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A U G U ST 1962 BUSINESS REVIEW More Cash Flow—A n d M aybe New Machines X = E x c e ss Capacity FEDERAL RESERVE BANK OF PHILADELPHIA BUSINESS R E V IE W is produced in the Department o f Research. Bernard Shull was primarily responsible for the article “ More Cash Flow— And Maybe New Machines,” and Evan B. Alderfer for “ X = E xcess Capacity.” The authors will be glad to receive comments on their articles. Requests for additional copies should be addressed to the Department o f Public In formation, Federal Reserve Bank o f Phila delphia, Philadelphia 1, Pennsylvania. The principal dynamo of economic growth in the United States has sputtered in recent years. Business spending on plant and equipment— the main power source in any free economy— has failed to grow beyond the heights achieved in 1 9 5 7. Through disappointing progress a search has been conducted for ways to stimulate investment. New depreciation guidelines and other proposals promise . . . MORE CASH FLOW—AND MAYBE NEW MACHINES The American economy has not lived up to its Depreciation allow ances potential over the past several years. Growth Depreciation is an invisible expense. Machines has been slow and substantial amounts of excess wear out and become obsolete as time passes. capacity We can no more see machines depreciate than and unemployment have developed. Many observers trace the sluggishness to a slow we can see time pass. Not even a slow-motion down in business investment. Some feel that camera would help. But it happens all the same. The Federal Government recognizes the grad higher levels of investment would increase in come and demand at home and also permit ual and continuous expense of depreciation and American business to modernize and compete provides for it in the tax laws. The law permits more effectively abroad; they believe that more a deduction in the computation of taxable income investment, despite the existence of excess ca of a reasonable amount for the exhaustion of pacity, would place the economy on the road to tangible (and some intangible) property. faster growth. The amount of depreciation a firm can deduct Of the many factors that influence business in any given year depends in part on the original investment, cash flow— frequently defined as re cost of its equipment. But the allowance will also tained earnings plus depreciation— has drawn vary with the number of years over which its increasing attention. To equipment is depreciated and the computing increase investment, the argument goes, first increase cash flow. method used. The Federal Government pretty much regulates both time and method. TO INCREASE CASH FLOW The useful lives of thousands of fixed assets— A number of policies and proposals have been from locomotives to honing machines and from designed recently to increase cash flow— to pro dip barrels to chairs— had been estimated, prior to vide business with more cash which can be used last month, in the Internal Revenue’s Bulletin F. for investment in productive capital. The basic Newly published depreciation rules set out ingredient of all these proposals is tax relief, useful lives estimates for about 75 classes of particularly for firms that are growing. property that should encompass all the assets 3 business review Treasury has estimated that the revision will CHART I increase depreciation allowances by about $3.4 bil INVESTMENT AND GROWTH lion this year, and save businessmen about Business spending on plant and equipment spurted after World War II and through the mid-fifties. It reached a peak in 1956 and 1957 and has been sluggish since. Gross national product— an over-all measure of economic growth— appears to have been significantly affected by the slow down in investment. From 1946 to 1957, GNP increased at an average rate of 3 l/j per cent a year; since 1957, its rate of growth has slowed down to a little over 2)4 per cent. RATIO SCALE BILLIONS OF 1961 DOLLARS RATI° SCALE BILLIONS OF 1961 DOLLARS $1.5 billion in taxes. There are several types of depreciation meth ods permitted under the tax laws. One, so-called “ straight line” depreciation, directs businessmen to write off an equal proportion of the cost each year— for example, 10 per cent of the original cost each year. For an asset costing $10,000 and having a 10-year life, this would amount to $1,000 each year. Accelerated methods permit businessmen to write off larger proportions in the early years and smaller proportions in the later years. Sev eral accelerated methods are permitted under the law. However, the currently permissible methods do not allow so rapid a write-off as is permitted in many countries of the Western World. If the Government would permit larger propor The R A T IO O F P L A N T A N D E Q U I P M E N T S P E N D I N G T O G N P has been generally dropping since 1948. Currently the ratio is lower than in 1946. Some observers feel that for the economy to grow faster, more than 9 per cent of GNP must be devoted to investment. PER CENT tions of an asset’s value to be written off earlier, firms owning the assets would generally take immediate increases in their depreciation al lowances. This would reduce their taxable income and increase actual cash available, even though reported earnings, reflecting the increase in de preciation expense, would decline. Immediate increases in depreciation allow ances— whether due to shorter useful lives esti mates or more rapid acceleration— might only postpone tax payments, not reduce them perma nently. Abnormally high depreciation when the asset is new could be offset by abnormally low Plant and e q uip m ent expenditures includ e nonresidential construc tion and p ro d u c e rs' d u ra b le equipm ent. Both G N P and plant and e q uip m e nt expenditures are in constant 1961 dollars. Source: Dep artm ent of C om m e rc e . depreciation when the asset is old. For a growing firm that continually increases its investment, however, depreciation allowances previously specified. The new guidelines have, on average, de should be systematically higher each year. A growing firm should be able to postpone ab creased