Rates of return on corporate investment.

• Author: Mueller, Dennis C.

28. Miller, Merton H. and Myron S. Scholes, "Dividends and Taxes." Journal of Financial Economics, December 1978, 333-64.

29. ----- and -----, "Dividends and Taxes: Some Empirical Evidence." Journal of Political Economy, December 1982, 1118-42.

30. Mueller, Dennis C., "A Theory of Conglomerate Mergers." Quarterly Journal of Economics, November 1969, 643-59. Reprinted in G. Marchildon, editor, Mergers and Acquisitions. London: Edward Elgar, 1991.

    In the last two decades productivity has lagged in the United States, markets have been lost to foreign competition, real income per capita has grown slowly. This experience has led to considerable discussion of possible causes |7~. One possible cause often mentioned is the quality of managerial investment decisions. Managers have been accused of overinvesting in obsolete technologies, of underinvesting in risky projects with long run payoffs, of undertaking unprofitable mergers, and of overall poor judgment in their investment policies |39~. This paper presents evidence on the returns on investment over the 1970-88 period for a sample of 699 large corporations that is consistent with this view.

    Although criticisms of management investment policies have focussed on the most recent two decades, evidence of low returns on investment was presented as early as 1970. Baumol, Heim, Malkiel and Quandt |2~ (hereafter BHMQ) estimated returns on reinvested cash flows by large corporations ranging from 3.0 to 4.6 percent. These were significantly less than their estimates of the returns on newly issued debt and equity, and less than the 13 to 18 percent returns corporate shareholders were able to earn on the market portfolio over the same time period |9~. Their results seemed to support the hypothesis that managers overinvested in pursuing the growth of their firm, and that the discretion to do so increased with available cash flows |24; 30; 31~.

    The BHMQ findings were soon challenged |10~ and a debate ensued with additional papers claiming either to contradict |6; 25~ or to support |3; 45; 46; 12~ the original BHMQ results.

    Given the inconclusive nature of the earlier debate and the importance of the issue, we think the topic deserves another look. A second justification for our study is that we use a methodology to calculate returns on investment that we believe is an improvement on the one used in the earlier studies. This methodology is described in the following section. In section II we present some examples to illustrate the methodology's properties. Estimates of rates of return on investment for our 699 firm sample are given in section III. Separate returns on investment are measured for different sources and uses of investment funds in section IV. Alternative interpretations of the results are discussed in section V. A brief set of conclusions are in the final section.

    1. Methodology

       BHMQ estimated rates of return on investment by regressing changes in profits over one time period onto the amounts invested in an earlier period. There are two objections one might raise to this procedure. First, the use of accounting profits data to measure economic profits has been challenged, and these criticisms cast doubt on estimates of returns on investment made from accounting profits data |8; 4~. Second, a degree of arbitrariness is introduced into the calculations through the choice of time periods over which both investment and profit changes are measured, and the lag asumed between investment and the resulting change in profits. The methodology we adopt avoids both of these difficulties.

       Following other recent studies in industrial organization,(1) we seek to avoid some of the problems inherent in the use of accounting data by using changes in the market value of the firm to estimate returns on investment. To the extent that a change in the market value of a firm today reflects the market's expectation of all future changes in profits, market value data avoid the question of the proper time interval and lag structure.

       The methodology is as follows: A firm's investment |I.sub.t~ in period t generates real cash flows |C.sub.t+j~, j = 1, |infinity~ with present value P|V.sub.t~:

       |Mathematical Expression Omitted~.

       With the same real discount rate |i.sub.t~, the investment |I.sub.t~ would have the same present value P|V.sub.t~, if it earned the return |r.sub.t~ in perpetuity.

       P|V.sub.t~ = |I.sub.t~|r.sub.t~/|i.sub.t~ (2)

       Since the firm could always increase shareholder wealth by |I.sub.t~ by using these funds to repurchase its shares or paying them as a dividend, shareholder wealth maximization requires that P|V.sub.t~ |is greater than or equal to~ |I.sub.t~, and thus that |r.sub.t~ |is greater than or equal to~ |i.sub.t~.

