Chapter: Three

Theories of Investment
 The concept of investment
• While spending on consumption goods provides utility to
households today

• spending on investment goods is aimed at providing a higher

standard of living at a later date.

• Investment is the component of GDP that links the present and

the future.

• Investment spending plays a key role not only in long-run growth

but also in the short-run business cycle because it is the most
volatile component of GDP.
 The concept of investment
• Investment can be defined as the process of
putting ones resource (money) in a given system
with expectation of some benefits
– (more income

– some products for sale

– for consumption

– satisfaction).
 The concept of investment
Some examples of investment process are:
 establishing a production plant or factory

 opening a new business

 expanding an existing business or factory

 depositing money in saving accounts with intention to collect

interest income
 constructing public infrastructures such as road, schools and

hospitals and
 building business centers or residential houses and so on.
 The concept of investment
There are many different ways you can go about making an
investment.
• This includes putting money into
– stocks

– bonds

– mutual funds

– real estate, gold etc.

• no matter the method you choose to invest, the goal is always

to put your money to work so it earns you an additional profit
 The concept of investment
Investment is considered to be an important part of

national income accounts.

It includes spending on

• new plant and equipment,

• net inventory investment;

• new residential construction

 Type of investment
1. Business investment – investment in machinery, tools and
equipment that business use in further production of
goods and services.

2. Residential investment – expenditure on constructing or

buying new houses or dwelling apartments for purpose of
living or renting out to others

3. Inventory investment – inventory of raw materials, semi-

finished goods and final goods.
Autonomous investment and Induced investment

• Autonomous investment – does not change with the

change in the income level and is therefore independent of
income.

• This investment take place in houses, roads, public

undertakings and other types of economic infrastructure
such as power, transport and communication.

• Autonomous investment depends more on population

• Induced investment- depends more on
income than on the rate of interest.
• Increase in national income lead to increase in
induced investment.
Autonomous investment Induced investment

Investment
Id
Investment

Ia I’a
Id

0 National income
National income
Why do people and government make investment?

• The answer to this question is either a profit motive

or non-profit motives.
• Most of the private investors have profit motive
where as government and non-governmental
organizations may involve in investment projects
because of non-profit motives such as welfare and
national growth issues.
 ……….cont’d
i) Profit Motives
• People or individuals like to invest their money on new
plants and equipments because they believe that this
helps them to make profit.
• The return to investment in plant and equipment is
spread over a number of years.
• For example, a manager who has invested in a machine
to increase output can expect profits from a particular
 …cont’d
• Present Value (PV) Criterion

• To understand this criterion let us take an example.

• Suppose an individual is to receive 1,100 Birr after

one year form today. If the market rate of interest is

10 percent, what is the value of 1,100 Birr today?

Let us solve the question.

• Let ‘X’ be the amount of money lent at 10% for one year

to get 1,100 birr by the end of the year.

Now let us find the value of X.

X money is lent for one year at 10 percent means after one

year 10% of ‘X’ interest will be added on X to give us

1,100.
 ……….cont’d
• individual investors and governments use
different investment decision criteria such as
present value criterion and marginal efficiency
criterion.
• These criteria basically compares whether
investment project is profitable or not.
 10 X 100 X  10 X
X  X (10%) 1,100  X  1,100  1100
100 100
 110 X (1100)(100) so X 1000

the present value (today’s value) of 1,100 Birr is only

1,000 birr at 10% rate of interest.

In the present value criterion, the present values of future

returns of different investment alternative are first calculated
and compared for decision.
 ……….cont’d

• These values actually depend on the level of

interest rates.
• Using the logic or method given in the above
example, we can develop the general formula to
calculate the present value of the future income
streams.
 ……….cont’d
• If an individual has an initial amount P0 which
he/she lends at market rate of interest ‘i’, then
he/she will have P1 at the end of one year.

• Now again he/she lends his initial amount of P1 at

‘i’ he/she will get P2 amount at the end of two

years and so on.
• Mathematically, this can be represented as follows:
 First year  P1 P0  iP0 P0 (1  i )1 .........................
Second year  P2 P1  iP1 P1 (1  i )1 ...........................

Since P1= P0(1+ i) , by substituting equation (1) in equation (2) we

get the following result:

2
P2  P0 (1  i )(1  i )  P2  P0 (1  i )
Similarly, the person again invests for another year at the market rate of
interest, and then he/she would have
3
P0 (1  i )
a general formula which can be written as:

Pn P0 (1  i ) n .....................................................
 ….cont’d
• Where Pn is the amount one gets at the end of ‘n’

years at market rate of interest (i) if one invests P 0

amount today or this year.

