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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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The possibility exists that different factors have unlike weightings in the decisions of different firms at different times and unlike weightings for the same firm at different times, or that all of the many factors are of about equal significance. If this is so, generalization becomes impossible, and one may infer that it is not feasible to predict business reactions to specific tax, monetary, and other measures. A priori considerations as well as some empirical evidence suggest, however, that analysis of numerous case studies would show that the number of highly influential variables is reasonably small, that the relative weightings of variables do not change rapidly through time, and that groups of businesses with similar characteristics behave in approximately homogeneous ways in deciding upon forms of financing. Certainly, the value of valid generalizations would be so great as to warrant an effort to determine whether they exist.

Adoption of an intensive case study approach raises subsidiary questions of methodology. Specifically, how should a "microscopic" examination of financing decisions be conducted? Recorded information — published and unpublished — provides only part of the necessary data, and the investigator must also get at the more elusive information contained in the minds of business policy-makers, especially the influential factors in management's evaluation of risks.

The pertinent questions are: Why did management make this decision? What alternatives were considered? Why were the alternatives rejected? What objections were raised to the decision? What degree of support did it have? What compromises were made? For the development of really informative answers to such questions the mailed questionnaire will not suffice. The investigator must conduct personal interviews with those who participated in the decision-making process, probably of the "depth" or indirect type often utilized in psychological research. He may find it advisable to "live with" the firm for an extended period of time, to obtain an accurate view of its internal organization and personnel.

One problem of research method is the range of subject matter to be included in the proposed case studies. Should such studies embrace the entire business organization and policy, be limited to financial policy, or even be confined to the restricted set of categories of factors influencing financing forms? The interconnection of financial decisions with other aspects of business policy formation, and the probable intercorrelations of the variables that bear directly upon choices of financing forms, both strongly suggest the economy of comprehensive business case studies. In other words, the same research effort would be more productively applied to comprehensive treatment of the same sampling population- of firms than


it would be to a series of narrower analyses of different sampling populations. There is danger in "departmentalized" empirical research before the most significant factors have been identified and weighed.

–  –  –

The nature of research is such that detailed advance prescriptions of the courses to be followed often have limited value. Worthwhile problems are more likely to be suggested to the investigator as incidents to the performance of other tasks than by the deliberate preparation of elaborate blueprints. Nevertheless, the organization of strategic factors in the compiehensive classification provides a fresh foundation upon which to project investigative work. It indicates ways of delineating segments of the whole sub ject in order to direct attention to specific issues. It furnishes a schema.

for assembling evidence prior to consultation with business policy-makers, and for developing interview guides, questionnaires, and other research tools, although it may be found that the most efficient procedure is to collect the information basic to the study of all areas simultaneously.

The following research areas are suggestive of the possibilities, rather

than exhaustive of the field:

Influential Factors in Internal vs. External Financing

An intensive investigation might be made of factors that govern managerial decisions to finance business expansion internally by retention of profits rather than externally by issuance of debt or equity contracts. If, as has been frequently suggested (vide the undistributed profits tax of the 193 0's), the comparatively large role played by internal financing in the.

expansion of American enterprises is undesirable, then clearly the strength of factors conducive to internal financing should be reduced and the strength of factors leading managements to finance externally should be increased. Public policies having the desired effect might well be called for. Taxes on undistributed profits may merely inhibit business investment rather than change the form of financing it. We must first know the influential factors and their respective weights.

Many unsettled questions would fall within the ambit of this study.

For example, does new investment financed by sale of new securities on the open market pass more searching and rigorous tests of economic value than does investment financed by earnings held in the business? Or is investment internally financed undertaken response to the desire of management for personal or "monopoly" power, with little regard for


its prospective profitability?35 Another way of stating the question is to ask whether the criteria by which business managements typically reach decisions to finance new investment internally are significantly different from those determining decisions to finance it externally.

An experimental exploration of the latter issue was made by the writers through the method of personal interrogations, by a depth-interview technique, of the policy-making executives of a small sample of nonfinancial business corporations. While so limited a study could not support any lasting generalizations, the preliminary findings tend to indicate a negative answer to the question asked above.36 That is, decisions to expand assets were based upon the fact, or expectation, of profitable use of additional assets, and not because surplus funds from profits were available. Most of the firms would not have expanded physical assets more extensively, if retained earnings had been larger.

Tests of profitability of new investment were typically the same, irrespective of the form of financing. These tentative findings at least indicate the need for more searching exploration of the matter. The results of the experimental study suggest the utility of the method employed.

Influential Factors in Debt vs. Equity Financing A companion study might be made of the factors that govern managerial D. Edwards has argued in his Maintaining Competition (New York: McGraw-Hill, 1949), pp. 145-47, that because large firms may expand by retaining profits, they are not obliged to compete for funds in the capital markets, and "no independent discretion is exercised in deciding whether the corporation shall be enlarged. Thus a concern that has enough bargaining power to obtain large profits enjoys a preferential status in increasing its size and bargaining power still further."

