1 Theory of Investment - Rahul Jain

2 Investment is … most unstable component of GDP. changes in investment are the primary cause of the business cycle

3 Types of Capital and Investment Fixed business investment inventory investment investment in residential structures

4 Gross and Net Investment I = J + dK where I = gross investment J = net investment dK = depreciation of the capital stock

5 Theory of Investment We begin with how households make investment decisions Household allocates income between consuming now and saving for the future We now allow the household to purchase investment goods

6 Household’s investment Decision Households may increase future output 2 ways lend money at interest rate of r (purchase bonds) purchase capital assets

7 Household must make 2 choices How much to consume and save How much to divide between saving and investing

8 Investment as a negative function of r Since MPk is downward sloping with respect to K, an increase in r must mean a decline in K Hence, I function is negatively sloped I = I 1 (r)

9 Investment Decision Marginal product (MPK vs r + depreciation) PV of income stream + scrap value versus the cost

Net Present Value Method Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project’s opportunity cost of capital. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. The project should be accepted if NPV is positive (i.e., NPV > 0).

Net Present Value Method Net present value should be found out by subtracting present value of cash outflows from present value of future cash inflows. The formula for the net present value can be written as follows:

Investment Evaluation Criteria Three steps are involved in the evaluation of an investment: Estimation of cash flows Estimation of the required rate of return (the opportunity cost of capital) Application of a decision rule for making the choice

Calculating Net Present Value Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.

Acceptance Rule Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV < 0 May accept the project when NPV is zeroNPV = 0 The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

What’s Franchise L’s NPV? % Project L: = NPV L

Evaluation of the NPV Method NPV is most acceptable investment rule for the following reasons: Time value Measure of true profitability Shareholder value Limitations: Involved cash flow estimation Discount rate difficult to determine

17 Goods Market Equilibrium Y = C d + I d + G Y - C d – G = S d S d = I d

18 Saving and Invesment: Classical view: interest rates adjust to ensure that S = I Keynes: Decisions to save and invest are made by different economic agents for different reasons No reason to think that interest rates will ensure that S = I at full employment Implication: the economy may achieve equilibrium at less than full employment