Investment Investment Investment is the thing that really
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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 Date change Level of Inventory Jan. 1, 2003 $120 million July 1, 2003 145 million Dec. 31, 2003 130 million Copyright 2002 by The Mc. Graw-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 Mc. Graw-Hill Companies, Inc. All rights reserved. 6 -16
Inventory Investment Includes only net (Continued) 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 Mc. Graw-Hill Companies, Inc. All rights reserved. 6 -17
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
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 Flow A stock is a quantity measured at a point in time. Stock 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 and net investment • The gross investment is the total purchase of capital per unit of time. • It consist of total annual expenditure on v plant , machinery , and equipment v. Residential land building vinventories
• 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 inventory level of 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 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 inventory investment $ 10 new P & E new RH gross investment 120 90 220 - depreciation - 30 net investment $ 190
The economy’s investment demand curve shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. Nominal interest rate (percent) Exhibit 8: Investment Demand Curve 10 8 6 D 0 0. 7 0. 8 0. 9 Investment spending (trillions of dollars) 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
Real planned investment (trillions of dollars) Exhibit 9: Autonomous Investment Function The horizontal investment functions imply that planned investment does not vary with real disposable income 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
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? . 12 = X $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? X= $120 $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 Mc. Graw-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