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Relationship between market power, leverage and systematic risk : the Canadian evidence Chan, Adrian Seng Giap 1977-12-31

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RELATIONSHIP  BETWEEN  SYSTEMATIC  MARKET  RISK:  THE  POWER, L E V E R A G E  CANADIAN  AND  EVIDENCE  by ADRIAN B.A.,  A THESIS THE  SENG  University  SUBMITTED  CHAN  of A l b e r t a ,  IN P A R T I A L  REQUIREMENTS  MASTER. OF  GIAP  FOR  BUSINESS  THE  1975  FULFILLMENT-OF DEGREE  OF  ADMINISTRATION  in THE  FACULTY  OF  BUSINESS  We  accept to  THE  this  COMMERCE  AND  ADMINISTRATION  thesis  the required  UNIVERSITY  OF  as  conforming  standard  BRITISH  COLUMBIA  A p r i l , 1977  ADRIAN  SENG  GIAP  CHAN,  1977  In p r e s e n t i n g t h i s  thesis  an advanced degree at the I  fulfilment of  for  the r e q u i r e m e n t s  the U n i v e r s i t y of B r i t i s h C o l u m b i a ,  L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e  f u r t h e r agree  that permission  for  I agree  r e f e r e n c e and  f o r e x t e n s i v e copying o f  this  representatives.  this  thesis  It  f o r f i n a n c i a l gain s h a l l  The  University of B r i t i s h  2075  Wesbrook  Vancouver, V6T  Date  Commerce  Place  Canada  1W5  April,  1977  that  thesis or  i s understood that c o p y i n g o r p u b l i c a t i o n not be allowed without my  written permission.  Department of  for  study.  s c h o l a r l y purposes may be granted by the Head o f my Department  by h i s of  in p a r t i a l  & Business Columbia  Administration  ABSTRACT A ship  number  between  of  market  theory  demonstrates  prices  and  resurce  the  of  no  and  firm  these  output  leverage,  explanation  the  of  for  firms  higher  greater  find  that  demonstrated  positive  r e l a t i o n -  p r o f i t a b i l i t y .  high  and  a  profits  Economic  imply  consequently  higher  i n e f f i c i e n t  a l l o c a t i o n .  a b i l i t y  fore  power  r e s t r i c t e d  Financial native  studies  empirical  observed  firms  increase  risk  leverage. to  other  because  low  cost  support between  less  it  This  a  study  the  possible  power  debt  could  the  also  then  a  be  fixed  increase  and  there-  the  result  attempted  f i n a n c i a l firms.  a l t e r -  may  capital  hypothesis  powerful  represents  be  Market  p r o f i t a b i l i t y  difference and  could  p r o f i t s .  support  evidence  significant  powerful  these  to  f i n a n c i a l  however,  that  to  there  structures Leverage  obligation  is  of  should to  the  f irm. The analysis sample  method  of  of  of  variance  Canadian  This  study  v i z .  CAPM  study and  a  regression  industry  represents to  employed  a  problem  during  f i r s t in  is  the  application  analysis the  attempt  industrial  to  period to  a  cross-sectional  1962  apply  a  of  to  1969.  finance  organization,  model  viz.concen-  tration. The lower  debt  results than  hypothesis.  As  lower  The  risk  risk. and  a  indicate  other a  less  result firm  of  with  conservative  that  powerful  powerful  firms,  firms thus  have  rejecting  lower  debt,  powerful  market  power  apparently  capital  structure.  r e l a t i v e l y  firms  the  incur  prefer  low  TABLE  OF  CONTENTS Page  LIST  OF  TABLES  iv  LIST  OF  ILLUSTRATIONS  v  ACKNOWLEDGEMENTS  vi  CHAPTER I.  INTRODUCTION A. B. C.  II.  III.  REVIEW  Statement of Purpose Background of Study Methodology  OF  THE  LITERATURE  19  A. B.  F i r m S i z e and P r o f i t a b i l i t y Market C o n c e n t r a t i o n and P r o f i t a b i l i t y  C. D.  Entry Barriers Summary  FINANCIAL  and  P r o f i t a b i l i t y  LEVERAGE  The  B. C.  Cost of Capital Financial Leverage and t h e C o s t of Capital Why 1 0 0 % D e b t F i n a n c i n g M a y B e a Disadvantage C o r p o r a t e Debt Capacity  E. F.  Concept  34  A.  D.  IV.  1  of  Financial  Leverage  Summary  SYSTEMATIC  RISK  A. B. C. D.  The The E f f i Syst  E. F.  Systematic Summary  '5 6  Concept of Risk Measurement of Risk c i e n t Portfolios and D i v e r s i f i c a t i o n ematic and U n s y s t e m a t i c Risks Risk  i  and  i  Return  Page V.  VI.  VII.  METHODS  AND  RESULTS...-.-  A.  The  B. C.  Methods of Analysis Empirical Results  D.  Corporate  METHODS  73  Data  AND  Debt  Capacity  RESULTS  89  A.  Evidence  Concerning  Market  B.  Return Evidence  Concerning  Risk  SUMMARY  AND  Power  and  and  Return  CONCLUSIONS  97  APPENDIX  A  100-  APPENDIX  B  1  APPENDIX  C  104  APPENDIX  D  1° ~  APPENDIX  E  1°-  0  2  6  BIBLIOGRAPHY  1  i i i  1  8  0  LIST  OF  TABLES  Table  Page  1.  A  Survey  2.  Mean  of  Common  1962 1969, T  3.  Mean  Common  1962-1969, 4.  Studies Equity  on  Ratios  C l a s s i f i e d Equity  Welfare  by  Ratios  C l a s s i f i e d  by  for  Losses 21  Average for  21  Industry  Results of the Regression of the Fixed Charges to T o t a l Assets by  9  Industries, Asset  Size  81  Industries, Concentration.  82  Percentage of the Leading  Four F i r m s on t h e P e r c e n t a g e o f I n d u s t r y Sales b y t h e L e a d i n g F o u r F i r m s f o r 21 Industries For 5.  the  Average  Average  of  EBIT/TA  and  Industries, Asset Size. 6.  7.  8.  9.  the  Years  Average  1962-1969,  1962-1969. EBIT/IE  C l a s s i f i e d  by  for  82 21  Average 87  Average,EBIT/TA and Average EBIT/IE f o r 21 Industries, 1 9 6 2 - 1 9 6 9 , C l a s s i f i e d by Industry Concentration.  87  Average Net I n c o m e / S t o c k h o l d e r s ' E q u i t y f o r 21 Industries, 1962-1969, C l a s s i f i e d by Industry Concentration.  90  Results of the Regression of the Monthly Group Mean R e t u r n on t h e TSE I n d u s t r i a l Index Over the P e r i o d 1962 t h r o u g h 1 9 6 9 .  94  Mean E q u i t y R a t i o s and Mean P r o f i t a b i l i t y Ratios o f t h e T o p - F o u r a n d t h e F r i n g e F i r m s f o r 21 Industries, 1 9 6 2 - 1 9 6 9 , C l a s s i f i e d by Industry Concentration.  96  i v  TABLE  OF  ILLUSTRATIONS  Figure  Page  1.  Deadweight  Burden  without  2.  Deadweight  Burden  with  3.  Traditional  4.  Modigliani-Miller  5.  Revised  6.  Attainable  X-Inefficiency  X-Inefficiency  View  7 42  View  Modigliani-Miller E-V  6  49 View  Combinations  v  50 64  ACKNOWLEDGMENTS  The all  those  author  who  particular•to John the  Murray  advice  h i s appreciation to  methodology.  and g u i d a n c e .  Carl  f o rtheir Sarndal  Finally,  i n preparation  of this  L u s z t i g , Eduardo  Centre  To P r o f e s s o r  assistance  t o extend  Professors"Peter  U n i v e r s i t y Computing  statistical  like  assisted i n the preparation  f o rtheir  programming.  her  would  t o my  of the  vi  thesis.  In  S c h w a r t z , and  To t h e S t a f f o f assistance  i n a i d of  f o rh i s advice  on  typist,.Colleen  manuscript.  for  1  CHAPTER  I  INTRODUCTION  A.  Statement  The to  support  of  Purpose  purpose  or  of  refute  this  the  study  is  following  to  n u l l  consider  evidence  hypothesis  and  its  alternative.  H  ,  Null  Hypothesis:  difference of  firms  with  between  with  less  the  great  market  l> Alternativ significant di structures of those with les  There  is  no  f i n a n c i a l  market  significant structures  power  and  those  power.  e Hypothesis: There is a f f e r e n c e between the f i n a n c i a l firms with great market power and s market power.  H  ( B.  Background  The is  the  wants.  power  and  deems and  basic  public  policy  of  desirable:  and  the  confronting  resources  Canadian governs  among  market  this  which  attainment  of  the  society  competing  forces,  economic  objectives  any  society  e f f i c i e n t attainment  market  a l l o c a t i o n . as  a  whole  production of  reasonable  p r o f i t s .  and  392-416.  production  productive  ^Harvey X - E f f i c i e n c y " , pp.  the  problem  minimization,  E f f i c i e n t efficiency  scarce  policy  pursues  cost  Study  economic  Within  thereby  prices  the  allocation  human  Public  of  two  aspects:  efficiency."'"  Leibenstein,  American  has  At  "Allocative  Economic  Review,  any  a l l o c a t i v e moment  Efficiency 56  (June  in  vs.  1966),  2  time,  society  input  factors,  i v i t y . these sure  possesses each  Allocative limited  minimum  with  input  of  in  the  efficiency  which  means  an  has  Production  dual  firm  ient  measures  tive  technique  given  w i l l  of  the  least  put  goods.  Allocative valued  of  requires capable iency inputs  also into  productive  and  product-  u t i l i z a t i o n combination  social  of to  output  i n -  at  then  implies  firm  w i l l to  efficiency  managerial  to, i n s u r e  the  highest In  short,  transformation  the  produce also  means  of  inputs  i n d i v i s u f f i c -  and  produc-  process  possible  productive  level  an  process  motivation  output  cost  given  that  productive  of  e f f i c i e n c y  lowest  any  productive  the  value  Productive  select  control,  that  productive  does  from  e f f i c i e n c y  into  a  means  completed  out-  ' d e f i n i t i o n , efficiency that  to  e f f i c i e n c y  demands  society's  producing.  firms of  that  components.  within  inputs.  output  capable  of  cost  the  valued  necessary  employ  the  cost  By  inputs  of  yield  set  optimum  individual  of  fact  means  precisely  two  of  in  stock  associated  efficiency  combination output.  limited  costs.  Allocative  that  an  a  e f f i c i e n c y  inputs  production  only  producing requires finished  the a  limited  the  least  given least  output.  cost  production  Productive  use  is  output,  Any  of  input  the  by  combination and  highest  resources  e f f i c i e n c y  cost  cost  minimization.  are  d e f i n i t i o n of  inputs  productive  e f f i c -  transformation conclusions  of  those  concerning  3  the  relative  implies  e f f i c i e n c y  conclusions Output  a l l  costs,  risk. only  this  society  prices  the  a  long  reasonable  and  benefits to  in  not  of  society  a  their  s u f f i c i e n t  the  the  of  producer to  producer  firms  of  cover  compensate  should holds  producers  should  receive  benefits  d i v e r s i f i c a t i o n  for  receive  policy  The  costs.  to  Public  production. the  group  minimization  p r o f i t run,  from  or  allow  p r o f i t .  e f f i c i e n t  firm  should  individual  result  given  concerning  including  But  of  that the  which  effects  accrue  of  collusion. Economic kets  better  theory  achieve  demonstrates  these  s o c i a l l y  that  competitive  desirable  public  mar-  policy  2 objectives and  than  monopolistic  participant capable forms  of  that  trasted, the  monopolistic  the  least  producing  a  desired  input  the  price,  of the  output  into  output  minimum  and  that  each  less  resource  and  models  transwhen  demonstrate  determine  charges and  flow  con-  monopoly.  more  price.  p r o f i t s ,  to  inputs  But  allocation.  inputs  of  cost.  quantity  prices  market  and  to  and  competitive  output  with  a b i l i t y  output  causes  of  associated  produces  of  the  monopolistic  monopolist  higher  Both  combination  l e v e l  at  entry  determined  assume  cost  r e s t r i c t e d  i n e f f e c t i v e  r e s t r i c t i o n  and  i n e f f i c i e n c y  generates  and  output  competitive  competitively monopoly  models  selects  allocative  Because  economic  markets.  output than Thus,  restricted The  into  monopolist's other  less  2 C.E. I l l i n o i s :  Ferguson,  Richard  D.  Microeconomic  Irwin,  Inc.,  Theory,  1966),  pp.  (Homewood, 192-219.  4  optimal nation  uses, of  r e a l i t y ,  elements  tion  leads  control  the  basis  for  the  c l a s s i c a l  condem-  monopoly.  In ing  forming  of  to  the  monopolist,  individual  competition  the  belief  major than  and  that  variables other  which  control  their  power  defined  as  group  of  world  more  monopoly.  some  of  markets  firms  their  "the  a b i l i t y  participants  to  are  said  a  market  of  influence  to  observa-  better as  firms.  are  vary-  Careful  existence,  competitive  environment  contain  able  to  could  ae  These  firms  possess  market  participant  or  price,  quantity 3  and  the  nature  is  to  understanding  markets  and A  between  a  the  power an  then  of  nebulous  the  of  proxies  and  ease  of  entry,  reviewed  in  Chapter  this  higher  higher  implies  the  for  or  rates  prices,  firms  have  more  firm  II,  the  concept, of  precisely  power  such  the  over  time  r e s t r i c t e d  is  more  number This  greater  p r o f i t a b i l i t y ,  and  and  of  in  the  easily sellers  power  existence because  consequently  i n e f f i c i e n c y .  3 (New  W.G. S h e p h e r d , M a r k e t Power and York, New Y o r k : Random H o u s e , Inc.,  them.  l i t e r a t u r e ,  market  condemned  output  important  relationship  certain as  Market  economic  participate  p r o f i t a b i l i t y . that  and  modern  that  examined  concludes of  market-place."  pervasive  the  market  and  in  performance  of  p r o f i t a b i l i t y  higher  a l l o c a t i v e  yet  studies  power,  measured  generates  of  conduct  number market  product  Economic Welfare, 1970), p.11.  of it  Because powerful  firms a  of  which  doing  so  only  value  of  society's  could  less  optimal  higher  satisfy  kind.  produced,  from  its  output  sellers  are  few,  covered  quickly,  tive  to  do  tain  prices  mutual  so.  by  at  of  each  conditions, a  level  imize  of  with  firm  prices  industry of  behavioral  assumptions  this  outcome  cuts  result each  any  and  of  the  firm  w i l l  purely  no  trust  firm  p r o f i t  share.  i . e . ,  the  conditions produce  and  or  outputs monopoly  disan  incen-  to  main-  recognition under the  accept-  these  w i l l  produce  that  max-  solution.  alternative  results  competitive  be  Under  maximization of  safe, If  others  effect  market  play  has  greatest  costs,  i n f l i c t  high.  This  i d e n t i c a l  can  to  w i l l  the  is  r e t a l i a t i o n  levels.  distribution  these  prices  prices  that  may  its  p r o f i t s ,  Relaxation  each  choose  its  entrants.  participants few,  i n -  these  market  may  fixed  a  new  total  other  prevent  s e l l e r  sellers,  and  by  produce  each  reaches  a  now  expect  fact,  of  of  and  super-competitive  few  stock  its  others  the  by  than  the  that  and  of  the  are  and  excess  Hence  market  sellers  firm  individual  joint  of  of  demand.  barriers  away  r e s t r i c t e d  dependence  conditions ance  If  upon  any  In  bid  in  permit,  inputs  entry  number  Accordingly,  keeping  of  And  apparent. harm  since  being  of  lower  managements  prices  would  r e s t r i c t e d is  the  output  market  output  role  i d e n t i f i a b l e " in  a  outputs.  profits  i n t u i t i v e l y  set  competitive  have  The  b a r r i e r s ,  presumably  those  puts  entry  one;  ranging  between  6  Divergences would as  result  a  basis  Monopoly put  and  for  power charge  result,  the As  a  society  consumer's long  run  as  a  a  Such  welfare  grants  producer  a b i l i t y  the above is  of  the  able  the  place.  to  marginal  is  a  "deadweight  welfare  loss  r e s t r i c t i o n  of  is  output  due  loss and  the  deadweight  burden  imposed  on  whole.  FIGURE  1  DEADWEIGHT BURDEN WITHOUT X - I N E F F I C I E N C Y  LRATC  Qm Where P P  m  = Monopoly  price,  c  = Competitive price,  % Q  m  = Monopoly  °output,  Qc = C o m p e t i t i v e  a  output  to imposed of  price  cost.  shows  As  out-  p r o f i t s .  burden" the  serve  r e s t r i c t cost.  i n e f f i c i e n c y  This  to  run  market  allocative  whole.  to  long  resources can  super-normal  there  due  the  the  of  losses  earn  output,  marginal  as  losses.  allocation  in  surplus  1  competition  intervention  price  of  the  government  result  Figure society  welfare  producer  r e s t r i c t i o n on  in  from  T Y  above  7  PcPmAB  In  Figure  is  the  welfare the  loss  extent  competitive  of  the  the  amount  the  area  of  depends  of  The  1,  ABC  excess  upon  the  is  the  profits. price  r e s t r i c t i o n  deadweight  of  The  amount  e l a s t i c i t y  output  and  burden  of  of  social  demand  price  and  and  above  the  level. presence  deadweight  of  X - i n e f f i c i e n c y  burden  of  monopoly  FIGURE DEADWEIGHT  BURDEN  would as  increase  indicated  the  in  size  Figure  2,  2  WITH  X-INEFFICIENCY  Price Cost  A  m  B  \  C ^-  E  .LRATC„ u \ F  (LRATC )  is  Q  burden  such  no  X - i n e f f i c i e n c y ,  also  is  the  If  a  the  area  observed  cost  cost  curve,  curve  and  the  of X - i n e f f i c i e n c y '  does  deadweight  ABC.  significant  degree  that  the  observed  (LRATC ),  the  deadweight  C  the  competitive  QTY  Q3  ^m With  LRATC  costs  exceed  burden  is  the now  competitive the  area  AEF  exist, costs and  therefore  8  a  larger  the  welfare  actual  larger  loss,  degree  than  the  of  Comanor  and  a l l o c a t i v e  l e v e l  as  Leibenstein^, estimated  i n e f f i c i e n c y  calculated,  may  because  be  of  very  the  that  much  presence  of  X-ineff iciency. Stanbury** indicate market  significant  power  by  Table  1  welfare  losses  l i s t s due  assumed reason  by  strongly  Harberger an  welfare  some  to  of  market  questioned  estimates  depend  that  the  empirical  losses  due  to  evidence  the  available  possession  of  producers.  Scherer^ those  concluded  assumed  the  assumed  of  demand  why  the  price-cost  industries  are  seldom  e l a s t i c i t i e s  are  often  substitution  between  much  loosely  test  concerning  producers.  the  assumptions  underlying  Schwartzman.  The  e l a s t i c i t y  demand.  of  demand  of  1.  margins  exorbitant  by  of  and  afoaelasticity  e l a s t i c i t y  empirical  power  some  Harberger  upon  the  of  higher  that than  related  2,  Scherer  observed is  of  in  while  or  Schwartzman  asserted  that  the  monopolistic  long-run 1.0  estimates  2.0  commodities.  price because To  the  of extent  4 W.S. C o m a n o r a n d H. L e i b e n s t e i n , " A l l o c a t i v e X-Efficiency and the Measurement of Welfare L o s s e s , " (August, 1969), pp.304-309. ^W.T.Stanbury, "T and Consumer R e s e a r c h " . Canadian A s s o c i a t i o n of Division), Edmonton, A l b extracted f r o m t h e same  E f f i c i e n c y , Economica,  he Consumer I n t e r e s t , Economic Welfare A Paper presented at the meeting of Administrative Sciences (Marketing e r t a , June 1975. F i g u r e s 1 and 2 a r e paper.  6 F.M. Performance,  Scherer, Industrial (Chicago, I l l i n o i s :  Market S t r u c t u r e and Economic Rand McWally & Co.,1970)p.402.  8A  that and  this  is  Schwartzman  correction Scherer power  found  in  welfare The to  the  are  factors  the  Scherer,  due  true,  loss  U.S.  due  empirical market  the  the l i e s  using  losses  understated. to  that  welfare  1966  to  of  dead-weight 0.5%  market  power  in  suggest  the  and  2%  U.S.  significant  Harberger  due  Schwartzman, to  market  GNP.  estimated the  and  loss of  by  m u l t i p l i c a t i v e  Harberger  welfare  data,further  evidence  power.  Applying  results  between  estimated  is  that 6.2%  the of  welfare  total GNP. losses  TABLE A  SURVEY  OF  STUDIES  1  ON  WELFARE  LOSSES  STUDY  METHODOLOGY  UNIVERSE  PERIOD  Harberger 19547  Hotelling's Model  73 U.S. Manufacturing  1924-  1928  WELFARE  LOSS  0.1%  national  of  income  Industries Schwartzman  P a r t i a l equilibrium  19608  analysis  Schwartzman 1961  P a r t i a l equilibrium analysis  9  Kamerschen  Hotelling's Model  1 9 6 6 10 Scherer  D.  Schwartzman,  "The  1960),  1954  U.S.  (October,  Kamerschen,  American  national  0.13%  of  national  income  industries  1956-1961  l%-8%  of  national  income 6.2%  of  and  Burden  Resource  of  A l l o c a t i o n , "  Monopoly,"  Journal  American  of  Economic  P o l i t i c a l  gro ss  "The E f f e c t of 1961), p.494.  "An  Economy,"  Estimation  Western  Scherer,op.cit.  p.408  of  Economic  Monopoly:  the  A  'Welfare  Journal,  Correction,"  Review,  Economy,  Losses'  (Summer,  from 1966),  Journal  of  P o l i t i c a l  Monopolyyin pp.  221-236.  the  vo  n  product  pp.627-630. ,  F.M.  Canadian Indust-  of  income  national  Harberger, "Monopoly 1954), pp.77-87.  Economy,  11  Pairs of and U.S. ries  0.1%  1966  9  D.R.  1954  ai  (December,  10  Canadian Indust-  1970  7; A.C. (May,  Pairs of and U.S. ries  10  Besides for  fostering  stand  the  above  allocative  accused  of  of  the  ownership  as  represented  control,  sional from of  as  modern  The  pressures  ownership  corporation by  a by  a  interests  simply  do  Powerful  firms  in  inflated  expenses.  of  observed a  profits  portion  of  can  associated  the  the  of  well.  One  separation  group  of  group  powerful market  of  profes-  firms  and  s t i l l  earn  superior  market  caused  be  by  scrutiny  productively  the  power  freed  the  to  correct,  of  stockholders,  have  If  power  firms  not  with  i n e f f i c i e n c y  as  unified  competitive  e f f i c i e n t . spite  a  market  powerful  is  diverse  managements  of  of  i n e f f i c i e n c y  represented  managers.  the  i n e f f i c i e n c y ,  productive  attribute  and  condemnations  profits  higher  reveal  market  only  power.  12 O.E.  Williamson  further:  powerful  unplanned  i n e f f i c i e n c y  management expenses benefit the  for  take  easier  Williamson  calls  The  12 .E. 0  to  those  increasing  this  notion  Williamson,  1032-1057.  13. Ibid.,  p.  1045  the  those that its  that  the  market  not  These  that  make  a  step out  preferences  expenses.  motives  of of  higher  personally job  of  managing  power.  