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Investment policy in industrial enterprises.

Clarification of concepts

Neither official statistics of investment, nor econometric analyses of investment procedures, nor investment tests, whose aim is to show the expectations of the investors, provide an answer to the question as to how firms, in particular industrial concerns, reach decisions regarding capital investment and as to what considerations they are guided by. But it is precisely the motives which in concrete instances bring about the decision to invest, which are of interest from the point of view of the economy of the firm. It is immediately apparent that these motives may be widely differentiated and that the structure of motivation is determined by the particular aims of the investments as well as by the special conditions of the branch of production and the peculiar character of the enterprise itself.

If one inquires into the reasons which give rise to investment for replacement of capital assets, one is immediately faced with an extraordinary variety of considerations which lead to such investment. It is not altogether easy to define the concept of capital investment (for replacement), when it is projected into investment practice. Difficulties arise in particular, when one attempts to define the relationship between investment for replacement purposes and investment for rationalisation. Since investment for replacement generally involves investment for improvement, it is impossible to draw a hard and fast line between investment for replacement and investment for rationalisation. The definition of investment for replacement which accords most closely with existing practice is: an investment primarily intended to replace old machinery, plant etc. with new, regardless of whether this involves a new type of plant or an increase in production capacity as a secondary effect so to speak. So that where investment for replacement leads to an improvement in conditions of production and possibly as a result to some increase in the volume of production, such investment may nonetheless be regarded as replacement investment, if it was not undertaken with the intention of expanding the total capacity of the enterprise by means of rationalisation.

Investment for expansion occurs on the other hand, where a primary aim of the investment is expansion of the production capacity of the enterprise. In this case the replacement of existing machinery by new plant of larger capacity must be classed as investment for expansion.

Timing Replacement Decisions

The question now arises: At what stage do industrial enterprises in Germany embark on investment for replacement? There is a good deal of variation in economic practice regarding the stage at which replacement is undertaken. And there are considerable differences too between the various enterprises and branches of production. Nevertheless it is essential to establish a certain basic scheme indicating at what stages replacements are made.

A possible scheme is as follows:

Enterprises make replacement decisions:

(1) when the old plant is still functioning satisfactorily from a technical point of view, but more modern and more efficient machinery is on the market. In this case the date of replacement is put forward as a result of technical progress;

(2) when the old plant is still usable from a technical point of view, but is beginning to need repair and showing a certain decline in efficiency;

(3) when the old plant is too worn to be usable;

(4) when the old plant is written off.

My own investigations have shown that in German industry (1) and (2) are by far the most frequent stages for replacement(1). There are naturally considerable variations between the different industries. For instance, technical progress exercises a particularly powerful influence in the oil producing and refining industries. These industries tend to invest in replacement as soon as new methods or equipment come on the market, regardless of the condition of existing plant. In this respect they probably occupy the leading position in German industry. For the coal-mining, chemical, electrical and mechanical engineering industries, as well as for the breweries, stage (2) is the most important. These enterprises thus tend in general to replace their machinery, when its efficiency begins to decline and repairs become increasingly necessary. These machines however are technically still perfectly usable. Stage (3) is only of very minor importance for German industry. Only in very few cases is the decision to replace machinery made only when the machinery is no longer in working order. There is no significant relationship at all between the date of replacement and the date when the existing equipment is completely written off. Table 1 indicates the situation, which characterises the choice of replacement dates in German industry.

TABULAR DATA OMITTED

The dates at which industrial firms replace existing equipment depend moreover to a large extent on prior management decisions. This is true because the physical life of a piece of equipment varies with the care given, the control of deterioration, the renewal of important parts, rebuilds, and, if necessary, capital additions. It seems doubtful therefore whether replacement dates can be reliably deduced from tables showing the age of mechanical equipment, quite apart from the fact advances in manufacturing methods and adaptions to these developments may lead to machinery which is still in good working order being prematurely scrapped. It was stated just now that the age structure of production plant does not determine investment expenditure in a simple and unambiguous fashion: that is to say, there are some enterprises and branches of industry, which go in for replacement, when the plant is by no means obsolete from a purely technical point of view. Other enterprises and branches of industry on the other hand only invest in replacements, when the technical efficiency of the machinery is on the point of being exhausted. This is the situation which is typical for German industry and it accords with the conclusions reached by Meyer and Kuh(1).