the number of years over which equip normally ment and machinery may be depreciated. The nitely. An economy in which growing firms 4 low depreciation allowances indefi business review C H A R T of II THE EXPANSION OF CORPORATE CASH FLOW Corporate cash flow— retained earnings plus depreciation allowances— has grown from $11 billion to $32 billion since the end of World War II. The growth of these inter nally generated funds is almost completely due to the constant expansion of depreciation. Retained earnings have fallen in recession and risen in prosperity, but they were about the same in 1961 as they had been in 1946. investment— investment in new tools and machines. The idea is that this type of investment should be especially encouraged; some believe it is mainly associated with innovation— tech nological advances and new products which con tribute most to rapid economic growth. The Treasury feels that the tax credit would stimulate new investment far more per dollar of BILLIONS OF DOLLARS tax revenue lost than any alternative type of tax relief. It estimates that this measure would re duce corporate taxes by well over SI billion in the first year of its operation. The tax credit would become a permanent part of the tax code. G en eral ta x reduction Depreciation revisions and the investment tax 1946 48 '5 0 '5 2 '54 '5 6 Source: "S o u r c e s and Uses of C o rp o ra t e F u n d s," C om m e rc e . '58 '60 D e p artm ent of credit are designed primarily to help the grow ing firm by paying a premium for faster growth. A general reduction of corporate tax rates would dominate should also systematically incur higher depreciation under these conditions. Consequently, adjusting depreciation require ments under the law could provide a systematic help all firms and, presumably, encourage a larger number to become growing firms. This kind of tax relief would not be tied to any specific corporate activity. expansion of cash flow, through tax relief, during periods of advance. But if investment is stable WILL CASH FLOW INCREASE INVESTMENT? or declining for any period of years— for a Like most important questions, the answer to firm or for the economy as a whole— these same this one is not clear-cut. There are pros and cons, adjustments would reduce depreciation allow and the pendulum of opinion swings back and ances and cash flow to levels lower than they forth with the expert testimony that appeared otherwise would have been. in last night’s paper. Twenty-five years ago a consensus held that cash retained by corpora The investm ent ta x credit tions out of earnings was being hoarded and The recently proposed investment tax credit is thereby injuring economic recovery— and a tax another tax-relief measure designed in part to was levied on retained earnings. Today many increase cash flow of the growing concern. A bill insist that an increase in retained earnings and currently before Congress provides that busi corporate cash would not be hoarded but in nesses may deduct up to 7 per cent of the cost vested, and tax relief is the order of the day. of most newly purchased equipment from their tax liability. There is no provision for new plant. This measure would encourage a specific type The current debate: affirm ative . . . The issue turns on what will be done with the 5 business review cash; the hope is that it will find its way into taking advantage of opportunities that may arise. investment. This hope is based on the belief Even when internally generated cash— cash that the supply of capital funds is limited rela flow— is used for investment, a cost is incurred. tive to investment opportunities. The shareholders might have received the cash in The word “ limited” requires some explanation. Some firms— for example, small or new busi dividends; and by investing it, they incur the loss of an immediate increase in income. nesses— simply may not be able to raise the total Real dollar costs, such as interest payments, amount of funds they feel they could profitably use. This is, of course, an absolute limitation. potential costs, such as are incurred in floating bonds, and the costs of giving up alternative But perhaps more often, the cost of raising funds is prohibitively high— so high that when opportunities such as are involved in selling the cost is taken into consideration, the invest costs of investment funds. ment project no longer seems profitable. Cost is the limiting factor. Governments and plowing back profits are the It is generally felt by financial analysts that the cost of financing internally is considerably No matter what funds are used— no matter lower than any other kind of financing; and the how they are obtained— there is always a cost. cost of financing rises after internally generated A firm may obtain funds by floating new stock. funds are exhausted. But underwriters must be compensated; fre Businessmen have additional reasons for favor quently a large cost is involved here. Moreover, ing internal financing. They generally prefer to the firm must be prepared to pay dividends to remain independent of outside influence; they are its new as well as old shareholders; dividends, frequently reluctant to make outsiders insiders, be unlike interest, are not tax deductible— they are they lenders or new owners. Moreover, it’s often paid out of after-tax income. Floating new stock easier to finance internally. External financing can be very expensive. will typically require numerous conferences and A firm may obtain funds by borrowing in the elaborate preparation; internal financing may capital markets or from banks. Interest must be require only that an increase in dividends not paid currently, and ultimately the loan must be be voted. repaid. The interest payments, especially on long So it seems to follow that an increase in cash term borrowing, represent a fixed cost that may flow will decrease the average cost of funds, help become extremely burdensome during periods of overcome business reluctance, and encourage economic decline; and loan repayments may be investment. There is some evidence to support come difficult also if the investment does not this view. succeed. Actual