An Isoquant Approach to Investment Decision Problems
The given notes constitute an attempt to solve, through the use of isoquant analysis, the problem of optimal investment decisions (in business parlance, the problem of capital budgeting). The initial section reviews the principles laid down in Irving Fisher's justly famous works on interest, to see what light they shed on two competing rules of behavior currently proposed by economists to guide business investment decisions--the Present-Value Rule and the Internal-Rate-of-Return Rule. The main concern is to show how Fisher's principles must be adapted when the perfect capital market assumed by Fisher in his analysis does not exist--in particular, when the borrowing and lending rates diverge, when capital can be secured at an increasing marginal borrowing rate, and when capital is 'rationed'. Finally, an error by Fisher in his treatment of multi-period investments which has been the source of much difficulty is corrected. In doing so, support is given the contentions of those who reject the internal rate of return as an investment criterion, showing more clearly, it is believed where the error lies and how the internal rate would have to be redefined if it is to be used as a reliable guide.
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