UNIT - II

INVESTMENT FUNCTION
CAPITAL:
Capital is a term for financial assets, such as funds held in deposit accounts and/or funds
obtained from special financing sources. Capital can also be associated with capital assets of a
company that requires significant amounts of capital to finance or expand.

Capital can be held through financial assets or raised from debt or equity financing.
Businesses will typically focus on three types of business capital: working capital, equity capital,
and debt capital. In general, business capital is a core part of running a business and financing
capital intensive assets.

Capital assets are assets of a business found on either the current or long-term portion
of the balance sheet. Capital assets can include cash, cash equivalents, and marketable
securities as well as manufacturing equipment, production facilities, and storage facilities.

Types of Capital
Debt Capital
A business can acquire capital through the assumption of debt. Debt capital can be
obtained through private or government sources. Sources of capital can include friends,
family, financial institutions, online lenders, credit card companies, insurance companies, and
federal loan programs.
Individuals and companies must typically have an active credit history to obtain debt capital.
Debt capital requires regular repayment with interest. Interest will vary depending on the type
of capital obtained and the borrower’s credit history.

Equity Capital
Equity capital can come in several forms. Typically distinctions are made between
private equity, public equity, and real estate equity. Private and public equity will usually be
structured in the form of shares. Public equity capital raises occur when a company lists on a
public market exchange and receives equity capital from shareholders. Private equity is not
raised in the public markets. Private equity usually comes from select investors or owners

Working Capital
Working capital includes a company’s most liquid capital assets available for fulfilling
daily obligations. It is calculated on a regular basis through the following two assessments:
Current Assets – Current Liabilities
Accounts Receivable + Inventory – Accounts Payable
Working capital measures a company's short-term liquidity—more specifically, its ability to
cover its debts, accounts payable, and other obligations that are due within one year.

Trading Capital

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 Trading capital may be held by individuals or firms who place a large number of trades
on a daily basis. Trading capital refers to the amount of money allotted to buy and sell various
securities.

INVESTMENT:
An investment is an asset or item accrued with the goal of generating income or
recognition. In an economic outlook, an investment is the purchase of goods that are not
consumed today but are used in the future to generate wealth. In finance, an investment is a
financial asset bought with the idea that the asset will provide income further or will later be
sold at a higher cost price for a profit.
Investment is elucidated and defined as an addition to the stockpile of physical capital such as:
1. Machinery
2. Buildings
3. Roads etc.,

Types of Investment:
1. Induced Investment:
Real investment may be induced. Induced investment is profit or income motivated.
Factors like prices, wages and interest changes which affect profits influence induced
investment. Similarly demand also influences it. When income increases, consumption demand
also increases and to meet this, investment increases. In the ultimate analysis, induced
investment is a function of income i.e., I = f(Y). It is income elastic. It increases or decreases
with the rise or fall in income, as shown in

Figure 1.

I1 I1is the investment curve which shows induced investment at various levels of income.
Induced investment is zero at OY1 income. When income rises to OY3 induced investment is
I3Yy A fall in income to OY2 also reduces induced investment to I2Y2.
Induced investment may be further divided into (i) the average propensity to invest, and (ii) the
marginal propensity to invest:

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(i) The average propensity to invest is the ratio of investment to income, I/Y. If the income is Rs.
40 crores and investment is Rs. 4 crores, I/Y = 4/40 = 0.1. In terms of the above figure, the
average propensity to invest at OY3 income level is I3Y3/ OY3
(ii) The marginal propensity to invest is the ratio of change in investment to the change in
income.

2. Autonomous investment
Autonomous investment is independent of the level of income and is thus income
inelastic. It is influenced by exogenous factors like innovations, inventions, growth of
population and labour force, researches, social and legal institutions, weather changes, war,
revolution, etc. But it is not influenced by changes in demand. Rather, it influences the demand.
Investment in economic and social overheads whether made by the government or the private
enterprise is autonomous.

