Transcript Investment - McGraw Hill Higher Education

The BusinessInvestment Sector
Chapter 06
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

After this chapter you should be able to:
1.
2.
3.
4.
5.
6.
7.
List the three types of business firms and discuss their
advantages and disadvantages.
Define investment and identify its main components.
Show how savings gets invested.
Distinguish between gross investment and net investment.
Explain how capital is accumulated.
List and discuss the determinants of the level of investment.
Analyze the graph of the C + I line.
6-2
Proprietorships, Partnerships, and
Corporations

Proprietorship
•
•

Some advantages of a proprietorship:
•
•

Proprietorships are owned by individuals.
Proprietorships are almost always small businesses.
 Grocery stores, barbershops, restaurants, family farms, gas
stations, etc.
You can be your own boss.
Your income is taxed only once.
Disadvantages:
•
•
•
Entire burden of running company falls on proprietor’s shoulders.
Owner may be sued for everything if the business is sued.
Much harder to raise money for capital as a small business.
6-3
Proprietorships, Partnerships, and
Corporations

Partnership
•

Some advantages of a partnership:
•
•

Partnerships are owned by two or more people.
 Some law and accounting firms have hundreds of
partners.
It is easier to raise more capital.
The work and responsibility can be divided.
Some disadvantages of a partnership:
•
•
Partnerships must be dissolved when one partner dies or
wants to leave.
Unlimited liability: All partners are liable for all debts
incurred by their businesses.
 If business is sued or partner absconds with funds, other
partners are personally liable.
6-4
Proprietorships, Partnerships, and
Corporations

Corporation
•
•
•
•
•

Some advantages of a corporation:
•
•
Limited liability: Corporation can be sued, but the
stockholders are not liable (with rare exceptions).
Corporations have potential perpetual life.
Corporations may pay lower federal taxes.
•
Corporations can sell stock to raise more money.
•

A corporation is a legal entity like a person.
Most corporations are small firms.
Corporations are owned by the stockholders.
It is easier to raise money by selling stock.
Most corporations are not publicly held.
Some disadvantages of a corporation:
•
•
You need a lawyer and have to pay a charter fee.
You may have to pay federal (perhaps state) corporate
income tax as well as personal income tax.
 60% of corporations were too small to owe taxes in 2007.
6-5
The Business Population and Shares of
Total Sales, 2009
Proprietorships lead in number; corporations lead in sales.
Source: Statistical Abstract of the United States, 2010
6-6
The Top Ten in U.S. Sales, 2008
Source: www.fortune.com
6-7
The Top Ten in World Sales, 2008
Source: www.fortune.com
6-8
New Hybrid Varieties of Businesses Have
Emerged

Limited Partnerships, S corporations, and Limited
Liability companies
•
•
•

Do not pay corporate income taxes
Taxes assessed solely on the individual level profits
Minimize legal risks to their investors
So far only a small minority of businesses have taken
advantage of these legal loopholes to enjoy the
security of limited liability without paying corporate
income tax.
6-9
Stocks and Bonds


Stockholders are the OWNERS of a corporation
Types of stock:
•
•
Common stock
 Voting rights
Preferred stock



Receive a stipulated dividend
No voting rights
Bondholders are CREDITORS rather than owners
•
•
Must be paid a stipulated percent of the face value of the bond
whether or not the company makes a profit.
If a company goes bankrupt bondholders are paid off before
stockholders.
6-10
Capitalization and Control

A corporation’s total capital (capitalization) consists
of the total value of its stocks and bonds.
•


Example
 1,000,000,000 in bonds +
 500,000,000 in preferred stock +
 2,500,000,000 in common stock =
 4,000,000,000 capitalization
Theoretically, you would need 50% plus one share to
control a corporation.
Practically speaking, holding 5% of the common
stock would probably give you control.
•
•
Most economist believe that you need 10% of the common
stock to be assured of control.
Many stockholders don’t bother to vote or give their proxies
to others.
6-11
Why Incorporation Came Late to Islamic
Middle Eastern Nations

Western Inheritance Laws
•
•
•
•

Enabled the accumulation of large fortunes.
Incorporation became the dominant form of business by the
second half of the 19th century.
Became the engine of economic growth.
Was the facilitator of the economy of mass production and
mass consumption.
Islamic Inheritance Laws
•
•
•
•
Encouraged economic equality.
Discouraged the accumulation of capital.
Discouraged the formation of large business
enterprises.
Prevented the advent of corporations well into the
20th century.
6-12
Questions for Thought and Discussion

What are the advantages of different firm structures?

