Investment - Upfront costs for future gains

Himalaya. Have you been trying to better manage your time,
become more mindful, start your own business? As regular listeners
of this show, no, Himalaya is a new audio first
learning platform with over one hundred and fifty courses on
personal and professional development, tap by instructors like Malcolm Gladwell,
divorce court judge Lynn Toler, mindfulness expert Sharon Salzburg, and
many other thought leaders.
What Himalaya is doing is different than a typical podcast,
as these are carefully curated audio courses rather than just
more folks talking. Each Himalaya audio course is organized so
that each lesson is a digestible, fifteen minute episode that
focuses on the big ideas. Think of as a pack
of snack sized lessons that will nourish your brain. It's
the best way for busy people like you to fit
learning into your life, and himalayas curated learning tracks make
it easy to find course you'll love on the topics
you'll need to transform.
Your life personally. I really enjoyed journalist Eric Wiener's course
The Good Fight because it teaches how to fight constructively
and creatively. His ideas are based on history, philosophy, and psychology,
but he also gets practical as he gives advice on
how to disagree and communicate effectively with the people we
love man even those we don't really care for, really,
anyone with whom we might come into conflict.
For a limited time, think like an economist. Listeners can
go to Himalaya dot com and into promo code econ
at checkout for a fourteen day free trial. That's Himalaya
dot com into the promo code econ at checkout for
a fourteen day free trial.
I started distilling gin back in twenty fifteen. I always
had a passion for drinking alcohol, but making alcohol runs
of my family. My granddad was a distiller, and I
decided that I was going to take up the mantle
to make what I loved jin. I'm Umbara, founder and
distiller of More, Irish gin, based here in Tullamore, County Offley, Ireland,
which is right in the heart of Ireland. I make
a gin called More which is inspired by the mountains
and the surroundings of tulltle Moore, so it's made with
things like raspberries and blackberries.
There's a gin distiller with a thriving business. No one
has to make a lot of decisions about whether to
spend money today which will help his business make more
money tomorrow. He also needs to buy ingredients and machinery
to make his award winning more Irish gin.
The ingredients that go into more Irish Gin are jennifer, coriander, angelica,
and rosemary. And then we blend in BlackBerry, raspberry and
cranberry distillate to give it a dry gin feeling, but
with a sweetberry finish.
Oh, that sounds delicious and refreshing. And actually I have
a confession to make. After listening to him, I went
and made myself a gin cocktail for this episode, cheers
Owen uses these ingredients and something called the still, which
is a piece of equipment used to make various types
of alcohol, including gin, whiskey, and also vodka.
Still is essentially a giant kettle. It has a big
boiling pot at the bottom. It has a neck leading
to a colume which is called a swan neck, and
then it'll have a condenser colume which is then responsible
for cooling down the vapors. Making gin involves weighing out
the ingredients, loading a still with neutral spirit and water.
Then you load the still with the ingredients to make
the gin, and then there's still a set to well
essentially boil, so at seventy seven degrees celsius, the ethanol
separates from the water and binds the oils in the
ingredients and goes up the condenser colume, which is then
cooled rapidly and condenses back into a liquid.
And that's how you get gin. Recently, business was booming,
so we had to make a decision about whether to
invest in a bigger still so he could make more gin.
Businesses have to make investment decisions all the time, and
there are a number of factors which go into whether
they'll end up making an investment or not. Investment is
a topic of this week's Think Like an Economist with
me Betsy Stevenson and.
I'm just a morphers. We're teaching you the super tools
of economics that will transform your life. Today's big question
is whether you should make that next big investment. Nestra
and Tabaculi fars with us.
I think a lot of us think of the stock
market when we hear the word investment, but investment means
something else for economists.
Well, that's right. Investment is about increasing how much we
produce in the economy. I always like to say the
stock market's a secondhand market.
