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Unformatted text preview: 65 ECON110B IV. Expectations and Investment To show how investment decisions depend on current and expected profits, and on current and expected real interest rates To look at the movements in investment over time 1. Investment behavior Basic theory of investment: the present value of profits the firm can expect from having this additional machine - Present value of profits vs. the cost of buying the machine - The role of expectations 1) Investment and expectations of profit a. To determine whether to buy a new machine b. Depreciation - As time passes, more and more expensive to maintain and less and less reliable - Assumption: a machine loses its usefulness at rate - Numbers between 4% and 15% for machines and between 2% and 4% for buildings and factories 66 c. The present value of expected profits - Assumption: a machine bought in year t becomes operational and starts depreciating only 1 year later, in year t + 1 . - : real profit per machine i) The present value, in year t , of the expected profit in year t + 1 : - e t t r 1 1 1 + +- e t+1 : Expected profit in year t + 1 ii) The present value of the expected profit in year t + 2 : - e t e t t r r 2 1 ) 1 ( ) 1 )( 1 ( 1 + + + + - e t+2 : Expected profit per machine in year t + 2- Depreciation: Only ( 1 - ) of the machine is left in year t + 2- ( 1 - ) e t+2 : Expected profit from the machine in year t + 2 Computing the present value of expected profits 67 iii) The present value of expected profits - + + + + + = + + + e t e t t e t t e t r r r V 2 1 1 ) 1 ( ) 1 )( 1 ( 1 1 1 ) ( d. The investment decision - Simple assumption: the real price of machine = one- The firms decision on whether or not to buy the machine depends on the relation between the present value of expected profits and the price of the machine....
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