Introduction

An investment is an asset or item acquired with the goal of generating income or appreciation.
Appreciation refers to an increase in the value of an asset over time. When an individual
purchases a good as an investment, the intent is not to consume the good but rather to use it in
the future to create wealth.
An investment always concerns the outlay of some resource today—time, effort, money, or an
asset in hopes of a greater payoff in the future than what was originally put in. For example, an
investor may purchase a monetary asset now with the idea that the asset will provide income in
the future or will later be sold at a higher price for a profit.

Investment
Investment is traditionally defined as the "commitment of resources to achieve later benefits". If
an investment involves money, then it can be defined as a "commitment of money to receive
more money later". From a broader viewpoint, an investment can be defined as "to tailor the
pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows".
In finance, the purpose of investing is to generate a return on the invested asset. The return may
consist of a gain (profit) or a loss realized from the sale of a property or an investment,
unrealized capital appreciation (or depreciation), investment income such as dividends, interest,
or rental income, or a combination of capital gain and income. The return may also include
currency gains or losses due to changes in foreign currency exchange rates.

Types of Investments

Today, investment is mostly associated with financial instruments that allow individuals or
businesses to raise and deploy capital to firms. These firms then rake that capital and use it for
growth or profit-generating activities. While the universe of investments is a vast one, here are
the most common types of investments:

Stocks: A buyer of a company's stock becomes a fractional owner of that company. Owners of
a company's stock are known as its shareholders and can participate in its growth and success
through appreciation in the stock price and regular dividends paid out of the company's profits.

Bonds: Bonds are debt obligations of entities, such as governments, municipalities, and
corporations. Buying a bond implies that you hold a share of an entity's debt and are entitled to
receive periodic interest payments and the return of the bond's face value when it matures.

Funds: Funds are pooled instruments managed by investment managers that enable investors to
invest in stocks, bonds, preferred shares, commodities, etc. Two of the most common types of
funds are mutual funds and exchange-traded funds or ETFs.

Investment Trusts: Trusts are another type of pooled investment. Real Estate Investment
Trusts (REITs) are one of the most popular in this category. REITs invest in commercial or
residential properties and pay regular distributions to their investors from the rental income
received from these properties. REITs trade on stock exchanges and thus offer their investors
the advantage of instant liquidity.

Alternative Investments: Alternative investments is a catch-all category that includes hedge

funds and private equity. Hedge funds are so-called because they can hedge their investment
bets by going long and shorts on stocks and other investments. Private equity enables
companies to raise capital without going public. Hedge funds and private equity were typically
only available to affluent investors deemed "accredited investors" who met certain income and
net worth requirements. However, in recent years, alternative investments have been introduced
in fund formats that are accessible to retail investors.

Options and Other Derivatives: Derivatives are financial instruments that derive their value
from another instrument, such as a stock or index. Options contracts are a popular derivative
that gives the buyer the right but not the obligation to buy or sell a security at a fixed price
within a specific time period. Derivatives usually employ leverage, making them a high-risk,
high-reward proposition.

Commodities: Commodities include metals, oil, grain, and animal products, as well as financial
instruments and currencies. They can either be traded through commodity futures which are
agreements to buy or sell a specific quantity of a commodity at a specified price on a particular
future date or ETFs. Commodities can be used for hedging risk or for speculative purposes.