preference:  we with  Managerial  American  analysis  expenses  of  expense  notion  connect  Behaviour",  pp.  of  forms:  this  excess  because  types  and  essential  order  Business  by  moved  incur  but  basic  management,  firm  1963),  firms  certain two  has  Economic  propose  in  behaviour  is  Discretion Review,  and  (December  11  that of expense p r e f e r e n c e . That Is, the management does not have a n e u t r a l a t t i tude toward costs. Directly or i n d i r e c t l y , certain classes of e x p e n d i t u r e have positive values associated with them-.l4  If a  Williamson's  reasonably  ful  firms,  iencies, can  both  may  higher  of  would  e f f i c i e n t prices  of  to  and  fixed  labor.  their  and  f i n a n c i a l l i t e r a t u r e  and  serious  prices  report  as  to  expenses.  These  over  time.  In  receive  objectives  and  the  superior  which  public  attainment  permits  addition,  of  the  compensation  Certainly  of  firms  i n f l a t e d  inflated  enterprises.  power-  i n e f f i c -  Powerful  exist  firms  of  productive.  power  of  firms  capital  equity  leverage is  processes  variable  Modern  stock  funding  to  conduct  is  such  con-  policy: reasonable  profits.  Productive input:  leads  the  market  both  production  of  preference  very  risky  violate  and  high  expense  the  powerful less  and  inflated  reinforce  managing  duct  power  allocative  prices  management for  market  spite  of  description  s u f f i c i e n t l y  in  expenses the  then  charge  profits  accurate  notion  reviewed  Tib i d . ,  p .  usually  have  assets  funding. or  optimum in  1032 .  have  the  two  types  represented option  by  some  This  is  of  the  III.  of  by  capital  financing  combination  capital  Chapter  basic  problem  structure  of of  and  debt <that  12  After Modigliani  and  leverage  can  level  risk.  of  porate As  put  have  low  the  sumably  earning  personal  of  stockholders'  This  than  firm.  This  market  power  is on  a  the  charges of  employ  by  would  employ  at  and  with  possible f i n a n c i a l  be  f i n a n c i a l  from  entering would  equity  attaining operating  for a  explanation leverage.  for  meet  would  and  the  thereby  dis-  industry.  permit  above satisfying  management  the  pre-  advertising  consistently of  thereby  to  position  funds  debt,  could  rates  would operation.  of  reduced,  out-  s t i l l  risk  amount  a c t i v i t i e s ,  prices  High and  lower  favourable  providing  stockholders'  a  i n e f f i c -  management  Management  development  output  and  optimum  risk.  and  competitors  associated  could  directing  strong  barriers  desires  to  costs  less  excellent  firms  p r o f i t s ,  cor-  p r o f i t s .  an  capital  quickly  on  be  high  of  overall  higher  to  f i n a n c i a l  which  these  money  returns  appear  by  costs.  raise  monopoly  for  its  capital  superior  and  means  risk  powerful  and  of  high  interest  research  a  use  and  l e v e l  entry  is  taxes,  the  costs  managements  overall  addition,  would  income  that  capital  higher  advantage  potential  prestige  risk  u t i l i z i n g fixed  campaigns,  average  trade  These  of  agree  leverage,  its  reinforce  In  to  firm's  absorb  opportunities.  courage  came  managements  could  firm's  corporate  leverage  f i n a n c i a l  the  reducing  new  can  preference.  By the  a  for  Financial  the  prices  permit  effect  f i n a n c i a l  for  expense iently  M i l l e r  management  such,  device  allowing  the profitable  influence  of  13-  There relationship. major  the  debt  which  alternative  Because  of  their  power  could  be  prices  between  fact,  observed  the  result  and  published  profits of  profits  power  may  firms  stated  have to  this  amounts  of  capital  capital  output,  the  reduce  debt,  costs. with  If market  and  not  breaking  the  i n e f f i c i e n c y . desirable  capital in  may  low-cost  costs  socially  p o s s i b i l i t y  that  the  firms  thereby  allocative  of  control  associated  lower  and  to  powerful  overall  r e s t r i c t e d  permitting clearly  large  their  explanation  a b i l i t y  existence,  support  lower  those  market  of  their  to  higher  monopoly  Scherer  of  would  the  perty  an  a b i l i t y  true,  In  also  variables  have  link  is  costs. a  proF.M.  recently  text.  It is possible that the high observed returns on s t o c k h o l d e r s ' equity in concentrated industries h a v e b e e n due as much to f i n a n c i a l leverage as to g r e a t e r success in r e a l i z i n g monopoly g a i n s on t h e t o t a l amount o f capital employed. That i s , firms in concentrated industries may h a v e e l e c t e d a c a p i t a l struct u r e w i t h an u n u s u a l l y high ratio of lowcost but i n f l e x i b l e debt o b l i g a t i o n s , so that r e t u r n s above i n t e r e s t charges were magnified in r e l a t i o n to the r e l a t i v e l y small quantity of e q u i t y c a p i t a l . Stigler found that concentrated industries had s i g n i f i c a n t l y more stable returns over time than unconcentrated industries, and t h i s may p u t t h e m i n a b e t t e r position to accept high leverage without incurring excessive risks. The p o s s i b i l i t y of interactions among concentration, leverage and p r o f i t a b i l i t y has not yet been subjected to thorough empirical analysis. Further research - - F.M. L  Economic Co.,  3  is  Scherer,  Performance,  1970),  p.  clearly  185.  needed.15  Industrial  (Chicago,  Market  I l l i n o i s :  Structure Rand  and  McNally  and  14  Whereas business its  risk  of a firm,  financial  passes  the investment  risk.  lity  i n the earnings  firm  increases  and  preferred  increase. the  firm  also. of  increases-.  are  cash  of  continues  i n every  earnings  charges  financial  charges.  be  75% l o w e r  than  to cover  consequence,  with  The  To  dispersion  illustrate,  charges'  of cash  incurred  of leverage  has  but  expected and  taxes.  whereas  f o r both  annual  firm firms  firm  worth  A has should  B will  be  cash, e a r n i n g s .  insolvency  As  increases  by t h e f i r m .  of financial  that  increases  risk,  the t o t a l  with  that  bankruptcy,  risk  involves the  o f i n c o m e ' a v a i l a b l e t o common  suppose  charges  B has'$500,000  earnings  As a  the p r o b a b i l i t y  interest  i . e . , $20,000,  the p r o b a b i l i t y  aspect  Each  Thus,  charges  charges  degrees  B are' $30,000,  If-cash  fixed  of financial  firm  encom-  commitments,  itself,  before  while  its financial  second  fixed  respect.  outstanding;  expected,  the f i n a n c i a l  relative  different  other  f o r firm  no  a  have  risk  the probability  to legal  this- n o t i o n  o f $80,000  bonds  equal,  lead  determines  stockholders.  structure,  these  the basic  and t h e v a r i a b i -  lease  to lever  w h i c h may  two f i r m s  6% p e r p e t u a l  unable  being  f i r m A h a s no d e b t ,  financial  of debt,  t o meet  To i l l u s t r a t e  that  However,  things  be u n a b l e  identical  annual  a v a i l a b l e t o common  A l l other will  financial  insolvency  stock' i n i t s c a p i t a l  insolvency,  suppose  of possible  determines decision  defined,  the proportion  As t h e f i r m  cash  the financing  Broadly  both, t h e r i s k  decision  the expected  future  stockholders.  annual  operating  15  incomes  over  the next  jective  random  five  v a r i a b l e s where  probability  distributions  deviations  $40,000.  f l  while'firm  earnings firm  A  about  from  values  each. $80,000  and t h e  assume  that  i n 6% b o n d s .  the expected  values  B.  d i s p e r s i o n of expected i s greater  standard  A h a s no  would  be  value  debt  f o r both  B than  of  $80,000 f o r  the standard  earnings  f o r firm  of the  the expected  Because  i s t h e same  firm  sub-  I f ,f o r s i m p l i c i t y ,  income' t a x e s ,  f o r firm  A and B were  the expected  t o common, s t o c k h o l d e r s  and $50,000  stockholders  f o r firms  As b e f o r e ,  federal  available  relative  were  B h a s $500,000  we ^ b ' s t r a c t  years  deviation  firms, the  available f o r firm  t o common  A.  For firm  A  $40,000 Coefficient  while  f o r firm  of variation  =  $80,000  =  0.50  =  0.80  B  $40,000 Coefficient As  a result,  icient  the r e l a t i v e  of variation, As  a firm  obligations  is for  effect  a firm's  a means by 1  higher  financial  i s less  increases  rises.  which  profits. leverage  $50,000  f o r firm  overall  by t h e c o e f f -  A.  the proportion  of  fixed-income'  s t r u c t u r e , the f i n a n c i a l  Therefore,  of risk.  management  Management  risk  the use of f i n a n c i a l  level  corporate  with  =  d i s p e r s i o n , as measured  in i t s capital  stockholders can  of variation  could  i t s associated  Financial  can trade  employ  to  leverage leverage  higher  inefficiently  low f i n a n c i a l  risk.  risk low  16  Chapter  IV i n t r o d u c e s  Capital  Asset It  P r i c i n g Model  i s necessary  ''unsystematic" ing  the concept  risk,  the s e c u r i t y  which  other  folio,  and i t s " s y s t e m a t i c "  cannot  be washed  away  diversification, eliminated, risk The  which  folio  i s highly  risk,  correlated  with  as  a whole.  and r e t u r n  equilibrium. assumptions, linear the  thus  group  the expected  average,  to test  and o v e r  long  should  asset  rate  to that  tends  t o be of  total  of the market.  on a w e l l - d i v e r s i f i e d p o r t -  under  and i t s v a r i a b i l i t y of the market  conditions  asserts  of return  factor.  ;  that,  between of market  under  on a s e c u r i t y and l e n d i n g In t h i s risk  certain is a  rate  and  study, the of the concen-  of the unconcentrated  group, and  to the r i s k - r e t u r n r e l a t i o n s h i p  empirical periods  port-  which  the p o r t i o n  f o r the systematic  have  combin-  increasing  a theoretical relationship  a contribution  i s right,  of return  risk,  the market,  on a m a r k e t  relative  By  gradually  of a r i s k - f r e e borrowing  return  by  of r i s k  of the v a r i a b i l i t y  of a capital  constitutes  t h e CAPM  rates  provides  i s employed  trated  risk  B a s i c a l l y , t h e model  function  expected  CAPM  If  CAPM  firm's  away  diversification.  the return  essentially a reflection  risk  the portion  systematic  is  The  a  to the o v e r a l l performance  i s that  and t h e  securities in a diversified  through  only  i s related  implication  c a n be washed  the unsystematic  leaving  risk  (CAPM).  to d i s t i n g u i s h between  risk  with  of systematic  tests  would  of time,  high  show  the firms  systematic  risk.  that with  on t h e high  17 For divided firms that  convenience,  into  and  two  structures  and  higher  of  of  lower  study.  power  in.the  ability  to from  powerful  such  opposition allocative  v  this  Asset  risk.  Pricing  i f market reduce  capital  do  would  of  economics power  not  the  to  financial firms. market earn  a  establish systematic  constitute  a  test  g r e a t e r amounts  and  to  p r o f e s s i o n s would the  then  socially  greater  and  the  power  market be  in  to  i t must  disadvantages.  amounts  strengthen  of  desirable  opposition  i t s advantages  employ  conclusions of  opposition  to c o n c e n t r a t i o n s 'of market inefficiency.  the  indeed  and  employ  grants  costs,  support  would  of  hypothesis  higher  summary  f i r m s do  a balancing of firms  the  rethinking and  do  *  Model.  VII- p r e s e n t s  legal  sample  concerning  incur  are  powerful  proceeds  This  a  the  less  firms  firms  results  between  evidence  chapter  powerful  systematic  serious  findings  the  other  i f powerful  If powerful  then  For  And  whether  debt,  If  examines  return-,  Chapter  result  VI  return.  order.  test  and  the C a p i t a l  this  empirically  firms  and  selects  of powerful  rate  or  to  V  difference  empirically risk  period  Chapter  i s no. s i g n i f i c a n t  Chapter power  chapters.  a time  there  the methodology  of debt,  then  traditional  for causing  18  C.  Methodology  The public used  data  analyzed, i n  documents  in  Returns  this  published  study  this  by  include  Statistics  the  Reports,  Corporation  Corporation  Taxation  Statistics.  used  risk  and  data  on  for  when  the  return prices,  a l l common  from  June  was  examined.  The  d i v i d e n d s , and listed  on  June  1973.  through  the  performance  relatives,  a l l dividends  invested  the  the  the  at  prices  are firms  data  over  the  used  to  The are be  summarized  sentially the a  period the  of  here  1969.  of  to  detail  only  of  these  what and  The  nature.  groups  groups.  do  the  from  The  not  V  method Such the  paid  VI,  of  statistical  is believed  that  greater  and In  missing  data.  and  study  i t will  is  approach  such  tests and an  weight.  any was  es-  permits  cross-section  It  accorded  re-  missing  an  analysis.  be  be  splits. be  and  variance  to  to  r a t i o n a l e behind  a n a l y s i s of  results  investment  criterion  about  of  the  relatives  Exchange  were  and  This  i n Chapters  briefly.  different  must  through  analysis  they  dividends  study  monthly  the  assumed  combination  regression permits  problem  the  cross-sectional in  comparison a  1962  i n more  a n a l y s i s of  involve  in  stock  Stock  computing are  tape  systematic  performance  month, i n w h i c h  for  included  method  explained  of  adjusted  addition,  avoid  end  and  TSE  contains  Toronto In  Unions  Statistics  tape  investment  documents  and-Labor  concerning  TSE  from  The  a d d i t i o n , the  empirical'evidence  stocks  1961  Financial In  obtained  Canada.  Corporations  Act  was  study.were  and  employed  simple, approach  19  CHAPTER REVIEW  This between  chapter  market  summarizes  some  profitability centration The  the  and  division size  of  the  might  firms  with  assets  as  a  the  firms  be  on  between  into  assets  $250  this  to  B,  explain  market  con-  profitability.  i s reviewed i n this  the  chapter  relationship summary  of  part.  between the  entry  conclusion  chapter.  assets  above  each  group  i s examined 1  or  into.three below  and  with  groups  market  For  power  Then  to  example,  firms  and  (3)  the  relative  groupings:  (2)  $500 m i l l i o n ,  million.  involves  according  assets.  $250 m i l l i o n ,  and  $500  examined  sheets  power  sales  million  total  balance  related  relationship  attempted to  In p a r t  Finally,.a  market  either  divided  Alexander  of  of market-power. c l a s s i f i c a t i o n  by  total  has  firm.  relationship  the  Part'A  which  factor  literature  with  mitting  of  on  Profitability •  method  as m e a s u r e d  firms  literature  reviewed i n this  and  literature  profitability.  size  this  LITERATURE  the  profitability.  Size  One  and  the  the  on  studies  Firm  reviews  i s suggested  C presents  barriers  A.  of  by  literature  Part  of  power  OF - THE  II  60 (1)  with  total  those  the p r o f i t a b i l i t y  firms of  compared. a l l American their  1937  manufacturing  federal  income  firms tax  sub-  returns  ^Sidney Alexander,."The E f f e c t of Size of Manufacturing C o r p o r a t i o n on t h e D i s t r i b u t i o n o f t h e R a t e o f R e t u r n , " R e v i e w o f E c o n o m i c s and S t a t i s t i c s , (August,1949),.pp.229-235.  20  and  found  a p o s i t i v e r e l a t i o n s h i p between  o f n e t income Alexander as  t o t h e book  emphasized  the size  in.two  analysis,  he  of  rate'is  among  ...  that  much  Second,  2  that  "from  corporations  by  a very  greater  among  after  a brief  fluctuate  He  equity rates  argued  year  ratio  (NI/SE).  increased  this  greater  statistical the dispersion  small' corporations' than graphical  t o good  more."  and t h e  careful  " f o rany g i v e n  bad times  size  of p r o f i t  declined.  First, that  firm  of stockholders'  variability  ways.  established  large.!'  concluded  value  of the corporation  variability  profit  --  a n a l y s i s , he  the p r o f i t  rates  of  small  :  3  4 Hall period firm  and Weiss  1956  size  t o 1962  years  from  plant  profit  rates  Third,  38  had  permit  sample  because  scales. were  firms  i n some  were  excluded  available  they  lbid.,  3  Ibid.,  467  were  no  from  f o rthe  firms  4 firms  the Fortune  Corporations"  f o rthe  b u t 126 o f t h e s e  reasons .  smaller  than  were  First,  t h e minimum  excluded  were  21  because  to public  regulation.  because  they  too  index  to which  were  industry.  they  were  their  diversified  Fourth,  of i n d u s t r i a l  firms  effi-  subject  to a particular  f o r the industry  firms  f o r various  way  firms  a p o s i t i v e r e l a t i o n s h i p between  were  excluded  because  341 A m e r i c a n  Industrial  Second,  assignment  2  their  There  with  selected  o f 500 L a r g e s t  excluded  cient  to  They  1956 t o 1962.  excluded were  and f o u n d  and NI/SE.  "Directories  worked  63  production  assigned.  firms was  Finally,  p.2 29. p.2 2 9 .  ^ M a r s h a l l H a l l and L e o n a r d W e i s s , " F i r m S i z e and P r o f i t a b i l i t y , " R e v i e w o f E c o n o m i e s ' a n d S t a t i s t i c s , ( A u g u s t , 1967) , p p . 319-331.  21 7  firms  ted  were  as a  separate  :  multiple of  after  were  dummies  for  Profit  each  rates  after  on  what  to  maximize.. of  tion  would  from  industry  and  input  growth  should  long-run toward  book  returns  analysis  variable  1956 of  to  some  the  industry As  firm  profit  but  assets.  of  of  time  of, s t o was variable.  differing  return  tax  bring  profit  on  equity  i n t e r e s t s would structure  maximization  is  an  to It  seek  ele'nii:--.  or  sales  maximiza-  borrowing  which  differs  depending  on  a  rates  of  rate  varia-  It  appropriate  best  rate'of  rates  the  competition.  capital  result,  the  theoretically correct.  such  i n d u s t r i e s , even  between Weiss  that  was  ratio  en t r y •• s h o u l d  rate  seems  optimal  in  return  things  of  as  return  oh  perfectlyon  equity  stability assets  competitive should  tend  industries. concluded  size  stockholders'  Stekler  examined  for  period  the  is  Either  between  between  prefers  trea-  stability,  the  because  under  was  NI/SE,  and  , and  t h e "most  year  independent  total  differ  equality  argument  mix.  was  The  a c t i n g • i n ' the - owners'  The  and  of  were  because"it  equilibrium,  value  of  after  might  study  assets  equality  tionship  taxes  taxes  prospects.  Hall  method  equity.  book'value  toward  require  differ  each  d i f f e r e n t i n d u s t r i e s , but  managers  ment  in  concentration;,growth  the  present  is  firm  dependent  year-end  after  taxes  total  The  observed  to  before  of  The that  on  year  profits  treatments rates  The  tax  ' equity  that  Each  observation.  s i z e s e l l e r  ckholders held  by.error.  regression.  return  bles  excluded  and  that  the  ratio  of  was  a positive  net  income'to  relathe  equity.  a l l American  1947  there  to  1949  firms  and  filing  found  income  tax  medium-sized'firms  .2 2 were  more  i s j the  profitable,  returns  $10,000,000 study  was  of  were  the  firms  higher  first  to  measure  of  measure  potential for  after  period  to  as  the  annual  1947  to  manufacturing found  measured were  profit least  by  rate,  to  NI/SE.  profit  Stekler's  Revenue  of  problem.  to  Service  and  Stekler's  question  what  That  $500,000  firms.  the  pointed  indicator.  but  tax  returns the  firms  more  fact,  Osborn  on  middle-sized  what  in  had the  for  what To  rates  data data  period  United  1931  profitable,  was for  the  noted  that  much  greatest  next  cycle  greatest,  depression  the  to  1946  what  the  the  States and  profitability  stage'of  in prosperity  and  largest  results  was  examined  variation large  medium-sized  the  summary  of  the  appear  the  as  the  corporations  profitable. may  be  concluded'from  Conclusions  firms  Stekler  during  corporations  the  of  In  6  depended  seem  and  appropriate  income  corporations  profitable,  size  with  by  between  or.smaller  carefully  appropriate  examined  most  What  measured  assets  larger  growth,  v a r i a t i o n . . Thus,  most  is  total  American'Internal  NI/SE.  small  studies?  deal  medium-sized  obtained  because  than  as  1949.  Osborn  also  with  profitability  taxes  limited  profitability  concerning  the  profitability  seem  to  selected,  time  period  the  depend  of  a l l  these  r e l a t i o n s h i p between heavily  studied  and  upon the  the  firm  sample  determination  H .0 . S t e k l e r j P r o f i t a b i l i t y and S i z e o f F i r m , . ( B e r k e l e y , C a l i f o r n i a : I n s t i t u t e of Business and E c o n o m i c R e s e a r c h , The U n i v e r s i t y of C a l i f o r n i a at B e r k e l e y , 1963), p.74. 5  ^ R i c h a r d Osborn, E f f e c t s of Corporate S i z e on Efficiency a n d P r o f i t a b i l i t y , (Urbana', I l l i n o i s : U n i v e r s i t y of. I l l i n o i s , B u l l e t i n No.72, 1 9 5 0 ) , p.58.  2 3  of  size  groups..  B. • M a r k e t - C o n c e n t r a t i o n  A of  the  second'method  of  Profitability  market  so-called concentration  review  of  problem  of  the  of  measures sure  and  literature,  determining  of  a  base  of  of  briefly  measurement  them  consists  Before'proceeding to  Many b a s e s  Some  classification  ratios.,  i t is useful  concentration.  concentration.  power  have  are  and been  sales,  to  a  summarize the  the  various  used  as  a  assets,  mea-  value  7 added in  and  favour  value  number  of  of  value  added'base  are  rarely  the  sales  none.of  added  i s often  available. base  as  the  which  has'gained  first  three  i f the  sales the  although  universal  the  a  out  base. value  present  strongly While  added  study  the  data  will  use  concentration,  of  concentration  indices,  acceptance.  