PATE OF RETURN, COST OF CAPITAL AND VALUATION
RATIO IN FINNISH MANUFACTURING 1960
-
1979*
Heikki Koskenkvld
Research Department
Bank of Finland
May 1981
*
Paper
to be preserited
ReturnConference,
at
the M.I.T.
June19.81.
Rate of
This paper is
revised version of an earlier draft from
September 1980
(see references).
a
CONTENTS
page
1
1.
Introduction
2.
Development of Total Capital, Own Capital
and the Rate of Profit
4
2.1.
Total Capital and Its Components
4
2.2.
Own Capital and Debt Ratios
11
2.3.
Profit, Taxes and the Effective Tax Rate
14
3.
Development of the Rate of Return on Total
Capital and on Own Capital
20
3.1.
The Rate of Return on Total Capital
20
3.2.
The Rate of Return on Own Capital
29
4.
The Rate uf Return to Investors
35
5.
The Valuation Ratio and the Cost of Capital
40
6.
Determinants of the Rate of Return and
the Effective
7.
Conclusions
Tax Rate
53
62
Footnotes
66
Statistical Appendix
73
List of Symbols
83
References
86
1
1
4
1.
INTRODUCTION*
The international background of this
investigation is
the ongoing debate and argument that started in the
mid-1970s about the development and possible decline
in the rate of return on corporate capital in most
western countries. The potential significance of the
behaviour of corporate profitability is clear, but its
actual development has raised many theoretical and
empirical issues.
W.
Nordhaus laid the ground for this discussion by
concluding that in the post-war period
(1948 -
1970)
the rate of return revealed a downtrend in corporate
profitability in the U.S.A.1 Feldstein and Summers
(1977),
on the other hand, disputed this finding,
their conclusion being that
"our analysis of
these
rates of return provides no support for the view that
there has been a
gradual decline in the rate of return
over the post-war period."
Malkiel
Von Furstenberg and
(1977) also doubt the argument for the overall
decline in profitability.
3
They emphasize the import-
ance of the reduction in real indebtedness on the
development of profit and retained earnings.
Holland and Myers
(1978, 1980) have very carefully
analyzed the performance of U.S. nonfinancial corporations since
the war by using both rates of return to
investors and rates of return on capital.4 They concludE
that these corporations have fared poorly since the
mid-1960s, but they, too, were unable to find evidence
of a long-term downtrend.
* The collection of statistical data and the calculations used in this paper were carried out by Ilkka
Salonen. Seija Leino typed this paper, and the
language was checked by Malcolm Waters.
1.
See Footnotes.
14
A
2
In many other countries researchers in this field have
found a significant downtrend in corporate profitability over the last decade and especially following
the first oil crisis in 1973.
Reference can be made
here to the studies made in the United Kingdom and
Sweden.5
International organizations have also devoted
attention to the development and measurement of
company profitability in the latter half of the 1970s
(OECD, etc.).
6
Against this background the principal objective of
this study is the analysis of the performance of
the Finnish manufacturing sector in the period 1960 1979. The analysis is restricted to manufacturing
companies because of data limitations. The performance
of these companies is examined by means of various
indicators.
Our main
emphasis is
on the movements
in
and measurement of rates of return on capital, although
we also make some calculations of the returns to
investors in these companies. Our second purpose is to
analyze the behaviour of capital costs in the manufacturing sector. Finally, we attempt to discover
statistically whether profitability has behaved in a
trendwise manner.
The basic data used in the calculations of this report
is taken from official national
income accounts, but
use is also made of firms' balance sheet data
accounts),
(book
industrial statistics and capital market
data. In addition, some self-constructed data is used
in the calculations of capital stock figures.
The contents of the paper are organized as follows:
3
at
3
In Chapter 2 various estimates of total capital,
physical capital and own capital as well as figures
for debt-equity ratios are presented. We also discuss
the basic formulas for calculating the economic rate
of profit, or operating income, and the official
(statutory) and effective tax rates for manufacturing
industries.
Chapter 3 attempts to trace the development of real
profitability in manufacturing by developing various
estimates of the real rate of return on total and own
capital.
In Chapter 4 we provide some preliminary estimates of
investors rates of return on total and eauity capital.
These are used as additional evidence in considering
the general performance of the manufacturing sector.
Chapter 5 provides an analysis of the development of
the cost of capital and the valuation ratio
q-variable) in relation to
(Tobin's
the real rate of return.
Finally, in Chapter 6 we perform some simple regression
analysis of the determinants of the rate of return and
try to discover whether or not there has occurred
trendwise behaviour. Similar tests are also carried
out for
effective
tax rates.
4
4
14
2. DEVELOPMENT OF TOTAL CAPITAL, OWN CAPITAL AND
THE RATE OF PROFIT
2.1. Total Capital and Its Components
The concept and measurement of capital
is a compli-
cated task both from the theoretical and the empirical
point of view, the main problems usually arising in
connection with the stock of physical assets, that is,
real capital plus inventories. It is generally felt
that financial assets can be estimated rather reliably
from official statistics. In this paper estimates of
total capital in manufacturing have had to be drawn
from a variety of statistical sources and earlier
Finnish studies. However, we believe that the estimates so obtained are quite reliable, especially for
the manufacturing sector.
In recent years, various
measures of the fixdd capital stock of Finnish manufacturing have been developed. The basic measure used i:
this investigation is that of net replacement cost
value. The capital stock series is based on an estimate of 5.4 per cent for
true economic depreciation.
This rate of depreciation is calculated with the aid
of
fire insurance values for the manufacturing capital
stock.
The time series for fixed capital stock
(in 1975
prices) is constructed by means of the perpetual
inventory method,
(1)
Kt
=t
+
(1-6) Kt- 1
where the depreciation coefficient 6 = 0.054, the
initial -alue
stands
for K
(K0 )
is estimated separately and It
manufacturing gross investment
(1975 prices)
5
statistics. The
and is taken from the national income
current value of this net capital stock is obtained
through multiplying by the price index of investment
goods.
Figure 1 shows three different estimates of the manufacturing capital stock, all expressed in current
prices. The first series is based on the method
CP
The second time
described above and is labelled K C.
series, K CP
2
is
ie8
that
constructed by the
recently
Central Statistical Office
of Finland.
It is based
on an estimate of 7.8 per cent for true depreciation,
which is somewhat higher than in our basic series. The
third series consists of fire
from the industrial statistics
insurance values taken
CP
(K 3
).
The fourth
series presented in Figure 1 is the book value of
fixed assets calculated by means of historical cost
accounting and accelerated depreciation rules for
taxation purposes. It has been obtained from the
official balance
sheet data of Finnish industry. This
data has been published since 1960, and has been
called
'enterprise statistics' since 1974.
From Figure 1 it can be seen that the fire insurance
series exhibits the largesL
absolute value of these
alternative estimates of the fixed capital stock in
Finnish manufacturing. The two capital stock series
mainly used in this study are rather close to each
other and clearly exceed the book values of fixed
assets.
The use of Finnish data for the estimation of the
current value of inventories raises various problems.
These have been analyzed in some other Finnish studies.
In Finland, the practice of revaluing inventori'es
Figure 1.
Various Estimates
1960 -
of
the Fixed Capital Stock in Finnish Manufacturing
1979, in current prices
KCP = net replacement cost value
(5.4 per cent depreciation)
= net replacement cost value
(7.8 per cent depreciation)
1
K
K
CP
3
KB
=
fire insurance value
= book value of fixed assets
FIM
billions
150
CD
K
-
100
101
CP
-
...
------
K
B
01965
1970
1975
1980
7
according to the so-called FIFO
(first-in-first-out)
principle is applied in taxation. It is,
however,
permissible to enter into the accounts certain future
inventory expenses;
i.e.,
undervalued. Since 1969,
the inventories can be
the maximum rate of under-
valuation has been 50 per cent of the acquisition cost
of inventories. Earlier the maximum rate was 100 per
cent. In effect this undervaluation means that
nowadays 50 per cent of the value of inventories
(at
historic cost) can be regarded as expenses when
calculating
the
taxable
income.
In this way, companies can create "hidden reserves",
or tax credits, which can at least to some extent be
regarded as comparable to other components of own
capital. This question will be discussed in the next
section when estimating the own capital of Finnish
manufacturing companies. The rationale behind this
undervaluation
lies partly in the fact that during
inflationary periods the FIFO principle operates in
such a way that the increase in the value of inventorieE
is transferred to sales
income and hence becomes
taxable income. Undervaluation is designed to at
least partially prevent these nominal capital gains
being subject to corporate income taxation. It is
worth mentioning that during the 1970s companies'
profitability levels did not allow full use of undervaluation.
(VO ) and
0
CP
(VO
).
Figure 2 shows the book value of inventories
the estimated current value of inventories
In addition, Figure 2 shows the value of the financial
assets of manufacturing companies. This series has
been taken directly from the enterprise statistics
(balance sheet data),
but can be regarded as reliable
Figure 2.
Various Estimates of
Inventories and Financial Assets in Finnish
Manufacturing 1960 - 1979
VOCP
= current value of inventories
VOB
= book value of inventories
RO
= value of all financial assets
net = value of net financial assets
RO
FIM
billions
40
UrOP
30
2-
B
10
1965
1970
1975
1980
9
data. The series RO includes all financial assets,
that is, cash, all kinds of deposits, accounts
receivables and some other financial items. The
series shown in Figure 2,
assets
RO net,
is gross
second
financial
less accounts payable and it is regarded as an
approximation of financial assets for net working
capital purposes.
We are now in a position to present our estimates for
total capital. The concept of total capital used in
this study includes
total physical assets,
fixed assets
capital
Thus tota]
the stock of
(K) and inventories
financial assets
all
i.e.,
(VO)
(RO)
(at current prices) is
the sum of
these three components,
(2)
+ VO
TC = K
+ RO
In addition, we employ some other definitions of
capital
in the rate of return calculations. Total
physical capital is defined as
(3)
+ VO
TFC =K
Figure 3 shows various estimates of total capital. The
time series TC
CP
estimate K1
CP
value of K2
,
is based on the fixed capital stock
whereas
1
(TC B
.pi 10
companies.-
2 is based on the
Figure 3 also shows the value for total
physical capital
capital
the series TC
(TFC) and the book value of total
employed by Finnish manufacturing
Figure 3.
Estimates of Total Capital and Total Physical Capital in Finnish
Manufacturing 1960 -
TC
TC
11
2
1979, in current prices
CP
= total capital
(based on KC
= total capital
(based on K 2
CP
TFC = total physical capital
(K1
)
)
C
+VO
)
TCB = book value of total capital
FIM
billions
150
100
T(
50
0
1965
1970
1975
1980
11
2.2. Own Capital and Debt Ratios
The analysis in the previous section provides the
basis for estimating the
"true" value of the own
capital of Finnish manufacturing companies. In section
2.1 we developed various estimates of
the net replace-
ment value of total capital and we found that these
were much greater than the book value of total capital.
