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Chapter 6
The Business-Investment Sector
McGraw-Hill/Irwin
©2009 The McGraw-Hill Companies, All Rights Reserved
Learning Objectives

In this chapter you’ll learn:
1.
2.
3.
4.
5.
6.
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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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Proprietorships, Partnerships, and
Corporations

Proprietorship
•
•
Proprietorships are owned by individuals.
Proprietorships are almost always small businesses.
•
•
•
Grocery stores, barbershops, restaurants, family farms, gas
stations, etc.
Some advantages of a proprietorship:
•
You can be your own boss.
•
Your income is taxed only once.
A major disadvantage of a proprietorship:
•
The largest is unlimited liability
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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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 of a partnership:
•
Partnerships must be dissolved when one partner dies or wants
to leave.
•
Unlimited liability
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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Proprietorships, Partnerships, and
Corporations

Corporation
•
•
•
•
•

Some advantages of a corporation:
•
•
•

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.
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
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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Proprietorships, Partnerships, and
Corporations


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 have taken
advantage of these legal loopholes to enjoy the
security of limited liability without paying corporate
income tax.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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The Top Ten in U.S. Sales, 2006
Source: www.Fortune.com
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The Top Ten in World Sales, 2006
Source: www.Fortune.com
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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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 century.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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Stocks and Bonds

Stockholders are the OWNERS of a corporation
•
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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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 (capitalized)
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Capitalization and Control


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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-12
The Business Population and Shares of
Total Sales, 2006
Source: Statistical Abstract of the United States, 2008
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-13
Questions for Thought and Discussion

What are the advantages of different firm structures?

How does the corporation facilitate business? (Hint:
Consider the case study of the Middle East.)
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-14
Investment

“Investment” is the thing that really makes our
economy go and grow!

Investment is any NEW plant and equipment.

Investment is additional inventory.

Investment is any NEW residential housing.
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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 million
Started the year with $120 million
Ended the year with
$130 million
Net change is a
$10 million
(+)
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-16
Inventory Investment, 1960–2005 (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, 2008; Economic Indicators, Feb 2008
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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Investment in Plant and Equipment

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.
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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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-19
Investment

Investment is the most volatile sector in our economy.
GDP = C + I + G + Xn

Fluctuations in GDP are largely fluctuations in
investment.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-20
Graphing Investment = C + I



Assume 100 billion dollar
investment added to the
consumption function
Planned aggregate
expenditures
(trillions of $)
C+I
C
This is 100 billion dollars at all
10.3
levels of consumption so it shifts
the function up by 100 billion 10.0
dollars
This 100 billion has a multiplier
effect on the economy of 300
billion dollars (we will talk about
multipliers later, but this is a
heads up).
100 billion dollars
worth of Investment
45º
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Output
10.0 10.3
(Disposable
Income -trillions $)
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Investment

Recessions are touched off by declines in
investment.

Recoveries are brought about by rising investment.
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6-22
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.”
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-23
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)
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-24
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
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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
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-26
Building Capital


Investment involves sacrifice (on someone’s part)
To invest
•
•
We must work more.
We must consume less (save).
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-27
Marx
“Capital 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 hours.
The 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
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-28
Determinants of the Level of Investment

Sales outlook

Capacity utilization rate

Interest rate

Expected rate of profit (ERP)
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6-29
The 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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-30
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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-31
Capacity Utilization Rate in Manufacturing,
1965–2007
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 2008; Business Cycle Indicators, January 2008.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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The Interest Rate
 You won’t invest if interest rates are too high.
Interest rate = the interest paid / the amount borrowed
Assume you borrow $1000 for one year at 12% , how
much interest do you pay?
Interest Paid
.12 =
$1000
Interest Paid = $120
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6-33
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?
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6-34
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 %
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6-35
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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-36
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 invest.
The less we invest, the slower our rate of economic growth.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-37
Gross Investment, 2007
(Numbers don’t add up because of rounding.)
Source: Economic Report of the President, 2008, www.bea.gov.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-38
Gross Investment and Its Components,
1995-2007, in 2000 Dollars
Source: Economic Indicators, February 2008.
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6-39
Questions for Thought and Discussion
 To whom are corporate leaders loyal?
• To their employees
• To their customers
• To their owners
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
6-40
Solution
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.
©2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
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