This is “End-of-Chapter Material”, section 9.5 from the book Theory and Applications of Microeconomics (v. 1.0).
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The performance of the stock market is one of the most closely watched of all economic statistics. This chapter provided some clues as to why people care so much about the value of stocks and other assets.
One reason is that people save by purchasing stocks and other assets. Thus savers want to know what determines the value of assets in the economy. Having read this chapter, you should now understand that the value of any asset is closely linked to the flow of benefits that the asset provides. Indeed, if markets are efficient, then the value of any asset should equal the discounted present value of the flow of benefits.
There are two other reasons why we pay so much attention to the stock market. (1) If the value of a stock reflects the discounted present value of expected dividends, then the market capitalization of a firm represents the best guess as to the value of that firm—which depends ultimately on the profits that it will generate in the future. In that case, a stock market index represents our best guess of the overall value of all firms. It truly is a measure of an economy as a whole. (2) The stock market plays a key role in allocating an economy’s saving to those firms that can make the most profitable use of those funds.
(Advanced) In the first row of Table 9.2 "Discounted Present Value of Dividends in Dollars", we considered a stock that pays a dividend of $1 this year and that will have a price of $2 next year. Suppose the inflation rate from this year to next year is 5 percent. There are two ways that you can correct for this inflation.
You can adjust next year’s price and put it in terms of today’s dollars, so next year’s price is a “real price.” Then you can discount using the real interest rate, which you can get from the Fisher equation.
Show that you get the same answer for the discounted present value using the second method as using the first method. (Note: when the interest rate is 10 percent, you should get exactly the same answer; when the interest rate is 5 percent, there will be a very small difference because the Fisher equation is an approximation.)
Table 9.4 Discounted Present Value Exercise
|Year||Number of Oranges||Price of Orange||Revenue||Interest Rate|