A reliable estimate of the value of the total debt of
the same companies can be obtained from the official
enterprise statistics. The measure of debt capital
includes all short- and long-term credits as well as
domestic and foreign debt.
The difference between the current replacement and
book values of total capital is an estimate of the
total amount of various
manufacturing companies.
"hidden reserves" held by
It could be argued that part
of these reserves belong to own capital and part are
due to deferred tax liabilities
in the form of
tax
credits. An extreme view which has been put forward is
that all these reserves should be included in the
11
concept of total own capital.
Figure 4 shows various estimates of own capital held
by manufacturing companies. The
lowest value is
obtained for an estimate of pure equity capital
(E)
taken directly from the enterprise statistics. Equity
capital forms the basis for the dividend payments of
manufacturing corporations. The
second measure shown
in Figure 4 is the total value of own capital as taken
from the enterprise statistics
(OC 1 ).
In addition to
equity capital this concept also includes various
"official" reserves and financial transfer and valuation items.12 It can be seen that the share of'these
Figure 4.
Estimates of Own Capital in Finnish Manufacturing 1960
-
1979,
in current prices
E
= equity capital
OC
=
(book value)
total own capital
(b'ok value)
OC2 = estimated own capital
OC
= estimated own capital
(maximum value)
(half of hidden reserves included in own capital)
FIM
billions
80
0C
60
.OC
40
.00
,
oo
0oO
/E
20
0
1965
1970
1975
1980
13
"official own capital" has risen con-
items in total
tinuously, being currently over 50 per cent.
The third measure of total own capital
(OC) is the
basis for most of our calculations in this paper. It
represents a compromise between the extreme interpretations of the role of total
footnote 11).
(see
"hidden reserves"
We have assumed that one half of these
reserves belong to own capital and one half to debt
capital in the form of interest-free loans. 1 3
The last measure of total own capital
(OC 2 )
is based
on the extreme assumption that all "hidden reserves"
belong to own capital. The magnitude of these reserves
is mainly attributable to inventory undervaluation and
accelerated depreciation rules. The size of inventory
reserves can be roughly seen from Figure 2 as the
difference between VO ~ and VOB. Depreciation charges
for tax purposes have on average exceeded true economic depreciation at-replacement cost value.
Table 1 shows three different measures of the ratio of
debt to own capital. The highest value for this ratio
is obtained when own capital includes only the
"official" amount as shown in book accounts. This
ratio is denoted as B/O
C
where B is
book value. The lowest value
ratio results when all
in own capital
total debt at
for debt to own capital
"hidden reserves" are included
(B/OC 2 ). The mean value for this ratio
is obtained when half of the reserves are included in
debt
(B*/OC). 12
From Table 1 it can be seen that all of these debt
ratios have increased in a trendwise manner. There
14
remains, however, a significant difference between the
levels of various debt ratios.
Table 1.
The Ratio of Debt to Own Capital in Finnish
Manufacturing 1960 -
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
2.3.
1979
Ratio of debt
Ratio of debt
to total book
value of own
to estimated
"maximum" value
capital
of own capital
B/OC1
B/OC
1.84
1.88
2.05
2.11
2.26
2.94
2.50
2.72
2.81
2.46
2.73
2.93
2.99
2.70
3.28
3.80
3.91
3.92
3.82
3.57
0.74
0.75
0.79
0.82
0.82
0.84
0.87
0.99.
0.92
0.97
1.02
1.13
1.15
1.15
1.11
1.18
1.23
1.21
1.25
1.11
Ratio of debt
plus tax credits
to estimated
own capital
B*/OC
2
1.61
1.62
1.72
1.77
1.82
1.88
1.94
2.16
2.11
2.00
2.13
2.28
2.34
2.26
2.42
2.69
2.76
2.75
2.78
2.51
Profit, Taxes and the Effective Tax Rate
In this section the formulas for determining profit
and taxes are derived together with estimates by
using both national income accounts and enterprise
statistics data. We also present the estimates of
effective tax rates and holding gains on physical
capital stock.
The ordinary national income account definition of the
value-added in manufacturing production is as follows
15
pQ
(4)
=
W + Deb + IR
+
7b
A,
wher e
pQ
W
= current price value-added production
= sum of wage- and social security payments
(total labour costs)
Deb = economic value of depreciation
IR
'b
Tr
= net interest expenses
= gross profit, i.e. profit before taxes
The values for the variables pQ and W
are taken from
the national income accounts data for the manufacturing
sector. An estimate of economic depreciation charges
is calculated along with the fixed capital stock
estimates. The series for net interest expenses
(all
interest payments minus interest receipts) originate
from the enterprise statistics.
From the basic formula for value-added production, the
variable
"profit before taxes" becomes following
7b = pQ - W - Deb -
(5)
The variables pQ, W
IR
and IR are the same in all our
calculations, but the variable Deb varies according to
which depreciation coefficient is used (5.4 or 7.8 per
cent, see section 2.1).
Operating income
(6)
(net) is defined as
OI = 7a + T +
IR
where
,a = profit after taxes
T
= direct corporate taxes (paid)
16
We thus have
(7)
b =7a + T
Table 2 shows the percentage distribution of operating
income into its three components.
Table 2.
The Distribution of Operating Income into
Its Components
Net profit
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1L79
72.51
71.18
62.12
64.69
64.22
58.45
53.32
52.60
61.67
72.89
72.77
58.93
60.36
63.72
69.79
45.73
32.21
22.12
46.86
57.98
(percentage)
Taxes
17.74
17.70
21.43
18.47
17.66
19.26
21.38
18.44
13.64
9.61
8.58
11.02
9.19
8.54
6.46
11.57
15.04
14.02
8.56
8.27
Interest
9.75
11.12
16.45
16.84
18.13
22.29
25.30
28.96
24.69
17.50
18.65
30.06
30.45
27.74
23.75
42.70
52.75
63.85
44.58
33.75
It can be seen from Table 2 that the relative propor-
tion of interest expenses has risen continuously
reflecting the trendwise increase in the debt-own
capital ratio
(see Table 1).
We next present the estimates of actual and effective
tax rates for Finnish manufacturing companies. The
actual tax rate is as follows
17
U T
TI
(8)
where
T
= paid taxes
TI = taxable income
(profit before taxes) at book
value
The effective tax rate is
T
(9)
f
7T=
thus it is the share of paid company taxes in economic
(true) profit before taxes. Table
estimates of these tax rates.
Table 3.
3 presents
13
Actual and Effective Tax Rates in Finnish
Manufacturing
Actual
tax rate
U
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
0.45
0.56
0.60
0.56
0.55
0.56
0.60
0.59
0.55
0.49
0.46
0.50
0.44
0.41
0.43
0.64
0.79
1.52
0.69
0.46
Effective
Effective
tax rate
(based on
tax rate
(depreciation
depreciation
coefficient
5.4 per cent)
coefficient
7.8 per cent)
Uf
Uf
0.20
0.20
0.26
0.22
0.22
0.25
0.29
0.26
0.18
0.12
0.11
0.16
0.13
0.12
0.08
0.20
0.32
0.39
0.15
0.12
0.23
0.23
0.31
0.27
0.26
0.31
0.36
0.33
0.22
0.13
0.12
0.19
0.16
0.14
0.10
0.27
0.48
0.76
0.19
0.14
2
18
It can be seen that the effective
tax rates are only
about half the actual rates. This is due to the fact
that taxable income is reduced by accelerated depreciation and inventory undervaluation as compared to the
estimates of
"true" profit before taxes.
In calculating the values of "true" profit in this
section we have not taken into account the effect of
capital gains or holding gains on existing capital
stock. This is done separately here because
the role
of holding gains on physical capital is a matter of
some dispute. The nominal relative holding gain on
total
physical capital
(TFC)
is
defined as
(l+g CUR)
(10)
1 + g =
(gCON)
where
CUR
=
annual rate of increase of the current value of
total
physical
capital
(TFC)
CON
=
annual rate of increase of the volume of TFC
(1975 prices)
Thus the variable g is the annual rate of increase in
the implicit price index for total physical capital.
4
Relative real holding gains are measured by the formula
(11)
g=
r
(1+cj)
(l+gCP)
Hence real holding gains are measured relative to the
rise in the general price level
(gCP = rate of
increase in the consumer price index).
In Table 4 are shown the percentage nominal and real
holding gains. The absolute values of these ficures
are given in the Appendix (Table A3) in addition to
19
the estimates for holding gains on fixed capital
stock. It can be seen that if real holding gains are
zero then operating income as calculated above equals
total real income. The role of holding gains will also
be discussed in the next section when calculating real
and nominal rates of return on total capital.
Table 4.
Nominal and Real Holding Gains in Finnish
Manufacturing 1961
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
-
1979, per cent
NHG,
per cent
RHG,
per cent
1.63
3.61
4.74
5.52'
5.60
2.11
6.26
10.44
4.71
8.22
10.25
11.78
19.78
24.60
13.50
10.28
10.56
10.74
9.14
-0.18
-0.82
-0.12
-4.38
0.75
-1.76
1.63
0.80
2.44
5.34
3.53
4.79
8.18
6.55
-3.67
-3.54
-1.85
2.96
1.72
We can observe from Table 4 that percentage nominal
holding gains increased rather rapidly in the 1970s
compared to the 1960s. Real holding gains were on
average almost zero in the 1960s and amounted to
less
than two per cent on average in the 1970s. Although
the relative size of real holding gains seems to be
rather low, they have been quite large in absolute
terms in some years. The year-to-year variations in
holding gain estimates should, however, be regarded
with caution because of difficulties in the measurement
of the composite price index for the total fixed
capital stock.
20
3.
DEVELOPMENT OF THE RATE OF RETURN
OWN CAPITAL
ON TOTAL CAPITAL AND
3.1.
The Rate of Return on Total Capital
In this section we present the estimates of the real
rate of return on total capital for Finnish manufacturing companies in the period 1960 -
The
1979.
main results are shown in Tables 5 and 6 and in
Figures 5 -
7, while some alternative estimates are
given in the Appendix. The means and standard deviations for both sets of estimates are presented in
Table 7.
The nominal rate of return on total capital before
taxes is
(12)
NB
RR
b
_
-
+ IR + NHG
T
TC
where the variables are measured as described in the
previous
section. The absolute value of nominal hold-
ing gains on total physical capital is obtained by
multiplying the current value of TFC by the relative
nominal holding gains. The absolute values for NHG are
given in the Appendix
nominal rate of return
7b in formula
(Table A3).
(RRNA)
The
after-tax
is obtained by replacing
(12) with post-tax profit
(7 a).
Total
capital as well as other concepts of capital used are
the averages of the beginning- and end-of-year values
of the corresponding-capital measures.
