Chapter 6. The Business-Investment Sector

Chapter 6The Business-Investment SectorCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-1Chapter ObjectivesThe three types of business firmsHow investment is carried outThe difference between gross investment and net investmentHow capital is accumulatedThe determinants of the level of investmentThe graphing of the C + I lineCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-2Proprietorships, Partnerships, and CorporationsProprietorshipProprietorships are owned by individuals and are almost always a small businessesGrocery stores, barbershops, restaurants, family farms, gas stations, etcAdvantages of a proprietorshipYou can be your own bossYour income is taxed only onceDisadvantages of a proprietorshipUnlimited liability Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-3Proprietorships, Partnerships, and Corporations (Continued)PartnershipPartnerships are owned by two or more peopleSome law and accounting firms have hundreds of partnersAdvantages of a partnershipIt is easier to raise more capitalThe work and responsibility can be dividedDisadvantagesPartnerships must be dissolved when one partner dies or wants to leaveUnlimited liability6-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.CorporationA corporation is a legal personMost corporations are small firmsCorporations are owned by the stockholdersIt is easier to raise money by selling stockMost corporations are not publicly heldProprietorships, Partnerships, and Corporations (Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-5CorporationAdvantagesLimited liabilityCorporations have potential perpetual lifeCorporations may pay lower federal taxesDisadvantages –You need a lawyer and have to pay a charter feeYou have to pay federal (perhaps state) corporate income tax Double taxationProprietorships, Partnerships, and Corporations (Continued)6-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-7Stocks and BondsStockholders are the OWNERS of a corporationCommon stock Voting rightsPreferred stock Receive a stipulated dividend No voting rights6-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Bondholders are CREDITORS rather than ownersMust be paid a stipulated percent of the face value of the bond whether or not the company makes a profitIf a company goes bankruptBondholders are paid off before stockholdersStocks and Bonds (Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-9A corporation’s total capital (capitalization)Consists of the total value of its stocks and bondsExample1,000,000,000 in bonds 500,000,000 in preferred stock2,500,000,000 in common stock4,000,000,000 capitalization (capitalized)Capitalization and Control6-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Theoretically, you would need 50% plus one share to control a corporationPractically, holding 5% of the common stock would probably give you controlMost economist believe that you need 10% of the common stock to be assured of controlMany stockholders don’t bother to vote or give their proxies to others Capitalization and Control (Continued)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-11The Business Population by Form of Legal Organization, 1997Form Number of FirmsProprietorships 17,176,000Partnerships 1,759,000Corporations 4,710,000Source: Statistical Abstract of the United States, 2001 6-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Business Population and Shares of Total Sales, 1997Source: Statistical Abstract of the United States, 2000Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-13Investment“Investment” is the thing that really makes our economy go and grow!Investment is any NEWPlant and equipmentInvestment is any NEWAdditional inventoryInvestment is any NEWResidential housing6-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Inventory InvestmentIncludes only net changeDate Level of InventoryJan. 1, 2003 $120 millionJuly 1, 2003 145 millionDec. 31, 2003 130 millionCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-15Inventory InvestmentIncludes only net changeDate Level of InventoryJan. 1, 2003 $120 millionJuly 1, 2003 145 millionDec. 31, 2003 130 millionStarted the year with $120 millionEnded the year with 130 millionThe net change is a (+) 10 million6-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Inventory Investment (Continued)Includes only net changeDate Level of InventoryJan. 1, 2003 $130 millionJuly 1, 2003 145 millionDec. 31, 2003 120 millionStarted the year with $130 millionEnded the year with 120 millionThe net change is a (-) 10 millionCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-176-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Inventory Investment, 1960-2000 (in billions of 1987 dollars)This is the most volatile sector of investment. Note that investment was actually negative during three recessionsInvestment in Plant and EquipmentInvestment in plant and equipment is more stable than inventoryEven in bad years companies will still invest a substantial amount in new plant and equipmentThis is mainly because old and obsolete factories, office buildings, and machinery must be replacedThis is the depreciation part of investmentCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-196-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Investment in Plant and Equipment, 1960-2000 (in 1987 dollars)There has been a strong upward trend in this investment sector over the last four decades. Note the periodic downturns, especially during recession yearsResidential ConstructionInvolves replacing old housing as well as adding to itFluctuates considerably from year to yearHas mortgage interest rates play a dominant roleCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-21InvestmentInvestment is the most volatile sector in our economyGDP = C + I + G + XnFluctuations in GDP are largely fluctuations in investment6-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Investment (Continued)Recessions are touched off by declines in investmentRecoveries are brought about by rising investmentCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-23How Do Savings Get Invested?Money saved is put into stocks and bondsBanks loan money based on their demand deposits and reserve requirementsBusinesses