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Peter Lewin
Naveen Jindal School of Management
University of Texas at Dallas
800W Campbell Road,
Richardson, TX 85080
plewin@utdallas.edu
Nicols Cachanosky
Department of Economics
Metropolitan State University of Denver
Campus Box 77, P.O. Box 173362
Denver, CO 80217
ncachano@msudenver.edu
(1)
1
2
+
+
+
=
(1 + ) (1 + )2
(1 + )
=1 (1 + )
=1
Where:
CV = the capital-value1 of the investment, being the present value of the investment. In some
contexts it is the original financial capital outlay. For a bond traded in a competitive financial
market it is the market price of the bond.
The use of the term capital-value, CV, synonymous with net-present-value, NPV, is deliberate, though, we realize
not without potential for confusion because of the simultaneous use of the word capital in the description of
certain productive inputs as capital-goods. One of our goals, however, is to examine the meaning and nature of the
2
CFt = the money-valued cash-flow expected from the investment in period t (t = 1, n) - which is
the net-value of earnings and outlays in that period and can be positive, negative or zero.
n = the time-horizon of the investment or the number of periods for which the investor is planning
from now until the investment is considered to end. It is the planning period of the investor. For
a fixed income investment like a bond it is called the term to maturity.
d = the rate of discount applied to any future-value to reduce it to present-value. As explained
below, depending on the context, d, can be considered the to be the rate of time-preference of
the investor, or it can be a market interest-rate that determines the market price of the
investment (as in the case of a bond), or something similar. We will refer to it as the discount rate.
As we shall see, the discount-rate is really a markup rate.
1
= (1+) which we shall refer to as the discount-factor.
This equation expresses a universal arithmetic relating value and time as perceived by human actors.
There are a large number of potential unknowns. For the equation to be of practical use information must
be supplied for all but one of the unknowns. So, for example, in the case of a fixed coupon bond the
equation would be:
(1a)
+
1
+
+ +
= [
]+
2
(1 + ) (1 + )
(1 + )
(1 + )
=1 (1 + )
Everything except y is known. Barring default the bond-holder knows that the bond will pay C per period
and FV at the end of the investment period, n. The price to purchase the bond, P, is given in the market.
y is calculated given P, C, n and FV. It is that number that solves the equation, making the present-value
of the stream of payments equal to the price.
Other special cases, like premium bonds, discount bonds and perpetuities, are well known and need not
be repeated here. The essential take-away point is the significance of y in connecting values over time. An
investor purchasing the bond knows that each dollar of investment of P dollars will be marked-up by y
percent in each sub-period of the investment period (Osborne, 2014). It is the essence of what is known
as the time value of money.
In a more general context, encompassing any kind of multi-period investment, y is known as the internal
rate of return, i ( or IRR) that rate that reduces the expected income stream of the investment to its
concept of capital and to provide a clarification of any potential confusion along these lines and for this purpose
the term capital-value is very appropriate.
2
This equation simplifies to
1
1
(1 + )
=[
]+
(1
+ )
3
It is well known that the IRR criterion is inferior to using the magnitude of NPV (net present-value) when deciding
among exclusive investment projects and that there are instances when the two criteria give different rankings.
Among available investments that cover the (the opportunity) cost of capital the investor should choose the one
with the highest NPV at that cost. This does not affect our discussion.
4
The line of reasoning and the examples that follow are taken from Osborne 2014, 2-3.
5
We banish any consideration of being able to invest the $1 during the year and thus accumulate more than $1. We
imagine this choice to be made in an environment where the market rate of interest that can be earned by investing
this $1 is zero.
4
(1b)
1
2
+
+ +
= [
]
(1 + 1 ) (1 + 1 )(1 + 2 )
(1 + 1 )(1 + 2 ) (1 + )
=1 =1(1 + )
It is apparent that a particular CV is compatible with an infinite number of different values for = d1,d2 dn
there are an infinite number of versions of this equation. Unless we have access to the type of
experiment described above, there is no way to determine an individuals detailed time preference
structure. To be sure, in a financial market of individuals, the term structure of market interest-rates (the
yield curve) gives us an estimate of the time preferences of the marginal traders, and, as we know, it is
not, in general, flat. Though the typical shape of the yield curve is upward sloping, representing higher
interest-rates for longer investment terms, short-term interest-rates typically fluctuate over time.
indeed, the prospect of interest-rate fluctuations, and the attendant fluctuations in capital-values that
this implies, motivates much discussion in financial economics.
