© John Tribe 10 Investment in the Private Sector

© 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

© John Tribe 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

© John Tribe UK Gross Fixed Capital Formation

© John Tribe Working Capital Skis in Hire Shop in Meribel, France

© John Tribe 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.

© John Tribe Cost of investment planning costs costs of capital goods cost of financing investment running costs of the investment

© John Tribe BAA Terminal 5 (Picture courtesy BAA)

© John Tribe Planning for T5

© John Tribe Revenue from investment price of output quantity of output sold other factors

© John Tribe Revenue Factors Strong demand from tourists causes new investment in accommodtaion in Koh Phi Phi, Thailand

© John Tribe Appraisal techniques payback method average rate of return net present value internal rate of return

© John Tribe Payback Appraisal

© John Tribe 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.

© John Tribe 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?

© John Tribe 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.

© John Tribe Sources of funds retained profits new share issues loans government assistance

© John Tribe Investment Conditions

© John Tribe 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.

© John Tribe 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.

© John Tribe 10 Investment in the Private Sector: The End