More on Interest and Profitability

Of course, different investments will have different discounted present values, whatever interest rate is chosen. For a contrast, consider a six-year investment that (again) costs $100,000,000 now, pays nothing in the second year, and pays back $30,000,000 of net revenues for each of the next four years, but pays back nothing thereafter. Clearly, this investment pays back much faster. Table 2 shows the discounting for this investment, for, again, three interest rates. Again, we see that the six-year investment in unprofitable at a 7% interest cost, losing $5,031,460.10. Again, it is profitable at a 5% interest rate, netting $1,312,871.55. But the internal rate of return for this investment is 5.40% -- that is, at an interest cost of 5.40%, the six-year investment just breaks even.

Now, let's suppose that investors are considering undertaking both the 20-year and the 6-year investments. If the interest rate is below 5.40%, both investments are profitable and both investments will be made. If the rate of interest is between 5.40% and 6.25%, the twenty-year investment is profitable and is made, but the six-year investment is not profitable, and it will not be made. If the interest rate is above 6.25% neither investment is profitable and neither will be made.

Notice how investment declines as the rate of interest increases: first from $200 million to $100 million and then to nothing. This is the key to the influence of interest rates on investment.

The Marginal Efficiency of Investment