Investment

Investment
• “Investment” is the thing that really
makes our economy go and grow!
• Investment is any NEW
– Plant and equipment
• Investment is any NEW
– Additional inventory
• Investment is any NEW
– Residential housing

6-14
 Inventory Investment
Includes only net change

Date Level of Inventory

Jan. 1, 2003 $120 million
July 1, 2003 145 million
Dec. 31, 2003 130 million

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-15
 Inventory Investment

Includes only net change

Date Level of Inventory
Jan. 1, 2003 $120 million
July 1, 2003 145 million
Dec. 31, 2003 130 million
Started the year with $120 million
Ended the year with 130 million
The net change is a (+) 10 million

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-16
Inventory Investment (Continued)

Includes only net change

Date Level of Inventory
Jan. 1, 2003 $130 million
July 1, 2003 145 million
Dec. 31, 2003 120 million
Started the year with $130 million
Ended the year with 120 million
The net change is a (-) 10 million

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-17
 Inventory Investment, 1960-2000 (in
billions of 1987 dollars)
75

50

25

Ð25
1960 1965 1970 1975 1980 1985 1990 1995 2000

This is the most volatile sector of investment. Note that

investment was actually negative during three recessions
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-18
Investment in Plant and
Equipment
• Investment in plant and equipment
is more stable than inventory
– Even in bad years companies will still
invest a substantial amount in new
plant and equipment
• This is mainly because old and obsolete
factories, office buildings, and machinery
must be replaced
– This is the depreciation part of investment

6-19
 Investment in Plant and Equipment,
1960-2000 (in 1987 dollars)
1200

1100

1000

900

800

700

600

500

400

300

200

100
1960 1965 1970 1975 1980 1985 1990 1995 2000

There has been a strong upward trend in this investment sector over the last
four decades. Note the periodic downturns, especially during recession years
Residential Construction
• Involves replacing old housing as well
as adding to it
• Fluctuates considerably from year to
year
• Has mortgage interest rates play a
dominant role

6-21
Investment
• Investment is the most volatile sector in
our economy
– GDP = C + I + G + Xn

• Fluctuations in GDP are largely

fluctuations in investment

6-22
Investment (Continued)

• Recessions are touched off by declines

in investment
• Recoveries are brought about by rising
investment

6-23
Capital and investment
• Capital is a stock concept.
• It refers to the capital accumulated
over a period of time
• Investment on the other hand is a
flow concept and it is measured per
unit of time., generally one year.
• It refers to the addition to the
physical stock of capital.
 Stocks vs.
Flows
A stock is a Flow Stock
quantity measured
at a point in time.
E.g.,
“The U.S. capital stock
was $26 trillion on January
1, 2006.”

A flow is a quantity measured per unit of time.

E.g., “U.S. investment was $2.5 trillion during 2006.”

Note: These lecture notes are incomplete 13

How Do 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 and equipment, and add to
their inventory
• Corporations also use “retained
earnings” and “depreciation allowances”
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 for the fact
that plant & equipment wear out and houses
deteriorate

6-25
Gross and net investment
• The gross investment is the total
purchase of capital per unit of time.
• It consist of total annual expenditure
on
 plant , machinery , and equipment
Residential land and building
inventories
• Net investment , on the other hand is
=gross investment – depreciation

Depreciation just not only include

capital worn out or used up.
It also include obsolescence of capital
i.e. capital becoming economically
obsolete due to change in technology
Gross Investment - Depreciation = Net Investment
– Depreciation is taking into account for 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)
Calculate Gross Investment and Net
Investment
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
6-27
 Solution
Date level of inventory
Jan1 $60 billion
July 1 55 billion
Dec 31 70 billion inventory investment $ 10
Expenditures on new plant & equipment new P & E 120
$120 billion new RH 90
Expenditures on new residential housing gross investment 220
$ 90 billion - depreciation - 30
Depreciation on plant & equipment and net investment $ 190
Residential housing $30 billion
 Exhibit 8: Investment
Demand Curve
The economy’s
investment
demand curve

Nominal interest rate (percent)

shows the 10
inverse
8
relationship
between the 6

quantity of
D
investment
demanded and
the market
interest rate, 0 0.7 0.8 0.9 Investment spending
(trillions of dollars)
other things
21
 Planned Investment and
Income
• Investment depends more on interest rates
and on business expectations than on the
prevailing level of income
– One reason for this is that some investments take
years to complete
– Additionally, investment, once in place, is
expected to last for years

