the investment decision and the demand effect

This PDF is a selection from an out-of-print volume from the NationalBureau of Economic Research

Volume Title: Tax Changes and Modernization in the Textile Industry

Volume Author/Editor: Thomas M. Stanback, Jr.

Volume Publisher: NBER

Volume ISBN: 0-870-14483-9

Volume URL: http://www.nber.org/books/stan69-1

Publication Date: 1969

Chapter Title: The Investment Decision and the Demand Effect

Chapter Author: Thomas M. Stanback, Jr.

Chapter URL: http://www.nber.org/chapters/c1191

Chapter pages in book: (p. 46 - 67)

Chapter 4

THE INVESTMENT DECISIONAND THE DEMAND EFFECT

HAS DEPRECIATION liberalization acted via the demand effect toincrease modernization outlays? In order to shed light on thisquestion the present chapter, based entirely on the interviewmaterial, examines how the investment decision is made.

It is important, first of all, to determine if the investment de-cision-making process reflects the effects of depreciation liberali-zation. The decision to modernize involves, fundamentally, de-termining whether replacing an existing facility with a new onewould have the effect of reducing unit costs of output, therebyincreasing net revenues sufficiently to cover the capital cost ofthe acquisition. It is appropriate, then, to raise the general ques-tion: Does the investment decision also take account of the effectof depreciation liberalization on net incomes and capital costs?

Second, we are interested in the type of investment computa-tion formula used. Does it measure the effect of depreciationliberalization on net revenues or on the capitalized value of thenet revenues expected over the facility's lifetime? If the type ofinvestment computation is discounted cash flow, the tax effectof liberalized depreciation will be revealed to management in theform of higher (after-tax) anticipated rate of return or higher(after-tax) present value of the anticipated streams of returns.If an after-tax pay-back formula is used, the tax effect of liberal-ized depreciation will appear as a shorter period required torecoup the initial investment. In either event the tax effects areevident. On the other hand if a formula is used which ignores the

THE INVESTMENT DECISION 47

tax effect (for example, a pretax pay-back formula), the tax sav-ings due to depreciation liberalization are not made explicit anddo not serve, more or less automatically, to increase the demandfor modernization.

Third, the demand effect may occur even though the effect ofthe tax savings is not made explicit by the investment computa-tion. This is possible even where pretax formulas are used ifmanagement recognizes the general proposition that liberalizeddepreciation serves to increase the rate of return or to reducethe pay-back period and accordingly revises its rules of thumbfor judging acceptability of investment proposals.

Finally, there is a modernization issue of special interest tothe textile industry: whether to modernize by modifying exist-ing equipment or by purchasing new equipment. Is this decisioninfluenced by liberalized depreciation?

Accordingly we ask four questions. (1) What factors are takeninto account in arriving at the decision to modernize? (2) Whatinvestment formulas are used? (3) Is there evidence that theeffect of tax savings on return or pay-back is recognized evenin those cases where pretax investment formulas are used? (4)Has liberalized depreciation served to alter the decision to mod-ernize by purchasing new equipment rather than by modifyingthe old?

FACTORS IN THE DECISION TO MODERNIZE

Cost and Savings Included in the Investment CalculationIt was not possible in the course of the interviews to collect a

detailed statement relating to costs and savings included in theinvestment calculation, but firms repeatedly emphasized that di-rect labor costs were the principal ones involved in moderniza-tion (see Table 3). Several firms made no attempt to includeother costs, although others did estimate costs or savings due toselected factors such as reduced maintenance, working capital,or waste, and some endeavored to track down a variety of costs.In every case for which such information was supplied wagerates and selling price of the final product were assumed to re-

TAB

LE 3

. Sel

ecte

d In

form

atio

n R

elat

ing

to U

se o

f Inv

estm

ent C

ompu

tatio

ns00

Com

pany

aTy

pe o

f For

mul

aC

osts

Con

side

red

Crit

erio

n of

Acc

epta

bilit

y(1

)(2

)(3

)(4

)

APr

etax

pay

-bac

kC

onsi

ders

onl

y la

bor c

ost s

av-

ings

. Sta

tes,

"ver

y in

form

al sy

s-te

m."

No

cuto

ff, b

ut st

ates

"ve

ry in

for-

mal

ly, l

ook

for f

our y

ears

. No

ad-

vers

efa

ctor

sar

ein

clud

ed."

Stat

es, "

if w

e ha

d co

nsid

ered

all

fact

ors .

..w

ould

neve

rha

vedo

ne a

ll th

e th

ings

we

did.

"

BPr

etax

pay

-bac

kC

ompa

ny u

ses v

ery

elab

orat

eco

st st

udie

s. In

vest

men

t cre

dit

incl

uded

on

pret

ax b

asis

.

No

cuto

ff, b

ut a

nyth

ing

over

five

year

pay

-bac

k ge

ts sp

ecia

l stu

dybe

fore

acc

epta

nce.

