BIG FOUR: GROWING DIVERGENCE IN FINANCIAL CAPITAL COSTS
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Confidential
D t.rate of
Int ence R
Big Four: Growing
Divergence in
Financial Capital Costs
)N FILE DEPARTMENT OF CORM RC
ELEASE INSTRUCTIONS APPLY
Confidential
GI 82-10080
April 1982
479
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Di rate of ?
Inte gence
Big Four: Growing
Divergence in
Financial Capital Costs
A Research Paper
Information available as of 13 April 1982
has been used in the preparation of this report.
This r was prepared by
0
Industrial Analysis Branch, Office of Global
Issues. Comments and queries are welcome and
may be directed to the Chief, Economics Division,
Confidential
GI 82-10080
April 1982
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Big Four: Growing
Divergence in
Financial Capital Costs
0
0
Foreword Analysts frequently argue that high financing costs put US firms at a
disadvantage compared with companies in other major countries, lessening
the ability of US firms to improve facilities or to aggressively pursue new
investment strategies. The recent surge in US interest rates has widened
this financial gap, particularly vis-a-vis Japan, and enhanced, some argue,
other relative advantages held by foreign competitors.
This report examines trends in financial capital costs through 1981 and
analyzes some of the causes for existing differences in Japan, France, West
Germany, and the United States. The estimates do not apply to interna-
tional comparisons for any given industry. Furthermore, these costs are
only one element in corporate investment decisions, which must also
consider overall corporate goals, the cost of physical capital, cash flow,
depreciation regulations, expected returns to investment, inflation and
exchange rate changes, and the availability of long-term funds.
Confidential
GI 82-10080
April 1982
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Big Four: Growing
Divergence in
Financial Capital Costs
0
Overview The cost of capital for corporations in Japan, France, West Germany, and
the United States has risen rapidly during the last decade, but the rise has
been smallest in Japan. In 1981 Japanese industrial corporations on
average faced financial capital costs only about half as high as US firms-
roughly 9 percent versus almost 17 percent. The cost for West German
firms was close to that in Japan; the cost for French firms was higher but
still below that in the United States. The spread is considerably greater
than it was throughout most of the 1970s. Thus, US firms now are more
disadvantaged than their foreign competitors. Specifically:
? The range of profitable investments is narrower for US than foreign
companies. The higher capital costs faced by US corporations increase
both the absolute investment threshold and the uncertainty attached to a
firm's ability to recover investment costs.
? US corporations require higher profit margins for capital-intensive
products than their foreign competitors. In strong price competition, this
disadvantage may deter US investors from challenging foreign firms or
substantially limit, if not eliminate, their profits should they compete.
Capital costs for Japanese, West German, and French firms have tradition-
ally been lower largely because of institutional factors:
? Foreign lenders charge a lower risk premium on business loans, in part
because corporate earnings are less variable than in the United States.
? Japanese and West German firms benefit from close and sustained ties to
their banks. French firms similarly benefit from substantial support by
government-backed banks. These relationships, in turn, have allowed
foreign firms to rely much more heavily on debt finance and thus to gain
substantially from the tax deductibility of interest payments.
Confidential
GI 82-10080
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? ?
The capital cost gap between the United States and Japan and West
Germany has widened in recent years because of the greater return
demanded by US lenders to compensate for the higher rate of inflation in
the United States. The gap would have been even greater, however, if
foreign governments had not matched a portion of the inflation-induced
rise in US rates to quell the flight of interest-sensitive funds. Greater
internal competition for funds from the West German and Japanese
Governments also played a role in raising interest rates in these two
countries.
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Big Four: Growing
Divergence in
Financial Capital Costs (u)
Cost of Capital to Corporate Borrowers
Firms in the four major industrial countries-the
United States, Japan, West Germany, and France-
are paying record or near-record rates for money
when recession and political uncertainties have
dampened investor expectations for returns to invest-
ment. The weighted after-tax cost of capital for
industry in these four countries soared to an average
of almost 12 percent last year, nearly double the rates
that prevailed in the early-to-mid-1970s.' The com-
bined impact of these two forces dramatically reduced
the rate of capital investment in manufacturing in
1974-80 (table 1).
The cost of capital is a guiding element in corporate
investment decisions and a significant determinant of
firm profitability.' A firm can undertake investments
that will generate a return below its cost of capital but
that will still earn adequate profits in an accounting
sense. Over the long run, however, regular invest-
ments in projects below the firm's cost of capital
would, other things remaining equal, drive the firm's
investors to other more profitable and less risky
investments.
Not only do higher capital costs thus constrain invest-
ment opportunity but they also significantly increase
the degree of uncertainty attached to investments. For
a given project, the closer a firm's cost of capital is to
the expected return from investment, the higher the
probability that actual returns will not exceed capital
costs. The firm with the lower cost of capital can be
more certain of covering its costs for any given
investment.
