Discussion

Most firms, no matter how large, find that stockholder value is enhanced if they borrow money. For many years, E. I. du Pont was proud of the fact that they never borrowed any money. As the go-go years of the 1980s approached, it was pointed out to them that the lack of debt and leverage, and hence the relatively modest rate of return on total continued

MANAGER’S BRIEFCASE (continued )

’50 ’55 ’60 ’65 ’70 ’75 ’80 ’85 ’90 ’95 ’00 Aaa bond yield minus prime rate –8

–6 –4 –2 0 2 4

Figure 5.3 Yield spread between Aaa corporate bond rate and the prime rate

investment, made them a possible unwilling target for takeover. They quickly remedied the situation and borrowed for investments and acquisitions, including but not limited to purchase of the Continental Oil Company (Conoco), which was later sold and then merged with Phillips petroleum.

Because interest payments are deductible, the arithmetic of increasing stockholder return by borrowing money is obvious, no matter how large the company. Nonetheless, the fact that these loans must be paid back increases the risk of a cash flow crunch during periods of recession. Sometimes firms do borrow in the bond market when rates are low, raising money by floating 30-year (or even longer) bonds; of course, interest payments must be made, but by refinancing when the business is flush and interest rates are relatively low, the repayment of principal can be postponed indefinitely. When interest rates fell to unusually low levels in 1993, a few companies actually floated 100-year bonds.

While the company must make more information public with a bond offering than if it borrows from a bank, that cannot be the principal reason for large corporations, which offer information because of stock offerings anyhow.

The principal determinant would appear to be the cost of borrowing from banks as opposed to borrowing in the bond market.

Figure 5.3 shows that some of the time, the Aaa bond yield is higher than the prime rate; other times it is lower.

Over the 50-year period, there is virtually no difference between the average of the two rates. So cost alone would not appear to be a compelling factor either.

Nonetheless, one could reasonably argue that this graph is misleading, or at a minimum not the whole story.

Many large companies desire lines of credit, for which they pay perhaps ¹₄%, allowing them to withdraw the money in times of unforeseen liquidity shortfalls without having the expense of managing a bond issue and paying interest for many years. In addition, many large corporations require that banks provide them with a large variety of services in return for “compensating balances,” so that the true cost of borrowing to the corporation is far less than would be indicated by the prime rate itself. For these reasons, then, many large well-managed corporations continued

MANAGER’S BRIEFCASE (continued )

continue to rely on bank financing. When the yield curve then becomes inverted, they may find their ability to borrow is either curtailed or becomes much more expensive. That is why the yield curve is an important determinant of capital spending even for large corporations.

5.6 The role of expectations

Because no firm can predict the future very accurately, all capital spending decisions are based on imperfect expectations. The role of the economist is to try to quantify the factors that determine these expectations.

Assume the firm has gathered the relevant information on the current rate of capacity utilization, the change in technology since the last similar investment, the cost of debt and equity capital, the current tax laws, internal cash flow, and the availability of funds in financial markets. Based on this information, it has calculated the expected rate of return for each projected investment. Should the firm go ahead with the project, or wait a while?

Several decades ago, many organizations, including the Commerce Department, McGraw-Hill, and what was then called the National Industrial Conference Board, prepared annual surveys predicting how much capital spending would change in the following year. These surveys were based on capital appropriations of large cor-porations. Since these firms represented a high proportion of total capital spending, it was initially thought these surveys would be quite accurate. However, the errors were so large that the exercise was finally downgraded or abandoned completely.

In spite of the fact that large firms carefully prepare capital budgets every year, it is clear that they also change their plans in midstream.

Perhaps the most obvious case arises when the economy plunges into recession;

even if various investment projects have been considered profitable based on exist-ing data, many of them will be postponed because of the ongoexist-ing decline in sales.

The expected rate of capacity utilization will fall, and existing plant and equip-ment will be adequate. For most firms, changes in the index of capacity utilization, stock prices, and corporate cash flow serve as the most important indicators that determine whether investment decisions should be postponed.

Since data on appropriations and anticipations for capital spending are no longer published on a regular basis, it is not possible to use recent data to determine which variables are most likely to affect changes in expectations. The key variable is probably the change in the volume of sales, which for manufacturing firms can be measured by changes in the rate of capacity utilization; if sales plunge, investment plans will be postponed even if the long-term outlook is still favorable. In addition, firms often modify existing plans for capital spending based on short-term changes in cash flow and stock prices. Even large firms with adequate access to capital markets usually trim capital budgets when cash flow targets are not met. Hence,

–0.15 –0.10 –0.05 0.00 0.05 0.10 0.15

’60 ’65 ’70 ’75 ’80 ’85 ’90 ’95 ’00

Four-quarter changes in investment ratio (%)

Four-quarter changes in capacity utilization, lag two quarters –15

–10 –5 0 5 10 15

Figure 5.4 The four-quarter percentage changes in the ratio of capital spending to GDP in current dollars are correlated with the four-quarter changes in the index of capacity utilization, lagged two quarters

on an empirical basis, changes in capacity utilization, cash flow, and stock prices over the past few years are also important determinants of capital spending.

