holland, d. m., & myers, s. c. (1980). profitability and capital costs for manufacturing...
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7/21/2019 Holland, D. M., & Myers, S. C. (1980). Profitability and Capital Costs for Manufacturing Corporations and All Nonfi
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EMPIRICAL STUDIES OF THE RA TE
OF
RETURN TO CAPITAL
Profitability and Capital Costs for Manufacturing
Corporations and All Nonfinancial Corporations
By
D A N I E L M . H O L L A N D A N D S T E W A RT C . M Y E R S *
This paper is a progress report on our
effort to measure and analyze the profitabil-
ity of U.S. corporations over the postwar
period. We are particularly interested in
comparing the behavior of manufacturing
corporations {MC) to that of the larger
aggregate of all nonfinancial corporations
{NFC). We analyzed
NFCs.
in an earlier
paper using data from both capital markets
and the National Income and Product
Accounts {NIPA). This paper's approach is
basically the same.'
Rates of return derived from the NIPA
are solid, useful numbers. However, we be-
heve the capital market data are essential. A
decline in ^ e real rate of return on capital
does not make investors worse off or
weaken the incentive to invest if the real
cost of capital declines proportionally. Also,
an independent measure of rate of retum
can be obtained from retums realized by
investors in debt and equity securities. If the
only object were to measure corporateprof
itability, we believe market rates of retum
would be superior to the NIPA figures.
However, both types of data are needed to
investigate the determinants of profitability
and to assess profitabihty relative to the cost
of capital.
I. DataandAssumptions
Our results appear in Tables
and 2. We
will briefly describe the statistics in these
'Professors
of finance, Massachusetts Institute of
Technology. We wish to thank John Gonnan of the
Bureau
of Economic Analysis, Bernard
Horn,
an d
Jerome
Dausman.
'However, the NFC statistics given in this paper
may
differ from those presented in our earlier paper.
The
differences reflect data revisions and minor proce-
dural
chan ges necessary to ensure comparability of the
tables before attempting to comment or to
interpret them.
The rates of retum {ROCs)in Table are
the ratios of before- or after-tax operating
income to capital stock. Capital stock is
defined as the current value of plant, equip-
ment, and inventories. Operating income in-
cludes interest, excludes inventory profit,
and is calculated after depreciation of the
net replacement cost of the capital stock.^
The ROCs for NFCs can be derived di-
rectly from the NIPA. The derivation for
MCs is more difficult, however, and the
estimates less satisfactory. Capital stock
estimates for M Cs are given in the NIPA on
an estabUshment basis, but several items
necessary for estimating operating income
are available on a company basis only. The
inventory valuation adjustment {IVA) is
given on an establishment basis, but for all
manufacturing, not just corporate manufac-
turing. A capital consumption adjustment
for manufacturing is not available in the
NIPA. The procedures we used to get
around these difficulties are briefly de-
scribed in the Appendix.
The retums to investors shown in Table 1
are the estimated real rates of retum on a
portfolio of all outstanding debt and equity
securities issued by MCs orNFCs? That is,
^Strictly
speaking, operating income equals real in-
come only in the absence of real holding gains on
inventory
and plant and equipment. In measuring
ROd we assume, in effect, that nominal holding gains
are just sufficient to offset changes in the CPI. W e
checkedthis assumption in our earlier study, and found
it
to be true
on average
for
NFCs,
although there are
substantial
year-to-year variations which we think re-
flect difficulties in measuring short-term rates of asset
appreciation
from accounting data.