costs and potential dangers are involved in borrowing. Businessmen have stated in a number of sur veys that they prefer to finance new capital in A firm may get cash by selling financial as ternally.1 And they do seem to finance a large sets, such as Government securities. Here, too, proportion of capital internally. They act as if a cost is involved, for the firm gives up interest they consider internal financing cheaper and income when it sells Governments. Moreover, it generally preferable. gives up some liquidity; and it therefore gives up some flexibility in meeting contingencies or Digitized for 6 FRASER 1 For a discussion o f these surveys, see The Investment Decision by Joh n R. M e ye r and Edw in Kuh, H a rv a rd U niversity Press, 1959. business review C H A R T But this money and investment have grown in III a comparable fashion. INSIDE FUNDS FOR INVESTMENT To this extent, then, the statistical analyses seem Funds generated internally by corporations— cash flow— and corporate investment have grown in step over the postwar period. Year-to-year changes have not always been in the same direction, but both have grown from about the same level and by about the same amount. to confirm what businessmen say. Cash flow ap pears to have been one of the important factors in fluencing the investment decision in recent years. BILLIONS OF DOLLARS . . . and negative In spite of what, on the surface, appears to be substantial evidence, the case is not airtight. It still requires a good jump to conclude that a boost in cash flow today will result in a sub stantial increase in investment tomorrow. First of all, how important is the cost of in vestment funds? Only a few years ago most businessmen and economists believed that capital costs were relatively unimportant. These costs generally represent a small proportion of the total cost of obtaining, maintaining, and replacing new plant and new machines. Many believed that even substantial variations in the cost of funds Moreover, cash flow and investment seem to would not significantly affect the total cost of new have been closely related during the postwar period. Mainly due to rapid and persistent in investments. Moreover, businessmen seemed to re quire high prospective returns on new investment creases in depreciation, internal funds have grown — partly, perhaps, to cover the risk of an uncer considerably from a little over $11 billion in 1946 tain future. For this reason also, even significant to $32 billion in 1961. As is shown in Chart III, changes in the cost of funds could hardly be internal funds have grown from about the same decisive. So while many businessmen have stated level and by about the same amount as plant a preference for cash flow, many at the same and equipment expenditures.2 time have also stated that they do not consider Of course, the internally generated funds could have been partly used to build up inven the costs of money a significant factor in de termining their investment expenditures. tories and extend credit to customers. There is The easiest though perhaps not the only way no way of distinguishing the dollars used for to reconcile these apparently conflicting views is investment from dollars used for other purposes. to conclude that many businessmen would rather 2 A sim p le linear correla tion of the da ta for these years ind icate d that a b o u t 83 per cent of the v a ria nce in investm ent was explained by internal funds. S im ila r con clu sio ns are reached in m ore e la b o rate correlation analyses in Variability of Private Investment in Plant and Equipment, Part I of m aterial subm itte d to the Jo in t Econ om ic C o m mittee, Ja n u a ry 1962, p. 68. O th e r e vid e nce su p p o rtin g the co n tention that cash flow stro n gly influences investm ent is sum m arized by Ja m e s Duesenberry in Business Cycles and Economic Growth, 1958, pp. 87-90. use internal funds, but do not feel restrained very much by having to borrow if the profit outlook is really good. Executives at one firm we talked to explicitly said that they do not feel their investment is limited in any fashion by the 7 business review have a preference for internal funds, but the CHART IV preference may not be crucial. OUTSIDE FUNDS FOR INVESTMENT External funds obtained by corporations— from new stock, bond, and other long-term financing— have grown at about the same rate as corporate spending on plant and equip ment over the postwar period. This interpretation of the ideas businessmen have expressed from time to time in surveys seems to conform to their behavior in the postwar period. Although long-term financing— mainly RATIO SCALE BILLIONS OF DOLLARS bond and stock flotations— has accounted for a relatively small proportion of corporate invest ment, it has not declined in importance over the postwar period; it has grown at least as rapidly as investment, as shown in Chart IV.3 In addition, there appears to be a fairly strong association between changes in investment and changes in external long-term financing. When corporations have increased their investment, as can be seen in Chart V, they have typically increased their long-term borrowing.4 The relationship between external financing and investment is obvious. Businesses would rarely The R A T IO O F E X T E R N A L L O N G - T E R M F U N D S T O P L A N T A N D E Q U IP M E N T E X P E N D IT U R E S has averaged almost 35 per cent during the postwar period. The ratio has fluctuated con siderably, generally falling in recession years and rising in years of expansion; but no downward trend has been evident. PER CENT borrow long-term if not to invest; long-term borrowing clearly permits investment. The rela tionship between changes in cash flow and in vestment, on the other hand, is somewhat less clear. While it is true that increases in cash flow can be used to increase investment in fixed assets, it is also true that increases in investment prob ably result in increases in cash flow— more profit and more depreciation. Moreover, with general economic advance, both investment and cash flow would tend to rise hand-in-hand, and Source: "S o u r c e s and Uses of