take this money and buy new plant and equipment, and add to their inventoryCorporations also use “retained earnings” and “depreciation allowances”6-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Gross Investment vs Net InvestmentIn the equationGDP = C + I + G + XnThe “I” represent gross investmentGross investment - depreciation = net investmentDepreciation is taking into account for the fact that plant & equipment wear out and houses deteriorateCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-25Gross Investment vs Net Investment (Continued) In the equationGDP = C + I + G + Xnthe “I” represent Gross InvestmentGross Investment - Depreciation = Net InvestmentDepreciation is taking into account for the fact that plant & equipment wear out and houses deteriorate. start the year with 10 machinesbought 6 machines (gross investment)worn out/obsolete - 4 machines (depreciation)end the year with 12 machinesactual gain of 2 machines (net investment)6-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Calculate Gross Investment and Net InvestmentDate level of inventoryJan 1 $60 billionJuly 1 55 billionDec 31 70 billionExpenditures on new plant & equipment $120 billionExpenditures on new residential housing $ 90 billionDepreciation on plant & equipment andresidential housing $30 billionCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-27SolutionDate level of inventoryJan1 $60 billionJuly 1 55 billionDec 31 70 billion inventory investment $ 10Expenditures on new plant & equipment new P & E 120 $120 billion new RH 90 Expenditures on new residential housing gross investment 220 $ 90 billion -depreciation - 30Depreciation on plant & equipment and net investment $ 190 Residential housing $30 billion6-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Building CapitalInvestment involves sacrifice (on someone’s part)To investWe must work moreWe must consume less (save)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-29Karl Marx “Capital is created by labor but stolen by capitalist”Assume it takes $3 to keep a person alive for 24 hoursAssume that one person can use a machine to produce $3 worth of cloth in 6 hoursThe capitalist owns the machine and pays $3 for 12 hours work12 hours of work produces $6 worth of clothCapitalist pays ------------> $3 wagescreates a surplus of ------->$ 36-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Determinants of the Level of InvestmentSales outlookCapacity utilization rateInterest rateExpected rate of profit (ERP)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-31The Sales OutlookYou won’t invest if the sales outlook is badIf sales are expected to be strong the next few months the business is probably willing to add inventoryIf sales outlook is good for the next few years, firms will probably purchase new plant and equipment 6-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Capacity Utilization RateThis is the percent of plant and equipment that is actually being used at any given timeYou won’t invest if you have a lot of unused capacityDuring recessions, why build more when you are not using all of what you haveOther factorsManufacturing is a shrinking part of U.S. economy due to imports and increasing investment overseas by U.S. CompaniesCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-33Capacity Utilization Rate in Manufacturing, 1965-2000Since the mid-1980s, our capacity utilization rate has been in the low 80s. Note that it fell during each recessionCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-34The Interest RateYou won’t invest if interest rates are too highInterest rate = The interest paid / The amount borrowedAssume you borrow $1000 for one year @ 12 %, how much interest do you pay?.12 = X$1000 X = $1206-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Interest RateYou won’t invest if interest rates are too highInterest rate = The interest paid / The amount borrowedX = $120$1000 X = .12 = 12 %Assume you borrowed $1000 for one year and paid $120 interest. What was the interest rate?Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-36Expected Rate of Profit(ERP)ERP = -------------------------------------------Expected ProfitsMoney InvestedHow much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?6-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?ERP = -------------------------------------------Expected ProfitsMoney InvestedERP = -------------------------------------------$1,650$10,000ERP = .165 = 16.5 %Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-38You Won’t Invest If Interest Rates Are Too HighIn general, the lower the interest rate, the more business firms will borrowTo know how much they will borrow and whether they will borrow, you need to compare the interest rate with the expected rate of profitEven if they are investing their own money they need to make this comparison6-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Why Do Firms Invest?Firm’s will only invest if the expected profit rate is “high enough”Firms invest whenTheir sales outlook is goodTheir capacity utilization rate is highTheir expected profit rate is highEven if firm’s invest their own money, the interest rate is still a considerationCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-40What Accounts for our Low Rate of Investment?The short time horizon of corporate AmericaThe quality of management in AmericaThe quality of labor in AmericaThe low savings rate in AmericaThe less we save, the less we can investThe less we invest, the slower our rate of economic growth6-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Graphing the C + I LineCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-42To keep things simple so we can read the graph we’re going to assume the level of investment stays the same for all levels of incomeGraphing the C + I LineCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-43How much is I when disposable income is 1000, 2000, and 3,000?The C line and the C+I line are parallel. Therefore I is about 480 at every level of disposable income. Summing Up InvestmentGross Investment 1997 2000P & E 845 (68.3%) 1203 (72.9%)R H 328 (26.5%) 403 (24.5%)Inventory change 65 ( 5.2%) 43 ( 2.6%)6-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.6-45