4
Time Horizons and Cost of Capital

America's financial climate is not conducive to long-term investments in technology and equipment, compared with Japan, Germany, and the most rapidly developing Asian nations. Several things contribute to this relatively unfriendly environment. High U.S. capital costs shorten the time horizons of investors, so do the pressures exerted on companies by the stock market, particularly by institutional investors and takeover specialists. In sum, both government policies and business practices reinforce an excessive concern with short-term profit in America.

—U.S. Congress, Office of Technology Assessment, Making Things Better: Competing in Manufacturing, (Washington, D.C., U.S. Government Printing Office, 1990), p. 9.

There are two related, yet clearly distinct, sets of questions about capital for technology investments. The first set is linked to the perspective of a single nonfinancial corporation and its interaction with financial markets.

The committee is indebted to Joseph Morone and Albert Paulson for their excellent work interviewing corporate executives and preparing their report to the committee, ''Cost of Capital—The Managerial Perspective,'' which is published as Appendix A of this report. Morone and Paulson's work helped shape the committee's deliberations with regard to the different perceptions of the importance of the cost of capital in different companies and industries, the ways in which a company can manage its cost of capital, and the importance of a technical and marketplace lead in allowing long-term thinking. As a matter of policy, however, it is important to note that findings, conclusions and recommendations of that report are Mr. Morone's and Mr. Paulson's and are not intended to reflect opinions or judgments of the committee or the National Academy of Engineering.



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4 Time Horizons and Cost of Capital America's financial climate is not conducive to long-term investments in technology and equipment, compared with Japan, Germany, and the most rapidly developing Asian nations. Several things contribute to this relatively unfriendly environment. High U.S. capital costs shorten the time horizons of investors, so do the pressures exerted on companies by the stock market, particularly by institutional investors and takeover specialists. In sum, both government policies and business practices reinforce an excessive concern with short-term profit in America. —U.S. Congress, Office of Technology Assessment, Making Things Better: Competing in Manufacturing, (Washington, D.C., U.S. Government Printing Office, 1990), p. 9. There are two related, yet clearly distinct, sets of questions about capital for technology investments. The first set is linked to the perspective of a single nonfinancial corporation and its interaction with financial markets. The committee is indebted to Joseph Morone and Albert Paulson for their excellent work interviewing corporate executives and preparing their report to the committee, ''Cost of Capital—The Managerial Perspective,'' which is published as Appendix A of this report. Morone and Paulson's work helped shape the committee's deliberations with regard to the different perceptions of the importance of the cost of capital in different companies and industries, the ways in which a company can manage its cost of capital, and the importance of a technical and marketplace lead in allowing long-term thinking. As a matter of policy, however, it is important to note that findings, conclusions and recommendations of that report are Mr. Morone's and Mr. Paulson's and are not intended to reflect opinions or judgments of the committee or the National Academy of Engineering.

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From the perspective of an individual corporation, competitive performance (market share or profitability, for example) derives in part from successful development and deployment of commercially viable products and services. That depends on investments—investments in things ranging from product research and development through production equipment upgrades and personnel training to market creation or development. Investment capital is a market commodity, and companies seeking to "purchase" capital face a typical set of buyers' options—some of the available products are relatively cheap and some are relatively expensive, some products can come with desirable features and some are packaged with a number of unwanted extras, some products are offered by a reputable dealer and some can be obtained from the financial equivalent of a guy selling watches from inside his trench coat. In other words, as purchasers of capital, companies face a range of choices, most of which affect a company's options for investing the resources in company operations. As was described in Chapter 2 and discussed in Chapter 3, companies have considerable control over, and latitude in, the way they make investment decisions. In addition, companies affect their internal investment options by a range of interactions with financial markets. The cost of funds, the pretax cost of capital, and internally established investment hurdle rates interact to affect the attractiveness of investments. The important questions, from the company perspective, revolve around whether the cost of capital is a high-priority concern, ways in which corporate actions increase or decrease the company's cost of capital, and noncost consequences (exposure to takeover, for example) of corporate financial decisions. The second set of questions relates to capital in macroeconomic terms. Technological advance and productivity growth depend on the aggregate amount and efficiency of investments in capital formation, research and development, and human resources. Perhaps the most problematic concern about capital costs from the macroeconomic perspective centers on "invisible" losses to the national economy, reflecting investments not made. At a macroeconomic level, the aggregate national rate of economic growth depends on rates of investment in plant and equipment, in the development of human resources, and in the development and application of technological advance. High national capital costs (relative either to capital costs in other nations or to different times in the same nation) will dampen virtually all investment in assets promising future returns and lead to slower rates of national economic growth. This impact may or may not show up in the performance of individual firms—depending on the industry, competitive position of the firm, and the ability of a company to cope with high relative costs of capital, any individual company may show few ill effects of high capital costs. It is, however, a serious national concern. Notwithstanding the considerable power of economic theory and empirical work, the extreme complexity and interdependence of this system make it