Which industries are represented among the largest
corporations in the U.S. and the world? Do any of the
names on the lists surprise you?

How does the legal establishment of corporations
facilitate business? (Hint: Consider the case study of the
Middle East.)
6-13
Investment

Investment is defined as any new plant, equipment
additional inventory, computer software, or residential
housing.
•

Note this is a different definition than an “investment” as buying a
stock or bond.
Three Categories of Investment:
•
•
•
Investment is any NEW plant and equipment.
Investment is additional inventory.
Investment is any NEW residential housing.
6-14
Investment and GDP



“Investment” is the thing that really makes our economy
go and grow!
Investment is the most volatile sector in our economy.
GDP = C + I + G + Xn
Fluctuations in GDP are largely fluctuations in
investment.
•
•

Recessions are touched off by declines in investment.
Recoveries are brought about by rising investment.
Inventories are the hardest component of investment to
control and predict.
•
Businesses do not want too much or too little inventory.
6-15
Hypothetical Inventory Investment
for a Company
Includes only net change
Date
Level of Inventory

Jan. 1, 2021
$120 million
July 1, 2021
145 million
Dec. 31, 2021
130 million
Started the year with $120 million
Ended the year with
$130 million
Net change is a
$10 million
(+)
6-16
Inventory Investment, 1960–2009
(in billions of 1987 dollars)
This is the most volatile sector of investment. Note that
investment was actually negative during recessions in 1975, 1980,
1982, 1991, and 2001. Notice how pronounced the drop was in 2001.
Source: Economic Report of the President, 2010; Economic Indicators, March 2010
6-17
Investment in Plant and Equipment


Almost half of today’s fixed investment is in
information processing equipment and software, in
contrast to less than 10 percent in the mid-1980s.
Even in bad years companies will still invest a
substantial amount in new plant and equipment.
•
•
•

Old and obsolete capital must be replaced (depreciation).
Most capital expenditures are planned years in advance.
Interest rates fall during a recession, so cost of borrowing
decreases.
In the year 2007, capital spending was over $1.3
trillion, almost 60 percent higher (in 2007 dollars)
than it had been just 10 years earlier.
•
It fell sharply during the ensuing recession.
6-18
Residential Construction


Involves replacing old housing as well as adding to it.
Fluctuates considerably from year to year.
•

Mortgage interest rates play a dominant role in determining the
level of residential investment.
End of the Housing Bubble:
•
•
Residential home building, which went into decline in early 2006,
and continued to fall well into 2008, pulled down total investment
during those years.
Millions of homeowners found that the amount of money they
owed on their home mortgages was greater than the value of
their homes.
6-19
Questions for Thought and Discussion

Why do inventories fluctuate more than other
components of investment?

Economists consider any spending on a person’s
education and training an investment in her or his human
capital.
•
•
•
Human capital is the accumulation of knowledge and skills that
make a worker productive. Your college education is certainly
adding to your stock of human capital.
Why are these expenditures NOT classified as investment?
Should national income accounts change this classification?
6-20
How Does Savings Get Invested?

Money saved is put into stocks and bonds.

Banks loan money based on their demand deposits and
reserve requirements.

Businesses take this money and buy new plant,
equipment, and add to their inventory.

Corporations also use “retained earnings” and
“depreciation allowances.”
6-21
Gross Investment vs. Net Investment

In the equation
GDP = C + I + G + Xn
• The “I” represent gross investment.

