LETTER TO HONORABLE LIONEL OLMER FROM WILLIAM J. CASEY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP84B01072R000300020023-0
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 27
• Document Creation Date: December 20, 2016
• Document Release Date: February 22, 2007
• Sequence Number: 23
• Publication Date: July 1, 1982
• Content Type: LETTER

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Big Four: Growing Divergence in Financial Capital Costs
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Big Four: Growing Divergence in Financial Capital Costs
Foreword
Analysts frequently argue that high financing costs put US
firms at a disadvantage compared with companies operating in
other major countries, lessening the ability of US firms to
aggressively pursue new investment strategies or to improve
existing facilities. The past 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 general trends in financial capital
costs through 1981 and analyzes some of the elements responsible
for existing differences in Japan, France, West Germany, and the
United States. The estimates cut across industries and thus are
not applicable to international comparisons for any given
industry. Firms facing higher financial capital costs, moreover,
are not necessarily less likely than their competitors to
undertake a particular investment; capital costs are only one
element in corporate investment decisions, which must also take
account of 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.
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The cost of. capital for corporations in the United States,
Japan, West Germany, and France 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 vs. 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 now than it was throughout most of the
1970s. Thus, US firms are more than ever disadvantaged relative
to their foreign competitors. Specifically,
o 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.
o US corporations require higher profit margins for
capital-intensive products than . their foreign
competitors. In markets characterized by strong price
competition, this disadvantage may deter *US investors
from going head to head against foreign firms or
substantially limit, if not eliminate, their profits
should they decide to compete.
Capital costs for Japanese, West German, and French firms
have traditionally been lower largely because of institutional
factors.
o Foreign lenders charge a lower Risk Premium on business
loans, in part because corporate earnings are less
variable than in the United States.
o 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.
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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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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 at a time when recession and
political uncertainties have dampened investor expectations for
returns to investment. The weighted after-tax cost of capital
for industry in these four countries soared to an average of
almost 12 percent last yea17 nearly double rates that prevailed
in the mid-to-early 1970s.- The combined impact of these two
forces dramatically reduced the rate of capital investment in
manufacturing in 1974-80 (see table 1).
Average Annual
Percentage Increase
1967 - 1973 1974
- 1980
United States
4.5
2.0
France
7.0
1.9
West Germany
6.2
1.5
Japan
13.5
2.3
.1 Includes housing investment.
SOURCE: OECD Quarterly National Accounts Bulletin
The cost of capital is a guiding element in corporate
investment de~~'sions and a significant determinant of firm
profitability.- A firm can undertake investments that will
11 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 cost of
capital data used in this paper are calculated on an after-tax
~7sis. See Appendix A for details of the calculation.
- The cost of capital concept 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
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generate a return below its cost of capital but which will still
earn adequate profits in an accounting sense. Over the long run,
however, regular investments in projects below the firm's cost of
capital would, ceteris paribus, drive the firm's investors to
other more profitable and less risky investments.
Not only do higher capital- costs thus constrain investment
opportunity but they 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. Alternatively stated, the firm with
the lower cost of capital can be more certain of covering its
costs for any given investment.
The importanc~/ of capital costs to investment decisions
varies by industry.- The capital intensity is often far greater
in high-technology areas; according to industry sources, $1 of
capital investment is *required for each $2.50 in annual revenues
for the latest generation of 64K random access memory devices.
Capital cost differentials can be striking in their
impact. 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 take into account a detailed cost of
capital analysis before deciding a particular course of
investment action. 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 make an effort
to meet or exceed their average cost of capital when weighing
investment alternatives.
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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
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.