When g is the proportional rate of increase in the
implicit price index of total physical capital, then
NHG = gTC and we get the standard expression for the
real rate of return
21
(13)
RRB = RRNB-
formula for the real rate of return
and the equivalent
after taxes
RA
(RR
g
).
Strictly speaking we should also
consider the effect of price changes on the value of
financial assets, but this is not taken into account
here because we are mainly interested in the value of
the appreciation of fixed capital and total physical
(13),
(12) and
capital. From expressions
we obtain an
equivalent formula for the real rate of return on
-total capital
(14)
RR
RB
(before taxes)
b
_
+
±IR
C=
TC
which is the ratio of operating income to total
capital. In the formulas
(13)
that real holding gains are
RA
formula for RR
and
(14) it is assumed
zero. The equivalent
b
is obtained by replacing 7
It was pointed out in section 2.3
a
with Tr
that operating
income equals real total income only if real holding
gains on capital
stock and inventories are
zero. This
means that the composite price index of this stock
value rises at exactly the
same rate as prices
generally. Including real holding gains
(or losses)
in
the measure of real income gives the second basic
formula for the real rate of return
(15)
RR RB
_
=
Tb
_______
+ IR + RHG
TC
and, taking into account the fact that the absolute
value of real holding gains equals g r TC
11),
(see equation
we obtair also a second formula for the relation-
ship between real and nominal rates of return
(16)
RRRB = RRNB
_ 9CP'#
-j
22
where gCP. is the rate
level
of
increase in the general price
(usually assumed to be the consumer goods price
level) .15
In all of the above cases, the real rate of return
after taxes
RA
(RR
) is obtained by deducting taxes
actually paid from the estimated profit before taxes
to get post-tax profit
(see section 2.3).
These general principles have been used to calculate
the real rate of return on alternative estimates of
total capital and total physical capital. In these
alternative estimates we have varied the concepts of
total assets and the depreciation coefficient on
fixed capital stock
Table 5.
(see Table A4 in the Appendix).
Real Rate of Return on Total Capital in
Finnish Manufacturing 1961 -
1979
cent, without real holding gains
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
RRRB
RR
12.77
9.99
9.95
9.52
8.19
7.31
7.03
8.69
11.82
11.05
7.56
7.69
8.45
10.58
5.89
4.94
4.40
6.45
8.03
10.51
7.85
8.11
7.84
6.61
5.74
5.73
7.50
10.68
10.10
6.73
6.98
7.73
9.90
5.21
4.20
3.79
5.90
7.37
in per
23
Table 6.
Real Rate of Return on Total Capital in
Finnish Manufacturing 1961 -
1979 in per
cent, including real holding gains
1961
1962
1963
1964
1965
1966
1967
1968,
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
RRRB
RRRA
12.61
9.28
9.85
5.79
10.35
7.14
8.01
4.11
7.26
4.25
7.10
8.19
12.71
14.65
9.72
10.99
14.89
15.90
2.03
1.18
2.21
8.28
8.80
8.83
5.82
8.37
9.37
13.84
15.59
10.55
11.70
15.61
16.58
2.71
1.93
2.83
8.84
9.47
From Tables 5 and 6 it can be
seen that the average
effect of real holding gains on the estimates of the
real rate of return on total capital is not very large
(less
than 1 per cent),
but
that
the year-to-year
effects
are much greater.
between
the levels of before- and after-tax measures
The
fairly
small difference
reflects the fact that the effective rate of
on corporate income has been rather low
2.3).
These
estimates
of the
"true"
total capital are almost twice the
rate
taxation
(see section
of return
on
size of the rate of
return on total capital at book-values.
Figure 5 shows the development of the real rate of
return on total capital
(before and after taxes) and
of total physical capital
(after taxes)
including real
24
holding gains. Figure 6 shows the development of the
same series without holding gains. Figure 7 shows the
effect of real holding gains on the rate of return on
total capital after taxes on a year-to-year basis.
From these figures
fluctuations
in the
it can be
real
rate
seen that the annual
of return
on total
capital in Finnish manufacturing have been very large.
On average, these series
seem to reflect very well the
general cyclical fluctuations of the manufacturing
sector as well as the whole Finnish economy. As is
well-known, the year-to-year variations
in the GDP of
the Finnish economy are among the highest of the OECD
countries.
In Table 7 we present means
for .selected measures of
and standard deviations
the real rate of return in
the Finnish manufacturing sector.
Some interesting observations can be made from Table 7.
The average real rate of return on total capital or
total physical capital before taxes varies between 8.4
and 9.4 per cent. The corresponding range for aftertax figures is somewhat larger. We can thus safely
conclude that our measures for real rate of return are
rather insensitive to the choice of the estimate for
the capital variable.
It can also be seen that the
standard deviations of estimates including real holding gains are about twice as large as those without.
There does not at present seem to be any method for
evaluating the reliability of the estimates of real
holding gains. However, we are tempted to express
some doubts about the year-to-year variations in RHG.
The third interesting observation is that the rate of
return on total capital measured at book value does
not vary very much. This is basically due to the fact
that, during periods of weak profit development,
Real Rate of Return on Total Capital in
Figure 5.
1961 -
1979, in per cent, including real holding gains
RRTCB
=
RRTCA
= total capital after taxes
RRTFCA =
Finnish Manufacturing
total capital before taxes
total physical capital after taxes
RR, %
20
15
i/0,
P
RRTFQA
20
-
\
\RRTICA
I,'
0
5|
RRTCB
A||
0
1965
Odle
1970
1975
1980
Figure 6.
Real Rate of Return on Total Capital in Finnish Manufacturing
1961 - 1979, in per cent, excluding real holding gains
RRTCB
= total capital before taxes
RRTCA
= total capital after taxes
RRTFCA = total physical capital after taxes
RR, %
14
12
10
-
-
\
RRTFCA
RRTCB
2
1965
1970
1975
1980
Figure 7.
The Effect
of Real Holding Gains on the Real Rate of Return
on Total Capital in Finnish Manufacturing
RRTCG = rate of return including RHG
(after taxes)
= rate of return excluding RHG
(after taxes)
RRTC
1961
-
1979
RR, %
20
15
10
-
PRRTCG
, RRTC
I
5
0P
1965
1970
1975
1980
28
Table 7.
Mean Values and Standard Deviations for Various.
Concepts of the Rate of Return in Finnish Manufactur-
ing, in per cent per year
Mean
(per cent)
Concept of Capital Used
(corresponding concepts
of profit and other
variables have been used)
Total capital
(including real
RRRB
holding gains):
Total capital
RR RA
HG):
Total capital with
Total capital
depreciation
(including RHG):
RRRB
(including RHG):
RRRA
2.0
8.8
4.5
6.7
3.9
9.7
5.5
8.3
2.5
4.6
0.3
6.3
1.0
(book value):
after taxes
before taxes
7.3
(excluding
RR
Total capital
2.2
(including
RRR
Total capital
8.4
with 7.8 per cent
Total physical capital
RHG):
4.3
7.8 per cent
Total physical capital
RHG):
8.3
(excluding real
RRRA
depreciation
4.3
(excluding real
HG): RRRB
Total capital
9.4
(including real
holding gains):
Total- capital
Standar Deviation of Series
(per cent per
year)
(book value):
29
net interest expenses have risen sharply both in
absolute and relative terms.
3.2.
The Rate of Return on Own Capital
The rate of return on own capital has been estimated
by means of two different methods. The first is based
on the ratio of profits to estimated own capital. This
calculation is analogous
to that of the rate of return
on total capital. The basic formula for the rate of
return
is
on own capital
(17)
where 7
RR
R
Tr
O
thus
'
is estimated profit
(after taxes) and OC is
the current value of own capital
The results derived by formula
as values for the
(see section
2.2).
(17) can be interpreted
"real" rates of return on own
capital. The nominal rate of return could in principle
be calculated by adding the rate of increase in the
general price level to the values given by
(17).
Table 8 shows the results for selected values of own
capital.
In section
2.2 we discussed the methodol-
ogical questions connected with various concepts of
the estimates of own capital
(see also footnote 11).
30
Table 8.
Estimates of the Rate of Return on Own
Capital in Finnish Manufacturing 1961 -
1979,
per cent
Estimated own
capital (OC)
includes half
of the hidden
reserves (i.e.
deferred tax
Estimated own
capital (OC
2)
includes
Book-value
estimate of
own capital
all hidden
reserves
liability)
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
(3)
RRR (1)
RR (2)
RR
23.78
16.60
17.69
17.12
13.67
11.35
11.28
16.77
26.24
24.69
14.30
15.37
17.74
24.75
9.60
5.93
3.66
11.38
15.84
10.99
11.64
11.14
8.76
7.23
7.15
10.46
16.7-6
16.08
9.27
9.93
11.56
15.68
5.78
3.51
2.17
6.75
10.13
7.77
6.57
6.61
6.60
7.04
6.14
4.85
5.45
6.37
5.90
4.60
5.06
5.44
5.25
2.50
1.37
-1.50
1.73
5.31
16.90
The estimates of the rate of return on own capital
calculated by expression
(17) can be regarded as
"flow" estimates s'ince they are based solely on the
estimated "true" profit account of firms. This procedure does not take into account any holding gains
which are accrued to own capital because of a decrease
in the real
icbtedness of firms. This effect is
included in t.
estimates of own capital based on the
following formula
31
r
x TCTCB
RR
R
(18)
RROC
x B
where
RR
= real rate of return on total capital
TC
= total
r
= real rate of interest
B
= total debt
capital
This general formula can be shown to lead to the
following form
R
RR c-
(19)
RR
R
+
B
R
(RRR-r)
The real rate of interest (r) is defined as usual by
the expression
r =
(20)
1 + p
where
i = nominal rate of interest
p = rate of
increase in the general price level
(taken to be gCP,
From formula
(19)
see formula
(11))
it can be seen that the rate of
return on own capital exceeds
total capital if the
the rate of return on
latter is greater than the rate
of interest.16 In that case, an increase in leverage
(B/OC) also tends
to increase the return on own
capital.
The difference between the rate of return estimates
of own capital obtained by formulas
( 1+p )B,
(17) and
(19) is
which measures the
17
decrease in the real indebtedness of firms.
largely due to the factor
32
Table 9 shows estimates of the rate of return on own
capital calculated by formula
Table 9.
(19).
Estimates of the Rate of Return on Own
Capital
in Finnish Manufacturing 1961
in per cent, as calculated by formula
Estimated with
capital OC
own
1979,
(19)
Estimated with own
capital OC
2
RR C(1)
RR C(2)
19.55
14.68
12.02
12.83
16.37
10.02
7.94
8.60
15.99
15.66
15.79
13.26
14 .35
20.09
29.36
21.67
16.80
13.51
12.78
15.01
C
1961
1962
1963
1964
1955
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
-
16.91
18.26
26.84
14.26
10.63
11.96
26 . 93
20.93
21.94
19.90
22.01
32.13
52.44
42.87
32.37
25.81
21.16
24.62
Figure 8 shows the difference between the two methods
for calculating the rate of return on own capital.
