Concept:

Concept:
The concept is based on the ordinary mathematical technique of
computing present value of a given series of returns discounted at
a specified discount rate.

Let’s take an example of a short-lived project (5 years). Let R1,
R2….R5 represent the expected stream of returns of this particular
investment project. As the returns are in the future, their values
have to be discounted to the present in order to get their present
value.

Let Sp be the cost of undertaking the project – i.e. the replacement
cost of capital or "supply price" of capital goods.
The internal rate of return (or marginal efficiency of investment)
would be the discount rate , which will equate the expected yield
with the supply price of capital.

Main conclusions:

Main conclusions:

Firm’s demand for the desired capital stock (k*) depends on
the rental cost (rc) and the expected level of output (Y);
The lower rc, the higher the level of K relative to output.
The higher the expected level of output, the larger the
desired capital stock.

An alternative approach to business investment decision is
the discounted cash flow analysis. In considering whether to build a
factory for example, a firm will have to work out how much it costs
to build the factory and the revenue it will bring about in each year
after it starts operation.

MEC (internal rate of return) is the rate of discount that would
make the present value of expected income from fixed capital
assets equal to the present supply price of the asset. The
level of investment is determined by the MEC relative to the rate
of interest. If MEC > r, investment will be stimulated; if not,
investment will be discouraged.

Changes in the desired capital stock

MPk is downward sloping for different sizes of capital stock (K)
as the marginal product of capital falls as the capital stock
increases (diminishing marginal productivity of capital. If rental
cost is rco, the amount of capital that maximizes the expected profit
is K*.

Changes in the desired capital stock
Any factor that shifts the MPk curve or changes the rental cost
changes the firms desired capital stock. A fall in rental cost
shifts the rc line down . At the original desired capital stock, MPk
is now greater than the user cost. The firm will be able to increase
increase profit by raising its desired capital stock. Technological changes
affects the MPk i.e. shifts the MPk curve and therefore also affects
the desired capital stock. Advancement in technology increases
the MPk, shifting the MPk to the right (upward) resulting in an
increase in desired capital stock for the same resource cost. How
will an increase in output affect the MPk?

Theories of Investment 2

Firms can determine the profit maximizing level of capital
stock by comparing the costs and benefits of using additional
capital. If the benefits outweigh the costs, the firm will raise its
profit by expanding its capital stock. If the costs outweigh the
benefits, the firm should not increase its planned capital stock.
The marginal product of capital (MPk) is the benefit from having
an additional unit of capital. MPk is the additional output a firm
can obtain by adding a unit of capital, all other things constant.

The cost of using capital (rental cost, rc), on the other hand, is
equal to the real interest rate times the price of the capital and
the rate at which capital depreciates.
rc = r.Pk + d

A firm’s desired capital stock is the capital stock at which the
marginal product of capital equals the rental cost of capital.

Theories of investment

Theories of investment

The two theories of investment we will be looking at are the
Neoclassical model and the accelerator model. Thereafter we
will proceed to look at other factors that might affect
investment.

The Neoclassical model of Investment
The Neoclassical model basically states that the desired capital
stock depends on two factors, namely the rental cost of capital
and the level of output.
K* = f (rc, Y)

Firms use both capital and labour to produce its output of
goods and services. Given that the objective of the firm is to
maximize profit, how then does the firm decide on the desired
capital stock?

Investment 1

Background

Investment is the most volatile component of GDP. In fact
most business cycles can be traced to fluctuations in investment.
Investment spending also determines the rate at which the
economy adds to its capital stock, which is important in
determining the economy’s long term growth and productivity
performance. In view of this, it is therefore important that we
understand what affects investment.

Investment is spending devoted to increase or maintain the
stock of capital. There are three major categories of
investment, namely (i) business fixed investment (business
spending on equipment and structures for use in production);

(ii) residential investment (purchase of new housing units); and
(iii) inventory investment (the value of changes in inventories of
finished goods, materials, supplies and work in progress).

In examining the determinants of investment, we will focus
mainly on business fixed investment and look at two issues:
How does a firm decide on the desired capital stock (k*)
to have (this is the capital stock the firm would like to
have in the long run)? and
What is the rate at which firms adjust from the existing
capital stock to the desired capital stock? The rate at
which the firm adjusts determines the rate of investment.

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