Comparing equation 1 with equation 1b, the former is clearly much more tractable and more useful in
most practical situations. For any investment of term n, of the form in equation 1, it is possible to calculate
a discount rate d, that is in some sense an average of all the different discount rates for all the sub-periods
involved. This invokes the metaphor of a common markup (discount) per dollar within each sub-period
over the life of the investment. But, it is important to emphasize, this is a matter of convention. There is
nothing natural about assuming that d = d1 = d2 = = dn. It is a very convenient convention used to
summarize an important aspect of any investment, especially given the number of alternative possible
ways of doing so.
To illustrate, consider an investment in a start-up business with an initial outlay, followed by fluctuating
earnings and expenses. Perhaps the large initial outlay is expected to be followed by a few years of
negative cash flows, after which, positive cash flow will materialize for an extended period, say ten years,
after which a year of restructuring will become necessary, etc. The calculated rate of return for this
venture will be very sensitive to the time-horizon presumed. If the investment is considered to terminate
before the advent of positive cash flows, the rate of return will appear to be negative. Waiting a few more
years may substantially turn this around. Terminating the investment before the ten-year restructuring
may yield a higher return than waiting for it. But staying the course beyond than may again raise the
return, etc. To ask at what rate a dollar is actually growing within any sub-period of a chosen investment
period, is rather irrelevant metaphysics. What matters to the investor with a chosen time horizon is the
calculated rate of return (and implied NPV) over that time horizon which will be compared to his timepreference or cost of capital in the making of his decision.
Not only Austrians have contributed key insights. Important names are Carl Menger, Eugene von Bhm-Bawerk,
William Stanly Jevons, Knut Wicksell, Frank Fetter, Ludwig von Mises, John Hicks, Friedrich Hayek, and Ludwig
Lachmann. For a summary see Lewin [1999] 2011, chapter 4 and the references therein.
7
The APP may succinctly express as follows:
=0( )
=0
=
=0
where T is the APP for a production process lasting n calendar periods; t, going from 0 to n, is an index of each subperiod; It is the amount of labor expended in sub-period t, and N = =0 is the unweighted labor sum (the total
amount of labor-time expended). Thus T is a weighted average that measures the time on average that a unit of
labor l is locked up in the production process. The weights (n-t) are the distances in time from the emergence of
the final output. T depends positively on n, the calendar length of the project, and on the relation of the time pattern
of labor applied (the points in time t at which labor inputs occur) to the total amount of labor invested N. Except for
6
(
)
=1
where the terms are as previously defined. Note D is a weighted average of the time-units involved in the
project, starting from 1, the earliest, to n, the last, where the weights are the proportions of the present
value of the investment received (or paid) in the time period (ftCFt/CV). It is the (present) value weighted
amount of time involved in the investment. As such it is a money-value of time measure.
The logic is simple. The economic significance of the time involved in the investment, the amount of time
for which one has to wait for payments to be made or received, is dependent on the relative size of
payments involved in each of the periods involved. The simple size of the calendar time, n, is not very
informative. The same n can have very different significance to the investor depending on whether the
payments occur sooner or later and in what proportions. The value-significance of the time involved must
be considered. Given time-preference, other things constant, a longer average period (duration) should
carry a higher markup.
These are the essentials of the money-value of time. the amount of time involved in any investment is
valued according to the influence of value on time.
very simple processes, this formulation is not theoretically sound, and is not at all helpful for real-world decisionmaking. This bears some resemblance to the discussion below concerning the question of capital reswitching.
8
For a recent summaries and assessments see Cohen and Harcourt (2003a, 2003b and Garrison 2006).
9
See also P. Lewin and N. Cachanosky, 2014.
7
(1)
=1 (1 + )
=1
()
1
[1 1 1 + 2 2 2 + + ]
=
( )
or
(2)
, =
()
=1
where E is the elasticity (or d log) operator. This follows from the rule that the elasticity of a sum is the
weighted average of the elasticities of its parts. , turns out to have a number of interesting
interpretations.
