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There is a strong correlation between investments and Net Income in most companies. Therefore, rather than think of Net Investments as an absolute number, it is often more convenient to think of it as a percentage of net income, especially when preparing pro-forma financial statements for business plans, preparing cash flow streams for present value analysis, and so forth.

This is done by defining the Investment Rate IR in Year n as the ratio of NetInvestn in Year n to Net Income NIn in Year n (Equation [2-7]).

[2-7]

Rearranging, Equation [2-7] becomes:

[2-8]NetInvestn = (NIn)(IRn)

Equation [2-8] is the First Envelope Equation. It is the cornerstone of the Net Investment Version of the Envelope Equations because it defines Net Investment in terms of Net Income and the Investment Rate and will surface many times in the following sections.

Special Case: Constant Investment Rate

Equation [2-7] is a solid definition for the Investment Rate under all circumstances. As will be seen, its more useful form is Equation [2-8].40 However, in many companies the Investment Rate doesn't change much from one year to the next and, therefore, in numerous situations or as a first approximation the IR can be viewed as a constant. Dropping the subscript on IR accomplishes this. Hence, under these conditions Equation [2-8] becomes

[2-9]NetInvestn = (NIn)(IR)