Question

Use the following data to work.First Call, Inc., a smartphone company, plans to build an assembly plant that costs \(\$ 10\) million if the real interest rate is 6 percent a year or a larger plant that costs \(\$ 12\) million if the real interest rate is 5 percent a year or a smaller plant that costs \(\$ 8\) million if the real interest rate is 7 percent a year. First Call expects its profit to double next year. Explain how this increase in expected profit influences First Call's demand for loanable funds.

Short answer

Expected profit doubling increases First Call’s demand for loanable funds to invest in a more profitable plant, potentially affecting market interest rates.

Step-by-step solution

- Understand the Key Variables

Identify the three different plant options and their associated costs based on various real interest rates: 1. Plant costing \( \$ 10 \) million with a 6% interest rate. 2. Plant costing \( \$ 12 \) million with a 5% interest rate. 3. Plant costing \( \$ 8 \) million with a 7% interest rate.

- Impact of Expected Profit Increase

Understand that the expected profit doubling implies First Call anticipates higher revenue in the future, potentially increasing the return on investment (ROI) for any of the plant projects.

- Reevaluate Demand for Loanable Funds

Given the increase in expected profit, First Call is more likely to invest in a larger or more expensive plant, as the higher anticipated returns may justify the higher costs. Thus, examine if the increase in expected profit could lead First Call to choose the \( \$ 12 \) million plant even at a lower interest rate.

- Influence on Loanable Funds Market

Conclude that with the expectation of higher profits, First Call’s demand for loanable funds is likely to increase as they may seek more capital to invest in the most profitable plant option. This increased demand for funds may lead to a rise in the interest rates in the loanable funds market if the supply of funds remains unchanged.

Key concepts

Real Interest Rate

The real interest rate is a critical factor in investment decision-making. It represents the interest rate after adjusting for inflation, reflecting the true cost of borrowing money. For First Call, Inc., the decision on which plant to build hinges on different real interest rates, each influencing the cost of the investment. For example, a plant costing \( \$ 10 \text{ million} \) is chosen if the real interest rate is 6%, while a \( \$ 12 \text{ million} \) plant is considered if the rate drops to 5%. The cheaper \( \$ 8 \text{ million} \) plant is an option when the real interest rate rises to 7%.
Understanding real interest rates helps businesses evaluate the genuine expense of taking a loan and strategize on capital investments.

Return on Investment

Return on Investment (ROI) measures the profitability of an investment. It is calculated as a percentage by dividing the net profit by the initial capital cost. For First Call, the expected doubling of profit means a higher future ROI for any plant option. This likely makes more expensive plants attractive due to anticipated higher returns.
An increased ROI can justify choosing a larger and costlier investment, which in this case, translates into potentially opting for the \( \$ 12 \text{ million} \) plant at a 5% interest rate, since the expected returns outweigh the initial higher cost.

Loanable Funds Market

The loanable funds market is where borrowers (like First Call) and lenders (banks, investors) interact to determine the interest rate and quantity of loans. When First Call anticipates higher profits, its demand for loanable funds increases as it seeks more capital for investment. More demand without a change in supply can lead to higher interest rates.
This adjustment in interest rates is crucial. If First Call demands more funds due to higher expected returns, it could drive up the market interest rate, impacting not just First Call, but potentially other borrowers as well. The balance between supply and demand in this market is essential for economic stability.

Expected Profit

Expected profit refers to the anticipated earnings from an investment. For First Call, the expected doubling of profit next year significantly influences its investment choices. Higher expected profit means a better outlook on potentially high ROI, encouraging more ambitious investments.
This optimism leads First Call to likely opt for the larger and more expensive plant, as the future higher returns are expected to cover and exceed the higher costs. Such an increase in expected profit underscores the firm's confidence in its future performance, which directly impacts its demand for loanable funds as it looks to maximize returns on its investments.