CPr

etax

pay

-bac

kPr

inci

pally

labo

r cos

ts. N

ot so

-ph

istic

ated

. Com

pany

has

no

ex-

pans

ion

prog

ram

. Mos

t pro

ject

sar

e of

mod

erni

zatio

n, p

ay-b

ack

type

.

No

cuto

ff. C

ompa

ny u

ses p

ay-

back

toes

tabl

ish

prio

rity

insp

endi

ng c

ash

flow

.

DPr

etax

pay

-bac

kLa

bor,

was

te, m

ater

ials

, rep

airs

,su

pplie

s com

pute

d. C

ompa

ny is

very

pay

-bac

k co

nsci

ous.

Exec

u-tiv

e st

ates

, "W

e try

to m

easu

reev

eryt

hing

."

Use

s sam

e cr

iterio

n fo

r all

proj

-ec

ts. S

tate

s, fiv

e ye

ar p

ay-b

ack

is"v

ery

acce

ptab

le.

.. a

nyth

ing

over

seve

n ye

ars .

.. w

ould

look

at v

ery

hard

."

k k

EPr

etax

pay

-bac

kTr

ies t

o tra

ck d

own

all c

osts

and

Thre

e—fiv

e ye

ar p

ay-b

ack

gets

all s

avin

gs,

subm

itted

to to

p m

anag

emen

tau

tom

atic

ally

. Abo

ve th

at "

gets

very

clo

se sc

rutin

y."

FPr

etax

pay

-bac

k (e

xcep

tb

Fiv

eye

ars.

Stat

es c

ompa

ny u

su-

retu

rn) o

n in

vest

men

tal

ly h

as e

noug

h pr

ojec

ts u

nder

for n

ew p

lant

sfiv

e ye

ars t

o us

e up

cas

h flo

w.

CPr

etax

pay

-bac

kb

Usu

ally

five

year

max

imum

, but

may

not

acc

ept l

owes

t pay

-bac

k.D

ecis

ion

affe

cted

by

qual

ity a

ndot

her c

ompe

titiv

e fa

ctor

s.0

HPr

etax

pay

-bac

kC

ompa

ny lo

oks f

or fi

ve y

ear p

ay-

back

or b

ette

r." "

Qua

lity

im-

prov

ing"

inve

stm

ent

does

n't

have

cut

off.

Qua

lity

dom

inat

esm

any

deci

sion

s, pr

obab

ly 5

0 pe

rce

nt.

Pret

ax p

ay-b

ack

Alm

ost e

ntire

ly la

bor s

avin

gs.

Five

yea

r cut

off.

Sam

e cr

iterio

nis

use

d fo

r all

proj

ects

if u

sing

for-

mul

a. P

resi

dent

ow

ns a

nd ru

nsco

mpa

ny. H

e do

esn'

t alw

ays u

sefo

rmul

a. M

ay ig

nore

if h

e se

esso

met

hing

he

wan

ts to

mak

e th

eop

erat

ion

mod

em.

(con

tinue

d)

TAB

LE 3

.(c

ontin

ued)

C;' 0

KPr

etax

pay

-bac

k

Dire

ct c

ost s

avin

gs.

Dire

ct c

ost s

avin

gs.

Four

yea

rs if

pro

ject

can

be

"fig

-ur

ed."

Exe

cutiv

e st

ates

"al

way

sfig

ure

if w

e ca

n. E

xecu

tive

stat

espr

esid

ent i

s ver

y pa

y-ou

t con

-sc

ious

.,,

Stat

es c

ompa

ny tr

ies t

o cu

toff

at

six—

seve

nye

ars,

but m

ay g

ose

ven—

eigh

t yea

rs.

k

LPr

etax

pay

-bac

kSt

ates

"sa

ving

s" c

ompu

ted

but

proc

edur

e is

"in

form

al."

Prin

ci-

pally

labo

r cos

ts c

onsi

dere

d.

Stat

es "

wou

ld g

et le

ery

if ov

erse

ven

year

s ..

. hav

ego

ne to

ten

year

s."

tzi

JPr

etax

pay

-bac

k

Com

pany

aTy

pe o

f For

mul

aC

osts

Con

side

red

Crit

erio

n of

Acc

epta

bilit

y(1

)(2

)(3

)(4

)

MPr

etax

pay

-bac

kN

ocu

toff

.Ex

ecut

ive

stat

es,

have

no

troub

le fi

ndin

g op

-po

rtuni

ties w

ith tw

o—th

ree

year

spa

y-ba

ck w

hich

take

up

our c

a-pa

city

to sp

end

or w

illin

gnes

s to

spen

d."

NPr

etax

pay-

back

for

equi

pmen

t. N

ew p

lant

uses

afte

r-ta

x re

turn

or

inve

stm

ent (

base

d on

stra

ight

-line

depr

ecia

-tio

n)

Prin

cipa

lly la

bor s

avin

gs.

