Download 10 Investment in the Private Sector

10 Investment in
the Private Sector
© John Tribe
© John Tribe
Learning outcomes
• By studying this section students will be able to:
– define and distinguish between different types of
investment
– analyse the factors which affect an investment
decision
– utilize techniques for investment appraisal
– understand the uncertainty surrounding investment
appraisal
– analyse the effects of investment on the economy
– evaluate government policy with regard to investment
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Definition
• Investment may be defined as expenditure
on capital goods and working capital.
– Fixed capital goods consist of buildings, plant
and machinery.
– Working capital consists of stocks of raw
materials, semi-manufactured goods and
manufactured goods which have not yet been
sold.
– Net investment = gross investment –
depreciation
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UK Gross Fixed Capital Formation
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Working Capital
• Skis in Hire
Shop in
Meribel, France
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Factors affecting investment
• Investment in the private sector is
undertaken to increase profitability.
• Organizations will seek to invest in those
projects which yield the highest return.
• The profitability of an investment project
can be analysed by investigating its costs
and revenue.
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Cost of investment
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planning costs
costs of capital goods
cost of financing investment
running costs of the investment
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BAA Terminal 5
(Picture courtesy BAA)
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Planning for T5
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Revenue from investment
• price of output
• quantity of output sold
• other factors
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Revenue Factors
• Strong demand from
tourists causes new
investment in
accommodtaion in
Koh Phi Phi, Thailand
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Appraisal techniques
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payback method
average rate of return
net present value
internal rate of return
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Payback Appraisal
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The accelerator principle
• Investment activity in economies tends to be volatile.
– When demand for consumer goods and services is relatively
stable in an economy, much of the demand for capital goods will
take the form of replacing worn-out plant and machinery.
– However, if demand for final goods rises and there is no spare
capacity in an industry, then new machinery will have to be
purchased. Thus the demand for capital goods will significantly
increase to include new machines as well as replacement
machines.
– Similarly, if the demand for final goods in an economy falls, firms
will find they have over-capacity and too many machines. They
will reduce the stock of machines to the new lower levels needed
by not replacing worn out machines, so the demand for capital
goods will fall.
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Aircraft Demand
• The demand for new
aircraft is very volatile
and explained by
reference to the
accelerator principle
• What are current demand
conditions for new
aircraft?
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Risk and sensitivity analysis
• Sensitivity analysis is a technique for
incorporating risk assessment in investment
appraisal.
• It works by highlighting the key assumptions
upon which investment appraisal figures were
based.
• Sensitivity analysis would calculate the effects
on an investment appraisal of changes in these
assumptions.
• It illustrates a project’s sensitivity to a variety of
scenarios.
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Sources of funds
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retained profits
new share issues
loans
government assistance
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Investment Conditions
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Review of key terms 1
• Investment =
expenditure on capital goods and working capital.
• Fixed capital =
durable capital goods such as buildings and machinery.
• Working capital =
finance of work in progress such as raw material stocks, partially
finished and unsold goods.
• Net investment =
gross investment – depreciation.
• Payback method =
appraisal technique to see how quickly an investment repays its
costs.
• Average rate of return =
appraisal technique where the average annual returns are
expressed as a percentage of the original capital costs.
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Review of key terms 2
• Net present value =
appraisal technique where all future revenues are recalculated to
their present value so that a comparison can be made with the
project costs.
• Internal rate of return =
the rate of return of a project on capital employed, calculated by
finding the rate that discounts future earnings to equal the capital
costs.
• Accelerator theory =
explanation why changes in consumer demand lead to larger
changes in demand for investment goods.
• Sensitivity analysis =
investigation of sensitivity of an investment project to changes in
forecasts.
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10 Investment in
the Private
Sector:
The End
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