Determinants of Investment

2 February 2017

Industrial sector in India has been undergoing significant changes both in its structure and pattern owing to the policy changes. Since the early 1950s up until the early 1980s the evolution of manufacturing sector was guided by protected industrial and trade policies, which restricted the growth of the economy in general and manufacturing sector, in particular.

Under old industrial and trade policy regime, manufacturing sector was characterized by extensive public sector participation, regulation of the private sector firms, restrictions on foreign investment, high tariff and non-tariff restrictions on imports, which held up the growth of the manufacturing sector in India. This has been replaced by a more liberal industrial and trade policy regime, through the inception of new economic policy in 1991.

Determinants of Investment Essay Example

The major focus of these policies had been to dismantle the complex web of controls that severely constrained the emergence and operation of the private entrepreneurs. Investment performance has been a key emphasis in the policy debate following the reforms (Athukorala and Sen 1998). It is observed that new policies have made tremendous effects on the industrial sector, in terms of conducive business environment and future growth process of industries. Understanding of the behaviour of investment provides an important insight into the process of economic development.

The economic growth critically depends on capital accumulation and it stems from investment. The economy’s productive capacity can be expanded by investment spending as a dynamic variable, on long life capital goods which embody technical advance. However, recent theoretical and empirical studies on the determinants of investment focused on the role of government policy and tried to derive an explicit relationship between the principal policy instruments and private investment (Blejer and Khan 1984, Greene and villaneuva 1991).

More importantly, as evidenced in many research works (1), it is the private investment that plays a greater role than public investment in determining economic growth in developing countries. Investment refers to increase in the total assets of a corporation, where new investment consists of addition to its assets, which enables it to produce more output. The growth in industrial output is primarily associated with new investment in plant and machinery. If firms are confident that demand will remain buoyant, they invest more in new plant and machinery which generate even more demand.

The escalating domestic demand and growing export orientation has brought an upsurge in the Indian manufacturing sector. Phenomenal growth is registered in automobile sector, iron and steel, machinery and equipment, including transport and basic chemicals sector in recent years. Emphasizing the role of private investment in determining economic growth in a developing economy, a short run analysis of investment determinants becomes crucial for understanding year to year changes in industrial performance.

In this paper, we made an attempt to assess the determinants of investment patterns of Indian Manufacturing sector over the years, at an aggregate level of major industry groups. The aim of this paper is to examine the role of accelerators and financial variables affecting on investment. The broad objective is to investigate, the significance of internal funds as a source of finance and the role of external funding (debt and equity) for industries in determining investment, which are usually channeled towards growing and profitable industries.

It is observed that an extensive volume of research works have emerged, both at the theoretical and empirical levels, to counter the above issues. Theoretically, in modeling the determinants of investment behaviour of a firm, five broad approaches are considered; which include the simple accelerator model, the liquidity theory, the expected profits theory and the neo classical theory of investment. One of the first theories of investment and the base for other approaches was the simple accelerator model, (Clarke, 1917) which maintains expected future sales as the main determinant of investment.

This acceleration concept hypothesized a direct functional relationship between a rate of change in a flow and additions to a stock, (Meyer. J and Edwin Kuh, 1955). Specifically, additions to the stock of physical capital were considered, as a simple function of the rate of change in output. This model was soon transformed into the flexible accelerator model of investment behaviour (Chenery, 1952 and Koyock, 1954), which states that, the adjustment of capital stock to the desired level is not instantaneous because of delivery lags and delayed responses to changes in the level of demand.

They incorporated financial variables along with future sales as the determinant for investment decisions, where they assumed the level of desired capital to be proportional to output. There are other theories, which are propounded as alternatives to the rigid accelerator theory i. e. Liquidity theory and Expected Profits theory. In the liquidity theory of investment behaviour, desired capital is proportional to liquidity (Jorgenson and Calvin D. Siebert 1968), where as in expected profits theory desired capital is proportional to profit.

The Profits theory holds that the amount of investment spending depends on the amount of profits that firms and industries are making i. e. profit expectations determine investment behaviour. As, against the above investment theories, the neo classical investment path, based on firm profit optimization, has been most dominant in applied research (Robert. S. Chirinko 1993). There are two major variants of this approach; one is the user cost of capital model, pioneered by Dale Jorgenson (1963), which postulates that output levels and user cost of capital are the two key determinants of investment.

The theory of a profit maximizing firm, subject to a production function through which a technical relationship between inputs and outputs get defined is central in the neo classical model. The model assumes flexible accelerator prices and capital markets. The other variant of the optimizing approach is the [q. sup. 2] theory pioneered by Tobin (1969), which incorporates Keynes’s analysis of share (stock) price instability into fixed investment volatility. According to Tobin, firm investment opportunities are summarized by the market value of its capital stock.