Exec

utiv

e st

ates

he

does

n't k

now

of a

ny c

utof

f.Sa

ys tw

o—th

ree

year

s on

labo

r sav

ing

proj

ects

has

been

the

aver

age.

tn

0Pr

etax

pay

-bac

kPr

inci

pally

labo

r sav

ings

.Fo

ur—

six

year

cut

off.

Sam

e cr

ite-

rion

used

for p

roje

cts.

Com

pany

test

s all

proj

ects

with

pay

-bac

kfo

rmul

a.

Stat

es to

p m

anag

emen

t tak

es ta

xsa

ving

s int

o co

nsid

erat

ion

but

not i

n co

mpu

tatio

n. A

ll pr

ojec

tsca

nnot

be

eval

uate

d, b

ut u

ses

sam

e cr

iterio

n w

here

savi

ngs c

anbe

est

imat

ed.

QA

fter-

tax

pay-

back

Prin

cipa

lly d

irect

cos

ts. C

harg

esin

tere

st o

n in

vest

men

t rec

ogni

zeD

DB

in c

ompu

ting

taxe

s.

Thre

e—fo

ur y

ear p

ay-b

ack

on a

llpr

ojec

ts w

hich

can

be

mea

sure

d.

RA

fter-

tax

pay-

back

(use

spr

etax

pay-

back

for

scre

enin

g)

Dire

ct c

osts

. Car

ryin

g co

sts o

fex

tra in

vent

orie

s but

not

was

tes

and

mai

nten

ance

cos

ts. R

ecog

-ni

zes t

ax sa

ving

s fro

m a

ccel

er-

ated

dep

reci

atio

n.

(con

tinue

d)

No

cuto

ff. T

ypic

ally

use

s cos

tco

mpu

tatio

ns, b

ut th

ere

are

som

epr

ojec

ts w

hich

mus

t be

adop

ted

to "

stay

in b

usin

ess."

C)'

I—I

PPr

etax

pay

-bac

k

z

TAB

LE 3

. (co

nclu

ded)

CR

Trie

sto

trac

k do

wn

all

cost

san

d sa

ving

s. R

ecog

nize

s DD

B in

com

putin

g ta

xes.

Stat

es sa

me

pay-

back

crit

erio

n(n

ot g

iven

)- u

sed

for a

ll pr

ojec

ts.

Exec

utiv

e st

ates

com

pany

is v

ery

pay-

back

con

scio

us.

TA

fter-

tax

pay-

back

UPr

imar

ilydi

scou

nted

cash

flow

Com

pany

atte

mpt

s to

trace

dow

nal

l cos

ts a

nd a

ll sa

ving

s. R

ecog

-ni

zes t

ax sa

ving

s fro

m a

ccel

er-

ated

dep

reci

atio

n. C

ompa

ny is

very

cap

ital b

udge

t con

scio

us.

Test

spr

ojec

ts w

ith c

are.

Im-

pute

s val

ue o

f int

angi

ble

con-

side

ratio

ns.

Use

s diff

eren

t crit

eria

for e

ach

ofth

ree

clas

sific

atio

ns: n

ew li

nes,

repl

acem

ent o

f exi

stin

g m

achi

n-er

y, n

eces

sary

pro

ject

s to

stay

inbu

sine

ss; c

riter

ia n

ot g

iven

.

VV

ario

us fo

rmul

as:

dis-

coun

ted

cash

flow

, re-

turn

onin

vest

men

t,af

ter-

tax

pay-

back

Com

pany

atte

mpt

s to

track

dow

nal

lco

sts.

Rec

ogni

zes t

axsa

v-in

gs fr

om a

ccel

erat

ed d

epre

cia-

tion.

Not

giv

en. I

n ge

nera

l sub

mits

all

proj

ects

to te

st. "

Com

pany

is v

ery

cost

con

scio

us."

SA

fter-

tax

pay-

back

Com

pany

aTy

pe o

f For

mul

aC

osts

Con

side

red

Crit

erio

n of

Acc

epta

bilit

y(1

)(2

)(3

)(4

)

k z z

WN

et re

turn

on

inve

st-

men

t afte

rta

xes a

ndaf

ter-

tax

pay-

back

Dire

ct c

osts

piu

s exp

ense

s in-

elud

ing

star

t-up

cost

s and

nec

-es

sary

car

ryin

g co

sts o

f wor

king

capi

tal.

101/

2 pe

r cen

t ret

urn

on in

vest

-m

erit

is m

ajor

obj

ectiv

e. W

ould

acce

pt lo

wer

rate

sif

"nee

ded

to."

Com

pany

alw

ays u

ses f

or-

mul

a. V

alue

of "

othe

r.cO

nsid

era-

tions

" es

timat

ed.

XA

fter-

tax

pay-

back

and

net r

ates

of r

etur

n on

inve

stm

ent

(afte

r-ta

x)du

ring

pay-

back

per

iod

Incl

udes

add

ition

al w

orki

ng c

ap-

ital r

equi

rem

ents

plu

s lab

or sa

v-in

gs. I

nclu

des i

nves

tmen

t cre

dit.

