Chapter 6-- The Business-Investment Sector

1. Proprietorships, Partnerships, and Corporations
1. The U.S. has about 20 million businesses.
1. 70% are sole proprietorships-- businesses owned by one and only one person.
2. 10% are partnerships-- business owned by at least, and often, two people.
3. 20% are corporations-- a separate legal entity that can be owned by an indefinite number of people, or as in many cases, just one person.



2. Sole Proprietorship
1. A proprietor is an owner. So, the name tells us that this is a business structure that indicates just one owner.



2. Most "Mom & Pop" establishments are proprietorships.



3. They are easy to form. Just click your heels and say three times "I wish I had a business, . . ." and poof! You have one! Just print up some business cards and away you go!
1. Of course, you may have to comply with certain pesky details:
1. business licenses, zoning issues, and . . . oh yeah! what kind of a business do you want to own, anyway?



4. The advantage? You're the boss.
1. The Big Kahuna, The Head Cheese, The . . . (enough!)



5. The disadvantages? You risk it all: your investment in the business, even your own personal savings, and assets-- including your home.
1. This risk is called unlimited liability, and it is just too much for many of us to swallow. That's why we work for others-- let them bear the risk. We'll just show up and go home at 5 o'clock.



6. A few more disadvantages:
1. Limited capital
1. Whose money started the business? Probably your own, perhaps mixed with some borrowed funds.
1. Hopefully not from an uncle, who will probably try to run your business so he can "protect" his investment.



2. Limited skills
1. Let's face it-- who can do everything well?
2. There are three basic skills needed in any business:
1. Selling (marketing)
1. You have to have a pretty good idea what people want and how to convince them to buy it from you.
2. Operating (productions & operations management)
1. someone has got to service customers, and handle the thousands of details that come your way.
3. Keep the books (finance and accounting)
1. How do you invest your capital? Are you making any money?



3. While many proprietors handle these tasks well, through hard work, dedication, and determination, most of us are best suited to specialize in one of these areas. We need help from others who specialize in the other areas.



3. The Partnership
1. "Two heads are better than one," so they say.
1. "They" also say, "Too many cooks spoil the soup!"



2. A partnership has two or more owners. Now, there are two pockets to fund the business, not just one.



3. And, there are two sets of skills at our disposal. Perhaps you are the "inside" person-- keeping the books, performing administrative tasks. Maybe your partner is the "outside" person-- meeting prospects and clients, selling and servicing. Since each of you allocate your time to your specialties, you will work efficiently.



4. OK, sounds great! Let's form a partnership.
5. Hold on! I need to tell you about the downside.



6. Like proprietorships, partnerships have unlimited liability. And, even worse, your partner can enter into agreements which legally bind you, and put your personal assets at risk.
1. Partnerships are not a very attractive business structure for this very reason.



4. The Corporation
1. The Latin root word "corpus" means body.
2. Our legal system regards corporations as legal persons.
1. And as a "person," this thing can do many of the things that people do:
1. sue, be sued, own property, buy and sell property, and be taxed.
3. So, if you own a corporation, you are insulated from its debts.
1. You have limited liability.
4. A corporation's debts are its own.
5. And most attractive of all-- if a corporation is sued for millions (or even billions) the owners of that corporation are shielded from the lawsuit.
1. There are exceptions where the courts have "pierced the corporate veil" and went after the corporation's officers in matters of criminal negligence.



6. This limited liability feature of the corporate form of business-- meaning, the most you can lose is your investment-- makes corporations a very attractive investment. As such, they are able to raise vast amounts of capital.



7. A couple of disadvantages to mention: costs of organizing and taxation.
1. Organizing costs-- state filing fees, attorneys' fees, promotional costs are usually in the thousands of dollars.



2. Taxation-- probably the biggest disadvantage. As a legal entity, profits are taxed. Then, some of these after-tax profits are given to the owners (as dividends), and taxed again!
1. This double taxation issue has been and continues to be debated for and against to this day.



8. Earlier we said corporations constituted 20% of all American businesses.



9. But, this 20% account for 90% of total business receipts!



10. There are about 4 million corporations in the U.S.



11. About 0.05 % of them are the large corporations. And it is that 5 hundredths of one percent (2 thousand out of 4 million) who are responsible for a good portion of the nation's output.
1. See table 1 on page 105.