• The present value of income to be received after

‘n’ years equals the amount an individual would
have to lend at the market rate of interest ‘i’ for ‘n’

years in order to receive the given amount P n.

 …cont’d
•The present value given by ‘Po’ is obtained by solving for

‘Po’ from equation (4) above.

•The general formula for the present value of future income

is given as follows:

Pn
P0  n
...................................................
(1  i)
 ….cont’d
• In investment decision making process, projects
with larger present values are preferred to be
invested in.
• The above equation shows that the present value and
market rate of interest are inversely related.
• If the market rate of interest increases, the present
value decreases.
 ….cont’d
• This means that higher interest rates leads to
lower investment and so lower national output or
gross domestic product (GDP).
• This is because of two major facts:

• Higher interest rate makes people interested more

in saving than to invest as they receive larger
interest income.
 ….cont’d
• As interest rate gets larger and larger, the cost of
borrowing will be higher and makes investment
through borrowing expensive.
• In investment projects, the streams of future
incomes in different times can be taken as sum of
these discounted values at the end of every year we
pass through for the life of the investment project.
 …cont’d
•For simplicity, we discount every year and add
the present value of each income received in
future.
•After discounting every year we can obtain the
general
Which formula
is: of present value (PV).

P1 P2 P3 Pn
PV  1
 2
 3
 ......  n
..................
(1  i) (1  i) (1  i) (1  i)
 …cont’d
Example
A $30,000 Certificate of Deposit with 5% annual interest in 10
years will be worth:
find: (Future Value)
Pn = P0 (1 + r) T
= 30 000 *(1 + 0 05)10 = 30,000 (0.05)
= $48,866.84
 …cont’d
(Present Value)

• P0 = Pn /(1+r)t (Present Value)

• The present value amount is the future value discounted

• (divided) by the compounded rate of interest

• Example: A $48,866.84 Certificate of Deposit received 10

years from now is worth today:

P0 = $48,866.84/(1+0.05)10 = $30,000
 Investment Criteria:
The Decision to Invest
•The decision to invest on plant and equipment
involves the same sort of analysis.
•Prospective investor must calculate the present
value of the income stream associated with the
investment project and compare with the cost of
the project.
 Investment Criteria
•If the cost of project is less than the present value
of the future income then it is profitable for the
investor to invest.
• In real life, of course, the process is more
difficult because of uncertainty associated with the
project.
 Investment Criteria:

The decision to invest depends on three related

elements

1. The expected income flow from the capital good

2. cost of the investment project

3. The market rate of the return from the project.

Example:
Given the present value of stream of returns and the required amount of money for
the investment by different parties (A, B, C, D and E) as follows, decide whether
each party has to make the investment or not if we consider the profit motive of
investment.
Investing Present value of the The amount of Decision whether to
parties estimated returns money required for invest or not.
from the investment the investment (in
(in Birr) Birr)

A 8,000 10,000 A
B 80,000 70,000 B
C 6,000 6,000 C
D 45,000 40,000 D
E 70,000 100,000 E
 …Cont’d
For the first party
• ‘A’, since the present value of the return from the
investment is less than the amount of money required,
which is the cost of the investment (8,000 < 10,000), it
is proper not to invest.
• ‘B’ since the present value of the benefit or the return is
larger than the cost (80,000 > 70,000) it is preferable to
 …Cont’d
• For party ‘C’, since both the present value of the return and the
cost are equal (6,000 = 6,000), it is the same for the party to
invest or not

• For party ‘D’, since the present value of the return is greater
than the cost (45,000 > 40,000) it is better to invest the money.

• For part ‘C’, the present value of the benefit of the investment is
highly smaller than the cost for the investment (70,000 <
100,000). So it is better not to invest; rather it is better to save
the money to provide fund for other investment activities.
 …Cont’d
• The major elements that individual investors consider in making decision whether

to make investment expenditure or not given that other factors at national level

– market demand,

– financial resource,

– political factors or political stability,

– level of uncertainty or risk,

– availability and efficiency of banking system,

– Government economic or investment policy

 Marginal Efficiency Criterion
• Marginal efficiency of capital (r) 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.
• Then, the discount rate (r) will be compared with
the market or banks interest rate (i), which is the
cost of borrowing or the return on saving.
 Marginal Efficiency Criterion
• If the discount rate (r) is greater than the market

or banks interest rate (i), it means that the money

put into the investment is increasing.