large  i s used.'  other  come  sales  i n d i c e s measures  largest three, any  the  superior,  major-classes  base  has  measuring  control  output,,  industry,  for  firms  of  and  result,  of  number  using  base  group  small  computed  a  base  are  Scitovsky  considered  As  There  The a  the  employees.  small  portion  This  four,  the  measure or  number  eight of  extent  to  of  industry  is  the  usually  firms  firms  which  in  would  each be  appropriate'. The class,  second  measures  the  class-of indices number  of  firms  closely required  r e l a t e d to to  the  accountfor  first some  T . S c i t o v s k y , " E c o n o m i c T h e o r y and t h e M e a s u r e m e n t o f Concentration " Business Concentration and P r i c e P o l i c y , ( P r i n c e t o n ,. New J e r s e y : P r i n c e t o n U n i v e r s i t y P r e s s , 1 9 5 5 ) , p.111.  2-V ;  percentage  of total  is  70 p e r c e n t .  usually  tion, A  increasing  major  the  because  This  they  curve  consider  The l e v e l  inverse  value index  of output  measure  of  as c o n c e n t r a t i o n i s that  i t does  chosen  concentradecreases.  not  consider  i n the industry.  two c l a s s e s  which  is•an  of this  number- o f f i r m s  These  output.  i n numerical  disadvantage  total  tion  industry  of indices  only  one p o i n t  relates percentage  a r e most  often  criticized  on. a c u m u l a t i v e of industry  concentra-  output  to the  8 number  of firms  producing  that  useful  measures  i n determining  output.  the monopolistic  particular industry. The t h i - r d c l a s s ' o f i n d i c e s industry  and i s n o t s u b j e c t  classes.  The b e s t  known  Nevertheless,  considers  are  potential in a  a l l the firms  to the c r i t i c i s m  index'of  they  of the other  this-class  i n an two  i s Herfindahl s 1  g summary sured upon  index.  This  as a p e r c e n t a g e the base. Let  measure of total  The i n d e x  i s t h e sum o f t h e f i r m industry, size  i s defined  as  or  sizes,  mea-  output.depending  follows:  S.S.Q.  = the concentration of the squares ,  index,  t h e sum  A.  = the proportion of industry output c o n t r o l l e d by t h e i t h f i r m ,  S.S.Q.  =  then  However, ces  2 (A.) summed I  i t i s n o t as s p e c i f i c  i n measuring  over  a l l  as t h e o t h e r  the monopolistic  i .  —  two c l a s s e s  p o t e n t i a l o f an  of  industry.  P  G.Rosenbluth, "Measures o f C o n c e n t r a t i o n " Business Concentration and P r i c e P o l i c y , ( P r i n c e t o n , N . J . : P r i n c e t o n U n i v e r s i t y P r e s s , 1955), p.59. 9  lbid.,  p.60.  indi-  25  Rosenbluth tration  indices  different largest  examined  of  numbers  two,  the of  three,  the  f i r s t  group  firms. four  relationship  Rank  and  on  an  between  employment  correlations  eight  concen-  firms  in  base  betwee  1947  n  using the  exceeded  0.90  10 in the in  a l l  cases.  f i r s t the  group  index In  on  an  in  excess  Therefore were  would  employment of  be  the  base,  0.97  would  selected,  not  comparing  it  in  the  number  thatif of  an  firms  index  of  included  c r u c i a l .  three  main  Rosenbluth  a l l  appear  cases.'''"''  classes found He  a  of  indices  rank  for  1947  correlation  concluded:  These three comparisons suggest that in the analysis of c r o s s - s e c t i o n data, the use of any one of the indexes considered here w i l l result in substantially t h e same o r d e r i n g of observations as any of the o t h e r s . Analytical results that rest on t h e " o r d e r i n g of observations willnnot be g r e a t l y a f f e c t e d by the index used.12 Thus,  the  choice  of  index  would  not  affect  the  a n a l y t i c a l  results. 13 Weiss the  made  concentration  principal dominant rates.  -  findings firms  The  a  profits in  were  46  associated  with  empirical  Ibid.,  p.64  1  1  Ibid.,  p.69  Ibid.,  p.69  tests  empirical  relationship The  0  a  of  table.  1  12 13  survey  provided  and  tests  presented  conclusion high  prices  support  devoted  to  was and this  to  the  that high  profit  conclusion  L.W. Weiss, "The C o n c e n t r a t i o n - p r o f i t s relationship an and A n t i t r u s t , " ' I n d u s t r i a l C o n c e n t r a t i o n : T h e New Learning, (Toronto; Ontario : L i t t l e , Brown and Comapny, 1974), pp.184-245.  26  for  the  period  hypothesis The  1967,  weakened  Canada,  general,  predicted at  -  in  the  by  variance  seemed  to  the of  relationship  States,  and  findings  lend  support  with  The  the  from  several  orthodox the  concentration-profits  accelerating  United  theory.  stem  though  periods  concentration-profits  B r i t a i n , in  is  1953  holds  Japan. to  Weiss  of  the  well  for  concluded  that  relationship  yielding  concentration  selection  equally  the  studies  i n f l a t i o n .  -  results  profits  sample  and  hypothesis  the  period  14 in  question.  For  the  period  between  profits 1940.  Using  concluded rate  and  he  found  is  not  highly  that the a  £.hat  there  many  concentration  and  p r o f i t  Exchange  of  1,106  there  was  some  low  did  "The rather  Commission  companies p r o f i t  of  is have  for  (after  positive  relationship  significant.  positive distinct  conclusion in  Bain  period  tax)  to  1936  equity,  between  other the  he  p r o f i t  hand,relationship  rates  as  which  to  average  Nevertheless,  p r o f i t  break  on  the  so  devoted  r a t e s . ^  data  the  (r=.33),  higher  studies  relation  industry.On  correlation it  Stigler.  negative  the  though  a  a  by  of  of  noted: is  one  ratio  concentrated  Bain  found  the  rather  conducted  p r o f i t a b i l i t y .  concentration  simple,  Thus  and  and  equities  was  he  written  between  Securities and  study  1942-1947,  Bain.has  r e l a t i o n  employed  to  such  concentration Joe  the  One  does  average  a  the group.  emerge  is  p r o f i t - r a t e  14  • G. S t i g l e r / C a p i t a l and R a t e s o f R e t u r n Manufacturing Indudstries, (Princeton: Princeton University Press, 1963). l  Joe Bain, "Relation of P r o f i t Rates to Concentration," Q u a r t e r l y J o u r n a l of Economics. pp. 293-324. " ~ " "  n  Industry (August,1951) '  27  showing there  at  is  average  the  a  profit  tration  by  profit  he  rate  of  a  22  the  of  0.73.  he  of  only  percent.  average  this  the  only  at  was  techniques,  he  ^  concen-  70  Such  confidence  reached  four-firm  concentration  U.S.  manufacturing  average equity  after-tax to  groups  those  with  with  be with  he  a  below  similar  II.  was  By ratios  able  to  industry.  For  profits  a  strongly  average  ratios  War  as  and  30  the  percen-  p o s i t i v e l y  correlation p r o f i t s  a  l e v e l .  average  groups,  a  percent,  World  industry  In  found  percent.  Weiss"^  industry  industries  under  .001  1  which  twenty  6.9  the  in  that of  l i n e . "  percent,  firms  concentration,  while  70  and  following  Stockholders'  Industry  the  industries  In  of  l i n e ,  period  found  with  in  below  over  eight  rate  the  percent, 8.8  by  two-digit  whole  correlated  was  significant  for  broad  and  percent.  profit  weighted  1949-1958,  of  firms  difference  conclusions computing  difference  twenty-two  12.1  was  concentration  above  concentration  Using  tage  the  eight  difference  cover  rates  in  revealed  for  percent  significant  particular,  where  70  of  percent  c o e f f i c i e n t 12.7 averaged  16 Ibid.,  pp.  313-314.  17 L.W. Weiss, "Average Concentration Ratios and Industrial Performance," J o u r n a l of Industrial Economics, (July, 1963), pp.237-253.  28  The orthodox  one  approach  his  meausre  dividends a  debt  departed of  on  and  stock  trade  following  and  of  than  with  economic Stigler  groups  below  profits adjusted  d i f f e r e n t i a l  systematic  His  60  those  attenuated,  with  a  that in his  than  smaller the  form  data  between  in  of a  high way  concentrated  adjustment  bias.  G.  o p . c i t . ,  which  has  that  5.22 of  the  years between  percent less  concentrated of  industries  apt  to  reap  wiped  shown  firms (13 their  salaries,  unconcentrated  pp.54-70.  the  four-firm  sales)  almost  been  for  ratios  by  more  to  owner-manager  and  technique  s t a t i s t i c a l  Stigler,  were  earnings  1951-1957  compared  (2%  payments,  three-digit  had  unconcentrated  firms  but  average  discovered  F i r s t ,  correlation  four-firm  fraction  18 Stigler.  financed!through  14  higher  percent,  Stigler  $250,000  or  average  smaller  Thus,  weighted  the  by  retained  the#ppsitive  percent  was  interest  including  with  6.64  Second,  included  Arguing  of  of  with  respects.  to  choice  groups  averaging  percent.  returns.  This  main  additions  concentration.  assets  cent).  assets,  variance  hypothesis  sum  and  industry  industries  the  capital  returns  50  was  eliminate,  ratios  at  two  not  concentration  54  in  did  industry  for  other  after-tax  total  manufacturing  capital  results  p r o f i t a b i l i t y  from  credit.  1947  to  -  p r o f i t a b i l i t y  percentage  returns  yielding  concentration  His  as  study  to  out  the  industry impart  a  per-  29  Collins assigning Instead  profits  they  estimated some and  and  As  was  price-cost  moderate margin  to  to  and  digit  industries  glass  products;  usually  could After  which  not  on  of be  others,  for is  in  ratios  food  products;  primary  metals;  fabricated  miscellaneous  depreciation  price-cost  the  stone,  metal  capital/  found  their for  the  in  they  between  concentration  avoiding  computing  related,  correlations  and  for  differences  groups:  and  penalty  of  basis.  prices  since  deducted  flaw  firm-wide  the  six  machinery;  a  between  case,  depreciation  four-firm in  the  correcting  positive  methodological  margins  acceptance  costs  strong  index  e l e c t r i c a l  the  the  industries  percentage is  margins.  ratios,  ,19 avoided  specific  the  costs.  advertising  output  to  used  problems  Preston  four-  clay  and  products;  manufacturing.  20 Jones,  Laudadio  evidence  relating  measures  of  ing  the  market  structure.  industries  on  1965.  independent  erentiation,  various  growth  requirements,  a  revealed  demand,  and  that  foreign  inter-industry  of  of  a  presented  industry  They  reported  the  sample  of  of  demand,  were  scale  Canadian  are  economies,  product  of  for  regressgoodc  the  year  product  absolute  d i f f -  capital  competition.  The  d i f f e r e n t i a t i o n ,  important  p r o f i t a b i l i t y .  various  consumer  structure  foreign  to  results  concentration,  and  concentration,  competition  30  market  variable,  in  empirical  Canadian  variables  differences  some  of  measures  regional  results  Percy-  p r o f i t a b i l i t y  p r o f i t a b i l i t y  The  and  determinants The  major  of  sources  19 N.R. Collins and L . E . Preston, C o n c e n t r a t i o n and P r i c e Cost Margins in Manufacturing Industries, (Berkeley: University of C a l i f o r n i a Press, 1968),pp.79-106. 20-J.C.H. .Profitability  in  Jones,L.Laudadio  and M . P e r c y ,  Canadian Manufa'ctufihg  (August,1973),pp.356-368.  "Market  Industry,"  Structure  Canadian  and  Journal of  Economics,  30  of  their  istics,  data'were  i n Manufacturing  Bloch  extended  concentration  domestic  data  gross  profit  such and  per unit  and on  that  prices  when  tariffs  on  profit  per unit,  on  profit  per unit.  C.  Entry  third  but that  and  method  of entry  theory'demonstrates ustry  has s t r o n g  that  industry.  than  others.  costs  were  tested  Canadian supported  and c o n c e n t r a t i o n  be'high  or both  were  p e r u n i t , and  The - t e s t s  The  of  both  such  low.  was  tariffs  a  tendency  The t e s t s - f u r t h e r  h a d an i n d e p e n d e n t  upward  tariffs  o r no  had l i t t l e  the  on  interdependence when  and  influence influence  Profitability  o f market  power  conditions' into  that  real  classification various  the c o n d i t i o n  influence Some  and p r o f i t s  but d i d not exhibit  concentration  Barriers  analysis  tended'to  or concentration  that  the  interdependent.  are high,  suggested  A  was  of t a r i f f s  Affairs,  the i n f l u e n c e  f o r a sample.of~corresponding  and c o s t s  concentration  to include  His hypotheses  industries.  Stat-  Canada.  on p r i c e s , c o s t s ,  the i n f l u e n c e  costs  study  Financial  and C o r p o r a t e  of  prices, direct  manufacturing  that  Industries  industries.  on t h e r e l a t i v e  States  hypotheses prices  and t a r i f f s  Corporation  o f Consumer  t h e above  import-competing  using  United  Canada,  1965 a n d t h e D e p a r t m e n t  Concentration  of  Statistics  upon world  The e x p e c t a t i o n  i n d u s t r i e s . Economic  of entry  the competitive markets  i s that  consists of  appear  blockaded  into  a given  ind-  conditions'within easier  to  markets  enter would  'Harry B l o c h , " P r i c e s , C o s t s ' and P r o f i t s i n C a n a d i a n M a n u f a c t u r i n g : , t h e I n f l u e n c e o f T a r i f f s and C o n c e n t r a t i o n , " C a n a d i a n J o u r n a l o f E c o n o m i c s ; (November,1974) , pp;594-610.  have er  higher  prices  higher that  prices  could  lead  expenses.  high  than to  Two-  market  competitive some  combination  researchers  entry  markets,  have  b a r r i e r s imply  of  and  that  higher  examined high  these  high-  profits  the  and  proposition  profitability  for  market p a r t i c i p a n t s . Bain and  NI/SE  during  examined.the  for  the  the  r e l a t i o n s h i p between  leading  periods  1936  firms  in  1940  and  to  published  s o u r c e s ' and " i n t e r v i e w s  estimated  the  each  of  the  existence  extent  20  of  which  industries.  economies  advantages' of ductive  to  of  established  resources  by  the  20  The-  1947  to  1951.  industry  factors  four  industries From  impeded  scale,  (2)  product  firms,24'  (3)  control  firms,25  various  executives, entry  factors*were:  established  conditions  oligopolistic  with  four  entry  (1)  Bain  into the  differentiation of (4)  scarce ability  proof 26  potential  entrants  With  the  extent  Bain  placed  industry tion:,  each  into  high  of  Bain  each  entry  of  and  three  barrier,  entry  presented  capital  f a c t o r upon  industry  one  moderate-to-low  to. r a i s e  the  to  enter  each  leading  categories  of  the  industry.'^"'  industry firms  within  overall  s u b s t a n t i a l entry  determined,  entry  barrier,  that condiand  b a r r i e r . ^ two  major  conclusions.  Industries  in  '.2 2'The l o w e s t four s e l l e r concentration ratio in Bain's s a m p l e o f f i r m s was 27%. S e e : J . B a i n , B a r r i e r s t o New Competit i o n , (Cambridge,Mass.: Harvard U n i v e r s i t y Press,1956), p.45. ; ,3lbid . , 2  24ibid.  ,  Chapter  3,  pp. 53-113.  Chapter  4,  pp. 114-143.  2  5  I b i d . , Chapter  5,  pp. 144-166.  2  6  Ibid.,  Chapter  5,  pp.144-166.  27ibid.,  Chapter  6,  pp.167-181.  ;  32  the  high  entry  industries showed  sales est  in  no  largest  eight  other  firms  higher  eight  ,  the  group two  earned  firms  higher  groups,  d i f f e r e n c e ' i n average  had  sales .  barrier  accounted NI/SE  accounted  for  these  NI/SE.  for  average  but  latter  70  percent  industries  less  NI/SE  than  70  in  of  in  groups which  the  industry  which  percent  than  two  Industries  over  than  average  of  the  larg-  industry  2 9  Mann increasing  r e p l i c a t e d Bain  the  number  of  1  s  study  for  the  period  industries•included  in  1950  the  to  study  1960 from  30  20  to  into  3 0.--' the  He  same  divided  three  the  market  30  industries  power  and  their  c l a s s i f i c a t i o n  leading  groups  as  firms Bain,  31  using  the  same  Mann, the no  NI/SE such  of  determinants like  the  Bain,  high  difference  of  found  entry  between  entry. condition a  significant  barrier the  group  substantial  .'->'  difference  and  the  and  two  between  others,  but  moderate-to-low  3 2"  entry  barrier  tries  in  cent  of  g r o u p s . --  which sales  the had  Mann,  largest higher  again  eight  NI/SE  like  firms  than  Bain,  found  accounted  industries  for  in  that over  which  indus70  the  perlarg-  • 3 3  est If  eight there  they the  firms is  must basis 2 8  2  be  a  accounted  consensus "very  high"  for  less  concerning to  l b i d . , p.  70  percent  e n t r y b a r r i e r s ,  influence  of a s s i g n i n g i n d u s t r i e s ' I b i d . . , p . 196 .  9 1  than  into  market the  of  sales.--  i t i s  that  performance.  three  market  However  power  196.  3-0'H-. M . M a n n , " S e l l e r C o n c e n t r a t i o n , B a r r i e r s to Entry,and R a t e s o f R e t u r n , " R e v i e w o f E c o n o m i c s and Statistics,(August,1966), pp.296-307. 3  1  3  2  Ibid.,  p . 2 97 .  'l'b"id. / • P •  2  9  9  •  3  3  ' I b i d . , p . 300 . •  33'.  classification  groups  was.  highly  arbitrary  since  i t was  based  on  33  intuitive  D .  judgment.  Summary : The  with  great  less  market  studies  market  the  power, h a v e  power.  are' the  barriers. to  studies.reviewed  The  size  value  of  of  higher  proxies the  Profitability  book  in.this  is  of  profitability  over  higher  prices, restricted  profit market  f i r m , market defined  stockholders'  higher  chapter  time  is  output  as  rates power  that  than used  the  ratio  condemned  The  of  in  these and  net  consequently  i t  entry  income  existence  because  firms  those'with  concentration  equity.  and  conclude  of  this  implies  allocative  in-  efficiency . There of  market  to  control  may debt  have  is  power the  the  which  a l s o the a l t e r n a t i v e e x p l a n a t i o n on  financial  major  variables  ability  would  leverage.  to  lower  of  support their  overall  higher  observed  profits  result  of  c a p i t a l , c o s t s - and  lower  ted  output,  and  allocative  ernative  thereby  inefficiency.  explanation. 3 3  associated  breaking  Ibid.,  p.301.  the The  Because  their  large  of  existence,  amounts capital  with not  of  of  the  influence  their  ability  powerful  low-cost  costs.  market monopoly  direct  link  next  chapter  power  If  debt,  true,  could  p r i c e s ' and  between  firms  be  the the  restric-  those'profits  examines  this  alt-  34  CHAPTER. I l l FINANCIAL  The that and  literature  greater the  demned  market  existence because  consequently capital of  ence, of  ability  lbw-cbst  costs. ket  link  between This  the  cost  of  the  concept  cost'of between  discusses be  of  large  is  financial  amount  may of  allocative the A  of  this  under'which  in  part  E  their  of  part C  amounts  with  and the  not  marmono-  direct  the why  structure  presents B,  of  debt  analyzes  capital  a  discusses  cost  100%  capital  costs  exist-  inefficiency.  In  explanation  Because  capital  associated  chapter  the  and  firm's  large  overall  conand  their  breaking  influence  leverage.  an  their  thereby  of  support  capital  leverage  provide debt  lower  Part  Finally,  to  profits  introduced.  the.conditions  which  variables  is  the  its profitability.  observed  Part  Alternatively,  lower  output,  financial  capital  output  restricted  would  discusses  profitability  prices,  ability  and  of  time  major  of  rates  concludes  p r o f i t a b i l i t y over  the  result  capital..  advantageous.  capacity a  of  higher  profits  chapter  the  which  restricted  those  higher  influence  may.have  debt  previous'chapter  inefficiency.  also  be'the  and  on  ship  firms  could  prices  higher  control  t r u e , the  poly  the  to  debt,  If  power  may  the  generates  this  allocative  powerful  in  i t implies•higher  structure  their  reviewed  power  of  LEVERAGE  a  review  discussion the  relation-  capital.  Part  f i n a n c i n g may corporate firms  structure.  do  of  D  not  debt  not  carry  35  A.  The  Concept  What which  funds  tain;  and  dia,  are  Leverage  "cost'of  capital"  used  i n which  to  Financial  i s the  ranging  claims,  of  from  pure  pure  share' i n the  at  three  specialist to  ensure  their  of  survival  the and  capital  concerned  with  explaining  o b t a i n e d by  giving  i n a world  many  are  venture?  This  (1)'  techniques growth;  budgeting;  and  investment  uncer-  money-fixed right  corporation  financing  to  the  managerial  (3)  the  economic at  vexed  so  economist  theorist  both  the  micro  economic  theorist  has  tended  to  side-step  the  essence  , thiis; "cos t - p f r e a p i t a l i p r b b i em' b y A p r p c e ' e d i n g u a S J t h o u g h . ' p h y s i c a l be  regarded  assumption,  the  the  owners  has  suggested  of  to  the  point  to  the  market  follow which of  from are  profits  a  as'yielding  theorist firm  sure  concluded  i s simply  the  rational  firm  where  the  marginal  yield This  rate  of  interest.  either  of  two  and  (2)  under  the to  criteria  the  i f i t will  on  the  cost  interest tend  of on  physical  namely,  of  market  net  this  capital  to  and  investment  assets be  is  equal  shown  to  decision-making (1)  the  maximization  value.  a physical profit  of  asset  the  i s wor-  owners  of  assets  bonds,  to' push  rational  criterion,  increase  the  Given  s u g g e s t i o n can  certainty,  first  of  will  of  maximization  streams.  that  rate  the  equivalent  acquiring  has  known,  that  According th  as  levels.  