Such investment includes expenditure on building, dams, roads, canals, schools,

hospitals, etc. Since investment on these projects is generally associated with public policy,
autonomous investment is regarded as public investment. In the long-run, private investment
of all types may be autonomous because it is influenced by exogenous factors.
Diagrammatically, autonomous investment is shown as a curve parallel to the horizontal axis as
I1I’ curve in Figure 2. It indicates that at all levels of income, the amount of investment
OI1 remains constant.

The upward shift of the curve to I2I” indicates an increased steady flow of investment at
a constant rate OI2 at various levels of income. However, for purposes of income
determination, the autonomous investment curve is superimposed on the С curve in a 45° line
diagram.

3. Business Fixed Investment:

Business fixed investment means investment in the machines, tools and equipment that
businessmen buy for use in further production of goods and services. The stock of these
machines or plant equipment etc. represents fixed capital.

4. Residential Investment:

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 Residential investment refers to the expenditure which people make on constructing or
buying new houses or dwelling apartments for the purpose of living or renting out to others.
Residential investment varies from 3 per cent to 5 per cent of GDP in various countries.

Induced Vs Autonomous Investment

1. Autonomous investment is income-inelastic. On the other hand, induced investment is
income elastic.
2. Autonomous investment is determined by consideration of social welfare. Conversely, the
induced investment is determined by consideration of profit.
3. Autonomous investment is related to government sector. While the induced investment is
related to private sector.
4. In graphical representation the autonomous investment curve remains parallel to X axis.
Inversely, the induced investment curves slopes upward or downward.

DETERMINANTS OF INVESTMENT
The expected return on the investment
Investment is a sacrifice, which involves taking risks. This means that businesses,
entrepreneurs, and capital owners will require a return on their investment in order to cover
this risk, and earn a reward. In terms of the whole economy, the amount of business profits is a
good indication of the potential reward for investment.

Business confidence
Similarly, changes in business confidence can have a considerable influence on
investment decisions. Uncertainty about the future can reduce confidence, and means that
firms may postpone their investment decisions until confidence returns.

Changes in national income

Changes in national income create an accelerator effect. Economic theory suggests that,
at the macro-economic level, small changes in national income can trigger much larger changes
in investment levels.

Interest rates
Investment is inversely related to interest rates, which are the cost of borrowing and the
reward to lending. Investment is inversely related to interest rates for two main reasons.

Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a
rise in interest rates increases the return on funds deposited in an interest-bearing account, or
from making a loan, which reduces the attractiveness of investment relative to lending. Hence,
investment decisions may be postponed until interest rates return to lower levels.

Secondly, if interest rates rise, firms may anticipate that consumers will reduce their
spending, and the benefit of investing will be lost. Investing to expand requires that consumers

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at least maintain their current spending. Therefore, a predicted fall is likely to discourage firms
from investing and force them to postpone their investment decisions.

General expectations
Because investment is a high-risk activity, general expectations about the future will
influence a firm’s investment appraisal and eventual decision-making. Any indication of a
downturn in the economy, a possible change of government, war or a rise in oil or other
commodity prices may reduce the expected benefit or increase the expected cost of
investment.

The level of savings

Household and corporate savings provides a flow of funds into the financial sector,
which means that funds are available for investment. Increased saving may reduce interest
rates and stimulate corporate borrowing and investment.

The accelerator effect

Small changes in household income and spending can trigger much larger changes in
investment. This is because firms often expect new sales and orders to be sustained into the
long run, and purchase larger quantities of capital goods than they need in the short run.

Interest Rate
The interest rate is the amount a lender charges for the use of assets expressed as a
percentage of the principal. The interest rate is typically noted on an annual basis known as
the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, or
large assets such as a vehicle or building. An interest rate is the amount of interest due per
period, as a proportion of the amount lent, deposited or borrowed (called the principal sum).
The total interest on an amount lent or borrowed depends on the principal sum, the interest
rate, the compounding frequency, and the length of time over which it is lent, deposited or
borrowed.

The Marginal Efficiency of Investment (MEI)

The marginal efficiency of investment is the rate of return expected from a given
investment on a capital asset after covering all its costs, except the rate of interest. Like the
MEC, it is the rate which equates the supply price of a capital asset to its prospective yield. The
investment on an asset will be made depending upon the interest rate involved in getting funds
from the market. If the rate of interest is high, investment is at a low level.