^Nominal
rates were estimated first, and then con-
verted
to real rates by subtracting Decem ber to De cem -
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RATE OF RETURN TO CAPITAL
TABLE
1ESTIMATED REAL RATES OF RETURN FOR
MANtrFAcruRiNO
CORPORATIONS
AND A ix NONFINANCIAL CORPORATIONS, 1946 78
(Shown in Percent)
321
1Manufacturing
After-Tax
Year Retum to Return on
Investors Capital
1947
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1947-50
1951-54
1955-58
1959-62
1963-66
1967-70
1971-74
1975-78
Mean
Standard
Deviation
- 0 . 6
2.5
18.3
28.7
20.9
16.9
- 2 . 5
56.9
34.9
4.7
- 1 3 . 5
39.6
10.8
- 2 . 6
25.2
- 1 0 . 5
21.2
14.8
10.6
- 1 3 . 1
20.9
5.2
- 1 3 . 6
-0 . 1
11.0
14.5
- 2 0 . 8
- 3 1 . 4
22.8
16.9
- 1 2 . 9
- 3 . 3
12.2
23.1
16.4
5.7
8.4
3.1
- 6 . 7
5.9
8.5
18.8
9.4
9.6
10.1
8.3
7.7
7.0
6.3
6.6
8.7
7.0
6.5
5.1
7.8
7.2
6.8
8.9
9.5
10.8
12.6
12.5
10.7
9.7
7.8
5.8
6.3
7.8
7.0
2.7
5.3
6.3
6.7
6.7
9.4
6.9
6.8
7.7
11.4
8.5
6.0
6.3
7.9
2.1
Effective
Tax Rate
55.7
44.6
37.9
58.2
63.4
57.7
61.3
52.9
52.8
53.9
52.4
51.0
49.5
48.5
49.5
44.8
45.0
42.1
41.4
41.3
39.5
44.8
46.1
43.1
43.6
41.5
46.3
66.4
39.7
43.7
43.8
44.0
49.1
58.8
52.5
48.1
42.5
43.4
49.5
42.8
Before-Tax
Retum on
Capital
16.8
17.7
16.1
20.1
21.0
16.5
16.1
14.0
18.5
15.2
13.7
10.4
15.5
13.9
13.4
15.7
17.3
18.8
21.5
21.4
17.6
17.6
14.5
10.1
11.2
13.4
13.1
8.0
8.7
11.2
12.0
11.9
17.7
16.9
14.5
14.6
19.8
15.0
11.4
11.0
Average for the Period
48.3
7.3
15.1
3.6
R e t u mto
Investors
- 5 . 1
2.2
17.1
17.7
13.0
14.7
- 0 . 7
42.6
24.4
1.9
- 1 0 . 6
33.8
8.3
0.3
22.1
- 7 . 3
16.7
13.1
8.2
- 1 1 . 6
14.7
4.7
- 1 4 . 5
1.7
10.1
12.4
- 1 9 . 7
- 3 1 . 9
21.4
17.4
- 1 1 . 7
- 4 . 7
8.0
17.4
12.4
5.9
6.6
1.7
- 7 . 3
5.6
1947-78
6.3
15.8
All Nonfinancial
After-Tax
Retum on
Capital
7.0
9.0
8.4
7.2
6.3
5.9
5.2
5.7
7.3
5.9
6.0
5.0
6.4
6.1
6.0
7.7
8.2
9.3
10.3
10.2
9.1
8.3
7.2
5.9
6.2
7.1
6.5
4.3
5.5
5.8
6.1
6.0
7.9
5.8
6.1
6.6
9.5
7.6
6.0
5.9
6.9
1.5
Effective
Tax Rate
52.1
44.2
38.7
55.4
61.5
56.5
59.3
51.7
50.8
53.2
51.3
49.4
48.4
46.9
47.2
41.7
41.6
38.7
37.6
37.5
36.5
40.9
41.9
39.8
39.0
36.8
40.0
47.9
37.7
40.0
39.8
41.0
47.6
57.2
51.2
46.1
38.9
39.8
40.9
39.6
45.2
7.2
Before-Tax
R e t u m o n
Capital
14.6
16.1
13.7
16.1
16.2
13.6
12.7
11.9
14.8
12.7
11.5
9.8
12.4
11.4
11.4
13.1
14.0
15.2
16.5
16.3
14.3
14.1
12.4
9.8
10.1
11.2
10.9
8.2
8.8
9.7
10.1
10.2
15.1
13.6
12.2
12.1
15.5
12.7
10.1
9.7
12.6
2.4
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22
Year
1947
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1
.96
.80
.60
.74
.62
.60
.62
.69
.98
.97
.92
.83
1.19
1.15
1.33
1.31
1.48
1.73
1.98
1.66
1.57
1.68
1.50
1.01
1.21
1.29
1.10
.54
.65
.68
.68
.56
Shown ii
Shown il
Capital-
ization Rate
7.8
12.3
16.8
11.3
12.5
11.6
10.0
9.5
9.0
7.1
7.1
6.2
6.6
6.2
5.1
6.7
6.4
6.3
6.4
7.5
6.8
5.8
5.2
5.7
5.2
6.0
6.4
4.9
8.3
9.3
10.0
12.0
percent.