' The average weighted cost of capital includes the cost of debt and
equity for nonfinancial corporations weighted by their shares in the
aggregate corporate balance sheet. All costs of capital data used in
this paper are calculated on an after-tax basis. See appendix A for
details.
' Cost of capital does not refer solely to the cost of external funds
for specific projects but to the opportunity cost of using funds from
all sources-external or internal. The assumption is that all funds
can be priced the same as the next dollar of capital raised in the
market. Furthermore, the concept assumes that a firm's debt/
equity proportions will remain the same as it generates additional
capital. (To do otherwise implies that the debt/equity ratio is not
optimal and that a shift to higher or lower leverage is appropriate.)
0
Real Gross Capital Formation for Business
Average Annual
Percentage Increase
1967-73
1974-80
United States
4.5
2.0
France
7.0
1.9
West Germany a
6.2
1.5
Japan
13.5
2.3
a Includes housing investment.
Source: OECD. Quarterly National Accounts Bulletin, 1981.
The importance of capital costs to investment de-
cisions varies by industry.' The capital intensity is
often far greater in high-technology areas; according
to industry sources, $1 of capital investment is re-
quired for each $2.50 in annual revenues for the latest
generation of 64K random access memory devices.
The impact of capital cost differentials can be consid-
erable. Last year, when US corporations typically
faced a weighted cost of capital of 16.6 percent, the
total cost of a $100 million investment amortized over
15 years was over $275 million. In Japan, where the
weighted cost of capital was only half as high, this
same investment cost $182 million or one-third less.
Even allowing for differences in relative depreciation
schedules, the stream of returns necessary to cover
capital costs is much higher in the United States than
in Japan.
' Not all corporations consider a detailed cost of capital analysis
before investing. A recent survey found that a significant number of
firms did not take adequate account of inflation, for example, in
projecting potential return on investment. However, the large
manufacturing corporations typically do try to meet or exceed their
average cost of capital when weighing investment alternatives.
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? ?
Big Four: Capital Formation and Its Financing a
The cost of capital is an important-but not the
only factor in determining the level of a nation's
industrial capital formation. The latter occurs within
a larger frame of reference-overall net capital
formation-which is shaped by a variety of other
national economic, regulatory, and behavioral char-
acteristics. Net capital formation as used in the
following table consists of additions to business in-
ventories plus net fixed investment-additional struc-
tures and equipment, including newly produced hous-
ing. This concept of net capital formation depicts a
Net capital formation (as a percent of GDP) 8.2
95.3
Net capital formation (as percent of GDP) 6.4
149.8
a Because of rounding, components may not add to totals shown.
NOTE: Derived from National Accounts of OECD Countries, 1962-
79, non-US data converted to US dollars at 1979 exchange rates.
nation's annual additions to its stock of real assets, a
major portion of which is associated with the manu-
facturing sector.
As indicated in the table, the United States devotes
substantially less of its gross domestic product to net
capital formation than Japan, West Germany, and
France. Between 1972 and 1979, Japan increased its
volume of net capital formation substantially, draw-
ing on a large pool of household savings.
22.1 15.9 16.1
93.0 71.6 37.1
18.9 13.7 12.3
188.9 104.3 67.8
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Cross-Country Comparisons
The cost of capital facing corporations in the United
States, Japan, West Germany, and France rose sub-
stantially over the past decade.4 With the exception of
the United States, costs rose in 1972-74, fell during
1975-77, only to rise again beginning in 1978. In the
United States there was little downward movement in
1975-77. This resulted in a widening divergence in
capital costs relative to foreign corporations by the
end of the period.
Our calculations show that, for the group as a whole,
the cost of capital rose to nearly 12 percent last year,
up from 7 to 8 percent for most of the 1970s. Among
the four, only Japan has managed to keep rates in line
with historic levels (table 2). Firms in the United
States, in contrast, pay nearly 17 percent today-
roughly double the average for the 1970s. Although
rates in France and West Germany are lower than the
US average, these countries also have financing costs
well above those paid during the early-to-mid-1970s.
More importantly, from a competitive standpoint, rate
spreads between countries have widened dramatically.
Last year, the average cost of capital faced by US
corporations was roughly double the rate in Japan and
substantially above West European levels (figure 1).
To get some sense of the reasons for the differences in
capital costs faced by corporations in the United
States, Japan, West Germany, and France we sepa-
rated the average weighted cost of capital into three
major components:'
? The "risk-free" rate for capital.
? The risk premium demanded by lenders to compen-
sate for the uncertainty attached to corporate
performance.
? The impact of tax deductions allowed corporations
for interest payments, the so-called leverage effect.