Net capital formation (as a percent of GDP)
8.2
22.1
15.9
16_L
95.3
93.0
71.6
37.1
Net personal saving
56.2
51.9
41.8
22.2
Net business saving
24.7
25.0
10.1
6.6
Net government saving
5.3
25.3
21.3
9.3
Net rest of world
9.1
-9.1
-1.6
-0.9
Net capital formation (as percent of GDP)
6.4
149.8
18.9
188.9
13.7
104.3
12.3
67.8
Sources of financing
Net personal saving
86.2
Net business saving
19.8
Net government saving
24.2
24.4
15.1
7.8
Net rest of world
19.6
9.0
6.2
-0.2
a Because of rounding, components may not add to totals shown.
NOTE: Derived from National Accounts ofOECD Countries, 1962-
79. non-US data converted to US dollars at 1979 exchange rates.
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Cross-Country Comparisons
The cost of capital facing corporations in the United
States, Japan, iyest Germany and France rose substantially over
the past decade.-!' With the exception of the United States costs
rose in 1972-1974, fell during 1975-1977, only to rise again
beginning in 1978. In the' United States there was little
downward movement in 1975-1977. 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 7-8
percent for most of the 1970s. Among the four, only Japan has
managed to keep rates in line with historic levels (see
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 are also experiencing 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 (see
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 separated the average weighted cost
of capital into three major components:)
o The "risk-free" rate for capital.
41 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
subsequently 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 approximated by
government bonds.
See Appendix B for a detailed description.
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AVERAGE WEIGHTED COST OF CAPITAL TO INDUSTRY
Legend
? FRANCE
? JAPAN
? USA
= WEST GERMANY
1971
1976
1981
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The Risk Premium demanded by lenders to compensate
the uncertainty attached to corporate performance.
The impact of tax deductions allowed corporations
interest payments, the so-called leverage effect.
Estimated Average
Cost of Capital to Industry
Risk-free rate
8.6
6.2
7.3
8.0
Inflation
6.0
4.9
5.8
7.8
Imputed real rate
2.6
1.3
1.5
0.2
Risk premium
3.0
5.7
4.1
1.6
Imputed leverage effect
-3.1
-1.9
-4.1
-2.7
Cost of capital
8.5
10.0
7.3
6.9
Risk-free rate
10.4
7.6
8.7
7.8
Inflation
7.2_
5.1
6.8
3.5
Imputed real rate
3.2
2.5
1.9
4.3
Risk premium
2.9
5.7
4.3
1.3
Imputed leverage effect -
-3.9
-2.0
-4.5
-2.5
Cost of capital
9.4
11.3
B.S.
6.6
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
The 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 components: 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
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percent, in West Germany, wherg, inflation rates have been much
lower over the last five years,
The uneven inflationary performances in the late 1970s,
which led to this divergence, resulted from differences in
government policy. Tokyo and Bonn chose to combat actual and
latent inflationary pressures more strongly than recessionary
problems; monetary 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 d.ifferenti-als 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 absolute increase over the last five
years--up 4.2 percentage 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 rate was estimated by netting imputed
inflationary expectations from the yield on government bonds--a
proxy for a nation's risk-free rate for capital. In actuality it
is determined by a combination of factors, but the key ingredient
61 The inflation components were determined by using a
six-quarter geometrically distributed lag of the GNP 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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remains the flow of and competition for loanable funds from
national household 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 saving
rates over the past decade, slowing the increase in the supply of
loanable funds.
o Household saving rates vary significantly
internationally--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 which existed
in the mid 1970s partly reflecting slower growth in real
incomes and higher effective tax rates.
o Corporate savings rates fell sharply during the 1974-
1975 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 number 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. Government 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
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estimated real rate for corporate capital -- from 1 .5 percent in
1971 to 6.1 percent last year.
o 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.
o 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 government borrowing as a share
of total demand for funds fell substantially, direct household
demand rose by 9 percentage points, to over 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 interest 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 movement 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 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 81in 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
"Business risk" can be defined as the premium attached to the
sensitivity of corporate performance to changes in business
climate. It is calculated by adjusting the observed cost of
equity capital by the degree of corporate leverage.
