The Business About INVESTMENT
I had fun that last time we wandered into Shady Valley's very own Happy-Time Gala-World Fun-Land Amusement Park, didn't you? Let's stroll through it again, just to see what adventures we might find. Okay, I admit to an ulterior motive. The Happy-Time Gala-World Fun-Land Amusement Park recently added a new ride -- the Cap'n Space Fright Whirl. If you thought the Monster Loop Death Plunge roller coaster was exciting, then you're in for a real treat with this one. My interest in the Cap'n Space Fright Whirl, however, is NOT from the standpoint of risking a recently eaten meal. On the contrary, I'm going to don my pointy-headed economist disguise and check out this mass of twisted metal and high-flying cages as a prime example of capital. In the process we might be able to gain some insight into the whys and wherefors of the thing we call investment.
Give a Little to Get a Little -- Or a Lot
We've come across this investment idea a number of times on our pedestrian amble through the economy. That's because investment is pretty darned important to topics like education, economic growth, transportation infrastructure, and wealth. it also pops up in the federal deficit, foreign investment, and the stock market. Let's spend the next few pages getting to the bottom of investment.
It's best to begin with what we already know. In Fact 1, Our Limited Pie, we saw that investment occurs when our resources produce more capital goods and fewer consumer goods. We sacrifice some well-being today, for capital that will (hopefully) give us more satisfaction tomorrow. While investment takes place in a number of day-to-day consumer areas -- like education, job training, personal planning, and the like -- our focus here is business investment on capital goods, such as factories, machinery, and equipment.
All Sorts of Capital
Here are some of the specific categories of capital bought as investment:
- Business structures. These are the buildings that house our economy's business operations, including factories, office buildings, warehouses, shopping centers, hospitals, and, well, any building that keeps the wind and rain from our nation's production. Pointy-headed economists refer to business structures as fixed plant -- meaning the buildings aren't easily moved.
- Durable equipment. This is the machinery and tools used by businesses to produce output. Although we could try for an exhaustive list of equipment, starting with abacuses, aircraft, anchors, awls, and axes, by the time we made our way to yokes and zeppelins, I would be out of space and you would be pretty darn bored. Durable equipment and businesses structures are what we usually think of when the term capital arises.
- Residential structures. A third category might not fall into preconceived ideas of capital. It includes the houses, apartment buildings, duplexes, fourplexes, and every other building designed to accommodate a bed, a refrigerator, and a television set for our sleeping pleasure. Like business structures give businesses a place to produce output, residential structures give consumers a place to produce home-made, but quite valuable, satisfaction.
- Inventories. These are the additions to, or subtractions from, the stockpiles of unsold products or raw materials awaiting processing that businesses keep on hand. It's best to think of inventories as sort of working capital -- the fuel that's needed to prime the pump of production. For example, if Mega-Mart Discount Warehouse Super Center built a new store, it would need to invest in the building, equipment, AND inventory. All three must be in place before Mega-Mart opens its doors.
- Infrastructure. Our last category includes streets, bridges, highways, railroads, airports, telephone systems, electric lines, and a bunch of other stuff that moves people, materials, goods, information, and energy. While some infrastructure investment is undertaken by businesses, most is done directly by government or at least subsidized by taxes.
Saving Some Pie
The pointy-headed economists use the term saving for the part of our economic pie NOT consumed and set aside for investment. Each of our three estates saves in their own way.
- Consumer saving. The hardworking, underappreciated, taxpaying consumers of the third estate do find a way to save a few bucks each year. This includes savings stashed in a bank account, like the $137.65 that I found on of our pedestrian journey and deposited in the Interstate OmniBank. However, it also includes such things as income you put into a private pension plan and the mortgage payments you make on your domicile. In fact, any portion of your income that is not spent, but diverted into the multitude of financial markets, would be considered saving.
- Business saving. While consumers save billions of dollars of their hard-earned income each year to help finance capital investment, businesses contribute two to three times that amount. Our second estate diverts a lot of income into investment long before it makes its way to the third estate. This diversion is accomplished in two basic ways: depreciation expenses and retained earnings. Depreciation expenses are part of business revenues that are set aside to replace worn out capital. Retained earnings are profit that a business decides to use for capital investment rather than paying out as dividends to the stockholders.
- Government saving. You're probably thinking: government saving?!?!? Does our government save? Our first estate, in principle at least, saves if tax collections are greater than spending. At the federal level, a budget surplus of taxes over spending is a rare event indeed. The norm for the federal-types is a budget deficit, with spending greater than taxes. However, many state and local governments do run budget surpluses. And their budget surpluses, when combined, cancel out some if not all of the federal deficit and occasionally generate a little extra for business investment. Moreover, part of the federal deficit is used by the first estate for a bunch of the infrastructure investment. As such, when government builds a highway, our tax dollars are actually saved and invested in capital at the same time.