'To determine financial capital costs faced by manufacturers in the
four major countries, we compiled an aggregate balance sheet for
manufacturing firms in each of the countries and assigned costs to
equity plus each type of debt. These costs were blended into a single
cost of capital based on the weighted average of the source of
corporate funding. The cost of short-term bank loans was based on
the prime commercial rate. Long-term costs were either bond rates
or commercial lending rates, depending on the degree of reliance on
bonds or loans as funding sources. The cost of equity capital was
determined by adding a risk factor-based on dividend yield and
stock price appreciation-to the risk-free long-term rate as approxi-
mated by government bonds.
' See appendix B for a detailed description.
Figure 1
Big Four: Average Weighted Cost of
Capital to Industry
France
Japan
United States
West Germany
Risk-Free Rate. The risk-free rate for capital is
defined as the yield on 10-year government securities.
It can, in turn, be viewed as containing two compo-
nents: the inflationary expectations of lenders and a
real price for capital.
Our calculations show that inflationary expectations
are the largest single factor behind the relatively high
cost of capital to US industry. The inflation factor in
US capital costs last year was 9.6 percent compared
with 2.6 percent in Japan and 4.6 percent in West
Germany, where inflation rates have been much lower
over the last five years.6
The uneven inflationary performances in the late
1970s, which led to this divergence, resulted from
differences in government policy. Tokyo and Bonn
6 The inflation components were determined by using a six-quarter
geometrically distributed lag of the gross national product deflator;
this, it is assumed, approximates the investor's view of what will
happen to inflation over the next several years.
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Estimated Average
Cost of Capital to Industry
8.6
6.0
2.6
3.0
-3.1
8.5
3.2
2.9
-3.9
9.4
Risk-free rate
16.6
12.9
8.7
10.5
Inflation
11.6
9.6
2.6
4.3
Imputed real rate
5.0
3.3
6.1
6.2
Risk premium
3.5
6.4
4.6
2.6
Imputed leverage effect
-5.8
-2.7
-4.1
-3.6
Cost of capital
14.3
16.6
9.2
9.5
chose to combat actual and latent inflationary pres-
sures more strongly than recessionary problems; mon-
etary authorities in both countries held the growth in
money supply to rates well below previous norms. In
contrast, the US and French money stocks grew much
more rapidly as Washington and Paris focused on
reducing unemployment from the high levels of 1975.
A second key factor in the differential inflation rates
of the 1970s appears to have been the wage policies of
the various countries. In Japan and West Germany, a
labor-business-government consensus that inflation
had to be kept in check led to very moderate nominal
wage gains. In contrast, the French Government's
greater emphasis on maintenance of real earnings
permitted larger wage increases; rises in wage rates
were also relatively rapid in the United States.
Finally, the differentials in inflation appeared to be
magnified by positive feedbacks between domestic
inflation and exchange rate movements. In Japan and
West Germany, low domestic inflation contributed to
appreciation of their currencies, which in turn lowered
imported inflationary pressures. In France and the
United States, where domestic inflation was more
rapid, the international feedbacks tended to boost
inflation.
The after-inflation, or real, cost of corporate capital
has risen sharply in recent years in the three foreign
countries to rates ranging from 5.0 percent to 6.2
percent. Japanese firms encountered the greatest ab-
solute increase over the last :five years-up 4.2 per-
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centage points from 1.9 percent in 1976. The real rate
in the United States, in contrast, rose moderately to
an estimated 3.3 percent last year.
The real rate was estimated by netting imputed
inflationary expectations from the yield on govern-
ment bonds-a proxy for a nation's risk-free rate for
capital. It is determined by a combination of factors,
but the key ingredient remains the flow of and
competition for loanable funds from national house-
hold sectors. Recently, however, the level of US
interest rates has also played a role in determining the
real cost of capital abroad.
The four nations in question experienced falling sav-
ing rates over the past decade, slowing the increase in
the supply of loanable funds:
? Household saving rates vary significantly interna-
tionally-from a high of 18.5 percent of disposable
income in Japan to 5.0 percent in the United States.
With the exception of France, household saving
rates are currently well below the levels of the mid-
1970s partly reflecting slower growth in real in-
comes and higher effective tax rates.'
? Corporate savings rates fell sharply during the
1974-75 recessionary period but-with the notable
exception of Japan-rose during the remainder of
the decade. Uncertain economic prospects have kept
fixed capital expenditures below cash inflows for
French and German corporations; the two nations
have become significant net lenders to the rest of the
world.
On the demand side, growing government borrowing
in capital markets appears to have been a major factor
behind the rise in the real price of capital available to
foreign corporations. Budget deficits in Japan, West
Germany, and France have continued to escalate,
while monetary policy has become far more restrictive
to contain inflation. Central banks, as a result, have
purchased a smaller proportion of the growing num-
ber of government securities issued to finance the
deficits. With a greater burden placed on private
savings to absorb central government debt, the funds
available to the private sector have, in most cases,
been insufficient to prevent a substantial rise in the
interest rates firms must pay for borrowed capital.
