Invenory Invesmen. Invesmen Decision and Expeced Profi Lecure 5
Invenory Accumulaion 1. Invenory socks 1) Changes in invenory holdings represen an imporan and highly volaile ype of invesmen spending. 2) Three basic kinds of invenory socks: a. Primary inpus o producion b. Semi-finished goods in he course of producion. c. Finished goods ready for sale o final users.
Invenory Socks as a % of Toal invenory in U.S Manufacuring, 1990 32% 31% 37% Primary merial work-inprocess Finished goods
Invenory Socks As a % of Annual Shipmens in U.S Manufacuring, 1990 60 40 20 0 As a % of annual shipmens Primary maerials Primary maerials Work-inprocess Finished goods
2. Firms need invenories of primary maerials o economize on he coss of producing final oupu. 3. Mos formal heories of invenory managemen focus on final goods invenories. 1) Producion smoohing 2) Avoidance of sockous The firm mus balance he coss of invenory holdings agains he coss of involunary sockous. So, i is imporan o derive a mahemaics rule for opimal invenory managemen.
Firms hpld finished goods invenories 1.They can mainain smooh rae of producion despie a variaable rae of demand for heir oupu; Rising MC of producion(each exra uni is more expensive o produce han he previous uni) 2. Sock ou avoidance: The firm mus balance he cos of invenory holdings agains he cos of involunary sockous. For opimal invenory managemen use some rules: i.e. Ss Rule
Ss Rule S and s denoes he levels of invenories. Profi maximizing firm ses producion each period according o expeced demand, plus a consan. Over ime, flucuaing invenories; If demand is higher han expeced, invenories will fall; if demand is lower han expeced invenories will rise. The firm replenishes is invenories whenever hese fall below a cerain low level, s. The firm arges producion so ha i will mee expeced demand and also increase invenory holdings back up o a level, S. where S greaer han s.
Empirical Invesigaions on Invesmen Expendiure 1. Even armed wih hese heories of invesmen, however, i is quie difficul o explain much less o predic paerns of invesmen spending. 2. Several economeric models have been developed o explain acual invesmen behavior. 1) The acceleraor Model of invesmen 2) The adjusmen-cos approach 3) The q heory 4) Theories based on credi raioning
Invesmen Decision Invesmen decisions depend on curren sales, he curren real ineres rae, and on expecaions of he fuure. The decision o buy a machine depends on he presen value of he profis he firm can expec from having his machine versus he cos of buying i.
Invesmen and Expecaions of Profi Depreciaion: The rae of depreciaion,, measures how much usefulness he machine loses from one year o he nex. Reasonable values for are beween 4 and 15% for machines, and beween 2 and 4% for buildings and facories.
The Presen value of Expeced Profis V( e ): The presen value, in year, of expeced profi in year +1 equals: 1 1 e 1 r In year +2, 1 1 ( 1 )( 1 ) ( r r ) e 1 e 2 In year, e e V( ) 1 r 1 1 ( r )( r ) ( 1 1 1 1 ) e 1 e 2
The Presen value of Expeced Profis Compuing he Presen Value of Expeced Profis 12 of 26
The Invesmen Decision Denoe I as aggregae invesmen, as profi per machine (or per uni of capial) for he economy as a whole, and V( e ) as he expeced presen value of profi per uni of capial. This yields he invesmen funcion: I e I( V ( )) ( ) In words: Invesmen depends posiively on he expeced presen value of fuure profis (per uni of capial). 13 of 26
A Convenien Special Case Suppose firms expec boh fuure profis and fuure ineres raes o remain a he same level as oday, so ha e e 1 2 and e e 1 2 r r r Economiss call such expecaions expecaions ha he fuure will be like he presen saic expecaions. Under hese wo assumpions, we ge V( ) e r 14 of 26
A Convenien Special Case e Puing V( ) and e r I I V ogeher give us an equaion for invesmen: ( ( )) I I r The sum of he real ineres rae and he depreciaion rae is called he user cos or he renal cos of capial. Therefore, Renal Cos ( ) r 15 of 26
Curren Versus Expeced Profi Invesmen depends on expeced fuure profi, bu also moves srongly wih flucuaions in curren profi. I e I( V ( ), ) (, + ) Firms may be relucan o borrow if curren profi is low. Bu if curren profi is high, he firm may no need o borrow o finance is invesmens. Even if he firm wans o inves, i migh have difficuly borrowing. Poenial lenders may no be convinced he projec is as good as he firms says. 16 of 26
Curren Versus Expeced Profi Changes in Invesmen and Changes in Profi in he Unied Saes since 1960 Invesmen and profi move very much ogeher. 17 of 26
Profiabiliy Versus Cash Flow Profiabiliy refers o he expeced presen discouned value of profis. Cash flow refers o curren profi, or he ne flow of cash he firm is receiving. Boh profiabiliy and cash flow are imporan for invesmen decisions, and are likely o move ogeher. 18 of 26
Profis and Sales Changes in Profi per Uni of Capial Versus Changes in he Raio of Oupu o Capial in he Unied Saes since 1960 Profi and he raio of oupu o capial move largely ogeher. Y K 19 of 26
The Volailiy of Consumpion and Invesmen Le s look a he similariies beween our reamen of consumpion and of invesmen behavior: Wheher consumers perceive curren movemens in income o be ransiory or permanen affecs heir consumpion decisions. In he same way, wheher firms perceive curren movemens in sales o be ransiory or permanen affecs heir invesmen decisions. 20 of 26
The Volailiy of Consumpion and Invesmen Bu here are also imporan differences beween consumpion decisions and invesmen decisions: When faced wih an increase in income ha consumers perceive as permanen, hey respond wih a mos an equal increase in consumpion. When firms are faced wih an increase in sales hey believe o be permanen, heir presen value of expeced profis increases, leading o an increase in invesmen. 21 of 26
The Volailiy of Consumpion and Invesmen Raes of Change of Consumpion and Invesmen since 1960 Relaive movemens in invesmen are much larger han relaive movemens in consumpion. 22 of 26
The Volailiy of Consumpion and Invesmen The figure yields hree conclusions: Consumpion and invesmen usually move ogeher. Invesmen is much more volaile han consumpion. Because, however, he level of invesmen is much smaller han he level of consumpion, changes in invesmen from one year o he nex end up being of he same overall magniude as changes in consumpion. 23 of 26
The end Quesions Discussion