Okay, so an eggs still can make more gin, which
is more produced to be sold in the economy. So
it sounds like when we talk about investing, we're talking
about things that can add to g Yeah.
So investment is spending on new capital assets that increase
the economy's productive capacity, like helping a new business get
started or an existing business expand.
Spending on software so that your business can do more,
or spending on a new office or factory space, which
again ultimately will mean that you can produce more. They're
all forms of investment. Investment also applies to intellectual property too.
We heard from our gender still at owen Bara earlier
business has been booming for him, so much so that
he's now expanding into whiskey production as well. He's going
to tell us more about his decision making in just
a minute, But I wanted to know what sorts of
things do business people like Owen generally consider if they're
deciding if they should go ahead and invest in, say
a new piece of machinery or maybe even a new space.
It's all about the costs and benefits. Does the benefit
of the investment exceed the cost of the investment, So,
does the value of the extra they'll get from this
investment exceed the cost?
In Owen's case, does the revenue from the extra gin
he can make with the biggest still exceed the cost
of buying the still?
That's right now. This decisions actually a bit more complicated
than it sounds, because I won and will be spending
money on a still today, but the benefits of the still,
which is the extra gin he'll make which he'll then sell,
Those benefits will come in the future, so there's a delay.
Owen could just put the money he'll spend on the
still in the bank instead and earn interest on it.
The opportunity cost principle comes into play here, is he
could spend money on buying a still to make more gin,
or he could put that money in the bank and
earn interest on it. So he's going to give up
that interest if he buys the still with his money.
This is why we look at the present value of
the costs and benefits associated with an investment. We do
calculations where we put everything into today's dollars, asking how
much money would you need to put in the bank
today to create a similar amount of money in the future,
and you should invest in new capital if the present
value of the benefits exceeds the present value of the costs.
We call this the rational rule for investors.
If you have to pay for your new equipment up front,
then the present value of the cost is simply the
cost of the investment.
I guess that's right. The cost parts easy. The tricky
part is that the extra revenue will all come in
the future, so we need to make those present value
adjustments to account for.
That before we go back to Owen. Is there anything
else businesses factor in when they're deciding whether to make
an investment.
Yeah, so machinery or equipment either breaks down over time
or there's wear and tear so it doesn't work as
well after a while. We call this depreciation. Most capital
has what we call a depreciation rate, which is basically
the amount of productive capacity that you lose on a
machine each year due to this wear and tear.
Okay, so let's go back to Owen to work out
the present value of his benefits. He's an island, so
we're going to be working in euros, which is the
currency they use there.
So May a year ago, we were running out of
capacity and we were making decision mothered to in a
bigger still or not. So business was good and we
needed the extra capacity. We had a five hundred leaders
still and we were considering upgrading to two thousand leaders
still and the reason for that was to get more
gin out of our runs, more more gin out of
our runs. A run is basically a cycle of the machine.
So essentially, when you're making gin, it takes about seven
hours from start to finish. So we did some numbers
on it. It looked like it was going to be
one hundred thousand euro investments.
Owen says he was planning on borrowing the one hundred
thousand euros needed for this bigger still. So how do
business people like Owen go about deciding whether they should
make this investment.
Owen will be able to make more gin if he
buys this bigger still. What we do is we look
at how much more he'll make in each future year,
making sure to convert this revenue stream into its present value.
Owen said the new still would add at least three
hundred thousand euros to his revenue every year. Typically ingredients
and labor costs and other costs eat about eighty percent
of the revenue. So this new investment will boost his
bottom line by about sixty thousand euros a year.
Great, and we also factor in the reality that his
still will depreciate, so it'll produce a little less each year.
He told me that the depreciation rate of the gin
still is seven percent, so that means the still will
make seven percent less gin each year.
We have a formula that works at the present value
of the future payment and and we'll get from the
amount of gin this still can make over the stills lifetime.
We take the annual boost to his bottom line and
divide it by the sum of the interest rate on
the investment as well as the depreciation rate of the investment.