The impact has been greatest in Japan because of the
dramatic increase in government borrowing. Govern-
ment debt issues took 43 percent of the domestic
credit supply in 1979, up from only 15 percent in
1971. The increased competition from the Japanese
treasury was a key factor in the increase in the
estimated real rate for corporate capital-from 1.5
percent in 1971 to 6.1 percent last year:
? In France, central government borrowing, as a share
of total credit raised, increased from less than 2
percent in 1971 to 12 percent in 1979.
? Bonn's demands on the West German credit market
also increased substantially during the 1970s, from
11 percent in 1971 to 19 percent in 1977.
US corporations, in contrast, found increasing direct
competition for loanable funds from the financial and
household sectors during the 1970s. While govern-
ment borrowing as a share of total demand for funds
fell substantially, direct household demand rose by 9
percentage points, to more than one-third of total
demand for funds. The share of financial institutions
more than doubled as they increased their capital base
to support additional lending.
While the market for investment capital remains
largely domestic in nature, higher US nominal inter-
est rates may have led foreign governments to raise
the real cost of funds in their capital markets. Despite
lower domestic inflation, foreign monetary authorities
have, to varying degrees, followed the upward move-
ment in US interest rates by raising central bank
discount rates. Failure to have done so would have
resulted in outflows of interest-sensitive funds to
dollar assets, currency depreciation, and ultimately
increased inflationary pressures on the domestic
economy.
Risk Premium. There are significant international
differences in the risk premium demanded by lenders
and investors to compensate for the uncertainty of
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10
s
Financial markets in Japan, France, and West Ger-
many were reorganized after World War II to ensure
that capital would flow to industry. Bond and stock
markets remained relatively undeveloped for a long
period with household savings flowing mainly to
banks which, in turn, became major holders of
corporate capital. The pattern of corporate-lender
relationships that has evolved has substantially af-
fected risk assessment and corporate debt levels in
these countries.
Japan. The Japanese financial system was designed
to enhance the ability of banks and financial authori-
ties to allocate credit to industry. Japanese compan-
ies, until recently, have had little alternative to bank
borrowing. The authorities have kept bond yields
artificially low and have rationed the volume of
issues. Until recently, stock could only be issued at
par, making stock issues a costly way of raising
funds. Although measures have been taken to im-
prove corporate alternatives to bank lending and to
free somewhat the flow of capital in and out of the
country, Tokyo has remained content with the limit-
ed nature of the capital market-a system consistent
with its objective of steadily increasing industrial
output.
The small number of major banks in Japan-13 city
banks backed by nationwide branch networks-has
centralized the supply of investment capital, allowing
major corporations to raise funds efficiently. Strong
competition for corporate business and banks' ability
to loan at 100 times equity-as opposed to 25 times
equity in the United States-have kept interest rate
spreads reasonable for major corporate customers.
More importantly, central bank supervision has often
kept interest rates below market levels. As a result,
the major city banks periodically need Bank of Japan
refinancing and thus become subject to government
guidance on the allocation of loans among industries.
This guidance bolsters banker confidence in the abili-
ty of targeted borrowers firms integral to Tokyo's
vision of industrial development-to sustain high
debt levels.
Although most commercial bank lending is short
term, explicit or implicit rollover agreements allow
Japanese corporations to view short-term loans as
long-term liabilities. Investment risks are, in fact,
substantially reduced by a large home market remote
from foreign competition and, in many cases, by the
internal demand of highly integrated Japanese firms.
Lending institutions, for their part, rely less on
balance-sheet criteria in making loans. The corpora-
tion's bank(s) usually has a detailed knowledge of
firm affairs. The bank counts on the firm as a stable
source of loan demand and, yin return, implicitly
guarantees that funds will be available to the com-
pany, even if it means recourse to temporarily une-
conomical sources offunding. Thus, Japanese bank-
ers take a long-term view of.firm prospects and base
lending on the corporation's traditional profit and
growth record, capacity for innovation, and potential
for growth as measured by its position within the
industry.
France. The French capital market is characterized
by an extremely complex set offinancial intermediar-
ies, most under government control, which channel
household savings into corporate investments. French
firms depend heavily on bank lending to supplement
internal funds; in the 1970s, domestic financial insti-
tutions supplied over 75 percent of the funds raised
by French corporations. The banking institutions are
funded from postal savings, life insurance, and annu-
ity accounts, which provide a tremendous flow of
savings-more than 20 percent of personal income-
at relatively low rates. The French stock market has
traditionally been somewhat thin, and the bond mar-
ket has been dominated by the nationalized indus-
tries and special credit institutions.