C o rp o ra t e F u n d s," C om m e rce. D e p artm ent of type of financing they would have to do. If the investment project was a good one and they had to borrow, they would. Yet this particular firm hasn’t had to borrow long-term for many years, though it has invested a considerable amount. It has been able to finance practically all its investments internally. The firm appears to 8 3 In recent years, sources of co rp o ra te funds have consistently exceeded uses. The d isc re p an cy m ig h t su g g e st som e upw ard bias in external funds, but this seems of m inor im portance. O n this point see "B u sin e ss C r e d it D e m ands— Proble m s of In te rp re ta tio n " in the J u ly -A u g u st issue of the Monthly Review o f the Federal Reserve Bank of Kansas C ity. 4 A sim ple correlation of c h an g e s in lon g-term financinq and c h an g e s in corp ora te expenditures for pla nt and e q u ip m e n t in the postw ar p e rio d ind icate s that a b o u t 43 per cent of the va ria n ce in the investm ent v a ria b le is e xplained by c h an g e s in external lo n g term financing. C o n sid e rin g the num be r of obse rva tio n s and the extent of the association that resulted, the existence of som e a sso ciation between investm ent and external fin a n cin g can be acce pte d with co n sid e ra b le confidence. The associatio n is further im p ro v e d if the ch ang e s in investm ent and b o rro w in g from 1957 to 1958 are not con sid e re d. In 1958, plant and e q uip m e nt e xpenditures fell by ove r $6 billion while long-term b o rro w in g d e c lin e d by $1 billion. A b o u t 49 per cent of fhe va ria nce in investm ent is e xplained when 1958 is elim inated. business review C H A R T V lion, and $5.1 billion, in 1950, 1955, and FINANCING INVESTMENT EXTERNALLY: SOME UPS AND DOWNS 1959, respectively. In the following years, 1951, During the postwar period, increases and decreases in in vestment have generally been accompanied by increases and decreases in external long-term financing. In 11 of the 15 years of comparison, the two have moved in the same direction. and equipment increased considerably— $4.7 bil BILLIONS OF DOLLARS 1956, and 1960, corporate expenditures for plant lion, $5.7 billion, and $3.1 billion, respectively. But these were special years. Let’s look at them more closely. Nineteen-fifty, 1955, and 1959 were years of economic recovery from recessions. During those years, cash flow in creased rapidly because profits were increasing rapidly. Probably the increases in profits were mainly due to the increasing utilization of capa city, and the spreading of burdensome overhead costs over larger amounts of sales. During those early years of recovery, plant and equipment expenditures changed very little. The increased ( Continued on Page 12) CHART VI CASH FLOW AND INVESTMENT IN THREE ACTS Source: "S o u r c e s and Uses of C o rp o ra te F u n d s," D e p artm ent of C om m e rc e . one could not be thought of as necessarily pull ing the other after it. Despite the statistical association found between cash flow and invest ment, it is not a simple matter to determine which is cause and which is effect or, in fact, In each of the three periods highlighted on the chart, internal sources of funds— cash flow— increased substan tially in the first year and corporate spending on plant and equipment increased substantially in the following year. The first year, in each case, was a year of recovery from recession. The expansion in investment in the following year may have been helped by the previous increase in cash flow; but it was also probably spurred on by im provements in the outlook for business and profit expec tations. BILLIONS OF DOLLARS whether both are simply not effects of a more important factor— the profit outlook. The postwar m ilieu In the postwar period, as can be seen in Chart VI, there have been three years in which internal funds have risen very rapidly, and these years have been followed by striking increases in in vestment.5 Retained earnings plus depreciation of corporations increased $5.9 billion, $6.8 bil 5 The lead, however, is not consistent. In only seven of the 15 postw ar years has investm ent m oved in the sam e dire ction as cash flow the year before. Internal sources of funds includ e retained e a rn in gs and d e p re c ia tion allow ances. Source: "S o u r c e s and Uses of C o rp o ra t e F u n d s," D e p artm ent of C om m e rce . 9 THE SEVERAL FACE Cash flow, like Eve, has more than one face. Each unique appearance is determined in the eye of the beholder. Several categories of beholders, having several different purposes, have created different images. There is a basic idea, however, from which the varying notions of cash flow spring. Think of a flow— some element moving smoothly and con tinuously like blood through our bodies. So we can conceive of cash flowing smoothly and con tinuously through a business. Cash is obtained from several sources and converted into produc tive factors and finally goods and services; these are then converted in the market place back to cash. The accompanying diagram depicts a general ized flow. Cash receipts flow into the business from lenders, owners, and from sales; cash is paid out for labor, capital, and materials in the process of building a finished inventory; cash is returned with the help of customers. Part of the cash must be paid out again immediately— in wages, for example, and in interest; part is earmarked on the books to cover specific expenses but cash need not be paid immediately; depreciation is a major expense of this sort. If a profit is earned, income taxes must be paid and perhaps dividends to stockholders. Corporate managements can record the amount of cash coming from the various sources and the amount spent for various purposes. W ith the help of their records, they can frequently CIRCULATION OF CASH THROUGH A BUSINESS S OF CASH FLOW project future cash flow with some success. Such statements and projections play an impor tant part in corporate budgeting; they help man agement determine the effects of its current and prospective policies on its cash position; and