• Thus, the investment decision is said to be

“forward looking,” based more on expected
profit than on current levels of income and
output

22
 Exhibit 9: Autonomous
Investment Function

The horizontal investment functions imply

that planned investment does
Real planned investment

not vary with real disposable income

(trillions of dollars)

0.9 I"
0.8 I
0.7 I'

0 2.0 4.0 6.0 8.0 10.0 12.0

Real disposable income
(trillions of dollars)

23
Building Capital

• Investment involves sacrifice (on

someone’s part)
• To invest
– We must work more
– We must consume less (save)

6-29
 Determinants of the
Level of Investment
• Sales outlook

• Capacity utilization rate

• Interest rate

• Expected rate of profit (ERP)

6-31
The Sales Outlook
• 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

6-32
 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
• Other factors
– Manufacturing is a shrinking part of U.S.
economy due to imports and increasing
investment overseas by U.S. Companies
6-33
 Capacity Utilization Rate in
Manufacturing, 1965-2000

90
80
70
60

196566676869707172737475767778798081828384858687888990919293949596979899 002001

Since the mid-1980s, our capacity utilization rate

has been in the low 80s. Note that it fell during
each recession
6-34
 The Interest Rate
• You won’t invest if interest rates are too
high

Interest rate = The interest paid / The amount borrowed

Assume you borrow $1000 for one year @ 12 %, how

much interest do you pay?

X
.12 =
$1000
X = $120
6-35
 The Interest Rate
• You won’t invest if interest rates are too
high

Interest rate = The interest paid / The amount borrowed

Assume you borrowed $1000 for one year and paid $120
interest. What was the interest rate?

$120
X=
$1000
X = .12 = 12 %
6-36
Expected Rate of Profit
(ERP)

Expected Profits
ERP = -------------------------------------------
Money Invested

How much is the ERP on a $10,000

investment if you expect to make a profit
of $1,650?

6-37
 How much is the ERP on a
$10,000 investment if you expect
to make a profit of $1,650?
Expected Profits
ERP = -------------------------------------------
Money Invested

$1,650
ERP = -------------------------------------------
$10,000
ERP = .165 = 16.5 %

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 6-38
You Won’t Invest
If Interest Rates Are Too High
• 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
6-39
Why Do Firms Invest?
• Firm’s will only invest if the expected
profit rate is “high enough”

• Firms invest when

– Their sales outlook is good
– Their capacity utilization rate is high
– Their expected profit rate is high

• Even if firm’s invest their own money,

the interest rate is still a consideration
6-40
Methods of investment
decision
• The present value method
• Method based on marginal efficiency
of capital
NPV METHOD
• NPV is defined as the difference
between the present value of future
income stream and cost of
investment
• NPV= PV-C
• PRESENT VALUE OF future income
is the value of future income
discounted at the market rate of
interest.( price remain constant)
PV=R/(1+i)
R amt expected after one year
i = rate of interest
e.g if a person receive Rs. 100 today
and invest it in bank at 10% rate of
interest
• Present value of an amount expected
at some future date is it is the sum of
money that must be invested today at
a compound interest rate to get same
amount at some future date.
Decision rule
• If NPV is substantially greater than C,
then project under consideration is
worth the investment
• The investor can borrow money at
market rate of interest and can make
investment.
MEC method
• Keynes has suggested an alternative
investment decision based on MEC.
• Also known as IRR i.e. internal rate of
return.
• MEC is the rate of discount which
makes the discounted PV of expected
income stream equal to the cost of
capital.
• If cost of investment project is C
• and it is expected to yield a return R
for one year , then MEC can be found
as
• MEC= R/1+r=C
• r is the rate of discount that makes
the discounted value of R equal to C.
• Thus r is the MEC of capital. Or it is
IRR.
• r= (R/c)-1
• If an investment project costs Rs. 100
million and it is expected to yield
Rs.125 million at the end of one year.
• Calculate MEC
• If two year investment project costing
Rs. 100 million expected to yield no
return in the first year and Rs. 144 m
in the second year. Find MEC for the
project.
Decision rule
• Once MEC or IRR is estimated ,
investment decision can be taken by
comparing MEC with the market rate
of interest
• If MEC>i, then the investment project
is acceptable
• If MEC<i, then project is rejected
What Accounts for our Low Rate of
Investment?
• The short time horizon of corporate
America
• The quality of management in
America
• The quality of labor in America
• The low savings rate in America
– The less we save, the less we can
invest
– The less we invest, the slower our
rate of economic growth