1 percent per
AMERICAN ECONOMIC ASSOCIA TION
TABLE 2ADDITIONAL STATISTICS
Manufacturing
Standard
Deviation*
4.9
4.8
4.9
3.3
3.6
3.7
3.2
4.0
3.9
4.3
4.1
3.5
2.3
3.1
3.3
4.5
4.5
2.2
2.0
2.9
3.5
3.5
3.5
4.3
4.4
2.7
2.8
4.3
5.3
3.9
3.1
3.1
month.
Adjusted
Standard
Deviation*
4.6
4.6
4.7
3.1
3.4
3.5
3.1
3.8
3.8
4.1
3.9
3.3
2.2
3.0
3.1
4.3
4.3
2.1
1.9
2.8
3.4
3.4
3.3
4.1
4.2
2.6
2.7
3.7
4.7
3.7
2.9
2.9
Market
Debt
Ratio,
Midyear
- . 0 1
- . 0 1
- . 0 1
- . 0 6
- . 0 4
.00
.00
.02
- . 0 1
.00
.02
.05
.03
.03
.04
.04
.04
.04
.05
.08
.10
.09
.12
.19
.16
.16
.21
.43
.22
.21
.25
.25
q
1.00
.87
.71
.79
.72
.72
.71
.77
.97
.98
.92
.91
1.15
1.10
1.29
1.24
1.39
1.49
1.57
1.43
1.41
1.38
1.31
.97
1.12
1.20
1.16
.92
.79
.88
.79
.71
All Nonfinancial
Capital-
ization Rate*
7.0
10.4
11.8
9.2
8.6
8.2
7.3
7.4
7.5
5.6
6.1
5.5
5.6
5.5
4.7
6.2
5.9
6.2
6.5
7.2
6.5
6.0
5.5
6.0
5.5
5.9
5.6
4.7
6.9
6.6
7.7
8.5
Standard
Deviation*
4.2
3.9
3.8
2.4
2.7
2.8
2.5
3.0
2.9
3.3
3.2
2.8
2.0
2.6
2.8
3.7
3.7
1.8
1.7
2.6
3.2
3.1
3.1
4.1
4.1
2.5
2.7
4.9
5.7
3.6
2.9
2.8
MAY 1980
Market
Debt
Ratio,
Midyear
.16
.18
.23
.17
.19
.20
.18
.22
.17
.16
.16
.19
.16
.16
.16
.19
.18
.18
.18
.18
.19
.17
.2 0
.27
.24
.23
.26
.32
.30
.26
.31
.35
it is a weighted average of debt and equity
retums, where the weights are the ratios of
debt to firm value and equity to firm value.
These are market, not book, ratios. We
estimated the weights by capitalizing inter-
est and dividend flows, following the proce-
dures described in our earlier paper.
Our major reservation about the capital
market data shown in Tables 1 and 2 con-
cems the equity indexes underlying them.
The estimates for NFCs and MCs reflect
dividend yields and retums for the Standard
and Poor's Composite and Industrial In-
are highly correlated, and either one is likely
to pick up major shifts in market values
over time. But if there are significant dif-
ferences between MC an dNFCequities, we
doubt that these two indexes will pick them
up.
We plan to construct indexes designed
to match the MC andNFCsectors.
The statistics in Table 2 require only brief
comment. The variable q is the ratio of
market value to capital stock; in other
words, the ratio of the value of all tangible
and intangible assets to the measured value
of tangible assets. The absolute level of q
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RATE OF RETURN TO CAPITAL
32 3
changesin q reflect changes in investors'
forecasts of profitabihty relative to the cost
of capital.*
The standard deviations are based on
twenty-four monthly observations of real
rates of retum to investors. The adjusted
standard deviation for MCs is the un-
adjusted figure multiplied by the correlation
coefficient between the rates of retum to
MC an d NFC investors. This adjustment
removes that part of the MC business risk
that would be eliminated in a diversified
portfolio of allNFC securities.
The capitalization rates are the ratios of
operating income to market value. The debt
ratio is the ratio of debt to debt plus equity
at market value.
II.
Comparing
MCs
and
The similarities between the time-series
for MCs and NFCs are more striking than
the differences. We will discuss the similari-
ties first.
Both MCs and NFCs have fared poorly
since the mid-1960's, which with hindsight
looks more and more like a vigorous golden
age. Average real rates of re tum to investors
were actually negative over the past ten
years: -1.7 percent for MCs and -1.9 5
percent for NFCs. Before and after tax,
ROCs have fallen substantially. So has q,
which confirms that profitability has fallen
relative to the real cost of capital.