permit management to adjust accordingly so that neither shortages nor substantial excesses of cash occur. Corporate treasurers, in particular, find cash-flow projections invaluable in deciding how much cash should be invested in what kind of securities. Moreover, many lenders will require a projected cash flow statement before making a loan to business. These projections help lenders evaluate the prospects of scheduled loan repay ments. Fund or cash-flow statements are frequently condensed. Such statements— usually entitled "Sources and Uses of Funds" or something simi lar— start with net earnings after taxes and fre quently after dividends. These earnings are typically reported on an accrual basis. They include noncash expenses and receipts. The large and easily available noncash expenses, such as depreciation and depletion are usually added back in more or less to adjust earnings to a cash basis. The figure that results— earnings plus depreciation and depletion allowances— may be considered a hopeful approximation of cash received during the period from internal operations. Funds received from external sources are composed of borrowing and equity financing. This, then, is approximately the total amount of cash that has flowed into the business over a given period of time, net of the amount required for operations. It may have been used to acquire inventories, or finance customers, to purchase new machines, or new plants, to repay debts, or to build up holdings of G o v ernment securities. It may just have been kept as cash. To these several uses, the cash inflow is appropriately allocated. Such source and use statements have supple mented balance sheet and income reports for years. They have been of help to management's boards of directors and, more recently, to stockholders in tracing the operations of the firm. In recent years, security and financial analysts have frequently restricted the term "cash flow" to cash from internal operations— net earnings (before or after dividends) plus depreciation and depletion. Security analysts are often concerned with the evaluation of the stock prices of various companies. Current and prospective earnings are the most important factors in such evaluation. But in some industries, various companies use different accounting techniques which make their reported earnings non comparable. Adjusting in comes to an approximate cash basis sometimes provides a better comparison. Financial and economic analysts are currently concerned about the rate of economic growth. Business investment, an important determinant of growth, has been sluggish in recent years. Since businesses need funds to invest, and since inter nally generated cash is a relatively cheap source, economists have given this part of the total flow considerable attention in recent years. This is the face of cash flow that has found its way from the scholarly journal to the financial and edito rial pages of the morning newspaper. business review (Continued from Page 9) to increase promotional expenditures or wages. cash flow helped to build up inventories, finance It should be recognized that there are many an expansion of trade credit, and increase hold possible leakages between increased corporate ings of Government securities; a little of it was cash flow and increased expenditures for plant simply kept in cash. and equipment. The expansion of investment in the years fol lowing those early recovery years seems closely N eeded: a new m ilieu associated with the dynamic improvement accom In the depressed 1930’s business investment was panying at very low levels. By current standards, the cost the recovery— improvement in the economic outlook, improved profit anticipations, of financing was also low. But the risks were the elimination of excess capacity, and the turn high and the returns uncertain. Many business over of inventories. men apparently reasoned that they needed a A large proportion of total investment was no large margin of error. Even sound investment doubt financed with current cash flow; but the opportunities had a way of going sour. Unless additional years the expenditure promised a very good return, “ growth years” were probably financed with the help of long-term borrowing and previously they could not afford to invest. In the 1930’s, there were relatively few investments that prom accumulated liquid assets— substantial amounts ised a good return. amounts that made those of Government securities were liquidated in Immediately after World War II, business 1956 and 1960. Some of the assets liquidated men also seemed to demand high returns on were no doubt acquired through cash flow of their investments. Surveys indicated that they former years. Nevertheless, when the investment expected their investments to pay for themselves outlook was good, businessmen did not restrict very quickly. Perhaps they were still uncertain themselves to current cash flow. They appear to as to the future. But the difference in the late have used whatever funds were available. The early postwar years were buoyant ones. Cash flow and investment grew together in a 1940’s was that there were substantial numbers of investment opportunities that met the re quirements. milieu of optimism and expansion. The atmos Today it appears that many firms are not phere seems somewhat different today; whether requiring so high a return on their investments or not an increase in the supply of corporate as was true in the late 1940’s and 1930’s. There cash can induce a significant expansion of in is not so much uncertainty as during the 1930’s; vestment in this different climate cannot easily but there also does not seem to be the abundance be foretold by either theoretical speculation or of high-yielding projects that existed in the late statistical analyses that look to the past. An 1940’s. To judge from profit margins and cur increase in cash, brought about by tax relief not rent returns on equity, prospective yields on specifically tied to new investment, can be used investments have probably fallen significantly in a number of ways. It can be used to increase in many industries over the past decade. dividends; it