5. Stocks and Bonds
1. How does one own a piece of a corporation? By buying a share of stock. You will then be referred to as a stockholder or shareholder.



2. You will be able to "vote" on matters concerning the corporation's activities at the annual shareholder meetings, if you own a share of common stock.



3. You will also have the right to share in the company's profits, proportionately, if distributed.

1. Corporations sometimes have different "classes" of stock, each with their own special features.
1. Common-- as described above
2. Preferred-- having priority over common on claims toward the corporation's assets in a liquidation.
3. Preferred stock also has priority on dividends over common stock.
4. The different classes of stock are just different investment "products" being offered to the prospective buyer. Just like how auto companies offer different models, each targeted at particular consumer needs and tastes.



2. It's important to know that when you buy stock, you are risking your entire investment. There are no guarantees you'll ever see a penny in return. You could lose it all. You are buying equity in a corporation. If they go out of business, creditors are paid first, owners last. If anything is left over, preferred stockholders get it, then common. If nothing is left, stockholders lose their money.
1. This sobering fact hasn't stopped most Americans from investing in stocks. They know that if there's risk, there is usually reward. And as of recent years, the rewards have been substantial!



3. Well, now you've got me a little uneasy about this stock thing. What else can I do?



4. Answer: Instead of investing into the equity of a company, you can lend them money! You can buy their bonds.



5. When you are a bondholder, you are a creditor. Guess what? You do get paid back-- every penny! What's more, the company will pay you periodic interest payments just to rent your money, then pay you back in full!



6. How exciting! No risk!
7. Hold on. You should know that in economics there's always a catch.
8. The catch is, the reward is low. But it's more secure-- especially if you lend the government money.



1. Capitalization and Control
1. Karl Marx said "whoever owns the capital owns the society."
2. The way to effectively control a company is to own 50% plus one share of common (voting) stock.
3. This doesn't usually happen with big corporations, though.
1. Most public corporations are widely held. That means the shares are spread around. No one person owns more than a small fraction of the total shares.

1. The text tells us that, in all practicality, it usually only takes about 5% ownership to effectively control the company, since most shareholders vote by proxy or don't even bother at all.
1. Sounds a little like our political system, doesn't it?



1. Investment (or Capital Investment)
1. Define: business purchases of inventory, plant, and equipment
1. In the context of an economics class, investment is what business does with the funding they receive-- either stock and/or bond proceeds, and their own retained earnings-- they invest these funds in plant and equipment.
1. Professor Slavin (our author-- let's have a round of applause for him) includes the purchase of residential housing by citizens as investment. In the last chapter, we talked about how buying a house is really a savings account in reality. Therefore, we will exclude residential housing from our discussion on business sector investment for now.



2. Plant includes factories, office buildings, shopping malls, etc.
3. Equipment is the machinery and computers used in the plants.
4. Inventories are the products that businesses sell or resell.
1. In accounting, inventory is not considered an investment since it has a short shelf life. However, plant & equipment are. So is land in that context.



5. Be careful not to confuse personal investing with business investment!
1. When you go online and buy securities through e-trade, you are not directly supplying businesses with funding. You are just exchanging stocks and bonds with other individuals in a private transaction.
2. So, while you may consider this to be investing, the company hasn't seen a dime.



2. Investment is one of the components of Gross Domestic Product (GDP).
1. GDP = C + I + G + X
1. Consumption, investment, government spending, net exports.



3. Firms invest to:
1. Replace worn out equipment
2. Replace obsolete plant and equipment with newer state-of-the-art p&e.
3. To grow



4. Savings and Investment
1. Whether you deposit money in a bank, or buy stocks and bonds through a broker, you are dealing with resellers, so to speak. You aren't giving Exxon-Mobil your money so they can invest in inventory, plant, and equipment.
1. So, how do companies get the money to invest?



