Investment Risk: the New Dimension of Policy

After the sharpest upheaval of the post-war period, the world's industrial countries are struggling, so far with mixed success, to get back on the path of balanced, non-inflationary growth^ The United States has probably been the most successful. After a strong burst of growth in output and employment, many observers foresee a sharp slowing in the rale of advance. The shortfall in the recovery to dale is easy to identify — a lack of private investment; and its cause — a failure of confidence. The uncertainty that plagues the investment commitment process today is embodied in investment calculations in the form of higher risk premiums and prevents a normal package of capital projects from meeting acceptable financial criteria.

The evidence of debilitalingly high-risk premiums is widespread and disturbing. Even in the United Stales, Iwo years removed from the low of Ihe cycle, planl and equipmenl inveslmenl is falling far shorl of what has typi­cally prevailed at this stage of the business cycle. The shorl-falls appear to be concentrated in longlived investments, particularly those for which profit expeclalions are espe­cially skewed towards the later years of the inveslment: 8, 10, 15 years in the future. Worst hit arc investments where high-risk premiums, acting heavily to discount expected future profit, make Ihe presenl value of Ihose prospective profits minimal.

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Short-lived assets, those with rapid rates of cash re-| turn, seem closer to normal levels of commitment at this stage of the business recovery. But long-lived assets, par­ticularly those related to major construction projects which typically do not repay their investment costs for many years are still lagging badly.

The bias against long-lived assets is evidenced by new_; orders for fabricated structural steel, a measure of the most durable of investment assets. After plummeting sharply] from the autumn into the spring, orders for fabricated struc- i tural steel have recovered only about one quarter of their decline during the pasl two years.

The rise in investment risk over the pasl decade is also clearly reflected in the American stock markets, where price/earning ratios have fallen to the lowest levels in two decades, largely as a consequence of the increased discount rate imposed on expected earnings growth. One would expect that the market value for existing assets (that is stock prices) would parallel the expected market prices, or present value of contemplated new capital projects. Instead, real investment parallels with a lag the ratio of stock prices to an index of the replacement cost of plant and equipment. The latter is a good proxy of the relation be­tween the prospective market value of new investment and the cost of producing that investment. Translated into rate of return equivalents, the larger the ratio, the greater the prospective rate of return implied.

While the causes' of this high-degree of investment risk vary from country to country, at root is a profound uncer­tainty of the shape of the future economic environment in which new facilities might be functioning. Although many reasons could be cited, first, and by far the most important is inflation — the fear of an increasing rate in the years ahead, and the instability that would follow it. An inflation ary environment makes calculation of the rate of return on investment more uncertain. Even if overall profits advance

in line with the rate of inflation, the dispersion of profits among business tends to increase as the rate of inflation climbs. The risk of loss rises or, at best, the attainment of profits becomes more elusive.

Thus, a much higher rate of discount is applied to inflation
generated profits than to those accruing from normal busi­
ness operations. ->

A second, although somewhat smaller, contributor to higher risk premiums is escalating business regulation. Since the rise of concern over health and environment the regu­latory process has mushroomed. Regulatory changes have directly increased the cost of new facilities in a major way. However, far worse for capital investment decision-mak­ing is the fact that regulations may, indeed will, change in future, but trrar way that is unknowable at present. This, rather than known costs, has engendered uncertainly and hesilalion among businessmen.

Adapted from "The Economist".

I

Using the words in brackets, explain the. meaning of the following terms:

1. trade cycle (the level of business activity, regular oscilla­tions in, over a period of years)

2. the low of the trade cycle (low level of business activity, slow growth in output and employment, a period of)

3. inveslmenl (real capilal goods, expenditure on)

4. long-lived inveslment (in 8, 10, 15 year time profits are
expecled, inveslmenl for which)

5. rale of relurn (nel profit after depreciation, average capi­
tal invested in a business, as a percentage of)

6. discount rate (to discount bills, percentage at which, the
officially announced, a country's central bank, is pre­
pared)

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145

II

Choose the word or phrase in brackets that would best sub - stitutefor the word or phrase in bold print in the following sentences:

1. After the sharpest upheaval of the post-war period the

world's industrial countries are struggling to get back on the path of balanced, non-inflationary growth, (disruption, revolution, violent changes) (budgetary, deflationary, financial)

2. Many observers foresee a sharp slowing in the rate of ad­
vance.

(acceleration, development, achievement)

3. The evidence of debilitatingly high-risk premiums is wide-

spread and disturbing.

