How does an increase in the interest rate affect the level of investment?

The key to answering this question is understanding that interest rates determine the cost of borrowing. If you borrow £1000 to buy a car at 10% annualised interest rate, your cost of borrowing would be less than if you borrowed £1000 from a different lender at 15% interest rate - a £50 lower cost of borrowing over the first year. This principle can be applied to firms - the economic agents responsible for investment in the capital stock (e.g. machinery, new workplaces, etc.).

If market interest rate increases, the cost of borrowing for firms will increase (see above). As a result of higher borrowing costs, the incentive to make new capital investments is lower. Why? Simply put, higher borrowing costs mean that any potential profits (returns on investment) will be lower from any given investment project. This means the risk to reward ratio increases (smaller reward), thus discouraging rational profit-seeking firms from starting new investment projects.

Note: This assumes 'ceteris paribus' holds true. This means that all factors, aside from the interest rate, remain equal. This is a good evaluation point for exams.