2. When companies want to raise money they sell their stocks and bonds to an investment banker, who then resells these securities to the general public through brokers.
1. Compare it to buying a pack of gum. Let's say you go to Sheetz and buy a pack of Winterfresh. Does the Wrigley family in Chicago get your money? Not directly. There are numerous middlemen (excuse the gender-specific term) involved. Such is a the purchase of stocks and bonds.



2. The middleman/woman is the investment banking firm. They bear the risk.
1. Examples: Merrill Lynch, Lehman Brothers, CS First Boston.



3. Savings in the old fashioned way through a savings account at a bank are loaned by the bank to other bank customers and capital hungry companies-- big and small.
1. Again, it only becomes investment when the borrower buys productive assets (inventory, plant, equipment).



5. Gross Investment vs. Net Investment
1. We've all come to realize the differences between gross and net.
1. Take our own personal incomes (please).
2. They always say, "It's not what you make, it's what you keep that counts."
3. We have gross incomes and net incomes-- the difference being all the deductions in between.



2. While we use GDP to measure the nation's productivity, we may also use a measure called NNP-- Net National Product.



3. NNP = C + Net Investment + Govt. Spending + Net Exports.



4. So, what is this Net Investment thing?



5. Ok, remember we said Investment was what business spends on plant, equipment, and inventories each year?



6. Each year after, that plant and equipment gradually lose a little bit of their value. This is the concept of depreciation.



7. We can then figure a net change in investment for the year.
1. For example, look at the table on page 112.



8. And while businesses add to their stock of inventories, obviously (and hopefully) some of them get sold. We can compute a net change in inventories for the year. (Again, see table 4 on page 112)



9. So, Net Investment = Investment - Depreciation.
10. And NNP = GDP - Depreciation on Plant and Equipment
1. We'll have to bear with the author's repeated inclusion of residential housing into this topic, and now the including of depreciation on residential housing into the mix.





6. Determinants of The Level of Investing
1. Sales Outlook
1. If good sales are projected in the short run, businesses may be willing to purchase or produce additional inventories to meet demand.
1. unless they're overstocked already.



2. And, if good sales are projected in a longer time horizon, businesses may also choose to expand by buying more plant and equipment to meet demand.



2. Capacity Utilization Rate
1. Businesses operating at full production may or may not be using their facilities to full capacity.



2. If they are "bursting at the seams" and sales outlook is good for quite sometime to come, they will probably decide to invest in plant and equipment.



3. If they are not "pressing the walls" and there is plenty of idle machinery and space, then only a fool would invest in plant and equipment.
1. As obvious as that sounds, we know that there are people out there who are in decision-making positions who would do just that-- MBA or not.



3. Interest Rates
1. Interest is the cost of borrowing money.
2. The higher the cost, the less businesses will want to borrow-- and visa versa.
3. The higher the interest rates, the more households will want to lend
4. Hey, that sounds an awful lot like supply and demand, doesn't it. Whaddya know!
4. The Expected Rate of Profit
1. Before a company decides to invest in plant and equipment, they usually do a little bit of analysis.



2. They consider alternatives.



3. For example, they might say, "If we buy these machines, we think we will increase revenues by $1 million dollars this year.
1. And if you happen to be the infamous Dr. Evil from the Austin Powers movies, everyone will laugh at your ridiculously small profit projections.



4. But, what if the cost of borrowing money and other necessary expenses exceeded $1 million?
1. Again, only the fool we mentioned above would invest. And we should always remember that they are out there and may even be our next boss!



2. So, just like with Dr. Evil, the board members would have a hearty laugh at our proposal.



5. Getting back to comparing alternatives, consider these:
1. Expansion of plant and equipment requires $10 million in investment and returns projected additional net profits of $1 million a year for 15 years.



2. Plan B is to invest in government bonds that yield 6% a year.



3. If analysis shows you that expansion will bring you about 5.5% return per year, which would you choose? Probably the bonds.



6. This kind of comparison of investment alternatives is called capital budgeting.
1. If you study managerial accounting, you will have this.



7. Here are the basic common sense rules regarding investment decisions using expected profits:
1. Plan A: If additional profits (marginal return on investment) < cost of capital, forget it!
2. Plan B: If marginal return > cost of capital, consider it!
3. Plan C: If this plan beats plan B, choose it!