       The market value of the firm at the end of period t can be defined as the market value of the firm at the end of t - 1(|M.sub.t-1~), plus the present value of the investment made in t, P|V.sub.t~, minus the depreciation in the firm's total capital over the period (||Delta~.sub.t~|M.sub.t-1~) plus any error the market makes in evaluating the present value of the firm's total capital at the end of period t, ||Mu~.sub.t~.

       |M.sub.t~ |is equivalent to~ |M.sub.t-1~ + P|V.sub.t~ - ||Delta~.sub.t~|M.sub.t-1~ + ||Mu~.sub.t~ (3)

       Using (3) to replace the first right hand term in successive periods yields

       |Mathematical Expression Omitted~.

       Let us call

       |c.sub.t~ = |r.sub.t~/|i.sub.t~. (5)

       Then, c, a weighted average of the |c.sub.t+i~'s over the n + 1 periods, with the |I.sub.t+i~'s as weights becomes

       |Mathematical Expression Omitted~

       which from (4) can be rewritten as

       |Mathematical Expression Omitted~.

       In any period the market's error in evaluating |M.sub.t~ could be large. The efficient market assumption implies that E(||Mu~.sub.t~) = 0, however, and thus that |Mathematical Expression Omitted~. As n grows large, the last term in (7) becomes approximately zero.

       Recall that the objective is to evaluate the firm's return on investment relative to its cost of capital. If management is investing at a rate of return at least as great as their cost of capital, then c will be no less than one. If depreciation were zero, equation (7) implies that the weighted average c would be 1.0 if the increase in the market value of the firm over the n time periods equaled the cumulative investment over that period. If shareholders perceive the rate of return on investment to equal their own opportunity cost of not receiving those funds directly, then market value will rise by an amount equal to the investment made. The middle term on the right hand side of (7) adjusts the calculation for the depreciation in firm capital that takes place over the time interval. Some of gross investment offsets the decline in the market value of the company that would otherwise occur from the normal erosion of a firm's assets.

       The methodology encapsulated in (7) avoids the difficulties inherent in previous techniques for measuring returns. The assumption of capital market efficiency allows us to finesse all issues relating to lags and time patterns of returns, and measure investment performance by examining the relationship between current investment and changes in market value. We discuss the market efficiency question below.

       A firm's c can be calculated over any time interval. Basic balance sheet and income statement data can be used to calculate the market value of the firm in each year and the total funds used for investment over the period. Equation (7) also requires some estimate of the rate at which the entire market value of the firm depreciates in every year. A firm's market value can be broken down into the value of its separate components: its physical capital, K|K.sub.t~, any intangible capital it has as a result of past advertising, A|K.sub.t~, or R&D, R|K.sub.t~, and any goodwill capital it has, G|K.sub.t~, i.e. intangible capital that is not the result of past outlays on physical capital, advertising or R&D.

       |M.sub.t~ |is equivalent to~ K|K.sub.t~ + A|K.sub.t~ + R|K.sub.t~ + G|K.sub.t~ (8)

       Estimates of depreciation rates on plant and equipment fall over a fairly narrow range around 0.10 |16~. Estimates of depreciation on advertising generally exceed 0.10, but some scholars have come up with even lower figures |5; 1~. Depreciation on R&D is typically found to be much smaller than for advertising |14~ and is probably reasonably approximated by a 0.10 figure.(2)

       Included in goodwill capital are all of the first and second mover advantages that result in some firms earning persistently higher average returns and market values |40; 33~. In some cases (e.g., Coca Cola, Kelloggs, Kodak), these advantages become associated with company brand names and seem to last indefinitely. On average, goodwill capital probably depreciates at less than 10 percent per year.

       To calculate c's for individual companies we shall assume a constant |Delta~ of 0.10 over the 1970-88 time period. The preceding discussion suggests that this is a reasonable figure for physical and R&D capital, too low for advertising and too high for goodwill capital. In section IV we use our data to estimate both returns on investment and depreciation rates.

       Since the market value of a firm reflects the present value of the profit streams stemming from all of its assets, we wish a similarly inclusive definition of investment. We thus define investment in year t as

       |I.sub.t~ |is equivalent to~ ||Pi~.sub.t~ + |Dep.sub.t~ - |Div.sub.t~ + |Delta~|E.sub.t~ + |Delta~|D.sub.t~ + |A.sub.t~ + R|D.sub.t~, (9)

       where |Pi~ is profits after interest and taxes, Dep is depreciation, Div is common and preferred dividends, |Delta~E is changes in the market value of outstanding equity, |Delta~D is changes in debt, A is advertising, and RD is research and development outlays. The first three terms in (9) are retained cash flow. To these we add the funds raised by issuing new equity and debt. These first five terms on the right hand side of (9) yield the...