The Determinants of Investment

The level of investment in an economy tends to vary by a greater extent than other components
of aggregate demand. This is because the underlying determinants also have a tendency to
change.
The main determinants of investment are:
The expected return on the investment
Investment is a sacrifice, which involves taking risks. This means that businesses, entrepreneurs,
and capital owners will require a return on their investment in order to cover this risk, and earn a
reward. In terms of the whole economy, the amount of business profits is a good indication of the
potential reward for investment.
Business confidence
Similarly, changes in business confidence can have a considerable influence on investment
decisions. Uncertainty about the future can reduce confidence, and means that firms may
postpone their investment decisions until confidence returns.
Changes in national income
Changes in national income create an accelerator effect. Economic theory suggests that, at the
macro-economic level, small changes in national income can trigger much larger changes in
investment levels.
Interest rates
Investment is inversely related to interest rates, which are the cost of borrowing and the reward
to lending. Investment is inversely related to interest rates for two main reasons.
Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a rise in
interest rates increases the return on funds deposited in an interest-bearing account, or from
making a loan, which reduces the attractiveness of investment relative to lending. Hence,
investment decisions may be postponed until interest rates return to lower levels.
Secondly, if interest rates rise, firms may anticipate that consumers will reduce their spending,
and the benefit of investing will be lost. Investing to expand requires that consumers at least
maintain their current spending. Therefore, a predicted fall is likely to discourage firms from
investing and force them to postpone their investment decisions.
General expectations
Because investment is a high-risk activity, general expectations about the future will influence a
firm’s investment appraisal and eventual decision-making. Any indication of a downturn in the
economy, a possible change of government, war or a rise in oil or other commodity prices may
reduce the expected benefit or increase the expected cost of investment.
Corporation tax
Firms pay corporation tax on their profits, so a reduction in tax increases the profits they retain
after tax is paid, and this acts as an incentive to invest. There current rate of 20% will fall to 19%
in 2017, and then to 18% in 2020.
The level of savings
Household and corporate savings provides a flow of funds into the financial sector, which means
that funds are available for investment. Increased saving may reduce interest rates and stimulate
corporate borrowing and investment.
The accelerate effect
Small changes in household income and spending can trigger much larger changes in investment.
This is because firms often expect new sales and orders to be sustained into the long run, and
purchase larger quantities of capital goods than they need in the short run.
In addition, machinery is generally indivisible which means it cannot be broken into small
amounts and bought separately. Even small increases in demand can trigger the need to buy
complete new machines or build entirely new factories and premises, even though the increase in
demand may be relatively small.
Difference between Gross Investment and Net Investment

Criteria Gross Investment Net Investment

Refers to the total expenses when Refers to the true expenditure incurred
purchasing capital goods over a period when purchasing capital goods over a
Definition
wherein depreciation isn’t accounted period of time with depreciation accounted
for. for.

Gross investment = Sum of all capital Net investment = Gross investment –

Formula
expenses over time Depreciation

Gross investment does not take into Net investment considers the impact that
Depreciation
account depreciation. depreciation has.

Gives you an idea of how much money

Gives you a true understanding of the
Value has been spent on capital goods in their
money spent on capital goods.
entirety.

Difference between Marginal Efficiency Of Capital (MEC) and Net Present

Of Value (NPV)
Marginal Efficiency of Capital Marginal Efficiency of Investment
(MEC) (MEI)

Meaning The MEC is a concept that The MEI is the expected rate of
describes the expected rate of return on investment for additional
return on investment, given the units of investments made over a
supply price of capital. period, given the induced changes in
demand for capital.
What it does The MEC determines the expected The MEI helps to determine the net
rate of return on investment and level of investment in the
helps to determine the optimal economy, given the expected
level of investment in the returns on investment and changes
economy. in demand for capital.

The measuring The MEC measures the expected The MEI measures the return on
component rate of return on an investment investment for a firm or the economy
relative to the cost of investment. as a whole, given changes in demand
for capital.
Determinants The determinants of the MEC The MEI’s determinants include
include the expected returns on the firm’s production function, the
investment, the productivity of demand for its output, and changes in
 capital goods, and the supply price the demand for capital.
of capital.

Difference between Fixed Investment and Inventory Investment

Basis of Fixed Investment Inventory Investment

Comparison

Meaning It refers to expenditure incurred It refers to expenditure incurred on the

on the purchase of fixed assets or purchase of raw material, semi finished
capital goods. or finished goods.

Purpose Here, the purpose is to continue Here, the purpose is to meet the
further production. demands of consumers in case of a
shortage.

Can be It can also be known as Capital It can also be known as Working

known as investment Capital investment.