The  could  a  finance  firms  (2)  behavior  me-  q u e s t i o n has  the  of  in  different  h o l d e r s ' o n l y the  economists:  with  with  macro  firm  instruments, representing  uncertain  concerned  and  be  issues,  classes  concerned  can  debt  equity  a  a c q u i r e a s s e t s whose' y i e l d s  capital  pro-rata least  to  to  of  36 the  firm.  of  return  to  the  But of  the  the  market  ates  at  w i l l  exceed  i t a l  the  between  market  of  existence  rate  of  and  of  their  finance  to  as'to  the how  of, the  gener-  bonds  value exceeds  cost  of  cap-  regardless  of  the  the  distinction  terminology. taken  into  supposed  be  based  on  to  satisfactory  explanation  determining in  the  response  to  account,  a  equivalent" yield  it.varies  i t  asset  i s  factors  to But  capitalized  certainty,  "certainty No  stream  uncertainty  economists.have  the  cost  specialist  responds  to  no each  plurality  and  and  longer  mutually  have  between In  firm  up  for  comparison with  has  the  yet  size  of  been the  changes  seriously  risk.  In  merged'with  economist.  the.two  fact,  defined. the  face  allowing  managerial  vanishes. well  to  endeavors  the  d e c i s i o n of of  begun  capital  equivalence  decision-making i s  of  interests  u n c e r t a i n t y , the  a  of  more  in  variables.  criterion  but  of  the  yield  on  increa-  acquisition.  formulation,,the  interest  world  or  of  this  i f the  either  then  interest. as  and  rate  According  i s , i f i t adds  costs  f u n d s ' i s one' o f  are  adjusted"  however,  problem  ional  a  the  decisions  only  of  When  process, the  the'rate In  the  expected  acquiring i f i t  by,capitalizing  Under  equity  "risk  than  that  i f the  interest.  i s worth  interest,  i f and  and  Recently the  of  only  rate'of  equity,  1  firm  rate  the  asset  i s given  funds.  discount  other  an  debt  provided, risk  the  adds  increase  exceeds  interest.  the  investment the  of  to  w i l l  owners  i t s cost  of  of  the  market  i s equal  source  of  of  asset  rate  asset  value  the  profit  criterion,  value  what  the  the  second  ses  net  the  not  unique  world  of  rat-  there  profit  which  of  maximization  uncertainty  e x c l u s i v e outcomes  a  c r i t e r i a  Under a  the  those'  In  profit  to  can  cor-  outcome, at  best  37  :  be  described  by  a  fit  outcome. in  its  maximization  isions the  which  funds  to  return sion  In  the  investment in  which the  and  value  a  for  test:  of  current  current  reinvest reciation  use'  only  of may  at  1  also the  well  increase of  pro-  as  such  For  dec-  to' a f f e c t  d i s t r i b u t i o n of  rather  cost  and  tend  debt  the  c o n d i t i o n s the  as  market and  is  test  but  yield  However,  firm's  a  profit  than  equity  the  expected  increased  outcomes  decisions,  expected  the well  value  the  shares? less is  than  approach  disper-  of  of  the  but  r e s u l t i n g from  has  owners  serious  pass'only  the  raise  market  prices' will  of  management is  free  benefit  management's  the  reflect  owners  and  from  decision.  capital tastes not  as  to  the  infol-  undertaking;  cost'of  independent  still  the  c h a r a c t e r i s t i c s of  i t i s worth  project,he  will  ranked  any  must  marginal  with  and  criterion,  financed,  a l l potential  disagrees of  plan  so,  the  alternative  a n a l y t i c a l purposes.  maximization  If  entirely  those  elsewhere,  utility  p r o j e c t , , as  market  valuation  other  as  of  compared  against  i t s financing  since  stockholder  the  will"  1  the  owners,  preferences  value  The  meaning.  a subjective•"utilityfunction"  Will  the  Such  operational  venture  but  normative  not,, i t s r e t u r n firm.  has  an  random, v a r i a b l e  c h a r a c t e r i s t i c s of  given  these  project  of  a  p a r t i c u l a r , , the  the  Under  over  other  distribution.  lowing  become  expected  and' f i n a n c i n g  weighs  vestment  probability distribution;  outcomes.  terms  drawbacks  has  longer  owners,  1  Under  only  no  finance  to the  of  short,  a f f e c t the  dispersion  outcomes.  subjective  i f  to of  only  the  their  well.  If  the  market  sell the  out  capital  the  any  and app-  .38  Financial A  given  can  firm  obtain'debt  financing a  can  leverage,  financing the  common  meet  i n t e r e s t payments option  dividends  of  thus  provides  urns  on  forcing a  i s under  will  such  studies  two  firms  yet  have  amounts study, i s  was.  their  the  of  firms  of  debt  capital  decisions  not  Financial interest  to  this  to  extreme minimize  leverage  income  And  is  may to  creditors'  . Financial  leverage  higher  this  of  sales,  ret-  trade-off  And  prices,  The  market  i f they  extent  of  reviewin  expenses, the  of  this  power,  the  their  did'not  whether  equity,  upon  amounts  explain  capital  and  objective  large  managerial  those  stockholders'  dependent  structure,  individual  profitability  Specifically,  may  by  s u c h "as  to  measures  decisions the  debt  failure  gives  leverage  measure  which  amounts  their  but  i t Debt  corporation  risk.  studies  utilized  equity.  fore  of  leverage.-  stockholders'  to  a  - r e l a t i o n s h i p between  s t r u c t u r e , debt  attributed  i n t e r e s t on  trade-off.of  utilized.  on  be  higher  that  i t s return.  charges  for. the  net  returns  could  fixed  usual  leverage  financial  in  of  financial  profitability  i f powerful  capital  of  the  provided  difficulty  similar-assets,  the  since  advantage.  control.  results  ratio  have  to.examine  determine  for  powerful  than  f irm ' s bankruptcy  usage the  financial  and  legal  other  equity  Since  differing  fitability to  II.  could  of  and the  of  lower  default  a  equity  The. d i r e c t o r s  managerial  influence  ed' i n . C h a p t e r  of  cost  d i r e c t mechanism  The-degree firms  risk  a  without  stockholders'  mechanism  at  obligations  pass  the  possesses  i n c r e a s e ' i t s • r e t u r n on  involves  contractual  then,  pro-  purpose of  is  debt'in  superior use  that  risk-aversion  large failure  and  there-  costs. i n d i v i d u a l firms  they  influence  are  capital  of costs.  (.. B .  Cost  of  Capital  Like with the  any  i t s use. precise  measurement  3 9  productive'factor,, capital  Theoretically  nature is  of  considerable  the "cost  surrounded  of  with  has  a  cost  agreement  capital,  but  associated  exists  as  in practice;  to  its  difficulty.  The c o s t o f c a p i t a l i s p e r h a p s t h e m o s t d i f f i c u l t and c o n t r o v e r s i a l t o p i c i n f i n a n c e ' . In theory, most would agree t h a t i t i s the r a t e of r e t u r n on the p r o j e c t t h a t w i l l l e a v e unchanged' the market p r i c e o f the f i r m ' s s t o c k . In p r a c t i c e , t h e r e are w i d e s p r e a d d i f f e r e n c e s as t o how this cost should be m e a s u r e d . -• 1  As from  two  noted  general  associated ing  their  costs gent ty,  of  with cost  the  to  the  are,  future  shares  debt  and  equity.  fairly  future  the  price  Since  but  not  latter,  the  solution  is  themselves,  the  costs  equity  investors,  and  of  then  but  capital also  upon  consequently depends  the  not  evaluation  of  no  of  the  future  that  the  which  upon  and  The  future  is,  contin-  i t can who  knows'the  indeterminant'.  Two  of  equi-  sell  its  purchase former unknowns  the  expectations'  of  solution  is possible.  Cost  the  actions  those'actions by 1  of  the  capital  firm, markets.  J a m e s Van- H o m e , F i n a n c i a l M a n a g e m e n t and; P o l i c y , (Englewood C l i f f s , N.J. : P r e n t i c e H a l l , I n c . , 1 9 7 1 ) , p.90.. 1  costs  determin-  costs  investors  presumably  precise  only  at  that  shares.expect.  present  firm  capital  stated,  determine  the  the  Since  haind , v a r i a b l e ,  benefits  the  raise  straightforward.  know  firms  contractually  other  In  must  section,  are  is  the  events.  and' t h e  debt  firm on  particular firm  common  previous/  sources, issuing  equity  upon a  in  ':  As  such,  C.  i t spractical  Financial  The  can  increase  use  o f leverage'..  there  the t o t a l To  assume  5  interest.  rate  Market value of debt T o t a l value of firm  implied  overall  =  0 V  =  increase With  r a t e , .k  1,00 0  that  has $ 3 , 0 0 0  traditional i n debt at.  the e q u i t y - c a p i t a l i z a of the firm  then i s :  850  rate  0.11 7,727 3,000 $10,727  rate i s :  9.3  the firm  value  leverage,  B/S  , . i s •10 p e r c e n t .  capitalization  of the  percent  1 0 , 7 27  the t o t a l no  =  the firm  through" t h e j u d i c i o u s  firm that  and t h a t  assu-  $1 , 0 0 0 150  capitalization  example'suggests  erage: tion  Q  structure  The v a l u a t i o n  B V  k  and  assume  se  k  and l e v e r a g e  one v a r i a t i o n  Net o p e r a t i n g income' I n t e r e s t on d e b t Earnings available to common stockholders Equity-capitalization Market value of stock  F E  This  to valuation  a hypothetical Further  difficult'.  of Capital  of the .firm  illustrate  that  i s most  capital  value  i s 11 p e r c e n t .  0  The  approach  i s an o p t i m a l  approach,  tion  and t h e C o s t  traditional  that  percent  determination  Leverage  mes  40  rate , k  can lower  of the firm = 0  i t s cost  and share  price  ,- a n d t h e o v e r a l l  Although  , as t h e f i r m  investors  becomes  more  of  capital  by  lev-  capitaliza-  raise  the  equity  financially  e For a d i s c u s s i o n of the d i f f i c u l t i e s involved i n the c o m p u t a t i o n o f c o s t of- c a p i t a l , s e e : M i c h a e l Keenan, "Models o f E q u i t y V a l u a t i o n : T h e G r e a t SERM B u b b l e , " J o u r n a l o f F i n a n c e , (May,1970), pp.243-273.  41  risky the  with  leverage,  benefit  uation  and  of using share  the increase  i n k^  cheaper  funds.  price  debt  increase,  does As  not o f f s e t a result,  entirely total  and t h e c o s t  of c a p i t a l  implies  beyond  val-  decreas-  es . The k  e  of  rises  a t an  debt,  k^  pose and  now  rise  the firm  that  percent  degree  may  and  of leverage  with  beyond  rate  that  leverage.  some  issue  To  from  to repurchase  t h e equi-fcyscapi t a l i z a t i o n  point,  a l l  rate,  The"valuation  the  illustrate,  $3,000  o f i n t e r e s t on  i s 14 p e r c e n t ;  some  Moreover,  point.  i t s debt  of the debt  the average that  rate  increases  the proceeds  also  approach  increasing  also  that  uses  sume 6  traditional  to  g  sup-  $6,000  stock.  debt k  cost  As-  rises  , at  to  that  of the firm  then  is :  O F E k S  e  B V  The  implied  Net o p e r a t i n g income I n t e r e s t on d e b t Earnings available- to common s t o c k h o l d e r s E q u i t y - c a p i t a l i z a t i o n rate Market value of stock'  overall  the t o t a l  This the  slightly  result  increase-in  =  1,000 10,571  valuation higher  i s due k..  6,000 $10,571  capitalization  2. V  = °  capital  640 0.14 4,571  Market value of debt T o t a l value of f i r m  k  Thus,  $1,000 3 60  rate i s :  =  9.5  of the firm  than  when  these  i s lower  t h e amount  to the increase From  percent  two  in k  and  i t s cost  of debt  was  of  $3,000.  and t o a l e s s e r extent, e. observations,.the optimal  capital ratio  structure  in this  o f 6,000/4,571  traditional  approach  example  o r 1.31.  occurs  before  Graphically,  i s shown  in  a  debt-to-equity  one v a r i a t i o n  of the  Figured.  FIGURE 3 > TRADITIONAL  VIEW  %  X  LEVERAGE  As  c a n be  sing  rate  seen  i n the f i g u r e ,  with  leverage,  significant cost  leverage  of c a p i t a l offset  entirely  the  weighted-average  use  of leverage.  than  offsets  ure,  and k  with  k,  begins  i .  At f i r s t ,  After  of c a p i t a l ,  debt k  o  to•rise.  The  debt rise  funds..  with  e  result,  in k  i s supported  e  The  optimal, c a p i t a l  structure  more  structfurther  o to r i s e .  does'  moderate  i n the c a p i t a l  in k  after  in k  As - a  the increase  funds  only  the r i s e  , declines  a pointhowever,  increa-  the weighted-average  because  t h e "use o f c h e a p e r cost  a t an  i s assumed t o r i s e  leverage  t h e use o f cheaper begins  i s assumed t o r i s e  has o c c u r r e d .  o once  e  whereas k  declines  not  k  i s the  43 point tal  at  which  structure  is  that  not  is  structure,  that  that  an  the  real  point,  equity;  the  of  optimal  cost-sof  beyond  of  traditional  marginal  the  out;  the  view  the  figure,  this  real  that  structure.  cost  equity.  of  For  real  point,  implies  optimal  the  capital, structure  capital  marginal that  in  capi-  X.  independent  there  marginal  bottoms  is point  Thus, tal  k  cost  the  debt  of  At  is  cost the  that  the  and  optimal  same  as  of  leverage'  of  is  less  marginal  capi-  firm  degrees debt  of  before  than  real  cost  of  proposed  that  the  the  that  debt  of  exceeds  equity. 3 Modigliani  ship  between  and  l e v e r a g e ' and  the  net  operating  ack  on  the  traditional  cation  for  having  throughout  income  a l l degrees  Capital  ure  operating•earnings  ive  random with  categorized in  markets  corporate  cost  of  approach.  approach  of  were  of  capital  They  by  capital,  leverage.  a  The  firm-were  a l l investors  regard  the  expected  into, "equivalent  was  the  same  not  essential  income'taxes  was  return;  return"  degree  of  for  had  their  assumed.  average  MM  att-  justifi-  constant  assumptions  were:  expected  subject-  homogeneous  expecta-  (3)  by  fut-  a  classes.,  business  by  formidable  represented  and  to  a  explained  k^ , r e m a i n e d  Their  p e r f e c t ; . (2)  of  made  was  relation-  offering behavioral  variable,  a•class'had  assumption  (MM)  the  the "cost  CD  tions  Miller  Firms and  risk.  proof. removed  could  all. firms However,  (4)  be  The  this  withthis  absence  of  assumption  F . M o d i g l i a n i and M . M i l l e r , "The Cost' of C a p i t a l , C o r p o r a t i o n F i n a n c e and t h e T h e o r y o f . I n v e s t m e n t , " A m e r i c a n E c o n o m i c R e v i e w , ( J u n e , 1 9 5 8 ) ; r e p r i n t e d i n : S t e p h e n A r c h e r and Charles D ' A m b r o s i a , e d i t o r s , The T h e o r y o f B u s i n e s s F i n a n c e : A Book' o f R e a d i n g s , ( N . Y . , N . Y . : The. M a c m i l l a n Co . •, 19 68 ) , pp ; 12 5-159 '. 3  44  later. which  these stock  same  dollar's any  price  notation  only.  This  given  of  Let  in  Or,  share  1/P^  MM,  finance  consider by  return  be  be  economy, i n  by  relaxed  be  equivalently,  must  assets  capital  must  an  corporations .  their  will  a perfect  expected  class:  o f .every  can  assumption  equilibrium  worth  as  a s s e t s . a r e .- o w n e d  corporations  In  of  the  a l l physical  that mon  Using  same  in.any  proportional  to  issuing  com-  later.  market  the  Assume  the  price  for  a l l  given  per  shares  c l a s s ' the  i t s expected  return.  the f a c t o r of p r o p o r t i o n a l i t y f o r the kth c l a s s ,  =  p. ^  =  the p r i c e per firm-in class  share k,  of  the  j_th  x. ^  =  the e x p e c t e d r e t u r n per share of the j t h f i r m i n c l a s s - k , .  then , P. 1 or,  =  1/P  constant  for  The given the  several  1/p  worth  k  of  kth  P  (1)  3  is  economic rate the  of  value  ;  for  of  which  the  of the  (one  return  return  as  of  k  k.  each  of  interpretations:  price  expected  class  p  (2)  k  a l l firms  regarded  expected  =  constants  expected  (1)  the  .x  equivalently>  x./P. D 3 a  k  in  any  ah the  market  firms.  investor class  rate  uncertain  share  of  the (a) in  classes)  From class  has  k.  k  to  (c)  (2)  each  k.  (b)  pay  From  for (1)  capitalization  streams  of  the  can  kind  a  is From dollar's  again,  for  be  p  k  the  generated  by  45  ^ The d r o p p e d . f o r  as s u m p t i o n  The  s h a r e s  i n  p r o p o r t i o n s e r e n t  p r o b a b i l i t y t w o  b a s i c  t i e s  i n  :  o f  an  .way.  i m p o r t a n t  d e b t  e v e n  i n  i n  p r o p o s i t i o n s w i t h  e x p e c t e d  d e n o t e  t h e  m a r k e t  v a l u e  i s  r e t u r n  m a r k e t  d e n o t e d  o f  b y  on  t h a t  i n  T h a t  any  f i r m  i s ,  o f  common  and  V  =  i n  D  s t r u c t u r e  t h e  r a t e  and  r e t u r n  =  X  +  D  r i s e  d i f f e r e n t o f  d i f f -  t o  d i f f e r e n t  t h e  f o l l o w i n g  v a l u a t i o n  o f  s e c u r i -  s t r u c t u r e s :  f i r m  j  by.  a n d t h e  d e b t s  T h e n  MM's  X'  S'  j  d e n o t e  j  f i r m .  a n d  m a r k e t  l e t  L e t  D_.  d e n o t e  v a l u e  o f  t h e  t h e  P r o p o s i t i o n  f i r m  I  o f  t h e  /  v a l u e  I  (3)  o f  c a n  any  b y  t o  c a p i t a l ,  m a r k e t  p  g i v e n  j  /V  i s  i n d e p e n d e n t  J  i t s  o f  i t s  e x p e c t e d  c a p i -  r e t u r n  be ,  1  s t a t e d  w h i c h  o f ' t h e  i s  f i r m .  i n ' t h e  t e r m s r a t i o  o f  t h e  o f  P r o p o s i t i o n  f i r m ' s  i t s  I'  e x p e c t e d  t h e n  any  X .  .+ 3 - D .)  3  f i r m  3  j  i n  =  c l a s s  Vj .  =  3  k  p  a t  c l a s s . -  a l s o X  f i r m  c a p i t a l i z i n g  i t s  v a l u e  X  f o r  a s s -  j  es':  CS  be  m a r k e t  h a v e  s h a r e s  d e r i v e d  t h e  The .  may  now  k.  a p p r o p r i a t e  c o s t  t o  )  i s  P r o p o s i t i o n a v e r a g e  t o  f i r m ' s  J  c l a s s  m a r k e t  t a l  k  S  t h e  g i v e  MM  owned  s h a r e s .  c h a n g e s  f i r m s  c a n  c a p i t a l  t h e  j  +  j  t h e  p  r e t u r n s .  a s s e t s  c a n  e q u i l i b r i u m :  V = ( S  f o r  o f  t h e  3 e r t s  c l a s s ,  r e s p e c t  b o n d s  s t r u c t u r e ,  C o n s i d e r ' a n y  v a l u e  i t s  V , ,  I.  B e c a u s e :  same  w i t h  i s s u e  f i n a n c i n g  c a p i t a l  d i f f e r e n t  P r o p o s i t i o n t h e  t h e  c a n n o t  d e b t  t h e i r  d i s t r i b u t i o n s  f i r m s  f i r m s  i n t r o d u c t i o n  o f  f i r m s ,  t h a t  (4) k  b e c o m -  46  That  i s , the average  independent ization  rate MM  (3)  of of  a pure  w i l l  financed  entirely  capital  firm;  V, 1  Y  2  of  firm  written  an  of  to the  as  and  firm  i n a  assume  and  The  return  2 has  V  > V  rD ) 2  X  =  total  return  r  =  the market now  secure  f o r himself  an  additional  and'earnings  of  this  be  debt  the  i n  levered  . 1  dollars'  fraction a  from  of  worth  the total  portfolio,  of  out-  denoted  by  (5)  of  the firm-  a  amount  h i s personal  X  =  2  X  s o l d ' h i s otS^ w o r t h  s' = 0CS 1 2 —  the proceeds, amount  aD^  on  When  debt  + D 2  as  ,.from  a  allowance  aD^,  ) of  h i s own  f r a c t i o n s^/S^ =  f i r m l .  =  1  ,  rate' of . i n t e r e s t .  the investor  u t i l i z i n g  an  holding  1  some of  the  as:  :  By  a  that  Let firm  tie t h e v a l u e firm  class-,  equalities.  firms.  stock'while  investor  capital-  the r e l a t i o n s  firms  class  f o r both  representing  a (X -  2  and bought  on  2  S^.  rowing  ments  long  restore' the stated  of the unlevered  =  1.  as  l e t  completely  i t sclass.  any p a i r  Further  further  firm  Suppose shares  i s  i s equal  of  i n t h e same  common  firm  2  , can be  where  with  structure.  stock,  Y  and  stream  i s t h e same  the value  shares  standing  and  firms  X,  Consider the  structure  between  place  two  return,  t o any  to'establish that  take  expected  capital  equity  d i d not hold  Consider  its  of  i t scapital  proceeded  o r - (4)  arbitrage  cost  ( S  2  the sale  D 2  ^/^i  i s made  the return  firm  the shares  credit, +  of  from  he °f  2  of  and  bor-  would t  h  e  shares  f o r interest t h e new  thus  pay-  portfolio  47  Y  , is  given  by: a.(S =•  Y x  +  2  D  •  ) '  "  x  raD  (6)  2  S 1 V a: V  Comparing be  greater  firm and MM  (5)  2  to  to  sell  (6) .  firms  own  in  holdings  because  is  2  proposition whose Let  firms  than  II.  V  =  3  is- greater  1  owners  cannot  than  of  have' the  a  option  conclusion  ,  Y  shares  S^,  and  Proposition the  structure  thus  holds  also  in  rate  of  I,  MM  return  i n c l u d e s , some  derived on  the  J  •  common  Proposition  X . 3  I,  equation  =  p  k  (S  j  +  (3)  D  un-  the  stock  debt. , on  the  (7)  S . 3 From  V  foll-  rD  j'  ,  of'substituting  then , -  V  .  From  3  of  premium'over  the e x p e c t e d r a t e of. r e t u r n , , i o f a n y f i r m j i n c l a s s k,  X  would  and'hence  raising  command  V  the  depressing  thereby  This  concerning  capital  i .  1,  investors  less  V_  i t pays  firm  1  V  as  thereby  personal' leverage .  where  firms  of  levered  Proposition owing  long  Therefore'  their  that  roD, 2  as  purchase'shares  levered  case  Y  -  1  with  than  concluded  their  X  2  j  )  is'given  as  stock  .  .48  i n (7)  Substituting  =  i .  That  class, plus  The have  ization  rate  be T  which  "true"  planning  p_ k ;  rate  when  changed.  k  i s equal  f o r a pure  equity  to financial  risk  between  adjusted  originals.  p  k  equal  k  continue  certain  be  identified  with  = X / V . j j  the firm  Proposition  III-.  The d i f f e r e n c e  of c a p i t a l is  to  inter-  In p a r t i c u l a r , .the a f t e r - t a x  longer  cost  to the  and r .  f o r taxes, However,  to the  stream i n  capital-  the average  — i s p  average  within  p  of stock  the spread  as t h e i r  c a n no  (8)  o f a. s h a r e  related  propositions,  must  capital  yield  a premium  form  ,  - r) D / S  ratio-times  t h e same  pretations  the  (p  capitalization  debt-to-equity  of  +  i s , the expected  appropriate the  p  and. s i m p l i f y i n g , t h e n  between  i s r e l e v a n t - when  cost  x  p  and  k  investment  considered.  