This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Conference on Research in Business Finance Volume Author/Editor: Universities-National Bureau Volume Publisher: NBER Volume ISBN: 0-87014-194-5 Volume URL: http://www.nber.org/books/univ52-1 Publication Date: 1952 Chapter Title: Costs of Debt and Equity Funds for Business: Trends and Problems of Measurement Chapter Author: David Durand Chapter URL: http://www.nber.org/chapters/c4790 Chapter pages in book: (p. 215 - 262) COSTS OF DEBT AND EQUITY FUNDS FOR BUSINESS: TRENDS AND PROBLEMS OF MEASUREMENT DAVID DURAND National Bureau of Economic Research It does not seem feasible at this timeto present a paper that will do justice to the title, "Costs of Debt and Equity Funds for Business: Trends and Problems of Measurement." To me this title implies a critical analysis of available data, and concrete proposals for research. The need for such research is great. We have heard a great deal recently about an alleged shortage of equity capital, and we have actually observed that many cor- porations finance expansion with cash retained from operations or by borrowing. This may mean, as some have argued, that the usual sources of equity capital have dried up, but it may also mean that corporations find selling stock much less attractive, or perhaps more costly, than other methods of financing. How, therefore, do the costs of stock financing com- pare with the costs of borrowing, or the costs of retentions? When, if ever, do the costs of financing discourage business expansion? And finally, does the tax structure have any effect on the costs of financing? I shall deal solely with conceptual problems and, in doing this, ruth- lessly brush aside the practical details in hope of clarifying the basic issues. Although we have, I believe, a rather rough notion of what we mean by the cost of raising capital, this notion needs to be sharpened before it is applicable for use in actual measurement. Furthermore, the sharpening process indicates that our conceptual groundwork is inadequate to deal with many questions of investment and capital cost. Hence, the formula- tion of a working definition of capital cost necessitates reformulating a good deal of basic and generally accepted economic theory. But even if we achieve a satisfactory definition of cost and a sound basic theory, the practical problems of actual measurement are going to be tremendous. However, a good theory should enable us to understand these problems much better, even if it does not diminish them appreciably. That these problems of measuring capital costs are much the same as the problems that arise in trying to appraise the going concern value of a 215 216 RESEARCH IN BUSINESS FINANCE business enterprise is the general theme of this paper. Almost any method 0' estimating costs will, I believe, at least imply an evaluation of the com- mon stock of a corporation or the proprietor's interest in an unincorporated business. That is, we can measure the costs of capital about as accurately as we can measure the value of common stock, and any of us who think that stock appraisal is a form of crystal gazing should prepare to include research on the cost of capital i.n the same category. Before going on with this argument, I wish to offer a general disclaimer. During the past three months of intermittent work on this paper, I have repeatedly had to revise my opinions, and I expect to have to revise them further in the ensuing three months. I do, of course, expect to stand by two general principles: 1) Ourbasiceconomic theory needs revisions; 2) Security appraisal is the key to measuring the cost of capital. But the details of the argument are, like a timetable, subject to change without notice. This paper is therefore a historical statement of the development of my ideas to date. Finally, I wish to thank Martin W. Davenport and Wilson F. Payne for contributing a large number of ideas, some of them basic, and for aid in formulating the argument. I BASIC CONSIDERATIONS A great of our economic thinking is derived from a few fundamental notions concerning self-interest. The businessman is supposed to know what is best for him and to act accordingly. From analyzing these self- seeking actions, we hope to derive a theory of economic behavior. This paper is conventional in accepting the principle of self-interest and apply- ing it to the problems of capital cost. If the businessman raises capital to finance a venture, it must be in furtherance of his interests; and any defini- tion of the costs of raising this capital must be consistent with this principle. This paper is unorthodox, however, in its conception of what actually constitutes a businessman's best interest. Instead of accepting the common dictum that the businessman's interest is to maximize his income, this paper counters with the alternative proposal that the businessman should try to maximize his wealth. This alternative has the advantage of greater flexibility, and for this reason it avoids errors that may result from forcing the principle of maximizing income on situations to which it is strictly inapplicable. 1 Maximizing income vs. Maximizing investment Value One can attack the principle of maximizing income simply on the grounds that mankind's motives transcend the pecuniary, and that these motives affect his behavior, even in the market place. But leaving these nonpecu- COSTS OF DEBT AND EQUITY FUNDS 217 niary motives aside, one can also attack the principle of maximizing income on the ground that it is totally meaningless in any world in which income is expected to change. Suppose, for example, that a businessman has two possible ways to operate his business. Operation A promises him an annual return of $6,500 in perpetuity, and Operation B promises him $10,000 in perpetuity. The principle of maximizing income well in this example. The businessman will certainly choose Operation B with its higher income (since nonpecuniary niotives are ruled out). But suppose this businessman has another alternative —OperationC — whichgets underway slowly and thus promises him $7,000 the first year, $9,000 the second year, and $10,500 thereafter. The principle of maximiz- ing income tells us that Operation C is preferable to Operation A because the income from Operation C is certainly larger than that from Opera- tion A. But the principle cannot tell us whether Operation C is also prefer- able to Operation B. Is the combination of $7,000, $9,000, and $10,500 thereafter greater or less than $10,000 in perpetuity? This difficulty can be readily resolved provided a discount rate or other index of time prefer- ence is available, and provided, further, that the principle of maximizing income is appropriately modified. The table below shows the discounted, or present, value of income under Operations B and C at four arbitrary rates of discount (standard compound interest tables were used). Thus, Operation B is preferable for rates of 10 percent and above, whereas Operation C is preferable for rates of 9 percent and below. DISCOUNTED VALUE Discount Operation Operation Difference Rate B C (Op.C —Op.B) 7% $142,857 $144,514 $1,657 8 125,000 125,832 832 9 111,111 111,314 203 10 100,000 99,711 —289 Toeffect this simple solution, it was necessary to modify the principle of maximizing income. The statement, "The businessman tries to maximize his income," was changed to read, "The businessman tries to maximize the discounted value of his future income." Of course, some variations in terminology are possible within the revised statement; and, in fact, this paper will henceforth use the term "investment value" to mean the dis- counted value of an expected income stream.1 This revision is more than mere verbiage. The shift from maximization of income to maximization of discounted value has important implications 1Amongthe possible alternatives are "going-concern value" and "intrinsic value." Some security analysts specifically think of intrinsic value as a sum of discounted future income payments; others are less specific. 218 RESEARCH IN BUSINESS FINANCE CHART 1 C I- .t. — — — Marginal — — Before S — — — — — S Ra fe A., Ass for the measurement of costs and the analysis of investment problems. It emphasizes the basic importance of appraisal and security analysis in molding business decisions. How can the businessman go about maximiz- ing investment value without developing a system of appraisal that is suitable, to him at least? Economic theory has used, the principle of maximizing income to demonstrate that business expansion will proceed until the marginal return on capital equals the rate of interest. A brief resumé of the argument is illustrated in Chart 1. Here the marginal return curve represents the rate of return on successive small increments to a businessman's assets. The curve always slopes downward because the businessman is supposed to make his successive small investments in order of profitability. Since the marginal return represents the net return before interest, the distance between this curve and the horizontal line representing the interest rate is the marginal net return after interest. Thus, if the businessman expands his assets to the point A1, his total profit is represented by the area between the marginal return curve, the interest line, the vertical axis, and a vertical line through A1. The maximum possible total profit is attained when assets are expanded to the point where marginal return crosses the interest line.