A low rate of interest leads to an increase in investment. Thus the MEI relates the
investment to the rate of interest. The MEI schedule shows the amount of investment
demanded at various rates of interest. That is why, it is also called the investment demand
schedule or curve which has a negative slope, as shown in Fig. 5(A). At Or1 rate of interest,
investment is OF. As the rate of interest falls to Or2, investment increases to ОI”.

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 To what extent the fall in the interest rate will increase investment depends upon the
elasticity of the investment demand curve or the MEI curve. The less elastic is the MEI curve,
the lower is the increase in investment as a result of fall in the rate of interest, and vice versa.

In Figure 5 the vertical axis measures the interest rate and the MEI and the horizontal
axis measures the amount of investment. The MEI and MEI’ are the investment demand curves.
The MEI curve in Panel (A) is less elastic to investment which increases by I’I’’. This is less than
the increase in investment I1I”2 shown in Panel (B) where the MEI’ curve is elastic. Thus given
the shape and position of the MEI curve, a fall in the interest rate will increase the volume of
investment.

On the other hand, given the rate of interest, the higher the MEI, the larger shall be the
volume of investment. The higher marginal efficiency of investment implies that the MEI curve
shifts to the right. When the existing capital assets wear out, they are replaced by new ones
and level of investment increases.

But the amount of induced investment depends on the existing level of total purchasing.
So more induced investment occurs when the total purchasing is higher.

Factors affecting induced investment

(1) Element of Uncertainty:
According to Keynes, the MEC is more volatile than the rate of interest. This is because
the prospective yield of capital assets depends upon the business expectations. These business
expectations are very uncertain. “They may change quickly and drastically in response to the
general mood of the business community, rumours, news of technical developments, political
events, even directors’ ulcers may cause a sudden rise or fall of the expected rate of yield.”

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(2) Existing Stock of Capital Goods:
If the existing stock of capital goods is large, it would discourage potential investors
from entering into the making of goods. Again, the induced investment will not take place if
there is excess or idle capacity in the existing stock of capital assets.

(3) Level of Income:

If the level of income rises in the economy through rise in money wage rates and other
factor prices, the demand for goods will rise which will, in turn, raise the inducement to invest.
Contrariwise, the inducement to investment will fall with the lowering of income levels.

(4) Consumer Demand:

The present and future demand for the products greatly influences the level of
investment in the economy. Even if we take the future demand for the products, it will be
considerably influenced by their current demand and both will influence the level of
investment. Investment will be low if the demand is low, and vice versa.

(5) Liquid Assets:

The amount of liquid assets with the investors also influences the inducement to invest.
If they possess large liquid assets, the inducement to invest is high. This is especially the case
with those firms which keep large reserve funds and undistributed profits. On the contrary, the
inducement to invest is low for investors having little liquid assets.

(6) Inventions and Innovations:

Inventions and innovations tend to raise the inducement to invest. If inventions and
technological improvements lead to more efficient methods of production which reduce costs,
the MEC of new capital assets will rise. Higher MEC will induce firms to make larger investments
in the new capital assets and in related ones.

(7) New Products:

The nature of new products in terms of sales and costs may also influence their MEC
and hence investment. If the sale prospects of a new product are high and the expected
revenues more than the costs, the MEC will be high which will encourage investment in this and
related industries.

(8) Growth of Population:

A rapidly growing population means a growing market for all types of goods in the
economy. To meet the demand of an increasing population in all brackets, investment will
increase in all types of consumer goods industries. On the other hand, a declining population
results in a shrinking market for goods thereby lowering the inducement to invest.

(9) State Policy:

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 The economic policies of the government have an important influence on the
inducement to invest in the country. If the state levies heavy progressive taxes on corporations,
the inducement to invest is low, and vice versa. Heavy indirect taxation tends to raise the prices
of commodities and adversely affects their demand thereby lowering the inducement to invest,
and vice versa.

(10) Political Climate:

Political conditions also affect the inducement to invest. If there is political instability in
the country, the inducement to invest may be affected adversely. In the struggle for power, the
rival parties may create unrest through hostile trade union activities thus creating uncertainty
in business.

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