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difficult to identify changes in fiscal policy, monetary policy, financial market regulations, or institutional structure that will unquestionably improve the allocation of resources. The task is even harder if the goal is to determine what actions will truly lead to stronger national performance in commercial technological advance. The policy arguments relating technological advance and financial markets have centered on ways to lengthen the time frame of investments by providing lower taxes on investments held for longer periods (e.g., lowering capital gains taxes on investments held for long periods of time); reducing the cost of capital by reducing government borrowing (i.e., deficit reduction); or increasing savings (e.g., shifting toward consumption taxes rather than income taxes). Of overall concern is the continuing fiscal deficit, which places pressure on capital availability in the United States and thereby increases capital costs to the detriment of all investments, long-term and short-term. These two perspectives—the corporate perspective and the macroeconomic perspective—are linked through financial markets. In general, the organization and functioning of financial markets reflect economic opportunities. Since there is money to be made making microchips, trading wheat futures, or renting apartments, financial instruments and institutions have evolved to allow investors to buy shares of microchip companies, participate in wheat futures trading, or own shares of real estate partnerships. Having said that, it is important to recognize that financial markets do not mirror economic opportunity perfectly or without constraint. Significant allocation problems arise when competing companies face different expectations on the part of lenders or shareholders (different costs of capital), which many argue has been the case in competition between U.S. and foreign competitors for at least the last 15 years. Tax structures or regulatory policies that unintentionally introduce a bias in favor of investments that pay back quickly can exacerbate the problems introduced by differing costs of capital. Also, information problems abound in financial markets in spite of regular government intervention (Securities and Exchange Commission regulation) designed to protect investors from fraud and market manipulation. Another issue is that financial markets are as susceptible to structural problems as any other market. Problems arise if financial markets are not organized to collect and deploy capital effectively, an argument made in recent years about the influence of institutional investors in the United States; financial organizations themselves become players, bringing with them all of the decision-making biases and limited rationality of any organization. In summary, the cost and availability of capital for all investment, as well as the economic efficiency of marginal investment decisions, need to be viewed through two lenses: (1) corporate financial structure and behavior; and (2) economic conditions that depend, in part, on government tax and fiscal policy. Both are inextricably and recognizably linked to financial market structure and the behavior of financial market actors. For example,

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in a recent survey of 139 members of the Industrial Research Institute, respondents named "general management practices" and "external financial pressures" as the primary causes of ''erosion in U.S. technology leadership" (National Science Board Committee on Industrial Support for R&D, 1991). In other words, Wall Street is commonly blamed, in part, for U.S. short-term behavior; nonfinancial corporation executives tend to blame financial intermediaries like banks and institutional investors for increasing short-term pressures on organizations. The following sections focus on the ways in which financial markets and companies interact to affect time horizons, and they suggest strategies, primarily from the corporate perspective, for improving levels of investment in long-horizon technology development and long-lived productive assets. A short section is included on national differences in costs of capital. Although this study does not take an international comparative approach in other matters it addresses, the committee judged the issue of international capital cost differentials to be to so much a part of the current debate over the role of time horizons in competitiveness that it deserved attention. The section is also useful in that it develops several explanations about the ways in which economic and financial market parameters affect company time horizons. FINANCIAL MARKETS AND TIME HORIZONS IN THE 1990S The amount of money controlled by institutional investors has grown significantly over the past two decades. The pool of institutional assets has increased from $569 billion in 1970, to $1,773 billion in 1980, and to $5,810 billion in 1989. These equity assets have grown as a percentage of the New York Stock Exchange (NYSE) from 27 percent in 1970 to 54 percent in 1989 (Salomon Brothers Inc., 1990). At the same time, turnover of securities has dramatically increased. On the NYSE the ratio of volume of shares traded annually to total shares listed has grown from 12 percent in the early 1960s to more than 50 percent in the mid-1980s (Chandler, 1990). This trend—the emergence of a liquid institutional market for corporate control—has been called the "commoditization" of corporate ownership (Jacobs, 1991) and is recognized as an important change affecting the pace and character of restructuring and redirecting U.S. industrial enterprises. As institutional investment managers hold and manage larger and larger portfolios, they have come to be a substantially more important and influential part of the financial structure of the nation. One manifestation of the growth of an institutionalized market for corporate control is a dramatic change in the character and pace of corporate restructuring. In the 1990s even a large public company can be bought, divided, reconfigured, and sold by individuals or institutions with no previous experience with, or substantial connection to, the company. The leveraged buy-outs, mergers, and acquisitions that

