Investing for Productivity and Prosperity (1994)

ments with payback. Significant differences in the cost of equity are therefore likely to have their most significant effects on investments in intangible assets. The board is concerned with relationships between technology and economic policy and believes that these observations elevate the importance of ensuring that U.S. corporations are not encumbered with a cost of equity disadvantage when they compete in global markets.

The cost of equity is more difficult to measure than the cost of debt for several reasons. Expected capital gains are an important component of financial investors’ expected returns, but they cannot be measured reliably. The high variability in stock returns from year to year makes it difficult to infer required returns from observed returns. Finally, required returns and observed returns can move in different directions. A decline in the required return on equities, for example, could boost stock prices and coincide with very high returns on stocks.

Although recognizing the foregoing difficulties with measuring the cost of equity, Hatsopoulos and Poterba argue that if investors in Japanese equities extrapolate recent rates of return on corporate assets into the future to assess the prospects for capital gains, then the return they expect to earn is lower than that expected by U.S. equity investors.¹³ This was true in the late 1970s and early 1980s, well before the dizzying increase in land prices after 1985, and the authors discuss why this later event would not materially affect the rate of return measurement. This situation has persisted for most of the past two decades. The board believes that the preponderance of evidence suggests that the cost of equity finance in the United States is higher than that in other industrial nations, especially Japan, whose firms, despite the recession, represent the principal competition to U.S. firms in international markets. Tax law differences still contribute to a sizable difference. As this report explains, the risk-adjusted returns to the investor and the cost of capital to the firm are quite different.

Three factors appear to contribute to a persistent disparity between the cost in the United States and Japan of equity to firms. First, the higher saving rate in Japan yields a larger pool of resources for equity investment, resulting in lower required returns on stocks. Second, the tax