can be used to build up inventories When anticipated returns are relatively low and extend trade credit; it can be used to increase and investment projects are not expected to pay liquidity, and then in the following years used for themselves for many years, the cost of money 12 business review looms more important than it otherwise would. not a panacea in an economy with excess capac Businessmen tend to become sharp-pencil cal ity and where the profit squeeze has developed culators who carefully evaluate the potential net primarily because of the rapid growth of many gains of alternative projects. So, in these terms, costs.6 the cost of money is probably more important in today’s environment than it was 10 or 15 THE PROMISE OF INVESTMENT years ago. So, also, in these terms, anything that If investment is to grow, the forces underlying increases the availability or reduces the cost of growth must be understood. Cash flow— the sup capital funds, such as increased cash flow, would ply of cheap, readily available funds— may be be of some merit. an important factor. But investment, in the past But how much benefit an increase in cash at least, has typically responded in a vigor flow can be is difficult to say. Important factors ous fashion to hopes and needs— the hope to that significantly affect the supply of capital earn larger amounts of profit and the need to funds have been favorable for investment for stay competitive to survive. Increasing foreign some time. Total cash flow has exceeded total competition has intensified the need to renovate corporate investment by about $5.4 billion over plant and equipment. But hope has typically the past three years. Rates on long-term borrow been the major emotion behind past investment ing have been relatively moderate by historical booms in the United States. From the railroad comparison, and loan funds appear to have been expansion of the 19th century to the postwar available for some time. Corporate holdings of boom from which we have recently emerged, the liquid assets have increased significantly over the past year and many, though not all, observers hope of making large amounts of money has stirred the business imagination. believe that corporate liquidity is at least ade quate. The hope of profit depends ultimately on ac tual or anticipated market demands for the Perhaps, then, concern with the prospective products or services that business is producing yields on new investment is more basic than the and on new products that meet strongly felt current concern with the cost of capital funds. needs. If investment has increased at too slow a The current tax-relief measures should tend to rate in recent years, it has more likely been improve prospective yields as well as increase “ limited hope” rather than limited cash flow cash flow. After-tax receipts should be higher; that has been the roadblock. The proposed meas the pay-back period on new investments should ures to stimulate cash flow meet this barrier by be shorter. The Federal Government, through its promising the reduction of one of many costs. tax policy, can improve profitability. In the current environment where demand seems But it cannot create profitability. Profitable op somewhat deficient, the question, “ can these portunities and ideas must exist first. There were measures help” can only be answered with a slumps in investment and business depressions maybe. long before there was a Federal income tax. Tax relief, then, can be considered a help but 6 See "T h e G re a t C o rp o ra t e Profits M y s te r y " in the Business Review of Ja n u a ry 1962. 13 X = EXCESS CAPACITY Stone-cold blast furnaces, silent coal tipples, cept of steel is likely to be, well, steel. Steel, smokeless chimneys piercing the skyline, empty however, is a rather complex chemical compound freight cars sitting on grass-covered sidings, cooked up in colossal cauldrons according to vacant lofts in center city, unoccupied hotel particular recipes. After solidification into ingots, rooms, the railway club car we had to ourselves from St. Louis to Indianapolis, and the cabby asleep in his taxi at a wayside station— all these the steel undergoes much additional processing look like excess capacity. capacity, it would be greater if all steel were If all the furnaces were aglow and all the chimneys belching smoke, to get the right sizes and shapes for razor blades, boiler plate, tail fins, etc. Whatever the industry’s alike. The point is that capacity is influenced by and all the taxis the size and nature of orders, about which cer jostling fares there would be a greater flow of tain assumptions must be made in estimating G.N.P. and less concern about growth, capital steel capacity. investment, and excess capacity. Disappointment How much any one plant can turn out is over these interrelated aspects of our economy influenced also by the condition and balance of is the plant. Old, substandard, or obsolescent ma commanding widespread attention among and chinery limits capacity. Most steel mills are in thoughtful people everywhere. An example is the tegrated so as to get the economy of continuous recent Congressional hearings on “ Measures of flow from smelting to refining, teeming, soaking, businessmen, legislators, commentators, Productive Capacity.” rough rolling, finish rolling, trimming, heat treating, and other finishing operations. Thus, Some troubles in solving for X the capacity of a mill depends in part upon how Theoretically, the calculation of excess capacity well the departmental capacities are geared into looks easy. Let X equal excess capacity; Y equal each other lest there be internal bulges and bot what we can produce; and Z equal what we do tlenecks. Furthermore, in the calculation of its produce; capacity, the question is asked, should the coke then X = Y — Z. Just substitute the Federal Reserve Board’s index of industrial industry (which feeds fuel to the steel industry) production for Z, what we do produce, and the include only its modern by-product ovens or only thing remaining to solve for X is to ascer should coke capacity include also the obsolete tain Y : what we can