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The high cost of confrontation.

Thanks to distant relationships between shareowners and executives who run corporations, America has a cost-of-capital problem.

Any business person who has ever tried to justify a capital expenditure to senior management is familiar with the concept of the cost of capital. Typically, the most important criterion in determining which projects will make the next year's budget is their net present value or internal rate of return. Both measures are derived from discounted cash flow (DCF) models that are driven by a corporation's cost of capital. Companies regularly reject proposals that they believe would help their competitive strategy but that fail to show a return high enough to meet or exceed the company's cost of capital.

There is a growing belief in American business that we should disregard discounted cash flow techniques in managerial decision-making. Critics argue that important strategic decisions should not be based on these rigid financial formulas. But the problem is not with the analytical framework. If it is too hot outside, we cannot blame the thermometer. Our problem is that America's high cost of capital is giving us answers we do not like, because high capital cost systematically bias against investment with distant payoffs.

Understanding the economic factors that cause short-term behavior requires an analysis of the cost of capital and how it affects investment decisions and corporate strategies. The cost of capital is one of the most talked about but least understood competitiveness issues.

Like labor and raw materials, capital homes with a cost. But unlike expenditures for labor and raw materials, the cost of capital is difficult to measure and is never reported in a company's financial statements. Interest payments may be easy to monitor, but a company's cost of equity and overall cost of capital are enigmatic. Academics and business people define the cost of capital differently. Even within each community there is no consensus. In fact, virtually every study on the cost of capital uses a different method to try to quantify a company's capital costs.

What little has been written in the business press about the cost of capital is superficial and in some cases misleading. The solution to lower capital cost in America is commonly believed to be lower interest rates brought about by reducing the budget deficit and increasing personal savings. Others believe that lowering taxes is the solution to America's high capital costs. Although savings and taxes clearly influence the cost of capital, these macroeconomic factors fail to account fully for the wide disparities in international capital cost that are though to exist.

A closer analysis reveals that structural factors within our financial system also contribute to America's cost-of-capital differential. Capital now flows relatively freely across borders. But once that capital enters a country, how it is allocated and monitored influences the returns investors require. In other words, there are ways to lower America's capital cost without changing saving, taxes, or interest rates whatsoever. And each of these structural problems has a common denominator: The U.S. financial system engenders confrontational rather than cooperative relationships between capital providers and capital users.

The cost of capital has only recently been regarded as a serious competitiveness issue. During the 1970s and 1980s, U.S. business leaders frequently blamed high labor costs for their waning competitiveness. Hundreds of American companies moved production offshore to take advantage of lower wages overseas, building factories from Singapore to Ireland to produce everything from electronic component to tennis shoes.

The two countries that seem to be achieving the greatest relative growth in global market share of capital-intensive business are Japan and Germany. Not surprisingly, studies show that Japanese and German companies pay less than American businesses for the capital needed to construct a manufacturing plant, purchase an assembly robot, or build a sales force and distribution network.

Measuring the Gap

Measuring the cost of capital for nation is not an exact science. However, putting aside the complexities of real vs. nominal rates and the myriad assumptions needed to compute a company's cost of capital, there is consensus that a gap exist between the U.S. cost of capital and the capital cost of companies in Japan and Germany. Generally, studies conclude that Japanese and German capital cost are roughly half America's cost of capital. The size of this gap varies, depending on the study's completion date and its assumptions. But what matters most to a company that has to complete in global markets is the relative disparity.

These studies are supported by some convincing circumstantial evidence - the amount of capital investment being undertaken in the U.S., Japan, and Germany. Something is obviously very different in these countries when it comes to evaluating the risks and returns of capital expenditures, since far more investments appear to meet the minimum criteria in Japan and Germany than in the U.S.

Required Returns

One reason that capital cost are higher in the U.S. than in Germany and Japan is that required equity returns are greater. According to most studies, investors in the stocks of U.S. companies command a higher return than investors in the stocks of our foreign rivals. Since the U.S. companies operate with a greater percentage of equity than German and Japanese companies, this disparity is particularly alarming.