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were so much a part of the financial news in the 1980s are a product, in part, of the growth of an institutionalized market for corporate control. The highly visible corporate restructurings of the 1980s have created a widespread perception of financially driven corporate restructuring as excessive and wasteful; many people in industry believe the kind of wholesale financial restructuring that took place in the 1980s is the curse of American capitalism. Others, not surprisingly, regard it as a natural and important part of free market competition. A second manifestation of the increase in institutional investor holdings is the impact that institutional trading has on the behavior of managers in publicly traded companies. Because institutional investors trade increasingly larger blocks of stock and can do this at an increasing rate, these investor's executives are driven to examine the performance of organizations constantly and to make decisions based on that performance. This may force investors' time horizons to be as short as one day. In turn, the argument goes, this can compel executives in publicly traded companies to have shorter and shorter time horizons.4 The effects that the rise of institutional investors and the commoditization of corporate control have on the time horizons of corporations are ambiguous. Pressure on corporate managers by institutional investors is, indeed, likely to increase (McCartney, 1990), perhaps creating new pressures on corporate governance; however, it is far from clear whether there is a unbreakable link between institutional investor trading and short-term behavior on the part of companies. For example, as institutions are becoming some of the largest shareholders in individual companies, some are behaving like long-term investors and flexing their muscle to bring about changes in corporate management. The California Public Employees' Retirement System (CALPERS) is perhaps the prime example of an increasingly activist institution, an institution that has pursued the traditional role of a large shareholder in corporate governance. In general, institutions have been most aggressive with stockholder resolutions, commonly pursuing a social agenda—divestiture of investments in South African companies, environmental practices, and reducing foreign 4   It is worth noting that institutional investors with short time horizons are often created by the same corporate managers who feel they suffer from the short-term orientation of financial markets. The orientation of some institutional investors toward quarterly performance is, in part, a reflection of the short-term orientation of boards of directors and executive managers of nonfinancial companies who want maximum return at all times in their own pension funds and often insist on measuring corporate pension fund managers on a year-to-year basis. This creates a situation that, in the long term, pressures fund managers to perform to match or beat market index numbers on a quarterly basis. To allow institutional investors to seek longer-run returns, both corporations and governments, in their administration of employee pension funds, can adopt policies that allow them to reward their fund managers for long-term performance rather than on the basis of the quarterly, annual, or, at most, two-year evaluations commonly in use today.

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oil-dependency. Recently, however, they have been moving closer to a traditional large shareholder's role. CALPERS garnered attention for a role it played in suggesting and supporting directors for a distressed company and, most recently, for refusing to reelect a board of directors as a protest against large compensation packages for senior management. Is including institutional investors in the governance of an organization better or worse than relegating their influence to the proxy mechanisms? Is a rapid and organized response from shareholders, if they perceive that management is failing to perform well, a problem or a solution? The nature and type of relationships between institutional investors and companies may be more at fault for "shortsighted behavior" than the incapacity or unwillingness of institutional investors to invest for the longer run. With regard to the impacts of corporate restructuring, companies with poor short-term financial performance are, it seems, increasingly exposed to the threat of hostile takeovers; in public companies a low stock price based on poor short-term performance can open up a takeover opportunity as the assets of the company can be deployed or sold at higher value than the value of the stock. In general, takeovers and acquisitions have been (must be) financed with debt, loaned against the value of the business. The result is that management is pushed to short-term actions to maintain or maximize cash flow to pay down the debt. To the extent this takes place in a company dependent on investments in expensive and uncertain technology development or deployment (R&D or process investments) it can harm the company's ability to compete effectively by shortening the company's time horizon dramatically. What is unclear is whether such outcomes are bad either for the company or for an economy; a company that has a low stock price because it is overinvesting in foolish or misguided R&D can be helped or mercifully dismembered by a takeover that forces attention to short-term cash return to investors. Was the frenzy of restructuring in the 1980s good or bad for the long-term performance or technological competitiveness of U.S. firms? The data are either unavailable or inconclusive or both (Coffee, et al., 1988; Flamm, 1990; Ravenscraft and Scherer, 1987). In particular, (1) the story is still unfolding with regard to the large bulk of those companies that took on a heavy debt load; and (2) the majority of takeovers—indeed the majority of all mergers and acquisitions have been in mature industries with little explicit research and development (Grundfest, 1990). What is clear, it seems, is that the amount of corporate restructuring during the 1980s—both "good" deals and "bad" deals—was enormous. Disagreement (or ambivalence) among the financial and business community about the value and impact of commoditization of corporate control is widespread. In spite of enormously important changes in financial markets in recent decades, individual companies continue to have substantial latitude to affect

