Investment in the Private Sector

Learning outcomes

• By studying this section students will be able to:– define and distinguish between different types

of investment– analyse the factors which affect an investment

decision– analyse the effects of investment on the

economy

Definition• Investment may be defined as expenditure

on capital goods and working capital.– Fixed capital goods consist of buildings, plant

and machinery.– Working capital consists of stocks of raw

materials, semi-manufactured goods and manufactured goods which have not yet been sold.

– Net investment = gross investment – depreciation

Factors affecting investment

• Investment in the private sector is undertaken to increase profitability.

• Organizations will seek to invest in those projects which yield the highest return.

• The profitability of an investment project can be analysed by investigating its costs and revenue.

Cost of investment

• planning costs

• costs of capital goods

• cost of financing investment

• running costs of the investment

Revenue from investment

• price of output

• quantity of output sold

• other factors

Revenue Factors

• Strong demand from tourists causes new investment in accommodtaion in Koh Phi Phi, Thailand

Appraisal techniques

• payback method

• net present value

• internal rate of return

The accelerator principle

• Investment activity in economies tends to be volatile.– When demand for consumer goods and

services is relatively stable in an economy, much of the demand for capital goods will take the form of replacing worn-out plant and machinery.

The accelerator principle (cont.)

• Investment activity in economies tends to be volatile.– However, if demand for final goods rises and

there is no spare capacity in an industry, then new machinery will have to be purchased. Thus the demand for capital goods will significantly increase to include new machines as well as replacement machines.

The accelerator principle (cont.)

• Investment activity in economies tends to be volatile.– Similarly, if the demand for final goods in an

economy falls, firms will find they have over-capacity and too many machines. They will reduce the stock of machines to the new lower levels needed by not replacing worn out machines, so the demand for capital goods will fall.

Risk and sensitivity analysis

• Sensitivity analysis is a technique for incorporating risk assessment in investment appraisal.

• It works by highlighting the key assumptions upon which investment appraisal figures were based.

• Sensitivity analysis would calculate the effects on an investment appraisal of changes in these assumptions.

• It illustrates a project’s sensitivity to a variety of scenarios.

Sources of funds

• retained profits

• new share issues

• loans

• government assistance

Investment Conditions

Investment in the public sector

Learning outcomes• By studying this section students will be

able to:– identify the sources of public sector

investment– identify different types of public sector

investment– describe different methods of public sector

investment– identify sources of funds for public sector

investment

Sources• National level

– government channels leisure and tourism investment through public corporations, quangos such as Sports Councils and government departments

• Local government

• Supranational level– e.g. the EU

Types• Buildings and land

– E.g. parks, leisure centres and museums.

• Plant and machinery – E.g. playground apparatus, computerized

booking systems and canal lock equipment.

• Infrastructure– E.g. roads, railways and airports, water and

sewerage, power and telecommunications.

• Research and development

Methods and aims

• Methods– projects which are wholly public sector-

financed– projects which are jointly financed by the

public and private sectors – private sector investments which are eligible

for public sector investment incentive grants.

Methods and aims

• Aims– provision of goods and services which have

significant public benefits, but which might not be profitable enough to attract private sector investment.

– economic development or regeneration of a particular area.

• Public-funded restoration projects on the island of Chios, Greece.

• Aims– Preservation of

cultural capital– Economic

regeneration– Provision of jobs

Investment appraisal

• Cf private sector

• Cost–benefit analysis– all the costs and benefits of a project are

identified and weighed up, including social as well as private ones.

Cost / benefits of canal restoration

Investment incentives• Governments offer incentives to encourage

investment particularly:– in areas of high unemployment– where there are clear social benefits offered by a

scheme– where structural changes in the economy have led to

geographic areas of economic decline (for example, rural decline etc.)

• Incentives can include – tax relief– subsidised loans

Sources of funds

• Sources of funds for public investment include:– operating profits– taxation– borrowing– national lotteries– Public Private Partnerships (PPPs)

Sydney Opera House• The first estimates for the

costs of the Sydney Opera House were $7 million.

• An appeal fund raised about $900,000

• The rest of the $102 million that the Opera House ended up costing came from the profits of a series of lotteries.

(Top photo courtesy of Sydney Opera House)

The public sector investment debate: Cons

• The public sector is not a good interpreter of people’s wants.

• The public sector is not good at ensuring efficient use of funds and tends to allow waste.

• Public sector investment causes an increase in taxation or public borrowing.

Opportunity Cost of Public Sector Investment

• An increase in public sector investment means either– A reduction

of other expenditure (BC)

– Or an increase in taxes (YZ)

The public sector investment debate: Pros

• There is insufficient incentive for the private sector to invest in public goods.

• The private sector under invests in goods which have mainly social benefits.

• The private sector may not be able to undertake the finance or risk for very large projects.

• Public sector investment can help regenerate parts of the economy which have suffered from restructuring.

• Public sector investments can generate jobs when unemployment is high.

Investment in the public sector:

The End

In-class group assignment:Aircraft Demand

• The demand for new aircraft is very volatile and explained by reference to the accelerator principle

• What are current demand conditions for new aircraft?