Investing for Productivity and Prosperity (1994)

both U.S. and Japanese firms (Poterba and Summers, 1993). The executives who answered their survey believe that, on average, U.S. firms have shorter time horizons than do their Japanese competitors.¹¹ Although it is difficult to measure this effect precisely, these studies support the board’s view that Japanese firms invest more than their U.S. competitors do because they use lower hurdle rates in evaluating investment projects, suggesting that Japanese firms operate with systematically lower perceived risk. This raises two questions: Why are hurdle rates in the United States higher than elsewhere? What, if anything, can public policy do to reduce them?

Hurdle rates vary for three reasons: differences in the cost of funds, in the tax treatment of corporate capital, and between the cost of capital and the hurdle rate set by managers. Financial investors and corporate managers can have different perceptions of risk. Such differences will result in a divergence between the hurdle rate managers use and the cost of capital, which is the rate shareholders would like them to use. At various times during the past two decades, each of these factors has contributed to the differential between hurdle rates in the United States and Japan. Corporate managers can also have different objectives, especially regarding the weight given shareholder interests. This is illustrated by tax-exempt institutions owning a large part of the shares in some large companies, while in others, especially more technologically risky companies, the shareholders are nearly all taxpaying. In the latter case, the managers may feel it necessary to achieve higher pre-tax returns on investment.

Numerous academic studies have attempted to measure the cost of capital or the cost of funds in the United States and Japan (Frankel, in press; McCauley and Zimmer, 1989; Poterba, 1991). There is general agreement that in the early 1980s, largely because of differences in real interest rates and leverage ratios, Japanese firms faced a lower cost of

funds than did U.S. firms. This translated into a lower cost of capital for Japanese firms, because other components of the cost of capital, such as the tax treatment of corporate income, did not differ dramatically between the two countries. As national markets for fixed-income securities (government and corporate bonds) became more integrated during the 1980s, the disparity between the costs of borrowing in the two nations has declined to the point where there is little difference today. Floating exchange rates will have an important effect on the perceptions of longer term investors, who can see anticipated returns offset by declines in the value of their principal in the investor’s currency. Hedging is difficult over longer periods and is expensive, which is why residential housing mortgages, for example, tend to be financed domestically.

The integration of equity markets is moving much more slowly for the understandable reasons that equities are more numerous and more complicated and their integration requires a much greater information flow. Although the pace has quickened, U.S. assets in international mutual funds are still less than 2 percent of the total value of U.S. equities (Poterba and French, 1991).¹² There is little doubt that integration on the equity side will continue, accelerate, and eventually eliminate cost of equity differences. Nevertheless, because tax laws in various countries may still differ, international integration of equity and debt markets will not necessarily equalize the costs of capital across countries.

The board is most concerned about persistent differences in the cost of equity because of its bearing on relative rates of investment in technology. Corporate investments in certain intangible assets such as research and development, new business development, and development of human capital or training are most often financed with equity, partly because they do not give rise in the short run to an easily visible asset that can be measured. As a result, they cannot be used to collateralize debt in the way that tangible assets can be used. In many industries, intangible investments are increasingly the decisive factor in establishing and maintaining a competitive position in an internationally competitive industry. Even in the absence of external markets, intangible investments are essential to raise growth rates and the standard of living. Furthermore, these types of investments tend to have long time horizons, so that a disadvantage in the cost of the particular kind of capital that is used to finance them has a bigger negative effect than it would have for invest-