Investment

Module 2

 Theory of Firm

 Tobin’s q theory

 The Accelerator theory of investment

 Investment and role of Fiscal and Monetary policy

 Investment

Investment refers to the accumulation of real capital goods

Real capital goods is : (two types)

 Fixed capital (Plant, machinery, buildings and transport infrastructures which keep their particular physical form)
 Working capital (stocks of raw materials, manufactured inputs and final goods awaiting distribution)
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Investment is a smaller component of aggregate demand than is consumption, It is more volatile

It is important in Keynesian analysis

1. It is a source of short-term changes in aggregate demand

2. Investment is also a crucial variable on the supply side of the economy as it is the means by which changes in
the real capital stock are brought about
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The choice of the size of the stock of capital is thus an intertemporal

choice problem as it involves trading off present consumption for future
consumption
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An economy can only produce additional output over time by acquiring greater quantities of factors of production,
or (through technical progress)

stationary economy is one in which technical progress is absent and the capital stock is constant

Amount of replacement investment is identical to the amount by which the capital stock depreciates (largely
influence by Government – allocation of resources for capital accumulation)

If the capital stock grows larger over time, the increase in capital stock per period of time is known as net
investment (influenced By individuals- saving and investment decisions)

Gross investment = Replacement investment and net investment

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Capital theory and the theory of the firm

Y =f(L, K, T)

Assume:
 State of technology, T, to be unchanged
 K, - stock variable (firms typically pay an initial lump sum for capital goods which will yield services over a
number of time periods)
 L, labour, - flow variable (because firms hire labour services, while to obtain capital services)
 Capital goods can also be leased, in which case the decision to invest in a stock of capital goods is made by the
lessor
 capital services are not hired but are acquired by purchasing a stock of capital goods
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a firm receives an inflow of cash, which is the total revenue from selling its net output, and experiences an outflow of cash due
to paying for labour and for new capital goods.

The net cash flow, N, for each time period is therefore

Nt = PtYt - WtLt - pktlt

where
Yt = physical output
Pt = price of product
WtL t = wage bill
pkt = price of a unit of capital goods
It = investment: the number of new capital goods purchased in
period t
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The objective of the firm: Maximizing the value of its net cash flow

In order to maximize the value of the firm it is not sufficient to consider only the current net cash flow

The present value of the future expected net cash flows is obtained by discounting the net cash flows by the rate of
interest, i, at which the firm can borrow or lend

Interest rate is exogenous to the firm. It can borrow as much as it wants without increasing the rate of interest it has
to pay
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What is Putty-clay models?

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where ∆V = net present value of investment project

∆ Nt = change in net cash flow due to the adoption of the investment project

the constraints faced by the firm are:

1. The production function.
2. The demand function for the firm's product.
3. The wage rate (or the supply curve of labour if the firm faces an imperfectly competitive labour market).
4. The price of new capital goods.
5. The rate of depreciation of the capital stock.
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The cost of owning capital is more complex. For each period of time that it rents out a unit of capital, the rental firm bears three
costs

1. When a rental firm borrows to buy a unit of capital, it must pay interest on the loan. If PK is the purchase price of a unit of
capital and i is the nominal interest rate, then iPK is the interest cost. Notice that this interest cost would be the same even if
the rental firm did not have to borrow: if the rental firm buys a unit of capital using cash on hand, it loses out on the interest
it could have earned by depositing this cash in the bank. In either case, the interest cost equals iPK.

2. While the rental firm is renting out the capital, the price of capital can change. If the price of capital falls, the firm loses,
because the firm’s asset has fallen in value. If the price of capital rises, the firm gains, because the firm’s asset has risen in
value. The cost of this loss or gain is - ∆PK. (The minus sign is here because we are measuring costs, not benefits).

3. While the capital is rented out, it suffers wear and tear, called depreciation. If d is the rate of depreciation—the fraction of
capital’s value lost per period because of wear and tear—then the dollar cost of depreciation is dPK. The total cost of renting
out a unit of capital for one period is therefore
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 A fall in the discount rate leads to a rise in the desired

stock of capital.

 If any of the other determinants of the desired capital

stock (factor prices and product demand) change, then
the KK schedule will shift
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Investment and capital-stock adjustment

Investment occurs when the stock of capital is adjusted:

1. To rate of Depreciation (Replacement Investment)
2. Additional increase in Capital stock (Net Investment)

Rate of investment

• Discrepancy between the desired and the actual stock of capital

Lags: Takes time for a firm to decide on its capital-stock requirements

Lag between delivery and installing the new capital goods
Limited managerial and administrative capacity
External factors
 Investment

Firm has some choice over the length of time it takes to adjust its capital stock
A firm concerned with maximising the present value of its net cash flow
The optimal rate of investment would be that for which the marginal adjustment costs just equalled
the resulting marginal net revenues

I = ὼ(L (t))(K*t – Kt-1)

ὼ (L (t) = a distributed lag

The general expression for the desired capital stock

K*t = F (z)
where Z = current and expected future product demand, wage rates, and the cost of capital services.
The actual capital stock, K 1-(' which firms start out with at the beginning of period t is determined by
past levels of gross investment and by the rate of depreciation
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Investment function -in the ISLM model -directly on the rate of interest
A determinate rate of net investment -some lagged function of the positive discrepancy between
the desired and actual capital stock
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2. Tobin's q-ratio

 The Q ratio was popularized by Nobel Laureate James Tobin and invented in 1966 by Nicholas
Kaldor