The Banque de France exercises close control over
the amount and cost of financial assets available to
firms. It sets annual ceilings for increases in bank
lending, with specialized provisions for favored cate-
gories such as export credits and housing. It also sets
interest rates on the money market and fixes rates
offered to household savers through the key savings
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instruments. As in Japan, commercial banks rely on
central bank refinancing of medium- and long-term
industrial loans and are thus subject to administra-
tive guidance. The Banque also offers refinancing
facilities at preferential interest rates to authorized
credit institutions.
The commercial banks are dominated by three
government-owned banks-Banque Nationale de Par-
is, Credit Lyonnais, and Societe General. These were
nationalized in 1945 and currently account for rough-
ly 70 percent of all deposits placed in France's 275
deposit banks. Although these three banks operate as
private institutions, the chairmen and managing di-
rectors are appointed by the government, and each
bank has a government representative on its board of
directors.
The central government further influences business
behavior via interest rate rebates on long-term indus-
trial loans, largely to small and medium-sized firms,
made by special credit institutions such as the Credit
National and Credit Hotelier. Investment funds pro-
vided by these institutions are often raised on the
French bond market under government guarantee.
Direct loans by the Credit National make up about 5
percent of all industrial finance in France. The bank
has tended to take the lead in the development of
national interest industries. French commercial
banks have not been particularly supportive of riskier
long-term investment in recent years. Bank profitabil-
ity has been depressed by the artificially low govern-
ment regulated lending rates, and government-im-
posed ceilings have limited the total amount of credit
that may be extended.
Citing French commercial bank caution in lending-
specifically the excessive weight accorded short-term
profits in deciding among potential borrowers-the
Mitterrand government has nationalized an addition-
al 39 commercial banks. As a result, the nationalized
banking sector directly or indirectly accounts for 97
percent of all resident deposits and 93 percent of all
loans. The government hopes that this additional
control will enable it to ensure that lending criteria
are adjusted in favor of long-term investments judged
to be in the national interest.
West Germany. In the West German financial system,
a few large banks are crucial in attracting long-term
deposits and relending to industry. The central gov-
ernment has not taken advantage of the financial
system to guide lending activities. Financial policies
are generally macroeconomic, with sectoral assist-
ance provided by specific lending institutions. The
banks own and control major blocks of corporate
stock and thus often play a major role in decision-
making. Corporations rely heavily on bank credit and
are highly leveraged. An active secondary market for
corporate bonds does not exist, and the stock market,
aside from being depressed, is thin. Equity has
traditionally been costly to market.
The interlocking relationship between the financial
and industrial sectors is perhaps greatest in West
Germany. Besides voting their own corporate shares,
banks generally receive authorization to represent the
interests of customers whose stock they held on
deposit. In 1980 banks voted an average of 63 percent
of corporate shares in the 74 largest West German
corporations; the big three banks alone accounted for
35 percent of the shares voted. Bank directors sit on
and frequently chair business supervisory boards; 570
bank executives, for example, are on the supervisory
boards of the top 400 companies.
As financial advisers and large holders of voting
rights, banks have the potential to exert considerable
influence on corporate behavior. At a minimum,
banks are interested in ensuring that decisionmaking
is consistent with long-term return to capital and thus
the ability to repay the extensive long-term bank
exposure. The firms benefit from the information
bankers bring to the boardroom and from the greater
degree of certainty that financial support exists for
corporate decisions.
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corporate performance. Our calculations for 1981
show that US corporations bear the highest premium
for corporate risk; 6.4 percent compared with 2.6
percent in West Germany, 3.5 percent in France, and
4.6 percent in Japan.'
The divergence in the risk premiums in part reflects
differences in earnings variability among countries.
An analysis of the variability in aggregate corporate
earnings for these four countries indicates the greatest
fluctuation in France followed by the United States,
Japan, and West Germany. In addition, private inves-
tors in Japan, France, and West Germany may
demand lower nominal risk premiums because favor-
able tax provisions enable them to obtain the same
after-tax yield on investments from lower nominal
returns. French investors may write off the first 5,000
francs in share income and may claim a tax credit for
50 percent of dividend earnings from resident corpo-
rations. West German shareholders may claim a tax
credit for 55 percent of all dividends, while Japanese
taxpayers may exclude the first 100,000 yen in divi-
dend income from a Japanese corporation.
Figure 2
Big Four: Composition of Corporate
Liabilities, 1979a
El Equity Holdings
Long-term debt
Short-term debt
West
Germany
United
States
a Manufacturing sector for Japan and West Germany; French industry; all
nonfinancial institutions in the United States; French data for 1978.
