Chapter 6

The Business-Investment Sector

McGraw-Hill/Irwin
Companies, All Rights Reserved

2009 The McGraw-Hill

Learning Objectives

In this chapter youll learn:

1.
2.
3.
4.
5.
6.

The three types of business firms.

How investment is carried out.
The difference between gross investment and net
investment.
How capital is accumulated.
The determinants of the level of investment.
The graphing of the C + I line.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Proprietorships, Partnerships, and

Corporations

Proprietorship

Proprietorships are owned by individuals.

Proprietorships are almost always small businesses.

Some advantages of a proprietorship:

Grocery stores, barbershops, restaurants, family farms, gas

stations, etc.
You can be your own boss.
Your income is taxed only once.

A major disadvantage of a proprietorship:

The largest is unlimited liability

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Proprietorships, Partnerships, and

Corporations

Partnership

Partnerships are owned by two or more people.

Some advantages of a partnership:

Some law and accounting firms have hundreds of partners.

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

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Proprietorships, Partnerships, and

Corporations

Corporation

Some advantages of a 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.
Limited liability
Corporations have potential perpetual life.
Corporations may pay lower federal taxes.

Some disadvantages of a corporation:

You need a lawyer and have to pay a charter fee.

You have to pay federal (perhaps state) corporate income
tax.
Double taxation

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Proprietorships, Partnerships, and

Corporations

The New Hybrid Varieties

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 on a small minority of businesses have taken

advantage of these legal loopholes to enjoy the
security of limited liability without paying corporate
income tax.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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The Top Ten in U.S. Sales, 2006

Source: www.Fortune.com
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The Top Ten in World Sales, 2006

Source: www.Fortune.com
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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.

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Stocks and Bonds

Stockholders are the OWNERS of a corporation

Common stock

Preferred stock

Voting rights
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.

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Capitalization and Control

A corporations 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 (capitalized)

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Capitalization and Control

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 dont bother to vote or give their
proxies to others.

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The Business Population and Shares of

Total Sales, 2006

Source: Statistical Abstract of the United States, 2008

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Questions for Thought and Discussion

What are the advantages of different firm structures?

How does the corporation facilitate business? (Hint:

Consider the case study of the Middle East.)

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6-14

Investment

Investment is the thing that really makes our

economy go and grow!

Investment is any NEW plant and equipment.

Investment is additional inventory.

Investment is any NEW residential housing.

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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

Net change is a

$10 million

(+)

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Inventory Investment, 19602005 (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 2001. Notice how pronounced the drop was in 2001.
Source: Economic Report of the President, 2008; Economic Indicators, Feb 2008
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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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.

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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.

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Investment

Investment is the most volatile sector in our economy.

GDP = C + I + G + Xn

Fluctuations in GDP are largely fluctuations in

investment.

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Graphing Investment = C + I

Assume 100 billion dollar

investment added to the
consumption function

This is 100 billion dollars at all

levels of consumption so it shifts
the function up by 100 billion
dollars

This 100 billion has a multiplier

effect on the economy of 300
billion dollars (we will talk about
multipliers later, but this is a
heads up).

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Investment

Recessions are touched off by declines in

investment.

Recoveries are brought about by rising investment.

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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.

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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)

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Questions for Thought and Discussion

Calculate Gross Investment and Net Investment given:
Date
Jan 1

level of inventory
$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
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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

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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Building Capital

Investment involves sacrifice (on someones part)

To invest

We must work more.

We must consume less (save).

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Marx
Capital is created by labor but stolen by capitalist
Assume it takes $3 to keep a person alive for 24 hours.
Assume that one person can use a machine to produce $3
worth of cloth in 6 hours.
The capitalist owns the machine and pays $3 for 12 hours
work.
12 hours of work produces $6 worth of cloth.
Capitalist pays ------------> $3 wages
creates a surplus of ------->$ 3

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Determinants of the Level of Investment

Sales outlook

Capacity utilization rate

Interest rate

Expected rate of profit (ERP)

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The Sales Outlook

You wont 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.

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6-30

Capacity Utilization Rate

This is the percent of plant and equipment that is

actually being used at any given time.
You wont 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.

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Capacity Utilization Rate in Manufacturing,

19652007

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 2008; Business Cycle Indicators, January 2008.
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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The Interest Rate

You wont invest if interest rates are too high.
Interest rate = the interest paid / the amount borrowed
Assume you borrow $1000 for one year at 12% , how
much interest do you pay?

Interest Paid
.12 =

$1000
Interest Paid = $120

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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?

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How much is the ERP on a $10,000 investment

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

ERP =

ERP =

Expected Profits
Money Invested
$1,650
$10,000
ERP = .165 = 16.5 %

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You Wont 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.

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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.

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Gross Investment, 2007

(Numbers dont add up because of rounding.)

Source: Economic Report of the President, 2008, www.bea.gov.

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Gross Investment and Its Components,

1995-2007, in 2000 Dollars

Source: Economic Indicators, February 2008.

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Questions for Thought and Discussion

To whom are corporate leaders loyal?

To their employees
To their customers
To their owners

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Solution

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.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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