 The Q ratio, also known as Tobin's Q, measures whether a firm or an aggregate market is
relatively over- or undervalued

 It relies on the concepts of market value and replacement value

 The simplified Q ratio is the equity market value divided by equity book value
 Investment

Tobin’s Q Theory

Finance and the cost of capital

The opportunity cost of accumulating capital is the present consumption thus forgone- Cost of
Capital

Given certainty and a perfect capital market, the market rate of interest on debt correctly measures
the opportunity cost of capital

firm can raise finance through Three main methods

1.The internal source of retained profits
2. Issuing new shares
3. Borrowing by issuing debt in the form of bonds or debentures
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Different assumptions can be made of how the various ways of raising finance affect the riskiness
of the returns from different financial instruments

what is the appropriate rate of discount is a controversial

outline some of the factors which will affect the cost of capital and hence the demand for new
capital goods
 Investment

Considering the cost of equity capital, i.e. the cost of finance obtained from share issues or
retained profits
Assuming:
 The return from new investment must at least equal the return shareholders are currently
getting
 The current rate of return on shares is the appropriate measure of the opportunity cost of
using equity finance
 To calculate the rate of return on shares : the future stream of dividends which the current
shareholders are expected to receive

 The firm must replace its real capital stock as it depreciates

 Assuming a constant growth rate of dividends, g
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The market value, S, of the firm's total equity will be the share price limes the number of shares outstanding. The present
value of the firm's equity will be obtained by discounting the sum of expected future dividends by the rate of return on
shares, e, which is the cost of equity capital:

cannot observe e directly but we can observe Sand estimate D and g

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All the factors will make retained profits a cheaper

form of finance than new equity
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The cost of equity capital greater than the cost of debt

n if the firm finances new investment by issuing more debt rather than by equity

To compensate for the greater financial risk of extra debt, potential shareholders demand a higher
rate of return (which they can achieve through a fall in the share price: a fall in S causes e to rise)

Thus the equity cost of capital rises with the firm's debt -equity ratio

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It is therefore appropriate to use as the discount rate the firm's average cost of capital, a. This is
the weighted average of the firm's equity cost of capital and the interest rate on its debt and is
given by equation

The greater probability of bankruptcy as the proportion of debt rises and this fear eventually increases the cost of capital
 Investment

Tobin's q-ratio

way of relating investment demand to financial variables

Investment is hypothesised to depend positively on the q ratio, where

q = rate of return on investment /cost of capital

The rate of return on investment is that rate of discount, p

the rate of return on investment is the value of p which will make the present value of the
expected change in the firm's net cash flows, N, equal to pkI, the initial cost of the capital
equipment:
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3. The accelerator theory of investment

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3. The accelerator theory of investment

Emphasises the relationship between the capital stock and the flow of output, while disregarding
the role of factor costs

Assume a constant returns to scale production function

Given constant returns to scale the optimal capital-Iabour ratio is determined by the cost of
capital relative to the cost of labour and is invariant with respect to changes in output

the optimal capital-output ratio, v, remains unchanged as output expands.

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The desired stock of capital, K*, related to the volume of output firms plan to produce by means
of v , K* = vy

The labour-capital ratio and the capital-output ratio are then fixed parameters rather than
decision variables

The desired capital stock, K1, which firms wish to have by the end of the current period in order
to produce next period's output optimally is related to the expected volume of future output, yet.
Thus
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The impact of inflation

The impact of inflation on the level of investment depends on whether the inflation is anticipated or
unanticipated
1. Anticipated
If inflation is fully anticipated, then the nominal rate of interest on fixed-interest debt will rise by the rate of
inflation – Price of NET cash flow increase and Market Value remain unaffected

May lead to increase in saving and lead to favourable impact on next period investment

2. Unanticipated:
Increase in inflation – diminishes incentive to invest – As increase in interest rate lead to increase
compensation which lead to decrease NET cash flow

Unanticipated inflation could have a favourable impact on investment if nominal interest rates rose less
than the rate of inflation, resulting in a fall in the real rate of interest, which the firm correctly perceived
 Investment

Fiscal policy

Fiscal policy can influence the level of private-sector investment through two distinct channel
1. Demand Side: Affect the level of future expected demand for output
2. Cost side: tax changes can alter the cost of capital services

 Investment Allowances: Help firm to reimburse depreciation cost from profit (reduce tax
liability)
 Investment Grants: Reimburse Capital Good Expenditure
 Corporation Tax: Concession
 Incentive to accelerate rate of Investment: raising long term interest rate
 Government deficit finance: through Bond financing : affect private investment
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Monetary policy

 Affects investment by inducing a process of portfolio adjustment

 Portfolio adjustment following an expansion in the money stock increases q by raising firms'
stock-market valuation and so stimulates investment

 Monetary policy Transmission Mechanism affects the investment or the rate of Investment
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The main questions for which empirical answers have been sought are as follow:

1. Is investment to be explained solely by output and capacity utilisation as in the accelerator

approach?

2. Does the cost of capital services contribute to explaining investment as neoclassical theory
suggests?

3. Are internal financial variables or extensions significant determinants of investment?

4. What is the lag structure of investment demand?

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Empirical Evidence focus on

1. Expected future demand for product

(proxy by: past level of output, sale, profit, cash flow)

2. Role of relative factor price

2.1: Desire Capital stock: Price of output relative to cost of capital
2.2: Tobin’s Q: Rate of return to cost of capital

3.Rate of Investment: Geometric lag distribution

https://www.saudijournals.com/media/articles/SJEF-37-298-304-c.pdf