Let us make an in-depth study of the investment decision process for market rate of interest.
In deciding whether to invest in plant and equipment, the prospective investor must calculate the present value of the income stream associated with the investment project and compare it with the cost of the project.
The process becomes a little difficult owing to the uncertainty associated with the investment project.
It is difficult to estimate the income stream associated with an increase in productive capacity. It requires year by year estimates of the increase in output associated with an increase in productive capacity, the price or prices at which the additional output can be sold, and the operating costs associated with the project.
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After obtaining these estimates, net income is found by subtracting operating costs of the additional plant and equipment in each year from the additional revenue obtained from the project in the corresponding year. Only then will the prospective investor have an estimate of the (net) income stream associated with the project.
After obtaining an estimate of the (net) income stream, the prospective investor can calculate its present value and compare the result with the cost of the project. If the present value of the income stream associated with the project is greater than its cost, the prospective investor should undertake the project.
If the present value of the income stream associated with the project is less than its cost, the prospective investor should not undertake the project.
In the investment decision-making process, the market rate of interest plays an important role. The interest rate is used to discount the future income stream associated with the project. The present value of the future income stream is then compared with the cost of the project in order to make the investment decision.
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If the interest rate changes, the present value of the income stream is altered. As a consequence, investment projects which were profitable at the old interest rate may be unprofitable at the new rate, and vice versa. Thus, investment, in part, depends on the market rate of interest, i.
There is an alternative view of the investment decision-making process which clearly stresses the importance of the market rate of interest. Under the present value approach, the comparison is between the present value, PV, of the future income stream associated with the investment project and the cost of the project, Q.
Under the alternative approach, the comparison is between the marginal efficiency of investment, r and the market rate of interest, i. The marginal efficiency of investment is the rate of interest which equates the cost of the project and the discounted value of the future income stream associated with the project. The general formula for calculating the present value of a future income stream is
To calculate the marginal efficiency of investment, r, we obtain estimates of the cost of the project, Q, and the future income stream associated with the project, P1, P2…. Pn. These values are substituted into the general formula to obtain which must then be solved for the unknown, r. The marginal efficiency of investment is often referred to as the internal rate of return.
After calculating the marginal efficiency of investment r, the prospective investor must compare it with the market rate of interest, I. If the marginal efficiency of investment is less than the market rate, the investment project is unprofitable or at least less profitable than the alternative, lending the money at the market rate of interest. Consequently, the prospective investor should not undertake the project.
On the other hand, if the marginal efficiency of investment r, is greater than the market rate of interest, I, the investment project is profitable or at least more profitable than lending the money at the market rate of interest. Consequently, the prospective investor should undertake the project even if he has to borrow all or part of the necessary funds at the market rate of interest.
To illustrate, suppose the marginal efficiency of investment on a particular project is estimated at 10 percent. If the market rate of interest is 12 percent, the prospective investor should not undertake the project. If the interest rate were to drop to 8 percent, the project is now profitable. Consequently, the prospective investor should undertake the project.
In the investment decision-making process, the market rate of interest plays an important role. If the interest rate is too high (greater than the marginal efficiency of investment), the project is unprofitable. On the other hand, if the interest rate is sufficiently low (less than the marginal efficiency of investment), the project is profitable.
Thus, whether investment in the project occurs or not depends on the market rate of interest. Consequently, economists often specify that investment depends on, or is a function of, the market rate of interest. Thus, we may write the investment function as
I=I (i),
where I represents investment, measured in real or constant dollars, and i represents the market rate of interest. Presumably there is an inverse relationship between investment and the market rate of interest. With a decline in the market rate of interest, investment increases as projects which were not profitable at the higher rate of interest become profitable and, hence, are undertaken.