It can be seen that, especially in the 1970s, the higher
rate of inflation has markedly increased the real rate
of return on own capital. This is mainly because of
the low real rate of interest and increasing leverage.
The rate of return on own capital also greatly exceeds
the rate of return on total capital.
Figure 8 shows that during the 1960s these two different measures for the real rate of return on own capital
Figure 8.
RR (1)
0
RR
OC
The Effect of Real Indebtedness on the Rate of Return
on Own Cap-ital in Finnish Manufacturing 1961 - 1979
rate of return on own capital, formula (17)
(1) = rate of return on own capital, formula
(19)
60
40
RR 0C
20
\
/
,RR
(1
R
R
RC(1)-RROR(1
000%-RR
0
\
-20.U
1-965
1970
1975
1980
34
(after corporate taxes) were on average almost equal.
In the 1970s
these two measures differed significantly
owing to the decrease
in the value of real debt. The
decrease in real indebtedness can be partly attributed
to own capital and interpreted as representing real
capital gains, the counterpart of the real rate of
return on total capital being real holding gains.
can also see from Table 9 and Figure 8
18
We
that the real
tate of return on own capital rose sharply in 1974
and 1975 when there was a rapid increase in both
nominal debt and prices and when the real interest
rate fell to a very low level.
Tables 5 and 6 indicate that, after a period when it
was at very low levels, the rate of return on total
capital
started to increase again in 1978 and continued
to rise in 1979.
From Table 9 it can be seen that the
real rate of return on own capital only started to
rise in 1979,
after having decreased for four
successive years in 1975 -
1978.
35
4.
RATE OF RETURN TO INVESTORS
In. the previous chapter we based the analysis of movements in real profitability on the real rate of return
on total and own capital. The calculation of these
rates was based on the joint use of national income
(balance
accounts, industrial statistics and enterprise
sheet) data. The rate of return measures can be interpreted as reflecting the attitudes and interests of
the companies themselves. In this chapter, we
turn to
the use of capital market data. The behaviour of the
stock market can in principle be assumed to reflect
the attitude of the owners of the companies.
It is, however, important to emphasize
that the capital
market does not play a very important role in the
financing of operations
(investment) by Finnish manu-
facturing companies. The share of equity capital in
total capital
(at book value) was about 10 per cent in
the 1970s. However, only part of the total equity
capital owned by manufacturing companies was quoted on
the stock exchange. In 1978, for example,
the nominal
value of total equity capital in the manufacturing
(FIM). The nominal
sector was 8.3 billion marks
(taxable) value of equity capital quoted on the stock
exchange was 3.0 billion marks, the market value being
4.3 billion marks.
The nominal rate of return to investors in companies
is calculated by the-formula
(21)
1
RI
=
DIV +
IRE + AE
MV
M
36
where
DIV = dividends
IRE = interest
payments
AEM = change in the market value of equity
MV
= total
market value
defined as
Total market value is
MV
(22)
capital
(OC
EM +
-E)
+ B + TB
where
(book value)
0C
=
total value of own capital
E
=
equity capital
B
=
total
TB
=
total amount of hidden reserves
EM
=
market value of equity capital
debt
(book value)
(book value)
(E)
The market value of the equity capital of the total
manufacturing sector is estimated by the formula
(23)
where f
EM
=
f x E
of market value
the ratio
is
for manufacturing
companies
to nominal
value
quoted on the stock
exchange. 19
The real rate of return to investors is calculated by
the usual formula
(24)
R
RI
= RI -
gCP
where
CP = rate of increase in the consumer goods
price index
37
Movements in nominal and real rates of return to
investors over the period 1961 - 1978 are shown in
Table 10.
Table 10.
Nominal and Real Rates of Return to
Investors in Finnish Manufacturing
1961 -
1978, in per cent
RI
(nominal)
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
0.53
3.76
3.89
2.47
1.52
0.52
2.10
6.29
5.74
6.16
4.61
9.21
8.19
0.43
2.42
1.96
2.85
4.99
Average
3.76
RIR
(real)
-1.28
-0.70
-0.98
-7.89
-3.29
-3.41
-2.45
-3.28
3.53
3.43
-1.88
2.54
-2.54
-16.51
-15.41
-12.37
-9.80
-2.58
.
-4.16
As can be seen, the real rate of return has been
negative in most years. It was about -1.5 per cent in
the 1960s, but decreased sharply in the latter half of
the 1970s. This result is perhaps not very surprising
because the real interest rate on ordinary deposits
was also negative in- the same period (about -2 per
cent). We have also calculated the real rate of return
to investors by omitting the total amount of hidden
reserves from the market value. The result was by and
large similar, although the rates were somewhat higher
(-0.3 per cent in the 1960s and -5.7 per cent in the
1970s).
38
The nominal and real rates of return to equity owners
were calculated by the formulas
(25)
REI
DIV + AEM
EM
(26)
REIR = REI
-CP
The results are shown in Table 11.
Table 11.
Nominal and Real Rates of Return to Equity
Owners in Finnish Manufacturing 1961
-
1978,
in per cent
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
Average
REI
(nominal)
RER
(real)
-5.55
11.89
11.98
3.89
-3.42
-13.95
-2.59
33.04
25.10
27.02
15.48
37.19
29.94
-15.08
-2.02
-10.77
,-4.42
19.83
-7.36
7.43
7.11
-6.46
-8.24
-17.89
-7.14
23.48
22.90
24.29
8.99
30.52
19.21
-32.02
-19.84
-25.10
-17.07
12.27
8.75
0.84
Table 11 shows that the rate of return on equity
capital has been much higher than the rate of return
on total invested capital
(Table 10).
It was positive
(0.84 per cent) on average over the whole period,
whereas the real rate of interest on ordinary deposits
39
was negative on average. From 1961 to 1973
the real
rate of return to equity investors averaged about 10
per cent, but in the period 1974
negative.
-
1977 it became
This was a period of very poor economic
performance by the Finnish economy and, as we have
seen earlier
(Chapter 3),
the
real rates of return on
total and own capital also declined appreciably. In
1978 the real rate of return on equity capital again
rose and became positive
(12.27 per cent),
the real rate of return on total capital
and 6).
as did also
(see Tables 5
Since 1978 the development of the Finnish
economy has been very favourable, with GDP rising 7 per
cent in 1979 and 5.5 per cent in 1980.
To some extent
return
to investors
c h a n g e s
in the real rate of
show similarities
with the move-
ments of real profitability, although zhe levels of
these two sets of measures of manufacturing performance
are very different. We believe, however, that the
estimates of investors' rate of return should be
regarded as preliminary, and especially
the analysis
of the development of real profitability in Finnish
manufacturing should be based on the real rate of
return on total and own capital
(Chapter 3).
40
5. THE VALUATION RATIO AND THE COST OF CAPITAL
In. this chapter we examine the development of the
valuation ratio
capital
(Tobin's q-variable) and the cost of
in Finnish manufacturing in the period 1960 -
1979. The analysis is based on the variables developed
in the previous chapters.
The valuation ratio is defined as
TOBQ
(27)
MV
where
MV = market value of
the manufacturing sector
TC = net replacement value of total capital of the
manufacturing sector
In Table 12 we present the results with three different estimates of market values. The
first estimate of
market value is calculated with the aid of formula
(22)
introduced in the previous
of four components:
chapter. It consists
market value of equity capital,
nominal value of other own capital, nominal value of
total debt and an estimated value of total hidden
reserves. The estimate of Tobin's q-variable employing
this concept of market value is denoted as TOBQ1.
The second estimate of market value is calculated
under the assumption that our basic value for own
capital OC (see Chapter 2) follows the development of
the ratio of market value to nominal value of equity
capital
(the f-variable of Chapter 4).
We thus have
41
MV2 = OCM + B
(28)
+ TB*
where
OCM = market value of estimated own capital OC
(includes total book value of own capital plus
half of the total hidden reserves)
B
=
total debt
TB*
=
estimated value of tax credits (half of the
value of total hidden reserves, i.e., deferred
tax liability)
The series for Tobin's q-variable calculated by means
of MV2 is denoted as TOBQ2.
The third measure of market value is defined as
(29)
MV3 = OC
+'B
where
OC M= market value of total book value of own capital
In this third measure of MV we have thus assumed that
the total book value of own capital (OC1) follows the
development of the f-variable. It has further been
assumed that "hidden reserves" do not affect the
market value. With this latter assumption we wanted to
check the effect of "hidden reserves" on the estimates
of market value. Tobin's q-variable based on the
estimate of MV3 is denoted as TOBQ3.
All three estimates of the valuation ratio are based
on our basic value for total capital (TCl), which
includes the net replacement cost value of fixed
capital and inventories as well as financial assets.
Estimates of the valuation ratio based on total physica.
capital are presented in the Appendix (see Table A7).
42
Table 12.
Estimates of the Valuation Ratio
Manufacturing 1960
market values MV1
1960
1961
1962
1963
1964
1965
1966
-1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
Avarage
1979, based on
-
in Finnish
MV3
TOBQ1
TOBQ2
TOBQ3
1.18
1.14
1.15
1.14
1.13
1.07
1.07
1.06
1.09
1.10
1.12
1.12
1.18
1.22
1.14
1.12
1.09
1.08
1.09
1.09
1.51
1.40
1.41
1.37
1.36
1.24
1.12
1.04
1.15
1.22
1.30
1.31
1.50
1.74
1.43
1.29
1.15
1.09
1.12
1.18
0.96
0.89
0.90
0.88
0.85
0.72
0.72
0.71
0.73
0.82
0.87
0.89
1.01
1.21
0.92
0.83
0.77
0.74
0.77
0.76
1.12
1.29
0.85
Table 12 shows that the movements
in the estimates
of Tobin's q-variable conform rather well with the
general pattern of business cycles in Finnish manufacturing. The highest value for the q-variable is
achieved in 1973, one year earlier than the peak for
real profitability. There also seems to have been an
upward turn in 1978 as in the various measures of the
real rate of return.
The level of the valuation ratio is, however, rather
sensitive to the choice of the measure for market
value. As the different concepts of market value
involve rather complicated issues concerning the
definition of market values for residual own capital
(OC -E) and for tax credits
(TB*), we should pay
43
attention
primarily
to' the.
c
h
a
n
g e
s
in
the q-
variables (marginal q).
Figure 9 shows the development of TOBQ variables in
the period 1960 - 1979, while Figure 10 shows the
development of TOBQ2 and the real rate of return on
total capital
(before taxes) over the same period.
Figure 10 indicates that changes in the q-variable and
the real rate of return have been rather similar during
the whole period.
It can further be noticed that
the
recovery of the manufacturing sector after its very
poor performance
in the latter half of the 1970s has
been much better in terms of real profitability
(RRR
than in terms of the valuation ratio.