Firstly, and obviously, , provides a measure of the sensitivity of the value of the project (investment)
to changes in the rate of discount, or (inversely) in the discount factor. So, anything that affects the
discount rate applied to investments will affect their relative valuations. Significantly, the perceived values
(3)
=
=
1+
where D is the duration of the investment evaluated at y. Thus, in general, while D is a measure of the
elasticity of CV with respect to the discount factor f, MD is a measure of the (semi) elasticity of CV with
10
In the finance literature the term capital structure signifies the debt-equity ratio. It is used here, as in capitaltheory economics, to signify the structure of physical-capital projects.
11
when we look at the form of this elasticity we see that it may be very properly described as the Average Period
[AP] of the stream [of earnings]; for it is the average length of time for which the various payments are deferred from
the present, when the times of deferment are weighted by the discounted values of the payments. (Hicks 1939: 186,
italics in original, see also 218-22)..
12
A number of useful surveys exist, including Bierwag et. al. 1983 and Bierwag and Fooladi, 2006.
13
()
( )
()
(1+)
()
dy
.
1+
= (1 + ). We have equation 3.
9
()
The matter is similar to the situation facing an economist trying to estimate the response of the amount demanded
to a discrete change in price in a real-world setting. The elasticity of demand (estimated for example from a simple
linear regression) is a rough linear approximation to the desired result. It is less accurate the greater the curvature
of the demand curve.
10
fv2 = p(1+d1)(1+d2)
we seek the solution d = d1 = d2
f = p(1+d1)(1+d2) = p(1+d)2 or p = f/(1+d)2
In terms of the numbers provided earlier, $1 accumulates (is marked up) to $1.50 in two years. What is
the rate of markup that applies to both years equally? Clearly it is the geometric mean (in this case square
root) of the two-year markup.
Using the numbers considered earlier, (1+d) = (1.5).5 = 1.2247, so that d is 22.47% which is the geometric
average of the two one-year rates, 20% and 25%. (1 +d) = (1+d1)(1+d2) = (1.2)(1.25)=1.2247.
In general (1+d) = [(1+d1)(1+d2) (1+dn)]1/n for the n-period case.
Now, p = f/(1+d)2 or p(1+d}2 f = 0 is an instance of the second-degree polynomial equation
ax2 +bx +c = 0, where x= (1+d), a = p, b = 0 and c = -f.
and it is well-known that this equation has two solutions of the form
2 4
2
4()
or (1 + ) =
. For p = 1 and f = 1.5, the values for (1+d) are 1.227 and -1.2247 implying values
=
for d of 0.2247 and -0.2247. The first solution confirms our earlier result.
The existence of two roots is well-known, and, since it is only the positive root that appears to have
economic meaning, the negative root is routinely ignored. This is not only understandable, it appears to
be the only defensible approach. Someone investing a dollar today in return for a promise of a dollar and
a half in two years has a clear understanding that the in two years the amount received will be worth
more than the dollar is worth today (assuming no inflation), that is, will be exchangeable for more or highvalued goods and services. To say that the dollar will be worth less than a dollar in two years if we apply
the second solution appears to be irrelevant. No one would choose that option.
Thus for purposes of borrowing and lending money (valuable things) the existence of multiple roots is not
evidently significant. Where, however, one wishes to use the mathematics to provide practical solutions
to the problem of managing, mitigating or avoiding the risk to capital values from interest (discount) rate
fluctuations, it might be more relevant. Such is the claim made by Michael Osborne. It is also implicit in
the famous debate between the two Cambridges about the meaning of capital that we will consider
briefly below.
To understand Osbornes claim, we need to consider cases of more than two roots, higher-order
polynomials. Again following Osborne, take the case of a three period investment, where in exchange for
$1 today you are promised $1.60 in three years, so that, f = p(1+d)3= 1.6.
11
=1
1 (1) =1
=1 (1 + )
where, (1+d1), (1+d2) , , (1+dn) are the n roots of the equation and which for most cases (patterns of
cash-flows) can be more simply written,
(4)
=1
1 + =2| |1
This dual expression tells us that the CV (the present-value) of a cash-flow equation can be written in
terms of its cash-flows divided by (1+) the product of all the roots of the equation; and that for most cases
involving financial assets the denominator reduces to (1+) the absolute value of the product all of the
15
Osborne quotes Kenneth Boulding (1936) as an example: Now it is true that an equation of the nth degree has n
roots of one sort or another, and that therefore the general equation for the definition of a rate of interest can also
have n solutions, where n is the number of years concerned. Nevertheless, in the type of payments series with
which we are most likely to be concerned, it is extremely probable that all but one of these roots will be either
negative or imaginary, in which case they will have no economic significance.
