To see why the cost of capital is considered to be a significant influence on firms’ investment, we can consider first the capital budgeting decision of firms It would have been beneficial to note why investment and therefore understanding the determinants of investment is important –for example investment is a key element for economic growth, also a significant component of aggregate demand.To see the impact of the cost of capital,(given the question some comment on the measurement/definition of the cost of capital prior to the discussion on different theories) we should know how individual firms decide on the level of investment. There are two widely used rules for investment decision.1. The Net Present Value Rule2. The Internal Rate of Return RuleThe Net Present Value(NPV) RuleThe equation of the Net Present Value rule is as followsNote that equation is meaningless unless notation is explained. For example what does CF denote.Using the summation sign , the equation is as followsIf NPV is positive we should take the project, if NPV is negative we should not. That is the NPV rule.Imagine that the firm considering to invest $200 in year 0, and the project is expected to get $110 in year1, and $120 in year2.Then the Cash Flow is as followsCF = -200 + 110 + 120 = +30In this case, we didn’t consider the time value of money.If the interest(discount) rate is 10%, then NPV is as follows.NPV = -200 + 110/(1+0.1) + 120/(1+0.1)2= -200 + 100 + 99.17= -0.83The NPV of this project is negative so it should be rejected.If the interest rate is 5%, then NPV change as follows.NPV = -200 + 110/(1+0.05) + 120/(1+0.05)2= -200 + 104.76 + 108.84= +13.60The NPV is positive, so it can be accepted to invest.Through this simple calculation example, we can understand the effect of the change of the interest rate on investment decision.Pleased to see you utilize examples to illustrate the NPV decision rule.The Internal Rate of Return RuleThe Internal Rate of Return(IRR) rule is measured by calculating what discount rate i* would cause the project’s NPV to be zero.In the equation, i* is the IRRIf the IRR(i*) of the project is greater than the discount rate than we should invest in the project. That’s the IRR Rule of investment decision.If we assume that the interest rate at which the firm can both borrow and lend is cost of capital, the firm should invest the project when the IRR of the project is greater than the interest rate.There are many other capital budgeting decision rules, which are ‘payback rule;, ‘hurdle rate’, ‘profitability index’, ‘free cash flow’, ‘economic value added’, etc.Interest rates and InvestmentIn equation of the NPV, assuming i as the interest rate, the NPV is lower when the interest rate is higher. And the NPV is higher when the interest rate is lower.So, when the interest rate is high, more projects will be rejected than when the interest rate is low.In the view of macro economy, when the interest rate is high, the size of aggregate private investment will be smaller than when it is low. Because logically every firm will decides their investment projects on the bases of NPV rule.Consequently, there is negative relation between investment and the interest rate in economy.In macroeconomics, the aggregate investment function can be described as follows.withIt means the private investment is the function of the interest rate when other things unchanged, and a change in the interest rate leads to a change of the investment in opposite direction.Main point noted.There is different story about cost of capital. Warren Buffet, chairman and chief executive of Berkshire Hathaway put ‘Forget formulae and trust gut instinct’ in Financial Times 14 May 2003. I agree with the idea that only data analysis can not be a absolute determinant of investment, We should use our common sense and experience when decide to invest or not.But guideline from the formulae is needed for normal investor, because our insight sometimes go wrong and its consequence is enormous.The assumptions of the NPV RuleDiscussion is a little disjointed, for example assumptions of the NPV model should have been considered prior to giving formula and example.The difficult part of decision is uncertainty and time, but this rule focus on time and leave uncertainty is not exist.In reality, there are many risks or uncertainty. And more complex and recent model is considering risk factor.And in the NPV rule we assume that the discount rate equals the interest rate at which the firm can both borrow and lend at the same rate without limitation. In other word, there is perfect credit market.In fact, there are many sources of finance in corporate. These are main 3 types of financing source.1. various distinct forms of credit(bank loan, corporate bonds, bills)2. new issues of shares3. internal fundsSo, the company uses the cost of capital which is combined with many types of finance.Pleased to see consideration given to some of the limitations of the model although there are more that could have been considered. I would also liked to have seen some empirical evidence in relation to this model.There are different models of investment.Tobin’s q Theory of investment and the influence of stock marketsTobin’s “q” is ‘the ratio between the value of firm’s shares and the replacement cost of it’s capital stock.