Thus, if it were to leave its decision until the uncertainty is resolved, and it discovers the outcome of the event, the firm would go ahead with the project only if the news was good. The probabilities of these outcomes, conditional on the event occurring, are 1-λ and λ respectively. As for the event itself, this has a per-period chance q of being realised. This means the expected duration of the uncertainty E[T] is equal to 1/q. If the firm expects to have to wait a long time for things to become clear this equates to a low value of q – there isn’t much of a chance, in any given period, of the uncertainty being resolved. A high value of q corresponds to an expectation that the resolution is imminent. 4  There is a direct parallel between the nature of this extra margin required for real investment decisions and the value of an option in financial markets. A financial “call” option gives its owner the right to buy an underlying security for a pre-set price, known as the “strike”. If the price of the security in the spot market rises above that level the owner can “exercise” the option and buy it for less than it’s now worth. In that sense he or she enjoys the same exposure to good news – to upside moves in the spot price – as the owner of the underlying security itself. The big difference is what happens when there’s bad news (i.e.
The blue line in Chart 10 measures profits of UK-quoted firms (including some that have operations outside the country) and, as the denominator, the market value of their capital (debt plus equity). Chart 11 subtracts the gilt yield from a national accounts measure of profitability: profits of firms located in the UK relative to the book value of their capital. But they’ve behaved in a similar fashion and convey very much the same message. 11  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  11  Chart 10: The required rate of return for UK firms  Chart 11: The combination of rising profit  has risen even as risk-free yields have fallen  margins, falling investment growth suggests significant increase in risk premium  Sources: Bank of England, Eikon from Refinitiv, TradeWeb, Bloomberg Finance L.P and Bank calculations. * Adjusted for changes in leverage. Sources: Bank of England, ONS and Bank calculations. UKCS are UK continental shelf companies. Before the crisis, rises in profitability (relative to interest rates) would lead to faster investment growth. That’s not been true in the past few years. Profits have been very healthy, relative to the existing stock of capital. The spread between the rate of return and the risk-free interest rate has risen significantly, from around 10% in the middle of the last decade to close to 15% today, a proportionate rise of 50%. On the face of it the financial incentive to expand capacity is very strong.