Five

yea

r pay

-bac

k.

YN

et ra

te o

f ret

urn

on in

-ve

stm

ent

and

pret

axpa

y-ba

ck

Savi

ngs

incl

ude

dire

ctla

bor

mai

nten

ance

.In

vest

men

tta

xcr

edit

and

tax

savi

ngs d

ue to

ac-

cele

rate

dde

prec

iatio

nre

cog-

nize

d.

Pay-

back

is b

asic

hur

dle.

Rou

ghru

le is

five

yea

r pre

tax

pay-

back

but c

heck

on

rate

of r

etur

n (a

fter-

tax

savi

ngs)

. Sam

e cr

iterio

n fo

ral

l pro

ject

s.

SOU

RC

E: C

ompi

led

from

inte

rvie

w m

ater

ial.

aC

ompa

nyal

phab

etic

al d

esig

natio

ns a

re u

sed

to p

rote

ct c

on-

fiden

tial n

atur

e of

inte

rvie

w m

ater

ial.

No

info

rmat

ion

avai

labl

e.

C"z tzl 0 0

54 TAX CHANGES IN THE TEXTILE INDUSTRY

main at current levels. In every case firms stated that computa-tions were based on an assumed full capacity operatiOn of 120hours per week.45

In general, firms made no effort to quantify gains which mightaccrue from improved quality. Only one firm stated that it re-quired the executive submitting the proposal to make such anestimate. This firm believed that there was a dollars and cents ad-vantage in having "first call" (the first preference of customers)in the marketing of its fabrics. Such a preferred position due toconsistently high quality enabled its mills to run full time, andthe executives were required to estimate the advantage.

In like manner, savings due to improved labor morale, reduc-lion in floor space used, and improved flow of work are notestimated. The difficulties encountered in estimating such savingsas well as savings due to the improvement in quality were men-tioned by a number of firms. A favorite example was the installa-tion of air conditioning, which was said to result in improvedquality and to have an effect on labor relations. Only one firm(that mentioned above) attempted to estimate pay-back or rateof return on air conditioning.

Management appeared to be aware of these factors, however,even though it did not attempt to quantify them in the invest-ment computation. The interviews indicate that such factors wereintroduced qualitatively as elements of judgment. A typical ex-pression was, "we take these matters into consideration."

The interviews leave little doubt that computations of savingscomprised a principal basis for judging the desirability of mod-ernization proposals. Executives pointed out that such proposalsusually anticipate results which are to a considerable extentmeasurable. In modernization projects the end product is usuallynot altered significantly (although quality may be improved),the objective being primarily to reduce production costs per unitof output.

Moreover, when only a limited number of costs or cost savings

This information is gathered from answers to question 4. Several firms statedthat they could recall cases in which full capacity had not been assumed but thatthese were exceptions to the rule.

THE IN VESTMENT DECISION 55

are considered, it should not be concluded that estimates aremade in a careless or haphazard fashion. Large and medium sizedfirms typically have cost engineering departments and smallerfirms attempt to estimate savings from experimentation withinthe plant by supervisory personnel. In some instances consultingengineers are employed, and firms work closely with engineeringrepresentatives of textile equipment firms. The latter, because oflong standing relationships, tend to take a conservative approachand to make cost estimates which mills consider with close atten-tion.

The tax treatment of depreciation allowances, of course, isnot related to the reduction in variable costs. Nevertheless, it isimportant to establish at the outset that in this important areaof investment decision making, management has displayed a highdegree of objectivity. Given this focus on increase in earnings, avery strong case can be made that the effect of depreciation lib-eralization in increasing the return on investment or reducing thepay-back period will be comprehended by management overtime. Where it is not understood at present a "learning process"may be anticipated.46

Cost of Capital: Risk of Obsolescence and of Other FactorsWhile not calculated with the same precision as are variable

costs, factors affecting real capital costs are also taken into ac-count. One such factor is the rate of obsolescence resulting fromtechnological advance. Other things being equal, acceleration ofsuch advance increases the risk of investment in depreciable fa-cilities since it becomes likely that the economic service life ofany newly acquired facility will be reduced. Accordingly, theamount of the investment to be recovered per year may be in-creased, enhancing the possibility that the full cost of the facilitymay not be recovered.

Depreciation liberalization bears on the weight of these factorsin the investment decision. Since liberalization accelerates the

46 See Ture, Accelerated in the United States, 1954—60, pp. 27—33,for evidence of growing appreciation by business of the advantages in usingaccelerated depreciation methods.


rate at which the investment in production facilities may becharged off against taxable incQme, it offsets, in part if not en-tirely, the effect of a reduced economic service life due to rapidtechnological advance. In other words, it tends to offset thegreater risk in modernization investment resulting from acceler-ating technical progress. The reduced tax liability from deprecia-tion liberalization in the years immediately following acquisitionof new facilities may also offset, in whole or in part, the effectson total unit costs of (anticipated) less than full rates of utiliza-tion.