• The implication of this criterion is that lower

market or banks interest rate (i) encourages

investment.
 Marginal Efficiency Criterion
• It also implies that the government or the central
banks have to maintain reasonably low interest
rates using different instruments such as money
supply regulation to have better investment
condition.
 ii) Non – Profit Motives
• People, non – governmental organizations and

governments also participate in investment

practices for non – profit motives.

• The most important non – profit motive is the

welfare reason or humanitarian issues.

 CONT’D
• Individuals and non – governmental organizations
spend their resources on investment to benefit a
community from the return from the investments
such as
– road,
– schools and
– health infrastructures.
 CONT’D

• The later usually accounts for a considerable

proportion of government expenditure (G) in

national income identity or gross domestic product

(GDP) given by:

 GDP = C + I + G + X – M or Y =C+I+G+X–
M or
GDP = C + I + G + NX or
Where Y = national income; GDP = Gross Domestic
Product
C = private sector consumption spending
I = private sector investment spending or
investment demand, G = government sector spending; NX
= X – M = Net export; X = Export value
M = Expenditure on import
 Crowding Out Effect
• Crowding effect represents the case where the
government action such as fiscal policy or
government investment activity itself reduces the
investment in the private sector.

• For instance an increase in government

expenditure on investment or some other activities
reduces the government saving.
Interest rate S2 S1

r2

r1

Investment Demand (I)

I2 I1

This increases interest rate and as a result

investment declines as borrowing become expensive.
 Crowding Out Effect
• When the government investment increases, the

government either cut its saving (shifting saving

curve from S1 to S2) as money moves to the

investment or the government increases

borrowing.
 Crowding Out Effect
• Both borrowing and reduction in saving pushes the

interest upward (from r1 to r2) making the borrowing

expensive for private investors.

• So, private investors cut their investment spending from

• I1 to I2.

• This is also contributed to by increased private saving

attracted by higher interest income.

 Determinants of Investment
– Market demand (required for investment in production);

– Financial resource

– Political factors (political stability

– Level of uncertainty (level of risk)

– Availability and efficiency of banking system (credit or lending

institutions)

– Government economic or investment policy

– Interest rate (cost of borrowing)

 Determinants of Investment

Some of the major factors that affect investment

decision are:
• Market demand (required for investment in
production); the larger the market demand the
larger the investment would be.
• The market demand is also positively related to
population size and income level of the
population.
 Determinants of Investment
• Financial resource; the availability of enough
financial resource also has positive implication for
the level of investment.
• Political factors (political stability); peace and
stable political situation encourages investment.
 Determinants of Investment
• Level of uncertainty (level of risk); the higher the level

of uncertainty the lower the incentive for investment will

be.

• Availability and efficiency of banking system (credit

or lending institutions); existence of efficient banking

system or lending institutions facilitates investment

process and so affect its size positively.

 Determinants of Investment
• Government economic or investment policy;
conducive investment and related economic policies
encourage investment and increases its level.

• Interest rate (cost of borrowing);

• higher interest rate means high cost of borrowing

and so affects investment negatively.
 Cont’d
• This also implies that lower interest rates
encourage investment for two reasons:
• low cost of borrowing and unattractive interest
income to save money instead of saving
 Determinants of Investment
• The size of liquid assets at dispose of the investor,
– level of development in research and development,
– population growth which represents the potential
demand for public infrastructure and
– future consumers demand are also some of the
factors that determine investment level
 Determinants of Investment
• For instance, the higher the population growth rate
the higher the level of future population and the
higher the demand for the public infrastructures
such as schools, public health services,
transportation and so on.

• Such larger population growth implies also that

there will be larger consumer demands.
 Types of investment
Three types of investment
– Business fixed investment
– Residential investment includes:
– Inventory investment
 Types of investment

Business fixed investment

• includes the equipment and structures that business
buy to use in production.
• It accounts for about ¾ of the total investment
spending of businesses.
 Types of investment
• Residential investment includes:

• Purchase of new housing by households to live in and

by land lords to rent them.

• The price of housing adjusts to equilibrate supply and

demand.

• The higher the relative price of housing, the greater the

incentive to build houses and the more houses are built.
 Types of investment
• According to this model of the housing market,
residential investment depends on the relative price
of housing.
• The relative price of housing, in turn, depends on
the demand for housing, which depends on the
imputed rent that individuals expect to receive
from their housing.
 …CON’D
• One important determinant of housing demand is the real interest
rate.

