What is Investment

Investment

InvestmentInvestment• “Investment” is the thing that really

makes our economy go and grow!• Investment is any NEW

– Plant and equipment

• Investment is any NEW– Additional inventory

• Investment is any NEW– Residential housing

6-14

Inventory Investment

Includes only net change

Date Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 million

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-15

Inventory Investment

Includes only net changeDate Level of Inventory

Jan. 1, 2003 $120 million

July 1, 2003 145 million

Dec. 31, 2003 130 million

Started the year with $120 million

Ended the year with 130 million

The net change is a (+) 10 million

6-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventory Investment (Continued)

Includes only net changeDate Level of Inventory

Jan. 1, 2003 $130 million

July 1, 2003 145 million

Dec. 31, 2003 120 million

Started the year with $130 million

Ended the year with 120 million

The net change is a (-) 10 million

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-17

Investment in Plant and Investment in Plant and EquipmentEquipment• Investment in plant and equipment

is more stable than inventory– Even in bad years companies will still

invest a substantial amount in new plant and equipment• This is mainly because old and obsolete

factories, office buildings, and machinery must be replaced

– This is the depreciation part of investment

6-19

Residential Construction

• Involves replacing old housing as well as adding to it

• Fluctuates considerably from year to year

• Has mortgage interest rates play a dominant role

6-21

Investment• Investment is the most volatile sector in

our economy

– GDP = C + + G + Xn

• Fluctuations in GDP are largely fluctuations in investment

6-22

II

Investment (Continued)

• Recessions are touched off by declines in investment

• Recoveries are brought about by rising investment

6-23

Capital and investment• Capital is a stock concept.

• It refers to the capital accumulated over a period of time

• Investment on the other hand is a flow concept and it is measured per unit of time., generally one year.

• It refers to the addition to the physical stock of capital.

Note: These lecture notes are incomplete without having attended lectures

13

Stocks vs. Flows

A flow is a quantity measured per unit of time. E.g., “U.S. investment was $2.5 trillion during 2006.”

Flow StockA stock is a quantity measured at a point in time.

E.g., “The U.S. capital stock was $26 trillion on January 1, 2006.”

How Do 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 and equipment, and add to their inventory

• Corporations also use “retained earnings” and “depreciation allowances”

Gross and net investment• The gross investment is the total

purchase of capital per unit of time.

• It consist of total annual expenditure on

plant , machinery , and equipmentResidential land and buildinginventories

• Net investment , on the other hand is

=gross investment – depreciation

Depreciation just not only include capital worn out or used up.

It also include obsolescence of capital i.e. capital becoming economically obsolete due to change in technology

Gross Investment - Depreciation = Net Investment– Depreciation is taking into account for 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)

Calculate Gross Investment and Net Investment

Date Date level of level of inventoryinventory

Jan 1 $60 billionJan 1 $60 billion

July 1 55 billionJuly 1 55 billion

Dec 31 70 billionDec 31 70 billion

Expenditures on new plant & equipmentExpenditures on new plant & equipment

$120 billion$120 billion

Expenditures on new residential housingExpenditures on new residential housing

$ 90 billion$ 90 billion

Depreciation on plant & equipment andDepreciation on plant & equipment and

residential housing $30 billionresidential housing $30 billion6-27

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

21

Exhibit 8: Investment Demand Curve

D

0

8

6

10

Investment spending (trillions of dollars)

No

min

al i

nte

rest

rat

e (p

erc

ent)

0.7 0.90.8

The economy’s investment demand curve shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant.

22

Planned Investment and Income

• Investment depends more on interest rates and on business expectations than on the prevailing level of income– One reason for this is that some investments take

years to complete– Additionally, investment, once in place, is

expected to last for years

• Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output

23

Exhibit 9: Autonomous Investment Function

Re

al

pla

nn

ed

in

ve

stm

en

t (t

rill

ion

s o

f d

oll

ars

)

0.8

0 2.0 4.0 6.0 8.0 10.0 12.0

Real disposable income

(trillions of dollars)

I

0.9 I"

0.7 I'

The horizontal investment functions imply that planned investment does not vary with real disposable income

Building Capital

• Investment involves sacrifice (on someone’s part)

• To invest– We must work more– We must consume less (save)

6-29

Determinants of the Level of Investment

• Sales outlook

• Capacity utilization rate

• Interest rate

• Expected rate of profit (ERP)

6-31

The Sales OutlookThe Sales Outlook

• 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

6-32

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

• Other factors– Manufacturing is a shrinking part of U.S.

economy due to imports and increasing investment overseas by U.S. Companies

6-33

The Interest Rate

• You won’t invest if interest rates are too high

Interest rate = The interest paid / The amount borrowedInterest 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

6-35

The Interest Rate• You won’t invest if interest rates are 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?

6-36

Expected Rate of Profit(ERP)

ERP = -------------------------------------------Expected Profits

Money Invested

How much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?

6-37

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 %

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-38

You Won’t Invest If Interest Rates Are Too High• 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

6-39

Why Do Firms Invest?• Firm’s will only invest if the expected

profit rate is “high enough”

• Firms invest when–Their sales outlook is good–Their capacity utilization rate is high–Their expected profit rate is high

• Even if firm’s invest their own money, the interest rate is still a consideration

6-40

Methods of investment decision• The present value method

• Method based on marginal efficiency of capital

NPV METHOD• NPV is defined as the difference

between the present value of future income stream and cost of investment

• NPV= PV-C

• PRESENT VALUE OF future income is the value of future income discounted at the market rate of interest.( price remain constant)

PV=R/(1+i)

R amt expected after one year

i = rate of interest

e.g if a person receive Rs. 100 today and invest it in bank at 10% rate of interest

• Present value of an amount expected at some future date is it is the sum of money that must be invested today at a compound interest rate to get same amount at some future date.

Decision rule • If NPV is substantially greater than C,

then project under consideration is worth the investment

• The investor can borrow money at market rate of interest and can make investment.

MEC method• Keynes has suggested an alternative

investment decision based on MEC.

• Also known as IRR i.e. internal rate of return.

• MEC is the rate of discount which makes the discounted PV of expected income stream equal to the cost of capital.

• If cost of investment project is C

• and it is expected to yield a return R for one year , then MEC can be found as

• MEC= R/1+r=C

• r is the rate of discount that makes the discounted value of R equal to C.

• Thus r is the MEC of capital. Or it is IRR.

• r= (R/c)-1

• If an investment project costs Rs. 100 million and it is expected to yield Rs.125 million at the end of one year.

• Calculate MEC

• If two year investment project costing Rs. 100 million expected to yield no return in the first year and Rs. 144 m in the second year. Find MEC for the project.

Decision rule • Once MEC or IRR is estimated ,

investment decision can be taken by comparing MEC with the market rate of interest

• If MEC>i, then the investment project is acceptable

• If MEC<i, then project is rejected