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how much they pay for capital. Companies determine their image in financial markets (and thereby the value of their stock) by their profitability and through choices about issuing new stock, paying dividends, borrowing funds, and retaining earnings. Management of debt-to-equity ratios and other choices about sources and uses of capital are importantly dependent on a corporation's board and senior management. It is the responsibility of the directors, working with senior management, to match capitalization assessment and needs to the corporate strategy. All of these actions affect the company's market cost of capital, leading to the conclusion that companies are themselves important players in determining their cost of capital. A COMPANY'S CONTROL OVER ITS COST OF CAPITAL The board of directors and management of public companies are partially responsible for a corporation's cost of capital through their impact on the performance of a company. Management's goal, regardless of strategy, is to create value for the stockholder either through appreciation in the value of equity holdings or in dividends paid to shareholders. The value of the stock determines whether the company will have access to capital, fixes the price of the capital that the firm raises, and influences the dividents that must be paid or the growth of retained earnings needed to hold onto the stockholders. The access to capital provides a firm with the opportunity to invest in projects that are likely to yield returns and affect future performance.5 This simple description—although accurate—hides the degree to which a company's prospects (and therefore its cost of, and access to, funds) depend on the characteristics of the company and the business the company 5   This section deals almost exclusively with public companies. Large private companies have clear advantages in terms of loyal "shareholders" (discussed in the next section), but they face a different set of issues when it comes to raising or using external capital. Smaller private companies face an entirely different set of constraints. As a general rule, small private companies are financed by personal savings, family and friends' investments, bank loans, finance company loans, or individual venture investors; public equity markets play almost no role in financing small companies. Additionally, organized venture capital funds are rarely interested in companies that are not expected to grow rapidly to a size and degree of profitability and promise at which it makes financial sense either to "take" a company public or to sell a major equity stake in the company to a larger public corporation. Although many of the central points of this section (e.g., the importance of managements' skill in communicating effectively with sources of finance) apply to smaller private companies, there is a substantial set of issues, which the committee did not choose to address, that are worthy of further exploration. Do the informal financial markets that serve technologically oriented start-ups in the United States function efficiently? Do small private companies have adequate access to credit for technological modernization? How do the typical sources of finance for these activities affect the time horizons of operations? What is the effectiveness of government programs, such as Small Business Innovation Research, aimed at supporting technological start-ups?