MM  proceeded  to derive  the  following  —  the rate  of return  on t h e i n v e s t m e n t ,  =  the average  proposition: Let  p p  If  a firm  holders ment  be the  k  i n class-k  at the time  project  point  *  i s acting  cost  i f p  f o r investment' i n the f i r m  completely  unaffected  investment.  by  capital,  i n the best  of the d e c i s i o n ,  i f and o n l y  of  >_  p  will  the type  and  i n t e r e s t of the  stock-  i twill  u n d e r t a k e - an  .  i s , the cut-off  That  i n a l l of security  used  p^ to  invest-  and  will  finance  49  The  MM  position  i s presented  i n Figure'4.  FIGURE ' J J 4 MODIGLIANI-MILLER  Durand and ing.  personal 4  questioned  leverage,  noting  In a d d i t i o n , Durand  imperfections',  most  t h e MM  5  notably  VIEW  assumed  identity  the r e s t r i c t i o n s  noted  corporate  on-margin  the existence  brokerage  of  of other  borrowmarket  commissions' and t a x c o n s i -  derations. Since corporations favors  interest  payments  and d i v i d e n d s  the use o f corporate  are deductible  t a x expenses f o r  are not, governmental debt.  MM  came  taxing  t o agree  policy  that  D a v i d Durand,, " T h e C o s t o f C a p i t a l , C o r p o r a t i o n Finance, and t h e T h e o r y "of I n v e s t m e n t : Comment, " A m e r i c a n E c o n o m i c R e v i e w , (June, 1963), pp.433-443 ; r e p r i n t e d i n : A r c h e r a n d D ' Ambrosia:,, o p : c i t . , pp;160-176. 5  Ibid.,  p.166.  •  corporate  income  taxes  this'tax  effect  their  position  i s presented  5  reduce  the  position in  0  was  %  of  debt,  unchanged.^  but  except  The. r e v i s e d  for MM  Figure'V?."  FIGURE REVISED  cost  5  MODIGLIANI-MILLER  VIEW  I  1  LEVERAGE  The  deductibility  purposes debt.  has  By  rate,  D.  100%  In the  interest  reduced  combining  ization  Why-  of  k  o  Debt  the  k  defined  for  as-the  corporate after-tax  income cost  k  w i t h the cheaper k , the o v e r a l l e' i d e c l i n e s w i t h e v e r y i n c r e a s e i n debt',  F i n a n c i n g May  previous  introduction  , now  payments  of  section,  corporate  Be  MM  a  tax of  capital-  Disadvantage  came  to  income' t a x e s ,  recognize the  cost  that of  with  capital  F . M o d i g l i a n i and M . M i l l e r , " C o r p o r a t e Income T a x e s and the Cost of C a p i t a l : A C o r r e c t i o n , " American Economic Review, (June,1963), p p . 4 3 3 - 4 4 3 ; r e p r i n t e d ' i n A r c h e r and D'Ambrosio, o p . c i t . , p p . 1 9 2-2 0 2 . 6  V can  be  lowered total  with  er  the  Is  i t reasonable  preferred  to  conditions  value  vented In  curve.  In  high  and  debt  Myers  postulated case;  degrees  assumption  of  of  there debt  as-a, r e s u l t ' o f be  correct.  To  earn  a  of  income-producing  less  than  come  is  would  would  be  vesting  MM  hold  real  in  The  actual  to  firm's  to  If  flows  actual  future  than  increase  cash  If the  in  estimated  i t s yearly i t is less,  pre-  capital  associated that  amount  interest and  order of  which  firm's  and  equity  to  investment may  actual income,  be  future the  managers  a more  conservative  approach  actual  future  cash  As  a  to  to  rein-  consequence,  A . R o b i c h e k and S . M y e r s , O p t i m a l F i n a n c i n g Decisions, (Englewood C l i f f s , N.J.: P r e n t i c e - H a l l , I n c . , 1965) , p p < 4 0 - 4 2 .  or  in-  firm  the  take  is  more  i n order  firm's  to  maintain  investment  flows.  7  f i r m p w i l l have  amount  income  the  debt  the  of  the  before  between  income,  the  life.  argued  of  be  described.  cost  further  earnings  choice  expected  assets.  further.  expected the  process  disadvantages  They  always  imperfections  are  obvious  capital.  disadvantageous.  market  not  high-  examined  U-shaped  i t s annual  firm's  expected firm  Myers  be  of  should  traditional  the•estimated•income.  the  and  arbitrage  expected  consistently larger  be  expand  the  that  I would  firm's  constant  a portion  dependent.on  i t s cost  unchanged' i n v e s t o r s ' e s t i m a t e s  the  its  leverage,, the  financing  Robichek  the  the  lower  debt  financing.  taxes  reinvest  the  f i n a n c i n g may  the  firm's  not  and  argued  a n d ' r i s k i n e s s . o f the  may  greater  financing?  operation-of  this  The  that  case',. MM ' s P r o p o s i t i o n they  the  firm  conclude  equity  full  Instead  with  of-the  under,which  the  this  leverage.'  to  Robichek  51  • /  the  estimates  must the  reflect firm's  the  to  t h e "case where  a  and  are  no  are  available  present  the  total  markets,  levered  financing  would  planned  fections  limit  of  are  taxes.  may.  these  future of  finding  be  investment  to  of  for equity  firm  an  may  itself meet  but  Consider  in a  fixed  in.  be  unlevered,  undertake.  investments.  situation charges  Assume  that  courses  of  to there  action  firm. make  foregone  firm  to  strategy  investment  debt  Two. a l t e r n a t i v e  not  will  investment always  able  available  levered  the  the  firm  a l l planned  firm  of  planned  substitution  f i r m w o u l d be  funds  the  value  firm's  whi,ch  the  value  a  income  events.  investments  t o make  First,  unexpected  profitable  c o r p o r a t e income  the  expect  expected  expected  levered  highly  to  with  the  i f a highly  identical,  creditors  faced to  of  structure  insufficient  firm's  when  riskiness  r e g a r d i n g the  be'changed'by.the capital  of  and  some' a s s u m p t i o n s  t o ' p a s s ' up  otherwise  amount  i s reasonable  firm's  forced  the  managers  It strategy  of  3 2  not  available  financing  investments  decline.  would  would  a l l planned  be  the  available  to  only the  in  additional  capital.  i f market  firm  then  perfect  since  cost,of  reduced  If  is positive,  Second,  be' r e d u c e d  at  investment.  at  the  The imper-  cost  of  capital. These icularly  market  for highly  results.  i m p e r f e c t i o n s appear levered  Difficulties  tions'Imposed  by  or  of  the  to  "unsafe"  because  lend  funds  firms  on  the  u n w i l l i n g n e s s of concerns.  exist,-  e x p e r i e n c i n g poor  i n borrowing  creditors  to  may  arise  financial  policies  part-  operating  because  institutional Similar  however,  of of  restricthe  investors  firm, to  considerations,apply  to  53  possible  results If  so,  the  The  attempt  may  be  stock  firm's  avoid  duced  issue  at  planned  a  of  up  These  1  sign  the of  would  face  of  poor  weakness  by  willing  to  be  discbunt  market  from  imperfections  operating  the  market.  purchase'  1  the  the  intrinsic  may  interrupt  investment. to  expect, f i n a n c i a l the. v a l u e  unavailability  the a  a  substantial  i s reasonable  On  stock, i n  shareholders  Investments  build  These  issues.  s i t u a t i o n s ' i n which  example. to  to  shares.  because  cing.  shares  interpreted;as  only  of.the  It to  equity  prospective  firm's value  new  or  of  high  liquid  alternatives  hand,  balance  represent  dividends of  cash  firm of  be  be  attempt  would  be're-  firm's  finan-  avoided,  reduced  marketable  i n the  to  additional  could  could  or  changes  the  cost  considered highly risky  other  managers  in  for order  securities. investment  strategy.  E.  Corporate  In the  Debt  spite  Capacity  of  determination  the  of  practical  cost  of  difficulties  associated  with  capital  struc-  capital, and.optimal  g ture,  businessmen  studied tions  the  escape  the  problem.  a t t i t u d e s , . . p r a c t i c e s and  and' t h e i r In  cannot  managements  general,  toward  Donaldson  justifications  the  use'of  cbrporateSihanagements  debt  are' w e l l  of  has corpora-  financing. aware  of  the  9 advantages nessmen  and. r i s k s  appear  to  shun  associated with the  direct  financial  computation  of  leverage. cost  of  Busicapital  __ Gordon D o n a l d s o n , C o r p o r a t e Debt C a p a c i t y , 9 M a s s a c h u s eItbtisd:. , H a p .r6v8a r.d U n i v e r s i t y P r e s s , 1967)".  (Boston,  and  tend  mine  to rely  the proper  ratio  itself  upon  a wide  level  i s an  range  of debt  of decision  financing;  important  decision  through'experience  determine  an  their  Another  operations.  The  rule.  appropriate  popular  decision  1  rules  to deter-  debt-to-equity Firms  0  level rule  evidently  of debt i s the  for  earnings  11 coverage before of  standard.  interest  the f i r m  est  advantage other  be  this  taxes,  charges,  fixed  in possibly  but  the n e t income  t h e amount  at least  and'other  rule,  available  a certain  number  charges.  Such  of focusing attention  fixed  standard  and  must  payments  By  upon  shares  fostering  income  for fixed  charges,  of times  the  a' s t a n d a r d  has  t h e payment  inter-f. the  of interest  the disadvantage non-optimal  or the  o f any  and  arbitrary  decisions.  12 Scanlon Bell  System  firm  could  risks  for  an  found  safely  that  carry,  i n that  and  future.  and  i t sability  A l l of these  System debt  high-grade  credit  to earn  there  has  an  have  of debt  to consider  varies  and  characteristics  adequate  entered  return  into  ratio  policy.  are r i s k s  cing,  t h e next, c h a p t e r w i l l examine T b i d . , pp.100-102.  influenced  Bell  associated with the question  of  a  among  demand of the unknown  determination to  the  basic  i n an  I n - a d d i t i o n , the need also  the  considerably  to the nature  the o p e r a t i n g  policy.  standing  Since  essentially  factors  ratio  This  f o l l o w e d by  t h e amount  necessary  business.  is. related  policies  i n determining  i t was  industry's product,  industry,  Bell  and  inherent  industries  examined the f i n a n c i a l  of  maintain  System  debt  debt  finan-  risks.  1 0  1  1  lbid.,  pp.103-105. -  1 2 John Scanlon, " B e l l System F i n a n c i a l Management, (Summer,1972), pp.16-26.  Policies , " Financia1  '5.5  F.  Summary  Proponents is  an o p t i m a l  the  total  When  we  must  capital  value  greater;  rise  with  Consequently, for  They  use of  its  the t o t a l  markets.  However,  leverage.  Their  cost  of capital  continually  cost  ground  when  leverage  ah for  there  IV w i l l  the risk  must  of  leverage  capital  financial  on t h e o t h e r  risk. calls  implies  that  with  of  the introduc-  of capital  that  value  t h e MM  argue  of arbitrage i n the  increased  the t o t a l  hand,  be t h e s a m e ' r e g a r d l e s s  the cost  with  However,  a firm  c a n be can lower  leverage.  of the firm  position  lowered  The  are r i s k s  require  and t h e  i s o n "the w e a k e s t  debt  the questionssbf . r i s k s .  associated with  debt  lower  N  associated with  a higher  its -  greater  i s extreme.  consider  i n v e s t o r would  of  leverage.  s t r u c t u r e i s n o t one t h a t  recognize  taxes,  position  the higher  of capital.  Since „ Chapter  income  they  with  its  the cost  of the presence  of corporate  leverage,  can i n c r e a s e  to increased  position,  of the firm  tion  the  there  debt.  f i n a n c i n g mix b e c a u s e  capital  that  the impact  that  owing  capital  o f t h e MM  value  the firm  income'taxes,  leverage  argue  the j u d i c i o u s use o f  f u r t h e r argue  the optimal  Proponents that  through  corporate  extreme  t h e maximum  position  s t r u c t u r e and t h a t  of the firm  for  allow  is.even  of the t r a d i t i o n a l  risk  premium  financing, As  a  consequence,  t o compensate  financing.  \  him  5 6  CHAPTER  IV  SYSTEMATIC ' RISK  Since an  investor  to  invest  there  would  the  measurement and  the  IV  between  of  systematic  the  relationship  A.  The  Concept  of  and  i s taken  Sauvain's  with  receipts  owners  may of  be  by  of  two  of  debt  case  of  equity  form  of  repayment  received  upon  of  Income  case  B  and  induce  him  major  parts.  i s concerned  Part  D  risks.  Part  with  the  portfolios  differentiates Part  E  examines  of  the  "risk"  Sauvain.  refers'to  the  1  In  the  estimated  magnitudes These (2)  of  in  degree  expected  expected  be  i n the  form  of  interest,  or  i n the  form  of  dividends,  issuers  securities  of  of  the  i n the  repayment  principal securities  or  may or  of  of future  future  may  Recovery  this  context  income  the  and  employed  (1)  instruments. by  from  of  receipts  recovery in  the  in  the  take  the  amounts  market.  Harry Sauvain, Readings i n Investment Management, (Bloomington, Indiana: Bureau of Business Research, Indiana U n i v e r s i t y , 1965), pp.2-3, 5-10. 1  A  return.  securities.  instruments,  sale  Part  definition  respect, to  kinds:  principal.  to  discusses.efficient  risk  financing,,  Risk  "risk"  uncertainty  five  unsystematic  specifically  theory,  debt  premium  into  diversification.  The. c o n c e p t u a l study  C  risk  with  firm.  risk.  Part  between  of  higher  i s organized  risk.  effects  a  associated  levered  concept  of  risks  require  in a highly  Chapter discusses  are  57  Sauvaih uncertainty, interest means  will  repayment concept amount  by  power  on  of f i n a n c i a l  risk,  "Financial  risk"  an i s s u e r  security  t h e open  i n the  market  as i s t h e c a s e ' w i t h  risk  financial  o f a s e c u r i t y where  also  the s e c u r i t y  includes c a n be  r e f l e c t s ' p s y c h o l o g i c a l as ' w e l l market  that  of the  of a  future  f i n a n c i a l • a b i l i t y • (or w i l l i n g n e s s )  sale'in  the i s s u e r ,  being  risk.  o f amounts  In the case  depends  than  the  as t o t h e  i n the market,  as f i n a n c i a l  on  stocks',  uncertainty  sold  recovery  rather  common  of  and  factors.which•  prices.  "Interest  from  of the size  in.the  to the source  classifications  1  f o r which  affect  value  according  and p u r c h a s i n g  to pay."  principal  risk  pay t o i n v e s t o r s i n t h a t  o f changes  issuer  this  risk,  "uncertainty  because  of  the p r i n c i p a l  rate  security  the  classified  rate  risk"  means  "uncertainty  o f s e c u r i t i e s and u n c e r t a i n t y  of the size  1  securities  upon  reinvestment  caused  by  of future  market  of future  income  f l u c t u a t i o n s i n the 3  general  level  of i n t e r e s t rates  "Purchasing of  the purchasing  in  the future  sale  power power  risk"  or redemption  f l u c t u a t i o n i n the general 4 the. c o s t o f l i v i n g . "  2  as u s e d  i n this  study,  Chapter  I I ,p . 3 .  Ibid.,  Chapter  III, p.2.  lbid.,  Chapter  IV, p . 1 .  3  4  of debt  level  Ibid.,  markets."  as t h e  to be'received  of income'and  the  "Risk"  i s defined  o f amounts  i n the form  of s e c u r i t i e s  i n the c a p i t a l  principal  "uncertainty by  recovered  ... c a u s e d  of prices  refers  investors  ...  simply  by" by  (i.e.) i n  largely  to  financial  58  risk, able the  as d e f i n e d portion  ability  investors'' To the  and w i l l i n g n e s s appraisals  capital  market  prices  of  the concept  dividends  future  time.  and  The Measurement  Perhaps  risk ' is  of "risk"  payments  and on  and w i l l i n g n e s s .  prices  of the stocks, i n t e r e s t rate  the risk.  r e f l e c t e d only, to the power  risk  affect  of  as used  i n this  study,  of uncertainty  represent  with  of return,  a,combination  (2) a n e x p e c t e d  respect  to  measured i n of  (1) e x p e c t e d  market  price  a t some  single  statistical  Risk  widely-used  the standard  a security;  6  d e p e n d on'  of i n t e r e s t rates i n  reflects  future'rates  t h e most  has been  Lintner,  also  degree  of expected  future  return,for  here  consider-  stocks.  d o l l a r s , which  risk  the market  power  to the estimated  realization  of  employed  ability  and a price  t o make  considerations' of purchasing  Thus,  B.  of issuers  market  i n the l e v e l  affect  purchasing  that  current  a l l the dividends  of the i s s u e r s '  changes  markets  extent  refers  that  of risk  Similarly,  since  of the f l u c t u a t i o n s ' in-the  the extent  concept  above.,  This  deviation measure  of annual  has been  rates  used  by  measure of  Markowitz,  7 Sharpe,  and o t h e r s .  ^Harry Markowitz, s i f i c a t i on o f I n v e s t m e n t s  I t focuses  directly  on t h e  Portfolio Selection; Efficient Diver( N . Y . : J o h n W i l e y & S o n s , I n c . , 1959) .  ^ J o h n L i n t n e r , "The V a l u a t i o n o f R i s k A s s e t s a n d t h e S e l e c t i o n o f Risky Investments i n Stock P o r t f o l i o s and C a p i t a l Budgets," Review o f Economics and S t a t i s t i c s , (February,1965), pp.13-37. 7 W i l l i a m Sharpe, "Risk-Aversion i n t h e Stock Market:. Some' E m p i r i c a l E v i d e n c e , " J o u r n a l o f F i n a n c e , ( S e p t e m b e r , 1 9 6 5 ) , pp;416-422.  59  variable of  of ultimate  return  lying  received.  influences,  expectations, The. p r e s e n t bility  analysis  variable  of return  f o r analyzing  have  certain  them  f o r use i n attempting  risk  associated  this  conceptual  study,  each  frequency-of ship  of the period  over  which  for  Since are sure  available  basis. than  or to derive  annually,  security  prices It  directly  since may  has been  measurable,  have  and  of the observed  basis,  i t would using  t o take  place that  Stock  some  in  (1) t h e  period  the formula of  return. (fSE) tape  be p o s s i b l e  t o mea-  observations or  more  annual frequently  fluctuation i n  year.  investors''  and. t h e r e f o r e  (3)  Exchange  significant  modifi-  the r e l a t i o n -  rates  observations  a  degrees, o f  to-the  monthly  that  incorporated  on a . q u a r t e r l y  within  return  concern  (2)  tradition-  three  been  They  are measured,  considerable  noted  These  i s measured  observations'  take  sta-  t o commend  the r e l a t i v e  of return;  risk  of the  advantages  reason.  of return  desirable  on  relevant'  of rates.of  securities.  on t h e T o r o n t o  of rates  as t h e  modifications  measurement  which  on a m o n t h l y  I t seems  three  of rates  returns  the data  with  factors.  risk.  to' measure  the s t a b i l i t y  stability  directly,  over  relative  measuring  the focus  for a different  under-  investors'  sympathy  or operational  observation  many  market  to the investor  different  i s , the rate  a great  dividends,  the s t a b i l i t y  of . the t r a d i t i o n a l  that  and f i n a n c i a l  t o measure  are,.however,  with  reflects  as e a r n i n g s ,  i s in full  i n . an a t t e m p t  procedure  cations  to the investor,  and p s y c h o l o g i c a l  There al  This  such  of the rate  variable  concern  expectations assumption(s)  are not must  be  .60  made t o an  justify  the  approximation  tion  most  choice  of  of  a measurable proxy  such e x p e c t a t i o n s .  commonly made i n t h i s  to  represent  The- p a r t i c u l a r  respect  in earlier  assump-  investiga-  g  tions  i s the  the  of  use  future  of  return  ex  (the  holding  This  post' v a l u e s  periods  It  returns.  actual  investors'  of  values  f o r the  seems a t of  least  rates  given  point  their  judgment o f The  of  ;  as  risk  i n t i m e , w h i c h would risk  on  extrapolation  pure  the  justify  rates  of  hypothetical  as•surrogates  t i m e one' may  i n connection  Therefore, observed  this  i n the  some p a s t  i n the  imply  for  that  the  wish to  of  investors of  any  based  observable  risk  expectations' regarding  f o r the  the  past  advantage can  be'meaof  investment'decision.  study used v a r i a b i l i t y proxy  1  as' p r o x y  examine, c h a r a c t e r i s t i c s  w i t h making an  past' as-a  as  one'important  d e g r e e of  consider  period  future  extrapolation  p r e m i s e has  the  investors''  during  during  of  sured  urn  to  d e v i a t i o n s ' of  in question)  return  omniscience'premise:  securities  used  and  r e a s o n a b l e , however, t o  o v e r the at  were i n -  variability  r a t i o n a l e was  realized  investors' expectations  data.  the  standard  stocks  i s , investors  expectations.  variability for  that  used b y . S h a r p e ,  i .pi.r.ecis.e. i n p r e d i c t i n g b o t h  fallibly levels  one  of  rates  of  uncertainty  of  security's future  ret-  perfor-  mance . The  measure o f 1  stability  employed  i n other  studies,  been the  standard  deviation  .  _  such of  as  rates  Sharpe, o p : c i t .  of  return  commonly  those'previously.cited,  annual  —  William  of  rates  of  return  for a  has  61 security mean  time,  of dispersion  t o be most  the  ies  using  portfolio  i s introduced. between  rate of  return  rate'of  return.  -  It vested no  will  in'the  stock  withdrawals  entire  portfolio  time  i n this  from  i s sold  central  t o be u s e d  in  that  ing  than  that central  and t o t h e p u r -  that  of  present  portfolio  are reinvested  value  aire  rein-  and  until  - Under  i s the appropriate  that the  these  measure'of  the "average"  the geometric  upward  mean  t h e payment,  date.  on  return.var^  a l ldividends  made  to'r e p r e s e n t  an  the arithmetic  the discounted  which  of return  periods,  the rate  the investor's  mean  of central  as r a t e s  time  study'that  However,  a l lproceeds  rate  rate'of  of' r e t u r n  and' t h e r e f o r e '  varies  size.. In-this  be  i t seems  as a measure  at a predetermined  geometric  assumes  mean  and a n o t h e r ,  of the firm  return• f o r the period.  