A big question about corporate income taxes is their effects on investment. Is it reasonable to expect that lower taxes on profits will lead to greater investment, or will the tax cuts simply be paid out to shareholders? When the tax bill was being finalized late last year, John Cochrane made a typically uncompromising case for the former, arguing that it doesn’t make sense even in principle to pose investment and shareholder payouts as alternatives. In press interviews he madethe same argument even more emphatically: “If you lower the price of something, you get more of it. That’s pretty basic.” The same argument that there’s a direct link between taxes investment, regardless of what individual firms do with the money, has been made by plenty of others, such as Justin Wolfers in a recent NYT piece.
I have written some things arguing the other side. But I don’t want to jump into polemic here. Instead I want to lay out as systematically as I can the kind of considerations that would lead one to one view or the other — the questions you need to ask before asking the question.
* * *
There are two sets of issues to consider. The micro issue is how tax cuts affect the choices facing an individual business. The macro is what outcomes one can consistently describe for the economy as a whole. In this post I will focus on the micro side. On the macro side, for now I just want to say that, contrary to what Cochrane and Wolfers seems to suggest, there is no logical reason why a corporate tax cut cannot simply result in greater cash holdings by corporations and/or shareholders. One might or might not see a reasonable story in which people would choose to behave this way, but there’s nothing nonsensical or incoherent about it in principle.
So what about the corporate investment decision? The natural way to think about this, as an economist, is in terms of two curves – one the expected return on each incremental dollar of investment, the other the cost of each incremental dollar of financing. 1 If the firm is maximizing profits, they will pick the level of investment at which these two values are equal. Even if they are not strictly maximizing (expected) profits, the analysis doesn’t change in any fundamental way – we can just think of a region around the intersection instead of a precise point. Investment is still more likely to proceed when the expected return is high relative to the cost of funds as perceived by the decisionmaker.
The basic situation is as shown in Figure 1. If the cost of funds rises with each additional dollar of investment, the cost-of-funds curve will slope upward. In particular, Minsky’s hierarchy of finance suggests that internal funds are cheaper than external funds, and the cost of external funds rises with the amount raised. Meanwhile, if the firm for whatever reason has limited investment opportunities and chooses the best ones first, then the return on investment curve will slop downward, since each additional unit of investment will be expected to yield less than the last one.
We see here that four kinds of development can change the desired level of investment. First, cheaper finance (lower interest rates, for example) shifts the cost of funds curve downward — the same level of investment costs less. Greater resources available to the firm — i.e. increased retained earnings or equivalent — shift the cost-of-funds curve to the right, since the firm can carry out more investment before cheaper funds are exhausted. Increased profitability (lower taxes, but also lower wages or other costs) shift the expected-returns curve up — the same level of investment generates a greater expected return. And increased demand for the firm’s output shifts the expected-returns curve to the right.
In this framework, vertical movements in the curves represent price changes – the price of additional funds (measured as an interest rate or equivalent), and the price the firm expects to produce for incremental output less the price of producing it. (Or if we imagine the investment to be raising productivity rather than increasing capacity, the price of the labor and other inputs saved per unit of output, less the cost of operation of the new capital goods.) Horizontal movements in the curves represent quantity changes – changes in the quantity of internal funds available to the firm in the case of the supply-of-funds curve, and in the quantity of output the the firm expects to sell (and the amount of new capital equipment it needs to buy this period to maintain its existing operations) in the case of the expected-returns curve.
With generic upward and downward sloping curves as in Figure 1, the price-quantity distinction doesn’t matter. Downward and outward shifts of the cost-of-funds curve are equivalent, as are upward and outward shifts of the expected-returns curve. And all four of these result in greater investment. Nonetheless it’s important to keep the four kinds of changes distinct. First, because the economic logic is different in each case. And second, because changes in the slopes of the curves will have the opposite effect in the first and third cases than in the second and fourth. It seems to me that a good deal of the differences in views on this issue can be interpreted in terms of different beliefs about the normal shapes of these curves. So let’s think through some alternatives.
The first case is that both curves are flat. This is the case for a firm that faces perfectly competitive markets both for its output and for funds. It can sell as much as it wants to at the going price, and borrow as much as it wants at the going interest rate (which is also the opportunity cost for internal funds). In the extreme case, the two curves are identical horizontal lines.
