Holland, D. M., & Myers, S. C. (1980). Profitability and Capital Costs for Manufacturing Corporations and All Nonfinancial Corporations. the American Economic Review

7/21/2019 Holland, D. M., & Myers, S. C. (1980). Profitability and Capital Costs for Manufacturing Corporations and All Nonfi

1/7

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 -


2/7

VOL.

70 NO.

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


3/7

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


4/7

VOL.

70 NO. 2

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


5/7

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


6/7

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.

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Documents

Holland, D. M., & Myers, S. C. (1980). Profitability and Capital Costs for Manufacturing Corporations and All Nonfinancial Corporations. the American Economic Review