The demand for capital; investment:
Calculating the benefits of capital investment involves taking account of their timing.
There are 2 ways of approaching this question of timing, the present value approach and the rate of return approach.
1) Present Value approach -
To workout out the benefit of an investment (its MRP), the firm must estimate all the future earnings it will bring and then convert them to a present value.
Is the investment worthwhile?
If the machine (or other) costs less than the present value, it will be worth buying. However, if it costs more, the firm would be better off keeping its money in the bank and earning a rate of interest.
The difference between the present value of the benefits (PV ) of the investment and its costs (C) is known as the net present value (NPV).
2) Rate of return approach -
This rate of return is known as the firms 'marginal efficiency of capital' (MEC) or internal rate of return (IRR). The same formula is used as for calculating the PV.
The risks of investment -
- The future is uncertain and investment can therefore be risky
- Risk may also be incurred in terms of the output from an invesment
How is this risk accounted for when calculating the benefits of an investment?
Use a higher rate of discount. The higher the risk, the bigger the premium that must be added to the rate.