He calls for an undistributed profits tax, with rate graduated upward in proportion to the absolute amount of earnings retained, as a device "to make sure that there is no continuous accretion of power to a few managements by virtue of their mere determination and opportunity to enhance their power."

A. S. Dewing has emphasized the role of managerial ambition in the internal

financing of business expansion. Cf. Financial Policy of Corporations (New York:

Ronald Press, 4th ed., 1941), p. 854.

To assure that a wide range of alternative forms of financing were available, and that the problem of financing expansion had recently been confronted by the management, twelve firms were selected at random from among manufacturing and distributing firms which had headquarters in the Los Angeles area and met the following criteria: (a) net profits were earned during each of the last three years; (b) at least 50% of profits had been retained in the business; (c) material expansion of assets and operations had occurred within the past three years; (d) size was over 500 employees and over $5 million of total assets; (e) securities were publicly distributed; (f) external forms of financing had been utilized in the past. The assistance of Mr. Benjamin Z. Katz, who conducted the field interviews, is acknowledged.


decisions to finance business expansion, or to refinance a stable total of assets, by means of ownership funds rather than by borrowed funds. In this context, retention of profits becomes, of course, a form of equity financing. What is the rationale of the determination, by managers of enterprises as well as by suppliers of funds, of particular proportions of debt and equity claims in the enterprise's structure of liabilities?

It is a plausible hypothesis that the desire to minimize the exposure to insolvency carries a heavy weighting in the mind of business management, and causes management to pay a heavy premium for equity funds over and above the cost of credit. But is this hypothesis borne out by the facts?

Is there a high degree of correlation between the actual cyclical fluctuations of profits, and the proportion, of total liabilities taking an equity form? How do managements attempt to evaluate the degree of risk attached to fixed commitments against future earning power, and to calculate the premium paid for equity financing?

Because interest is an expense deductible in computing corporate income subject to tax, while dividends paid on equity securities are not deductible, the present tax structure provides a strong inducement to debt financing. What would probably happen if this inducement were removed?

Are there other factors than exposure to risk of insolvency that account for the prevalent preference of American business management for ownership funds? If managements held expectations of general business stability rather than their present set of expectations, would a strong shift' to debt financing occur?37 Again, it appears necessary to bring all of the influential factors bearing upon this primary type of financial decision into the equation, and to determine their relative weights in the decision-making process. A solution to this problem would have obvious bearings upon business and public policy. Managements would be enabled to choose proportions of debt to equity funds that would more fully maximize the capitalized net income of the firm, for whatever schedule of risks they desired to carry. Legislators and public regulatory bodies would be able to predict more accurately the In this connection, it is interesting to speculate upon the question whether there has been a secular shift from debt to equity financing during the past century, concurrent with rising entrepreneurial expectations of future instability. Studies in the Financial Research Program of the National Bureau of Economic Research show that since about 1900 there has been no marked change in the ratio of equity to credit employed in nonfinancial businesses. On the other hand, the heavy emphasis

•given to the significance of the borrowing undertaken by businessmen by the classical economists suggests that debt financing may have occupied relatively, a more important position in the structure of business liabilities during the nineteenth century than it has in the twentieth.


responses of enterprises to public laws and regulations. Among other things, the urgency of the need for channeling more of the nation's savings into investment in an equity form could be measured.

If equity financing is more desirable, as many have argued, because it makes the individual firm less likely to behave in ways that reinforce and cumulate a general business boom or recession, a knowledge of the influential factors bearing upon decisions to finance with owners' rather than creditors' funds should suggest means of modifying these factors so as to bring about the desired pattern of financing.

Influential Factors in Short-Term vs. Long-Term Debt Financing

In the same series as the preceding studies, and logically following them, is a proposed study of factors governing managerial decisions to finance the indebtedness of the enterprise on a short-term rather than a long-term basis. Many unsettled issues might be examined in this investigation.

Why does trade credit — a form of short-term indebtedness — occupy the high position among liabilities that business balance sheet analysis reveals? To what extent are short-term and long-term debt considered to be substitutable, and to what extent complementary? Is there a high degree of correlation between the proportion of the total assets of an enterprise that are short-term in nature and the proportion of its total liabilities that are also of short term? To what extent are the loans of commercial banks and other lenders which are formally written as short-term credits actually treated and regarded by business managements as long-term funds? Would managements make much heavier use of long-term credit, 1) if it were more generally available and if there were a smaller differential between its cost and the cost of short-term credit, or 2) if long-term rates were lower than short-term rates as they have been at times in the past?

The implications of the findings of such a study for public policy are obvious and important. If the public interest is, in fact, served by increasing the proportion of outstanding business credit that is long-term in character, then the factors influencing decisions to utilize this type of credit need 'to be identified and strengthened.

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