Twenty of the twenty-three firms responding to question 9a47indicated that they regarded the recent years a period of ac-celerated technological change. The general discussion which ac-companied the executives' remarks made it clear that such devel-opments were deemed far more rapid than anything previouslyexperienced.

Thirteen of these twenty firms indicated that such changeshad made for greater uncertainty as to the economic service livesof new equipment (question and nine the same twentyfirms stated that such uncertainty had caused them to retainequipment which otherwise would have been replaced (questionlob).

These answers do not necessarily convey a very accurate indi-cation of the extent to which uncertainty influenced moderniza-tion expenditures, however. When asked to evaluate the impor-tance of uncertainty as to rate of obsolescence, firms simply citedexamples of postponed modernization and made no attempt toevaluate the general importance of this factor.

Two of the executives interviewed, however, gave very de-tailed accounts of the situation as it existed in their firms at thetime of interview. The executives were in charge of the moderni-zation programs in two large, progressive firms. Each was abreastof current technology as a result of company research, attend-

Question 9a: Do you consider that the rate of technical advance in the textileindustry in the last five years has resulted in more rapid obsolescence of equipmentthan in the previous period?


ance at textile machinery shows, and direct contact with ma-chinery producers both here and abroad. Both executives dis-cussed the various textile processes, pointing out what advanceshad recently been made in each and commenting on whetherthese developments were in the pilot stage or appeared to befully developed. They also stated whether their companies werecurrently purchasing given types of equipment or postponingpurchase. The general impression conveyed was that while somedevelopments were considered as too uncertain for adoption therewas an abundance of acceptable alternative projects at hand.Moreover, it appeared that in most instances equipment tech-nology was proceeding at a relatively predictable pace from pilotstage to stage of adoption.

The impression was supported by smaller firms. The process oftechnological change in basic textile equipment was sufficientlyslow that even they could proceed with considerable confidence.Some noted that not only was there a lapse of time between theappearance of pilot models and the availability of units for in-stallation, but the productive capacity of the machinery pro-ducers was so limited that it would take years to equip the in-dustry. Accordingly, firms desiring to proceed with caution couldchoose their modernization projects in such a way as to avoidfacing a high probability of early obsolescence.

On the other hand, there were examples given in which tech-nological obsolescence had been rapid and costly. Machinery usedin the processing of twisted "stretch" yarns had a series of radicalimprovements, each of which made newly purchased machin-ery uneconomical almost as quickly as it was installed. An earlierbut similar case pertained to combing equipment.

The general impression conveyed was that uncertainty as torate of future obsolescence has not acted as a major deterrent toinvestment. There have been a series of technological changes,but they have tended to be centered first on one stage of textileprocessing and then on another. The amount of uncertainty inthe rate of obsolescence was greater than in the past and variedamong the firms, depending on the importance of the develop-

58 TAX CHANGES IN THE TEXTiLE INDUSTRY

ment to the firm in its effort to remain competitive. When highlevels of uncertainty are encountered by a firm, they appear tohave been handled by giving the project in question a lowerpriority than would be indicated by the investment computation,or by simply postponing its consideration. This behavior is con-sistent with the use of varying cutoffs on years required for pay-back among a number of the firms using the pay-back approachin their investment computations.

All but one of the twenty-two firms answering question 748stated that it did not regard uncertainty as to rate of utilizationas an important consideration in individual modernization deci-sions. The reason was clear from the discussion which followedthis question. Most modernization proposals involve improve-ments in basic textile processes. A given improvement, such asthe introduction of metallic clothing used in carding equipment,cannot be isolated from the entire production process. Manage-ment does not think in terms of the probable rate of utilizationof one type of equipment but of an entire mill or a major portionthereof. Moreover, since the final product is frequently cloth oryarn of standard construction many firms follow a policy of main-taining operation at or near capacity even at the cost of con-siderable accumulation of inventory.

Under such conditions management does not attempt to dealwith the problem of weighing possibilities of variations in rate ofutilization of the mill as a whole when replacing a given type ofequipment. This is consistent with the previous finding that firmsassume 100 per cent utilization in their computations.

This does not mean that firms do not face uncertainty regard-ing the future course of demand. Characteristic to the economicsof the textile industry is that prices are relatively flexible, oftenvarying from day to day and widely over the, business cycle. Inindividual fabric markets margins between raw material costs andselling costs may be depressed by shifts in demand or increased

48 Question 7: Are there frequently cases in which pay-back (or rate of return)prospects for new equipment meet your investment criteria but you do not under-take investment because of uncertainty as to whether equipment will be fullyutilized?


foreign or domestic competition. In answering question 8 sev-eral companies called attention to the fact that competition couldaffect margins more than the rate of utilization. How is this typeof uncertainty dealt with by management? It seems probablethat changes in uncertainty of business prospects would alterthe size of the budget which management will appropriate formodernization expenditures. This type of action was mentionedby several firms responding to question 30 which deals with in-vestment policy during cyclical contraction. Certainly the datafor expenditures already noted in Chapter 1 indicates a sensitiv-ity to cyclical forces both by individual firms and the industry asa whole.