The "echo effect", according to which expenditure on investment for replacement will be greater the older the machinery is, has not received confirmation from the investigations of these two writers. Both the simple and the partial correlations between depreciation reserves and investment expenditure were relatively low, to some extent negative, according to the results of the investigations of these two writers. This fact suggests that where investment policy is concerned, industrial enterprises behave as they have in the past, i. e. in accordance with their own tradition and the tradition and character of their branch of production.

Motives for early replacements

The question to be considered now is: What conclusions can be reached concerning the motives which governed business investment policy in German industry say in the mid-fifties?

For these investment motives a catalogue of reasons for investment can be drawn up. The initial assumption here is that these reasons are only of interest where an enterprise does not delay replacement of plant until it is completely worn out, in other words, where the replacement date has been advanced. The reasons for undertaking replacement before the machinery to be replaced is completely worn out may be different:

An enterprise may advance the date for undertaking replacements

a) because the proposed equipment promises more efficient methods of production. It may be more efficient because of

1) technological improvement, 2) shortening of work time,

b) because of the need to economise in labour, as a result of the tense state and increasing difficulty of the labour market,

c) in order to improve the quality of its products,

d) because of high liquidity,

e) because it fears further increases in the price of capital goods,

f) because rival firms have invested,

g) because it wishes to obtain tax deductions.

TABULAR DATA OMITTED

From table 2, which is based on the results of a questionnaire, the following inferences can be drawn: Of the motives for advancing the date of replacement decisions the motive of rationalisation is by far the most important, whether the emphasis in this rationalisation is on "technical improvements in methods of production" or "economy in manufacturing time". Differences between individual producers and patterns of manufacturing technique are effected in this distribution of emphasis. In the coal-mining industry the possibilities of rationalisation below ground are largely dependent on geological conditions. These conditions frequently restrict the possibilities of rationalisation. On the other hand in the petroleum industry and in foundries and steel works the motive of rationalisation of operating methods exercises a decisive effect on investment for replacement and the advancement of investment dates. The same is true of the chemical industry, the electrical engineering industry, of many branches of mechanical engineering, and of the motor-car industry, but rather less for tractor-building, for the breweries and in very varying degrees for the textile industry. A surprisingly important factor in the investment decisions of the firms questioned by us was improvement in product quality. The investment policies of oil refineries of steel works, above all of chemical works as well as of electrical engineering works and--with certain variations--mechanical engineering and textile factories are strongly influenced by this investment motive. There are considerable regional variations in the degree to which works have been influenced in their investment decisions in the period under discussion by the strain on the labour market.

The remaining investment motives are only of slight significance for the investment policy industrial concerns. The two investment motives: rationalisation of production methods and improvement of the product preponderate so strongly that there is a complete lack of balance between investment motives. The fact that industrial enterprises are obliged to reckon with increases in the price of capital goods exercises no very considerable influence on their investment decisions. The same is generally true of investment by rival firms, although there are one or two interesting peculiarities, especially in the chemical industry.

A high degree of liquidity and financial benefits from tax allowances granted do in some cases permit early replacement decisions, but it cannot be said that an excessive degree of solvency and considerations of tax benefits have led to investments which were not necessary for the economy of the firm. In individual cases and for small projects it may be that considerable financial liquidly and tax considerations lead to early replacements, in order to create the possibility of depreciation for tax purposes. But large scale capital investment is not dictated by such considerations. If tax concessions are granted, firms tend to take advantage of them. Admittedly the tax saved in this way goes to swell the investment fund. To this extent it represents a process in the field of the financing of industrial concerns. But the use to which this investment fund is put is an investment process and thus a part of the general investment policy of industrial enterprises, which is generally speaking dictated strictly by considerations of industrial management.

