Reply To: Overinvestment


The present value of future revenue is found be discounting the future revenue by the factor (1+i) raised to the exponent corresponding to the future time period. For example, revenue to be earned after two years at 5 percent is discounted by 1.05 squared or 1.1025. So, $1,000 to be received two years from today has a P.V. of $907.03. Revenue to be earned ten years from now at 5 percent is discounted by 1.05 raised to the 10th power or 1.629. So $1,000 to be earned in ten years has a P.V. of $613.87. If the interest rate falls from 5 percent to 4 percent, then the corresponding discount factors are now 1.0816 and 1.480. So the 2 year discount falls by 1.9 percent while the 10 year discount falls by 9.2 percent.

So, for two investment projects of different time horizons, when the interest rate falls the discount on shorter term projects falls less than the discount on longer term projects. The result is that longer term projects gain in P.V. compared to short term projects.

To see the effect of a lowering of the interest rate on the length of the entire capital structure, take a look at Murray Rothbard’s illustration in chapter 8 of his book, Man, Economy, and State: