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«Volume Title: Conference on Research in Business Finance Volume Author/Editor: Universities-National Bureau Volume Publisher: NBER Volume ISBN: ...»

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In many closely controlled corporations, the dilution of the asset value of stock is a critical factor. An original owner-management group often thinks in terms of its own investment per share, including retained earnings, and categorically refuses to sell stock at less than that amount, regardless of the effect on earnings. When stock of established companies is selling at substantial discounts from asset values, the stock of closely controlled companies at prices equivalent to book value as a minimum, with all its disadvantages as regards liquidity, is not likely to appeal to investors unless the prospects for capital gains are unusually high.

One brief digression may be appropriate in view of the several remarks made earlier on the effects of taxation on financial policy. The advantage given to debt financing through the deductibility of interest is widely recognized as a tax influence. I have already noted that relative costs of different methods appear to be less important than the absolute cost of equity financing which may be deemed to be prohibitive.

At the present time, taxation is encouraging the use of high debt and preferred stock ratios in newly incorporated closely controlled companies because of the advantage of retiring senior securities, in effect from earnings, but in a manner which constitutes a return of capital rather than income, with an increase in the common stock equity and an eventual capital gain. The senior securities are usually held pro rata, by the same group which owns the common stock. If the common stock is purchased with independent funds by children or grandchildren of those providing most of the capital, a saving in estate taxes is often secured by having the build-up in equity interest achieved through the retirement of senior securities go to the benefit of younger generations. Capital structures of this sort may over the years very considerably influence certain of our statistics relative to smaller companies. But since the senior obligations are in identical, or at least in friendly hands, the rigidities and vulnerability which are usually feared as a result of thin common stock ratios will not be At various times during the discussion here, questions have been raised as to the differences, if any, between the use of retained earnings and funds from new security issues. I believe there are very great differences, both in logic and in fact, in this area. In closely controlled corporations the stockholders think of their proportionate shares in corporate


earnings as their own; but subject to taxation if the funds are paid to them in dividends. The higher the individual income tax to which they are subject, the less capital, and hence the less income, they can receive if they use the funds individually. Thus the inducement to have earnings accumulate is strong. A relatively low rate of return through a corporate use, therefore, can be more attractive than a higher rate from personal use. In more than a few situations some ingenuity has been exercised to find a use that will remove the danger of a Section 102 penalty tax on unreasonable accumulations. The prospectivô rate of return is likely to be secondary; at least, the rate of return considered satisfactory from retained earnings under these conditions is likely to be much lower than the rate necessary to justify additional stock financing with its dangers of dilution.

In widely owned companies, the same logic exists, but the diverse individual tax status of its stockholders prevents a direct calculation of the relative attractiveness of corporate retention and use as compared to distribution and personal use of funds. In some cases, but by no means in all, and perhaps not even in a majority, the reduction of dividends by individual income taxes does seem to be at least implicit in the thinking of directors in voting dividends. More commonly important, perhaps, is the simple fact that any return on retained earnings increases per share earnings. After traditional — or seen from some other standpoint as reasonable — dividends are paid, remaining funds are available for use without a calculation of the opportunity cost based on the gross and net returns available to stockholders if more funds were distributed among them. In this respect and to this extent the concept of a widely owned corporation as a separate entity appears to be rather broadly held.

In the past several years a somewhat peculiar set of conditions in various industries has made conspicuous the difference between the use of funds available from operations and those acquired from new financing.

With stock selling at less than book value, *hich in turn is much less than replacement cost, new companies with high-cost assets could not be established and financed to yield competitive rates of return. Nor could established companies do new equity financing to secure funds for new separate units substantially similar to old ones without diluting both the earnings and assets per share. Adequate returns for new companies or on new plants considered separately would require price levels which would give very high profits for established companies or plants acquired at lower price levels. But though a new company could not be successful, or even a new plant, if financed by stock issued for the purpose, established companies can and do successfully use funds becoming available through operations and retained earnings to replace low-cost with high-cost equipment and to


build additional capacity including separate new plants. As high-priced capacity bulks larger as part of the total, it is reflected in depreciation charges and, in the long run, presumably in prices, unless offset by greater productivity in the new capacity. Established companies can show appreciable increases in per share earnings from the use of retained earnings, and in the process of maintaining their competitive position may justifiably use funds in ways that would not give reasonable returns for newly established companies. This condition is one of the many lags that develop in, and following, an inflationary period.

These remarks are intended merely to stress the importance of systematic inquiry on actual financial behavior, which itself may be quite nonsystematic. In conclusion, I wish to emphasize what appears to me to be the importance of recognizing that financial decisions are also human decisions and as such are subject to conflicting influences many of which may be rational though nonlogical. We have come to recognize in labot relations that our traditional concept of the economic man was a gross oversimplification. It is time to recognize that in management problems even pecuniary motivation is highly complex, and that nonpecuniary forces are also relevant and may be dominant.

Comment:MRS. RUTH P. MACK, National Bureau of Economic Research

The classification of factors used in Messrs. Jacoby and Weston's study seems to me to be too long and too complicated. After all, everything influences the decision to buy equipment, just as everything — personality, circumstance and society — influences the patterns of consumption. What we need to know is which of myriad influences are the important ones and, perhaps, important under what conditions. A classification of the sort used in this study does not, on the one hand, provide the requisite system of weights to attach to the answers to such questions as are asked;

nor, on the other hand — and this is the point I want to elaborate for a moment — does it insure against the failure to ask important questions.

The selection of items in this classification is based in effect on preknowledge of the subject under investigation — pre-knowledge which is chiefly derived from venerable theoretical formulations. Such questions may be the important ones to ask if we are-interested in learning how business men ought to act. If, on the other hand, we are interested in how they do act, or in the direction in which government ought to endeavor to


influence their action, it is, I think, ill advised to start with a set of questions of this sort. The thinking of the people who are interviewed is forced into a Procrustean bed. Whether the bed fits or whether amputation was required, one cannot tell, since no one has taken independent measurements of their figures.

I do not think it safe to short-circuit what ought to be the first step in an investigation of this sort: learning what questions ought to be asked.

And I know of no better way to learn this than to ask — to talk informally with people who participate in investment and financing decisions to learn what questions they put to themselves. Interviews of this sort cannot be assigned to a number of students, however gifted. They must be done by one person — the man who plans the study and whose judgment can cumulatively ripen. His judgments can later be tested, amplified and corrected by questionnaires, other sorts of detailed surveys, study of time series, or econometrics.

There have been suggestions in our discussions that there is little use in talking with businessmen: one man says one thing and another something dramatically different. This seems to be put forward as proof that businessmen do not really know much about their motives and, by implication perhaps, that economists do. It reminds me a bit of the quip about how the theatre critic is obviously a smarter man than the author, for it certainly takes a smarter man to find a mistake than it does to make one.

Actually, the conflicting testimony may not even be a mistake. Sometimes what appears to be a contradiction is really just another way of looking at substantially the same thing; sometimes it represents a real contradiction, but one of importance to the understanding of the investment process.

Let me illustrate from a study of investment in inventories, rather than in durable goods, on which I am working.

Some businessmen have said on the one hand that they increase their holdings of raw (actually semi-processed) materials when they believe prices will rise; others have said that they increase such holdings when they suspect they will not be able to get as much as they need if they wait until close to the time when production must get under way. This sounds like conflicting testimony but it really is simply two ways of thinking about the same thing: rising prices and lengthening delivery schedules occur together. The apparent conflict poinis toward a very important question

that has not, so far as I know, been asked in the study of inventory policy:

how do delivery periods vary from time to time and what effect does this fluctuation have on buying?

An example of a case in which apparently contradictory statements are actually found to conflict can be drawn from inventory policy in an


industry that processes raw materials. Some men have said that they buy somewhat further ahead than they otherwise would when they expect that prices will rise; others claim that they do so when they can sell their finished product currently at prices that afford a better than usual margin over the current raw materials cost. Now margins and prices do not move together, and therefore the two statements do not amount to the same thing. Investigation suggests that both statements are valid, though prices become more important when sizable price change is in process, whereas margins are watched more or less all the time. There are many interesting implications of the distinction.

