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Research notes: financing plant and equipment expenditures.

With this issue, we offer a new feature that may catch on with our readers. Occasionally as a part of our research we all encounter an interesting idea that doesn't warrant a full-length article but might be of interest to other business economists. The following note is an example of what we have in mind. We welcome similar contributions from our readers.

AN INTERESTING shift has occurred in the past two decades in corporate financing of plant and equipment spending (P&E). In analyzing this shift, data on nonfinancial corporations from the flow of funds statistics of the Federal Reserve Board provide the most useful source of information.

Figure 1 presents a comparison of nonfinancial corporate P&E relative to corporate sources of funds, both internal and external, for 1970-90. External sources of funds include primarily debt and foreign direct investment in the U.S. Equity sales as a source of funds have been negative in every year since 1983. Internal sources of funds include profits after dividend payments, capital consumption allowances, foreign earnings (foreign branch profits, subsidiary profits retained abroad and remitted), and an inventory valuation adjustment plus a capital consumption adjustment to put profits on a current cost basis.

As the figure indicates, prior to 1983 P&E generally was greater than funds generated from internal sources, so that outside funding was necessary. Beginning in 1983, P&E was equal to or less than internal sources of funds.

Figure 2 provides a breakdown of internal sources of funds and compares them with P&E for the 1970-90 period. The most striking feature shown on the chart is the growth of capital consumption allowances. Since 1985, this source has accounted for more than 84 percent of P&E. In sharp contrast, undistributed profits were of diminishing importance, falling from a high of 44 percent of P&E expenditures in 1977 to 10 percent in 1989 and 4 percent in 1990. Shrinking undistributed profits reflect dividends growing faster than earnings, so that the payout ratio, which was about one-third of earnings in 1974-79, reached 74 percent in 1989 and 88 percent in 1990.

Figure 3 provides the same information on a quarterly basis for 1989 through the second quarter of 1991. In the first half of 1991, capital consumption allowances and foreign earnings provided most of the internal sources of funds; undistributed profits were minimal.

What can be said about the sources of funds for P&E in the future? External sources of funds appear limited. Foreign direct investment has shrunk and is not likely to increase significantly. Corporate borrowing may be constrained by debt-equity ratios around 75 percent and interest payments that have grown to 40 percent of operating profits plus interest. Because of the current high level of stock prices, equity financing may be encouraged; in fact, equity financing in the second quarter of 1991 was positive for the first time since the fourth quarter of 1983. However, the amount of equity financing, $11 billion at an annual rate, was small compared to P&E at a rate of $355 billion.

Turning to internal sources, undistributed profits are negligible and the growth of foreign earnings of U.S. corporations will be limited by the depreciation of the dollar and the slowing of economies abroad. The major source of funding therefore will be capital consumption allowances, which are now running about 95 percent of P&E. Because of the stable growth of these allowances, in the future P&E may exhibit considerably less volatility in business cycles than it used to -- the mild decline in the 1990-91 cycle supports this idea. [Figure 1 to 3 Omitted]
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Publication:Business Economics
Date:Jan 1, 1992
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