‘ (David Miles and Andrew Scott)If company A’s valuation of shares is $150million, and the company’s replacement cost of capital, for example, plant, machines, new workers is $100million, then it’s good decision to invest more in capital stock.In this example, Tobin’s q is 1.5 ( = 150/100). Normally, we can think that when q is larger than 1 it’s good to invest, and when q is less than 1 it’s better not to invest.A very brief discussion of the q theory and no mention of the cost of capital.When valuating corporations in a stock market, expectation on future profits of the company is one of the important factors. If there is a boom like dot.com bubble in 1996~2000, Market valuation was so high, and the stock of physical capital was so low due to the over investment on branding and software innovation, consequently Tobin’s q was meaningless.But empirical evidence does not support Tobin’s q theory fully. The change is US stock prices and the change in private sector investment in US doesn’t have high correlation, according to the figure13.8 in the book, Macroeconomics (David Miles and Andrew Scott).The reason why Tobin’s q theory couldn’t acceptable fully in the country like US is explained by the hypothesis called “short termism” – what is short-termismIf short termism does exist, corporation will reduce the project which produces profit over the long term, and increase the project which produces profit in the short term.The short termism is maybe due to the shareholder’s impatience. It means they use higher discount rate, i, in the formulae of DCF(NPV).If higher discount rate is applied, long term CF is affect more than short term CF, because in the short term discountIn countries where the stock market was really significant and takeovers often shifted corporate control, the firms have to pay too much attention to their stock price and short-term change in equity prices have over influence.Another explanation of low relationship between stock market and investment in reality is high financing investment rate from internal funds than external finance (bonds or equities). In the US, the ratio of financing from internal funds is 94.0% during 1970~94. It’s 95.6% in UK.High reliance on internal funds to finance investment suggests that a change of current profits can have much more influence on investment decision. It’s reasonable thought.But it is hard to find empirical evidence about it. Because current profit go with future profitability of investment, so there is positive relationship between current profits and future profitability and investment expenditure.If it’s true of current profit hypothesis, then business cycle of macro economy will be exacerbated.Pleased to see consideration given to empirical evidence.Financing hierarchy theoryIn the previous section, we assumed that a corporate can lend any time they want with any amount and can issue new shares freely. In other words, different sources are perfect substitutes.But in reality, it may not. There might be preference of sources of finance. The firms prefer internal funds to external funds.The reason why is that tax benefit, transaction cost with various fees, agency problems, cost of financial distress, and asymmetric information.A theory that explaining preference for internal funds is ‘asymmetric information’. Because financier don’t have the same information as firm’s managers about risk and profitability of the project, they might charge high price of finance on low risk project.It can be explained using ‘lemons’ problem by George Akerlof. New shareholders will require a premium for a share of good firm to recover possible loss from bad choice.Asymmetric information problem also applied to bond markets. So, borrowers have to pay premium of uncertainty about goodness of the firm to the lenders.Figure 1. Investment and Financing Decisions (Fazzari, Hubbard and Petersen, 1988)This is one explanation of financing hierarchy. The cost of internal finance is low, the cost of new share issue is high, and the cost of new debt financing is in the middle of 2 financing sources.The main implication of financing hierarchy theory is that some firms determine their investment by the quantity of a particular type of finance available. – that is the quantity of the firm’s current cash flow – see page 17 Unit 3.Small and medium enterprises have a difficulty of borrowing money from banks because of their low credit or uncertainty. And in countries with weak financial system, banks often unable to finance private industrial or agricultural investment.So, quantity of finance matters in many cases and it’s not a special event. We can think that quantity of finance is one of main factor which affect the level of investment.But it doesn’t mean that a change of interest rate by monetary policy don’t have impact on the level of investment. The channel of influence by interest rate is different from the price of finance model (cost of capital). – expand discussion to explain this statement.The financing hierarchy model is empirically valid. Because we can see the data which says that 4 main countries, Germany, Japan, U.K., U.S, are mainly financed by internal funds from 69,9% to 95.6% in a recent quarter-century period.(pp326, Table 13.2, Miles and Scott)This theory is supported by the study of Fazzari, Hubbard, and Petersen in 1988, and many others followed with same results.But also there was a challenge to the theory by a study of Kaplan and Zingales.ConclusionThere are many factors which have much influence on investment, for example, interest rate and quantity of finance, and stock market.There is no factor that has absolute impact on investment. Every factor have an important role in the investment theory so it’s hard to say a theory has much more influential than others.But in macro view of economy, the interest rate is most important to understand whole picture because a change of interest rate affect all corporate at the same time.Stock market or the quantity of finance has an effect on investment not by the same direction in total but it affect individual company by its situation. .Basic conclusion based on previous discussion.ReferencesDavid Miles and Andrew Scott, Macroeconomics : Understanding the Wealth of Nations, NY : Wiley, second edition, 2005.Graham John R and Harvey Campbell (2002) ‘How do CFOs make capital budgeting and capital structure decision?’, Jonural of Applied Corporate Finance 15:1, 2002, 8-23Kaplan Steven N and Luigi Zingales (1997) ‘Do investment-cash flow sensitivities provide useful measures of financing constraints?’ The Quarterly Journal of Economics, Vol. 112, No.1, (February) pp.169-215Miles David (1993) ‘Testing for short termism in the UK stock market’, The Economic Journal vol 103, number 421, pp.1379-96SM Fazzari, RG Hubbard and BC Petersen (1998) ‘Financing constraints and corporate investment’ Brooking Pagers on Economic Activity, Vol. 1998, No. 1, pp.141-95