Obviously, this extreme case doesn’t make sense. Firms don’t grow without limit, so they must face either a declining return on investment, or an increasing cost of funds, or both. But there is case close to this one which is useful to think about, at least as a baseline. We can imagine a Modigliani-Miller world in which external and internal finance are perfect substitutes and the firm can borrow without limit at the market interest rate. This is represented by a horizontal supply of funds line. The return on investment curve slopes downward, but gently — this corresponds to a case where the firm expects it can sell additional output at very close to the price it gets now, and/or where the investment opportunities open to the firm do not depend very much on its current operations. The larger the universe from which the firm can pick investment projects, the smaller the gap between the best one and the second-best one. This is the kind of world that Cochrane and Wolfers have in mind.
(Why does the expected-return curve slope down at all? If the firm is small relative to the market, why doesn’t the next unit of investment have exactly the same return as the last one? You might say, technology. But that doesn’t work — it tells us at best the size of the establishment, not the firm — new investment can simply reproduce an existing establishment, with the same output and costs. A better argument for declining returns is some kind of non-purchaseable factor, often glossed as entrepreneurship.)
In this world, because internal and external funds are perfect substitutes, it makes no difference if a firm uses its profits for its own investment spending, lends them to another firm, or pays them out to shareholders. There is one economy-wide cost of capital that all investment projects are evaluated against, regardless of the details of how they are financed. (That’s the horizontal line in Figure 2.) Meanwhile, because the expected-return curve is nearly flat, any change in the expected return should lead to a large change in the volume of investment. If the expected return on the next project is only a little lower than the return on the last one, then a fall in the cost of capital should lead to a large number of projects moving from the not-profitable to the profitable column. So if Figure 2 is a good description of the investment decision, then Cochrane should be right, at least at the micro level: A fall in capital taxation should lead to higher investment regardless of whether the newly untaxed profits are invested by the same firms that receive them.
Wolfers states this clearly: “Companies with profitable investment opportunities can usually find ways to finance them.” Cochrane is even blunter: “Real decisions are … independent of financial decisions.”2
I’m quite sympathetic to Wolfers view that, for large corproations expecially, what is scarce is profitable outlets for investment, not funds to pay for them. But in its strong form, this view faces some problems. Clearly some businesses are financially constrained, as Wolfers acknowledges – but small businesses aren’t responsible for much investment and presumably don’t face pressure from shareholders. A more serious puzzle is the existence of a vast industry for getting around the financial constraints that Wolfers and Cochrane dismiss. If finance isn’t a problem, what is the purpose of venture capital? Why do even larger corporations worry about their credit rating? Why do we have so many different instruments for finance, many with costs substantially above “the” interest rate? What are banks for, if not deciding what gets financed and what does not? What is finance for in general? If, as Wolfers says, finance is not scarce, why is there so much money to be made selling it?3
There’s also the question of how monetary policy works in a world of abundant finance — thoughtful central bankers have long argued that quantitative limits on lending, and not just the interest rate, are important to the transmission of policy. And of course there is a vast empirical literature exploring the importance of credit constraints for investment. No doubt there are cases where the Wolfers-Cochrane position is a reasonable first approximation. But it doesn’t seem like something one can state as an unproblematic matter of fact.
Let’s move on to the other possible cases.
A second possibility is where the cost-of-funds curve is still flat or close to it, but the expected-return curve is steep. This is shown in Figure 3a. The steep downward slope means that the expected return on the next investment project might be much lower than the expected return on the last one. Why might this be the case? First, it can’t be easy to substitute capital for labor or other factors of production. (This is the intensive margin.) Second, the return on new capacity must be well below the return on existing capacity, at least past some threshold. (This is the extensive margin.) This latter might be the case either because the firm enjoys significant market power, or because it faces significant demand constraints. In the case of market power, increased capacity is not worthwhile since higher sales will reduce the margin on existing sales; in the case of demand constraints, higher capacity is not worthwhile because it’s not feasible to increase sales at all. (In some contexts these might be just two ways of describing the same phenomenon, but I think they are worth distinguishing at least conceptually.) Either way, you can have a firm whose current operations are quite profitable but nonetheless expects only a very low return on new investment.
