Monday, October 27, 2014

What we always believed about investment decisions

It is not the rate, but the cash flow that matters. From the latest paper by SP Kothari, we learn that interest rate declines have a small impact on whether new corporate investments projects are taken on. The key drivers are clearly an increase in profits and an increase in the return to shareholders. A increase in profits should mean that sales are improving and revenues are increasing. These are sure signs that expansion should be undertaken. An increase in returns to shareholders is telling the company that they are doing something good. The positive feedback is a reason for expansion. If the environment is better for taking on new investments, there will be new investments. The rate of interest is of secondary importance. 

Now we have had increases in profits and increases in shareholder return, but investment has lagged.  Or put differently, investments have not matched the retrenchment in consumer behavior.  What is the issue? There has been an increase in corporate leverage but buybacks are not new investments. Most important, there has still been a high degree of uncertainty on the future of return on investment. This is not going to be solved with just monetary policy.

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