The Leverage F4ffect. Foreign corporations benefit 586359 4-82
from a close and longstanding relationship with lend-
ing institutions, which results not only in relatively
low-risk premiums but more importantly in an as-
sured supply of funds. These tendencies are strength-
ened in France by direct government lending and in
Japan by commercial banks' confidence that they
have little to risk in lending to firms targeted by
Tokyo for expansion. Rapid corporate expansion in
the 1960s and early 1970s, facilitated by the close
relationship between banking and industry, has led to
high debt-to-equity ratios. In France and Japan, the
ratio of borrowed money to equity is, on average, 2 to
1 compared with a 1 to 2 ratio in the United States
(figure 2).
The financial benefits to leveraging are significant.
Interest on borrowed capital is a tax-deductible busi-
ness expense whereas dividend payments-the return
on equity-capital are taxed as part of corporate
earnings. The impact is particularly great in the
' Business risk is the premium attached to the sensitivity of
corporate performance to changes in business climate. It is calculat-
ed by adjusting the observed cost of equity capital by the degree of
corporate leverage.
United States where distributed income is taxed at
normal corporate rates. In Japan, France, and West
Germany, the advantages of leveraging are reduced to
some extent by tax breaks on distributed income,
which were enacted to avoid double taxation of
dividend income.
Implications for the United States
Firms paying relatively low capital costs have a
distinct advantage in the international marketplace.
First, they can undertake investments that their com-
petitors would consider unprofitable. Second, when
these firms compete against firms facing higher cap-
ital costs, they can price output at levels that would
not be profitable for competitors or, by pricing at the
competitors' level, derive a superior return on invest-
ment.
The US disadvantage in capital costs, in conjunction
with a greater uncertainty about capital availability,
may serve to reduce the willingness or ability of US
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corporations to engage in anticipatory or rapid capac-
ity expansion or other high-risk investment. At the
margin, it would seem to be easier for non-US firms,
which are far less reliant on equity capital and thus
less subject to short-term investor pressures, to under-
take investments with below-cost-of-capital returns.
US firms would tend to be downgraded by the
investor ratings services, thus raising capital costs and
thinning out the supply of capital.
The crunch caused by high financing costs in the
United States will be particularly acute over the next
year. Lenders are still demanding a large premium for
their money. Moreover, with inflation headed down-
ward, corporations cannot count on the ability to raise
product prices in the future to offset high nominal
financial costs. Hence, the uncertainty of investing is
particularly great. In Japan, on the other hand, the
relatively even inflation and cost-of-capital perform-
ance provides more certainty for investment in either
new product development or improved facilities.
International differences in the availability and cost
of capital to corporations may prove crucial in high-
technology industries, where substantial benefits ac-
crue to firms able to undertake rapid anticipatory
expansion and thus experience decreasing costs as
production increases. Rapid expansion enables a firm
to obtain a lower cost, higher profit position than
competitors. Once a lead is established in an industry,
the leading firm tends to increase its lead through the
rapid generation of funds for additional investment.
In the past, US corporations could count on superior
production technology to shelter their market from
foreign competition. Under these circumstances, they
could be relatively assured of demand despite the
profit margins needed to cover their relatively high
cost of capital. In recent years, however, US techno-
logical advantages in key markets have been eroded
by foreign competitors, principally Japanese firms. As
a result, competition has become increasingly charac-
terized by aggressive pricing and the ability to meet
tight delivery schedules. Higher capital costs substan-
tially disadvantage US firms under these conditions
and, in some cases, may lead to the surrender of key
markets to foreign competitors.
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Appendix A
The Average Weighted
Cost of Capital:
A Methodology
In this paper the cost of capital is defined as the
minimum rate of return necessary to properly com-
pensate investors-both debt holders and sharehold-
ers-for risks undertaken by investing in an enter-
prise. This cost of capital concept incorporates the
external financing costs for specific projects as well as
the opportunity cost of using funds from all sources-
external or internal. The assumption is that all funds
can be priced the same as the next dollar of capital
raised in the market.
To avoid confusing the merits of an investment with
the manner in which it is financed, a weighted average
cost of capital is used in decisionmaking. This calcu-
lation is made, in turn, by weighting the cost of each
component-short-term debt, long-term debt,
equity-by the proportion of each in the total capital
structure. It is assumed that a firm's debt/equity
proportions will remain the same as it generates
additional capital.
A balance sheet for manufacturing was used to
analyze the cost of capital for industry as a whole. US
balance sheet data were taken from US Department
of Commerce figures aggregated by industrial sector.
Japanese data were taken from Ministry of Finance
compilations. French data, based on surveys of 500
manufacturing enterprises, were compiled for the
OECD Financial Statistics series. West German fig-
ures, based on sample data from 45,000 firms, were
also published in the OECD Financial Statistics.