He told me that lenders offered him this one hundred
thousand euro alone at a real interest rate of eleven
point five percent.
Wauser, That is a high interest rate, He told me.
That's island, and explain that leans for specialized equipment such
as the still tend to be especially high.
Wow, what a business to be in. Anyhow, let's do
the calculation. If this still brings in sixty thousand euros
a year, and the interest rate on the loan is
eleven and a half percent and the depreciation rate is
seven percent, then the present value of all the future
money that Owen will make from the still is around
three hundred and twenty thousand euros.
So we're saying that over the time that this still works,
it will add the equivalent of three hundred and twenty
thousand of today's euros to Owen's profits.
Exactly, and this still costs one hundred thousand euros. So
here's the advice to Owen invest in the still. The
flow of future profits is more valuable than the upfront.
Cost gin is valuable.
This formula makes clear that the bigger the real interest rate,
the less likely it is that you'll invest in new machinery.
And this makes sense because if the real interest rate
is higher, then you'll be better off just putting your
money in the bank instead of investing it.
Yeah, and interest rates play a really important role in
investment decisions. They're partly determined by monetary policy. Central banks
influence interest rates to change how much people invest, or save,
or even spend in the economy. We'll look more at
monetary policy and central banks and how they set interest
rates in a future episode.
What are other factors that will impact whether a business
invests in a capital good.
Technological advances can make capital goods more efficient, and that
will make them more attractive as an investment.
You mean there will be more efficient and produce more.
That's right, as it will ultimately mean higher revenues as
a result of that investment.
Businesses also look at expectations.
Expectations have been coming up a lot in our recent episodes.
Yeah, and they're particularly important for investment because the benefits
of investing it are all about future revenues. If business
is a confident that the economy is going to be
strong incoming years, they'll invest. But if they see a
recession on the horizon and predict that people will be
buying less, well, it makes less sense for them to
invest in new machinery because they're not likely to be
able to sell the extra product that they'll be able
to make.
Another big factor is how much tax a business has
to pay. The lower the corporate tax rate is, the
more a business gets to keep from the new profits
it generates from an investment, so a business may be
more likely to make that investment. This is what the
US was betting on when it cut the corporate tax
rate in twenty seventeen that it would release a flood
of investment activity by businesses, and did it work.
Not really.
I mean, remember the marginal principle. Businesses are asking whether
they should invest one more dollar when tax rates are lower.
That could make that marginal dollar worth investing. But equally,
businesses just might not have very many ideas for investment
that are on the margin, you know, not good enough
to do if the tax rate they face is just
a few percentage points higher, and so worth doing if
the tax rate is a bit lower.
The final key factor is about whether you can get
access to the money you'll need to fund your investment.
A lot of businesses have to borrow money from a
bank to invest in a capital good. Sometimes banks can
be risk averse, or they might find it hard to
assess if an investment will be successful or not, so
to guard themselves, they'll charge a high interest rate.
Yeah, Owen said this was the case with the Jinstill.
Eleven and a half percent is a really high interest rate.
But he said that the bank charged this because it's
a piece of specialized equipment.
Yeah, so if a business has money saved up, it
won't need to rely on banks and the rules they
have for lending money, and so it'll be more likely
to invest.
So we've been talking about how to make good investment decisions,
but let's take this upper level and think about what
this means for the macroeconomy. How is investment related to GDP.
When businesses are in new machinery, it's a form of spending.
So each dollar of spending immediately counts as an extra
dollar of today's GDP.
And it also matters for the economy's future GDP. All
of that new machinery, including all those new gin stills,
increase the economy's productive capacity, leading business people like Owen
to produce more in the future.
So overall investment is spending that boosts the economy today
and allows businesses to produce more in the future, which
will boost future GDP. This episode, we've looked at how
businesses make investment decisions. Are their lessons for us even
if we don't run a business.
