Investment means spending money on an asset to generate future income. It’s a fundamental element in the economy, it stimulates economic growth through job creation and increased consumption.
Many theories attempt to explain and influence markets and investor behavior within them. The most discussed are:
The Accelerator Theory of Investment
Accelerator theory assumes that investment increases when either demand or incomes increase.
According to the accelerator theory, firms respond to increased economic growth in the economy by increasing investment.
Because when the demand increases, companies want to increase their production capacity too to align with the demand for the goods and services.
In the opposite situation, if the economy slows down, firms may reduce their investment in response to decreased demand.
The main idea of this theory is that investment is a function of the change in outputs.
When the growth rate of GDP exceeds the expected or normal rate, it creates a gap between the existing production capacity and the demand for goods and services.
This gap, or the “acceleration principle,” motivates firms to invest in additional capital to close the gap and meet the increased demand.
The Internal Funds Theory of Investment
According to this theory, firms are more likely to rely on their internal funds, generated through retained earnings, to finance their investment activities.
The theory suggests that firms prioritize internal financing for several reasons.
First, internal funds do not incur transaction costs associated with external financing, such as fees for issuing new equity or debt.
Second, relying on internal funds allows firms to maintain control and flexibility over their investment decisions without being subject to external constraints imposed by creditors or shareholders.
Also, the internal fund theory assumes that companies with financial capacity are more interested in investing in long-term strategies and plans because of the stable and independent source of financing.
The Neoclassical Theory of Investment
According to this theory, firms make investment decisions based on the comparison between, the expected incomes and the costs.
This means that firms will invest in projects or assets that are expected to generate a rate of return that is greater than the cost of capital.
Consequently, changes in output, or changes in the price of capital services relative to the price of output, change the desired stock of capital and thus change investment.
The neoclassical theory of investment suggests that investment decisions are primarily driven by factors such as interest rates, expected future profits, and the cost of capital.
When interest rates are low, the cost of borrowing is reduced, making investment more attractive. Higher expected profits also increase the incentive for firms to invest.
Conclusion
While these theories are useful to know, it’s also important to remember that no single theory can explain the world of finance or investing.
In the world of finance, change is the only real constant.