should invest—buy a new machine—and finance it by issuing a share. Each machine costs the firm Rs 50 to purchase, but stock market participants are willing to pay Rs for a share corresponding to this machine when it is installed in the firm.

relationship between capital stock and investment

In effect, the stock price tells firms how much the stock market values each unit of capital already in place. So the investing firm has a simple exercise to perform. It has to compare the purchase price of an additional unit of capital to the price the stock market is willing to pay for it.

relationship between capital stock and investment

If the stock value exceeds the purchase price, the firm should buy the machine; otherwise, it should not. On the basis of this simple exercise Tobin constructed a variable corresponding to the value of a unit of capital in place relative to its purchase price, and examined how closely it moved with investment.

Its construction goes as: We have to take the total value of Indian corporations, as assessed by financial markets, that is, compute the sum of their stock market value the price of a share times the number of shares. We also compute the total value of their bonds debentures outstanding firms finance themselves not only through stocks but also through bonds and debentures. So we have to add together the value of stocks and bonds.

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Then we have to divide this value by the value of the capital stock of Indian corporations at replacement cost the price firms would have to pay to replace their machines, their plants, and so on. The ratio gives us, in effect, the value of a unit of capital in place relative to its current purchase price. Intuitively, the higher the q, the higher the value of capital relative to its current purchase price, and the higher will be investment.

relationship between capital stock and investment

So it is not profitable to invest in additional capital. Link between the Stock Market and Investment: By assuming output constant, the relationship between the interest rate and the desired capital stock may be plotted. If the interest rate is plotted on the vertical axis and the desired capital stock on the horizontal, the relationship is shown in the left panel of Figure 8.

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Should the interest rate decrease to i1, the desired capital stock increases to because, with a lower interest rate, it is profitable for firms to employ more capital.

If the actual capital stock, also measured on the horizontal axis, is K1, there is no discrepancy between the desired and actual capital stocks. Hence, net investment is zero.

relationship between capital stock and investment

Gross investment is, however, positive, since firms must invest to replace plant and equipment that has worn out or been destroyed. This combination is shown in the right panel of Figure 8.

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Since the actual capital stock is A0, the desired capital stock exceeds the actual capital stock, and net investment is positive as firms add to their productive capacity. But firms do not attempt to eliminate the gap between the desired and actual capital stocks in a single period; they do so over a number of periods.

relationship between capital stock and investment

This combination is depicted in the right panel of Figure 8. Since I1 exceeds I0, an inverse relationship exists between the market rate of interest, i, and investment, I; as the interest rate decreases, investment increases. Over time, the discrepancy between the desired and actual capital stocks will be eliminated.