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Financial markets. in Japan, France, and West Ger-
many were reorganized after World War 11 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, in return, implicitly
guarantees that funds will be available to the com-
pany, even if it means recourse to temporarily une-
conomical sources of funding. 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 industrv. 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
German v. 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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by the United States, Japan, and West Germany. In addition,
private investors in Japan, France, and West Germany may demand
lower nominal risk premiums because favorable tax provisions
enable them to obtain the same after-tax yield on investments
from lower nominal returns. French investors may write off the
first 5000 FF in share income and may claim a tax credit for 50
percent of dividend earnings from resident corporations. 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 dividend income from a Japanese corporation.
0 The Leverage Effect
Foreign corporations benefit from a close and longstanding
.relationship with lending institutions which results not only in
relatively low risk premiums but more importantly in an assured
supply of funds. These tendencies are strengthened 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 relationiship
between banking and industry, has led to high debt-to-equity
ratios. In 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 (see figure 2).
The financial benefits to leveraging are significant.
Interest on borrowed capital is a tax-deductible business expense
whereas dividend payments--the return on equity-capital ar.e taxed
as part of corporate earnings. The impact is particularly great
in the 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 competitors would consider
unprofitable. Second, when these firms go head to head against
firms facing higher capital costs, they can price output at
levels that would not be profitable for competitors or, by
pricing at the competitor's level, derive a superior return on
investment.
The US disadvantage in capital costs, in conjunction with a
greater uncertainty about capital availability, may well serve to
reduce the willingness or ability of US corporations to engage in
anticipatory or rapid capacity expansion or other high-risk
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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 undertake
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 downward, 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 performance provides a much
more certain environment 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 accrue 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 technological advantages in key markets have been eroded by
foreign competitors, principally Japanese firms. As a result,
competition has become increasingly characterized by aggressive
pricing and the ability to meet tight delivery schedules. Higher
capital costs substantially 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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DEBT/EQUITY RATIO IN 1979
Legend
? EQUITY HOLDINGS
= SHORT-TERM DEBT
? LONG-TERM DEBT
WEST
GERMANY JAPAN
UNITED NOTE: FRENCH DATA FOR 1978
FRANCE STATES
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APPENDIX A
THE AVERAGE WEIGHTED COST OF CAPITAL: A METHODOLOGY
The cost of capital is defined in this paper as the minimum
rate of return management should realize in order to properly
compensate investors--both debt holders and shareholders--for the
risks they undertake by investing in an enterprise. This cost of
capital concept does not refer solely to the external financing
costs for specific projects. It incorporates 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.
In order to avoid Qonfusingtthe merits of an investment with
the manner in which it is financed, a weighted average cost of
capital is used in decisionmaking. This ation is made, in
turn, by weighting the cost of each component--short-term debt,
long-term debt, equity--by the proportion of each in ttre total
capital structure. It is assumed that a fi-rm'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 figures, based on sample data
from 45,000 firms, were also published in the OECD Financial
Statistics.
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The average weighted cost of capital for the manufacturing
sectors in each of the Big Four was calculated using the
following equation:
Ck = Ki (1 - T) B + Ke S
B + S B + S
Ki = Pretax cost of debt
K = Cost of Equity
Be = 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 figures exclude accounts payable, which are an
essentially costless form of short-term credit.
Pretax Cost of Debt (Ki)
The pretax cost of debt is the finance charge associated
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 conmercial 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.
o 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
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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 between Japan's
long-term credit banks and the Federation of -Banker's
Associations of Japan . It 1is, in effect, the basic
rate for long-term bank loans.-
o The French and West German short- and long-term charges
are commercial bank lending rates as published by the
central banks. Since the early 1970s, industrial bonds
have lost much of their importance as an instrument for
long-term borrowing by German enterprises. They have
been largely replaced by loans against borrower's notes
(Schuldscheindarlehen). Likewise in France, industrial
bonds do not constitute a significant part of total
long-term debt.
o 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. Yearend equity values for
French and West German manufacturing firms were taken from
central bank data; Japanese yearend equity values for
manufacturing firms are published by the Ministry of Finance in
its Quarterly Bulletin of Financial Statistics. US equity
figures were taken from Department of Commerce data.