In summary, investment computations are typically based pri-marily on savings in labor costs and other explicit variable costs,to which depreciation liberalization is not directly relevant. Butsince the ultimate concern in these calculations is the effect onafter-tax earnings, it is probable that the favorable effect of lib-eralization of depreciation will sooner or later also be taken intoaccount.

The weight of changes in capital costs in the investment de-cision is not evident. Uncertainty as to obsolescence due to tech-nological change has increased recently but there is no evidencethat it has been so great as to impose a serious limitation on thetotal volume of acceptable projects. Firms handle this type ofuncertainty informally, i.e., without explicit costing. They tendto postpone those projects whose technology is in a state of fluxor to give such projects a lower priority. Similarly, where the in-vestment decision involves the purchase of individual units ofequipment, no explicit attempt is made to estimate the effect onoverhead costs of uncertainty as to probable rate of utilization.Uncertainty as to future prices and profits is probably important,however. The history of cyclical instability in investment expen-

Question 8: What are the major sources of uncertainty as to full utilization ofproposed new equipment?

a. Change in domestic demand for the product producedb. Increased foreign competitionc. Increased domestic competitiond. Other (specify)


ditures indicates that over-all prospects for the firm are importantin determining the size of the capital expenditure budget.

While the adverse effects of accelerating obsolescence and un-certainty as to rate of utilization may not be explicitly measuredin the investment decision, they are taken into account, at leastinformally. Depreciation liberalization tends to offset these in-hibiting considerations.

INVESTMENT FORMULAS USED

All of the interviewed firms used more or less formal rules forevaluating investment proposals. While considerable diversity wasevident in the details, all but one of the firms used some versionof the pay-back computation. This formula computes the num-ber of years required for the anticipated increase in net earn-ings resulting from the proposed investment to aggregate to thecost of the project. A widely used rule of thumb is that a projectmust be expected to pay back its costs—on a pretax basis—withinfive years if it is to be undertaken. But this rule is not universallyfollowed, in fact, only a few firms indicated rigid adherence toany set rule. The types of investment formulas used for moderni-zation projects (see Table 3) are summarized as follows: 50

Pretax pay-back only (firms A—P) 16After-tax pay-back only (firms Q—T) 4Combination discounted cash flow and selected

additional after-tax formulas (firms U, V) 2Combination after-tax rate of return on investment

and after-tax pay-back (firm W) 1Combination after-tax pay-back and rate of return

during pay-back period (firm X) 1Combination after-tax rate of return and pretax

pay-back (firm Y) 1

There is no evidence indicating that the more profitable firms made use ofmore sophisticated investment formulas, but this is by no means conclusive. Amongthe sixteen firms using pretax pay-back formulas there were ten for which profitdata were available. Seven of these had average rates of return on investment abovethe textile mill products industry average of 5.1 for the period 1954—62. Among thenine firms using some form of after-tax formula, profit data were available for five.Three of these had average rates of return of more than 5.1 per cent.


Sixteen firms restricted themselves to the use of pretax pay-backcomputations. The tax savings which result from the use of DDBor SYD methods or from shorter permitted tax depreciation liveswere not made explicit.5' For such firms, the results of the invest-ment computation were exactly the same with or without liberal-ized tax depreciation.

Among the remaining nine cases, tax savings appear to be re-flected by the formulas used by six firms (Q through V). The re-maining three require special consideration,

The first of these three (firm W) stated that it chiefly relied onits estimated annual return on investment computation but usedan after-tax pay-back (called "years required to cover cash, out-lay") as an additional measure. From the detailed descriptionprovided by the company it appears that the estimated annualreturn on investment computation did not reflect tax savingsdue to liberalized depreciation. The after-tax pay-back computa-tion did reflect tax savings due to use of double declining bal-ance depreciation, but not savings due to shorter depreciationlives.52

The second (firm X) made use of two computations: after-tax pay-back and rate of return during the pay-back period. The

51. This group includes two firms which use pretax pay-back computations forordinary modernization type computations but more elaborate computations wherea new plant is considered (see Table 3).

