Capital Investment,IGCSE,GCEO

Capital Investment

Introduction

Investment involves buying capital goods to provide us with goods and services in the future

Investment is a decision to postpone consumption and to accumulate capital which can lift an economy’sproductive potential.

Investment is a component of aggregate demand and capital expenditure also has important effects on both the demand-side and the supply-side of any economy

Net and gross investment

• Net investment = gross investment minus replacement investment required to replace obsolete capital. The level of net investment tells us what is happening to the stock of fixed capital
• Gross fixed investment is spending on fixed assets including buildings, plant and vehicles

Factors that affect investment demand 

Profit-seeking businesses will be prepared to go ahead with an investment if they believe that it will - over its projected lifetime - yield a real rate of return greater than if the money had been invested in the next best alternative way. Opportunity cost is a useful idea to use here.
Private sector businesses usually focus on these objectives when investing in new capital inputs:

1. Improving productivity / efficiency to drive down unit costs and achieving economies of scale
2. Investing in capital embodies the most recent technological improvements
3. Expanding capacity to meet rising actual demand and to supply to new markets (e.g. exports)
4. Increasing capacity in advance of an expected increase in market demand (i.e. the accelerator)
5. Replacing obsolete capital equipment and buildings

Social cost benefit analysis

For government sector investment such as new roads, schools and prisons, priorities may be subtly different. Public sector capital projects are still subject to tests about their expected rates of return and thecost-benefit analysis will include estimates of the social costs and benefits of the investment rather than a narrow focus on private costs and benefits.

Returns to an investment project

• The expected returns from capital investment are determined by the demand for and the price of the output generated by an investment and by the costs of production
• A rise in demand will increase the revenue streams that a business can expect from a new project
• A change in the costs of purchasing capital inputs the costs of training workers to use new capital and in maintaining the capital stock will impact on the expected rate of return

The importance of business expectations and uncertainty

• One of the important lessons of Keynesian economics is the crucial role played by business ‘animal spirits’ in determining how much firms are willing to commit to capital spending
• There is always uncertainty about the expected rate of return particularly when market demand is volatile and sensitive to changes in interest rates, the exchange rate and real incomes
• The expected rate of return from an investment is also influenced by the rate at which a new capital project depreciates over time and the effects of changes in corporation tax on profits

The marginal efficiency of capital (MEC) – the demand curve for investment

The marginal efficiency of capital (MEC) is the rate of interest, which makes an investment project viable “at the margin”. In the diagram above, at lower rates of interest (i.e. R2) the cost of borrowing money is lower and the opportunity cost of using retained profits as a source of finance is reduced. A fall in interest rates should lead to an expansion along the investment demand curve. Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled.

• For the UK, recent evidence suggests that the demand for new capital goods is interest rate inelastic. Partly this is because many firms prefer to use the capital market through the issue of new shares and bonds to raise funds for investment rather than relying on bank loans.
• But the rate of interest can and does affect capital investment decisions – perhaps through its effect on confidence and also expectations of changing demand and the links between interest rates and the exchange rate.

The Accelerator Model

• The accelerator suggests a positive relationship between investment and the growth of demand
• Accelerator theories assume that for a business there is a desired capital stock for a given level of output and interest rates. A rise in output or a fall in demand may prompt increased levels of investment as firms adjust to reach the new optimal capital stock level
• The accelerator model works on the basis of a fixed capital to output ratio. For example if demand in a given year rises by £4 million and each extra £1 of output requires an average of £3 of capital inputs to produce this output, then the net level of investment required will be £12 million
• Consider the diagram below that shows an outward shift of AD that then causes an expansion of production, higher profits and prompts an increase in planned investment at each rate of interest. This boost in demand and output is said to bring about a positive ‘accelerator effect’

• One criticism of this simple accelerator model is that the capital stock of a business can rarely be adjusted immediately to its desired level because of ‘adjustment costs’ and ‘time lags’. The adjustment costs include the cost of lost business due to installation of new equipment or the financial cost of re-training workers.
• Firms will usually make progress towards achieving an optimum capital stock rather than moving smoothly to a new optimal size of plant and machinery. The time lags might be caused by supply-bottlenecks in industries that manufacture buildings and items of capital equipment and technology.
• A further criticism of the accelerator model is that it ignores the spare capacity that a business might have at their disposal. At the end of a recession, businesses are operating below capacity limits and if demand then picks up in the recovery, they make more intensive use of existing capacity.

Business profitability

Business profits play an important role in allocating resources – for example, higher profits provide the funds for capital investment and also for research and development projects

Profits tend to follow a cyclical pattern – they fall during a recession or an economic slowdown. And they recover during phases of stronger economic growth

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