We next turn to the analysis of the behaviour of the
cost of capital
(discount rate) in Finnish manu-
facturing in the period 1961 -
1979.
Basic financial
theory shows that the market value of a company equals
the capitalized value of the long-run income from
present assets
(Y/p) plus the present value of future
growth opportunities
(PVGO).21 Market value
is hence
defined as
(30)
Income
(31)
MV
=
p
+ PVGO
(earnings) are defined by the expression
Y = RR x TC
where
RR = rate of return
TC = total capital
Neglecting the PVGO term, we get the following formula
for Tobin's q-variable
Figure 9.
Valuation Ratio in Finnish Manufacturing 1960
-
1979
q-variable
1.75
d9M
1.50\
*,
d
S
*
1.00
1.25
1-.
0o0
A
0 .75
0.50
1965
1970
1975
1980
Figure 10.
Valuation Ratio and Real Rate of Return on Total
Capital in Finnish Manufacturing 1960 -
1979
TOBQ2
RR
1.8
20
1.6
15
1.4
10
1.2
5
1.0
0
1965
1970
1975
198 0
46
q=
(32)
PR
which for the cost of capital gives 2 2
p = RR
(33)
q
In Table 13 are shown the estimates of the real cost
of capital in the case where the real rate of return
(RRR)
includes real holding gains on total physical
capital. As
for the real rate of return
the values
are before corporate taxes, the real cost of capital
estimates are a pre-tax series. Measures of the posttax real cost of capital are provided in the Appendix
(see Tables A8
-
A9).
The three estimates of the real
cost of capital are calculated by means of the corresponding estimates of the valuation ratio
TOBQ3).
(TOBQ1-
Table 13 also shows the real interest rate
(average 'ending rate).
Table 13.
Estimates of the Real Cost of Capital and
the Real Rate of Interest in Finnish
Manufacturing 1961 -
1979,
in per cent,
including real holding gains
Pi
P
2
p3
r
9.03
6.58
7.22
4.26
7.11
5.19
8.04
8.16
11.39
12.02
8.08
7.78
8.99
11.57
2.11
1.67
2.59
7.86
8.06
14.13
10.35
11.17
6.80
12.28
8.10
11.87
12.87
16.86
18.03
11.81
11.55
12.94
17.97
3.25
2.49
3.84
11.47
12.39
8.41
7.25
11.06
0.50
Standard devi'-ation 3.71
3.26
4.50
.3.08
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
Average
11.06
8.10
8.61
5.11
8.27
5.43
7.88
8.61
12.61
13.91
9.41
9.90
12.77
14.53
2.41
1.76
2.62
8.11
8.70
5.09
2.46
2.17
-2.81
2.53
3.46
2.87
-1.70
5.38
4.90
2.11
1.41
-1.60
-6.07
-6.62
-3.67
-2.36
0.88
1.14
47
Table 13 shows that the movements in the real cost of
capital follow closely the development of real
profitability because there is more variability in the
real rate of return than in the q-variables. It can
also be seen that the real rate of interest is on
average much lower than the real cost of capital. This
is partly due to the fact that the
real rate of return
on own capital is on average much higher than the real
rate of return on
total capital
(see sections 3.1 and
3.2).
Table 14
shows the estimates of the real cost of
capital in the case where the real rate of return on
total capital excludes real holding gains.
Table 14.
Estimates of the Real Cost of Capital
Finnish Manufacturing 1961 - 1979,
cent, excluding real holding gains
P2
pl
p3
11.19
8.72
8.70
8.40
7.66
6.82
6.60
7.98
10.76
9.86
6.74
6.51
6.91
9.28
5.24
4.52
4.08
5.92
7.38
9.14
7.08
7.29
7.00
6.60
6.52
6.74
7.57
9.72
8.52
5.79
5.11
4.86
7.38
4.58
4.29
4.03
5.73
6.83
14.31
11.14
11.28
11.18
11.39
10.18
9.95
11.93
14.39
12.78
8.46
7.59
7.00
11.47
7.07
6.39
5.97
8.37
10.51
7.54
Average
Standard deviation 1.94
6.56
1.58
10.07
2.53
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
in
in per
48
From Table 14 it can be seen that changes in the
cost of capital
real
(excluding RHG) are very similar to
the P-variable which includes RHG. The most noticeable
difference between these two series for the cost of
capital is the much lower standard deviation in the
case where real holding gains are excluded.
Figures 11 and 12 show the development of the real
cost of capital
(before taxes) with and without real
holding gains. In the mid-1970s the real cost of
capital fall to a rather low level, but it has been
rising again since
1978. There seems to be some indica-
tion of a declining trend in the cost of capital
without RHG, but no trend in the measure which includes RHG. Figure 13 shows
real
cost
of capital
after
the development of the
corporate
taxes.
We could
argue that from the point of view of investment behaviour what matters is the behaviour of real profitability relative to real capital costs. The average
real rate of return on total capital in Finnish manu-
facturing in the whole period 1961 per cent
1979 was
(including RHG) and 7.3 per cent
8.3
(excluding
RHG) after corporate taxes. The average values
for the
real cost of capital measure
same,
i.e.,
P1
are almost the
8.4 per cent and 7.5 per cent, respectively.
Because a lower value for P would imply a capital
shortage, it seems reasonable
to state that
"an
equilibrium situation" has existed in this sense in
the manufacturing sector. It also seems
justified to
assume that the availability of or possibility to
acquire tax credits which are non-interest bearing has
been rather important in this
respect.
During the period of very weak performance by the
Finnish economy (1976 - 1978), real profitability
Figure 11.
Real Cost of Capital in Finnish Manufacturing
1961 -
1979, in per cent, including real holding gains
and before corporate taxes
20
15
10
5
0
1965
1970
1975
1980
Figjure 12.
Real Cost of Capital in Finnish Manufacturing
1961 -
1979, in per cent, excluding real holding gains
and before corporate taxes
15.
0
12.5
2
%4
10.0
'4
%
'
ON
\I%
I0
c>
5.0
2.5
1965
1970
1975
1980
Figure 1-3.
Real Cost of Capital in Finnish Manufacturing
1961
-
1979,; in per cent, including real holding gains
and after corporate taxes
20
15
I
I
10
10
5
14
-
0
1965
1970
1975
1980
52
declined proportionally more than the real cost of
capital. It is possible that this behaviour contributed to the sharp decline in manufacturing investment during those years. It should,
emphasized that the development of
however, be
the cost of capital
relative to real profitability is not enough to
determine the behaviour of real investment outlays.
Most important in this respect is the behaviour of
real profitability as measured by the real rate of
return on total, capital
(RRR)
relative to the real
user cost of fixed capital stock. The real cost of
capital only measures the capital costs as regards the
use of financial capital, but not the cost of real
capital invested by the companies. The analysis of the
development of user cost in Finnish manufacturing is,
however, beyond the scope of this investigation.
53
6.
OF THE RATE OF
DETERMINANTS
RETURN AND
THE EFFECTIVE TAX RATE
In this chapter we perform some statistical tests in
order to discover whether there has been trendwise
behaviour in the real rate of return on total
and own
capital as well as in the effective tax rate. This is
done by means of standard regression analysis of the
determinants
of the rate of return and the effective
tax rate.
The aim is not a thoroughgoing analysis of the factors
affecting the behaviour of these explanatory variables
because we think this would be rather difficult using
the single equation method.
It can be assumed that
both the rate of return and the effective
tax rate
depend upon the development of various price and cost
factors as well as economic policy variables. We shall
try to capture the effect of the general
business
fluctuations
by two
in
the manufacturing
sector
variables, namely the annual percentage chance
in the
GDP of this sector and the rate of capacity utiliza-
tion in the whole economy.23
In addition to a trend variable
(time),
we also use
the rate of price changes, which can take the form of
different price
indexes. Our hypothesis is that the
price variable might reflect to a large extent
the
impact of inflation on effective corporation income
tax rates. It could also be argued that the inflation
rate takes into account the impact of holding gains
in the case of the return on total capital and capital
gains
(decrease in the real value of debt) in the case
of own capital. We have, however, also directly experimented with the tax rate variable as an independent
54
variable. Finally, similar models are tried with the
effective tax rate as the dependent variable.
Table 15 shows the results for the real rate of
return on total capital before
(RR
)
(RRRB)
and after taxes
excluding real holding gains. Table 16 shows
the results for the rate of return
including real
holding gains. The models are estimated by the ordinary
least squares method.
Tables 15 and 16
show that our equations explaining RR
are rather effective but crude. Profitability responds
to more than just inflation and the growth of GDP or
capacity utilization. This can be interpreted from the
rather low D-W statistics.
Table 15 reveals almost
uniformally that the real rate of return on total
capital has behaved in a trendwise manner downwards,
as inspection of Figure 6 would have
(p. 27).
led us to expect
Both the production and the CU variables
seem to capture equally well
the general business
fluctuations. Neither of the inflation rate variables
proves to be significant.
An interesting fact emerging from Table 16 in compariso
with the results of Table 15
is that there does not
seem to be any time trend in.real profitability if
real holding gains are included in the rate of return
measure. In this respect the role of capital gains
(or
holding gains) is again rather crucial for our results
(see also Figure 5).
Capacity utilization now seems
to capture the cyclical variations a little better
than the change in GDP. Generally there is not much
evidence of a significant price effect, although the
investment goods price variable has a positive effect
in two equations
(2a and 2b).
Table
15.
Equation
No.
Determinants of the Real Rate of Return on Total Capital in Finnish Manufacturing
1961 - 1979, RR excluding real holding gains
Independent variables
Dependent
variable
Trend
Production1
CU2
Inflation/
CP
la
RR RB
lb
RR
2a -
RRRB
D-W
Inflation/
4
3
IP
0.26
(3.85)
0.12
(1.22)
0.70
1.50
0. 37
0.13
0.62
1.50
(2.19)
(3.94)
(1.29)
-0.24
(3.90)
0.31
0.72
1.50
(4.27)
0.11
(1.71)
0.31
(4.50)
0.12
(2.07)
0.67
1.63
-0.24
(3.43)
-0.16
2b
RR
-0.16
(*2.62)
3a
RRRB
-0.15
(1.94)
35.94
(3.18)
-0.05
(0.53)
0.64
1.27
3b
RR
-0.06
-0.04
(0.46)
0.59
1.34
(0.76)
39.34
(3.66)
4a
RRRB
-0.14
(1.80)
40.38
(3.28)
-0.04
(0.56)
0.64
1.27
4b
RRRA
-0.05
42.81
(3.65)
-0.03
(0.45)
0.59
1.34
(0.70)
Note:
t statistics appear in parentheses under the coefficients.
1. Annual percentage change in real GDP of manufacturing sector.
2. Rate of capacity utilization.
3.
4.
Annual percentage change in consumer price index.
Annual percentage change in investment goods price index.
Table 16.