52 Firm W's procedure for computing annual return on investment does not makeuse of the discounted cash flow concept. The company computed an annual straight-line depreciation based on the expected service life of the equipment. This de-preciation expense was deducted from expected annual savings and the remainderregarded as taxable income. The estimated income tax of 54 per cent was thendeducted from the original estimate of savings to yield a residual called "averageannual return." It is this average annual return which is used to compute a rateof return on the cost of the installation. In such a computation neither the taxrecovery through use of DDB (the company's depreciation method) nor shortertax depreciation lives is recognized. For second measure the procedure was tocompute "annual after-tax income" (equal to 46 per cent of the estimated costsavings) and then to add back an additional cash recovery due to tax avoidanceequal to 54 per cent of straight-line depreciation multiplied by a constant of 1.3.The constant is intended to approximate the tax saving resulting from the use ofDDB. The result is a figure called "annual cash recovery." Initial investment costwas then divided by annual cash recovery to yield "years required to recover cashoutlay." It would appear that this computation does at least partially recognize taxsavings as a result of DDB but it does not take account of shorter depreciationlives.


former is the more important, the latter being designed, accord-ing to management, to provide "an idea of the expected effecton the books of the company." Accelerated depreciation servesto improve the showing of a proposed investment by reducingthe after-tax pay-back period but, on the other hand, it reducesthe after-tax book profit estimates since a discounted cash flowtype of computation is not used.53 The executive did not appearto be aware that the two computations as used would reflect ac-celerated depreciation in contradictory ways.

The third (firm Y) was in a stage of transition from simple pre-tax pay-back to after-tax return on investment. The executivestated that both were used but that, through a process of educa-tion, management had come to place increasing reliance on themore sophisticated measure. There was still a tendency, however,to use the older computation.

These three firms made use of investment computations whichat least partially reflect the improved returns or pay-back arisingout of liberalized depreciation. There is, therefore, at least primafacie evidence that nine of the twenty-five firms (36 per cent)recognized such tax advantage in considering whether or not toadopt a modernization proposal.

Relatively few of the large firms relied oniy on the pretax pay-back formula. On the other hand, only one of the seven smallcompanies used any sort of after-tax formula:

Pretax pay-back formula onlyLarge 3Medium 7Small 6

Total 16

In the after-tax pay-back computation both savings and SYD depreciationcharges are projected for a number of years. Taxes are estimated each year basedon savings less SYD depreciation. These estimated taxes are then deducted fromsavings (before depreciation charges) and the after-tax pay-back period is com-puted. In the second type of computation, however, both accelerated depreciationand taxes are charged as expenses in order to arrive at a figure called "annualsavings after taxes (including depreciation) ." These annual savings are averagedover the pay-back period (already computed above) to provide an "average esti-mated annual book profit during the pay-back period." This average book profitis then converted to a return on investment during the pay-back period.


After-tax formulas, all typesLarge 5Medium 3Small 1

Total 9

In other words, the larger firms which account for a substantialpart of the total investment in the industry show a greater tend-ency to use the kind of formula in which depreciation changesare explicitly taken into account. Thus we see that the impor-tance of the demand effect as a route by which liberalized depre-ciation influences modernization is somewhat greater than isindicated by the proportion of firms employing after-tax formulas.

INDIRECT DEMAND EFFECTS

As was previously noted, it is possible that liberalized deprecia-tion legislation may cause management to relax the standard bywhich it judges the acceptability of proposed projects even wherepretax formulas are used. For example, let us suppose that man-agement uses pretax pay-back computations and traditionally hasmade use of a five year pay-back cutoff point. Realizing thatthe tax law changes result in a more favorable after-tax pay-backon a project, it might continue to use the old formula as a mat-ter of simplicity in making computations but raise the acceptablecutoff point to, say, six years. Under such conditions we wouldobserve that the firm is using a pretax formula but that liberalizeddepreciation has nevertheless served to increase the number ofprojects for which management is willing to appropriate funds.

In order to investigate this possibility executives were askedthe following question (Question 25): What is your understand-ing of the benefit you derive from more liberal depreciation pro-visions? a. Increased cash flow? b. Shorter pay-back period aftertaxes or higher rate of return?

In general, answers indicate a lack of awareness by firms us-ing pretax formulas that liberalized depreciation acts to reducethe after-tax pay-back period or to increase the rate of return. Inmost cases these firms ignored the second part of the question

64 TAX CHANCES IN THE TEXTILE INDUSTRY

or answered it in the negative. Four of the sixteen firms usingsuch formulas did state that they understood that such an effectwas possible, but two of these stated that in practice they ig-nored it.

On the other hand, those firms using after-tax formulas tendedto show an awareness of the demand effect, although executivesof three failed in their answers to recognize that an improvedpay-back or rate of return resulted from liberalized depreciation.

Taken as a whole the evidence points to relatively little "in-direct" recognition of the demand effect on the part of firms us-ing pretax formulas. Additional firms may, however, recognizethe demand effect as time passes. The way is open for a "learn-ing process." It is not unreasonable to expect management to a!-ter its rules of thumb or to change its formulas after it has livedwith the new provisions for a time.

In this connection, it is important to point out once again thatfirms based their modernization decisions largely upon analysisof savings in variable costs. There is no lack of evidence that theinvestment formula plays the key role in this type of investmentdecision. It is our opinion that this fact increases the likelihoodof a learning process occurring through time. If the decision werelargely intuitive it would be far more difficult for managementto become aware of the effect of liberalized tax depreciation onprofits than is the case when cost computations are continuouslybeing examined and cost concepts reviewed.