produce. The Y looks so beehive ovens that are fired up only in cases of unassuming but, as we shall see, it requires a national emergency? tremendous amount of assuming before we can solve for X. How much an industry can produce also de pends on how hard it works. Working time in Before tackling big Y — what the economy can manufacturing industries shows a surprising produce, let’s tackle little y, what one industry variation. The latest monthly report of industrial can produce; steel, for example. How much activity in our district, for example, shows that steel can be produced depends, first of all, on the chemical industry averaged 42.1 hours a the kind of steel. The walnut-paneled-office con week and, at the other extreme, the apparel in 14 business review dustry worked only 35.8 hours. Whether by The fog overhanging the concept of capacity convention or pressure of demand, some plants thickens as we encounter other realities of eco operate single shift, others double shift, and nomic life. One of these is seasonality. The sun’s some three shifts. Technology imposes on some rhythmic shuttle between Cancer and Capricorn branches of the steel and paper industries con causes periodic stresses and excesses of capacity tinuous work around the clock. Such irregularity in many industries, notably textiles and apparel of work schedules further complicates estimation where the irregularities are further accentuated of capacity, and again certain assumptions must by styles and fashions. Moreover, the capacity be made. of an industry may undergo sudden expansion Despite all the talk about automation, most or contraction as a result of, say, tariff legisla machines do not run themselves. Capacity is very tion, collapse of much influenced by the supply and efficiency of products, or other contingencies. demand for the industry’s labor and its continuity on the job. How much could be produced would be enhanced materially Some success in solving for X if periodic disagreements between labor and Notwithstanding all the difficulties, some trade management associations— notably pulp and paper, petroleum could be settled without work stoppages. refining, and steel— make monthly estimates of Factory organization and managerial ability capacity operations in their respective industries. also affect capacity. An industrial consultant of The steel industry, however, no longer publishes wide repute once made the remark that only estimates of capacity operations and it is not quite clear whether publication was discontinued 10 per cent of the country’s plants were well run; that the others operated with varying degrees of inefficiency and ineptitude. If the below-average managers were to imitate their abler operators, capacity could be improved considerably. a bearing on capacity. Though considerably more difficult to esti mate, indexes of capacity operations for aggre The amount of raw material available and its quality have because of technical difficulties or for reasons of public relations. gates of manufacturing industries are also Plants available. The Federal Reserve Board makes processing agricultural products readily come to estimates of capacity and output for Major Ma mind as an illustration. A plant that processes a terials. Included in the index are such items as highly perishable vegetable like tomatoes must steel, cotton yarn, paper, and synthetic rubber. have enough capacity to handle a bumper crop, The Board has also developed an index of manu but there is much idle capacity if the crop is facturing capacity as part of a study of the decimated by drought, flood, or other catastro determinants of quarterly capital spending by phes of Nature. Or, a plant may have its capacity curtailed if it is geared for the processing of manufacturers. The Wharton School of the Uni versity of Pennsylvania arrives at excess capacity high-grade raw materials and is forced to accept by comparing the Federal Reserve Board’s index inferior materials through some emergency be of industrial production with “ capacity” yond its control. For example, if a tannery’s tained by stretching a straight trend line between supply of hides deteriorates, it can’t turn out its the latest peaks of industrial production. Though customary amount of good leather. confined primarily to manufacturing, the Whar ob 15 business review ton School’s index also includes mining and streams with Plimsoll line and plummet, and utilities. McGraw-Hill goes directly to the leading shoals of a different character are encountered manufacturers in each industry with a ques in agriculture, construction, mining, and the tionnaire, asking for capacity change and the services such as communications, finance, gov current rate of operations. McGraw-Hill assumes ernment, insurance, and trade. that output was at 100 per cent of capacity at In agriculture, for example, assumptions must the end of 1950, and is interested more in be made about weather and insect pests. In measuring capacity trends rather than ascertain mining, assumptions must be made with respect ing an absolute level. The National Industrial to underground reserves and water seepage. Each Conference Board index is based on deflated trade values of both fixed capital and value of ship uncertainties. has its own peculiar problems and ments of manufacturing corporations. Fortune Another aspect of capacity to produce is magazine’s measure of capacity in use is based human capital. Nobody denies that capacity is on the relation between total stock and total increased when the existing stock of productive output. equipment is augmented by the construction of As might be supposed, the different methods new plants and the installation of new machinery employed by these pioneers of a comprehensive and equipment. But how about investments in index of capacity utilization do not produce human capital? identical results. Though the range is too wide Enormous sums, both public and private, are to suit the statisticians, it is not too alarming, spent annually on education. While much of considering the obstacles of the hunt and the this is regarded as consumption, such expendi elusiveness of the