1/ 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.
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Cost of Equity (Ke)
The cost of equity is defined as 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
compensation 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 realistic market ri2sJc-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 compensates 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 3~isk premium
from the results of a University of Chicago study.- The study
21 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 public sec.urities issues, the issue
rates do not fully reflect market forces. For example, a recent
Chase Manhattan Bank study comparing US and Japanese electronics
firms used the more widely traded Nippon Telephone and Telegraph
(NTT) issue .rates as more closely reflecting market-determined
costs of a relatively."riskless" instrument. In Japan, NTT issue
rates substantially exceed (often by 2-3 percentage points) those
either category of central government rates.
- Ibbotson and Sinquefield, "Stocks, Bonds, Bills and
Inflation: Year by Year Historical Patterns, 1962-1974",
The Journal of Business, January, 1976. Updated periodically.
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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 1925-1979. The average annual return on the
Standard & Poor index was found to be 5.9 percentage points
greater than the risk-free rate as approximated by government
bond yields. We assumed 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
percent).. In each case long-term series for annual changes in
common stock prices and dividend yields were sunmed and the
average long-term central government bond rates for the years
1951-81 subtracted to derive proxies for market risk premiums.
A further risk premium is demanded by investors to account
for the variability in earnings for any single firm. In order to
quantify this additional charge, risk indices, or betas--the
ratio of the volatility of the common stock to the volatility of
the market as a whole--are calculated for every common stock.
Multiplying the market risk premium by its beta will yield an
estimated additional cost to compensate for the risk associated
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 averaging firm stock-price
volatility data (betas) for seven industrial sectors in the
United States-11 and deriving an average beta (1.1.1) 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.
Effective 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 pre-tax cost of investment capital. To adjust for
the effects of the tax deductibility of interest payments, the
4/ Steel, chemicals, petroleum, non-ferrous metals, general
machinery, electrical machinery, and transportation equipment.
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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 .5 as the marginal rate for all four countries.
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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
understanding the reasons behind international differences in
capital costs. The following table shows these various elements
for the four countries in 1981:
US
France
West
Germany
Ja
an
p
Risk-free rate
12.9
16.6
10.5
8.7
Inflation
I
9.6
11.6
4.3
2.6
mputed real rate
3.3
- 5.0
6.2
6.1
Risk Premium
6.4
3.5
2.6
4.6
Imputed Leverage
-2.7
-5.8
-3.6
-4
1
Effect
Cost of Capital
16.6
14.3
9.5
.
9.2
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 estimated by
applying a six- quarter geometrically distributed lag to national
GNP deflators. The derived annual averages are assumed to be
proxies for that portion of the risk-free rate which 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.
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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 non-financial institutions, the central
-government, and private individuals. The estimates should be
regarded as indicative of trends rather than as preci-se numbers.
Risk Premium for Business
Corporations must pay lenders/inves'tors an additional
premium to compensate for the uncertainties attached to business
performance and, in particular, 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. A 1980 Chase Manhattan Bang
financial study of US and Japanese semiconductor firms -//
defines business risk as the cost of equity less the financial
risk premium.(The netting out-is eequired to compensate for the
impact of a firm's debt structure on variables --stock
appreciation and dividend payout-- that determine the cost of
equity. Interest payments have first claim on corporate
earnings. Thus, in bad years, dividend payout may be lower for a
firm heavily in 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 interest
payments lower the effective rate faced by the firm. This
benefit is partially offset, however, by the higher nominal rates
faced by firms who depend heavily on debt financing. While a
direct calculation 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 differences in
coporate reliance on debt financing, tax rates, and nominal
interest levels.
11 US and Japanese Semiconductor Industries: A Financial
Comparison, 1980.
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