The Business-Investment Sector

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter 6

THE BUSINESS-INVESTMENT SECTOR

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Chapter 6

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Learning Objectives

After this chapter you should be able to:1. List the three types of business firms and discuss their

advantages and disadvantages.2. Define investment and identify its main components.3. Show how savings gets invested. 4. Distinguish between gross investment and net investment.5. Explain how capital is accumulated.6. List and discuss the determinants of the level of

investment.7. Analyze the graph of the C + I line.

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Proprietorships, Partnerships, and Corporations

Proprietorships Are owned by individuals. Are almost always small businesses.

Major Advantages: You can be your own boss. Income is taxed only once.

Major Disadvantages: Entire burden of running company falls on proprietor’s

shoulders. Unlimited Liability: Owner may be held personally liable if the

business is sued. It is much harder to raise money for capital.

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Partnerships Owned by two or more people.

• Some law and accounting firms have hundreds of partners.Major Advantages:

It is easier to raise more capital. The work and responsibility can be divided among partners.

Major Disadvantages: 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. • studiestime.com

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Corporation Is a legal entity like a person. Most are small firms. Are owned by the stockholders. Is easier to raise money by selling stock. Most are not publicly held.

Major Advantages: Limited liability: Can be sued, but the stockholders are not

liable (with rare exceptions). Have potential perpetual life. May pay lower federal taxes. Can sell stock to raise more money.

Major Disadvantages: Need a lawyer and have to pay a charter fee. May have to pay federal (perhaps state) corporate income tax as

well as personal income tax. studiestime.com

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The Business Population and Shares of Total Sales, 2012 (studiestime.com)

Source: Statistical Abstract of the United States, 2010

Proprietorships lead in number, Corporations lead in sales.

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Source: www.Fortune.com

The Top Ten in U.S. Sales, 2012

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Source: www.Fortune.com

The Top Ten in World Sales, 2012

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New Hybrid Varieties of Businesses Have Emerged such as:

Limited Partnerships, S Corporations, and Limited Liability Proprietorships Do not pay corporate income taxes. Taxed solely on the individual level profits. Pose minimum legal risks to their investors.

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Stocks and Bonds

• Stockholders are the OWNERS of a corporation• Two Types of stock:

Common stock which has voting rights. Preferred stock which do not have voting rights but receive

a stipulated dividend.

• Bondholders are CREDITORS rather than owners. They 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.

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Capitalization and Control

A corporation’s total 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 do not bother to vote or give their

proxies to others.

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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.)

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Business-Investment

Is any new plant, equipment additional inventory, computer software, or residential housing. Note this is a different definition than a financial

transaction “investment” as buying a stock or bond.

Three Categories: NEW plant and equipment Additional inventory NEW residential housing

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Investment and GDP

• Investment is the thing that really makes our economy go and grow!

• It is the most volatile sector in our economy. 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.

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Hypothetical Inventory Investmentfor a Company

Includes only net changeDate Level of InventoryJan. 1, 2021 $120 million

July 1, 2021 145 million

Dec. 31, 2021 130 millionStarted the year with $120 millionEnded the year with $130 millionNet change is a (+) $10 million

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Note that Investment was actually negative during recessions in 1975, 1980, 1982, 1991, 2001, and 2007.

Inventory Investment, 1960–2012 (in billions of 1987 dollars)

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Investment in Plant and Equipment

Almost 50% of today’s fixed investment is in information processing equipment and software, in contrast to 10% 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 2007, capital spending was over $1.3 trillion,

almost 60% higher (in 2007 dollars) than it had been just 10 years earlier. It fell sharply during the ensuing recession.

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Residential Construction

Includes replacing old housing as well as adding to it.

Fluctuates with interest rates from year to year. 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 which is called being “underwater.”

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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?

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How Does Saving Get Invested?

Money saved is put into stocks and bonds.

Businesses take this money to buy new plant, equipment, and add to their inventory.

Businesses use “retained earnings” and “depreciation allowances.”

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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.

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Problem:

Calculate Gross Investment and Net Investment given:Date Level of InventoryJan 1 $60 billionJuly 1 $55 billionDec 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

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Solution:

Inventories up $10 billionExpenditures on plant and equipment = $120

billionExpenditures on New Residential Housing = $90

billionGross Investment = $220 billionDepreciation of plant and equipment and

residential housing = $30 billionNet Investment = $190 billion

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Determinants of the Level of Investment

Many factors determine the level of investment. We will focus on four:

Sales outlook Capacity utilization rate Interest rate Expected rate of profit (ERP)

Note that Disposable Income (DI) is NOT a determinant.

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The Sales Outlook

Firm’s sales outlook is the ultimate determinant of the level of investment. Will NOT invest if the sales outlook is bad. If sales are expected to be strong the next few months

the business will add inventory. If sales outlook is good for the next few years, firms

will purchase new plant and equipment.

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Capacity Utilization Rate

Percent of plant and equipment that is actually being used at any given time.

Do NOT invest if there is unused capacity. Capacity utilization reached a low of just 68.3 in mid-

2009.

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Capacity Utilization Rate in Manufacturing, 1965–2013

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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

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Expected Rate of Profit (ERP)

ERP =

Expected ProfitsMoney Invested

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

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ERP =Expected Profits

Money Invested

ERP =$1,650

$10,000

ERP = .165 = 16.5 %

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

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You Won’t Invest if Interest Rates are Higher than ERP

In general, the lower the interest rate, the more business firms will borrow. Compare interest rate with 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. A 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).

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Graphing Investment = C + I

Assume $1 trillion Investment added to the Consumption Function

This is $1 trillion 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?

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Gross Investment, 2012(Numbers don’t add up because of rounding.)

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Source: Economic Indicators, March 2010.

Investment fell during the 2001 recession and during the 2007–2009 recession..

Gross Investment and Its Components, 1995-2012, in 2005 Dollars

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To whom are corporate leaders loyal?o Their employees?o Their customers?o Their owners?

Answer: Their ownerso One thing should be perfectly clear: If a corporation does

not maximize its profits, it is disloyal to its owners.o 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? studiestime.com

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The Business-Investment Sector