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Transcript
The Business About INVESTMENT
I had fun that last time we wandered into Shady Valley's very own Happy-Time Gala-World
Fun-Land Amusement Park, didn't you? Let's stroll through it again, just to see what
adventures we might find. Okay, I admit to an ulterior motive. The Happy-Time Gala-World
Fun-Land Amusement Park recently added a new ride -- the Cap'n Space Fright Whirl. If you
thought the Monster Loop Death Plunge roller coaster was exciting, then you're in for a real
treat with this one. My interest in the Cap'n Space Fright Whirl, however, is NOT from the
standpoint of risking a recently eaten meal. On the contrary, I'm going to don my pointyheaded economist disguise and check out this mass of twisted metal and high-flying cages as
a prime example of capital. In the process we might be able to gain some insight into the whys
and wherefors of the thing we call investment.
Give a Little to Get a Little -- Or a Lot
We've come across this investment idea a number of times on our pedestrian amble through
the economy. That's because investment is pretty darned important to topics like education,
economic growth, transportation infrastructure, and wealth. it also pops up in the federal
deficit, foreign investment, and the stock market. Let's spend the next few pages getting to the
bottom of investment.
It's best to begin with what we already know. In Fact 1, Our Limited Pie, we saw that
investment occurs when our resources produce more capital goods and fewer consumer goods.
We sacrifice some well-being today, for capital that will (hopefully) give us more satisfaction
tomorrow. While investment takes place in a number of day-to-day consumer areas -- like
education, job training, personal planning, and the like -- our focus here is business
investment on capital goods, such as factories, machinery, and equipment.
All Sorts of Capital
Here are some of the specific categories of capital bought as investment:
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Business structures. These are the buildings that house our economy's business
operations, including factories, office buildings, warehouses, shopping centers,
hospitals, and, well, any building that keeps the wind and rain from our nation's
production. Pointy-headed economists refer to business structures as fixed plant -meaning the buildings aren't easily moved.
Durable equipment. This is the machinery and tools used by businesses to produce
output. Although we could try for an exhaustive list of equipment, starting with
abacuses, aircraft, anchors, awls, and axes, by the time we made our way to yokes and
zeppelins, I would be out of space and you would be pretty darn bored. Durable
equipment and businesses structures are what we usually think of when the term
capital arises.
Residential structures. A third category might not fall into preconceived ideas of
capital. It includes the houses, apartment buildings, duplexes, fourplexes, and every
other building designed to accommodate a bed, a refrigerator, and a television set for
our sleeping pleasure. Like business structures give businesses a place to produce
output, residential structures give consumers a place to produce home-made, but quite
valuable, satisfaction.
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Inventories. These are the additions to, or subtractions from, the stockpiles of unsold
products or raw materials awaiting processing that businesses keep on hand. It's best to
think of inventories as sort of working capital -- the fuel that's needed to prime the
pump of production. For example, if Mega-Mart Discount Warehouse Super Center
built a new store, it would need to invest in the building, equipment, AND inventory.
All three must be in place before Mega-Mart opens its doors.
Infrastructure. Our last category includes streets, bridges, highways, railroads, airports,
telephone systems, electric lines, and a bunch of other stuff that moves people,
materials, goods, information, and energy. While some infrastructure investment is
undertaken by businesses, most is done directly by government or at least subsidized
by taxes.
Saving Some Pie
The pointy-headed economists use the term saving for the part of our economic pie NOT
consumed and set aside for investment. Each of our three estates saves in their own way.
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Consumer saving. The hardworking, underappreciated, taxpaying consumers of the
third estate do find a way to save a few bucks each year. This includes savings stashed
in a bank account, like the $137.65 that I found on of our pedestrian journey and
deposited in the Interstate OmniBank. However, it also includes such things as income
you put into a private pension plan and the mortgage payments you make on your
domicile. In fact, any portion of your income that is not spent, but diverted into the
multitude of financial markets, would be considered saving.
Business saving. While consumers save billions of dollars of their hard-earned
income each year to help finance capital investment, businesses contribute two to three
times that amount. Our second estate diverts a lot of income into investment long
before it makes its way to the third estate. This diversion is accomplished in two basic
ways: depreciation expenses and retained earnings. Depreciation expenses are part of
business revenues that are set aside to replace worn out capital. Retained earnings are
profit that a business decides to use for capital investment rather than paying out as
dividends to the stockholders.
Government saving. You're probably thinking: government saving?!?!? Does our
government save? Our first estate, in principle at least, saves if tax collections are
greater than spending. At the federal level, a budget surplus of taxes over spending is a
rare event indeed. The norm for the federal-types is a budget deficit, with spending
greater than taxes. However, many state and local governments do run budget
surpluses. And their budget surpluses, when combined, cancel out some if not all of
the federal deficit and occasionally generate a little extra for business investment.
Moreover, part of the federal deficit is used by the first estate for a bunch of the
infrastructure investment. As such, when government builds a highway, our tax dollars
are actually saved and invested in capital at the same time.
We could end our discussion of the saving with these three estates. However, in so doing, we
would leave out a source that's becoming increasing important in light of our interdependent
global economy. That is, our economy also gets investment funds from other countries.
