The decision to invest in a new capital asset depends on whether the expected rate of return on the new investment is equal to or greater or less than the rate of interest to be paid on the funds needed to purchase this asset. It is only when the expected rate of return is higher than the rate of interest that investment will be made in acquiring new capital assets.
In reality, there are three factors that are taken into consideration while making any investment decision. They are the cost of the capital asset, the expected rate of return from it during its lifetime, and the market rate of interest. Keynes sums up these factors in his concept of the marginal efficiency of capital (MEC). Besides these, other factors which directly or indirectly influence capital investment decisions. They are discussed below:
(1) Marginal Efficiency of Capital (MEC):
The MEC means its productivity efficiency. In general, MEC shows the possible income from the additional capital investment. Any entrepreneur, before investing compares the prospective yield from the investment and the rate of interest for the loan taken for investment. If the rate of rerun (or MEC) from the capital is more than the rate of interest for that capital investment, then the entrepreneur will invest. But, if the rate of return is less than the rate of interest, then the entrepreneur will not invest. So, according to Keynes, the most important factor that influences the demand for capital for investment is the marginal efficiency of capital.
(2) Rate of interest:
The amount of investment is influenced by the marginal productivity of capital and the rate of interest. However, government investment is not influenced by these factors. Only private investment and entrepreneurs are affected by these factors. The investment is more affected by the marginal productivity of capital than the rate of interest. When marginal productivity of capital is more, investment increases even if rate of interest is high. Likewise, when marginal productivity of capital is low, investment diminishes even if rate of is very low.
(3) Technological changes:
Technology is the changing concept it changes day-by-day. The improvement in technology, increases the productivity of labour and capital. The selection of new technology depends on the net benefit over the cost of adopting technology. Thus, technological factors also affect investment.
(4) Demand Forecast:
The long-term demand forecast is one of the determinants of investment decisions. If the firm finds potential market for the product in the long-run, the firm will increase its present investment.
(5) Fiscal policy:
Various tax policies of the government relating the tax exemption on priority-based investment, rebate on new investment, method allowing depreciation deduction allowance, etc., also affects on capital investment.
(6) Cash Flow:
Every firm makes a cash flow budget. Its analysis influences capital investment decisions. On the basis of cash flow budget, the firm plans the funds for acquiring the capital assets.
(7) Outlook of management:
Investment decision depends on the outlook of management. If the management is modern and progressive in its outlook, the innovations will be encouraged. Innovations increase the output as well as profit of the firm. The modern and progressive management takes decision to invest. Therefore, outlook of management is most important determinant of investment at present time.