tendency  measure'of  to the data  over-successive  assumptions,.the tendency  that  s e r i e s > such  be h i g h e r  a r e made  of central  i fa  i s ' used..  period  i s assumed  arithmetic  However,  purpose,  around  To t h e e x t e n t  one t i m e  the  of return.  f o r any g i v e n  the arithmetic  f o r a' c o m p o u n d  investment  bias  the data  about  some m e a s u r e  i s most' a p p r o p r i a t e  pose' f o r which  tendency  around  rates  should'be•measured  which  By  yearly  meaningful  dispersion  tendency  an  o r t h e second'moment  of the consecutive  measure is  over  study,-when  r e f e r r i n g to the single equation:  we'mention interval  rate  measure  of return, given  we  by t h e  will follow-  6 2  V R  _  -  V  1  +  D  0  CD  1  P  V  0  whe r e V  =  the p o r t f o l i o interval,  market  value  at  the  end  =  the p o r t f o l i o market of the interval,  value  at  the  beginning  =  cash distributions'• to interval.  1  V  0  D 1  C.  Efficient  of  and  All  risk  concepts  of  each  investor's  function type  Portfolios  utility  function  Max. - U  [E (W ) ] t  the  investor  of' the  during  the  Diversification  have  been  based  wealth.  can  be  A  on  von  written  the  utility  Neuman-Morgehstern  as:  C2)  where  In  U  =  utility,  W  ='  wealth;  addition;  Rt  the  return  W _ _ t  =  and  -  on  investment  can  be  written  as:  W t-1  C3-)  W t-1  where W W  = t-1  wealth =.  at  wealth  the at  end  the  of  the  beginning  period of  the  t, period  t.  .63  Rewriting  equation  W  =  (3),  RW  we  +  t  W t-l'  t-1  Because.wealth  in  on  the  investment,  Max.  U  E(R)  =  a  have  certain maximum  the  following  (4) ;  period utility  (W  ) i s - a f u n c t i o n of return t f u n c t i o n i s t h a t of R:  (5)  [E(R)]  where the  expected  value  of  the  return  on  investment.  9  . . .  Markowitz of  discounted  folio of two  return  model.  expected  synthesized  He  the  and. r i s k  The  1  two  concepts  risk-aversion  developed  value  equations .  and  the  first  as is  into  an  two-parameter represented  as  by  o f • maxim.i'z a t i o n explicit  rule  port-  which'consists  variance.  He  used  follows:  N E (R. ) = p  where  ECR  ) = P =  X  Ei=l  i E(R  X  the  the ) =  E CR i  )  (6)  i  expected  proportion the  return  on  invested  portfolio  in on  p,  security i ,  expected  return  security i .  that  the  expected  the  individual return  i This the tion  equation sum  of  states  the  invested The  a  2  in  each  of  CR  ) = .  Harry  of  a and  portfolio the  N  N  £ i=l  I j=l  Markowitz,  is  as  follows:  x x Cov i  j  op : c i t  C7) i j  is  propor-  security.  second' e q u a t i o n  p 9  product  return  •  64  where a (R  ) =  2  the variance  of the return  on p o r t f o l i o  p,  P X  =  the proportion  invested  in security i ,  =  the proportion  invested  i n security j ,  i X j Cov  =  the covariance between t h e r e t u r n s s e c u r i t y i and s e c u r i t y j .  ij This  equation  portfolio and  states  the variance  i s t h e sum o f t h e v a r i a n c e  the covariance  included  that  U =  f  IE  CR ) ,  each  and, v a r i a n c e , ECR  p defined  ) and  combination  -  return  o f t h e two s e c u r i t i e s  2  p' , X  combinations  following  o f s e c u r i t i e s h a s an e x p e c t e d has a c h o i c e  (R ) , d e p e n d i n g  by t h e X  ,  C8)  P  the investor  !>-  E-V  security's  CR ) ]  0  P  of  of the  i n the p o r t f o l i o . Max.  Because  of the return  o f each  between' t h e r e t u r n s  of  X  of various  on h i s c h o i c e .  Markowitz  of  combinations  portfolio  suggested  attainable  n•  2  as r e p r e s e n t e d  by t h e shaded  figure. FIGURE ATTAINABLE  value  E-V  6  COMBINATIONS ,B  V  area  i n the  6 5  Even for  the  though a t t a i n a b l e  rational investor,  risk-averse return. be  is  set  accepted of  The  the  s t o c k ' and other,  remaining  expected  ) = p.  expected  either  t a k e more, r i s k  increased  X E (-R)  stock,  ) =  2  on  In  be  return  = .  2  E (R).  i s invested  returns,  that  to in  the is a  (9)  the  portfolio  i s thus  ( 7 ) , the  they  variance  of  equal are  the  to  the  that  of  same.  two-stock  port:  as.follows:  x a 2  2  + x a 2  2  + 2x x :t  22  cov  12  (10)  12  the  variance  of  the  return  of  security  1,  the  variance  of  the  return  of  security  2,  the  proportion  invested  in security  1,  X  =  the  proportion  invested  in security  2,  =  one  = E (R)  =-  1 2  of  is, -  X  Cov  risk.  If part  1  .2 _  and  Assume  where i  AB  characterized  two-stock p o r t f o l i o  expected  variance  4,  Figure  X^ , i s a l l o c a t e d  1 - X^  this  + X E (R)  11  p  additional  return,  i t i s assumed t h a t  is calculated  a (R  X^~  A  more  d i f f e r e n t common s t o c k s .  part,  two  efficient.  expected can  feasible  2  on  since  of  are  without  that  return.  same e x p e c t e d  1 •  return  them a r e  phenomenon  two  return  From e q u a t i o n folio  not  f o r investment,  average'of.the  E(R  a l l of  combinations  Consider  available  the  not  diversification  the  weighted  The  f o r an  t h e y b o t h have the wealth  combinations  combinations'show  efficient  quantitatively. that  would  The. e f f i c i e n t  should the  investor  E-V  the c o v a r i a n c e s e c u r i t y 1 and  between the r e t u r n s s e c u r i t y 2.  of  66  :  The  covariance  fication.  I f t h e two  ly  other,  o f each  always  possible  term  i s crucial  securities  then  fluctuate in price  the covariance  t o choose  to the effect  term  the r e l a t i v e  of  diversi-  independent-  i s zero,  and, i t i s  proportions,  X  and X  :  1 in  such  that  a way  of either  effect o  2  1  that  = a  equal  of squaring 2  2  numbers  2  =  i n each  (.5) a 2  +  2  of either  not  reduced,  such  as  therefore  always  securities. ties order  two  having  Hence,  stocks  into  (11)  2  one-half,of  the expected preferable  return i s to a  single-  investor. some  cannot  be  of risk  positive  comove-  realistically  i n that  case  i s not  independent,  but i t can  than  average  o f t h e two  the simple  perfect  and L a u  of  securities'were  ;  Exchange  term  diversification  than  of a portfolio  to only  exhibit  The r e d u c t i o n  to r e d u c e p o r t f o l i o Wagner  equal Since  securities  smaller  less  .5a  i s clearly  the covariance  when  1  security.  a s i f t h e two  b e made  =  2  f o r any r i s k - a v e r s e  to be'zero.  large  2  a portfolio  Typically,  assumed  (.5) CT  i s due t o t h e  F o r example,  the risk  than  i s :  has a v a r i a n c e  variance  merit;  security  i s smaller  This  one'.  2  the  portfolio  than  i s zero,  1  the p o r t f o l i o  security  separately.  less  and t h e c o v a r i a n c e  ap  of the p o r t f o l i o  s e c u r i t y taken  investment  Thus,  the r i s k  2  1 0  results  correlation  risk  from  among  holding their  securi-  returns i n  risk. divided  a sample  s i x subgroups  based  o f 2 0 0 New  York  on t h e S t a n d a r d  Stock and  W a y n e Wagner a n d S h e i l a L a u , "The E f f e c t o f D i v e r s i f i c a t i o n on R i s k , " F i n a n c i a l A n a l y s t s J o u r n a l , . (November/December, 19 71) , p p ; 4 8 - 5 3 . 1 0  67  Poor's  Stock  additional in  Quality  Ratings  diversification  the p o r t f o l i o r e s u l t s  as o f June  by  1960, and f o u n d  increasing  in rapidly  t h e number  diminishing  that  of  holdings  reduction  in  risk.  D.  Systematic  and U n s y s t e m a t i c  Another study  i s that  important  while  s i f i c a t i o n ,.others between ted  by  was  first  eliminated,  For  which this  and a l s o  related  diversified its of  only  with  through  risk  implication  1  1  c a n be  as c o n s i s t i n g  risk,  By  the portion  the return  Irrespective  with  of  risk  o f two increasing t o be' of  total  of the market.  referred  correlated  diver-  Sharpe  tends  performance  i s also  elimina-  the portion  gradually  diver-  to d i s t i n g u i s h  "systematic".  i s that  in a.diversified portfolio,  through  securities in a  is essentially a reflection  as a w h o l e .  and Lau  diversification.  risk  to the o v e r a l l  which  risk,  risks  the term  portfolio i s highly  the market  risk  other  systematic  systematic  The  variability  ings  risk,  the unsystematic  i s related  risk.  b e w a s h e d away i t i s necessary  the idea?6f  coined  leaving  reason;  Thus,  o f t h e Wagner  and i t s " s y s t e m a t i c "  b e w a s h e d away  diversification,  risk  cannot.  to consider  components  risks'can  the s e c u r i t y  portfolio, cannot  conclusion  "unsystematic"  combining  sified which  a firm's  some  Risks  t o as on a  marketwell  the market,  of the  variability  o f t h e number  investors' cannot  and  of  hold-  avoid' market  Ibid.  William Sharpe, " C a p i t a l Asset P r i c e s A Theory o f Market E q u i l i b r i u m Under'Conditions o f Risk," Journal of Finance, ( S e p t e m b e r , 1 9 6 4 ) , pp 4 2 5 - 4 4 2 . 1 2  ;  68  risk.  King  uation  of a p a r t i c u l a r  movements,  estimated  1 3  a n d some  remaining  individual  E.  Systematic  The  ship of  market  Risk  and  explained  i s that  by o v e r a l l  of that  fluctmarket  industry.  The  due t o t h e c h a r a c t e r i s t i c s  of  risk  Return  Asset  Pricing  and o t h e r s ,  1 5  and r e t u r n  equilibrium.  assumptions,  security,  c a n be  as 50% o f t h e p r i c e  10% by t h e f l u c t u a t i o n  Capital  between  a s much  firm.  Lintner,  l t f  certain  firm  40% f l u c t u a t i o n  the  Sharpe,  that  denoted  Model  provides  of a capital  Basically, the expected  by'E(R  (CAPM) , . a s d e r i v e d a theoretical asset  the model rate  asserts  of return  ), i s a linear  under  function  by  relation  conditions that,  under  on t h e j_th of a  risk-free  j borrowing market  and l e n d i n g  factor E(R  where  3,  relative  such  ) = j ,  rate,  and t h e e x p e c t e d  as t h e S t a n d a r d  R  +  8  f  j  i s a measure t o the market  [ E (R ) m  3  factor,  = Covariance  pal  above  the variable  theoretical  denotes  assumptions  Benjamin King, Behavior," Journal 1 4  1  5  William John  Sharpe,  Lintner,  Index,  ]  E (R  (12)  o f t h e j_th s e c u r i t y  'Vi  (R  'Vi  .  , R •)/ o j m  a random  o f t h e model  of systematic „  risk.  i\,  (R ) w h e r e t h e m  variable. a r e as  The  princi-  follows•  "Market and I n d u s t r y F a c t o r s i n S t o c k o f F i n a n c e , ( J a n u a r y , 1 9 6 6 ) , pp . 1 3 9 - 1 9 0 .  1 3  Price  Stock  on a  f  o r a measure  j tilde  R  of the v o l a t i l i t y  •  Mathematically,  a n d P o o r ' 500  return  op/cit.  op . c i t . .  69  (a)  A l l investors utility  (b)  returns  have  for  perceptions  summarized  by  single There is  .  It  a  a  or  the  moments  future  of  the  may  be  probability  return.  borrow  as  much  as  they  like  at  a  rate.-  be  noted  costs  that  the  the  equation  theoretically  computing  a l l securities  security's  Therefore,  using  about  or  taxes.and  each, s e c u r i t y  divisible.  should  is  two  transactions  perfectly  expectations  about  first  lend  no  estimated  ion  of  risk-free  expectations. ble  the  may  are  It  expected  security.  Investors'  Investors  (e)  homogeneous  each  distribution (d)  single-period, risk-averse,  maximizers.  Investors  (c)  are  market  parameters  based model  for  the  model (12)  time  of  observa-  i t may  This  1 6  terms  directly  However,  Sharpe.  following  in  1  i s not  result. of  is stated  be  involves  series • regress-  model: /  R  = • a j,t  where  t  represents  parameters of  obtained  regressing  return, market  +  R. 3  11  index  6  j  the  R j m,t  + ' e  individual  using  (13) j ,t  the  periods',  ordinary  periodic observations  , on  temporally  returns , R  r e p r e s e n t s ' the  ro,t  of  The  ej.. j ,..t  unsystematic  r  a  j  and'  least-square' the  corresponding .  and  is  risk  6  j  are  technique  j_th s e c u r i t y ' s observations the  the  random, e r r o r  term  and  (New  W i l l i a m S h a r p e , P o r t f o l i o T h e o r y and C a p i t a l M a r k e t s , Y o r k , New Y o r k : McGraw H i l l B o o k Company,1970) , p . 1 1 8 . 1 6  1  of  of  the  j_th s e c u r i t y .  .-  In,other unique  words,  t o t h e j_th f i r m .  statistical  ) =  of the  In a d d i t i o n ,  assumptions  E(e  70  % e; . i s a r e f l e c t i o n D,t  characteristics  the following  principal  hold:  0  (14)  j ,t E(e  ,e ) = j,t j , t - l  «u E(e  * ,e j,t  Equation is not  zero.  I t follows  compensated that  no  terms.  Finally,  equation  that  between  when  Equation  successive  (15)  error  the expected  t h e j_th s e c u r i t y  and t h e v a r i a n c e  term  the i n v e s t o r i s  risk.  (16) a s s e r t s t h a t when  of the error  i s not  value equal  t h e 2_th s e c u r i t y a n d  equation  (14) h o l d s ,  equation  (13) c a n be  as f o l l o w s . :  j  parameters'  least-squares expected  Asset  this  value  are equal.  that  E (R ) =  As  i s zero  (16)  (for j = i )  the expected  equation  the i t hs e c u r i t y ,  the  2  J' # i)  exists  to  approximated  from  a  r  correlation  term  Given  (f°  unsystematic  the error  The  {  f o r bearing  of  i t hsecurity  (15)  0  ) = i , t  (14) s t a t e s t h a t  asserts  the  0  +  6 E (R )-+  j  j •  m  a. and  3,  c a n be  technique..  by Weston,  Model  (17)  obtained  Therefore,  r e t u r n o f t h e j_th f i r m  noted  Pricing  a  i s that  given c a n be  "the great  from  the market  return,  computed.  advantage  a l l i t sfactors  the ordinary  other  of the than  Capital g  are  71 marketwide  constants.!'  strated  equivalent  having  an to  resort, to  If  the  use  in  ary  through  must  be  which in  will  be  the  period  systematic  generally  The omic  i s , the  (8)  the  is  the  implication  environment• i s  systematic  under  risk  to  be  of  using  from  1 8  estimates  obtain  risk. to  not  be  able  changed  over  portfolio  Furthermore.,  demonstrated  a  station-  to  stable  as  be a  historical  6 the  has  practical  selecting  important  fairly  market  without  to  over  that  time,  data,  assume the  a  firm's  (b)  and  can (c)  whole.  foregoing  is  that  i f the  econ-  s t a b l e , i f i n d u s t r y c h a r a c t e r i s t i c s do  will  policies  be  have  relatively  c o n t i n u i t y , the  stable  over  the  not.  measure  period  consideration. Levy  1 9  like  Blume  using  the  Stock'Exchange  York  weekly  tested  coefficients New  •is  Blume  (a)  c h a n g e a n d ' i f management of  directly  is  future  portfolio  accurately to  risk  investor  i n d i c a t i o n of  consideration.,  tends  g  Weston, demon-  analysis.  systematic  p o r t f o l i o s i t  very  computing  p a s t . h i s t o r i c a l data  good  risk  forecast  o f  observation,  s e l e c t i n g p o r t f o l i o s , , i t must  r i s k i n e s s of  under  of  That  use  a  evaluating  that  be  to  this  regression  and  time.  able  method  concept  evaluating  From  1 7  data  for  for  over  the  500  the  s t a t i o n a r i t y of  common  period  stocks  30th  the  listed  December  8 on  1960  F r e d Weston, "Investment D e c i s i o n s U s i n g the C a p i t a l Model'," F i n a n c i a l M a n a g e m e n t , . ( S p r i n g , 1 9 7 3 ) , p.25. 1 7  Pricing  Marshall Blume, F i n a n c e , (March,1971), 1 8  of  "On the Assessment pp.1-10.  of  Risk,"  Journal  R o b e r t L e v y , "On the Short-Term S t a t i o n a r i t y of Beta C o e f f i c i e n t s , " Financial Analysts' Journal, (November/December, 1971) , p p ; 55-6 2 . ' 1 9  72  :  through same  1 8 t h December  as t h o s e  proxy  order  o f Blume.  f o r future  statistical  risk.  Both  is,  outside  individual stable  risk  product  the  of this  3  moment  correlations  and t h e r e f o r e  and  rank  of s t a t i o n a r i t y .  study.  return  excellent  two m e a s u r e s o f  3  i t  by r e g r e s s i n g  on t h e m a r k e t  c a n be u s e d  coefficients  As a c o n s e q u e n c e ,  c o e f f i c i e n t s obtained  security's  e s s e n t i a l l y the  i s an  f o r the s t a t i o n a r i t y of the  the scope  that  past  studies•used  c o r r e l a t i o n s , f o r the test  assumed  F.  The r e s u l t s were  That  association:  Testing is  1970.  return  as p r o x i e s  are  f o r future  i s  the  relatively risks.  Summary  Since an  investor  to  invest  Pricing  there  would  are r i s k s  require  i n a highly  the best  currently  available.  higher  Therefore,,  power  and h i g h e r The  empirical Chapter  I.  next  results  Because  return  debt  firms we  would  two c h a p t e r s f o r the test  to induce  him Asset  and r i s k , i t  of the r i s k - r e t u r n r e l a t i o n s h i p Asset  can earn  t o have  financing,  the C a p i t a l  considers' uncertainty  I f the Capital  powerful  with  risk'premium  firm.  description  correct,.then risk.  a higher  levered  Model' e x p l i c i t l y  represents  associated  will  a higher  expect  higher  P r i c i n g Model i s  those 3  examine  return with  only  great  at a market  coefficients. the methodology  of the hypothesis  stated i n  and  -7  3  CHAPTER METHODS  Chapter data  used  in  empirical  V  AND  i s organized  this  study,  results,  and  (B)  (D)  V RESULTS  into  the  the  four major  methods' o f  evidence  parts:  (A)  analysis,  concerning  the  (C)  the  corporate  debt  capacity.  A.  The  Data  This uring and  study  industries  Labour  Financial  i s based  f o r which  Unions  Returns  Statistics  and  annual  reports.  and  important,  and  The  1965,  for  25  percent  percent  of  The 1969 shown  inclusive  a  and  in.each  sufficiently  economic  theory  Reports  are A,  to  add  to  of  taken  which, a l s o  period  demonstrates  to  percent  from  the  the  21  The  achieve that  even  two  at  large  and  number  assumption  of i t s  accounted  factor  cost,  salaries. 1962  manufacturing  perfectly  is  activity  period  major  (CTS)  knowledge  wages  time  i n c l u d e s the  year.  Statistics  the  manufacturing  cover  Corporations  s e c t o r i n Canada  and study  manufact-  Corporation  Taxation  product  28  major  i n the  gross'domestic  i n d u s t r y , by  long  21  (CALURA),  manufacturing  of  of  are"recorded  f o r example,  in this  i n Appendix  contained  Act  employment,  data  data  analysis  i t i s desirable  In  25  the  (CFS),.Corporation  structure. roughly  on  of  1  through  industries firms  i s that  benefits.  i t is First,  competitive  "'"Department o f C o n s u m e r a n d C o r p o r a t e A f f a i r s , C o n c e n t r a t i o n i n the M a n u f a c t u r i n g I n d u s t r i e s of Canada, (Ottawa: Queen's P r i n t e r and C o n t r o l l e r o f S t a t i o n a r y , 1 9 7 1 ) , p.13.  74  markets fits  may  and  porate dures ging  endure  short-run adjustment  p r i c e s ' a b o v e the  managements in timing  over  a  have  the  number  c o m p e t i t i v e are  discretion  recognition of  years  fluctuations' attributable The study must  must not  be  any  data  profits  and'interest  1969.  Second,  f o r the  necessary  spectrum  of  that  the  business  priori.basis,  and  The  Second,  cor-  accounting  proce-  expenses.  Avera-  potential  chosen  f o r the expense  and  pro-  short-run  factors;  criteria.  industries  not  above  statistical  risk.  modern  revenues  industries  sales,  is  the  following  missing  of  under  possible.  minimizes.any  to  manufacturing meet'the  p e r i o d s d u r i n g which  for inclusion  First,  the  variables; over  the  testing  selected  a c c o r d i n g t o . any  assets, 1962  equity, through  be'meaningful,  represent a  industries  the  industries  period  to  in  were  measure  broad  chosen of  i t  on  an  a  variability. 2  Essentially, cipal  aim  the  i s to  This 21  same  provide  study  manufacturing  would  provide  since  the  a high  i n the  a  vital  compiled  between the  1962  degree data  this  f o r each and  are  treatment to  been  used  a heterogeneous  industries.  consistency  were  has  c o n s i d e r s the  financial  condition  method  It of  entire  study,  the  p o p u l a t i o n i n each that  this  precision.  from  basic  the  same  of  the  procedure In  addition,  source,  accounting information,  i s ensured. f o r the  prin-  sample.  statistical  of  The  1  is believed  a l l taken  industry  by Wippern.  The  average'of  following the  data  years  1969.  R o n a l d W i p p e r n , " F i n a n c i a l S t r u c t u r e and t h e . V a l u e F i r m , " J o u r n a l o f F i n a n c e , ( D e c e m b e r , 1966) , p p . 6 1 5 - 6 3 3 .  of  ;7 5  Assets:  Included  nts  receivable,  ted  corporations  are' c a s h ,  inventories, fixed and o t h e r  shown  on t h e b a l a n c e  ances  f o rdoubtful  assets,  assets.  sheets  marketable  investments  The amounts  of corporations  accounts,  securities,  amortization,  accou-  in affilia-  reported  are  after, deducting depletion  those allow-  and d e p r e -  ciation . Equity: the  net assets  amount in  This of'the  of a l l issued  the business  and  capital  represents corporation and p a i d - u p  and o t h e r  and g e n e r a l l y share  surplus  capital,  accounts  such  interest in.  includes  the t o t a l  earnings  retained  as  contributed  surplus.  Common ' E q u i t y ; stated  the shareholders'  value  plus  This  paid-up  includes  surplus,  common  retained  stock, a t p a r o r earnings  and  surplus  reserves . Sales ; from  The f i g u r e  non-financial Profits.:  investment after  depreciation  as s a l e s  i s gross  revenues  operations. This  income'and  deducting  reported  comprises  net earnings  net capital  allowances~for  but before  income  gains.  