• Many people take out loans mortgages to buy their homes; the
interest rate is the cost of the loan.

• Even the few people who do not have to borrow to purchase a

home will respond to the interest rate, because the interest rate is
the opportunity cost of holding their wealth in housing rather than
putting it in a bank.

• A reduction in the interest rate therefore raises housing demand,

 …CON’D
• Another important determinant of housing demand is
credit availability.

• When it is easy to get a loan, more households buy their

own homes, and they buy larger ones than they otherwise
might, thus increasing the demand for housing.

• When credit conditions become tight, fewer people buy

their own homes or trade up to larger ones, and the
demand for housing falls.
 Inventory investment
• Inventories are goods that businesses put aside in
storage.
• It consists of raw materials, goods in the process of
production and completed goods held by firms in
the anticipation of the product sale.
• It is one of the smallest component of spending
(=1% of GDP).
 Inventory investment
Firms would invest in inventory for different
reasons.

Some of these are:

1. To smooth the level of production over time:

2. May allow firms to operate more efficiently:

3. To avoid stock out.

 Inventory investment
• To smooth the level of production over time:

• The demand for goods may highly fluctuate and producers or sellers fill
the gap created through inventory investment.

• This is because; fluctuating or changing production along with demand

may be costly.

• When sales are low, the firm produces more than it sells -put the extra into
inventory.

• When sales are high, the firms produce less than it sells -take goods out of
inventory.
 Inventory investment

2. May allow firms to operate more efficiently:

• Goods on hand to show customers (for display) and keeping
spare parts to replace damaged machines would be
efficiency improving.
• In some way, we can view inventories as factor of
production - the larger the stock of inventories a firm hold,
the more output it can produce.
 Inventory investment
3. To avoid stock out.
• That means to avoid running out of stock for
sudden increase in demand.
• The process is called stock out avoidance.

• If demand exceeds production and there are no

inventories, the good will be out of stock for a
period.
 Inventory investment

4. To help Production process: When production

involves a number of steps, partially processed
goods are stored as inventory, called work- in -
process.
 Theories of Investment

• Keynesian Marginal Efficiency of Capital (MEC)

• Keynesian marginal efficiency of capital (MEC) is an

alternative theory or approach in making investment decision
under profit oriented investment motive.
• In this approach, the comparison is between marginal
efficiency of capital (r) and market rate of interest (i).
• Marginal efficiency of capital (r) 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.
 …CON’D

To calculate the marginal efficiency of capital (r), we obtain

the estimates of the cost of the project (C) and the future
income stream associated with the projects, P1, P2… Pn.
• Where the subscripts: 1, 2, 3………………..n. represent the
years (from now) in which the returns are received.
•These values are substituted into the general formula of
discounting process.
P1 P2 P3 Pn
C 1
 2
 3
 ......  ......................(7)
(1  r ) (1  r ) (1  r ) (1  r ) n
 …CON’D
• In equation (7), we must solve for the unknown ‘r’.

• Then the investor must compare it with the market rate

of interest (i).
• If the marginal efficiency of investment (r) is less than
the market rate of interest (i), the project is not
profitable.
• The investor can be better off by simply lending or
saving at market rate of interest (i) rather than
 …CON’D
• If the marginal efficiency of investment (r) is
greater than the market rate of interest (i), the
project is profitable.
• This means that the return on the money used for
investment given by the marginal efficiency of
investment (r) is larger if we put or use the money
for the investment than the return on it if we save
or lend at market interest rate (i).
 …CON’D
• From the point of view of profit oriented private or

government investment, it is suggested by this theory that

investment resource or money is better used for investment

activity than to save.

• This implies that the capital or the money will be more

efficient at margin if it is invested than if it is saved or lent at

market or banks interest rate.

• This suggestion can be summarized as follows:

 …CON’D
If Investing is Preferred use of the capital or money

r>i More For investment

profitable
r<i Less profitable To save or to lend to use the money in
other alternative investment activity.

•In the investment decision-making process, the market rate

of interest plays a crucial role.
 …CON’D
• If the rate of interest is very high, then it may make
investment projects very expensive and unprofitable.

• This is because the marginal efficiency of capital is

less than the cost of the investment which is the
market interest rate.

• If market rate is low then it may make some

previously unprofitable projects as profitable because
this is equivalent to lowering the cost of investment.