Motives leading to capital investment for expansion

Under the heading of investment for expansion it is best to include investment for modernising plant equipment with the object of expanding the production capacity of an enterprise and investments intended to extend the production capacity of an enterprise regardless of whether the new machinery shows any significant technical difference from that previously used. As a rule an expansion of production capacity is obtained with the help of additional modern machinery.

An investigation of the reasons for investment under this heading again enables a TABULAR DATA OMITTED catalogue of possible motives for investment to be drawn up. A firm may undertake investment for expansion because:

a) it expects a favourable market,

b) it hopes in conjunction with the expansion of production capacity to effect an improvement in running costs,

c) it sees its share of the marked threatened by investment by rival concerns,

d) it wants to get rid of bottlenecks in operation,

e) it fears further increases in the price of capital goods,

f) rival firms are offering improved products,

g) tax concessions lead to investment for expansion.

During the mid-fifties, that is to say in a boom period German industry was guided in its investment for expansion, as Table 3 shows, in a surprisingly clear-cut manner by long-term expectations regarding the market. For this field of investigation it can be said: favourable long-term expectations of markets and returns force a decision to invest, unfavourable expectations of markets and returns curb activity in the sphere of investment policy, as far as investment for expansion is concerned. A state of the market which may be regarded as temporary exerts no significant influence on investment policy. The prospect of a cut in running costs is always shown to be a strong incentive to investment for expansion. There are quite a number of cases where enterprises have only decided to take advantage of the prospect of a favourable market by an expansion of production capacity when there was also a fair prospect of cutting costs. But many enterprises have extended their production capacity because they saw a chance of a favourable market and returns, where there was no expectation of a significant cut in costs.

It was primarily large enterprises which based their investment decisions on systematically conducted market investigations carried out by themselves. Other enterprises had recourse to market research institutes or trade associations. In addition large-scale investigations in a given branch of production, like those undertaken by the Coal and Steel Community, were consulted in making decisions regarding investment. Many enterprises relied simply on their own experiences and their own judgement of the situation, without going to the length of more thorough and systematic market research.

Most enterprises--there are individual variations--are extremely cautious about capital investment. They have frequently opposed investment for expansion, when their selling prospects suggested in any way whatever a need for caution. Factories have not been tempted by a momentarily favourable condition of their markets to develop production capacity which would have to remain unused in the event of an economic recession. The experiences of the past decades still appear to be exercising an influence in the German economy.

A large number of enterprises found themselves obliged to invest in expansion in order to put new or improved products on the market. This is true above all of those industries in which there is competition not so much in price as in quality. On the other hand in those industries whose products and production programmes may be regarded as having reached a comparatively mature stage of development competition in quality has not had the effect of stimulating investment.

The remaining motives (d to g) provided no impulses of practical significance in leading to investment for expansion. The fear that rival concerns might threaten one's share of the market only exerted an influence on the investment plans of the firms questioned on relatively rare occasions. And the fact that increases in the price of capital goods have to be reckoned with was not generally a decisive factor in the investment decisions of industrial enterprises. The same is true of considerations of taxation. German enterprises have always made use of the advantages offered by the tax laws, and have used the taxes saved in this way wholly or partially for investment purposes. In this way tax economies have provided the possibility of advancing the dates of investments for expansion (and for rationalisation). But the actual process of investing must be distinguished from this process of financing investment. For the assistance in financing provided by the tax economies does not necessarily lead to investments which are not essential for the running of the concern and are therefore not justifiable.

Interest rates exert only a minor influence on investment decisions, where the expected net return from the investment after allowance for interest on the capital invested is large. If, however, the expected return is small, interest rates (in the form of calculated interest cost) may be very important indeed. Variations in the interest rate of one or two percent may in such circumstances exercise a decisive influence on the investment decision.