from  Profits  amortization,  operations, are reported  d e p l e t i o n and'  tax provisions  or declaration of  dividends. Interest expense  paid  certificates As public  This  on d e b e n t u r e s  noted  earlier,  prepared  principles..  consists  and mortgage  and i n v e s t m e n t  reports  accounting  Expense:  of interest bonds,  and  discount  guaranteed  trust  certificates;  data  f o rthis  i n accordance As s u c h ,  study  with  came  from  generally  the data'possessed  published  accepted several  ,7 6 l i m i t a t i o n s A l t h o u g h i n c o m e  a  t h e  c o r p o r a t e  o v e r  v a r i o u s o v e r  f o r  t h e  m a n a g e r s  l i f e  a c c o u n t i n g  t h e  t i m i n g  c o n s e q u e n c e ,  o f  t h e  t h e y  a n d , a s s e t  i n c o m e  a s s e t  t h e  i n c o m e '  o f  r e q u i r e m e n t s  do  t h e  n o t  h a v e  e n t e r p r i s e  p r o c e d u r e s ,  r e p o r t i n g o r  m e a s u r e m e n t  t h e y  r e c o g n i t i o n  do  h a v e  a  d e g r e e  v a l u a t i o n .  v a l u e s  c o u l d ,  r e c o g n i t i o n  and  by  do o f  t h e  o f  t h i s ,  a b i l i t y  a  and  c o n t r o l  i n  t h e  a s s e t  s h o r t  o f  c o n t r o l  e x p e n s e s .  As  i n c o m e  c o m p a r i s o n s  r u n ,  v a l u a t i o n  among  o v e r  I n t e r - i n d u s t r y  c r e a t e  f r o m  d e g r e e  r e v e n u e s o f  t o  s e l e c t i n g  h a v e '  s t u d y .  d r a w  o f  b i a s  p r o c e d u r e s  f r o m  e m p l o y e d  i i n  p a r t i c u l a r  m i n i m i z e d  .i n d u s t r i e s .  t h e  e f f e c t s  C o r p o r a t i o n s o r  may  n o t  o l d e r  f i r m s  c i a b l e  l a n d ,  h a v e  i n  a s s e t  f i x e d  c h a r g e s  B e c a u s e  o f  v a l u e s . o f c i a l f a v o r  o f  r e a s o n s . t h e  t i m e  l o w  .  t o and  o f - d a t a ,  As  F i r s t ,  t h e  e f f o r t  t o  a v e r a g e s  t h i s  o f  .  o f  w i t h  f i r m s ,  o f  T h e s e t h i s t h e  s t u d y . c o v e r a g e  t o  a s  m e a s u r e  t o t a l  a s s e t s ,  d i d  t h e  u s e  common  m o n o p o l y  m a r k e t  t h e  r e s u l t s  n o t o f  :  v a l u e s  o f  v i e w e d ' a s  may  m a r k e t e q u i t y  p r o f i t s ; w o u l d  e s p e -  d i f f e r e n c e s  f o r c e d  was  may  n o n - d e p r e -  s t u d y  f u t u r e  c o m p i l e .  1  w h i c h  s t o c k  I t  S e c o n d ,  some  h o l d i n g s  v a l u e s  d e a l  c o s t s  p r e f e r r e d  m a r k e t - v a l u e  v a l u e  i s o l a t e .  and  u s e .  C l e a r l y  c o n c l u s i o n s '  s h o u l d  t o  h i s t o r i c a l  l a r g e  a s s e t  a - c o n s e q u e n c e  l e v e r a g e  c a p i t a l i z e d  v a l u e  l e a s e s  c o m m o n . e q u i t y  l e v e r a g e  w i t h  t h e  s t u d y  a t  v a l u e s .  f i r m s  l i m i t  t h i s  w i t h  l a c k '  a s s e t s  c u r r e n t  and  e i g h t - y e a r  t h i s - l i m i t a t i o n .  u n d e r s t a t e d  v a l u a t i o n I d e a l l y  o f c a r r y  r e p r e s e n t ,  c i a l l y  B y • a s s u m p t i o n , .  u s e  be  d e b t .  t h e  b o o k  o f  f i n a n -  b i a s e d  i n  v a l u e s c o u l d t h e  r e q u i r e  f o r  t w o  r e f l e c t  p r e c i s e e n o r m o u s  7 7.  B.  Methods  of  Three in  this  ing  power  approach  industries into  three  market  limits firm  average of  to  measure,  The  the  cited  by  power  in  certain  to  the  $ 5 , 0 0 0 ,000, As book'values of  of  each (1)  In  to  be  capital  a  barrier.  a d d i t i o n , the  assets  of  1969.  of  risk  each  as  industry  on  was  the  assigned  -  to  one  the  reasons  of  three  assets  between  $1,000,000  assets  average'  the  assets  As  increase.  of  average  a  total  done'for  basis  :  losses.  assets  calculated for This  Then  to'spread  group.-  below  actual market  $1,000,000,  group  -  and  (3)  Top  group  assets  above  $5 ,000 ,000 .  in  the  previous'section, this  study  used  noted of  average  to  that  4  Bottom  manufactur-  assets  for  was  a  used  of  spreading  section.  21  according  lumps  its•ability  and  were  is believed  large  assets  industry  groups  size  f i r m s - - was,  1962  previous  assets,  some  the  i t represents  fields.  average  number  power  financing  degree,  classification  classified  Asset  because  is  between  the  Middle  some  there  groups:  essence  power  actual  years  average  size.  d i f f i c u l t y • of  entry  divided  asset  market  consequence,  (2)  market  first  i s the  of  of  The  measure  a  methods  study.  relative  It  Analysis  common  equity  an. i n d u s t r y ' s  -  to  average  total  financial  assets  to  structure.  and  capture This  was  the  the the  mea-  3 sure study  employed by  Scott  in  a  and  1967  study  Martin.  4  by In  Schwartz  and  a d d i t i o n to  Aronsbn  the  reasons  and  a  cited  1975 in  3  E l i S c h w a r t z a n d J . R i c h a r d A r o n s o n , "Some Surrogate Evidence i n Support of the Concept of Optimal F i n a n c i a l S t r u c t u r e , " J o u r n a l of Finance', ( M a r c h , 1967 ) , p p . 1 0 - 1 8 . 4  Financial  David Scott, Structure,"  J r . and J o h n M a r t i n , " I n d u s t r y I n f l u e n c e on F i n a n c i a l M a n a g e m e n t , ( S p r i n g , 1975) , p p . 6 7 - 7 3 .  78  the  previous'section  measure  of  leverage,  sources  of  capital  are  to  a high The  ure  for  between uring  to  degree  industry  1962  and  based  on  points  the  researcher  average  a measure  of  output,.the economic this to  power  power  act  size,  income  and  in  the  the  average  each  of  power  mean  groups  from  power  groups  by  structthe  21  years  manufact-  market  power  equity  ratios  in  sample.  the  a,drawback. are  The  cut-  specified  by  arbitrary. groupings,  approach,  concentration  shipments  assets  of  the  i n d u s t r i e s by  second  that  financial  non-representative  employed  out  the  another.  essentially  The  as  the  instead  ratio,  largest  a of  that i s ,  four  firms,  power.  being  highly  equal,  for  large  Highly  smaller  the  proportion  concentrated  i t enjoys. the  a  the  i s the  a  an  industry  concentrated  p r e s e n c e "of o n l y  of  number  few  of  industry's and  the  industries rivals  lead-  more  have  enables  them  inter-dependently. The  firms  on  one  suffers  of  ratio  pointed  permitted  market  followed.  equity  for  the  market  are  industry  because  done  size  the  three  account  more  asset  pitfall  things  for ratio  arranging  approach  market  which  equity  as'such  the  of  claims  calculated for  of  the  was  prior  This'was  each  asset  Other  was  this  avoid  approach  firms  Aronson^  average  and  percentage  ing  and  Then  between  To  as  Schwartz  1969.  for  off  the  common  substitutable  each  However,  using  the  average'common  be,derived  second  using  carrying  industries.  groups  for  for  5  percentage  each  E l i  of  industry  Schwartz  industry  was  and  shipment  computed  J.Richard  for  the  by  the  largest  average'of  A r o n s o n , , op . c i t . ,  the  p.11.  four years  7 9  between the  1962 a n d 1 9 6 9 .  cut-off,point,  market was  power  each  t h e same  specified  top  and'middle  products average  concentration  falls  i n the bottom  above  70 p e r c e n t With  the  statistical  the  difference  sampled power  hypothesis differences  deliberate To  employing to  be  rather  throw more simple  tested  by  greater  s*  a  i n the  t h e above industry  70 which  belongs  to the  i t was  possible  equity  that  of the various  o f sample than  between by  analysis  regression  b.POWER  was  ratios  the null, hypothesis  means  within  groups  among  groups,  imply  the market  that  market the  null  the  power- g r o u p s  chance.  l i g h t ' on t h e r e s u l t s , a t h i r d  +  fall  was.  a r e j e c t i o n would  follows':  LEVERAGE  that  Except  of variance  means  occurring  regression simple  now  manner,  It tests  structure  than  group  The a n a l y s i s  I f the v a r i a b i l i t y  in financial  suffers  point i s  products  i n t h e mean  among, t h e p o p u l a t i o n  Such  ratio  essentially arbitrary.  i n this  differences  is significantly  procedure  The- c u t - o f f  size  as  group.  classified  i s rejected.  This  leather  asset  employed.  i t sconcentration  also-belong,to  power- g r o u p s .  test  i s zero.  groups  The  70 p e r c e n t  t o o n e o f two  the i n d u s t r i e s  groups  concentration  market  point.  industry,  group.  the data  various  on w h e t h e r  and t h u s  average  selecting  was- a s s i g n e d  earlier.  asset  test, f o r significant  among  are  noted  by t h e r e s e a r c h e r  the leather  to  industry  the c u t - o f f  drawback  for  percent  arbitrarily  groups, d e p e n d i n g  above' o r b e l o w  from  Then  followed.  analysis  was  procedure The  formulated  hypothesis as  .8 0  In  other  power. sales  words, The  leverage  measure  of  by  the  largest  computed  for  the  Similarly leases firms This  for  plus for  was  1969.  computed for  significant to  address  Capital  C.  may  Pricing  Empirical  Results  Table  in  21  industry  sample  on  relative  average' asset  F - r a t i o s , and  cance  both B  for  a  divided  computed  Appendix  is  1%  only to  industry.  next  1962  mean  of  are  21  extent  the  sets  the  four  whan  chapter  of  We we  plus  largest  leverage. 1962  and  observations'. variable,  there  equation..  was.  1969..  between  that  industry  of. d e b t  financial years  of  and  ratio  of  market  This  one' i n d e p e n d e n t  the  from  the  percentage  assets  there  upon  may  will  be return  discuss  the  Model.  2jL p r e s e n t s  the  total measure  biased  problem  Asset  at  to  variables missing this  each  average' of.the  there  be  the  years' between  regression,  since  dependent  v a r i a b l e , the  i s the  the  is  for  the  equity  for the  coefficients  of  power  firms  dependent  industry  However, the  four  preferred  Thus-,  assumed  market  average  the  each  is  into size:  the  and  summary  three  mean  equity  market  top,.middle,  critical  5%' l e v e l s .  a more, c o m p l e t e  of  data  F-ratios The.  ratios  for  the  power  groups  based  and  bottom;'  the  needed  reader' i s  presentation.  for  signifi-  referred  to  :  81 TABLE 2 MEAN COMMON E Q U I T Y R A T I O S (COMMON E Q U I T Y / T O T A L A S S E T S ) FOR TWENTY-ONE I N D U S T R I E S , 1 9 6 2 - 1 9 6 9 , . C L A S S I F I E D BY AVERAGE A S S E T S I Z E AND R E S U L T S OF THE A N A L Y S I S OF VARIANCE  AVERAGE A S S E T SIZE  MEAN  COMMON E Q U I T Y 1962-1969  TOP GROUP (6 I N D U S T R I E S )  5 6 .89  MIDDLE GROUP (9 I N D U S T R I E S )  50 .83.  BOTTOM GROUP (6 I N D U S T R I E S )  4 5 .7,1  COMPUTED DEGREES  F-RATIO  4.48  OF FREEDOM  2;18  C R I T I C A L F-RATIO 1% L E V E L 5% L E V E L  Table 21  industry  industry above  3  6.01 3.55  presents  sample  i n the table  F-ratios  needed  levels.  into  ratios:  and i n d u s t r y  Included  cent  a summary  divided  concentration  70 p e r c e n t  RATIOS  o f mean e q u i t y  two m a r k e t industry  f o rsignificance  F-ratios  a t both  groups  concentration  concentration  a r e computed  power  ratios  below  70  f o r the based on ratio  percent.  and t h e c r i t i c a l  the 1 percent  and 5 per-  82 '3  TABLE  MEAN COMMON E Q U I T Y R A T I O S (COMMON E Q U I T Y / T O T A L A S S E T S ) FOR TWENTY-ONE I N D U S T R I E S , 1 9 6 2 - 1 9 6 9 , CLASSIFIED BY INDUSTRY C O N C E N T R A T I O N AND R E S U L T S OF THE A N A L Y S I S OF• VARIANCE  INDUSTRY CONCENTRATION  MEAN  COMMON-EQUITY 196 2-19 69  ABOVE 7 0 % GROUP (9 I N D U S T R I E S )  55 .14  BELOW 7 0 % GROUP (12 INDUSTRIES)  48 .07  COMPUTED DEGREES  F-RATIO OF  5 .69 1 ;19  FREEDOM  C R I T I C A L F-RATIO 1% L E V E L 5% L E V E L  Table percentage firms  8 . 18 4.38  4 presents  of fixed  on'the  RATIOS  the r e s u l t s  charges  to total  percentage'of.industry  of the regression assets sales  by  of the  the leading  by.the  leading  four  four'  firms.  TABLE  4  R E S U L T S OF THE R E G R E S S I O N OF THE P E R C E N T A G E OF F I X E D CHARGES TO T O T A L A S S E T S BY THE L E A D I N G FOUR FIRMS ON THE PERCENTAGE OF INDUSTRY S A L E S BY THE' L E A D I N G FOUR FIRMS FOR TWENTY-ONE I N D U S T R I E S FOR THE AVERAGE OF THE YEARS BETWEEN 1962 - 1 9 6 9 . *  a. 26.0500 (5.5793)  b -0.0129 (-0.1613)  F-RATIO 0.0260  R  2  0 .0014  * t - s t a t i s t i c s • s h o w n i n p a r e n t h e s e s below t = 2 .539 , t =2.861 0.005 0.01  S.E . :  D.W.  8.155  1.395  the coefficients: t = 1 .729 . 0.05  83 As null The  the tabulation  hypothesis resulting  various fact,  market  power  power  groups  average  and l e v e r a g e ,  T a b l e 2i  As  turn  is'significantly  asset  percent  market  than  significantly although  standard  significantly  that  of the greater  (50.83)  group  top than  which i n  o f the bottom  70  equity (55.14)  percent  ratio  average  o f the over  i s significantly  market  concentration  of analysis  of variance  the significant  differences  a t t h e 5%  correlated  results.  error  hand, with slope  indicates  market  power  coefficient  The low c o e f f i c i e n t  and a Durbin-Watson from  two i n a c r o s s  the p o s s i b i l i t y  that  a variable  equation.. market  In a d d i t i o n ,  power  i s a poor  summary, have  less  the high predictor  the results debt  leverage i s  even  a t t h e 20%  i s consistent of determination, with  section  has been  standard  a  regression  omitted  error  value  from  suggests  of leverage.  indicate  i n their  that  statistic  different  firms  ratio  technique  the negative  high  In  between  i s inverse. equity  t h e mean  o f the under  34, o n t h e o t h e r  the e a r l i e r  ful  size  than  The s t a t i s t i c a l  with  that  relation  In-  level..  Table  suggest  greater  f o r , , and c o n f i r m e d  confidence  level,  asset  c o n c e n t r a t i o n group  that  (48.07).  tested  average  T a b l e 3?' i n d i c a t e s ,  As  group  t h e mean  different.  group'(45.71).  size  greater  the r e l a t i o n  structures ofthe  s i z e ' g r o u p - (5 6'. 89) ' i s s i g n i f i c a n t l y  asset  of the middle  the  the f i n a n c i a l  positive  3 indicates, the  of.significance.  are' s i g n i f i c a n t l y  indicates,  that  not  i s that  i n contrast t o the expected  market  70  a t . t h e 5% l e v e l  i s rejected  inference  2 and'Table  i n Table  that  financial  relatively  structures  powerthan  84  those used  with  as. a p r e d i c t o r  indicated Schwartz tries by  l e s s market  developed  study.therefore industries. the  and  study  ratios examines  The f o u r  that  lated  include  regulated The-  financial of  funds  If  this  o f a sample  within  suggest  to adjust  to the business  power  6  relation  E l i  of firms  drawn  indus-  for significantly The  used  present  of  twenty-one  by  them  structure  from  firms.  bias  concept.  railroad,,  electric  I t may  argued  the Schwartz structure from  be  and A r o n s o n pattern  that  i n d u s t r i e s used  a-conscious  t o which  of  of unregu-  here  d i dnot  structures  schwartz  b e much  of firms way,  financial  and J . R i c h a r d  on t h e p a r t  of their  the firms  the v a r i a b i l i t y  groups, s h o u l d  between  policy  the composition  do c l u s t e r i n a d e f i n i t e  central  of  conditioned  structures  significantly  risk  not the case,  the f i n a n c i a l  classes  structures  financial  1  as  industries:  managers  market  made  The t w e n t y - o n e  be  those' o f  industries.  and i n d u s t r i a l  of whether  findings  were  four  classes  industries differs  industries.  with  o f t h e optimal'' f i n a n c i a l  mining  cannot  The. f i n d i n g s  tested  the f i n a n c i a l  broad  i s composed  simply- a t e s t  regulated  group  f o r only-  power  risks.  and A r o n s o n  the i n c l u s i o n of u t i l i t i e s  study  that  financial  business  Schwartz  gas u t i l i t y ,  leverage.  i s , the various  optimum  results i n favor  Their  a  That  6  the i n t e n s i t y of their  different, equity  market  -2 a n d ;3 a r e c o m p a t i b l e  and A r o n s o n .  However,  although  of financial  i n Tables  have  power,  greater.  supporting structure  Aronson,  sources  are exposed.  of equity  i n a given  of  ratios I t appears  market  the notion  power that  and t h e v a l u e  op;cit.  of  85 the  firm  is  recognized  explanation mining to  how  is  fact  that  one' t o the  supported  much, d e b t  consider  the  a  basic  risks  that  relatively  returns  increased  structure  pressure  equity  base  in  ownership  so  years,  investment  on  in  of  these  firms  have  of  leverage. more  maximization,  relatively  while  -  •  debt  firms  take  some  risks  in  their  aggressively firms  are  maintaining in  a more  The leads of  rather-  firms  to  Canadians  their  own  their  financial of  pursuing satisfied  80  increased  increase can  participate In  Financial  r e -  foreign  percent  of  about  managers  the  managers  of  the  use  these  firms  leverage. the  objective  attaining a credit  structures.  of  profit  reasonable  rating  with  Because  of  .... >  less  debt  and  forego  a higher- p r o f i t  maintaining  a.high-grade  rating. 7  their  towards  financial  a high-grade  financial  of  country.  animosity  choice  conservative  consequence  i n c r e a s i n g l y concerned  thus  credit  necessary,  leverage  non-residents,  with  of  deter-  lower  approximately  firms  use  "in  i t is  reduced  of  increasing  satisfied9'g^fo,'ffta^'Ajd-j?> powe J:f u 1 the  that  This  business."  towards  number  consequence,  powerful  less  of  movement  by  become  than  margin,  form  Because  cautious  Rather  powerful  industries in  owned  a  choose  foreign-owned  been  Canada. are  being  this  the  has  firms  that  managers.  leverage.  a greater  of  powerful  in  i s an.understandable  that  As  in.the  found  safely, carry,  power  powerful  there  who  inherent  conclude  public  profit  can  market  financial  are  Scanlon  firm  Alternatively,  cent  by  with  through  the  practicing financial  those  exceptional  than  by  John J.Scanlon, " B e l l System F i n a n c i a l M a n a g e m e n t , (.Summer , 197 2 ) , p . 1 9 .  Policies,"  margin  86  D .  Corporate  Debt  Since sis  that  the  there  Capacity  data  is a  clearly  significant  between  the  various'market  measure  the  relative  measures before of  of  debt  interest  earnings  supported  difference  power.groups,  debt  c a p a c i t y of  c a p a c i t y were and  before  the  taxes  to  interest  the  study  the  to  hypothe-  financial  various  assets  and. t a x e s  In  this  examined:  total  alternative  structure  attempted  groups.  ratio  Two  of. e a r n i n g s  ( E B I T / T A ) ,. a n d interest  to  the  expense  ratio  (EBIT/  IE) . Ideally, charges  with  because  of  fect  leases  study  and  should  preferred  lack  of  data, .this  substitute  of  coverage  The firm's and  this  ratio  total  a s s e t base  financial  measures  As  provides  a good' i n d i c a t i o n  EBIT/TA,  t h e ' g r e a t e r the  such, of  coverage'of  of  to  rate  use  the  of  However,  the  imper-  r e t u r n on  effects  measure  of  capacity since  of.a  debt.  fixed  expense.  the  this  debt  ability  the  was. f o r c e d  interest  independent  leverage.  with  e q u i t y viewed'as  study  of  of.EBIT/TA  deal  firm's  of  a  taxation  profitability the  higher  operations  to  the  support  debt. The  second  times  earnings  Thus,  the  interest  power and  before  of  the  number  expense,  the  greater  <5 p r e s e n t s  f o r the  groups  bottom  21  based  group.  debt  interest  greater  Table EBIT/IE  measure  a  c a p a c i t y was  and  of  taxes  times  the  debt  summary  i n d u s t r y sample on The  average reader  asset  of  a  the  covered firm  number  interest  i s able  to  of expense.  cover i t s  capacity. average  EBIT/TA  divided' into size:  is referred  top to  three group,  Appendix  and  average  market middle C  for  group a  87 more  complete  data  presentation.  TABLE ' 5 AVERAGE E B I T / T A AND AVERAGE E B I T / I E FOR 21 I N D U S T R I E S , •1^962-1969 , C L A S S I F I E D BY AVERAGE A S S E T S I Z E  AVERAGE A S S E T SIZE  AVERAGE EBIT/TA 1962-1969  AVERAGE EBIT/IE 1962-1969  TOP GROUP (6 I N D U S T R I E S )  12.71  20.11  MIDDLE GROUP (9 I N D U S T R I E S )  10.59  17.20  BOTTOM GROUP (6 I N D U S T R I E S )  8.40  13.33  Table  § presents  a summary  EBIT/IE  f o r t h e 21 i n d u s t r y  tration  groups:  and  industry  industry  concentration  sample  of'average divided  concentration ratio  below  into  ratio 70  EBIT/TA and average two m a r k e t  a b o v e 70  percent  percent.  T A B L E 6, AVERAGE E B I T / T A AND AVERAGE E B I T / I E 1 9 6 2 - 1 9 6 9 , C L A S S I F I E D BY INDUSTRY  INDUSTRY CONCENTRATION  concen-  FOR 21 I N D U S T R I E S , CONCENTRATION  AVERAGE EBIT/TA  AVERAGE EBIT/IE  ABOVE 7 0 % GROUP (9 I N D U S T R I E S )  12.01  19.29  BELOW 7 0 % GROUP (12 INDUSTRIES)  9 .50  15 .15  88 On powerful  the  basis  firms  as  of  measured  concentrationcould firms. a  As  higher  more  return  times  suggests of  debt  Table  than  that than  4 on  have  and  powerful they  The  ed  previous  both  supported 5  EBIT/TA  average more  less  powerful  firms  section.  average  asset  debt  their  firms.  c o u l d have  did with  reasons  and  size  than  why  little they  expense evidence  greater  amounts  of  debt  payment  have  been  suggest-  danger  did' not  enjoyed  empirical  supported  market  :  interest The  and  EBIT/IE  less powerful  reveal,,powerful firms  and. c o v e r e d  actually  possible  average  by  Table  assets  other  default. i n the  both  89  CHAPTER METHODS  Chapter examines return  the  on  risk  The described  B  were  in  two  parts.  