The correlation between the four-quarter percentage changes in the ratio of capi-tal spending to GDP and the four-quarter changes in the rate of capacity utilization, lagged two quarters, is shown in figure 5.4. This lag is short, representing modifi-cations of plans; the rate of capacity utilization also affects the equilibrium demand for capital stock with a longer lag. Similar lags occur for cash flow and stock prices as modifications variables, but the correlations are not as strong.

5.7 Lags in the investment function

When most consumers want to buy a particular good – even a durable good that is expected to last several years – they get in their car, go to the mall or dealership, and buy the item that day – or they check for the best bargains on the internet.

However, except for consumer-type goods such as personal computers or motor vehicles, most capital goods cannot be delivered the day they are ordered. In addi-tion, most capital budgeting undergoes a much more rigorous process than the average consumer purchasing decision.

In determining how investment affects the economy, several lags must be con-sidered. The first is the appropriations lag: the time between changes in economic conditions and the time that the capital good is ordered. The second is the delivery lag, which varies widely depending on the type of equipment or plant. The third,

–15 –10 –5 0 5 10 15 20 25

1980 1985 1990 1995 2000

Change in capital spending (%) Change in other GDP (%) –6 –4 –2 0 2 4 6 8 10

Figure 5.5 Four-quarter percentage change in real capital spending and real GDP excluding capital spending

which is really a corollary of the delivery lag, is what we call the asymmetry lag: the decision to cancel can be made much more quickly than the decision to purchase.

That means, other things being equal, that capital spending has a longer lag on the upside than it does on the downside.

The empirical magnitude of these lags is illustrated in figure 5.5, which com-pares the percentage change in capital spending with the percentage change in the sum of all other components of GDP; both series are in real dollars. Three factors can be noted. First, the lags are not very long on the downside. Second, they are longer on the upside: in recent recessions, the rest of the economy usually turns up almost a year before capital spending started to improve. Because the 1980 reces-sion was caused primarily by the imposition of credit controls, which primarily affected short-lived assets, the lags were not as long in that brief recession. Third, fluctuations in capital spending are much greater than the remaining components of GDP. The dip in capital spending in 1986, which is not mirrored in the rest of GDP, reflects the cancellation of the investment tax credit in that year.

5.8 The effect of changes in tax policy on capital spending decisions

The corporate income tax code changes virtually every year, but most of these changes represent minor tinkering with existing regulations, or attempt to adjust those regulations to mean what Congress and IRS thought they meant in the first place. Our comments consider only the major changes, which can be grouped into three categories: changes in the marginal statutory corporate income tax

rate, adding or removing the investment tax credit, and adjusting depreciation schedules. The major changes in these categories can be summarized as follows:

1951–3: Certain wartime facilities can be written off over five years instead of the life of the capital good (known as accelerated amortization allowances, or AAA). An excess profits tax was also imposed during the war.

1954: AAA is terminated along with the end of the Korean War, but several other changes are made to the tax code, includ-ing a limited deduction of dividends against corporate income; some depreciation allowances are liberalized.

1962: Investment tax credit (ITC) introduced at a rate of 7%. The amount of the ITC, which is equal to the rate of credit times the amount of the qualified capital equipment purchased (it does not apply to structures), can be deducted directly from the income tax owed by a corporation.

1964–5: Terms of the ITC become more generous although the rate stays at 7%. The marginal statutory corporate income tax rate is lowered from 52% to 48% in two steps, and deprecia-tion allowances are further liberalized, permitting quicker writeoff times.

Sept. 1966–Mar. 1967: ITC and accelerated depreciation temporarily suspended.

Mid-1968 to mid-1970: 10% corporate income tax surcharge.

Apr. 1969–Aug. 1971: ITC and accelerated depreciation temporarily suspended.

1975: Rate of ITC increased to 10%.

1981: Further liberalization of depreciation allowances, espe-cially for structures, and several other corporate income tax breaks; income tax rate is cut from 48% to 46%.

1982: Some of the 1981 advantages are terminated, but acceler-ated depreciation allowances remain on the books.

1986: Most corporate tax advantages are terminated, including the end of the ITC and accelerated depreciation. The top marginal corporate income tax rate is lowered from 46% to 34% in two steps.

1993: Corporate tax rises from 34% to 35%; other changes raise the effective tax rate slightly.

Economists are divided in their opinion about the impact of these tax changes on purchases of capital equipment, other than to change the timing (e.g., firms rushed to place orders shortly before the ITC was canceled). Figure 5.6 shows the relationship between the rate of investment tax credit and the ratio of purchases of producers’ durable equipment to GDP for the four major categories: industrial, high-tech, transportation, and other, which is largely resource-based equipment such as energy and agriculture.

0.014

(a) Industrial equipment (b) High-tech equipment

(c) Transportation equipment (d) Other industrial equipment 0.010

Figure 5.6 Rate of investment tax credit and ratio of purchases of producers’ durable equipment to GDP

CASE STUDY 5.1 DID THE INVESTMENT TAX CREDIT BOOST