1. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 6 THE BUSINESS-INVESTMENT SECTOR Chapter 6

2. 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.

3. 6-3 Proprietorships, Partnerships, and Corporations Proprietorships  Are owned by individuals.  Are almost always small businesses. Major Advantages:  You can be your own boss.  Income is taxed only once. Major Disadvantages:  Entire burden of running company falls on proprietor’s shoulders.  Unlimited Liability: Owner may be held personally liable if the business is sued.  It is much harder to raise money for capital.

4. 6-4 Proprietorships, Partnerships, and Corporations Partnerships  Owned by two or more people. Some law and accounting firms have hundreds of partners. Major Advantages:  It is easier to raise more capital.  The work and responsibility can be divided among partners. Major Disadvantages:  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.

5. 6-5 Proprietorships, Partnerships, and Corporations Corporation  Is a legal entity like a person.  Most are small firms.  Are owned by the stockholders.  Is easier to raise money by selling stock.  Most are not publicly held. Major Advantages:  Limited liability: Can be sued, but the stockholders are not liable (with rare exceptions).  Have potential perpetual life.  May pay lower federal taxes.  Can sell stock to raise more money. Major Disadvantages:  Need a lawyer and have to pay a charter fee.  May have to pay federal (perhaps state) corporate income tax as well as personal income tax.

6. 6-6 The Business Population and Shares of Total Sales, 2012 Source: Statistical Abstract of the United States, 2010 Proprietorships lead in number, Corporations lead in sales.

7. 6-7 Source: www.Fortune.com The Top Ten in U.S. Sales, 2012

8. 6-8 Source: www.Fortune.com The Top Ten in World Sales, 2012

9. 6-9 New Hybrid Varieties of Businesses Have Emerged such as: Limited Partnerships, S Corporations, and Limited Liability Proprietorships  Do not pay corporate income taxes.  Taxed solely on the individual level profits.  Pose minimum legal risks to their investors.

10. 6-10 Stocks and Bonds Stockholders are the OWNERS of a corporation Two Types of stock:  Common stock which has voting rights.  Preferred stock which do not have voting rights but receive a stipulated dividend. Bondholders are CREDITORS rather than owners.  They 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.

11. 6-11 Capitalization and Control A corporation’s total 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 do not bother to vote or give their proxies to others.

12. 6-12 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.)

13. 6-13 Business-Investment Is any new plant, equipment additional inventory, computer software, or residential housing.  Note this is a different definition than a financial transaction “investment” as buying a stock or bond. Three Categories:  NEW plant and equipment  Additional inventory  NEW residential housing

14. 6-14 Investment and GDP Investment is the thing that really makes our economy go and grow! It is the most volatile sector in our economy.  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.

15. 6-15 Hypothetical Inventory Investment for a Company Includes only net change Date Level of Inventory Jan. 1, 2021 $120 million July 1, 2021 145 million Dec. 31, 2021 130 million Started the year with $120 million Ended the year with $130 million Net change is a (+) $10 million

16. 6-16 Note that Investment was actually negative during recessions in 1975, 1980, 1982, 1991, 2001, and 2007. Inventory Investment, 1960–2012 (in billions of 1987 dollars)

17. 6-17 Investment in Plant and Equipment Almost 50% of today’s fixed investment is in information processing equipment and software, in contrast to 10% 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 2007, capital spending was over $1.3 trillion, almost 60% higher (in 2007 dollars) than it had been just 10 years earlier.  It fell sharply during the ensuing recession.

18. 6-18 Residential Construction Includes replacing old housing as well as adding to it. Fluctuates with interest rates from year to year.  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 which is called being “underwater.”

19. 6-19 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?

20. 6-20 How Does Saving Get Invested? Money saved is put into stocks and bonds. Businesses take this money to buy new plant, equipment, and add to their inventory. Businesses use “retained earnings” and “depreciation allowances.”

21. 6-21 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.

22. 6-22 Problem: 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

23. 6-23 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

24. 6-24 Determinants of the Level of Investment Many factors determine the level of investment. We will focus on four:  Sales outlook  Capacity utilization rate  Interest rate  Expected rate of profit (ERP) Note that Disposable Income (DI) is NOT a determinant.

25. 6-25 The Sales Outlook Firm’s sales outlook is the ultimate determinant of the level of investment.  Will NOT invest if the sales outlook is bad.  If sales are expected to be strong the next few months the business will add inventory.  If sales outlook is good for the next few years, firms will purchase new plant and equipment.

26. 6-26 Capacity Utilization Rate Percent of plant and equipment that is actually being used at any given time. Do NOT invest if there is unused capacity.  Capacity utilization reached a low of just 68.3 in mid-2009.

27. 6-27 Capacity Utilization Rate in Manufacturing, 1965–2013

28. 6-28 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

29. 6-29 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?

30. 6-30 ERP = Expected Profits Money Invested ERP = $1,650 $10,000 ERP =.165 = 16.5 % How much is the ERP on a $10,000 investment if you expect to make a profit of $1,650?

31. 6-31 You Won’t Invest if Interest Rates are Higher than ERP In general, the lower the interest rate, the more business firms will borrow.  Compare interest rate with 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.  A 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).

32. 6-32 Graphing Investment = C + I Assume $1 trillion Investment added to the Consumption Function This is $1 trillion 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?

33. 6-33 Gross Investment, 2012 (Numbers don’t add up because of rounding.)

34. 6-34 Source: Economic Indicators, March 2010.. Investment fell during the 2001 recession and during the 2007–2009 recession. Gross Investment and Its Components, 1995-2012, in 2005 Dollars

35. 6-35 Questions for Thought and Discussion To whom are corporate leaders loyal? o Their employees? o Their customers? o Their owners? Answer: Their owners o One thing should be perfectly clear: If a corporation does not maximize its profits, it is disloyal to its owners. o 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?