Gross investment – depreciation = net investment
•

Depreciation is taking into account the fact that plant &
equipment wear out and houses deteriorate.
Gross Investment – Depreciation = Net Investment
•
•
•
•
•
•
Depreciation is taking into account the fact that plant &
equipment wear out and houses deteriorate.
Start the year with 10 machines
Bought 6 machines (gross investment)
Worn out/obsolete – 4 machines (depreciation)
End the year with 12 machines
Actual gain of 2 machines (net investment)
6-22
Questions for Thought and Discussion
Calculate Gross Investment and Net Investment given:
Date
Jan 1
level of inventory
$60 billion
July 1
$55 billion
Dec 31
$70 billion
Expenditures on new plant & equipment
$120 billion
Expenditures on new residential housing
$ 90 billion
Depreciation on plant & equipment and
residential housing $30 billion
6-23
Solution

Inventories up $10 billion

Expenditures on plant and equipment = $120 billion

Expenditures on New Residential Housing = $90 billion

Gross Investment = $220 billion

Depreciation of plant and equipment and residential
housing = $30 billion

Net Investment = $190 billion
6-24
Determinants of the Level of Investment

Many factors determine the level of investment. We will
focus on four:
1.
2.
3.
4.

Sales outlook
Capacity utilization rate
Interest rate
Expected rate of profit (ERP)
Note that Disposable Income (DI) is NOT a determinant.
This means that we do not vary I with DI in building our
model.
6-25
The Sales Outlook

Business firm’s sales outlook is the ultimate determinant
of the level of investment:
•
•
•
You won’t invest if the sales outlook is bad.
If sales are expected to be strong the next few months the
business is probably willing to add inventory.
If sales outlook is good for the next few years, firms will probably
purchase new plant and equipment.
6-26
Capacity Utilization Rate


This is the percent of plant and equipment that is
actually being used at any given time.
You won’t invest if you have a lot of unused capacity.
•
•

During recessions, why build more when you are not using
all of what you have?
Capacity utilization reached a low of just 68.3 in mid-2009.
Other factors
•
Manufacturing is a shrinking part of U.S. economy due to
imports and increasing investment overseas by U.S.
companies.
6-27
Capacity Utilization Rate in Manufacturing,
1965–2010
Since the mid-1980s, our capacity utilization rate has been
below 85.
Note that it fell during each recession, which is indicated by
a shaded area.
Source: Survey of Current Business, March 2010; Business Cycle Indicators, March 2010.
6-28
The Interest Rate
 You won’t invest if interest rates are too high.
Interest rate = Interest paid
Amount borrowed
Assume you borrow $1000 for one year at 12% , how much
interest do you pay?
.12 =
Interest Paid
$1000
Interest Paid = $120
6-29
Expected Rate of Profit (ERP)
Expected Profits
ERP =
Money Invested
How much is the ERP on a $10,000 investment if you
expect to make a profit of $1,650?
6-30
How much is the ERP on a $10,000 investment if
you expect to make a profit of $1,650?
Expected Profits
ERP =
Money Invested
$1,650
ERP =
$10,000
ERP = .165 = 16.5 %
6-31
You Won’t Invest If Interest Rates Are
Higher than ERP
 In general, the lower the interest rate, the more
business firms will borrow.
• To know how much they will borrow and whether they will
borrow, you need to compare the interest rate with the
expected rate of profit.
 Even if they are investing their own money they need
to make this comparison.
• Spending money on investment has opportunity costs.
• Foregone alternative could be putting the funds in a safe
money market fund. The ERP of investing has to be higher
than the opportunity cost (potential interest).
6-32
Graphing Investment = C + I

Assume $1 trillion dollar
investment added to the
consumption function

This is $1 trillion dollars at all
levels of DI so it shifts the C + I
function up as a parallel line.
How much is I when DI is $1
trillion? When DI = $4 trillion?
When DI = $8 trillion?

6-33
Gross Investment, 2009
(Numbers don’t add up because of rounding.)
Source: Survey of Current Business, March 2010, www.bea.gov.
6-34
Gross Investment and Its Components,
1995-2009, in 2005 Dollars
Investment fell during the 2001 recession and during the 2007–2009
recession.
Source: Economic Indicators, March 2010.
6-35
Questions for Thought and Discussion
 To whom are corporate leaders loyal?
• To their employees?
• To their customers?
• To their owners?
 Answer: their owners
• One thing should be perfectly clear: If a corporation does
not maximize its profits, it is disloyal to its owners.
• If shifting production and jobs abroad will maximize profits,
then almost every firm will do it.
 Should government policy intervene when
corporations shift jobs and production overseas?
6-36