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is in, and on such uncertain factors as the rate of overall economic growth, the rate of growth in a particular market, and the performance or likely performance of competitors. The growth potential and degree of risk or uncertainty, as perceived by markets and investors, are major factors that control the availability of capital to firms. One common measure to manage is the price-to-earnings ratio of public securities; the P/E ratio can be kept high through revenue and profitability growth, and the expectation of that growth is one way to maintain long-term stockholders. At an industry level, if the potential for growth and profitability is questionable, the money available to firms in that industry will dry up. The cost of borrowing money to invest in technology development—if it can be obtained at all—will be very high. Conversely, a high growth potential is directly linked to low capital cost. Financial Markets, Technology, and Company Valuation Although there is much that managers cannot control about a company's interaction with financial markets, there is an important question over which they have considerable influence: How do investors (markets) know and judge the timing and magnitude of a company's "prospects" when there is significant technological or technology-related market uncertainty? Information about prospective returns creates financial markets, and governments have long been in the business of regulating basic financial information to certain standards of reliability—in the United States, individual states took the lead in such regulation, and the Securities and Exchange Commission was established in 1934. Standard financial information about a company, however, does not begin to provide the information necessary to judge the likely impact of a new long-term corporate research program or a systematic (and probably expensive) in-house effort to bring new production technologies into existing facilities. As such, information becomes a significant problem in the relationships between providers and users of capital. While providers of capital to technology-based enterprises want predictability and the maximum possible assurance of success as well as high returns, the users of capital often need abundant resources and considerable latitude and time to solve technical, organizational, and market problems. It is, by design, an uneasy relationship of mutual interest, lubricated primarily by information. At one extreme is the venture capital community, which often invests substantially in single-product, technology-based start-up firms, usually with the goal of growing the company to a sufficient size to take it public through an initial public offering of stock. The high risk of such investments—from the investor's perspective—is offset by a variety of structural mechanisms. The most important of such mechanisms is the direct involvement of the venture capitalists in governance of the organization, giving them both the

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best available information about likely outcomes and significant control over operations (Sahlman, 1990). At the other extreme is the information exchange between large, multiproduct corporations and the providers of funds, such as banks and stockholders. In some cases, information about technological matters in large companies is easy to interpret—a court judgment granting a disputed patent right or the announcement of a new major R&D or capital investment program—but most often the value of technology-related company actions is clouded by questions of execution (how effective will the company be in turning technology into profits) or lost in the small impact that any single technological development will have on a large, multiproduct company. Quality programs, which for the most part consist of management actions and worker practices in combination with some small design, production, or product technology changes, are a model for long-time-frame, hard-to-interpret, technology-related actions that can substantially affect a company's performance. The executives in a firm do have some influence over who purchases the stock through effective communication of company information, by management, to money sources. In addition, management can affect how markets perceive the firm's potential as an investment opportunity by establishing long-term relationships with key participants. Most financial market actors—both providers and users of capital—seem to be insufficiently engaged in assessing, analyzing, and valuing technologically uncertain company actions. From the company perspective, strategies for investor relations can more readily allow a company to invest in technological efforts that have a long time frame. From the investor perspective, there may be strategies for information gathering and investment selection that favor long-term, highreturn technological investments (Fisher, 1992). Both sets of strategies have the potential to allow a better match between investor preferences and the demands of technical innovation, and both deserve substantial exploration and development by the finance and technology management research communities. Time Horizons, Technology Investments, and Ownership Structures Additionally, the ownership structure of the firm may have a direct impact on the cost of capital to the firm; if the firm is private or a large block of the stock is held by a single investor, a family, or a trust, the firm can be provided with more stability than a firm whose stock is virtually all traded openly. Family-owned companies have the reputation, at least in the first generation, of being able to make long-term investments—the investors are willing to be more patient than a firm whose stock is traded in large blocks by institutional investors. Therefore, another aspect of managing the cost of capital arises from the advantages of loyal shareholders. Although

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most corporations cannot adopt a wealthy family as a long-horizon patron, they can seek to increase the loyalty of their shareholders by the following means, among others: Employee stock ownership plans (ESOPs), which can create a block of votes representing the interests of employees (a voting block that is usually assumed to support long-term survival and growth of the company) Cooperative R&D arrangements or joint ventures with another company that is particularly skilled in a technology that is important to a venture can reduce the risk of the venture allowing both companies to invest with longer time horizons Alliances or partnerships that may have the effect of lowering the cost of capital (teaming up with a firm that has lower cost capital available) Cultivation of financial investors who have both a reputation for being, and the expressed intent to become, stable, long-term investors Cultivation of longer-term investors—institutional or others—requires constant attention and effective use of information transfer. This cultivation also demands constant contact; it is critical that this information flow be maintained in both good times and bad. Too many companies limit their information sharing with stockholders when there is bad news and, consequently, investors are left with an increased level of discomfort about the investment and will eventually sell their shares. In most cases, managers have many opportunities to affect both the stockholder profile and the investment community's perception of the organization with the effect of lowering a company's cost of capital and thereby providing management with the opportunity to lengthen investment time horizons. In large part, the incentive for senior managers to pursue these strategies depends heavily on their own time horizon. Senior corporate managers should develop and cultivate the following relationships with the financial community and with stockholders: Long-term relationships with banks and insurance companies and constant communications with these institutions Long-term relationships with analysts, investment bankers, and institutional investors, focusing on constant communications, especially in bad times Good relationships with stockholders, providing them with realistic analysis of each of the corporation's major businesses and providing them with warnings of downturns well in advance. In all of these relationships, managers must manage the conflict between the desire for full disclosure of information and the needs of proprietary secrecy.