THE DEMAND EFFECT AND THE CHOICE BETWEENMODIFICATION AND PURCHASE

In discussing the possible effect of depreciation liberalization onthe choice between modification of old equipment and purchaseof new it is important to recall that liberalized depreciation willhave its principal effect on marginal investment decisions. It wasnoted at that time that "where the investment proposal is ex-tremely attractive (e.g., pay-back in two years) or where it isabsolutely essential for the operation of the business

the firm will somehow manage the financing and make the


expenditure regardless of tax considerations. The effectiveness ofthe tax change depends upon the quantity of projects which lieat the threshold of decision. . . ."

A solid finding from the interviews is that in the past the modi-fication alternative has in a very large proportion of cases beenso much more attractive an alternative than purchase of newequipment, that the issue of whether to modify or purchase hasfrequently not lain at "the threshold of decision." All of the firmsresponding to questions ha and lib indicated that they hadbeen confronted in the past by the alternative of modifying exist-ing equipment versus purchasing entirely new equipment andthat on many such occasions modification was "just as good" or"almost as good" and much cheaper. This was particularly trueof much of the modification which had taken place earlier inspinning and the modification of carding equipment which wasoccuring at time of interview throughout the industry.

On the other hand, a wide variety of experience was noted.Several firms indicated that modification was often "at best acompromise" or that new equipment frequently works out inpractice to be a much better alternative than it appears to be ona strictly pay-back basis, presumably because of better qualityand lower maintenance, or because the original computationsunderestimated the savings eventually realized. In general, it wasfound that the desirability of modification depends upon theprocess involved (some processes cannot be modified at all), theage of the equipment (several firms indicated that they refuse tomodify very old equipment even when it appears to offer an at-tractive pay-back), the type of fabric or fiber (where the fabricis of high yarn count or high quality or where expensive syn-thetics are being used new equipment is preferable), and the ex-tent to which modification has occurred in the past (where modi-fication has akeady occurred further modification is frequently

Question 1 la: In considering proposals for modernization are you confrontedwith the alternative of modifying existing equipment versus purchasing entirelynew equipment?

Question 1 lb: Where such alternatives exist is it typical that new equipmentoffers substantially greater efficiency than modification (do not consider costs anddollar returns in answering this question)?

66 TAX CHANCES IN THE TEXTILE INDUSTRY

not feasible). Several firms indicated that modification was a com-promise which was made when the prospects for technologicaldevelopment were sufficiently uncertain that purchase of newequipment seemed undesirable.

The impression received is that, with the exception of modi-fication of carding equipment, the industry is nearing the end ofan era of modification and that purchase of new equipment mightreasonably be expected in the future. This impression was gainedlargely from discussion with several executives regarding thestate of technology as it has affected their firms. In addition,several other firms indicated that modification was no longer animportant alternative for them.

The above sheds little light, however, on the question ofwhether or not liberalized depreciation has resulted in firms pur-chasing new equipment rather than modifying old. Here, as whenthe alternatives are simply replacement or continued use of exist-ing equipment, the influence of liberalized depreciation may oc-cur as a result of the "demand effect," the "cash flow" effect, oran effect on management attitudes.

Question 13 was asked to determine the extent of influenceof liberalized depreciation on this type of management decision.Sixteen firms responded to the question. Of these, eight answeredin the affirmative, of which three answered that by increasingcash flow liberalized depreciation would make it possible to pur-chase new equipment which would require larger initial outlaysof funds. Another stated that by permitting the firm "to get itsmoney out of a piece of equipment earlier" it would increase thelikelihood of replacement.

The remaining four indicated that the effect of liberalized de-preciation on rate of return or after-tax pay-back of proposednew equipment would be to increase the tendency to purchasenew rather than modify old equipment. It should be noted that

Question 12: Where the decision has been in favor of modification what factorsother than pay out have influenced your firm to modify old equipment rather thanpurchase new?

56 Question 13: Is it your impression that liberalized depreciation laws havealtered, or could alter, a decision in favor of purchasing new equipment rather thanmodifying old equipment? Please explain your position.


these four firms were among those previously designated as mak-ing use of after-tax investment formulas and, therefore, presum-ably were influenced in their modernization decisions by demandeffects.

The interview evidence suggests an affirmative answer to thequestion asked at the beginning of the chapter: "Has deprecia-tion liberalization acted via the demand effect to increase mod-ernization outlays?" While the additional riskiness of such invest-ment resulting from acceleration of technological progress doesnot appear to be a dominant concern, neither is it ignored inthe investment decision. The more liberal tax treatment of depré-ciation tends to offset this impediment to modernization outlays.The formulas used for investment decision-making varied widely,but in nine of the twenty-five firms, the formulas were such thatchanges in depreciation rules would affect the measured profita-bility or desirability of the proposed investments. Finally, in sev-eral of the firms, particularly those using after-tax pay-back orrate of return formulas, depreciation liberalization encouragedmodernization by purchasing new facilities rather than modify-ing existing equipment.

the investment decision and the demand effect

Documents