Page 93 - DECO402_Macro Economics

Macroeconomic Theory

Notes A A A A A
PV = 1 + 2 + 3 + 4 + 5
(1 r+ ) (1 r+ ) 2 (1 r+ ) 3 (1 r+ ) 4 (1 r+ ) 5
1,000 1,000 1,000 1,000 1,000
= + + + +
(1 0.12+ ) (1 0.12+ ) 2 (1 0.12+ ) 3 (1 0.12+ ) 4 (1 0.12+ ) 5

1,000 1,000 1,000 1,000 1,000
= + + + +
(1.12 ) (1.12 ) 2 (1.12 ) 3 (1.12 ) 4 (1.12 ) 5
= 892.86 +797.20 +711.78 + 635.52 + 567.43
= 3,604.79 rupees
It is clear, rupees 3604.79 (present value)>3500 rupees (present cost)
An alternate approach can be used by investor, under which the related rate of return (i) is found and
it is compared to market rate of interest (r), on which the loanable funds are available for purchasing
that asset. To estimate the relative rate of return, all expected receipts are so discounted perfectly that
their total current price becomes exactly equal to replacement rate. This discount rate which makes the
total current price of expected annual income series in its life time from capital asset equal to capital
price of the asset is called as Marginal Efficiency of Capital. In following formula, (i) is the Marginal
Efficiency of Capital.
A A A A
C = 1 + 1 + 1 + ............ + n
( ) i + ( ) i + l 2 ( ) i + l 3 ( ) i + l n
l
Here A , A , A , ……………………..A are the relative expected incomes in the end of first, second,
3
2
1
n
third, fourth, …………….. nth year. C is the supply price of asset and i is the relative rate of return
from capital asset. For a definite value of C and A , A , A , ……. A the unique price which satisfy this
1 2 3 n
equation, is called the Marginal Efficiency of Capital (MEC). In Keynes words the Marginal Efficiency
of Capital “is that rate of discount which makes the total current price of expected annual income
series in its life time from capital asset equal to capital price of the asset.”

Self Assessment
Multiple Choice Questions:
3. The mean of financial investment is the right of..................... from one person to another.
(a) transfer (b) non-transfer
(c) expenditure (d) none of These.
4. When a buyer is investing, the other (seller) is..........................
(a) investment (b) disinvestment
(c) sell (d) buy
5. Investment is called hold or ................ investment.
(a) minimum (b) maximum
(c) intended (d) none of These.
6. Unplanned investment is .................... from entrepreneur’s side.
(a) constrain Investment (b) divestment
(c) structured investment (d) none of these.

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