16
Readers requiring more information as to the meaning and significance of imaginary and complex numbers, and
the basis of Osbornes claim are referred to Osborne, 2005, 2014.
12
= | |
=2
and that this is a precisely accurate measure of duration for any change in the (selected) discount rate to
m1. (Osborne 2014, pp, 85-86).
As written, however, the expression is unsuitable for practical use to the extent that it requires the
calculation of all of the roots, some of which will be complex numbers. Osborne shows, however, that
there is an exact equivalent expression that does not require this, namely,
(5)
=0[1 + (1 + 1 )]
= (
)
=1
(2)
(
)
=1
The difference between D and D* is that for the latter each of the CFt is marked up by the sum
=0[1 + (1 + 1 )] . Only real numbers are involved, so, while involving quite a lot of computations, this
formula is eminently calculable.
Writing out the equation for n = 4 is illustrative.
=
1
[( (1 [1]) + (2 (2 [1 + (1 + 1 )]) + (3 (3 [1 + (1 + 1 ) + (1 + 1 )2 ])
1
+ (4 (4 [1 + (1 + 1 ) + (1 + 1 )2 + (1 + 1 )3 ])]
13
==
1
[( (1 [1]) + (2 (2 [2]) + (3 (3 [3]) + (4 (4 [4])]
1
According to Osborne D* will yield precisely accurate measures for the change in the bond price for any
discrete change in the yield to maturity whereas all other measures are approximations. Once programed
there should be no extra computational effort to worry about. This work is very recent and has not yet
received the attention and review it deserves, so it is too early to tell if it will be accepted and integrated
into common practice.
All of the discussion about duration so far has applied mainly to bonds for which, barring default, the
coupon payments are known in advance and the yield to maturity is calculated assuming that the oneperiod interest-rates are all equal, in other words, that the yield curve is flat. If this is not the case, there
are more unknowns and the matter is more complicated.
Too many unknowns?
The most general form of the TVM equation, equation 1b above, reveals that at any point of time the
market price of a financial asset is the discounted value of the expected stream of future payments,
where the discount rates for each payment are the one-period rates expected in each future period up to
the date of payment. Given this price, the yield to maturity is computed as that single rate that equates
the price and the value of the future cash payments (Bierwag et. al. 1983, p.18). In well arbitraged
markets the term-structure of interest-rates (the yield curve) reflects the pattern of expectations of
traders regarding future short term rates (though, as we argued above, preference for liquidity, aversion
to risk, which may be presumed to rise with term, also plays a part). Thus, for coupon bonds, the yield to
maturity will equal the simple average of the one-period discount rates, or the holding-period yield, only
if all the rates are equal that is, only when the term-structure is flat. Where it is not, changes in discount
rates are not uniquely related to changes in yields to maturity. Any given change in the pattern of discount
rates is consistent with a variety of changes in the yield to maturity, and vice versa. Duration as measured
above thus does not provide an accurate measure of the proportional change in bond prices for all
changes in the pattern of relevant interest-rates, which may produce different yields to maturity.
The response to this in the literature is to consider how knowledge of changes to the term-structure may
be obtained and connected to changes in bond prices to provide better measures of duration. It is posited
that the pattern of interest-rates is generated by an invariant stochastic process, so that derivation of a
correct duration measure requires knowledge of or assumptions about the actual stochastic process
driving interest-rate changes (Bierwag, et. al., 1983, p.18, italics added). Under a variety of such
assumptions different, more complicated, measures of duration have been developed (Bierwag, et. al.,
1983, p.18, appendix, pp.34-35).
The assumption of a stochastic process mechanically generating interest-rates may appear problematic
to many. The pattern of interest-rates in financial markets at any point in time, is, in large part, a
distillation of the subjective preferences and expectations of the many trading individuals in the market
and not generated by any given and fixed stochastic process. Realization of the role played by the structure
of interest-rates as opposed to simply the level of interest-rates adds a significant degree of
uncertainty to the reliability of predictions based on the idea of duration. How important this is in practice
depends on just how much additional uncertainty is added in practice, that is, on whether the use of
simple and/or complex measures of duration still continue to provide measures that are useful to real-
14
15
17
For a recap of the debate see Cohen and Harcourt (2003) and the references therein.