Failures of investment projects are generally due to the fact that firms make no detailed investment plans and use incorrect methods of investment analysis rather than to the fact that investment proposals can be financed from funds generated within the firm ("interest free"), if one ignores the possibility of bad judgment in the appraisal of future technological and economic developments.

Viewed in this light, it is understandable that enterprises should reject a policy of investment for expansion with the sole purpose of creating additional possibilities of depreciation.

Responsibility for Business Investment Decisions

In German industrial enterprises the usual practice is for replacement and rationalisation proposals to generate with department heads or, in big business, with works managers. This has proved a sound practice, as these people know the requirements of their departments better than anyone else. They also have the most precise knowledge of the latest technical developments in their field. No enterprise can afford to dispense with the long experience and technical knowledge of its works managers. Naturally this does not necessarily imply that the suggestions are approved, but the investment proposals, which--from as wide a field as possible--come in from large numbers of factories and factory departments, certainly provide a strong impulse towards the maintenance and improvement of technical production equipment and thus towards capital investment for replacement and rationalisation. In this field particularly large-scale enterprises are opposed to the idea of running affairs exclusively "from above". There is quite generally an obvious tendency to try and avoid bureaucracy. At the same time these suggestions and proposals regarding investment are conveyed to the competent quarters through the prescribed official channels.

Investment for expansion is usually proposed by top management. There are often special departments of a staff character, which keep a constant check on technical and marketing developments in given fields. In the chemical industry the departments in charge of planning investment work in close co-operation with the research and development departments. In the coal, iron and steel industries the normal procedure is for the labour manager to propose investments on the social side of the enterprise. Where power, machinery, coking plant or mining plant is concerned, it is the task of the relevant manager to prepare investment proposals and submit them to the department competent to make decisions on investment.

Types of Investment Analyses

Investment analyses are generally comparatively rare in the case of routine investments. It is normally regarded as sufficient in these cases to study the offers of the suppliers, which generally contain the necessary technical data. But where large-scale technical equipment is involved, German firms tend to go in for very detailed calculations of the probable profitability of the projects. Admittedly such calculations are not undertaken when it is a case of investment to provide housing or social facilities such as washrooms, canteens etc. There is particularly acute concern to demonstrate profitability, where large-scale projects are involved. It is open to doubt whether these profitability calculations invariably conform to the most modern standards. The investment analyses partly take the form of a cost comparison, partly that of the so-called payoff-period. The payoff-period test confronts the decrease in the first year's running costs resulting from the investment proposal with the installed cost of the project. An attempt is then made to compute the period necessary for the project to pay for itself, i.e. what time it takes for the installed cost of the asset to be paid for out of cost savings. Frequently rate-of-return analyses to figure the expected profitability of an investment proposal are based on a comparison of its revenue and cost over a long period.

Only a few firms calculate their investments for replacement according to a fixed, uniform scheme. In general the type and depth of the calculation varies according to the investment project, the magnitude of the capital outlay involved and its importance for the works as a whole.

Ranking of Projects

It can be assumed in general that investment proposals are more numerous than approvals. It is therefore necessary to establish a certain order of priority for investment projects. It is impossible to make any generalisations about the order of priority.

The most urgent investments are normally those aimed at maintaining the technical efficiency of production plant or in other words, at maintaining the ability to compete in quality and price. The only rivals to such investments are those connected with the safety of the works, and these may include investments which have to be made for hygienic or social reasons, above all in mining, but also in other branches of industry, especially the chemical and iron-producing industries. Investments for the purpose of overcoming bottle-necks in production also have high priority. But whether the emphasis is on investment for rationalisation purposes, or for the inclusion of new products in the product line, or for technical improvements, or for the construction of new departments, or for expansion of production capacity, is largely dependent on the business policy pursued by the firm at the time. This attitude is characteristic above all of the coal-mining, iron and steel producing and processing industries and of the chemical industry, but of many other industries too. In the textile industry the priority of investment projects is strongly influenced by developments in fashion. A typical scale of investment priorities is:

1. The guaranteeing of a smoothly-running manufacturing process,

2. Improvement of product quality,

3. A more rational method of operating (higher profitability, cost savings),

4. Retention of a share in the market,

5. Extending the share in the market.

This order is not dogmatic in character. It merely indicates a possible ranking of investment projects in a given enterprise. Many firms find it impossible to give generally valid criteria for the establishment of priorities for investment projects. They are of the opinion that the order of priorities emerges from the line to which they are committed in their long-term planning, their long-term budget.

