chap006-the business-investment sector
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Chapter 6The Business-Investment Sector
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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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Proprietorships, Partnerships,
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
Proprietorships, Partnerships,
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
Proprietorships, Partnerships,
and Corporations
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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
Proprietorships, Partnerships,
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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Inventory Investment
Includes only net change
Date Level of Inventory
Jan. 1, 2003 $145 million
July 1, 2003 120 million
Dec. 31, 2003 130 millionStarted the year with $145 million
Ended the year with 120 million
Net change is a (-) 25 million
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Inventory Investment
Includes only net change
Date Level of Inventory
Jan. 1, 2003 $130 million
July 1, 2003 145 million
Dec. 31, 2003 120 millionStarted the year with $130 million
Ended the year with 120 million
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
$10,000
ERP = .165 = 16.5 %
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Why Do Firms Invest?
Firms wont invest unless the expectedprofit rate is high enough
Firms invest whenTheir sales outlook is good
Their capacity utilization rate is high
Their expected profit rate is high enough
Even if firms invest their own money,the interest rate is still a consideration
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What Accounts for our Low
Rate of Investment? The short time horizon of corporate
America
The quality of management in America The quality of labor in America
The low savings rate in America
The less we save, the less we can investThe less we invest, the slower our rate of
economic growth
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Disposable income ($)
45
C
1,000
1,000
2,000
3,000
2,000 3,000
Disposable income ($)
45
C
C + I
1,000
1,000
2,000
3,000
2,000 3,000
Graphing the C + I Line
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To keep things simple so we can read the graph were going to
assume the level of investment stays the same for all levels of income
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Disposable income ($)
45
C
1,000
1,000
2,000
3,000
2,000 3,000
Disposable income ($)
45
C
C + I
1,000
1,000
2,000
3,000
2,000 3,000
Graphing the C + I Line
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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
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