08 April 2012 Written by  Tesfaye Abate

Elements and Economic Principles of Investment

Elements of Investment

There are three factors that are considered as elements of investment.

a) Reward (return);

b) Risk and return; and

c) Time [1]

 

A. Reward

 

We have seen above that investment is made with the intention to gain profit. Thus, investors, generally, may expend their fund to earn a return on it. The return is known as reward from the investment, and it includes both current income and capital gains or losses which arise by the increase or decrease of an investment.

 

Let’s say, Ayal has started producing bread in a modern way at Arat Kilo and distributes it to the customers in Addis Ababa. The capital for the investment is Birr 10,000. She invested on the sector with the expectation of profit. Moreover, let us assume that she has got Birr Two thousand within six months of her investment. This is a reward from the investment.

B. Risk and Return

 

The second element of investment is risk and return. Risk may be defined as the chance that the expected or prospective gains, or profit or return may not materialize. It also includes the fact that the actual outcome of investment may be less than the expected outcome. It is important to note that the greater the variability or dispersion in the possible outcome, the greater the risk will be.

 

In addition, risk means estimation about the degree of happening of the loss. Risk and return are inseparable. Return is an expected income from the investment. It represents the benefits derived by an investor from his/her investments. The rate of return required by the investor largely depends on the risk involved in the investments. Thus, the investment process must be considered in terms of both aspects of risks and return. Risk can be quantified by using precise statistical techniques. Therefore, risk is a measurable element.

Example: Hailu has invested on flower on the road to Jimma. He must assess the risks involved in the investment. For instance he should consider the possible pests that may cause damage to the flower, the risk of the market failure, the risks involved in transporting the flower to Bole, and then the air transport to export it to foreign countries and so on. On the other hand, Hailu should estimate the expected return, i.e. profit from the investment. We have seen that risk and return are inseparable. Thus, Hailu should consider both the risks and return of his investment together.

C. Time

 

Time is the third element of investment. It offers several different courses of action. Conditions change as time moves on and investors should re-e valuate expected return for each investment.

 

An investment could not be materialized within a very short period of time. In other words, investment is of long-term in nature. For example, if one needs to invest on a cement factory, s/he should conduct market research to ensure the viability of the investment. Conducting research needs a certain period of time. After the research is done, machineries should be imported and installed. This also is to be done through time. Then, the factory should produce sample cement, distribute the product, and collect the feedback from the customers. Then, the factory would start production and distribute cement to customers. All the above-mentioned activities need to be done through time.

 

Let us consider another example. Almaz wishes to invest on the textile. First, she saved a certain amount of money, and let us also assume that she was granted a loan from the Commercial Bank of Ethiopia. Secondly, she has to import necessary machineries from, say, German, Italy or any other country. The machineries should reach Ethiopia and an installation is necessary. Then, the factory starts production. The production process needs a certain period of time. In general, investment by its very nature is of a long-term process. During this time, the investor has the opportunity to re-e valuate the risks involved in that particular investment, and take necessary measures to minimize the degree of risk.

 

Further, investment requires a continuous flow of decisions. As we can observe from the above examples, the investors should decide on each and every level of the investment. Thus, investment is the result of a series of decisions.

Moreover, investors should from time to time reappraise and revaluate their various investment commitments in the light of new information, changed expectations and ends.

Investment decisions are based on data which represent the observable environment and the general and specifics of a given investment. It takes the ability to analyze the data and specifications properly to make an appropriate decision. Thus, investment is the result of a series of decisions.

 

Thus, investment is an art and depends on the art the individual investor employs to be successful. An investment may be successful where the investor employs a suitable art. On the other hand, investment is a science because there are rules and principles developed through time. In general, investment is an art and a science.

 

ECONOMIC PRINCIPLES OF INVESTMENT

 

We have seen that investment is both an art and a science. As a science, there are fundamental principles applicable to investment. Under this part of the material, we shall discuss the essential ones.

Safety of Investment

 

An investment needs safety since the investor invests his/her fund and time. Thus, adequate protection should exist against the risk of loss of capital. Investing in the form of shares is said to be relatively safe because the risk is spread due to diversification among different scripts of companies.[2]

 

For instance, if Abebe invests his fund alone, the risk of loss is higher compared with the investment made together with others in the form of Share Company. In general, what is required is maximizing the chance of getting profit in any manner.

Liquidity

 

Liquidity is the second principle of investment. Any investment is said to be liquid, if it can be converted into cash or sold as and when required. A liquid investment would enable the investor to encash his/her investment whenever the need arises. It would also permit the investor to sell off an unremunerative investment, there by minimizing the losses, and switch over to a more prommising investment. Thus, the liquidity of an investment offers flexibility in the face of changing economic and political environment.[3]

 

For instance, Dendir was investing on food processing in Eritrea before the prevailing regime came to power. Investment on this sector is safe since the return is very high in that particular area. However, Dendir has sold it easily and came to Ethiopia as the political conditions changed dramatically. Thus, the investment Dendir has made is liquid since it was possible to encash it whence it was required.