Thus someone with a ten- or fifteen-year
memory would see a steep downtrend. How-
ever, the trend disappears when you look
back further and correct for changing busi-
ness conditions. Table 3 displays the results
of regressing the ROC series on time, the
percentage change in real GNP, and the
^Market value
MV
equals the long-run earnings
from assets already in place
Y
capitalized at the cost of
capital p, plus the present value of future growth
opportunities
PVGO): MV-= Y/p+PVGO; Y
equals
ROC
times the capital stock CS. Thus
q = MV/CS =
ROC/p+PVGO/CS.
An increase in
ROC
relative to
p increases q directly, and also indirectly through
PVGO.
Higher future profitability from existing assets
percentage change in the CPI. There is a
hint of a downward trend in the before-tax
ROCs, but none in the after-tax figures.
(The reason for this difference is that the
effective tax rate on real operating income
has fallen over the postwar period.)
The rate of inflation affects only after-ta.
profitability. In the short run at least, in-
creased inflation increases the effective tax
rate. However, over longer periods, the
effective tax rate has decreased in the face
of substantial inflation. The major reason is
that inflation and increasing debt ratios
have increased interest payments and
shielded a greater proportion of operating
income from the corporate tax. Modifica-
tions of the tax, for example, accelerated
depreciation, shortening of depreciable lives
and the investment tax credit, also contrib-
uted to the decline.
The capitalization rates can be thought of
as earnings-price ratios generalized to in-
clude both debt and equity, with income
stated in real terms. The most interesting
feature of the capitalization rate series is
its stability, at least from the Tmd-1950's
through 1976. In other words, changes in q
over this period have been primarily due to
changes in real profitabihty {ROC),and ap-
parently not to shifts in the real cost of
capital. (We cannot be sure the real cost of
capital has been stable, however, because
the capitalization rate is only a rough
measure of it.) However, in the last two
years the capitalization rate has moved
sharply upwards, to 8.5 for NFCs and 12.0
for MCs in 1978, the highest rate since the
late 194O's. We cannot explain this shift; it
may prove transitory.
The standard deviation series measure
business risk. Here we see no evident trend.
We can only note the quiet period in the
mid-1960's and the extreme volatility of the
mid-1970's. Note that the standard devia-
tions have come down since the 1975 peak,
so high business risk does not explain the
high recent capitalization rates.
Now we tum to the differences between
MCs and NFCs. The most obvious dif-
ference is that the MCs seem to have been
more profitable. The before-tax ROCs are
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324 AMERICAN ECONOMIC ASSOCIA TION MAY 1980
TABLE
3REGRESSION ANALYSIS OF REAL RATE OF RETURN
ON CAPITAL,
1947 78
Series
Manufacturing,
Before Tax
NFCs, Before Tax
Manufacturing,
After Tax
JVfCs, After T ax
Time
- . 2 0
(-1.30)
- . 1 3
(-1.20)
.09
(1.12)
.08
(.96)
Percent
Change in
Real
GNP
.60
(8.36)
.35
(8.47)
.25
(4.32)
.17
(4.58)
Percent
Change
in CPI
.06
(.60)
- . 0 4
(.60)
- . 2 9
(-3.51)
-.18
(-3.54)
R^
.87
.90
.77
.81
Note: Fitted by standard Cochrane-Orcutt procedure; /-statistics shown in parentheses.
larger
NFC
aggregate. The average gap be-
tween the two peaked at 4.3 percentage
points from 1963-66, although it has de-
clined to an average of 1.3 percentage points
since then. The gap also exists in after-tax
^OCs,
at least through the niid-1960's.
Since then the after-tax ROCs have, on the
average, nearly converged. The convergence
of after-tax ROCs reflects growing dif-
ferences in effective tax rates, which have
been consistently lower for NFCs.
The higher profitability of AfCs also
shows up in higher average rates of retum to
investors and in generally higher ^s.
One possible explanation for higher re-
tum is higher risk. The evidence we have
favors that explanation. We note that the
AfCs' standard deviations are a bit higher
than the
NFCs ,
except in the 197O's.* The
MCs'
before- and after-tax ROCs are more
variable, and more sensitive to the rate of
growth of realGNPand theCPI.(See Table
3.) MCs waxed fatter in the mid-1960's and
suffered more in the 1974 crunch. The MCs
lower debt ratios may be lenders' and
managers' response to higher business risk.
Finally, capitalization rates for MCs are
generally
higher
than for
NFCs.