Determinants of
1961 Equation
No.
1979,
Independent variables
4b
IP
D-W
-
Production
-0.06
0.10
(0.37)
0.44
1.61
(0.30)
0.70
(2.87)
RR RA
0.03
(0.16)
0.71
(2.84)
0.11
(0.39)
0.42
1.57
RRRB
-0.20
0.71
(4.58)
0.66
2.31
(3.06)
0.71
(4.57)
0.42
(3.16)
0.67
2.32
RR
-0.11
(0. 84)
3b
CU
Trend
(1.48)
2b'
Finnish Manufacturing
RR including real holding gains
Dependent
variable
RRRB
2a
the Real Rate of Return on Total Capital in
CP
0.41
RRRB
0.16
(1.15)
102.85
(4.91)
-0.18
(1.05)
0.67
1.86
RR RA
0.16
(1.04)
108.37
(4.62)
-0.17
(1.01)
0.67
1.90
RRRB
0.15
(1.13)
104.11
(4.32)
0.04
(0.61)
0.66
1.80
RRRA
0.16
(1.04)
108.37
(4.62)
0.03
(0.25)
0.65
1.81
LU,
CT)
Note: see Table 15.
57
the GDP
As a general remark we can state that
variable accounts for about 40 -
(or CU)
50 per cent of
the
explanation and the trend variable for about 30 per
cent in the models of Table 15. The equivalent percentages in Table 16 are 50 -
60 and 10 -
2-0,
respectively.
We also carried out some tests with the effective tax
rate as an independent variable. It proved to be
significantly negative and took the role of GDP
(or
as a measure of general business fluctuations.
CU)
This can be
interpreted to mean that the effective tax
rate behaves in a countercyclical manner. This latter
aspect was tested with a direct model of the effective
tax rate. The result can be seen from the following
equation:
UFl = 2.17 - 0.006TREND - 1.98 CU
(5.66) (2.56)
(5.09)
R
=
0.63
D-W = 1.81
The explanatory variable was UFl
(see Table 3, Chapter
2) and the independent variables are as in Table 15.
The estimation period was 1961 -
1979.
This equation
shows that there is a downtrend in the effective tax
rate and that UF varies countercyclically
(see also
Table 3, p. 17).
Finally, we used regression methods to examine the
determinants of the real rate of return on own
capital. The dependent variables are those constructed
in Chapter 3 (section 3.2).
The results for the real
rate of return calculated by formula
Table 17.
(17) are shown in
It should be remembered that this formula
does not take into account the effect of capital gains
58
for the rate of return on own capital. Capital gains
(19),
are taken into account by formula
an-increase in leverage
in which case
(debt-equity ratio) raises
the
rate of return on own capital if the rate of return on
total capital exceeds the real rate of interest. The
results produced by formula
R
(19) with RROC as
an ex-
planatory variable are given in Table 18.
Table 17
R
shows some evidence of a downtrend in RR 0 ,
although the trend factor is not significant in all
the equations. Changes in the production and the
capacity utilization variables seem to reflect equally
well business variations, and the inflation rate is
not significant. We also tried the other price
variable used in Tables 15 and 16,
but it also
proved not to be uniformally significant.
Table 18 shows that the trend variable is either insignificant or shows some sign of uptrend, contrary to
the results of Table 17 with RR
variables. Capac-iy
utilization seems to better reflect general business
conditions than the production variable. The most
interesting observation is that the inflation rate
now has a positive effect on the real rate of return
on own capital. This effect is especially strong if
the price variable is the price index used in the
calculation of holding gains. Thus it seems likely
that the inflation rate reflects the effect of real
capital gains due to the decline in the value of the
real debt burden of the manufacturing sector.
The RROC variables used in the equations of Table 18
were calculated by means of the real rate of return on
total capital including real holding gains
formula
(19)).
(see
Similar models were also tested in the
Table 17.
Determinants of the Real Rate of Return on Own Capital in Finnish Manufacturing
1961 - 1973, RR0 estimated by formula (17),
Equation
No'
Independent variables
Dependent
variablea
Trend
0 (1)
-0.44
(1.96)
RRR (1)
0
-0.13
(0.46)
3
RRR(2)
-0.33
(2.23)
4
RR
-0.11
(1.76)
RR
2
(2)
see Table 8
Productionb
CUc
D-W
Inflationd
1.19
(4.12)
131.68
(4.03)
0.77
(4..08)
87.96
(4.27)
0.45
(1.41)
0.62
1.60
-0.10
0.60
1.42
0.28
(1.39)
0.63
1.54
-0.03
(0.90)
0.65
1.41
(0.40)
Note:
a. In the RR (1) variable own capital includes one half of the "hidden reserves", in the
RR 0 (2) measure it includes all of them.
b. Annual percentage change in real GDP of manufacturing sector.
c. Rate of capacity utilization
(see Table 15).
d. Annual percentage change in the consumer price index.
Table 18.
Determinants of the Real Rate of Return on Own Capital in Finnish Manufacturing
1961 -
Equation
No.
1979,
Dependent
variable
1
RR C(1)
2
RR
OC
(1)
OC.
3
RR RC(2)
4
5
RR
(2)
a
Note:
RROC estimated by formula
RROc(2)
see Table 17.
(19),
see Table 9
Independent variables
Trend
0.40
(0.65)
Production
2.15
(2.67)
334.58
(5.00)
1.10
(2.42)
0.21
(0.52)
CU
1.41
(2.68)
Inflation
D-W
2.44
(2.75)
0.61
1.58
1.62
(3.01)
0.75
1.95
1.16
(2.11)
0.50
1.50
223.80
(5.29)
0.63
(1.86)
0.70
1.91
(2.34)
0.05
(0.21)
148.31
(4.02).
2.31
(8.80)
0.94
1.51
0.67
61
case where real holding gains were excluded. The
results conformed with those of Table 18. With respect
to declining trends in the real rate of return on own
capital, we can rather safely conclude that there is
no trend.
62
7.
CONCLUSIONS
Our principal objective was to analyze the development
of real profitability in the Finnish manufacturing
sector in the period 1960 -
1979. Various measures of
the real rate of return were used for this purpose.
In addition, a variety of factors which are closely
linked to the rate of return were examined and finally
we attempted to discover the basic determinants of the
rate of return. We shall comment briefly here on the
main results of this study.
(1)
The debt ratios
(debt to own capital ratios)
have risen in a trendwise manner during the
period 1960 -
1979. The level of this ratio,
however, largely depends upon the measure of
own capital used.
(2)
The effective tax rate has experienced a
downtrend and it also seems to vary in a
countercyclical way. This rate has been less
than 20 per cent in the 1970s, whereas the
statutory corporate income tax rate has been
about 60 per cent.
(3)
Real profitability as measured by the real
rate of return on total capital at replacement cost value has been at a rather high
level during the whole period.
It, however, declined considerably after the
mid-1970s, but has risen again in.1978 1979. The real rate of return before taxes
has been on average about 8 -
9 per cent and
the post-tax rate about one percentage point
63
lower. This small difference is due to the
low effective
tax rate.
On average, real holding gains are of little
importance for the level of real profitability,
but they have quite a substantial effect on
the year-to-year fluctuations in the real
rate of return. Including real holding gains
in the measures of the real rate of return
increases the variability of this rate con-
siderably.
The role of real holding gains is also rather
crucial for the trend behaviour of the rate
of return. Without real holding gains,
there
is some evidence of a downtrend, whereas
there is no trend in the real rate of return
on total capital when they are included.
(4)
The real rate of return on own capital has on
average been at a much higher level
than the
corresponding rate for total capital. Capital
gains on own capital are the result of a
decrease in real indebtedness. This effect
has been very impurtant in the 1970s, in
particular, and it has prevented the real
rate of return from declining in a
trendwise
manner.
The real rate of return to investors in the
(5)
manufacturing sector has been negative on
average, and it has also exhibited marked
annual variations. The real rate of return
.
to equity investors in the period 1961 1973 was about as high as the real rate of
64
return on total capital, but it has declined
considerably in the latter half of the 1970s.
Even so, we do not believe that the measures
of investors' rate of return are a very
reliable indicator of real profitability.
(6)
The average valuation ratio
(Tobin's q-
variable) has reflected quite well the general
business fluctuations in the manufacturing
sector. The variations in this ratio have
been smaller than those of real profitability.
The estimates of the q-variable are rather
sensitive
to the measure of market value
employed.
Our estimates of the real cost of capital
have on average been about the same as the
real rate of return. The fluctuations in the
real cost of capital follow closely the real
rate of return. The real rate of interest has
been much lower than the real cost of
capital.
(7)
Annual changes
in the real rates of return on
total and own capital can be explained quite
satisfactorily by changes in GDP or by capacity
utilization. There is also some evidence that
the rate of inflation has had a positive
impact on the rate of return. The inflation
rate probably captures the effect of holding
or capital gains on the rate of return. It
should, however, be emphasized that our
analysis has been of partial equilibrium
character and rather
tentative in this respect.
In particular, we have not taken into account
65
the effect of decreasing price competitiveness
on the manufacturing sector, which relies
heavily on foreign demand
(exports).
As an overall conclusion we may say that
the performance of Finnish manufacturing
companies was rather good in the period
1961 - 1979, at least in light of the development of real profitability. The annual
fluctuations in the real rate of return have,
however, been very large and this may have
also exacerbated the otherwise severe business
cycle problems of the Finnish economy. Book
values do not constitute a reliable basis for
the analysis
of the development of real
profitability. Current replacement cost
values of total
capital and the equivalent
measures of real income
(profit) are necessarv
for this kind of analysis.
66
FOOTNOTES
(1974) in references.
1.
See W. Nordhaus
2.
See Feldstein and Summers
3.
See von Furstenberg and Malkiel
4.
See Holland and Myers
5.
(1978) and
'The Bank of England has,
various
(1977),
p.
225.
(1977).
(1980).
since the mid-1970s, published
articles on company profitability in its
Quarterly Bulletin. Of the Swedish studies on profitability, we can mention especially those by the IUI
(The Industrial Institute for Economic and Sosical
Research);
for
1979, p. 204 -
example,
210.
"Att vdlja
80-tal",
See references.
(1979) in references.
6.
See, for example, T.P. Hill
7.
The calculation of this capital stock
described in Koskenkyl.
8.
Stockholm
(1979),
series is
see references.
This series is published at current and fixed prices
(1975) for the years 1965 -
1977. We have extended
this series forwards and backwards by using a constant
depreciation coefficient
(7.8 per cent annually) which
was estimated from the capital stock series by using
gross investment data.
9.
See especially the studies by S. Salo
Ylti-Anttila
(1977) and P.
(1980) in references. We have used the
book value of inventories as the basic
series and
converted this to the corrected value by using the
undervaluation percentages shown in Yla-Anttila!'s.