concerning  examines  Market  the  Power  obtained  Chapter  used  into  Part  market  empirical  A  power  and  evidence  return.  Concerning  in  RESULTS  evidence  Part  and  data  AND  organized  empirical  Evidence  fication  is  equity.  concerning  A.  VI  VI  V.  this  from  The  the  method  section  is  and  same  of  the  Return  sources  market  as  power  percentage  those  c l a s s i -  of  industry  r  shipments the  by  smaller  large  the the  enjoys.  is  the  them  behave  to  The  of  firms  the  was  This  of  the  more  industries a  few  paribus,  which  output,  and  only  account  the  more  this  competitors  a  highly  economic  have  for  power  it  power  enables  inter-dependently.  each  of  industry  industry 1962  percent  as  to  procedure  Ceteris  firms  industry's  between  concentration  leading  concentrated  for  assigned  firms.  industry  percentage  70  four  of  an  presence  years  selecting  of the  Highly  because  four  number  proportion  concentrated  largest  one  ratio  of was  suffers  was  and  the two  computed  1969.  cut-off groups  above from  shipments  Then  for  depending  same  the  the the  largest average  a r b i t r a r i l y  point,  or' below  the  by  each on  industry whether  cut-off  drawback  noted  its  point. e a r l i e r  90  in  Chapter  V.  Following measure Equity also was  the studies  of p r o f i t a b i l i t y (NI/SE).  noted  the s t a t i s t i c a l  ratios power  7  i s Net  The r a t i o n a l e  i n Chapter  Table  II.  test  presents  industry  based  concentration  ratio  I I ,the  Income/Stockholders' behind  such  a measure  The one-way a n a l y s i s  a summary sample  on i n d u s t r y  concentration  i n Chapter  of  was  variance  employed.  f o r t h e 21 i n d u s t r y groups  reviewed  ratio  below  o f mean  profitability  divided  into  concentration  above  two  market  ratios:  70 p e r c e n t  and  industry  70 p e r c e n t .  TABLE  7  AVERAGE NET INCOME/STOCKHOLDERS' E Q U I T Y FOR 21 I N D U S T R I E S , 1 9 6 2 - 1 9 6 9 , C L A S S I F I E D BY INDUSTRY C O N C E N T R A T I O N  INDUSTRY CONCENTRATION  AVERAGE NI/SE  ABOVE 7 0 % GROUP (9 I N D U S T R I E S )  10.54  BELOW 7 0 % GROUP (12 I N D U S T R I E S )  8.15  COMPUTED F - R A T I O  6.32  DEGREES  1;19  OF  FREEDOM  CRITICAL F-RATIO 1% L E V E L 5% L E V E L  8.18 4.38  91  Table 7  As  70 p e r c e n t  above  significantly market nique  market  greater  of analysis  significant  B.  Evidence This  section firms  dends  and i n v e s t m e n t  the Toronto  are  In computing  assumed  which  they  dividends tains the  time  this  section  percentage Since  there  monthly  averaged  level.  on t h e a n a l y s i s  data  on p r i c e s ,  f o r a l l common from  July  on t h e T S E  stocks  1961 through  relatives,  divilisted June  a l l dividends  a t t h e end o f t h e month i n  and t h e p r i c e s  are adjusted  f o r stock  In a d d i t i o n ,  t h e TSE tape  also  indices.  of market  The d a t a 1969 power  shipments  there  investment  i n this  classification  by t h e l a r g e s t  36 f i r m s  relatives  to o b t a i n the monthly  section,  i n t h e above  were  section  concover  inclusive.  to the previous  9 industries  group,  tech-  confirmed  are recorded  the investment  of i n d u s t r y  concentration The  Exchange  i s similar  were  f o r , and  i s based  data  relatives  1962 through  method  70 p e r c e n t  Return  contains monthly  paid  market  period  The  and  f o r which  and s p l i t s .  five  Risk  of the  (10.54) i s  a t t h e 5% c o n f i d e n c e  t o be r e i n v e s t e d were  rates  The s t a t i s t i c a l  tested  of the study  Stock  profit  of the below  (8.15),  differences  The TSE t a p e  1973.  that  of variance  tape.  on  than  Concerning  84 l e a d i n g  t h e mean  c o n c e n t r a t i o n group  c o n c e n t r a t i o n group  the  of  indicates,  mean  i . e . , the four  firms.  70% market  i n this  o f t h e 36 f i r m s  group  used i n  over  group. were  the period  92  the  concentrated  group)  and  the  group  group  suggest  the  ing  and  is  the  unconcentrated  s t a t i s t i c s for  1*84  market  for  a  the  (2.51  for  the  unconcentrated  significant  variable  group) a f f e c t -  returns. The  have  results  r e l a t i v e l y  industries  as  established have  less  in  debt  industries decision  lower  the in  the  sustained  decision  As  obligations  a in  stockholders income with  no  their  its  the  in  to  In  common  of  the  industries  the  the a  un-  investment  firm,  risk.  the  Financial  insolvency  available  the  was  concentrated  While  risk  to of  common  is  stock-  fixed-income  f i n a n c i a l  r e l a t i v e  stock-holders  risk  to  dispersion  less  for  a  of  firm  debt. r e l a t i v e l y  less  concentrated  industries  are  the  dispersion  of  r e l a t i v e  lower  r-isk.  proportion  addition,  It  than  that  possible  the  unconcentrated  betas.  f i n a n c i a l  of  industries  concentrated  was  structure,  With  smaller,  given  earnings  c a p i t a l  the  structures  its  increases  rises.  that  business  risk  the  than  estimated  business  basic  concentrated  risk  chapter  determines  both  the  f i n a n c i a l  high the  firm  available  by  explanation  v a r i a b i l i t y  holders.  systematic  their  One  encompasses  that  previous  determines  financing risk  suggest  indicated  concentrated.  and  0.02  DurbihsWatson  concentrated that  and  and  therefore  f i n a n c i a l  risk  less  in  lower  than  their  l i k e l y  income  incur  more  debt  to  f i n a n c i a l be  available  compensates  insolvent  to  f i n a n c i a l  structures,  investors  risk.  for  the  The high  and is  93  If that  on  the  firms  with  risk.  It  that  the  rates  the  high has  of  8  than  of  the  a  at  confidence  groups  alpha  for  group,  the  the  year  over  excess  explains  the  of  the  that  two  the  that  the  is  for  period.  return hand,  group.  is  market The  on  group For per  the  average  The  per  month, 1.08  unconcentrated  month, 0.72  of  estimated  averaged  indicating  percent  group that  group.  c o e f f i c i e n t  is  The  the  the  suggesting  explains  (0.9158)  index.  averaged  of  on  significant  percent  the  remainder  higher  industries beta  concentrated  0.45  a  average,  that,  percent  variation has  section  (0.9402).  both  period.  group  of  the  systematic  industries.  0.09  for  The  the  estimated  are  0.06  the  time,  high  the-market  8-year  alpha  the  on  indicate  return  show  previous  industries  than  would  concentrated  lower  group  excess  of  have  have,  the  and  risky  return  the  groups  level,  over  other  the  in  r e l a t i v e l y  the  periods  unconcentrated  determination of  the  the  tests  should  industries  less  8-year  suggesting  variation to  of  45%  on  for  estimated  .oefficient  0.72  year  the  return  concentrated  that  per  that  group,  were  the  indicating percent  of  long  unconcentrated  betas  1%  over  indicates  have  empirical  established  estimated  both  and  rates  been  return  that  the  right,  concentrated  average,  than  is  average,  Table the  CAPM  has the  The  a market  unconcentrated  determination  72%  of  the  due  to  factors  low  standard  errors  of  the  two  groups  of  return unique  group. The  per  (0.03  for  94  1962  through  means. TSE  1969.  These  group  industrial  this  a second  group,  relatives  means  index  Similarly, group,  As a r e s u l t ,  over  t h e same  regression were  regressed  70% m a r k e t  was r u n .  With  mean  over  the period  means  were  then  regressed  index  over  t h e same  against the period.  concentration 12 i n d u s t r i e s i n  to obtain  1962 t h r o u g h against  1962-1969  group  The monthly i n v e s t m e n t  were averaged  group  8 presents  w e r e 96 m o n t h l y  1962-1969  48 f i r m s .  o f t h e 48 f i r m s  Table  there  were then  f o r t h e below  there  7  1969.  the TSE  the monthly  These  group  industrial  period.  the r e s u l t s  of the regression  of  y  the  monthly  over  group  the period  mean  return  on t h e TSE i n d u s t r i a l  index  1962 t h r o u g h 1 9 6 9 .  TABLE 8 R E S U L T S OF T H E R E G R E S S I O N OF T H E MONTHLY THE T S E I N D U S T R I A L INDEX OVER T H E P E R I O D  REGRESSION  q  §  R  2  GROUP MEAN RETURN ON 1 9 6 2 THROUGH 1 9 6 9 *  F-RATIO  S.E.  D.W.  ABOVE GROUP  70%  0.0902 (0.8561)  0.9158 (8.7552)  0.4507  77;13  0.0369  2.51  BELOW GROUP  70%  0.0566 (0.9229)  0.9402 (15.4235)  0.7184  239.81  0.0215  lj.8'4  *t  - statistics  'COOS'  shown 2  -  8  6  1  i n p a r e n t h e s e s below '  'O.OI "  2  '  5  3  9  '  the c o e f f i c i e n t s :  '0.05 = 1  7  2  9  '  95  business This  risk  is  the  sustained  evident  by  concentrated The  the  is  not  group  explained  on  the  by  Capital  detailed  betas  of  Asset  the  D  of  1969. tion  is  The  industries the  mean  for  industries  estimated  have  market.  group  alpha  In  is  .  beta  for  suggests  higher other  higher  than  that,  excess  words,  on  return the  that  predicted  Model.  Appendix  E  into  behavior  the  have  been  prepared  of  to  individual  provide firm  groups. a  histogram  concentrated the  group  group  i  of  the  frequencies  over  the  period  is  0.9158  and  the  of  1962  36  firm  through  standard  devia-  0.1438. Appendix  betas  is  lower  estimated  Pricing  different  the  The  by  and  D  concentrated  industries.  higher  insights  Appendix betas  of  concentrated  Appendix more  the  r e l a t i v e l y  concentrated  return the  the  r e l a t i v e l y  average,  that  by  E  is  a  histogram  of  the  unconcentrated  mean  for  the  group  is  of  group  0.9402  the  over and  frequencies  the  the  same  of  48  1962-1969  standard  firm period.  deviation  is  0.1592. As mean  beta  that  of  indicated for  the  dispersion that of  of  the  the  the  by  Appendix  concentrated  unconcentrated of  the  betas  of  unconcentrated  different  groups  are  In  Appendix  is  As  addition,  "good"  a  E,  the  r e l a t i v e l y  concentrated  group. a  and  group  group. the  D  result,  measure  of  lower  the  group  estimated  relative  is  the  than  less mean  risk.  than betas  96  To was  used.  firms by  throw The  for  the  each  of  selecting assigned  to  one 9  p r o f i t a b i l i t y industry  years  of  as  were  each  THE  EQUITY  cut-off  of  a  summary  the  1962  -  INDUSTRY CONCENTRATION  1-969,  from  industry was  1969.  procedure the  computed  Then  fringe  shipment for  the  a r b i t r a r i l y  point,  each  industry  mean  equity  ratios  of  top-four  c l a s s i f i e d  AND  different  was  groups.  RATIOS  TOP-FOUR  of  industry and  by  AND  THE  MEAN BY  the  fringe  and  firms  mean  for  the  concentration.  9> PROFITABILITY  FRINGE  CLASSIFIED  and  industry  TABLE MEAN  a  separated  percentage  for  the  presents  sample  results,  betweennl962  two  ratios  the  firms  The  firms  percent  Table  21  four  on  four  industry.  the 70  light  largest  largest  average  more  FIRMS  FOR  INDUSTRY  TOP-FOUR FIRMS AVERAGE AVERAGE E Q U I T Y NI/SE RATIO  21  RATIOS  OF  INDUSTRIES,  CONCENTRATION  FRINGE FIRMS AVERAGE AVERAGE E Q U I T Y NI/SE RATIO  ABOVE 70% GROUPS  10F54  58.03  8.69  50.74  8.15  48.35  7.78  48.26  BELOW 70% GROUP A.s trated lower  industries f i n a n c i a l  providing firms  Table." 9 v i n d i c a t e s ,  The f i n a n c i a l firms  in  less  than  the  to  debt  their  in  also  dominant  r e l a t i v e l y  support  results  leverage the  a  leverage  greater  employ  have  the  the  unconcentrated  by  higher  e a r l i e r  the  group  concen-  margin  and  a  thus  that  powerful  structures.  the  dominant appear  the  firms,  findings  f i n a n c i a l that  in  p r o f i t  non-dominant  indicate  employed  firms  to  profit firms be  margin and  the  similar.  and  the  fringe  97  CHAPTER V I I SUMMARY  The  purpose  statistically taining The  erence and  hypothesis  that that  on  their  powerful  combination a sample  data  TSE t a p e .  was  felt  that  financial  per-  structure.  i s no  significant  diff-  structures  of powerful  firms  firms.  employed  of a n a l y s i s  f o r the study  theory  A  secondary with  hypothesis  a greater  return  equity.  cross-section  the  there  are associated  stockholders'  t o examine  in financial  o f an o p t i m a l  powerful  technique  has been  question  i s that  firms  CONCLUSIONS  study  the f i n a n c i a l  of less  The  of  a frequent  between  is  a  of t h i s  to the e x i s t e n c e  main  AND  were  Despite the data  to test  of variance  the hypothesis and-.r e g r e s s i o n  of the Canadian  obtained several were  from  economy.  CALURA,  limitations  sufficiently  was analysis,  The  C F S , CTS a n d  i n the data, i t  accurate  to  justify  analysis. The measured a  by b o t h  greater  other  return  less  relatively refutes could With  be  powerful  market  debt  relatively  less  i n this  These  i n their that  of great debt  their  earned  (NI/SE)  than  firms  observed  of f i n a n c i a l  capital  as  size,  structures  higher  amounts  i n their  equity  powerful  capital  study,  and a s s e t  stockholders'  firms.  the suggestion the r e s u l t  examined  concentration  on t h e i r  powerful less  firms  used which return leverage.  structures,  98  powerful which As  a  firms  more  than  that  of  firms, the  estimated average, the  alpha have  the  powerful  a higher  The  the  excess  high  risk  that  risk.  of  the  lower  relatively  powerful  return  risk  business  is relatively  firms. that  financial  systematic  average,  suggests  results  traditional  these  of  of  this  allocative  firms  than  higher  firms, i s not  market  violate  the  production  of dual  and  output,  put  i t s limited  the  prices  and  stock  profits  of  c o m p e t i t i v e markets  would  earn  supports prices, the of  these them  on  the  explained  the  theoretical  profits  and  market entry  the  and  made  possible  By  of  returns bid  away.  are  market.  a  As  the  number  restrict-  valued  out-  and  greater  Powerful  than  firms  entry  barriers  such,  this  predictions function  then  producing  f i r m s were  since  the  efficient  profits.  permit.  and  by  firms  policy:  as  return  output  Powerful  capable  profits  higher  was  economic  output  The  highest  particularly into  oligopoly  r e c e i v e the  would  being  support  restricted  public  powerful  excessive from  of  prices  d i d not  input  from  participants.  objectives  society  higher  practices  those  prohibited  came  reasonable  ing  of  therefore  inefficiency.  presumably  small  number  study  condemnation  pricing  ease  the  estimated  non-competitive  of  for  lower  market.  indicative of  the  on  less  The the  compensates  consequence,  powerful  by  therefore incurred  that  study market  of  the  structure  of  sellers  and  99  The market  power  because  it  managers the  and  port  adjust  the  to  r i s k  suggests  This  finance v i z .  f i n a n c i a l a  greater  risk.  indicate  suggests  business  further  to  the  on  finding the  their were  but  a  a  did  problem  in  important  of  f i n a n c i a l  of  exposed.  not  f i r s t  part  the  between  is  sources  firmscdHid have  represents to  of  firms  leverage  CAPM,  relationship  This  policy  composition  powerful  also  v i z .  inverse  leverage.  which  that  study  an  conscious  f i n a n c i a l  model,  funds  The  evidence  capacity  because  attempt  of  to  to  the  apply  industrial  to  supr  inherent a  organization,  concentration. If  firms policy would  are  be  represent market  the less  conservative than  The  s u f f i c i e n t l y expenses. only  power.  benefits  structure  and  customers  in  conservative  a  and  to  such, of  the  form  capital  cost of  structures  they  these the  present  prices  produce  managements  f l e x i b i l i t y  pass the  As  then  output  high  portion  The  c a p i t a l  optimal,  implications.  inflated  the  results  superior  powerful  despite  would  associated  firms  could  with maintain  withaconservative  prices.  require  public  firms  profits  thatcconservation  excessive  structures  important  profits  i n e f f i c i e n c y of  powerful  powerful  superior  associated of  of  of  to  their  Clearly  these  additional  capital  research.  100  APPENDIX SAMPLE  SIZES  BY  A  INDUSTRY  AND  YEAR  INDUSTRY SIC  CODE  INDUSTRY  1969  1968  1967  1966  1965  145  Beverages  393  391  408  411  443  374  Chemicals  916  906  938  980  1058  243  Clothing  1660  1630  1675  1788  1849  335  Elec  617  627  591  625  595  101  Food  2518  2549  2474  2771  2892  261  Furniture  924  927  896  860  958  231  K n i t t i n g ,  292  299  314  327  337  172  Leather  375  382  382  381  394  311  Machinery  854  829  778  838  830  302  Metal  Fab  3122  3093  3045  2854  2777  381  Misc  Manuf  1822  1732  1751  1771  1849  341  Non-Metallic  940  952  1006  986  1027  271  Paper  441  447  437  447  440  365  Petroleum  55  60  67  78  79  291  Primary  444  386  357  393  384  286  Printing  2549  2481  2356  2239  2285  163  Rubber  102  96  93  89  88  183  Textile  631  686  665  667  714  153  Tobacco  26  27  23  29  37  323  Transport  711  691  647  609  626  251  Wood  1690  1662  1723  1790  1843  21082  20853  20626  20934  21505  TOTAL  Prod  Prod  Metal  Prod  Prod Equip  101  APPENDIX  A  -  Continued  INDUSTRY SIC  CODE  INDUSTRY  1964  1963  1962  CONCENTRATION RATIO  145  Beverages  149  149  150  47.69  374  Chemicals,  373  371  362  72.24  243  Clothing  501  497  468  25.47  335  Elec  268  265  274  56.31  101  Food  939  962  877  58.07  261  Furniture  215  223  215  48.65  231  Knitting  132  126  126  28.36  172  Leather  146  150  144  65.24  311  Machinery  274  268  266  73.46  302  Metal  Fab  641  633  624  47.94  381  Misc  Manuf  347  342  332  21.62  341  Non-Metallic  275  279  274  50.35  271  Paper  236  237  241  76.98  365  Petroleum  35  35  36  92.16  291  Primary  138  129  132  78.23  286  Printing  316  335  327  13.21  163  Rubber  44  46  44  75.41  183  Textile  237  239  242  80.23  153  Tobacco  21  25  26  87.36  323  Transport  221  217  206  74.73  251  Wood  578  589  586  42.07  6086  6117  TOTAL  Prod  Prod  Metal  Prod  Prod Equip  5951.  102  APPENDIX  B  MEAN COMMON E Q U I T Y RATIO (COMMON E Q U I T Y / T O T A L A S S E T S ) FOR 21 I N D U S T R I E S , 1 9 6 2 - 1 9 6 9 , C L A S S I F I E D BY AVERAGE A S S E T S I Z E TOP GROUP INDUSTRIES  MEAN  COMMON E Q U I T Y 1962-1969  Paper  56.73  Petroleum  65.74  Primary  55.75  Rubber  Metal Prod  Tobacco  AVERAGE  54.38  Prod  Transport  55.36  Equip ^  53.39  FOR TOP GROUP  56'. 89  MIDDLE GROUP INDUSTRIES  MEAN  COMMON E Q U I T Y 1962-1969  Beverages  50.69  Chemicals  5 3.38  Elec  Prod.  51.33  Food  50.07  Machinery  50.52  Metal  50.04  Fab  Noh-Metallic  51.73  Textile  51.03  Wood, AVERAGE  ' FOR MIDDLE  RATIO  GROUP•  48.65 50.83  RATIO  103  APPENDIX  B-Continued  MEAN- COMMON E Q U I T Y 1962-1969  BOTTOM GROUP INDUSTRIES  Clothing  43 .14  Furniture  46.88  Knitting Leather Misc  46.48  Mills  44.6 0  Prod  4 6.23  Manufacturing  Printing AVERAGE  &  Publishing  FOR BOTTOM  GROUP  46 .95 4 5.71  RATIO  104  APPENDIX'C AVERAGE  OF P R O F I T RATES ( E B I T / T A ) FOR 21 I N D U S T R I E S , 1 9 6 2 - 1 9 6 9 , C L A S S I F I E D BY AVERAGE A S S E T S I Z E  TOP GROUP INDUSTRIES  AVERAGE (EBIT/TA) 1962-1969  Paper  12.06  Petroleum  13.04  Primary. M e t a l s  11.33  Rubber Tobacco  Prod  9.31  Prod  18.61  Transport. Equip  11.88  AVERAGE  12.71  FOR TOP GROUP  MIDDLE GROUP INDUSTRIES  AVERAGE (EBIT/TA) 1962-1969  Beverages  18 .96  Chemicals  10 .96  Elec  PrOd  8 . 69  Food  9.57  Machinery  11.16  M e t a l Fab  9 .79  Non-Metallic  8 .85  Textile  9.61  Wood  7.75  AVERAGE  FOR M I D D L E  \  GROUP  10; 59  105  APPENDIX  BOTTOM GROUP INDUSTRIES  C-Continued  AVERAGE ( E B I T / T A ) 1962-1969  Clothing  6.65  Furniture  7.00  Knitting Leather Misc  Mills  7.45  Prod  6.66  Manufacturing  Printing AVERAGE  10.01  & Publishing FOR BOTTOM  GROUP  12.65 8.40  106  APPENDIX  Appendix firm  betas  through  of  1969.  the  D  i s a  histogram  concentrated  D  of  group  the over  frequencies the  period  of  36  1962  FREQUENCY o  VJ1  * o  i f * if if •»• •«• # i f * * * * * * * * * * *  -if if  o  -H-  o  td I_I  •H*  ,o  *  *  *  i  f  i  f  i  f  i  f  *  *  *  *  *  *  *  *  vO CO  * * * # * * * * * * •* * » * * * * « » • * » » * » * # * * * # * # * «• * «• * * # * * # * * * # * * * *  o o  •*  M.# <  *  *  •  *  *  if  If  *  *  *  *  *  *  #  *  »  »  •* if * if # -if *  ro o  «• *  if  o •  if  if  i f if If if if *  *  if * if J!' if if  .+ *  *  *  *  *  -if *  if  if ff *  *  *  *  *  *  <f *  if *  if i f  i f if *  <f  : 108  APPENDIX  Appendix. E firm  betas  through  of  1969.  the  i s a histogram unconcentrated  E  of  the  group  f r e q u e n c i e s of  over  the  period  48 1962  FREQUENCY o  ui  o  o  -P» •  O  O  o o « •  »\.n •  *• it-  •  •*  O •  • c »  *  *  *  • * * # # # * • « • # * * * • » - » • o •  <-> • »  o o  •  -* *  • t • »  o  tt*******-**-**  ca * o •  3-  #  •  w  '  '  H  #  o •  *  w •ft*» # * * » * * # * * > CO  -a* * -a-  vT) o O • .  t—  O O  • •  • o  * #  * « »• * # •**•*#**••**•*•* *  * •«•  »  *  -a- if j f * * * * * * * * •  * #•»•*•«•*•«•«•##  # if -tf -a *  •  *  • •  if  * * » * * * * # * * # # # # * * f - ! f * f * # #  NJ • O •  • • o • • •  -a•»  • •  •  **************************  if  if -*f  * if  if * • « • « • • » • *  110  BIBLIOGRAPHY PUBLIC  DOCUMENTS  Department o f Consumer and C o r p o r a t e A f f a i r s , C o n c e n t r a t i o n i n the M a n u f a c t u r i n g I n d u s t r i e s o f Canada, (Ottawa: Queen's P r i n t e r and C o n t r o l l e r o f S t a t i o n a r y , 1971). 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