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THE ECONOMIC COST OF CAPITAL: NATIONAL DIFFERENCES AS A CRUCIAL ISSUE Numerous studies have shown that, over the past two decades, the market cost of capital in Japan and Germany has been as little as half that in the United States, and that this difference has been and continues to be a source of competitive advantage for companies based in those countries.6 The lack of low-cost capital in the United States, particularly to smaller companies, relative to that in other countries is argued to create a severe competitive disadvantage for U.S. firms in terms of investment in plant, equipment, and R&D. The difference is often offered as an explanation for the shortsighted behavior of U.S. executives when compared with their foreign counterparts. Changing world financial conditions—in particular, the increasing liberalization of national capital markets (and concomitant globalization of financial markets, including floating currency exchange rates)—are chipping away at the measurable differences in the costs of debt. In particular, there have been substantial increases in debt flows across national borders but substantially less equity holding than debt holding across national borders. In 1990, for example, gross purchases of U.S. securities by foreigners were $2,120 billion. Of these, $1,947 billion, or 92 percent, were for debt instruments and $173 billion, or 8 percent, for corporate equities (U.S. Treasury Bulletin, June 1991). While debt markets have truly globalized, equity markets continue to have a substantially national character, probably primarily as a result of limited information flows about equity opportunities in other countries. As a result, market clearing rates for debt are nearly equal in the United States and major industrial competitor countries (Hatsopoulos, 1991). This has focused increasing attention on the cost of equity and the impact of corporate financial structures and national financial market structures (both of which vary considerably among nations) on the cost of capital a company faces. It is clear that the relationships between firms and financial institutions are different in the United States, Europe, and Japan. There are important international differences in the banking system and in the relationships between banks and firms. One often cited difference between the United States and Japan is the role that Japanese banks play in holding equity in a company. In particular, Japanese banks are allowed to hold shares in corporations, allowing them to be both lenders to, and shareholders of, a corporation. In Japan, financial institutions (banks and insurance companies) have held as 6   See, as examples, Abuaf and Carmody (1990); Cordes (1991); Hatsopoulos et al. (1988); Hatsopoulos and Brooks (1986); and McCauley and Zimmer (1989). It is important to note that the most common result of these studies—that U.S. capital costs are substantially higher than capital costs in Japan—has been questioned in a number of studies. See, as examples, Kester and Luehrman, 1989; and Nachbar, 1990.

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much as 40 percent of total outstanding corporate shares (Kester, 1986; Federal Reserve Bank of San Francisco, 1991). In Germany, also, banks may play a substantially more important role in the governance of nonfinancial corporations through supervisory boards involved in the day-to-day affairs of borrowers. The capital and ownership structure of many Japanese corporations reduces the risk of both lending funds and holding equity and serves to lower the real cost of capital to firms. In financial terms, the nation's financial structure is such that risk of holding equity in a Japanese corporation is lower than the risk of holding equity in a seemingly comparable company (size, asset base, competitive prospects) in the United States. Referring to the earlier discussion of risk and return (the capital market line), it is clear that mechanisms that reduce financial risk also reduce the rate of return expected by investors and, hence, the cost of equity capital for the corporation. Particularly noticeable is the degree to which risk-reducing financial arrangements involving banks, companies, and the government (Kester, 1986)—arrangements that would be abnormal and perhaps illegal in the United States—allow some Japanese firms to operate with high relative debt/equity ratios in their financial structure and still maintain stability in operations. For a variety of reasons, many U.S. firms borrowed heavily in the 1980s and substantially substituted debt for equity in their corporate financial structures (Blair, 1990). According to Benjamin M. Friedman (1990), ''On average during the 1950s and 1960s, it took 16 cents of every dollar of pre-tax (and pre-interest) earnings to pay [U.S.] corporations' interest bills. The corresponding average for the 1970s was 33 cents. Since 1980 it has been 56 cents. In no year since 1981 has the interest share of earnings been below 50 cents on the dollar." Highly visible private leveraged buy-outs and threats of takeovers were particularly evident signs of this trend in the 1980s. This rush to leverage during the 1980s moved many U.S. firms toward debt/equity positions similar to Japanese firms but without the benefits of a financial system organized to minimize the risk of operating in such a manner. What is clear is that high debt/equity ratios (high leverage) in U.S. firms can substantially increase a firm's susceptibility to business cycles (Cantor, 1990). Highly leveraged companies tend to be more unstable, having greater cyclicality in their investment and employment. This includes instability in capital investment and in R&D investment and more and higher cycles of hiring and firing employees. Clearly, in this situation a company would be extremely unlikely to have a long-term perspective; time horizons would be driven to the very short term. It is beyond the committee's scope to settle the various uncertainties about the existence and magnitude of national differences in costs of capital or the impact of different types of corporate financial structure and restructuring on long-term investment. Most of the uncertainties are likely to

