rates and planned capital investment:
Keynesian theory of investment places emphasis on the importance of interest
rates in investment decisions. But other factors also enter into the model -
not least the expected profitability of an investment project.
in interest rates should have an effect on the level of planned investment
undertaken by private sector businesses in the economy.
fall in interest rates should decrease the cost of investment relative to the
potential yield and as result planned capital investment projects on the
margin may become worthwhile. A firm will only invest if the discounted yield
exceeds the cost of the project.
inverse relationship between investment and the rate of interest can be shown
in a diagram (see below). The relationship between the two variables is
represented by the marginal efficiency of capital investment (MEC) curve. A
fall in the rate of interest from R1 to R2 causes an
expansion of planned investment.
in the marginal efficiency of capital
investment can change at each rate of interest. For example a rise in the
expected rates of return on investment projects would cause an outward shift
in the marginal efficiency of capital curve. This is shown by a shift from
MEC1 to MEC2 in the diagram below.
a fall in business confidence (perhaps because of fears of a recession) would
cause a fall in expected rates of return on capital investment projects. The
MEC curve shifts to the left (MEC3) and causes a fall in planned investment
at each rate of interest.
importance of hurdle rates for investment
firms are continuing to demand rates of return on new investments that are
far too high, undermining industry's ability to re-equip and close the
productivity gap with competitor countries according to a survey by the
Confederation of British Industry. “Hurdle rates" for major investment
projects are 50 per cent higher than they need to be, while the payback
periods required are much shorter than in countries such as Germany.
CBI survey of more than 300 firms showed that they expected to earn an
internal rate of return averaging 17 per cent and recover the cost of their
investment in two to four years. But experts said that post-tax real returns
of 10 per cent were sufficient to justify most investments.
poor investment record has been a concern both for the CBI and government
ministers. Gordon Brown believes that low investment is one of the main
reasons for sluggish economic performance, and that macroeconomic stability
and a tax regime less biased towards dividends will encourage capital
CBI survey shows that small firms set the highest hurdle rates - averaging 24
per cent. Two thirds of all firms said that projects which failed to meet the
required level of return were seldom or never given the go-ahead.