During the 1980s and early 1990s, foreign sources financed almost as much capital
investment as did consumer saving. It's big, it's important, and it's not likely to disappear any
time soon.
The Investment Choice
Let's talk a stroll behind the scenes to examine the whys and wherefors of business investment.
Our story picks up with Hortense McClintock, the owner and proprietor of the Happy-Time
Gala-World Fun-Land Amusement Park. The setting is her office, the time is one year ago,
the topic of discussion is Cap'n Space Fright Whirl. Should Hortense add this new ride to her
assortment of thrill-instilling adventures at the Happy-Time Gala-World Fun-Land
Amusement Park, or should she decline?
What does Hortense need to know before making her decision?
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First, the investment cost. Construction, from start to finish, of the Cap'n Space
Fright Whirl is $500,000 and it will take approximately one year to complete. That
means, our economy must forego $500,000 would of consumption goods for a year
while construction is underway.
Second, the source of funds. From our saving list, we can identify two ways
Hortense can get the $500,000 needed for the Cap'n Space Fright Whirl -- existing
amusement park profits or the financial markets. She either uses her own money or
borrows it. How the borrowed money gets into the financial markets -- from
households, governments, or foreigners -- is unimportant to her situation.
Third, the interest rate. What is important, however, whether she borrows the money
or uses her own, is the interest rate. If Hortense borrows the $500,000 from a bank,
raises it by selling shares of stock in the amusement park, or issues some sort of
corporate bond, then she needs to consider the payment for those funds, a cost that
depends on the interest rate. If Hortense uses amusement park profits, then she must
consider the opportunity cost of any interest that she could have received.
Fourth, the return on the capital. Lastly, but not leastly, Hortense needs to consider
the expected profit to be had from operating the Cap'n Space Fright Whirl. This, of
course, is the whole reason for doing the investment. Hortense expects that her patrons
will be willing to pay for the Cap'n Space experience. The creation of extra
satisfaction with this capital is one example of our whole "expansion of our economic
pie" thing.
Let's throw some numbers together and see what sort of investment choice Hortense should
make. We already know that the investment cost is $500,000. Let's say that the interest rate
Hortense would pay to borrow the needed money is 8 percent. She also has $500,000 of
retained earnings receiving a 6 percent interest rate in the financial markets. And finally,
Hortense calculates that enough additional patrons will be attracted to the amusement park by
the Cap'n Space Fright Whirl to add about $50,000 a year in profits.
Do the prospects for investing in the Cap'n Space Fright Whirl look promising or not?
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Let's take that $500,000 in retained earnings that's getting 6 percent. If left in the
financial markets, Hortense collects $30,000 per year. If that money is used to finance
the Cap'n Space Fright Whirl, she would get $50,000 per year -- an extra $20,000.
This alone tells us that the Cap'n Space Fright Whirl is a sound investment. But can
she do better by borrowing?
If she borrows the needed $500,000, then her interest cost at 8 percent is $40,000. The
$50,000 generated by the Cap'n Space Fright Whirl would more than cover this
expense, leaving her with a cool $10,000. While this option would be good choice, it's
not as good as using her retained earnings.
Let's sum this up. When a business ponders an investment, it needs to consider the vast array
of potential interest rates and returns to be had, or to be paid, in the financial markets. If a
business has the money in hand, then it merely searches out the highest return. This could be
the capital investment or in the financial markets. If a business borrows the money, then needs
to compare the interest cost with the anticipated return on the investment capital.
The World is a Risky Place
The tricky thing about investment, though, is that the expected returns are only that -expected. You're never quite sure if the return you expect is what you'll actually get. Hortense
would be most disappointed if the Cap'n Space Fright Whirl failed to generate $50,000 in
profit. If the return ends up in the $10,000 range, then hindsight tells us that she made a bad
investment. But this risk, my friends, is the heart and soul of investment. Many businesses
have passed up capital investments that ended up far exceeding their expected returns when
picked up by others. Others have dumped gadzillions into the toilet by making capital
investments that fell far short of expectations.
Most of the big-time investment falls in the domain of the second estate. That, however,
doesn't mean it should be ignored by the third. Here are a few tips to consider:
Investment Tips for the Third Estate
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Begin by thinking about the "investments" that you make on a daily basis. Anytime
you give up current satisfaction in hopes of getting more future satisfaction, then
you're investing. Buying a house, car, or other durable goods is an investment.
Changing jobs, getting an education, or moving to another state are also investments.
Even things like exercising, dieting, or visiting a dentist fall into this investment
category.
Once you identify a potential investment, the next step is to compare expected returns
with the cost. If you borrow $10,000 for a car, will it provide you with enough
satisfaction each year to compensate for the interest expense? If you use your own
savings to buy the car, does the satisfaction compensate you for the lost interest?
You should also keep these investment rules in mind for when you get the chance to
dabble in the financial markets. For example, you might want to think twice about
borrowing at 15 percent (as with a CREDIT CARD) while you're lending at 3 percent
(as with a savings account).
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=pdg&c=dsp&k=31, 16.2.2013, 11.54M