Enterprises are constantly revising their investment plans, in order to adapt themselves to situations which were not foreseen in the original plan. They are aware that long-term plans can only rarely be adhered to in their original form and in their original detail. For this reason flexible investment plans are set up, so that corrections can be made without upsetting the basic plan.

In the case major projects, where the period of installation and break-in will extend over several years, it is of course only possible to keep the planning flexible to a very limited degree. Nevertheless an attempt is made even here to attain some measure of flexibility by planning the building in stages. Firms look upon rigid plans as a danger to flexibility in business management.

Changes in the priority of investment projects are normally decided upon exclusively by the management, except possibly for projects which are only of minor importance in the framework of the volume of investment as a whole.

Financing of Investments

When the ranking of investment proposals is determined, the question arises how this schedule can be brought in line with the available capital funds of the enterprise. The financial resources shown in the capital budget may be larger, but they may also be smaller than the demand for capital originated by the investment projects. The demand for capital investment funds is moreover not a datum. It is only because this is the case, that there is any possibility of making up a balanced capital budget over a year or over a longer period. Frequently the state of the market makes it appear inadvisable to utilise the financial resources of an enterprise for investment purposes. In this case an unused financial reserve is retained, which may be regarded as a financial reserve fund for investment purposes. On the other hand it may occur that an enterprise is not even in a position to satisfy the most urgent demand for investment funds. In this case capital expenditures are so to speak cut off by the financial limit. Only very rarely does investment extend to the upper limit of the firm's financial resources. A firm which behaved in this way would gravely narrow its financial margin of latitude, thus offending against the principles of sound business policy. It might perhaps be said, that German enterprises only go to the extreme limit of their maximal possibility of borrowing in exceptional cases.

In preparing the capital budget account is taken of the following sources of funds:

a) Basing their calculations on depreciation for tax purposes in the previous year, and taking into account any special circumstances in the new period, firms calculate the amount from depreciation which they have at their disposal for investment purposes from the assumption that this depreciation will be returned in the price of the product. It is in this sense that the term "earned" or "earnable" depreciation is used in practice. One frequently finds that capital budgets anticipate depreciation allowances of future years. Where this happens the depreciation sums disposed of in advance are not included in later investment budgets.

b) Many large industrial concerns in Germany have formed provisions for pensions for their staff and work-people. These provisions are calculated according to the principles of actuarial theory. Since these provisions are of a long-term character, firms sometimes make use of the sums corresponding to these provisions for the purpose of long-term financing. Admittedly it is invariably only the net increases of the pension funds which are involved; and these net increases are no longer very significant.

c) A third source of funds to finance investment projects are the expected profits of the budget period which are retained within the business. The income tax, directors' compensations, and other items are subtracted from these profits. The net profits are then inserted in full or only in part on the capital budget. These profits which are not claimed by the owners of the enterprise (e.g. stockholders) as dividends are part of the firm's equity. The term "equity financing" in German practice thus covers equity flotation (cf. paragraph f) below) as well as internal financing from retained earnings. These internally generated funds show up on the balance sheet as reserves or provisions against assets.

d) As a fourth source for long-term financing firms have in certain circumstances the possibility of releasing capital for long periods by selling part of their assets (e. g. land, holdings, securities etc.) or by cutting down on stocks normally held or reducing the level of debtors. These possibilities however are limited. They are not generally available when an increase in turnover is combined with the investment. In these cases the working capital tends to increase also.