We could end our discussion of the saving with these three estates. However, in so doing, we would leave out a source that's becoming increasing important in light of our interdependent global economy. That is, our economy also gets investment funds from other countries. During the 1980s and early 1990s, foreign sources financed almost as much capital investment as did consumer saving. It's big, it's important, and it's not likely to disappear any time soon.
The Investment Choice
Let's talk a stroll behind the scenes to examine the whys and wherefors of business investment. Our story picks up with Hortense McClintock, the owner and proprietor of the Happy-Time Gala-World Fun-Land Amusement Park. The setting is her office, the time is one year ago, the topic of discussion is Cap'n Space Fright Whirl. Should Hortense add this new ride to her assortment of thrill-instilling adventures at the Happy-Time Gala-World Fun-Land Amusement Park, or should she decline?
What does Hortense need to know before making her decision?
- First, the investment cost. Construction, from start to finish, of the Cap'n Space Fright Whirl is $500,000 and it will take approximately one year to complete. That means, our economy must forego $500,000 would of consumption goods for a year while construction is underway.
- Second, the source of funds. From our saving list, we can identify two ways Hortense can get the $500,000 needed for the Cap'n Space Fright Whirl -- existing amusement park profits or the financial markets. She either uses her own money or borrows it. How the borrowed money gets into the financial markets -- from households, governments, or foreigners -- is unimportant to her situation.
- Third, the interest rate. What is important, however, whether she borrows the money or uses her own, is the interest rate. If Hortense borrows the $500,000 from a bank, raises it by selling shares of stock in the amusement park, or issues some sort of corporate bond, then she needs to consider the payment for those funds, a cost that depends on the interest rate. If Hortense uses amusement park profits, then she must consider the opportunity cost of any interest that she could have received.
- Fourth, the return on the capital. Lastly, but not leastly, Hortense needs to consider the expected profit to be had from operating the Cap'n Space Fright Whirl. This, of course, is the whole reason for doing the investment. Hortense expects that her patrons will be willing to pay for the Cap'n Space experience. The creation of extra satisfaction with this capital is one example of our whole "expansion of our economic pie" thing.
Let's throw some numbers together and see what sort of investment choice Hortense should make. We already know that the investment cost is $500,000. Let's say that the interest rate Hortense would pay to borrow the needed money is 8 percent. She also has $500,000 of retained earnings receiving a 6 percent interest rate in the financial markets. And finally, Hortense calculates that enough additional patrons will be attracted to the amusement park by the Cap'n Space Fright Whirl to add about $50,000 a year in profits.
Do the prospects for investing in the Cap'n Space Fright Whirl look promising or not?
- Let's take that $500,000 in retained earnings that's getting 6 percent. If left in the financial markets, Hortense collects $30,000 per year. If that money is used to finance the Cap'n Space Fright Whirl, she would get $50,000 per year -- an extra $20,000. This alone tells us that the Cap'n Space Fright Whirl is a sound investment. But can she do better by borrowing?
- If she borrows the needed $500,000, then her interest cost at 8 percent is $40,000. The $50,000 generated by the Cap'n Space Fright Whirl would more than cover this expense, leaving her with a cool $10,000. While this option would be good choice, it's not as good as using her retained earnings.
Let's sum this up. When a business ponders an investment, it needs to consider the vast array of potential interest rates and returns to be had, or to be paid, in the financial markets. If a business has the money in hand, then it merely searches out the highest return. This could be the capital investment or in the financial markets. If a business borrows the money, then needs to compare the interest cost with the anticipated return on the investment capital.
The World is a Risky Place
The tricky thing about investment, though, is that the expected returns are only that -- expected. You're never quite sure if the return you expect is what you'll actually get. Hortense would be most disappointed if the Cap'n Space Fright Whirl failed to generate $50,000 in profit. If the return ends up in the $10,000 range, then hindsight tells us that she made a bad investment. But this risk, my friends, is the heart and soul of investment. Many businesses have passed up capital investments that ended up far exceeding their expected returns when picked up by others. Others have dumped gadzillions into the toilet by making capital investments that fell far short of expectations.
Most of the big-time investment falls in the domain of the second estate. That, however, doesn't mean it should be ignored by the third. Here are a few tips to consider:
Investment Tips for the Third Estate
- Begin by thinking about the "investments" that you make on a daily basis. Anytime you give up current satisfaction in hopes of getting more future satisfaction, then you're investing. Buying a house, car, or other durable goods is an investment. Changing jobs, getting an education, or moving to another state are also investments. Even things like exercising, dieting, or visiting a dentist fall into this investment category.
- Once you identify a potential investment, the next step is to compare expected returns with the cost. If you borrow $10,000 for a car, will it provide you with enough satisfaction each year to compensate for the interest expense? If you use your own savings to buy the car, does the satisfaction compensate you for the lost interest?
- You should also keep these investment rules in mind for when you get the chance to dabble in the financial markets. For example, you might want to think twice about borrowing at 15 percent (as with a CREDIT CARD) while you're lending at 3 percent (as with a savings account).