It is our conviction that the assertions of the neo-Ricardians were decisively debunked by Yeager (1976) who
clarified the source of the so-called paradoxes and provided an alternative perspective for understanding the nature
of capital and its earnings, in which no such paradoxes appear. In effect, Yeager shows that the entire case of the
neo-Ricardians is based on a fundamental category mistake in regards to what capital is and what it earns. We shall
make use of this in what follows. In a more recent contribution, Garrison (2006) returns to Yeagers analysis in order
to explain why the neo-Ricardians summarily dismissed Yeagers argument without even considering it. We shall
make use of this too.
18
16
Time Period
1
2
3
Total
Labor required
Technique A
100
Technique B
210
110.16
210.16
210
The two techniques are distinguished mainly by the timing of their (original) labor inputs (units of laborservice), and only minimally by the amount of labor required. Technique B is identified as the more
capital-intensive because it requires less labor to produce the same output. Capital-intensity is a purely
physical matter.19 If we now consider the cost of financing each technique we get a paradoxical result.
Imagine each unit of labor costs $1, then the cost of financing each technique at a 5% interest-rate is given
in table 2.
Table 2: Cost by Technique (interest-rate = 5%)
time period
1
2
3
Cost
Technique A
$100.00
$105.00
$220.41
Technique B
$205.88
$210.00
$220.50
The general expression is in table 2A, where r is the rate of interest used to compound labor inputs. Note,
although, for concreteness, we are using money values (dollars) to value the labor inputs by assuming
each unit to be worth $1, this assumption is unnecessary. The analysis applies whatever metric is used to
value the labor inputs as long as it is constant. The analysis would work even if we used elementary laborunits and count the interest-rate as the mechanism by which such labor is augmented. Metaphorically the
interest-rate grows the labor inputs in the production process.
Table 2A: Cost by Technique for interest-rate r
time period
1
2
3
Cost
Technique A
$100.00
$100.00(1+r)
$100(1+r)2+110.16
19
Technique B
$210.00
$210(1+r)
The neo-Ricardians identify all capital as intermediate goods, like machines, tools, or raw-materials. They are
goods-in-process from the original labor that constructed them, to the emergence of the final consumer good. So all
capital-goods (can be) and are reduced to dated-labor. In this way, we get a purely physical measure of capital, one
that, by construction, does not vary with the interest-rate.
17
At 5% technique A is the cheaper to finance, hence the one that will be chosen. But, this is not true for all
interest-rates as can be shown by repeating the process for various interest-rates according to the
information in table 2A. Techniques A and B can be described by the expressions 100(1+r)2 + 110.16 and
$210(1+r), respectively. Calculating their NPVs at various interest-rates yields table 3. The output
produced by both techniques is identical and invariant and thus can be ignored in this analysis.
Table 3: NPV by technique
Relative Costs
NPV (A)
NPV (B)
210.16
210
212.17
212.1
214.2
214.2
216.25
216.3
218.32
218.4
220.41
220.5
222.52
222.6
224.65
224.7
226.8
226.8
228.97
228.9
231.16
231
Interest-rate
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
This bears a close relationship to our earlier discussion of multiple interest-rates. Another way to tell the
story is to consider techniques A and B as aspects of a single decision, with the option not-chosen seen as
18
7. Conclusion
The colloquial understanding of capital as financial capital is after-all close to the mark, at least closer than
thinking of capital as a collection of physical things. The latter is perhaps responsible for more confusion
and controversy than clarity. A consideration of the role of time in production and investment decisions,
as explored in this paper, brings one to the realization that capital is the result of a process of evaluation.
Capital is the result of capital-accounting. It is the ability to use capital accounting that is in large part
responsible for the phenomenal success of capitalism. Productive physical resources, whether natural or
produced, are either never capital in this sense or else are all capital. They are never capital in their pure
physical nature. But they are all different types of capital, human or non-human, when considered as a
stock of potential value over time. 21
20
Yeager (1976) suggests that it makes sense to think of capital as a stock of waiting whose price is the interestrate. As Yeager points out, this line of thought goes back at least to the Swedish economist Gustav Cassel (1903).
21
Productive resources are all capital in that they know how to do certain useful things, they embody useful
knowledge. See Lewin and Baetjer, 2011.
20
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21