EC 202 Week 5 Sessio 5A In modern industrial societies investment decisions are made primarily by rms Households decide how much to save and in the long run savings limit or constrain the amount of investment that rms can undertake Financial markets exist to direct savings into pro table investment projects Firms have an incentive to expand in industries that earn positive pro ts that is a rate of return that is above normal and in industries in which economies of scale lead to lower average costs at higher levels of output Positive pro ts in an industry stimulate the entry of new rms The expansion of existing rms and the creation of new rms require investment in new capital Expected bene ts potential investors evaluate the expected ow of future proactive services that an investment project will yield Expected costs potential investors also compare the project with the possible alternative uses of the funds required to undertake the project They consider opportunity costs At a minimum funds for a project could earn interest in nancial markets If the expected bene ts from making an investment exceed the expected costs of the necessary investment then the rms should undertake the project E bene ts E costs undertake the project If the expected bene ts from making an investment fall short of the expected costs of the necessary investment then the rm should NOT undertake the project E bene ts E costs don t undertake the project The presented discounted value PDV or present value PV of an amount of F dollars to be paid t years in the future is the amount you need to pay today at current 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 years Compound interest formula If the present value of an expected stream of earrings from an investment exceeds the present value of the cost of the investment necessary to undertake it then the investment should be undertaken PV bene t PV cost undertake the project If the present value of an expected stream of earrings falls short of the present value of the cost of the investment then the nancial market can generate the same stream of income for a smaller initial investment and the investment should not be undertaken PV bene t PV cost don t undertake the project Expected rate of return the threshold interest rate where the rm is indifferent between investing or not The annual rate of return that a rm expects to obtain through a capital investment The 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 or revenue The expected amount of revenue from each year If 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 project If 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 project If the expected rate of return of a project is equal to the prevailing interest rate it doesn t matter what the rm does The demand for loanable funds to purchase new capital depends on the interest rate When the interest rate is low rms are more likely to invest in new plant equipment The interest rate determines the direct cost interest on a loan or the opportunity cost alternative investment of each project