EC 202 Week 5Sessio 5A In modern industrial societies, investment decisions are made primarily by firms- Households decide how much to save; and inthe long run, savings limit or constrain theamount of investment that firms canundertake- Financial markets exist to direct savings intoprofitable investment projectsFirms have an incentive to expand in industries that earn positive profits – that is, arate of return that is above normal – and in industries in which economies of scalelead to lower average costs at higher levels of output- Positive profits in an industry stimulate the entry of new firms- The expansion of existing firms and the creation of new firms requireinvestment in new capitalExpected benefits: potential investors evaluate the expected flow of future proactiveservices that an investment project will yieldExpected costs: potential investors also compare the project with the possiblealternative uses of the funds required to undertake the project- They consider opportunity costs- At a minimum, funds for a project could earn interest in financial marketsIf the expected benefits from making an investment exceed the expected costs ofthe necessary investment, then the firms should undertake the project- E[benefits] > E[costs] → undertake the projectIf the expected benefits from making an investment fall short of the expected costsof the necessary investment, then the firm should NOT undertake the project- E[benefits] < E[costs] → don’t undertake the projectThe presented discounted value (PDV) or present value (PV) of an amount of Fdollars to be paid t years in the future is the amount you need to pay today, atcurrent interest rates, to ensure that you end up with F dollars t years from now- The PV is the current market value of receiving F dollars in t yearsCompound interest formula:If the present value of an expected stream of earrings from an investment exceedsthe present value of the cost of the investment necessary to undertake it, then theinvestment should be undertaken- PV benefit > PV cost → undertake the projectIf the present value of an expected stream of earrings falls short of the presentvalue of the cost of the investment, then the financial market can generate thesame stream of income for a smaller initial investment, and the investment shouldnot be undertaken- PV benefit < PV cost → don’t undertake the projectExpected rate of return: the threshold interest rate where the firm is indifferent betweeninvesting or not- The annual rate of return that a firm expects to obtain through a capitalinvestmentThe expected rate of return on an investment project depends on:- The price of the investment- The expected length of time the project provides additional costs savings orrevenue- The expected amount of revenue from each yearIf the expected rate of return of a project is greater than the prevailing interest rate,then the investment should be undertaken- Expected rate of return > r → undertake the projectIf the expected rate of return of a project is less than the prevailing interest rate,then the investment should NOT be undertaken- Expected rate of return < r → don’t undertake the projectIf the expected rate of return of a project is equal to the prevailing interest rate, itdoesn’t matter what the firm doesThe demand for loanable funds to purchase new capital depends on the interest rate- When the interest rate is low, firms are more likely to invest in new plantequipmentThe interest rate determines the direct cost (interest on a loan) or the opportunitycost (alternative investment) of each