67
study. The series thus obtained is
interpreted as
the
current value of inventories. The volume version of thi:
series is obtained by using the price index for stocks
constructed by Salo and calculated since 1977 by means
of the price index of value-added production. It
should be mentioned that the ratio of total sales
(gross) to the corrected value of inventories was
nearly three in the 1970s.
This means that the
velocity of inventories has been rather high. We can
that at the end of each year the value of
thus assume
inventories resembles
that of the current value of new
products and raw materials.
10.
The notion
"basic series" usually refers here to the
estimate of total capital based on the fixed capital
CP
stock series K1
11.
This extreme position has been taken by, for example,
the IUI in its profitability calculations of own
capital,
see
references
"Att vdlja
This procedure produces the
80-tal",
p.- 207.
"maximum value" of an
estimate of own capital. In the calculations of the
rate of return on own capital, the numerator should in
this case include an estimate of the value of profit
after taxes. If, however, part
(or all) of the "hidden
reserves" are regarded as interest-free
tax credits,
then theoretically the correct way to measure the rate
of return on total capital and on own capital
(before
taxes) would be to include some present value esti-
mate of future tax payments in the definition of the
numerator. This is, however, rather difficult to do,
and hence the interpretation of the role of these
reserves usually only leads to various estimates of
total own capital and thereby directly affects the
levels of the rate of return calculations for own
capital. The denominator of the measures for the rate
68
of return on total capital is, however, unaffected by
the interpretation of the role of these reserves. The
method of using the corporate tax rate multiplied by
total hidden reserves as a measure of tax credits has
been used by Valvanne' and Lassila
(1965, references),
and also in the Bank of England studies
12.
(1981).
This "residual" part of balance sheet own capital
includes such items as reserves for bad debts and
guarantees, reserve funds, investment funds, other
funds and various valuation items. It is interesting
to note that the share of total own capital in total
capital
(at book values) was, in the 1930s, over 50
per cent in a rather representative sample of Finnish
manufacturing companies
(see references A.E. Tudeer,
1938).
13.
For Finnish corporations, the
statutory income tax
43 per cent in the 1970s,
rate in state taxation was
while the local and church taxes amounted to about
17 per cent. Thus,
the total tax rate was about 60 per
cent. In principle, this would mean that the share of
tax credits should be somewhat higher
than that of own
capital. Because the actual tax rates
(the ratio of
paid taxes to taxable income) have varied around 50
per cent,
we have
used this
"half-half"
assumption.
It should be noticed that up to the year 1968 there
was also a wealth tax on companies' net property. The
actual
tax rate
presented
in
Table
3
takes into
account
both the corporate income taxes and wealth taxes before
1968.
It'
There was a
temporary wealth tax also in 1976.
should also be mentioned that since 1969 corporate
income taxation has been based on a
split-rate principle
meaning that retained and distributed earnings are
taxed on a different basis.
69
14.
The same procedure has also been used by Holland and
Myers
(1978) . They conclude, however, that on average
real holding gains are zero in the U.S. non-financial
corporation sector. In section 2.1 we described the
calculation of the volumes of fixed capital stock and
inventories.
15.
Strictly speaking relative real holding gains are
g
= 1 + g CP
*we have used the general approximation, gr
In this case, the expression for RR
R
RR
=T
71b
+ IR +
R
is
rC
=9
CP'
(g-gCP)TC
TC
which gives the result of
16.
(16),
In deriving formula
(see formula 11).
Formula
(16).
(19) can be shown to be equivalent to the
following expression
(19)'
R
RRO
=
r +
R
(RR -r)
TC
The effects of various factors on the
rate of return
on own capital in these formulas have been analyzed
in Finland by K. Alho (1980). The results for the
Swedish manufacturing industry have been presented by
the IUI
(Att vdlja 80-tal, p.
207
-
208).
In the U.S.A.,
the effect of a decrease in real indebtedness has been
analyzed and emphasized by von Furstenberg and Malkiel
(1977).
17.
See references von Furstenberg and Malkiel
Felstein and Summers
(1977).
(1977),
70
18.
In this paper we have
only
calculated the rate of
return on own capital after corporate taxes. The same
concept, but before company taxes, could be estimated
just as well by adding paid taxes to
principle our measure RR
the numerator. In
8 is a rather
0 (2) in Table
general approximation to the pre-tax and post-tax rate
of return on own capital, if in the former case taxes
are included in the numerator. In the post-tax case
the problematic question is whether, apart from the
paid taxes, some estimate of tax accruals
(future)
should also be deducted from the numerator. An estimate of contingent
tax liability
(tax accruals due to
deferred taxation) has been calculated in the U.K.
(see Fleming et al.,
studies
1976 and Williams, 1981).
They have also estimated the deferred taxation by
multiplying the difference between replacement and
book values of fixed capital stock by the corporate
income tax rate.
19.
The series for market and nominal values of the equity
capital of industrial companies quoted on the stock
exchange have been provided by Kim Lindstrbm
Bank of Finland).
that the ratio f
exchange
(Union
When cal-culating EM we have assumed
for companies quoted on the stock
approximates
of all
the behaviour
manufactur-
ing companies. It has further been assumed that the
nominal values of residual own capital
(OC -E)
and
(B) are equivalent to their market values. The
debt
components of OC -E are described in footnote 12.
a very small proportion of debt is
market in Finland. The total
as' the difference
between
total
quoted on the stock
amount of TB is estimated
capital
cost and the book value of total capital
2).
It
Only
at
replacement
(see Chapter
could be argued that the residual component of
own capital and that part of the hidden reserves which
71
can be attributed to own capital also have market
values similar to equity capital. This approach has
been used when calculating the Tobin q-variables in
5.
Chapter
20.
K.
(1980) has estimated the real rate of return
Alho
taxes) for indus-
(before personal
to equity owners
trial companies to be 11.1 per cent in the period
1960 -
1973 and 3.9 per cent
years 1974 -
1978) for the period 1960 -
references, Alho, p.
21.
(negative values
for
1979. See
114.
(1978) and
See references, Holland and Myers
(1980).
It can be assumed that the effect of the growth factor
(PVGO) might be rather important in a growing and
(or sector).
profitable firm
reliable
estimates
for
value
the present
If
growth possibilities.
However, we have no
this
of future
remains
factor
constant,
then our reasures of the cost of capital can be regarded
as reliable
estimates
for changes
in
the discount
factor.
22.
It is difficult to separate the effects of RR and P
on the q-variable, because we lack a reliable direct
estimate of p.
With formula
(33)
we can, however,
obtain a rough measure of the cost of capital. In
(33)
effect expression
operating income
means that p is the ratio of
(01) to market value. This ratio can
be thought of as a
"generalized earnings-price"
ratio.
MV is an approximation for "price" and real operating
income is an approximation for "earnings". There
remains, however, the question of whether real operat-
ing income should also be included
(or excluded) in
real holding gains. Both approaches have been tested
here.
72
In effect this method for calculating the real cost of
implies
capital
that
the cost
of capital
is
a weighted
average of real rates of return on own capital,
debt
capital and deferred tax liability. The weights are
the proportional shares of these components in the
total
market value.
We could have
alternatively
calculated other estimates of the cost of capital by
making various assumptions about these proportional
shares.
23.
We could not test the effect of capacity utilization
in the manufacturing sector, because this measure was
not available up to the year 1979. An estimate of
capacity utilization in the whole economy has been
constructed by Ilkka Salonen of the Bank of Finland's
Research Department.
73
STATISTICAL APPENDIX
In this Appendix we tabulate the estimates of some
basic variables used in the calculations of rate of
return and the related figures. The series presented
here are based on various data sources, national
income accounts, industrial statistics, enterDrise
data
(profit and loss and balance sheet data),
financial market statistics and capital market data.
All of the series presented here are concerned with
Finnish manufacturing in the period 1961 (or 1960 -
1979).
1979
74
Table Al
Various estimates of total capital in Finnish manu-
facturing 1961 -
1979,
FIM millions
The series are the averages of start and end of year
values.
net replacement
cost value of
total capital
(depreciation
coefficient
5.4 per cent
TCl
1961
1962
1963
1964
1965
1966
net replacement
cost value of
total capital
(depreciation
coefficient
7.8 per cent)
TC2
book value
of total
capital
TCB
1310", 32
12229.25
1 7)-y
14592.04
16039.05
17907.32
10522.73
11384.23
1168.62
12991.17
14372.82 '
1 60 .15+22
8526.16
9503.01
2
20145.06
19741 . 29
12733.
1967
1968
1969
1970
1971
1972
22030.69
21413.10
24808.79
23428. 07
33257.26
23901.02
39553.48
46206.03
1973
55662.33
1974
72845.24
1975
1976
1977
91631 . 74
105270 .02
37357.08
43301 .23
51798.95
67526.00
84533.42
9639 .53
106597. 90
11480 1 .85
14701.1,
16484, Z5
19112.02
23011.43
27792.49
1978
1979
117458 .28
127372 .6 2
1404234
27183.12
31610.78
126218.26
32911.89
40247.39
51345.94
62676.96
72474. 17
31135 .31
96450.44
75
Table A2
Estimates of operating income in Finnish manufacturing
1960 -
1979,
FIM millions
operating income
based on the 5.4
per cent depreciation coefficient
OIl
1960
1961
1962
1332.61
1492.09
1298.07
1963
1430.25
1964
1965
1966
1525.14
1432.40
1471.73
1548.96
2154.67
3359.01
3675.60
2989,81
3553.73
4702.99
7710.53
,.69
5401
5198.76
5170.96
8214.03
11276.33
1967
1963
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
based on the 7.8
per cent deprecia-
tion coefficient
012
1164.94
1311.50
1104.68
1229.31
1316.79
1257.80
1237.14
1304.29
1881.51
3075.49
3350.11
2612.20
3119.21
4197.54
7065.11
4639.20
4358.25
4261.17
7337.92
10356.76
76
Table A3
Nominal and real holding gains in Finnish manufacturing 1961 -
1979,
nominal holding
gains on total
physical
capital
1564
1965
1966
1970
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
nominal holding
gains on fixed
capital stock
real holding
gains on
total
physical
capital
NHG2
RHG1l
166.46
497. 61
-18.12
407.07
576.45
751 .87
872.65
358 .82
1151.57
22 2. C:
1110.15
2 3231.24
3435.24
4554.33
9641.99
16412. 16
10729.83
9199.70
749 .37
-924 15
-14.05
-597.56
116.34
-299.96
299.97
170. 16
576.75
1510.5?
1134.09
1852.97
3985.27
4367.58
NHG1
1961
1962
1963
FIMI million
10524.21
11047.91
10690.28
702.75
660.70
991-.83
544. 34
836.30
1800.96
824.62
2302.11
295.7
3292.01
4967.96
8421.33
7715.50
5317.11
7403.81
1128.68
6272.8
-2917.89
--3171.09
-1844.37
3040.84
201-7.85
real holding
gains on
fixed
capital
stock
RHG 2
533477
. 472. 29
397.22
102.