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continue until more and better data exist and researchers better understand the various situations and trends. There are, however, emerging areas of apparent agreement. In particular, it appears, on the one hand, that national differences in market rates for debt are not likely to exist except for relatively short-lived fluctuations arising from national economic or monetary policies. On the other hand, however, national differences in the cost of equity are likely to persist at some level. Differences in national equity costs will be sustained where they are introduced (1) as an intended or unintended effect of differences in corporate capital and ownership structures and practices; or (2) as an intended or unintended effect of national policies that isolate national financial markets or that direct and subsidize investment; or (3) where significant information asymmetries among national equity markets exist. This does not present an optimistic scenario for U.S. firms with regard to capital cost differentials. If the structural relationships among Japanese banks and companies (or European banks and companies) continue to produce stable but more highly leveraged capital structures in Japan and Europe than in the United States, then for the foreseeable future—even with all trade barriers removed and the cost of debt equalized—the "playing field" will remain inherently uneven. Japanese and European firms will continue to have a competitive advantage of investing with longer time horizons and potential access to more patient capital than their U.S. counterparts. A variety of U.S. government policies have the potential to reduce the cost of equity capital in the United States: Reduce the federal deficit. Federal budget deficits are a burden on financial markets and, as such, drive up real interest rates. Some combination of government spending cuts and new tax revenues are required to reduce the federal deficit. The direct impact of reduced federal budget deficits would be reductions in the cost of debt, with indirect impacts on equity costs. Reduce or alter capital gains taxes. Taxes on returns on investments drive a wedge between the return the market demands for a particular level of risk and the pretax return an investment must generate (i.e., an investment must return an amount that pays both the tax and the investor). Some industrialized countries currently tax capital gains at a much lower rate than in United States; a lower rate of U.S. capital gains taxation (or a rate that decreases substantially as the investment is held longer) would reduce the pretax return demanded, reduce the cost of equity capital, and lengthen time horizons. There are a host of well-developed schemes for changing capital gains taxation (prospective, retrospective, indexing, etc.) each of which has its advantages and disadvantages (Congressional Budget Office, 1991a; Hatsopoulos, 1989; Shoven, 1990).

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Eliminate or reduce ''double taxation" of corporate profits. Corporate profits are taxed first as corporate profits and then as individual income (dividends or appreciation at sale). Double taxation of corporate profits has been fully or partially eliminated by the United Kingdom, France, Germany, Canada, Japan, and Australia through "dividend relief" schemes or by the existence or establishment of low capital gains tax rates. Reduction in this double tax wedge between before- and after-tax rates of return would lower the cost of equity capital in the United States. Proposals to eliminate double taxation or to mitigate its impact on time horizons include (a) taxing income generated from equity sales on a graded scale such that the tax rate decreases with increases in holding time; and (b) providing to sellers of equity a tax credit per share sold that is equal to the U.S. federal income tax paid by the corporation on that share during the period of the seller's ownership of the share. Remove barriers to risk-reducing financial arrangements. Some of the risk-reducing financial arrangements prevalent in other countries (allowing bank ownership of corporate stock, for example) or aspects of government regulation that affect corporate structures (antitrust laws, for example) may be amenable to change without endangering the health of the financial system or exposing the public to monopolists. Promote household savings. At a fundamental level, a relatively high national cost of equity is a reflection of a relative preference by citizens for consumption rather than savings. Tax policies such as those allowing all wage earners to make before-tax contributions to Individual Retirement Accounts (instituted in 1981 and eliminated in 1986) have been offered as ways in which to shift the preferences of consumers toward savings with an expected increase in the availability of capital for long-term investment. Such actions are sensible and necessary if the United States is to remain an attractive place to produce for global markets and to avoid disadvantaging existing U.S. firms in global competition. However, such moves are unlikely to eliminate remaining differences in the capital costs faced by U.S. and foreign competitors. Rather, policies that reduce the cost of capital in the United States may be able to remove as much of the difference in relative costs of capital as is possible given the different financial market structures and financing arrangements in different nations. U.S. companies should (1) take advantage of opportunities to reduce any relative equity capital cost differential by tapping global financial markets; and (2) prepare themselves to operate with a cost disadvantage in the area of equity capital. There is a wide range of options by which to attempt to lower equity capital costs in the United States, and the NAE study committee chooses not to endorse particular proposals; it is beyond the scope of the committee's expertise to evaluate the likely impact of alternative policies on important