The average weighted cost of capital for the manufac-
turing sectors in each of the Big Four countries was
calculated using the following equation:
Ck=K;(1 - T)B+S + Ke B + S
K;=Pretax cost of debt
Ke=Cost of Equity
B = Value of debt
S = Value of equity
T = Marginal tax rate
Value of Debt (B)
Traditional analysis of capital costs regards the value
of bonds outstanding as a proxy for total debt. We
have expanded this definition to account for the
growing importance of short-term bank and other
money market funding as a source of capital among
US corporations and the traditional heavy reliance on
bank debt in the three foreign countries. The value of
debt used in our calculations thus consists of the
balance sheet totals for short-term bank debt and
long-term debt, including bonds. The short-term fig-
ures exclude accounts payable, which are an essential-
ly costless form of short-term credit.
Pretax Cost of Debt (Ki)
The pretax cost of debt is the finance charge associat-
ed with the issuance of bonds or the drawing down of
bank credit. Each type of debt has its own cost,
depending on term, money market conditions, and
other factors. An attempt was made to use interest
rates that are comparable among the four countries
and that reflect rates close to the actual charge on
each type of debt. Data on exact rates charged on
business loans are not published, but base rate figures
are available for short-term (under one year) and long-
term commercial lending and industrial bonds. The
various interest rates-in each case annual averages
of daily rates-were blended into composite debt costs
for each country, based on the weighted average of
the term segments making up total debt as compiled
from the balance sheet data:
? For Japanese debt costs, the short-term standard
rate of interest and long-term top priority lending
rate were applied to the two categories of debt. The
standard rate is the rate for the discount of first-
class bills. It is regarded as the representative
indicator of interest rates for short-term bank loans.
The top priority lending rate for loans granted to
Japan's basic industries is determined by agreement
Big Four: Average Weighted Cost of Capital to Industry
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0 ?
7.3
6.9
7.2
8.7
8.1
8.5
7.7
7.1
8.0
9.8
9.2
7.1
6.6
5.9
5.4
6.7
7.9
9.5
8.5
7.8
9.3
11.1
9.4
9.4
9.6
9.7
9.4
12.1
14.3
11.6
11.3
11.2
12.1
13.1
15.1
16.6
between Japan's long-term credit banks and the
Federation of Bankers Associations of Japan. It is,
in effect, the basic rate for long-term bank loans.'
? The French and West German short- and long-term
charges are commercial bank lending rates as pub-
lished by the central banks. Since the early 1970s,
industrial bonds have lost much of their importance
as an instrument for long-term borrowing by Ger-
man enterprises. They have been largely replaced by
loans against borrower's notes (Schuldscheindar-
lehen). Likewise in France, industrial bonds do not
constitute a significant part of total long-term debt.
? For the United States, the commercial bank prime
rate is used as a proxy for short-term costs. Since
most US long-term debt is bond financed, the 10-
year rate for triple-A industrial bonds was used as a
proxy for long-term debt costs.
Value of Equity (S)
Equity consists of share capital and corporate funds
held in reserve to cover anticipated future expenses
and to protect against potential business losses. Year-
end equity values for French and West German
manufacturing firms were taken from central bank
data; Japanese yearend equity values for manufactur-
' A bond rate was not used, since bonds were a negligible source of
funding over the period 1971-81 as a whole. Although now growing
rapidly, the market for industrial bonds in Japan is not yet large
enough to meet a significant share of demand for long-term
financing.
ing firms are published by the Ministry of Finance in
its Quarterly Bulletin of Financial Statistics. US
equity figures were taken from Department of Com-
merce data.
Cost of Equity (Ke)
The cost of equity is the minimum after-tax rate of
return that must be earned from an investment to
compensate shareholders for business and financial
risk. The commonly accepted method for estimating
equity cost is to add the sum estimated for risk
elements to an interest charge that represents com-
pensation for an investment carrying virtually no risk.
Risk-Free Rate. The proxy for the theoretical risk-
free rate in all four countries is assumed to be the
issue rate for long-term central government bonds. An
alternative would be secondary market yields on
central government bonds. The difference between
issue and secondary yields on central government
bonds in the four countries has, for the most part,
averaged under 1 percentage point in the past 15
years, with some widening in recent years. Because of
the uncertainty over exactly what constitutes a realis-
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tic market risk-free rate, we chose to use the central
government issue yield.
Risk Premium. Holding common stocks entails risk,
because the actual return may differ from what is
expected. This risk premium is generated from two
components; a "market risk" premium, which com-
pensates investors for the underlying variability in
returns associated with holding stocks in general, and
a "corporate risk" premium, which accounts for the
variability in earnings of any given firm in comparison
with the stock market as a whole.
For the United States, we determined a market risk
premium from the results of a University of Chicago
study.' The study examined the rates of return earned
on investments in long-term US Treasury Bonds and
compared them with Standard and Poor's 500 Stock
Index from 1925 to 79. The average annual return on
the Standard and Poor index was found to be 5.9
percentage points greater than the risk-free rate as
approximated by government bond yields. We as-
sumed that this premium (which was rounded to 6
percent) represents the market risk demanded by
investors. We applied this methodology to determine
the market risk premiums in Japan (9.7 percent),
France (5.0 percent), and West Germany (3.0 per-
cent). In each case long-term series for annual
changes in common stock prices and dividend yields
were summed and the average long-term central
government bond rates for the years 1951-81 sub-
tracted to derive proxies for market risk premiums.
