The net worth of a firm is equal to the value of the firm’s assets (things the f
ID: 1206191 • Letter: T
Question
The net worth of a firm is equal to the value of the firm’s assets (things the firm owns) minus the value of the firm’s liabilities (things the firm owes).
In our model, the representative firm owns capital, K. One way to value capital is at replacement cost. Simply put, this means the value of capital is the value of the investment goods the firm would have to buy to replace its entire capital stock.
To replace the capital stock, the firm would need I = K units of investment goods. This has a nominal value of P × K. We have not discussed liabilities of the firm in class. A substantial amount of the money owed by firms is in the form of loans owed to banks and bonds. Both loans and bonds are promises by the firm to pay a fixed amount of dollars. Assume the total fixed amount of dollars the firm has promised to pay is B.
This means that the net worth of the firm is given by NW = P × K B 1 What happens to the net worth of firms in response to the bank closures in i.)?
Explanation / Answer
Note that the net worth of a firm (NW) is equal to the value of the firm’s assets minus the value of the firm’s liabilities. The representative firm owns capital, K units which has a market value of P*K. Hence, the value of the firm’s assets is P*K. As far as the liabilities are concerned, the total fixed amount of dollars the firm has promised to pay is B so taht the value of the firm’s liabilities is B.
This means that the net worth of the firm NW is P*K B.
In case of bank failures, the link or the channel between savers and investors is broken. Those who wish to borrow are unable to do so since savers withdraw their deposits. Bank closures implies that the firms who had taken a loan amount B from a creditor and has promised to pay B will firnd its Net worth depleting.
The reason is that bank pays interest on the amount deposited and firms who acquire debt from a creditor often deposit the present value of loan in banks, which is discounted for current period.
When banks fail, the same amount of money has to be borne out of NW and so it falls.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.