Absolutely these same principles apply whenever you need to decide
whether to incurn upfront cost for a benefit you'll enjoy
in the future.
It's not just about buying machinery and capital equipment. It's
about any investment in your future and whether it's worth
today's big upfront cost.
So you mean like making a lifestyle change.
Perhaps think about deciding to get fit. There's a big
upfront cost. You've got to have to get used to
setting your alarm earlier, going out and working out. There'll
be all those aches and pains, but there's a long
run payoff. There'll be a stream of future benefits. You'll
feel great, you'll be healthier, you'll live longer.
You can also think about something like networking events for
your job. A lot of us dread those. I know
that I do, but all those awkward mixers we go
to can really pay off helping us meet people that
can help us find the job that we really love
in the future.
My economic students are making an investment in curring the
upfront cost of studying today and the hope that learning
more economics will help them get better jobs and earn
higher incomes in the future.
And how do we use this week's principles, whether it
comes to the cost of college or arranging to start
working out, Just.
Apply the rational rule for investors.
Something to notice is that often our upfront cost is
time you have to spend today. You need to spend
time exercising, or going to those mixers and networking events,
or even studying for your upcoming exams.
Yeah, I understand the idea, but I think when it
comes to investing in the future, whether it's going to
these networking mixes or working out or studying, a lot
of us end up procrastinating and not living up to
our plans. Can economics help us do a better job
on that front?
Well, First, it helps to reward yourself. Doing these hard
tasks can be daunting, so reward yourself with a trait
for getting them done or impose a penalty if you don't.
Here we're using the cost benefit principle. Remember we're more
likely to do something if the benefits exceed the costs.
Next, it helps to break a hard task up into
more manageable, smaller parts. Here we apply the marginal principle.
You don't need to finish mapping out your financial future
in one evening. Spend the day getting printouts of all
your accounts than another day going through them. Maybe on
the third day you get out your spreadsheet and start
it in Before you know it, a daunting task like
planning your financial future or planning for retirement, has been
spread out over several days and you've actually gotten a
lot of it done.
It can also help to constrain yourself. Cancel your Netflix
account during that fortnight you've put aside to invest in
getting something done. Tell your friends you can't make them
for after work drinks. Here we're using the opportunity cost principle.
What would you be doing if not making these difficult investments.
We'll make those other options unavailable, and you've reduced the
opportunity cost.
You know, lowering your temptation is actually really powerful. Often
in the moment, we're gonna make the easier decision than
the decision which is most beneficial for us in the
long run. That's just human nature. But if you add
some distance, you can make a better choice.
You know.
It's a bit like how you're likely to eat a
healthier lunch if you plan ahead, but if you're ravenous,
you're just gonna grab whatever you see that will fill
you up, or like I did today, broken too a
bag of cookies.
Here the interdependence principle comes into play. Your choices right
now depend on the choices and temptations around you. So
make your choices in the best surroundings, plan for which
nights are for socializing and which are for doing your finances,
and stick to that plan.
Let'sy justin thank you. It's been great to learn about
the economics of investment.
Funny thing is it's an idea that the listeners of
this podcast already understood. After all, you decided to invest
in learning to think like an economist, you assess the
upfront cost of listening to us and figure it's worth
doing because the long run benefits of learning the super
tools of economics exceed those costs.
So they were thinking like an economist as they decided
to learn to think like an economist. How is that
even possible? Thanks for listening.
There's a lot more from this show and others like
it on the Himalaya learning platform.
Him Earning provides bit size courses from world class thinkers
and industry experts for you to enjoy in the app.
On the go.
For exclusive content, including bonus episodes and supplemental materials, go
to Himalaya dot com slash econ and enter promo code
ekon at checkout via first fourteen days.
Free Himalaya dot com slash econ has loads of great
shows like ours, so try it out. Using the promo
code econ at checkout to get your first fourteen days free.
It's time to think like an economist.