Abstract
We study how firms’ management can make effective investment decision under the influence of random interest rates. We define the threshold interest rate value below which investment can be effectively done and above which investment is not optimal. We use a stochastic differential equation with alternating drift to find the optimal investment policy under stochastic interest rate. One of our results indicated that, the optimal condition for investment expansion is when the interest rate is low and the profit level is high. Also, there exists the threshold interest rate value which forms the basis for investment decision of a company. Moreover, we revealed that it is not optimal for the managers to plan for firm’s business expansion when is already making extremely high profits. At the end we were able to confirm that business is generally more stable when the interest rates are lower than those when they are high. Since firms in emerging economies suffer most from interest rate fluctuations, they need more effective investment strategies. Monetary policy makers of such economies need to ensure low interest rates in order to promote firms’ investment and therefore boost the general economy.
Highlights
The variation of the interest rates affects business decision about how to save and invest [1] [2]
Studies have revealed that the impacts of interest rates on capital investment are more substantial in emerging market countries (EMCs) as compared to developed economies [2] [7] [9] [10]
We present a numerical determination of the threshold interest rate value
Summary
The variation of the interest rates affects business decision about how to save and invest [1] [2]. Décamps and Villeneuve [11], for example, study the interactions between dividend policy and investment decision in a growth opportunity and under uncertainty They consider a firm with a technology in place that has the opportunity to invest in a new technology that increases its profitability. In our study we model investment as related to revenue rather than the cash holding of a firm because we assume that from the collected revenue the decision is immediately made on whether to expand investment or consume (or pay dividend) Such a managerial decision is made depending on the level of the interest rate which is assumed to be a continuous stochastic process that can generally be modeled as a term structure.
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