605.27
172.50
366.09
756 . 03
981 .97
2144.76
1501.91
1842.65
2526.02
-11583 .0-2364 .3 2
-827.91
-3954.30
2461. , 55
77
Table A4
Estimates of real rate of return on total capital
in Finnish manufacturing 1961 -
B refers to before
taxes and A
real
rate
of return
on
physical capital
total
(fixed capital stock
at 5.4 per cent
depreciation plus
inventories)
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1979,
per cent
to after
real rate of return on
total capital
(7.8 per cent depreciation coefficient)
RRTFCRB
RRTFC
RR2 RB
14.69
10.78
11.56
11 .7
10.58
7,56
10.37
8.20
9.31
4.52
8.41
4.65
9.71
10.99
16.65
1 9.21
12.71
14.12
19.02
20.03
2.52
1 .43
8.09
9.52
15.21 .
17.99
11.64
13.22
18.10
19.16
1.66
0.51
1.74
10.10
11.10
9.41
10.25
taxes values.
8.33
4.48
7.67
4.75
7,49
8.58
13.44
15.38
10.16
11.48
15.80
16.93
2.04
1.23
2.27
9.04
9.80
RR2R
8.42
5.49
6.52
2.81
6.03
3.15
6.16
7.35
12.25
14
.
3,
9.28
10.73
15.02
16.19
1 . 30
0.42
1.59
8.43
9.07
78
Table A5
Estimates of real rate of return on own capital
Finnish manufacturing 1961 -
1979,
per cent
RRR (1) and RRR (2) are calculated by formula
OC
OC
by excluding RHG from RR (see section 3.2)
RR
R
OC
(1)
RR
R
OC-
19.15
14.98
17.99
16.31
14.40
10.75
16.11
6.26
11.20
5.15
16.27
1969
27.01
36. 17
11.31
17.31
19.65
1970
1971
1972
29.71
35 .40
55.49
1973
72.93
1974
1975
1976
1977
1978
31.11
21. 05
19.92
30.18
29.66
f1979
(19)
(2)
1961.
1962
1963
1964
1.965
1966
1967
1968
29.06
in
12.65
9,59
24.98
19.64
C;,6
35.45
41.99
14.74
10.07
10.04
18.16
18.05
Note:
R
In RRR (2) all hidden reserves are included in the
OC
measure of own capital.
R
(1) half of these reserves are added to
In RR
total debt as an estimate for tax credits.
79
Table A6
Estimates of market value in Finnish manufacturing
1960 -
1979,
FIM millions
(See also chapter 4 and 5)
The series are the end of year values.
E +(OC
-E)+B+TB
(formula (22))
MVl
13044.38
14048.52
15651.77
17243. 31
19219.00
20569.39
22545. 22
24511 .31
1970
1971
1972
1973
1974
1975
1976
1977
1978
1.979
06,U:,J 1 - 4 6
4.
(formula
(28))
(formula
MV2
1960
1961
1962
1963
1964
1965
196 6
1967
1968
2J.A. 5
0C +B
OC +B+TB
-
MV3
24029,*S
3053). 33
10628.47
10989.34
12261.71
13307. 91
1 443 32
13342.21
15103.31
16271 . .8
19366.13
47051 . 62
31362. 12
16692.43
17193.83
19270.54
20586.27
.
. 47
252
239,03.502
3~
5r-51.
*32
175487.17
95754.81
1i 7 0 . 75
121436.07
133507. 3 ,
14 23 1.5 . 60
163074.31
(29))
107293.01
120304.97
127789.20
127892.11
135192.15
147352.62
176059.76
2 7 3
. 6 5
5 0226.6*412
74507.71
77417.95
32730 . 21
85962.18
91179.45
100960.97
114486.44
80
Table A7
Estimates of Tobin's q-variable in Finnish manufacturing 1960 -
1979
Market values MVl -
MV3 are divided by the value of
total physical capital.
TOBQF1
1960
1.442
1961
1.37
1.39
1962
1963
1964
1965
1966
1967
1.42
1.41
1.32
TOBQF2
.81
.68
.71
.69
.69
.53
.38
1972
1973
1974
1975
1.32
1.33
1.35
1.41
1.44
1.43
1.51
1.55
1 .44
1.41
1976
1.36
.80
.61
.43
1977
1,.34
1.39
1 . 39
.36
.43
.50
1.40
.62
1968
1969
1970
1971
1978
1979
Average
.31
.43
.56
.66
.67
.93
.20
TOBQF3
1,15
1.08
1.09
1.10
1,06
0.89
0.89
0.88
0 . 91
1.05
1.11
1.14
1.30
1.53
.1.16
1.04
0.96
0.92
0.98
0.98
1.06
81
Table A8
Estimates of real cost of capital in Finnish manufacturing 1961 -
1979, per cent
Based on the real rate of return on total capital
after taxes
and including real holding gains.
Market values are MVl -
CClA
1961
9.07
1962
1963
6.23
7.01
1964
1965
3.63
6.79
1966
1967
1968
3.97
6.66
7.52
11.57
13.07
8.67
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
MV3.
CC2A
7.41
5.06
5.87
3.02
5.84
3.80
11.60
7.96
9.08
6.80
10.04
11.24
7.13
10.46
11.29
12.18
7.45
7.31
8.57
13.93
1.80
1.08
11.09
1.58
1.03
2.05
7.60
2.03
7,37
8.09
7.49
9.31
CC3A
4.83
10.09
5~ 4 9 '-p
15. 40
16.93
10.8 :
10 .85
12.34
17.23
2.43
1.53
3.01
10.75
11.52
82
Table A9
Estimates of real cost of capital in Finnish manufacturing 1961 -
1979, per cent
Based on the real rate of return on total capital
after corporate taxes and excluding real holding
gains.
Market values are MVl
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973.
CC2AC
CC3AC
9.21
6.85
7.09
6.92
6.19
5.36
7.53
11.77
5.39
6.89
9,73
9.02
6.00
5 .91
6.32
1975
1976
3,84
1977
3.51
5.41
6.77
1978
1979
MV3.
CClAC
8.68
4.64
1974
-
556
8.75
5.94
5.77
5,33
5.13
9.19
5.49
6.53
8.11
10.30
13.01
1 1.68
7.53
8.79
7.79
5.1.5
4.64
4.45
6.91
4.05
9.21
9.20
8.00
6.89
6.41
10.73
6.26
3.65
3,46
5.43
5.24
7.65
9.64
6,27
5.14
I
83
LIST OF SYMBOLS
K
CP
1
= fixed capital stock
current
(5.4 per cent depreciation),
cost value
K2C
2
=
KCP
= fire insurance value of fixed capital
KB
= book value of fixed assets
VO C
= estimated value of inventories
VO B
=
book value of inventories
RO
=
book value of financial assets
ROnet
=
book value of net financial assets
B
=
book value of total debt
E
=
book value of equity capital
OC
=
book value of total own capital
3
TC
fixed capital stock
current cost value
total
capital,
(7.8 per cent depreciation),
replacement
cost
stock
value
TFC
=
total physical
TC
=
K
TC
=
book value of
TB
=
total value of hidden reserves
TB*
=
tax credits, i.e.,
OC
= estimated value of own capital
(TC-B-TB*)
OC2
= estimated value of own capital
(TC-B)
B*
= estimated total debt
pQ
= value-added of production
W
= total
Deb
= economic value of depreciation
IR
= net interest expenses
+ VO
capital, replacement cost value
+ RO
(also TCl)
total capital
(TC-TCB )
deferred tax liability
(B+TB*)
labour costs
84
IRE
= interest payments, (gross)
iT
= profit in general meaning
7b
= profit before taxes
7Ta
= profit after taxes
T
= paid corporate taxes
0I
= operating income
u
= actual tax rate
u
= effective tax rate
TI
= taxable income,
(pre-tax)
(post-tax)
(also UF)
i.e.,
profit before taxes
at book value
g
= rate of change in the price index of TFC
(proportional or percentage)
gCUR
= rate of change in the current value of TFC
gCON
= rate of change in the volume of TFC
gCP
= rate of change in the consumer price
NHG
= nominal holding gains
RHG
= real
g
=
rate of change of g relative to the change in consumer
price index
r
=
real rate of interest
i
=
nominal rate of interest
p
=
rate of change in the general price level
DIV
= dividends
MV
= market value (total)
MVl, MV2 etc.
E
= market value of equity capital
f
= ratio
of market value to nominal value of equity
capital by industrial stock companies
Y
=
holding gains
index
(per cent or absolute value)
(per cent or absolute
value)
-
income, general expression
85
PVGO = present value of growth opportunities
(also CC)
= cost of capital
p
TOBQ = Tobin's q-variable
TOBQl, TOBQ2 etc.
RRNB = nominal rate of return before
(on total
capital)
taxes
RRNA = nominal rate of return after taxes
RR
RB
= real rate of return before taxes
RRRA = real rate of return after taxes
R
= real rate of return on own capital, formula
RR
RR (1),
RR
R
RR
(2) etc.
= real rate of return on own capital,
RROC(1),
RR~OC(2) etc.
RI
= nominal rate of return to investors
RIR
=
REI
= nominal rate
REI R
=
real
rate
(17)
of
return
of
return
formula
to investors
to equity investors
real rate of return to equity investors
(19)
86
REFERENCES
T.
Airaksinen
Tutkimus kannattavuuden mittaamisesta ja komponoimisesta, sovellutuksena
Suomen tehdasteollisuus
vuosina 1960 -
1975, Teollistamis-
rahasto Oy, B:1, 1978.
K.
Alho
Pauoman tuottoaste, korko ja kansantalouden padomanmuodostus, Etla B:26,
Helsinki 1980.
T.A. Clark and
"Measures of real profitability",
N.P. Williams
Bank of England Quarterly Bulletin,
1978, 18(4).
G.
Eliasson et al.
Att vdlja 80-tal,- IUI,
Stockholm
1979.
M.
Feldstein
L.
Summers
and
"Is the Rate of Profit Fallina?"
Brookings Papers on Economic Activity
1977:1, p.
211 -
227.
G.M. von Furstenberg and
"Financial Analysis in an Inflationar
B.G. Malkiel
Environment", The Journal of Finance,
Vol.
p.
T.P.
Hill
XXXII,
575
-
No.
2, May 1977,
587.
Profits and Rates of Return, OECD,
Paris 1979.
D.M. Holland and
Trends in Corporate Profitability
S.C. Myers
and Capital Costs, MIT, WP 999-78,
May 1978.
87
D.M. Holland and
"Profitability and Capital Costs
S.C. Myers
for Manufacturing Corporations and
All Nonfinancial Corporations",
The American Economic Review, Vol.
70 No. 2, May 1980.
H.
Koskenkyls
The Definition and Measurement of
Capital and Its Role in the Investment Function, TU 4/1979, Bank of
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