Quick Notes on Investment Function

The below mentioned article provides a quick notes on Investment Function.

The volume of investment function varies inversely with rate of interest.

So the investment function may fee expressed as:

Here I is (autonomous) investment and r is the market rate of interest.

As a general rule the lower is the rate of interest, the large the number of profitable investment oppor­tunities and, consequently, the greater the investment expenditure that firms will like to make. In short, the volume of desired investment expenditure is nega­tively related to the rate of interest, rising as the rate of interest falls.

1. Exception:

There is, however, one major excep­tion to this general rule. During depression there is widespread business pessimism. So investment op­portunities are lacking. At such times changes in the rate of interest are unlikely to affect investment deci­sions appreciably.

2. The Marginal Efficiency of Capital (or the Yield):

J. M. Keynes first introduced the term ‘marginal efficiency of capital’ in 1936. According to Keynes it is an important determinant of autonomous invest­ment.

The stock of capital of a firm at a fixed point of time may be measured in physical units—so many machines, factories, etc. As with labour or land, there is an average and a marginal product of capital. The marginal (physical) product of capital is the contribu­tion made to the firm’s output when the quantity of capital is increased by a single unit (the quantities of all other factors being held constant).

A profit-maximizing firm is not very much in­terested in the marginal physical product of capital. It is more interested in knowing how much money can be earned by selling the output produced by one extra unit of capital. So we have to arrive at a mea­sure of the value of the marginal physical product (MPP). This can be obtained by multiplying MPP by the market price of the output.

The marginal efficiency of capital (MEC) gives the monetary return on each extra rupee’s worth of capital added. In short, the MEC is the rate at which the value of the stream of output of a marginal rupee’s worth of capital has to be discounted to make it equal to Re. 1. And since the quantities of other factors are held constant the MEC tends to fall, due to the operation of the Law of Diminishing Returns.

The following example illustrates the concept. Suppose a machine costs Rs. 100, if purchased to­day Suppose, if put to use to produce children’s toys, it yields a net revenue of Rs. 110 after one year. Its productive life is one year. So it has to be scrapped af­ter receiving a return of Rs. 110 in a year’s time.

The yield of the asset may be expressed as a percentage, known also as the rate of return on capital:

Yield = 110/100 = 1.1 per cent

We may now look at the capital asset from a dif­ferent view point. Suppose we know only that it will yield a return of Rs. 110, one year from now. That yield will, of course, be worth something, even today, because the asset could be sold for cash to someone who wanted Rs. 110 next year. Whatever that person was prepared to pay for the asset today gives us the present value of the capital—its purchase price.

Thus, in the words of Lipsey, the MEC is “the rate of discount that will just make the present value of the flow of receipts it generates equal to the pur­chase price of the piece of capital.”

If the cash flow is constant (uniform) throughout, we can calculate the MEC using the formula: e = R/C, where C is the purchase price of the piece of capital, R is the constant flow of gross return and e is the unknown MEC. In this simple case e = R/C = Rs. 110/ Rs.100 =1.1 per cent.

Usually the present value is calculated by using the rate of interest as the discount factor.

If the rate of interest is 10 per cent the present value of Rs. 110 in a year’s time is calculated by using the following standard formula:

Present value (PV) = Yield/ 1+r

where r is the rate of interest. It is expressed as a decimal fraction, rather than a percentage.

As the yield is Rs. 110 and r = 10 per cent (0.1), we get:

PV = 110/1.1 = Rs. 100

Thus the PV of a capital asset represents the pur­chase price that an individual will be expected to pay to enjoy its yield in the future