Considered Here, the investment can be And, this investment can be considered
as considered as an expenditure on as expenditure on income yielding
long-term assets. short-term assets.

Resale of In this type of investment, the Here, the inventory is not meant to be
assets assets are not meant to be resold at resold immediately but stays in stock to
any period of time. raise inventory level.

Calculation The stock of fixed assets at the end Inventory stock at the end of the year –
of the year – Stock of fixed assets Inventory stock at the beginning of the
at the beginning of the year. year.

Significance In short, it leads to a higher rate of Generally, it avoids the uncertainties

economic growth. related to price and availability of
raw material

The Keynesian Investment Theory

According to the classical theory there are three determinants of business investment, viz.,
(i) cost, (ii) return and (iii) expectations.
According to Keynes investment decisions are taken by comparing the marginal efficiency
of capital (MEC) or the yield with the real rate of interest (r).

So long as the MEC is greater than r, new investment in plant, equipment and machinery
will take place.

However, as more and more capital is used in the production process, the MEC will fall due
to diminishing marginal product of capital. As soon as MEC is equated to r, no new
investment will be made in any income-earning asset.

Marginal Efficiency of Capital:

The marginal efficiency of capital (MEC) is the rate of discount that equates the present
value of cash flows from an income-earning asset to its cost. It determines the break-even
point for a project, based on expected profits and expected decline through price reductions
or increases in raw materials and fuel costs. The MEC is different from the marginal product
of capital, which only considers the immediate effect of additional capital on output. The
amount of investment depends on expected returns and the cost of capital, with profitability
reaching the point where the marginal efficiency of capital equals the cost of capital.

It will be readily apparent from Fig. 18.1 that there is a link between the monetary side of
the economy and the real economy a fall in interest rates will stimulate more investment,
which, in its turn, will result in a higher level of national income.

If expectations change and investors expect to receive better returns from each investment
— because, for example, of technological progress — then at any given rate of interest such
as 20%) more investment will be undertaken than before; that is, the marginal efficiency of
capital schedule will shift to the right, as shown in Fig. 18.1(b), and investment will
increase from OI2 to OI0.
The MEC is calculated by using the following formula:

where C0 is the purchase price of the machine in the base year, R1, R2, etc. are the expected
cash flows from the machine in the first, second and subsequent years and e is the MEC
which acts as the balancing factor. It makes the two sides of the above equation equal. Here
Rn is the expected cash flow from the machine in the last year which also includes the scrap
value of the machine.

It may be noted that e varies directly with r and inversely with C0, i.e., the initial cost of
purchasing the machine. A simple method of calculating e for an infinitely durable capital
good is available. In this case the economic life of the machine (which depends on the
annual rate of depreciation) is not known. We know that

The term R is called by Keynes the expected (prospective) rate of return on new investment
(the machine) and C0 is the purchase price of the machine. If e exceeds r, an income-earning
asset like a machine should be purchased.

Math: Suppose you have an opportunity to purchase an asset which costs Rs. 1,000. It is
expected to yield Rs. 585 at the end of the first year and Rs. 585 at the end of the second
year (and zero thereafter). If the market rate of interest is 10%, is it to your advantage to
purchase the asset? Explain your answer.

Factors Determining Investment:

Anything which increases a firm’s profit prospects by increasing R will increase its level of
investment. On the other hand, if the purchase price of capital (C 0) increases, investment
will fall.

The following factors affect a firm’s investment decisions:

 Increased optimism among managers

 An increase in the growth rate of the economy
 An increase in capital stock
 A change in technology
 Changes in the rate of interest

Conclusion
Investing is an effective way to put your money to work and potentially build wealth. Smart
investing may allow your money to outpace inflation and increase in value. The greater growth
potential of investing is primarily due to the power of compounding and the risk-return tradeoff.
Investment adds to the stock of capital, and the quantity of capital available to an economy is a
crucial determinant of its productivity. Investment thus contributes to economic growth.