Incidentally, to investigate investment in inventories by these raw material processors, I 'have found, one really cannot ask about inventories at all. Because of the important reservoir function of stock in these enterprises, the term "policy" or "intentions" with respect to inventories applies in only a very limited sense. For the most part the decisions that determine the size of inventories focus on Other management problems and only secondarily result in a certain behavior of stockpiles. The questions that seem to me important to ask are four: How is customer demand experienced and what impact does it have on management decisions? What effect do changes in the supply of raw materials have on buying? How is operating efficiency conceived and enforced? How is pecuniary efficiency in selling and purchase prices conceived and achieved?

I have selected these situations from the inventory investment field, but they might have been selected from the field of investment in durable goods in which much more work has been done. Take as a single example the conception of the pay-off period. The importance of this idea in business investment decisions is now fairly well recognized and it has manifold implications. Yet it has not really penetrated the field of econometrics or many other individual studies of equipment purchasing.

What I am trying to suggest is something very simple. A fundamental first step in the study of investment policy is the determination of the important questions to ask. Decision-making is a very subtle process that can be seriously distorted by an improper turn or emphasis of a thought.

The fact that it may be possible to translate a business decision into language conforming to Marshallian tenets does not mean that it can be safely studied in these terms to start with. Economists can only learn what to ask if they seriously try to understand how businessmen think about those problems whose solution ends in the purchase of investment goods.

If this first step is omitted, and it is only a first step, we are all too likely to end by crossing t's and dotting i's in nonsense sentences.


Comment:WALTER HOADLEY, Armstrong Cork Company

Throughout a large part of the discussion runs the basic question: what reasoning underlies the economic, and specifically the financial, policies of business managements? Examination of the various questionnaireinterview techniques to ascertain how business decisions are reached gives promise of some useful results, but it also clearly indicates that many short.comings in method remain.

A wide gap continues to exist between the terminology and thinking of business executives on the one hand, and of economists generally, on the other, regarding almost any subject of mutual interest. Here is a real barrier to economic research and economic understanding, and one which seems to be retarding business financial research. There is an obvious need to narrow this gap in terminology and understanding to the benefit of all concerned. Until these differences are reduced, questionnaire-interview techniques cannot be too effective.

In actual business operations, one is impressed by the great variety of products, prices, and competitive market conditions, in contrast to the necessarily limited number of variables normally found in most theoretical involving economic literature. Questions addressed to business such terms as "product," "industry," "price" and "policy" — not to mention "marginal, efficiency" or "capital formation" — commonly bring a quizzical response. Such words or expressions typically have no clear-cut meaning to businessmen. The latter ordinarily 1) deal in many products and variations of products, rather than one or two; 2) see no easy way to classify their firm into a homogeneous industry group because of their complex product-mix; and 3) think of policy-making primarily in terms of many small individual decisions rather than a few sweeping ones, as is often supposed. Part of the confusion arises because these executives are too close to the day-to-day affairs of their company to have a broader perspective. Equally evident is the failure of many economists to appreciate fully the complexity of business operations and decisions, the importance of non-price motivations, and the importance of developments external to the concern, including government actions, upon company policies and procedures.

In the face of unsettled business conditions, there seems to be a gradual trend for more business organizations to employ economists at a policymaking level. Two possible useful results for economic research may evolve from this tendency. These business economists may help 1) to provide in at least general terms — but far more specifically than currently


the kind of information needed to answer research inquiries available about business decision-making, as well as frame questions for detailed studies and interviews, and 2) to obtain the cooperation of many topranking executives in furthering business economic research of economists not attached to private firms. An increasing number of corporations are inviting university professors to spend extended periods of time in their offices and plants to get firsthand knowledge of actual operations and policies. This comparatively recent development seems to be another worthwhile step tbward improving understanding between business managements and academic economists, and indicates that cooperation of certain business executives in financial and other economic research programs very likely will be forthcoming.

Later conferences might well begin with a carefully chosen panel of business executives who would tell as much as possible about how financial and other policies are determined, and also be• available for questions on specific points. The natural hesitation of many business executives to expose themselves to the detailed scrutiny of professional economists probably could be reduced by inviting some of the speakers through, or in cooperation with, the business economists in their particular firms. Also the business economists may be able to fill in gaps of information not otherwise covered.

Certainly with all the unresolved questions remaining in business finance and economics generally, every effort should be made to use the most direct means of research available. The methods suggested here should help fill in some of the needed information about business decisionmaking. Obviously a careful study of all findings regardless of method will be necessary to insure valid conclusions.

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