 # The Investment Function Investment refers real investment which

• Slides: 7 The Investment Function Investment refers real investment which adds to capital. Capital refers to any previously produced input that can be used in the production process to produce other goods. The available capital is stock of capital I t =K t -K t-1 Types of Investment Induced investment It is profit or income motivated. Factors like prices, wages and interest changes which affect profits influence induced investment. Demand increases. In the ultimate analysis, induced investment is A function of income I=f(Y). I” I’ I Autonomous Investment • It is independent of the level of income. . It is thus income inelastic. • • I I’ Determinants of Investment • Marginal Efficiency of capital (MEC)Is the highest rate of return over cost of the asset. • i=y/p i- mec, y is the prospective yield of a capital asset per unit of time and p is the supply price of the asset. 8000/60000*100=13. 3%. • 10000/60000*100=16. 7% Keynes has defined MEC “the rate of discount which would make the present value of the series given by the returns expected from the capital asset during its life just equal to its supply price”. Marginal efficiency of capital • The concept of marginal efficiency of capital is the general form of Keynes. If R 1, R 2, R 3, ……. . Rn. Represent a series of annuities, the present worth of these annuities is computed by discounting them at a certain rate such that the sum of the discounted prospective yields become equal to the supply price of the capital assets Methods of Investment Decision • 1. Net Present value Method • 2. Marginal Efficiency of Capital Method • The Net Present Value (NPV) Method NPV = PV – C • PV - present value • C – cost of investment • The present value of a future income is the value of the future income discounted at the current market rate of interest. No inflation & deflation. Formula for PV • PV = R/1+I = R 1/1+I • Where R = amount expected after one year and i = rate of interest. • The market rate of interest is regarded as the opportunity cost or time value of money. • PV of Rs. 110 = 110/1+0. 1 = Rs 100 • Total Present value (TPV) of an income stream over n years. • TVP = R 1 /1+i + R 2 /(1+i)2 …………… Rn /(1+i)n • NPV = sum R /(1+i)n - C n Marginal Efficiency of Investment(MEI) • The concept of marginal efficiency of investment is the some fixed amount of investment is to be undertaken in a particular project rather than the particular capital asset. • MEC = R/1+r =C • r is rate of discount that makes the discounted value of R equal to C. r is the MEC or the internal rate of return IRR. • r = (R/C)-1 • Investment 100 million yield 130