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aspects of national priorities such as the distribution of the tax burden, the impact on federal government revenues, and the stability of U.S. financial markets and institutions. Such matters should be carefully, explicitly, and promptly weighed and acted upon by the executive and legislative branches of government. SUMMARY AND RECOMMENDATIONS The cost and availability of capital for all investment, as well as the economic efficiency of marginal investment decisions, can be viewed through two lenses: (1) corporate financial structure and behavior; and (2) economic conditions that depend, in part, on government tax and fiscal policy. Both are inextricably and recognizably linked to financial market structure and the behavior of financial market actors. The emergence of a liquid institutional market for corporate control, or the "commoditization" of corporate ownership, is an important change affecting the pace and character of restructuring and redirecting U.S. industrial enterprises. As institutional investment managers hold and manage larger and larger portfolios, they have come to be a substantially more important and influential part of the financial structure of the nation. The growth of an institutionalized market for corporate control has driven dramatic change in the character and pace of corporate restructuring and is changing the relationships among boards of directors, top corporate management, and institutional investors. Even in the context of these strong trends in capital markets, corporate senior managers and boards of directors continue to be able to influence both the structure of company ownership and the way in which markets perceive the firm's potential as an investment opportunity. Most financial market actors—both providers and users of capital—are weak at assessing, analyzing, and valuing technologically uncertain company actions. From the company perspective, strategies for investor relations can more readily allow a company to invest in long time-frame technological efforts. From the investor perspective, there may be strategies for information gathering and investment selection that favor long-term, high-return technological investments. Additionally, the ownership structure of the firm may have a direct impact on the cost of capital to the firm; if the firm is private or a large block of the stock is held by a single investor, a family, or a trust, the firm can be provided with more stability than a firm whose stock is virtually all traded openly. Corporations can seek to increase the loyalty of their shareholders, and therefore the time horizons of decisions, by such activities as employee stock ownership plans, and cultivation of financial investors who have a reputation for (and the expressed intent of) being stable, long-term investors.

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In most cases, managers have many opportunities to affect both the stockholder profile and the investment community's perception of the organization and thereby lower a company's cost of capital and provide management with the opportunity to lengthen investment time horizons. In large part, the incentive for senior managers to pursue these strategies depends heavily on their own time horizon. The committee recommends that managements and boards of directors of companies dependent on long-horizon technological developments (a) implement investor-relations strategies that aggressively and clearly communicate the technological prospects of a company; (b) work to develop long-term relationships with lenders and equity investors; and (c) aggressively pursue joint ventures or other arrangements to reduce the risk of specific technological ventures. With regard to international differences in the cost of capital, national differences in market rates for debt are not likely to exist except for relatively short-lived fluctuations arising from national economic or monetary policies. However, national differences in the cost of equity are likely to persist at some level. The committee recommends that the federal government move to allow longer investment time horizons for U.S. corporations through tax policy changes designed to reduce the pretax cost of equity capital. A variety of policy actions have been proposed to lower the relative cost of capital in the United States, but such moves are unlikely to eliminate remaining differences in the capital costs faced by U.S. and foreign competitors. U.S. companies should (1) take advantage of opportunities to reduce any relative equity capital cost differential by tapping global financial markets; and (2) prepare themselves to operate with a cost disadvantage in the area of equity capital.