1 It has been argued that, because of the thin, undeveloped nature of
bond markets in Japan and Western Europe, as well as government
manipulation of publ" ec.11rifles ksues the issue rates do not fully
reflect market forces.
' Ibbotson and Sinquefield, "Stocks, Bonds, Bills and Inflation:
Year by Year Historical Patterns, 1926-1974," The Journal of
Business, January 1976. Updated periodically.
A further risk premium is demanded by investors to
account for the variability in earnings for any single
firm. To quantify this additional charge, we calculat-
ed risk indexes, or betas-the ratio of the volatility of
the common stock to the volatility of the market as a
whole-for every common stock. Multiplying the
market risk premium by its beta will yield an estimat-
ed additional cost to compensate for the risk associat-
ed with a specific investment. Thus, the risk-free rate,
plus the market risk premium times a risk index,
yields an estimate of the cost of equity.
The risk premium for the manufacturing sector in
each country was subsequently calculated by averag-
ing firm stock-price volatility data (betas) for seven
industrial sectors in the United States' and deriving
an average beta (1.11) for these seven sectors to yield
a composite investment risk for manufacturing as a
whole. In the absence of reliable foreign data, and
because studies have shown that stocks within the
same industry have fairly highly correlated price
fluctuations, the average beta for the United States
was used as a proxy for the three foreign premiums as
well.
Marginal Tax Rate (T)
The blended cost of debt times its share of total
capital, plus the cost of equity times its share of total
capital, equals the estimated pretax cost of investment
capital. To adjust for the effects of the tax deductibil-
ity of interest payments, the cost of debt is reduced by
the effective tax rate on interest payments. Although
specific tax provisions vary among the four countries,
corporations generally were subject to an effective tax
rate of 50 percent during the period under study. For
this reason we used 0.5 as the marginal rate for all
four countries.
'Steel, chemicals, petroleum, nonferrous metals, general machin-
ery, electrical machinery, and transportation equipment.
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Appendix B
Elements of the
Cost of Capital
The cost of capital as calculated in appendix A can
be subdivided into three principal elements; the
risk-free rate of return, the risk premium demanded
by investors, and the interest rate savings accruing
from the tax deductibility of interest payments.
This presentation provides a framework for under-
standing the reasons behind international differ-
ences in capital costs. The table on page 16 shows
these various elements for the four countries in
1981.
25X1
Risk-Free Rate
The risk-free rate of capital, determined by issue
rates for long-term central government bonds, is
assumed to be representative of lender demands for
guaranteed returns on investments. In effect, this
rate can be viewed as an indicator of the supply and
demand relationships affecting capital markets.
The inflationary component of this rate was esti-
mated by applying a six-quarter geometrically dis-
tributed lag to national GNP deflators. The derived
annual averages are assumed to be proxies for that
portion of the risk-free rate that represents
investor/lender expectations concerning the future
rate of inflation. Other lags may be equally valid,
but, unless the distribution were substantially
changed, the impact on the results would not be
substantial.
The underlying real rate of interest for risk-free
capital was imputed by subtracting inflationary
expectations from the risk-free rate. The real rate,
in theory, represents the result of basic supply and
demand factors, including the flow of household
and corporate savings and the competition for funds
among financial and nonfinancial institutions, the
central government, and private individuals. The
estimates should be regarded as indicative of trends
rather than as precise numbers.
Risk Premium for Business
Corporations must pay lenders/investors an addi-
tional premium to compensate for the uncertainties
attached to business performance and, in particu-
lar, the variation in profitability over the business
cycle. This "business risk" premium is independent
of a firm's "financial risk," which stems from its
capital structure, specifically its ratio of debt to
equity and the composition of its debt.
The Imputed Leverage Effect
The impact of a firm's debt structure on its overall
after-tax capital costs was derived by subtracting
the risk-free rate and the estimated premium for
business risk from the nominal average weighted
cost of capital. The leverage effect is uniformly
negative because corporate tax deductions for inter-
est payments lower the effective rate faced by the
firm. This benefit is partially offset, however, by
the higher nominal rates faced by firms that depend
heavily on debt financing. While a direct calcula-
tion of the leverage effect is theoretically possible, it
would be exceedingly difficult because of the lack
of hard information on the structure of and interest
payments on outstanding debt and the exact degree
of tax breaks provided to the corporation. The
imputed leverage effects appear consistent with
what would be expected given international differ-
ences in coporate reliance on debt financing, tax
rates, and nominal interest levels.
US France West Japan
Germany
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