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Alternative measures of the rate of return on direct investment.

Alternative Measures of the Rate of Return on Direct Investment

The rate of return on direct investment can be measured in various ways. This note illustrates two alternative ways of measuring direct investment rates of return based on recently published BEA estimates of direct investment valued at current-period prices.(1) One measures returns on the market value of direct investment positions, and the other measures returns on the positions valued at current cost (table 1, chart 4).

Previously, BEA has published rates of return on U.S. direct investment abroad (USDIA) and on foreign direct investment, in the United States (FDIUS) on the basis of estimates of the direct investment positions valued at historical cost. However, a major limitation of using historical costs for this purpose was that the resulting rates of return on otherwise similar investments could vary simply because the investments were made at different times and at different prices. Consequently, the published rates of return on USDIA and FDIUS--representing investments that differed considerably in age and therefore in price--were not comparable. The alternative current-period measures overcome this limitation by presenting rate-of-return estimates on a consistent valuation basis.

Table 1 and chart 4 show these current-period rates of return--a "market-value" measure and a "current-cost" measure. They also show a comparable market-value rate of return for all U.S. businesses(2) and a comparable current-cost rate of return for all U.S. nonfinancial corporations(3). Finally, the chart and table show rates of return based on the direct investment positions valued at historical cost; these are the only rates available that can be disaggregated by country and industry.

The market-value rate of return is the ratio of direct investment income to the average of the beginning- and end-of-year direct investment positions at market value.(4) The current-cost rate of return is the ratio of direct investment earnings, adjusted to be consistent with after-tax profits as measured in the national income and product accounts,(5) plus net interest paid by affiliates to their U.S. or foreign parent companies to the average of beginning- and end-of-year direct investment positions at current cost. The rate of return based on the historical-cost positions equals direct investment income divided by the average of the beginning- and end-of-year direct investment positions at historical cost.

For rates of return on both USDIA and FDIUS, the current-price estimates are lower, on average, than the historical-cost estimates. However, the differences are much larger for USDIA because the adjustment needed to shift direct investment assets or positions from historical costs to current-period prices is much larger for USDIA than for FDIUS. This inflation adjustment is larger for USDIA because most USDIA occurred in the 1960's and 1970's and thus tends to be "older" than FDIUS, most of which occurred in the 1970's and 1980's.

The estimated rates of return for USDIA are higher than those for FDIUS during 1983-90, according to all three methods of valuation. For the market-value measure, the average rate of return for USDIA was about 8 percent, compared with 3 percent for FDIUS. For the current-cost measure, the average rate of return for USDIA was about 7 percent, compared with 2 percent for FDIUS. For the historical-cost measure, the gap between the average rate of return for USDIA and that for FDIUS was much larger--about 14 percent for USDIA, compared with 3 percent for FDIUS--probably because of the different ages of USDIA and FDIUS.

The rates of return in current-period prices for all U.S. businesses tend to be near or somewhat lower than those for USDIA and higher than those for FDIUS during 1983-90. For example, the market-value rate of return for all U.S. businesses averaged roughly 8 percent, about the same as the rate for USDIA but substantially higher than the rate for FDIUS. The current-cost rate of return for all U.S. businesses averaged roughly 4 percent, lower than the rate for USDIA but higher than the rate for FDIUS.

Rates of return on investment would tend toward equality under conditions of perfect information, equality of risk, and complete international mobility of capital; however, differences in rates of return persist because these conditions do not exist in the real world and because investors may be motivated by considerations other than current profitability. For example, the relatively low rates of return on FDIUS may reflect long-term strategic objectives of foreign-based multinational companies, such as gaining access to the large U.S. market or to U.S. natural resources, reducing exchange-rate and other risks by diversifying internationally, exploiting economies of scale, and ensuring continued access to U.S. markets in the event that steps are taken to limit imports. They may also reflect the relative "newness" of FDIUS and the tendency for investments to reach maximum profitability only over time.(6) Rates of return on FDIUS also may be relatively low because some foreign companies in a few major investing countries, such as Germany and Japan, apparently have access to lower cost funds than U.S. companies do, and thus may find some investments attractive that other investors would not.

Other factors that may affect the rate of return on investment include differences in industry mix and differences between the pricing of transactions within multinational companies and the pricing of transactions between unrelated businesses. The effects of such factors on the rates of return for USDIA, FDIUS, and all U.S. businesses are difficult to assess. Note.--This special note was prepared by Ned G. Howenstine and Ann M. Lawson. [Table 1 Omitted] [Chart 4 Omitted] [Tabular Data Omitted]

(1)See "The International Investment Position of the United States in 1990" in the June 1991 Survey of Current Business; a discussion of the concepts and estimating procedures underlying the current-period estimates of direct investment appeared in "Valuation of the U.S. Net International Investment Position" in the May 1991 Survey. (2)This measure is a weighted average of the after-tax earnings per dollar of stock for Standard and Poor's Composite 500 companies and the average yield on corporate bond holdings rated AAA by Moody's Investors Service. The returns to debt and equity are weighted by the ratio of debt to equities at market value for nonfinancial corporate businesses published by the Federal Reserve Board in Balance Sheets for the U.S. Economy, 1945-90. (3)This measure is the ratio of after-tax profits from the national income and product accounts (NIPA's) plus net interest paid to the average of beginning- and end-of-year total assets for all U.S. nonfinancial corporations. Profits originating in the "rest of the world" are excluded from NIPA after-tax profits when these rates of return are computed. The measure of total assets used in this ratio is that published by the Federal Reserve Board in Balance Sheets for the U.S. Economy, 1945-90; the published totals have been adjusted to exclude claims on foreign affiliates. In this measure of total assets, tangible assets are valued at current cost, and claims on other nonfinancial corporations are excluded. (4)To be consistent with the corresponding measure for all U.S. businesses, direct investment income is measured before the deduction of withholding taxes on distributed earnings. (5)In this adjustment, the measure of direct investment earnings used excludes reported capital gains and losses and is before the deduction of firms' depletion expenses and withholding taxes on distributed earnings. In addition, an inventory valuation adjustment (IVA) and a capital consumption adjustment (CCAdj) were prepared for this presentation and applied to direct investment earnings. The IVA is used to convert the value of inventory withdrawals from historical cost to replacement cost; a rough estimate of the IVA was prepared based on the relation of current-cost to historical-cost inventory stocks for nonfarm corporations in the U.S. NIPA's. The CCAdj is used to convert the depreciation expenses that are deducted when earnings are computed to a consistent accounting basis and to a replacement-cost valuation; it was derived from BEA's replacement-cost estimates of direct investment plant and equipment. (6)One consequence of the relative "newness" of FDIUS is that rates of return may be reduced as the result of the amortization of goodwil that is entered on affiliates' balance sheets to reconcil the book values of recently acquired companies with their higher market values. When a company's books are revalued after an acquisition, an entry for goodwill may be made to refect any excess of market over book value that cannot be allocated to other assets, such as plant and equipment. U.S. generally accepted accounting principles, which companies are required to follow in reporting on BEA's direct investment surveys, require that the goodwill be amortized over a number of years. Because existing U.S. affiliates of foreign direct investors have made a large number of acquisitions in recent years, amortization of goodwill may significantly reduce both earnings and rates of return on FDIUS. Amortization of goodwill is probably smaller for USDIA because these investments tend to be older, because acquisitions have been fewer, and because the acquisitions that do occur are usually by the U.S. parents rather than by existing foreign affiliates, and thus any subsequent amortization appears on the books of the U.S. parents rather than on the books of the foreign affiliates.
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Publication:Survey of Current Business
Date:Aug 1, 1991
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