Grea ter risk
ought to mean higher capitalization rates,
other things equal.
not put much weight on this evidence alone,
because we use indexes of equity retums that are highly
correlated, and may miss significant differences be-
m . Conclusion
We have emphasized that the estimates
we have derived for MCs are probably less
accurate than the NFC statistics. Accord-
ingly we have restricted our comments to
general points that are unlikely to be upset
by more detailed analysis or improved
measurement procedures.
The m ain points are these. Both M Cs and
NFCs show the same behavior over time:*
great performance in the 196O's, much
poorer performance since, but no longer-
term trends. Business risk and the real cost
of capital seem to have been stable over
most of the postwar period. MCs appear to
be riskier than the larger NFC aggregate,
however, and MCs' average real rates of
retum have been higher.
APPENDIX
The estimates of the retum on capital in
Table 1 are derived from data in U.S.
Bureau of Economic Analysis, 1976b, sup-
plemented by annual revision and updating
in the Survey of Current Business, BEA,
1976a, and unpubhshed series generously
provided by John Gorman of BEA.
For both A^FCs and MCs the capital
stock equals the average of beginning- and
'This is not preordained. The MC capital stock was
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VOL.
70 NO. 2
RATE OF
RETURN TO C PIT L
32 5
end-of-year values of plant and equipment
{BEA, 1976a), plus second-quarter invento-
ries{BEAunpublished data). (Prior to 1958,
inventories, too, are averages of beginning-
and end-of-year values.)
In what follows all numbered references
are to tables in BEA (1976b) and the
Survey
of urrentBusiness.
For NFCs all the elements of the num-
eratorcorporate profits with inventory
valuation and capital consumption adjust-
ments, net interest, and profits tax liabiHty
are taken directly from (1.15).
For MCs however, a number of items
were estimated. While we found the meth-
ods developed by Jerome Dausman very
helpful, a number of loose ends remain. As
a consequence, the
ROCs
for MCs are not
as accurate as for A^FCs, and are subject to
revision.
To estimate the capital consumption ad-
justment for corporate manufacturing, we
applied the ratio of capital consumption
allowances with and without the capital
consumption adjustment for all corpora-
tions (8.7) to capital consum ption allowance
for all manufacturing (6.1), and then sub-
tracted corporate manufacturing capital
consumption allowance (derived by sub-
tracting noncorporate manufacturing cap-
ital consumption allowance (6.15) from
manufacturing capital consumption allow-
ance (6.1)) to end up with corporate manu-
facturing capital consumption adjustment.
In effect, we assumed that for manufactur-
ing corporations the net capital stock was
the same age as for all corporations.
Taxable profit on an establishment basis
was estimated by adding back the IV A for
all manufacturing (5.8) to aU manufactur-
ing profit-type income (6.1) and subtract-
ing manufacturing sole proprietorship and
partnership income (6.14).
Corporate manufacturing profits tax lia-
bihty on an establishment basis was esti-
mated by using the effective tax rate on a
company basis (6.19 and 6.20).
Up to 1970, we used the IV A of (6.16)
which is for corporate manufacturing on a
company basis and differs from that which
adjusts book value inventories. From 1971
on, our IV A was that fraction of the manu-
facturing IV A of (5.8)which is not the
same as that which adjusts business in-
com e in (6.16)that the corporate manu-
facturing IV A (6.16) is of the corporate and
noncorporate manufacturing IV A (6.16).
Our IV A is not a good estimate, and could
be seriously off in 1974 and 1978, when the
IV A was extremely high, causing our esti-
mates of the ROC to be too low.
Net interest (6.17) is for all manufac-
turing, and, therefore, an overstatement
for corporate manufacturing. However, the
error is so shght
ROCs
would be off by
less than one-tenth of one percentage point
that we made no adjustment on this
score.
REFERENCES
J. F. Dausman, Corporate Manufacturing
Rates of Re tum , 1947-76, unpublished
Master of Science dissertation, M.I.T.
1978.
D.
M. HoUand and S. C. Myers, Trends
in Corporate Profitability and Capital
Costs, in Robert Lindsay, ed.. The
Nation s Capital Needs: Three Studies,
Washington 1979.
U.S.
Bureau of Economic Analysis, (1976a)Fixed
Nonresidential Business and Residential
Capital in the United States, 1925-75,
Washington 1976.
, (1976b) The N ational Income and
Product Accounts of the United States,
1929-74,Washington 1976.
U.S.
Office of Business Economics,Surv. Curr.
Bus.,
Washington, various issues.
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