Lecture No. 8
Internal Rate of Return Theory of Investment. OR
Discounted Theory Of Investment. OR
Present Value Criteria of Investment
P1=P0 P1 = return after 1 year.
I = investment rate.
P0 = original deposit.
I= rate of investment.
P0 = present value
P1 = returned after one year
I = invest Rate.
P1 = returned after one year
I = invest Rate.
R---- Return from Bond on which fix rate of interest was given
V= present value of demand price
if the maturity rate of the bond is for of in the future then formula is reduced to as below:
In inverse to if maturity rate of the bond is ready to be cashed. Then present value of the bond will be equal to the market value.
Present value = market value
The above equation explain the present formula of a band on which a fix rate of interest is given and it is discounted by the market value of the interest. But then investment take place and return of every year in different. Then we cannot use above formula. We have discount the income series of different year by expected rate of return (MEC). we meay define this (MEC) as being equal to that rate of discount which would make this presence value the series are annuities given by the return capital from any investment project during its life just equal to its supply price.
Present value = market value
The above equation explain the present formula of a band on which a fix rate of interest is given and it is discounted by the market value of the interest. But then investment take place and return of every year in different. Then we cannot use above formula. We have discount the income series of different year by expected rate of return (MEC). we meay define this (MEC) as being equal to that rate of discount which would make this presence value the series are annuities given by the return capital from any investment project during its life just equal to its supply price.
V = demand price
R = rate of discount
C = supply price
J = when its value become scrape
Fiqure 8.1
Explain cost of capital theory of investment. OR
Source of fund theory of investment
This theory has been developed by the financial School of Economics according to them investment depends upon the cost of capital and the cost of capital related to the source of financial. According to them these are there source of finance.
Retained earning
External finance
Sale of equity in the market. (shares of the company) keeping in view. The three source of finance we can drive cost of capital curve as shown below:
Diagram:
Cost of capital curve shows the relationship between cost of capital and level of investment. In the diagram above when investment is being made by retained earnings. There is no cost of capital or the cost of capital remained the same. When investment is being made through external finance cost of capital increased by the increase in the rate of interest and cost of capital decrease by the decrease in the state of interest. All the external finance is associated with the rate of interest in the market
Classical economist were concerned with the retained earning as source of finance and they were also concerned with the external finance
According to them rate of interest (cost of capital) was the major determinant of investment and investment demand curve was very much elastic in response to the change in the rate of interest as shown below:
Diagram:According to Keynes economics external finance play an important role in investment. But according to them rate of interest not the major determinant of investment or we can see that according to Keynes investment demand curve is not so much elastic in response to a change in interest rate as shown in the diagram below:
In the above diagram it is shown that below the point “C” investment is not affected by the change in rate of interest but above the point investment demand curve become elastic in reponse to a change in the rate of interest
According to Keynesian change in corporate taxes also effect level of investment (corporate tax are those taxes which are imposed on joint stock companies).
When there is a reduction in corporate taxes retained earnings of the firm will increase, cost of capital will be reduced and there will be increase in the level of investment as shown in the diagram below:
Diagram:
When corporate taxes are reduced cost of capital curve are shifted down ward to C.O.C2 at the same time (MEC) expected rate of profit is increased from I0 to I level of investment if there is increasing in the corporate taxes. It will reduced profit margin of the firm’s, capital will increase and level of investment will be reduced as shown in the diagram below:
Diagram:
When corporate taxes are reduced cost of capital curve are shifted down ward to C.O.C2 at the same time (MEC) expected rate of profit is increased from I0 to I level of investment if there is increasing in the corporate taxes. It will reduced profit margin of the firm’s, capital will increase and level of investment will be reduced as shown in the diagram below:
Diagram:
Diagram:
In the above diagram in this way, it is prove that rate of interest is not the only determinant of cost of capital. Another important factor of cost of capital is investment taxes credit.
Investment taxes credit: is the rebate given on the purchase of machinery for a specific this rebate is deducted from the taxable income of the firm in this way the owner of this form get financial year end and his cost of capital reduced. when there is increase in the investment tax credit cost of capital is reduced and level of investment will be increased. if there is decrease in the investment tax credit cost of capital will be increased level of investment will reduce. in the above lines we have shown that different determinant of cost of capital and we you have also shown that change in the cost of capital affected the level of investment but in modern time period not only the cost of capital determinants of investment but also other factors for example change in technology, change in International factor, role of government and role of general behavior of the consumer which is affected the modern mode of advertisement also play an important role in the determination of investment. In spite of the fact that other factor play a role in determining the level of the investment cost of capital remain the major factor as the determinant in an economy. It is due to this reason that they have been difference in the level of investment in developed and underdeveloped country.
In the above diagram in this way, it is prove that rate of interest is not the only determinant of cost of capital. Another important factor of cost of capital is investment taxes credit.
Investment taxes credit: is the rebate given on the purchase of machinery for a specific this rebate is deducted from the taxable income of the firm in this way the owner of this form get financial year end and his cost of capital reduced. when there is increase in the investment tax credit cost of capital is reduced and level of investment will be increased. if there is decrease in the investment tax credit cost of capital will be increased level of investment will reduce. in the above lines we have shown that different determinant of cost of capital and we you have also shown that change in the cost of capital affected the level of investment but in modern time period not only the cost of capital determinants of investment but also other factors for example change in technology, change in International factor, role of government and role of general behavior of the consumer which is affected the modern mode of advertisement also play an important role in the determination of investment. In spite of the fact that other factor play a role in determining the level of the investment cost of capital remain the major factor as the determinant in an economy. It is due to this reason that they have been difference in the level of investment in developed and underdeveloped country.
An the above diagram consumption will be maximum at point B. when saving line interest balance gross investment line saving will be equal to the consumption will be equal to the distance BC. Because total output is equal to the AC
Golden Rule No (2):
Saving in the economy should be equal to net Investment. If capital is paid according to its marginal productivity. To explain this we can take help from the above diagram. we draw a line QN tangent to the output line at point “C” and parallel to balance growth investment line, slope of QN will be equal to the slope of n= K/L Line.in the above diagram, the triangle oAB and and triangle QCP will Congruent. In the this way PQ will be equal to AB ,it is proved that saving is equal to investment and share of capital is equal to marginal productivity of capital. In the above 2 rules of Economics growth every component of the system expand at an equal rate whatever maximize consumption in any period will maximize it in other period also.
Golden Rule No (2):
Saving in the economy should be equal to net Investment. If capital is paid according to its marginal productivity. To explain this we can take help from the above diagram. we draw a line QN tangent to the output line at point “C” and parallel to balance growth investment line, slope of QN will be equal to the slope of n= K/L Line.in the above diagram, the triangle oAB and and triangle QCP will Congruent. In the this way PQ will be equal to AB ,it is proved that saving is equal to investment and share of capital is equal to marginal productivity of capital. In the above 2 rules of Economics growth every component of the system expand at an equal rate whatever maximize consumption in any period will maximize it in other period also.
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