The Business- Investment Sector Chapter 06 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2 Learning Objectives  After this chapter you should be able to: 1. List the three types of business firms and discuss their advantages and disadvantages. 2. Define investment and identify its main components. 3. Show how savings gets invested. 4. Distinguish between gross investment and net investment. 5. Explain how capital is accumulated. 6. List and discuss the determinants of the level of investment. 7. Analyze the graph of the C + I line.

6-3 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.  Disadvantages: Entire burden of running company falls on proprietor’s shoulders. Owner may be sued for everything if the business is sued. Much harder to raise money for capital as a small business.

6-4 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: All partners are liable for all debts incurred by their businesses.  If business is sued or partner absconds with funds, other partners are personally liable.

6-5  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.  Some advantages of a corporation: Limited liability: Corporation can be sued, but the stockholders are not liable (with rare exceptions). Corporations have potential perpetual life. Corporations may pay lower federal taxes. Corporations can sell stock to raise more money.  Some disadvantages of a corporation: You need a lawyer and have to pay a charter fee. You may have to pay federal (perhaps state) corporate income tax as well as personal income tax.  60% of corporations were too small to owe taxes in Proprietorships, Partnerships, and Corporations

6-6 The Business Population and Shares of Total Sales, 2009 Source: Statistical Abstract of the United States, 2010 Proprietorships lead in number; corporations lead in sales.

6-7 The Top Ten in U.S. Sales, 2008 Source:

6-8 The Top Ten in World Sales, 2008 Source:

6-9  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 only a small minority of businesses have taken advantage of these legal loopholes to enjoy the security of limited liability without paying corporate income tax. New Hybrid Varieties of Businesses Have Emerged

6-10 Stocks and Bonds  Stockholders are the OWNERS of a corporation  Types of stock: 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.

6-11  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  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. Capitalization and Control

6-12 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.

6-13 Questions for Thought and Discussion  What are the advantages of different firm structures?  Which industries are represented among the largest corporations in the U.S. and the world? Do any of the names on the lists surprise you?  How does the legal establishment of corporations facilitate business? (Hint: Consider the case study of the Middle East.)

6-14 Investment  Investment is defined as any new plant, equipment additional inventory, computer software, or residential housing. Note this is a different definition than an “investment” as buying a stock or bond.  Three Categories of Investment: Investment is any NEW plant and equipment. Investment is additional inventory. Investment is any NEW residential housing.

6-15 Investment and GDP  “Investment” is the thing that really makes our economy go and grow!  Investment is the most volatile sector in our economy. I GDP = C + I + G + Xn  Fluctuations in GDP are largely fluctuations in investment. Recessions are touched off by declines in investment. Recoveries are brought about by rising investment.  Inventories are the hardest component of investment to control and predict. Businesses do not want too much or too little inventory.

6-16 Hypothetical Inventory Investment for a Company  Includes only net change Date Level of Inventory Jan. 1, 2021 $120 million July 1, million Dec. 31, million Started the year with $120 million Ended the year with $130 million Net change is a (+) $10 million

6-17 Inventory Investment, 1960–2009 (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 Notice how pronounced the drop was in Source: Economic Report of the President, 2010; Economic Indicators, March 2010

6-18 Investment in Plant and Equipment  Almost half of today’s fixed investment is in information processing equipment and software, in contrast to less than 10 percent in the mid-1980s.  Even in bad years companies will still invest a substantial amount in new plant and equipment. Old and obsolete capital must be replaced (depreciation). Most capital expenditures are planned years in advance. Interest rates fall during a recession, so cost of borrowing decreases.  In the year 2007, capital spending was over $1.3 trillion, almost 60 percent higher (in 2007 dollars) than it had been just 10 years earlier. It fell sharply during the ensuing recession.

6-19 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 in determining the level of residential investment.  End of the Housing Bubble: Residential home building, which went into decline in early 2006, and continued to fall well into 2008, pulled down total investment during those years. Millions of homeowners found that the amount of money they owed on their home mortgages was greater than the value of their homes.

6-20 Questions for Thought and Discussion  Why do inventories fluctuate more than other components of investment?  Economists consider any spending on a person’s education and training an investment in her or his human capital. Human capital is the accumulation of knowledge and skills that make a worker productive. Your college education is certainly adding to your stock of human capital. Why are these expenditures NOT classified as investment? Should national income accounts change this classification?

6-21 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.”

6-22 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)

6-23 Questions for Thought and Discussion Calculate Gross Investment and Net Investment given: Date 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 billion

6-24 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

6-25 Determinants of the Level of Investment  Many factors determine the level of investment. We will focus on four: 1. Sales outlook 2. Capacity utilization rate 3. Interest rate 4. Expected rate of profit (ERP)  Note that Disposable Income (DI) is NOT a determinant. This means that we do not vary I with DI in building our model.

6-26 The Sales Outlook  Business firm’s sales outlook is the ultimate determinant of the level of investment: 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.

6-27 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? Capacity utilization reached a low of just 68.3 in mid  Other factors Manufacturing is a shrinking part of U.S. economy due to imports and increasing investment overseas by U.S. companies.

6-28 Capacity Utilization Rate in Manufacturing, 1965–2010 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 2010; Business Cycle Indicators, March 2010.

6-29 The Interest Rate   You won’t invest if interest rates are too high. Interest rate = Interest paid Amount borrowed Assume you borrow $1000 for one year at 12%, how much interest do you pay?. 12 = Interest Paid $1000 Interest Paid = $120

6-30 Expected Rate of Profit (ERP) ERP = Expected Profits Money Invested How much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?

6-31 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 %

6-32 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. Spending money on investment has opportunity costs. Foregone alternative could be putting the funds in a safe money market fund. The ERP of investing has to be higher than the opportunity cost (potential interest).

6-33 Graphing Investment = C + I  Assume $1 trillion dollar investment added to the consumption function  This is $1 trillion dollars at all levels of DI so it shifts the C + I function up as a parallel line.  How much is I when DI is $1 trillion? When DI = $4 trillion? When DI = $8 trillion?

6-34 Gross Investment, 2009 (Numbers don’t add up because of rounding.) Source: Survey of Current Business, March 2010,

6-35 Gross Investment and Its Components, , in 2005 Dollars Source: Economic Indicators, March Investment fell during the 2001 recession and during the 2007–2009 recession.

6-36 Questions for Thought and Discussion  To whom are corporate leaders loyal? To their employees? To their customers? To their owners?  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.  Should government policy intervene when corporations shift jobs and production overseas?