(discouragingly, proportionally, extremely)

(well-known, causing concern, important)

4. The shortfalls appear to be concentrated in long-lived
investments.

(commitments, surpluses, deficits) (non-productive, modernization, long-term)

5. Short-lived assets seem closer to normal levels of com­
mitment at this stage of business recovery.

(cash,, liquid, unmarketable) (liability, performance, engagement) (reaction, revival, cycle)

6. Long-lived assets are still lagging badly.

(are close to normal levels of commitment, haven't reached the expected levels of commitment, have exceeded the expected levels of commitment)

7. One would expect that the market value for existing as­
sets would parallel the expected market prices,
(long-term assets, stocks and shares, capital assets)
(contrast, compare, match)

8. The latter is a good proxy of the relation between the
prospective market value of new investment and the cosl
of producing that investment.

(alternate, synonym, substitution)

9. The larger the ratio, the greater the prospective rate of
return.

(secured profit, surplus profit, profitability)

10. Even if overall profits advance in line with the rate of
inflation, the dispersion of profits among business tends
to increase as the rate of inflation climbs.

(lag, diminish, increase proportionally) ^J (accumulation, scattering, dimension)

11. Since the rise of concern over health and environment,
the regulatory process has mushroomed.

(anxiety, care, interest) (legislation, formality, lawfulness)

III

Choose the right answer:

1. The United States has probably been the most successful
in:

a) reaching the peak of the business cycle,

b) recovering from the low point of the business cycle.

2. The shortfall in the recovery to date is due to:

a) a lack of private investment,

b) a lack of incentives., ^

3. In the U.S. plant and equipment investments:

a) are typical for this stage of the business cycle,

b) arc smaller than could be expected at this stage of the
business cycle.

4. High-risk premiums included in investment calculations:

a) discount prospective profits,

b) enlarge expected future profits.

5. The bias against long-lived assets is evidenced by:

a) a sharp increase in orders for fabricated structural steel,

b) a slow recovery in orders for fabricated structural steel.

6. In the American stock market price/earnings ratios:

a) have fallen to the lowest in two decades,

b) have remained stable for the last 20 years.

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147

7. Real investment parallels:

a) the expected market prices,

h) the ratio of existing assets to an index of the replace­ment cost.

8. The larger the relation between the future market value
of new investment and the cost of its production:

a) the greater the prospective rate of return,

b) the more uncertain the prospective rate of return.

9. A profound uncertainty of the shape of the future eco­
nomic environment is caused by:

a) an increasing rate of inflation,

b) an incalculable rate of return.

10. Inflation makes calculation of investment profitability:

a) more difficult,

b) more uncertain.

11. Business regulation will change in the future:

a) in a way that is unknowable at present,

b) in a way that is predicted by scientists today.

IV

Say what is true and what is false. Correct the false sen­tences:

1. The world's industrial countries are struggling with con­
siderable success to return to balanced, non-inflalionary
growth.

2. Higher-risk premiums included in investment calculations
prevent average capital projects from satisfying accept­
able financial criteria.

3. High-risk premiums discount heavily expected future prof­
its on present long-lived investments.

4. Long-lived assets return more quickly to normal levels of
commitment during the period of business recovery.

5. The rise of price/earnings ratios in American slock mar­
kets was a consequence of the increased discount rate
imposed on expected earnings growth.

6. The market value of slock prices parallels the present value of contemplated new capital projects.

Complete the following sentences:

1. Many observers foresee.......

2. The slow recovery is due lo.... caused in turn by........

3. The uncertainty of investment commitments is visible in

4. High-risk premiums prevent........

5. The rise in the investment risk is also reflected in.......

6. At present in the American stock markets real investment

parallels.......

I. The larger the relation between the fulure market value
of new investment and the cost of ils construction, the
greater.........

8. The fear of an increasing inflation rate is......

9. Inflation makes calculation of the rate of return on......

10. With the rate of inflation growing, the risk of loss......

II. Business regulations concerning health and environment
increase directly.........

12. It is difficult to foresee......

VI

Answer Ше following questions:

1. What was the economic situation of industrial countries in

the mid sevenlies?

2. What was the slow rate of recovery due to?

3. What made a normal package of capital projects Unaccept­
able financially?

4. Considering the situation in the United Slates, which types
of investment fall shortest of the expected level at Ihis
stage of business recovery? What arc the reasons?

5. Which types of assets are closer to normal levels of com­
mitment at that stage of business recovery and why?

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149

.

I

6. What is the best measure of the most durable investment
assets?

7. How did the American stock markets react to the rise in
investment risk?

8. What is the relationship between the prospective value of
new investment and the cost of producing it?

9. What are the most important reasons of this high-degree
of investment risk?

10. What are the economic consequences of the climbing in­
flation rate?

11. What has caused the escalation of business regulations?

12. Which is the worst factor for capital investment decision
making?

Part Two

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