In particular, firm investment expenditure is positively related to average q (also known as Tobin’s q) defined as the ratio of the market value of the firm to the replacement cost value of its assets. The use of q is based on the idea that investment opportunities can be captured by equity market. On the other hand, a vast literature (3) suggests that in addition to real sales growth and the user cost of capital, financial factors are also imperative in explaining short-run fluctuations in investment. However, irms first utilize internal funds for investment purposes so as to maintain their control.

But, the external finance is also sought for financing their investment plans if the desired rate of growth is higher than that permitted by the internal finance. According to financing hierarchy hypothesis, i. e. Myers (1984) “pecking order” theory of financing, the firm’s capital structure will be driven by the desire to finance new investments, first internally, then with low-risk debt, and finally with equity only as a last resort.

In contrast, transaction costs / or information asymmetries induce a cost premium that makes external finance an imperfect substitute for internal finance (4). Therefore, in a world of heterogeneous firms, financing constraints would clearly influence the investment decisions of firms. In particular, investment may depend on financial factors, such as availability of internal finance, access to new debt or equity finance, or the functioning of particular credit markets.

In the following empirical works where we found the contradictory views regarding investment determinants. The studies, like Dhrymes, P. J. , and M. Kurz (1967), Sachs, Reynolds and Albert. G. Hart (1968), investigated the determinants of fixed investment in a broader way, where they determined the structure underlying the dividend–investment–external finance triad of decision making process and found external finance activity of firms to be strongly affected by their investment policies.

They indicated the considerable relevance of accelerator and profit theories in explaining the empirical behaviour of investment. Krishnamurthy. K and Sastry (1971, 1975), Bhattacharya. S (2008), also argued along similar lines, found the positive effects of accelerator, retained earnings and flow of external finance in determining investment behaviour of Indian manufacturing sector. These studies claim a significant support for the investment–accelerator relationship. Similarly, Bilsborrow E.

Richard (1977) analyzed the determinants of investment of manufacturing firms with different institution and cultural context of a developing country study of aggregate Colombian firms, where along with the accelerator and financial variables he appraised the importance of foreign exchange as a significant influence on annual variation in investment. Recent empirical works (5), revealed the dependence of investment on financial factors. Hubbard. G, (1998) emphasized on the contemporary models of capital market imperfection and the implications of these models in firm’s investment process.

The study considers the applications of these models to a range of investment activities including research on inventory investment, research and development, employment, business formation, survival, pricing and corporate risk management. However, identifying a specific channel (debt covenants) and the corresponding mechanism (transfer of control rights) through which financing frictions impact corporate investment, Chava. S and Michael. R. Roberts, (2008), show that capital investment declines sharply following a financial covenant violation, when creditors use the threat of accelerating the loan to intervene in management.

Further, the reduction in investment is concentrated in situations in which agency and information problems are relatively more sever, highlighting how the state-contingent allocation of control rights can help mitigate investment distortions arising from financing frictions. On the other hand, Cava La, Gianni (2005), Bond. S and Costas Meghir (1994), explored the impact of financial factors on corporate investment, and indicated the severity of financing constraints of firms. The study on innovation is that they distinguish financially distressed firms from financially constrained firms.

The presence of financially distressed firms appears to bias downwards the sensitivity of investment to cash flow. The paper also explores the effects of cash flow on investment, where the availability of internal funding could significantly affect the investment of financially constrained firms. Real sales and the user cost of capital, which incorporates both debt and equity financing costs, also appears to be an important determinant. Their views have been contradicted to some other studies which argue for the government intervention in the allocation of investment finance (6).

Emphasizing on the implications of the recent structural adjustment policy reforms of 1990s, for investment behavior Athukorala and Sen (1996) examined the determinants of private corporate investment in India. The results of their econometric analysis suggest that the net impact of the reforms on corporate investment has been salutary. The decline in real public sector investment brought about by the fiscal squeeze carried out as part of the reforms seems to have had a significant adverse impact on corporate investment.

However, this adverse impact was outweighed by the salutary effects of the reform process on investment operating through the decline in real rental cost of capital and favourable changes in investor perception in the aftermaths of the reforms. Finally, they indicated the strong complimentary relationship of public investment with private corporate investment in India. The previous empirical studies focused on investment determinants, on the manufacturing sector as a whole for the pre and post reform period, with the variables such as level of output, expected future earnings, cost of capital, profits, and bank credit.

How to cite Determinants of Investment essay

Choose cite format:
Determinants of Investment. (2017, Feb 02). Retrieved July 29, 2021, from
A limited
time offer!
Save Time On Research and Writing. Hire a Professional to Get Your 100% Plagiarism Free Paper