Profit

 

We have seen that profit is an element of investment. The main reason of investment is to accrue profit. Profit can be realized in either or both of the  capital appreciation yield[4]

 

Capital appreciation occurs when an investment is disposed of at a higher value compared to the price for which it was purchased. Where the difference between the net selling price and the purchase price is positive, it is said to be capital appreciation.[5]

 

Yield, on the other hand, is derived in the form of interest or dividend. The rate of dividend may fluctuate from year to year, depending on the profitability of the area in which money has been invested where as the rate of interest is usually fixed.[6] If for example Kedir invests on purchasing shares, such shares are expected to yield a dividend at the end of the year. This is an investment for Kedir i.e  a capital appreciation or yield.

 

Tax Implications

 

The investor may be required to pay tax on his/her income.[7] According to Proclamation No. 286/2002, Article 4, “every person having income as defined here in shall pay income tax in accordance with this Proclamation”. Income is defined as “… Every sort of economic benefit including nonrecurring gains in cash or in kind, from whatever source derived and in whatever form paid credited or received.[8]

 

In addition, an income from business activities is taxable income under Proclamation No 286/2002 (Art. 6(b)). We have seen that investment is made to gain profit. An activity recognized by the Commercial Code of Ethiopia as trade and is made to gain profit is known as business activity.[9]

The rate and manner of business income tax is regulated by the provisions of Income Tax Proclamation No 286/2002.[10] According to this proclamation, business organizations shall pay 30% of their income as tax.[11]

Inflation

 

Inflation erodes the value of money invested. To earn a rate of return, the money should be properly invested. We have seen that investment is a business activity. Business is undertaken  for profit, and the investment must at least compensate for the rate of inflation.[12]

 

What do we mean by inflation? The term generally means, “increase in prices coinciding with a fall in the real value of money”.[13] The increase of price and the decrease of the real value of money definitely will have a negative impact upon the investment. For instance, the capital of the investor is Birr 220,000. If inflation occurs, the real value will decrease and the capital will not have the power that it was at the time of investment. Therefore, the investor might be forced to increase the capital.

Government Control

 

Government controls certain economic sectors and that may affect investment. For instance, pursuant to Article 5 of Proclamation No 280/2002, it is only possible to invest on electric energy under a joint investment with the Ethiopian Government. Thus, Government control affects investment and it must be considered.[14]

Legality

 

The investor is required  to invest on areas that are allowed by law. S/he should also fulfil other requirements like license etc. For instance, grinding mills, retail and brokerage, among others, are areas exclusively reserved for domestic investors.[15] Therefore, no foreign investor is allowed to invest on areas that are reserved only for domestic investors.

 

Pre- requisite for investment

 

To have an investment, the income during one period of time should produce earning in future periods. In order to obtain a greater return in the future, consumption in the current period is foregone. In general, for an economy as a whole to invest, total production must exceed total consumption.[16] In other words, there must be saving. Saving is the process of setting aside a portion of current income for future use. Saving may take the form of increases in bank deposits, purchases of securities, or increased cash holdings.[17]

 

Saving is important to the economic progress of a country because of its relation to investment. An individual should be willing to abstain from consuming his/her entire income and save. The preference of individuals for future over present consummation, their expectations of future income and to some extent the rate of interest affect the extent of saving by individuals.[18]

 

Once individuals do saving, they must be willing to invest their money so as to increase productive capacity.[19] To invest, it is essential to fully understand the principles of investment we have discussed hereinabove.

 

Investment increases an economic capacity to produce. In addition, investment is the factor responsible for economic growth. For growth to occur smoothly, It is necessary that savers intend to save the same amount that investors wish to invest during a time period. It is worth noting that if intended saving exceeds intended investment, unemployment may be the result. In addition, inflation may occur if investment exceeds saving.[20] Therefore, it is essential to balance the saving with investment. In general, saving is an essential pre-requisite for investment. A saving should be properly invested otherwise, inflation may occur.

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[1]V.  Gangadhar and Ramesh Babu; Investment Management including Portfolio Management And Security Analysis, Anm Publications Pvt, Ltd, New Delhi,2003, Pp. 3

[2] Gangadhar and Babu, Ibid, p 15

[3] Ibid

[4] Ibid, p. 16

[5] Ibid

[6] Ibid

[7] Ibid

[8] Proc. No 286/2002, (as amended), Ibid, Art. 2 (10)

[9] Ibid, Art. 2(6)

[10] See ibid, Arts. 17-30

[11] Ibid, Arts  2(2) and 19(1)

[12] Gangadhar and Babu, Ibid

[13] Bryan;  Ibid, p. 794

[14] Gangadhar and Babu, Ibid

[15] Council of Ministers Regulations No 84/2003, Federal Negarit Gazeta,     Year, No……, Addis Ababa, Schedule

[16] Encyclopaedia of Britannica; vol. 10, Pp. 837-38

[17] Ibid, p. 482

[18] Ibid

[19] Ibid

[20] Encyclopaedia of Britannica ,Vol. 6, P. 363

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Last modified on Friday, 07 February 2014 14:12