quarry. The capacity of all of tures are also an investment in human capital, our manufacturing industries is not merely a and the investment greatly increases the capacity matter of physics and chemistry, but also eco of the labor force to produce. According to nomics. All industries compete with each other preliminary estimates by Theodore W. Schultz, for materials, for labor, for capital, and for the the stock of education in the labor force rose grand prize— markets. Furthermore, they must about eight-and-a-half times between 1900 and keep within the rules of the game; they must 1956, in contrast with a rise of four-and-a-half make profits or they cease to compete, and that times in the stock of reproducible capital, both too affects capacity. It is not only a matter of in 1956 prices. engineering but also economics. The problem of The money that people in the labor force calculating capacity borders on metaphysics. spend to improve their health, and expenditures Still more difficulties job opportunities are also examples of investment for internal migration to take advantage of better The courageous efforts to measure capacity of in human capital with beneficial results upon manufacturing industries capacity to produce. are admirable, but manufacturing contributes only about one-fourth of the total stream of national income. To Not all excess is excessive measure the capacity and excess capacity of the The widespread interest in capacity probably economy, we must ply the other major income grows out of the widespread complaint about 16 business review BUSINESS EXPENDITURES ON PLANT AND EQUIPMENT BILLIONS OF DOLLARS after allowing for changes in the value of the dollar, that business has been on a capacity expanding binge ever since the end of World War II. Expenditures in the early postwar years were largely in the nature of reconversion and catching-up with investment that had to be postponed during the war. In recent years, most of the spending has been for modernization rather than for expansion of capacity. Of course it is conceivable that in the process of moderni zation some elements of expansion seep in. When a company replaces obsolescent machinery with new equipment the chances are that the mod excess capacity. It afflicts big industries like ernized plant has not only lower-cost capacity petroleum and small industries like mushrooms but also enlarged capacity. and broilers. Steel was recently reported to be Regardless of when and how it came about, operating around 50 per cent of capacity. The idle capacity, both men and machines, is a stern coal industry has much excess capacity; many reality and a drag on the economy currently mines are unable to operate profitably most of lacking vigor. Some surplus capacity in a more the time, but operations are eagerly resumed the or less free competitive economy is almost in moment the market improves. The railroads are burdened with excess capacity because they have evitable. Indeed, it is a necessary and healthy lost much business to motor trucks, pipelines, would not have the flexibility required to ac and air transport; and overcapacity is chronic commodate sudden changes in demand or supply. in agriculture, judged by the billions spent Some surplus is needed to meet emergencies. annually to buy and store the surplus. The condition. Without any reserve, the economy The question is: how much of the excess is present state of affairs may be unusual, but excessive? That is a question that defies a excess capacity seems persistent except in times precise answer until we get a more precise of national emergency. measure of capacity. The perfect measure may Upon examination of the chart showing busi never be attained, but the progress already made ness expenditures on new plant and equipment by the several explorers is commendable and over the years, one gets the impression, even encouraging. 17 FO R TH E R E C O R D BILLIONS 2 YEARS AGO YEAR AGO $ MEMBER BANKS 3RD F.R.D. JUNE 1962 Third Federal Reserve District United States Per cent change Per cent change Factory* Department Storef Employ ment Payrolls Sales Stocks Check Payments Per cent change June 1962 from Per cent change June 1962 from Per cent change June 1962 from Per cent change June 1962 from Per cent change June 1962 from mo. ago mo. ago mo. ago mo. ago mo. ago SUM M ARY 6 mos. 1962 June 1962 from mo. ago year ago June 1962 from year ago mo. ago year ago 6 mos. 1962 from year ago LO CA L CHANGES M A N U FA C T U RIN G Electric power consumed....... Man-hours, total*................ Employment, total.................. W a ge income*..................... C O N S T R U C T IO N ** C O A L PRODUCTION 0 1 0 + 1 +27 + + 11 + 7 + 3 + 1 + 6 +31 +22 + 12 + 4 + 2 + 7 +26 4- 1 + 8 + + 15 + 1 + 7 1 + 3 + 0 + 4 - 3 + 12 + 8 +24 +16 +14 + + + + 4 + -f 1 — 1 + B A N K IN G (All member banks) Deposits............................. Loans................................. Investments.......................... U.S. Govt, securities............. Other............................... Check payments.................... - + + + - 7 0 1 1 0 1 2 It + 4* + + + 5 6 5 7 7 4" 6 + 4 4" 8 + 10 + 5 9t + 15t 3 2 + 2 4" 1 + 1 0 + 4 - 1 2 9 + 8 + 9 + 9 + 3 +24 + 8 6 + 8 + 7 + 10 + 7 +20 + 11 Lancaster........ •Production workers only. ••Value of contracts. •••Adjusted for seasonal variation. + 6 + 2 + 4 4- 5 Philadelphia. . . . 0 0 + 0 4" 5 ot + It + lt year ago year ago 0 0 + + 1 1 + f20 Cities jPhiladelphia 0 1 - — 1 — 2 3 +13 1 + 0 + 12 4 - 1 + 10 - 8 0 + 7 + 7 - 2 +10 - 1 + 0 + 4 - 1 - 2 - 2 -1 7 1 + 2 + 2 - - 3 + 8 +14 0 + 2 + 1 + 3 4" 5 + 12 - 5 - 4 1 + 3 + 3 + - 9 - 5 0 + 1 - 1 + 10 - 8 - + 3 + 2 4- 6 - 5 + 3 0 + 3 + - 1 + 4 + 1 + 2 2 +n 0 +10 + York.............. 3 9 +25 + Wilkes-Barre. . . - 2 Scranton......... 9 4 4" 6 + 2 + Trenton.......... Wilmington...... PRICES Consumer............................ year ago 1 + 12 Reading.......... TRADE*** Department store sales........... Department store stocks.......... year ago +n + year ago - 5 2 - 9 1 + 2 +22 1 + 1 •Not restricted to corporate limits of cities but covers areas of one or more counties. t Adjusted for seasonal variation.
@FedFRASER