Some expert regard these studies with great skepticism because there is no universally accepted way to quantify the returns investors in stock expect in the future. The most popular technique that economist have devised to measure equity cost relies on the fact that price-earnings multiples are dramatically higher in Japan and to a lesser extent, in Germany than in the U.S. This is true even after adjusting for accounting differences. This means that for every incremental dollar a Japanese or German company earns, its stock will go up further than an American competitor's will. Looked at another way, German and Japanese companies do not have to earn as much to make their share prices rise the same amount, which allows them to price their products more aggressively.

Other methods besides using price-earnings multiples have shown similar results. Some studies look at return on equity ratios, and one study conducted by Burton Malkiel of Princeton University surveyed the expectations of stockholders, regardless of which approach is take, surprisingly similar conclusions about equity costs have been reached.

Perhaps the primary reason that equity is more expensive for U.S. companies is that shareholders in American business perceive greater risks. Because of the distant relationships between owners and the executives who run corporations, it is a harder for shareholders to monitor a company's performance and to ensure that management is looking out for their interest. This is particularly true for larger public companies in the U.S., where ownership is highly fragmented.

Lack of Information

Additionally, because owners are not actively involved with corporations directly on an ongoing basis, they lack the information to know whether management's plans and strategies make sense, which raises a degree of uncertainty.

The trade-off between management accountability and the return required investors has always been acknowledged for debt securities. If a company issues two bonds, one with no covenants and the other with restrictions on the companies behavior, to ensure that the bondholders' interests are protected and that the bondholders are kept well informed, the bond with no covenants will obviously require a higher yield.

The same principle applies to a stock. A stock that has little or no ownership rights involves greater risks, and thus requires a higher return, than a share in the same company that enables the owner to influence who sits on the board and to hold management accountable for its performance.

Given the lack of constructive dialogue and accountability between shareholders and corporate officers in the U.S., relationship between the owners and managers have drifted apart. Business executives detest fickle owners who dump their shares in the heartbeat for a slight profit, and they especially loathe the takeover artist who purchase such shares. Owners, on the other hand, are frustrated by proxy rules that inhibit collective action, and feel frozen out of the boardroom by a corporate governance system in which management handpick directors and then constructs impenetrable barriers to prevent outsiders from replacing board members.

It does not matter whether one view this void as contributing to poor corporate performance or as raising the risk of stock ownership and escalating the cost of equity. In either case, this problem affects investor time horizons.

One of the fatal mistakes business leaders make is to assume that their cost of equity does not matter unless they plan to issue new shares to finance growth. Nothing could be further from the truth. Remember that the value of a company is the sum of all future cash flows that shareholders expect to receive through dividends or stock appreciation, discounted by the return required by the shareholders, which is the cost of equity, A higher discount rate, or cost of equity, translates into a lower stock value even if expectations about a company's future prospects remain constants. That may be why Pennsylvania-based companies saw their share prices plunge when the state enacted a law severely limiting shareholder rights.

Failed to Keep Pace

Sadly, the strong performance of stocks in the U.S. in recent years has produced complacency in many quarters. But even the booming U.S. stock market of 1980s failed to keep pace with securities markets in the rest of the world. Between 1985 and 1990, when the U.S. equity markets more than doubled in value, stocks, in Japan, Germany, France, Italy, Switzerland, and United Kingdom, and virtually every other developed country outpaced American equities.

The evidence is overwhelming - America has a cost-of-capital problem. And conventional wisdom about the cost of capital is not going to solve it. Increasing savings and lowering taxes are both important to out nation's economic health. But to achieve competitive capital cost, we must address the structural factors that inflate the U.S. cost of capital.

How well informed capital providers are and how much confidence they have in the systems through which the use of their capital is monitored are important components of the cost and availability of capital. As long as our financial system promotes distant relationship between U.S. companies and their capital providers, America continue to suffer from a high cost of capital which will perpetuate the short-term behavior that is at the heart of our country's competitiveness problem.
COPYRIGHT 1992 Directors and Boards
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Chairman's Agenda: Governing for Shareholder Prosperity
Author:Jacobs, Michael T.
Publication:Directors & Boards
Date:Mar 22, 1992
Previous Article:The long and short of it.
Next Article:The buddy system.

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