e) If the above sources of funds are insufficient, firms are obliged to raise loans, either on a medium or long-term basis. There are special banks for this purpose, for example the Kreditanstalt fur Wiederaufbau and the Industriekreditbank. In certain circumstances and if the required conditions are fulfilled, firms can take up so-called bond loans or obtain an advance. Admittedly the lending limit is of great importance here for the size of the loan. Although these institutions do not have a definite, fixed lending limit, there is nevertheless an upper limit for loans, since the banks demand security in real estate. This lending limit restricts medium and long-term possibilities of borrowing. Beyond the upper limit of long-term borrowing there are normally no credit facilities available to firms for long-term financing of investment projects. In this connection it must be pointed out that the investment considerations of industrial enterprises are also restricted by another factor, namely the short-term solvency of the enterprises. Further borrowing is often excluded because of the strain on their liquid resources. One speaks of the financial equilibrium being upset when there is a dangerous development in the ratio between short-term and long-term borrowing, between equity and borrowed capital, between the portions of borrowed capital and between fixed and current assets. In these circumstances it may be advantageous to take on long-term loans, possibly even to go to the extreme limit of long-term borrowing, in order to lessen the pressure of short-term borrowing, and so to repay short-term loans or to exchange them for long-term ones. Such a process is however the exact opposite of the process of investment. It might be termed a process of desinvestment.

Tension in the financial structure of enterprises can also put a stop to further investment when the taking up of long-term loans leads to further short-term borrowing. This has to be reckoned with where an expansion of production capacity involves the necessity of obtaining short-term credit for the purpose of financing the required increase in current assets, particularly in stocks.

f) The final possibility of obtaining long-term capital to be considered is equity flotation. There is however no organized capital market for private firms and partnerships. If the partners or owners are not in a position to increase their equity by additional private funds, the only other course open to them is to take on new partners. Whether it is advisable and advantageous to take this course, is something that has to be decided in each case on its merits. The same situation occurs with corporations which have no or only limited access, to the capital market. When large corporations with access to the capital market have reached the upper limit of borrowing, the only remaining possibility for them is to raise new equity. As long as the limit has not been reached, there is usually a choice between a bond issue (or raising a bond loan) and a stock issue. It is not proposed here to deal indetail with the arguments for one or the other of these alternatives. It may, however, be pointed out briefly, that interest on bonds is tax-deductable. The interest burden of bonds is fixed and independent of the level of the firm's profits. Dividends on the other hand are far more elastic. In the case of bonds being issued the voting rights in the company remain unchanged. If on the other hand shares are issued, the possibility arises of a change in the voting situation and of a consequent possible significant shift in the control of the enterprise. The issuing of bonds is normally conditional on the presence of real estate to serve as security for the loan. In the case of an equity this factor is irrelevant.

This and the special conditions obtaining on the capital market at the time of issue exercise a decisive influence on the choice of a particular procedure for the intended issue. But conditions in the different enterprises are too diverse, for a unique criterium to be established here which could in every case determine whether a firm should cover its demands for long-term capital by issuing shares or bonds.

The interest rate on long-term loans may be regarded as the third factor restricting the possibilities of long-term borrowing. A firm will only completely exhaust the financial margin it still has, if the expected rate of return from the investments exceeds the interest rate on the loan it is taking up by a given amount, or--in theoretical terms--if the internal rate of return of the investment is greater than the market rate of interest.

The increase of a corporation's equity by a common issue is limited by the danger of stock watering, i.e. it is by the danger that the expected additional profits will not be sufficient to pay adequate dividends on the new equity. With private firms and partnerships the restriction consists in the fact it is either not a practical possibility to increase the owners' capital or to take on new partners or that is not desired for one reason or another to extend the capital basis of the firm in this way.

1 R. J. Meyer and E. Kuh, The Investment Decision, Harvard University Press, Cambridge, Mass. 1957, p. 91 ff.
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Title Annotation:Policy and Planning
Author:Gutenberg, E.
Publication:Management International Review
Date:Jan 1, 1992
Words:5284
Previous Article:Policy-formation and policy-execution in the business undertaking.
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