User Cost of Capital

3 Key excerpts on "User Cost of Capital"

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  Can the Free Market Pick Winners?

  What Determines Investment

  • Paul Davidson(Author)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  8The user cost of fixed capital in Keynes’ theory of investment JOHAN DEPREZ    

  “It is by reason,” wrote Keynes, “of the existence of durable equipment that the economic future is linked to the present” (1964, p. 146). It was Keynes’ opinion that by “the introduction of the concepts of user cost and of the marginal efficiency of capital” one could go beyond the limits of the static nature of classical economics and effectively model the intertemporal aspects of fixed capital and the expectations that surround it “whilst reducing to a minimum the necessary degree of adaption” from the classical theory (1964, p. 146).

  User cost is the opportunity cost of currently engaging in production and the using of plant and equipment, as opposed to currently abstaining from production and leaving the fixed capital idle, measured in terms of the expected loss of discounted future profits. Such cost may be expected if current production negatively affects the future productivity of capital, increases the required replacement of capital equipment, negatively affects future expected sales, or increases the cost of future inputs. In the real world where firms face an uncertain future in terms of sales, costs, technological change, and new products, user cost is a pervasive consideration affecting the production and investment decisions of firms.

  The emphasis in the literature has generally been on the concept of the marginal efficiency of capital to the neglect of the concept of user cost. This is the way in which Keynes’ model is characterized by most textbooks (see Peterson and Estenson, 1992, pp. 303–320). Traditional expositions of Keynes’ General Theory,1 like Hansen’s (1953, pp. 56–58), have trivialized the role of user cost. Post Keynesian expositions of Keynes’ aggregate supply and demand model have tended to ignore the concept completely (see Weintraub, 1957; Davidson and Smolensky, 1964; Wells, 1977)2

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  The Cost of Capital

  Theory and Estimation

  • Cleveland S. Patterson(Author)
  • 1995(Publication Date)
  • Praeger

    (Publisher)

  .-1 The Concept and Uses of the Cost of Capital This chapter introduces the concept of the opportunity cost of capital and re- views its use for corporate and public policy decisions. It also briefly discusses some of the difficulties involved in the estimation of its magnitude for an indi- vidual asset or firm. I. THE CONCEPT OF THE COST OF CAPITAL Most productive enterprises require a mixture of inputs to make them viable. Some of these inputs, such as labor, have clearly identifiable out-of-pocket annual costs associated with them in the form of wages, salaries, benefits, or directly assignable overheads. Others, however, take the form of capital inputs or investments. Essentially investments represent decisions to defer present consumption until a later date, and their "cost" is largely an opportunity cost rather than an out-of-pocket cash cost. We define the opportunity cost of a particular investment, A, as the expected return on the best comparable alternative, B, which is foregone as a result of the decision to commit capital to A. Although costs are normally thought of as dollars paid out, dollars not received have exactly the same effect on the ability to purchase goods. For example, assume that a firm decides to invest $100,000 in a productive asset, which promises, with certainty, to yield a payoff in constant dollars of 2 The Cost of Capital $120,000 at the end of one year. Investors usually require an inducement to defer consumption and the specific rate of return that they require for a riskless one-year investment is established by supply and demand conditions in capital markets. Let us say that it is possible to obtain a guaranteed annual return of 10% by investing in traded market securities such as one-year discount govern- ment bonds. Then the opportunity cost of investing in the project is 10%. If there are no transactions costs or taxes, this is also the project's cost of capital.

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  The Cost of Capital

  • E. Porras(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  6 1 A General Introduction to Risk, Return, and the Cost of Capital The relevance of the cost of capital The cost of capital to a firm is the return 1 investors receive on their investments. Therefore, in this context, an investor is anyone who lends money to a firm or agency in exchange for some ‘profit’. The providing of funds to the firm could be done by purchasing some of the company’s common stock, bonds, 2 or in a number of additional ways we shall comment on later. The higher the profit desired by the investor, the greater the cost to the firm or paying agency. One reason why firms calculate their cost of capital is to determine a mini- mum discount rate 3 to use when evaluating proposed capital expenditure projects. The purpose of capital expenditure analysis is to decide which, if any, of a list of planned projects, the firm should actually undertake. It is then logical that the cost of capital to be estimated and compared with the expected benefits from the proposed projects is equated with the marginal cost of capital the firm raises (the price of acquiring the next dollar, pound, yen or euro ...), not a historical-cost estimate. This is because firms must incorporate the real costs into their calculations when capital is going to be raised, and past histori- cal information is of no use for this purpose. If the marginal cost of capital is too high, the firm might find out none of its list of proposed projects is capable of returning sufficient profit to cover that cost. For example, let us say you want to open a photocopying business. This project is going to be financed exclusively with equity 4 and, considering the return that could be made on equivalent investments, your shareholders want a 35 per cent return. If all you can expect to make with this project is 10 per cent on each dollar invested, you could not afford to repay what your investors demand.

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