Chap006-The Business-Investment Sector

8/14/2019 Chap006-The Business-Investment Sector

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Chapter 6The Business-Investment Sector

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 6-1


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Chapter Objectives The three types of business firms

How investment is carried out

The difference between gross investment

and net investment

How capital is accumulated

The determinants of the level of investment

The graphing of the C + I line



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Proprietorships, Partnerships,

and Corporations

ProprietorshipProprietorships are owned by individuals

Proprietorships are almost always a small

businesses Grocery stores, barbershops, restaurants, family

farms, gas stations, etc

Some Advantages of a proprietorship

You can be your own bossYour income is taxed only once

Some Disadvantages of a proprietorship The largest is unlimited liability



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and Corporations Partnership Partnerships are owned by two or more people

Some law and accounting firms have hundreds of

partners

Some Advantages of a partnership

It is easier to raise more capital

The work and responsibility can be divided

Some Disadvantages

Partnerships must be dissolved when one partner

dies or wants to leave

Unlimited liability 6-4Co

pyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.


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CorporationA 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


and Corporations



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Corporation Some Advantages of a corporation

Limited liability

Corporations have potential perpetual life

Corporations may pay lower federal taxes

Some Disadvantages of a corporation

You need a lawyer and have to pay a charter fee You have to pay federal (perhaps state) corporate

income tax

Double taxation


and Corporations

6-6Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.


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The New Hybrid Varieties 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 on a small minority of businesses havetake advantage of these legal loopholes to enjoy

the security of limited liability without paying

corporate income tax


and Corporations



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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 centuryCopyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 6-10


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Stocks and Bonds

Stockholders are the OWNERSofa corporationCommon stock

Voting rights

Preferred stock Receive a stipulated dividend No voting rights



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Bondholders are CREDITORSrather than owners

Must be paid a stipulated percent ofthe face value of the bond whether ornot the company makes a profit

If a company goes bankrupt Bondholders are paid off before

stockholders

Stocks and Bonds



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A corporations total capital(capitalization)

Consists of the total value of its stocks andbonds

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 (capitalized)

Capitalization and Control



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Theoretically, you would need 50percent plus one share to control acorporation

Practically, holding 5 percent of thecommon stock would probably giveyou control

Most economist believe that you need 10

percent of the common stock to beassuredof control

Many stockholders dont bother to voteor give their proxies to others

Capitalization and Control



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The Business Population and Shares of

Total Sales, 2002

Source: Statistical Abstract of the United States, 2006



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Investment Investment is the thing that reallymakes our economy go and grow!

Investment is anyNEW:Plant and equipment

Investment is:

Additional inventory Investment is anyNEW

Residential housing



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Inventory InvestmentIncludes only net change



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Inventory Investment

Includes only net change

Date Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 millionStarted the year with $120 million

Ended the year with 130 million

Net change is a (+) 10 million



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Net change is a (-) 25 million



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Net change is a (-) 10 million



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Inventory Investment, 1960-2005 (in billions of 1987 dollars)

Economic Report of the President, 2001:Business Cycle Indicators, May 2005

This is the most volatile sector of investment. Note that investment

was actually negative during three recessions


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Investment in Plant and

Equipment Investment inplant and equipmentis

more stable than inventory

Even in bad years companies will stillinvest a substantial amount in newplant and equipment

This is mainly because old and obsoletefactories, office buildings, and machinerymust be replacedThis is the depreciation part of investment



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Residential Construction

Involves replacing old housing as

well as adding to it

Fluctuates considerably from year to

year

Mortgage interest rates play adominant role



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Investment Investment is the most volatile sector in

our economy

GDP = C +II+ G + Xn Fluctuations in GDP are largely

fluctuations in investment



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Investment

Recessions are touched off by declines in

investment

Recoveries are brought about by risinginvestment



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In the equation

GDP = C + I + G + Xn

the I represent Gross Investment

Gross Investment - Depreciation = Net Investment

depreciation is taking into account for the fact

that plant & equipment wear out and housesdeteriorate.

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)



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Calculate Gross Investment

and Net InvestmentDate level of inventory

Jan 1 $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 billionCopyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 6-29


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Solution

Date level of inventory

Jan1 $60 billion

July 1 55 billion

Dec 31 70 billion inventory investment $ 10

Expenditures on new plant & equipment new P & E 120

$120 billion new RH 90

Expenditures on new residential housing gross investment 220

$ 90 billion -depreciation - 30

Depreciation on plant & equipment and net investment $ 190

Residential housing $30 billion



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Building Capital

Investment involves sacrifice (onsomeones part)

To invest

We must work more

We must consume less(save)



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MarxCapital is created by labor but stolen by

capitalist

Assume it takes $3 to keep a person alive for 24 hours

Assume 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

work

12 hours of work produces $6 worth of cloth

Capitalist pays ------------> $3 wages

creates a surplus of ------->$ 3



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Determinants of the

Level of Investment Sales outlook

Capacity utilization rate

Interest rate

Expected rate of profit (ERP)



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The Sales Outlook

You wont invest if the sales outlookis bad

If sales are expected to be strong thenext few months the business isprobably willing to add inventory

If sales outlook is good for the next fewyears, firms will probably purchasenew plant and equipment



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Capacity Utilization Rate

This is the percent of plant andequipment that is actually being used atany given time

You wont invest if you have a lot ofunused capacity

During recessions, why build more when youare not using all of what you have

Other factorsManufacturing is a shrinking part of U.S.

economy due to imports and increasinginvestment overseas by U.S. Companies



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Capacity Utilization Rate in Manufacturing, 1965-2005

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



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The Interest Rate

You wont invest if interest ratesare too high

Interest rate = The interest paid / The amount borrowed

Assume you borrow $1000 for one year @ 12% , how

much interest do you pay?

.12 =X

$1000

X = $120



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The Interest Rate

You wont invest if interest ratesare too high

Interest rate = The interest paid / The amount borrowed

X =$120

$1000

X = .12 = 12 %

Assume you borrowed $1000 for one year and paid $120

interest. What was the interest rate?



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How much is the ERP on a $10,000

investment if you expect to make a profit

of $1,650?

ERP = -------------------------------------------

Expected Profits

Money Invested

ERP = -------------------------------------------$1,650

$10,000

ERP = .165 = 16.5 %



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Why Do Firms Invest?

Firms wont invest unless the expectedprofit rate is high enough

Firms invest whenTheir sales outlook is good

Their capacity utilization rate is high

Their expected profit rate is high enough

Even if firms invest their own money,the interest rate is still a consideration



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What Accounts for our Low

Rate of Investment? The short time horizon of corporate

America

The quality of management in America The quality of labor in America

The low savings rate in America

The less we save, the less we can investThe less we invest, the slower our rate of

economic growth



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Disposable income ($)

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C

1,000

1,000

2,000

3,000

2,000 3,000


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C

C + I

1,000

1,000

2,000

3,000

2,000 3,000

Graphing the C + I Line


To keep things simple so we can read the graph were going to

assume the level of investment stays the same for all levels of income


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45

C

1,000

1,000

2,000

3,000

2,000 3,000


45

C

C + I

1,000

1,000

2,000

3,000

2,000 3,000

Graphing the C + I Line


How 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.


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Gross Investment as a Percentage of GDP

C t I


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Current Issue

Benedict Arnold Corporations

To whom are corporate leaders loyal?

To their employees

To their customers

To their ownersAnswer: Their owners

One thing should be perfectly clear . . . If a

corporation does not maximize its profits, it is

disloyal to its ownersIf shifting production and jobs abroad will

maximize profits, then almost every firm will do it

Chap006-The Business-Investment Sector

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