Question

Please discuss any 4 factors which affect the choice of investments securities.

Answer 1

Investment levels are influenced by:

1. Interest rates (the cost of borrowing)

2. Economic growth (changes in demand)

3. Confidence/expectations

4. Technological developments (productivity of capital)

5. Availability of finance from banks.

6. Others (depreciation, wage costs, inflation, government policy)

Main factors influencing investment by firms

1. Interest rates

Investment is financed either out of current savings or by borrowing. Therefore investment is strongly influenced by interest rates. High interest rates make it more expensive to borrow. High interest rates also give a better rate of return from keeping money in the bank. With higher interest rates, investment has a higher opportunity cost because you lose out the interest payments.

2. Economic growth

Firms invest to meet future demand. If demand is falling, then firms will cut back on investment. If economic prospects improve, then firms will increase investment as they expect future demand to rise. There is strong empirical evidence that investment is cyclical. In a recession, investment falls, and recover with economic growth.

3. Confidence

Investment is riskier than saving. Firms will only invest if they are confident about future costs, demand and economic prospects. Keynes referred to the ‘animal spirits’ of businessmen as a key determinant of investment. Keynes noted that confidence wasn’t always rational. Confidence will be affected by economic growth and interest rates, but also the general economic and political climate. If there is uncertainty (e.g. political turmoil) then firms may cut back on investment decisions as they wait to see how event unfold.

4. Depreciation

Not all investment is driven by the economic cycle. Some investment is necessary to replace worn out or outdated equipment. Also, investment may be required for the standard growth of a firm. In a recession, investment will fall sharply, but not completely – firms may continue with projects already started, and after a time, they may have to invest in less ambitious projects. Also, even in recessions, some firms may wish to invest or startup.

5. Wage costs

If wage costs are rising rapidly, it may create an incentive for a firm to try and boost labour productivity, through investing in capital stock. In a period of low wage growth, firms may be more inclined to use more labour-intensive production methods.