In this case, reducing the cost of capital has only a modest effect on investment (or none at all in the extreme case where the expected-returns curve is vertical). But it does still increase the firm’s profits. Those profits can be either held as cash or investments, or paid out to shareholders. If only some firms are in the position of Figure 3a, then the paid-out or lent-out cashflow will eventually make its way to the firms that face a flatter expected-returns curve. But if market power and/or demand constraints are ubiquitous, then the cash will simply circulate until it is held by someone who wants a more liquid balance sheet. (This includes paying down debt – the old law of reflux revived by Richard Koo under the name balance-sheet recession.) In this story, shareholder payouts aren’t the reason for the failure of investment to respond to tax changes (or interest rate cuts). But, along with increased corporate cash holdings, they are an important symptom.
Before moving on to the next case, it’s worth considering an alternative representation of the demand-constraints case, as in Figure 3b.
Here, the firm has some guess about the sales it can achieve in the relevant future period. If this requires more capacity than it will have (taking into account depreciation) then the return on new investment will be high. But once it has raised capacity enough to meet expected demand at a reasonable level of utilization, the return gets steeply lower. In this case, it makes a big difference whether the cost-of-funds curve crosses the expected-return curve in its horizontal or its vertical segment. In the former case, the firm is genuinely credit-constrained — it believes it could sell more output at current prices, but financing increased capacity is too expensive (or simply not possible). In this case, investment will be responsive to changes in the cost of capital, or the supply of credit on other dimensions. But where the cost-of-funds curve crosses the expected-return curve on its vertical segment, we will be in the situation of the previous paragraph, where investment responds mostly or entirely to shifts in demand and little if at all to changes in the cost of capital. To me, this is a useful framework, since it captures what seems to be a genuine feature of modern economies — financing is more likely to matter when demand is strong, or for fast-growing firms, than when demand is weak or for mature firms.
The third case is where the expected-return curve is relatively flat, but the supply-of-funds curve slopes steeply upward. This case is discussed at length by Minsky. 4 The essence of this view is that finance is not frictionless. Because of various risks, information asymmetries, or other reasons, firms cannot borrow at “the” interest rate but only at some premium above it. And the costs of borrowing are not merely the interest rate. Both borrowers and lenders face risks from debt, and for the borrower there are also the various legal restrictions (covenants, etc.) that taking on debt implies. So for the lender the effective interest rate is below the market rate, and for the borrower it is above it; and both these wedges widen as the level of debt increases. The implication is that internal funds are cheaper than external funds, that the next dollar of borrowing will be more costly than the last, and that past a certain point further funds may not be available at all.
This perspective is captured in the supply-of-funds curve in Figures 4a and 4b.5 The critical thing about this case is that while financing matters, the important shifts are horizontal movements in the supply-of-funds curve rather than vertical ones. In other words, for financially constrained firms the issue is not the price at which they can borrow so much as how much they are able to borrow. (This is even more true if we add the realistic detail that the firms’ profitability will also affect the terms on which it can borrow.) With respect to monetary policy, this corresponds to what Bernanke and Gertler call the bank-lending channel — changes in policy work not so much through moving the whole curve up or down, as in conventional models, but moving the steep portion of it left or right.
In the extreme case here, the cost of funds makes no difference to investment. But taxes and interest rates can still be quite important, because they affect the internal funds available to the firm. If external funds are not a good substitute for internal funds, then anything that allows a firm to retain more of its own funds will tend to raise investment. In a superb empirical article, Brown, Hubbard and Fazzari claim that the 1990s tech boom got a major boost from earlier tax cuts — but for this was because lower taxes left corporations with more internal funds, not anything to do with incentives.
It’s in this setting that shareholder payouts become important not just a symptom but as a problem in their own right. If shareholders exercise a first claim on the firm’s earnings, then they are no longer available as a low-cost form of finance. This case is shown in Figure 5 (adapted from my Disgorge the Cash paper) where the new dotted line shows the minimum return acceptable to shareholders – what I call the rentier constraint. In a world in which dividends are relatively constant — the assumption of Minsky’s framework — they are essentially a fixed cost; each additional dollar of earnings is a dollar available to the firm. But if, thanks to some set of legal and institutional changes, shareholders are really able to exercise their notional claim on every dollar of profits, then new investment projects will need to show a high enough expected return to justify retaining the money for them rather than paying it out. Now, investment takes place only ewhere the expected-return curve is above the cost-of-funds curve and the rentier constraint. In the situation shown, you can see that higher earnings — a rightward shift in the supply of funds curve — do not imply a greater supply of cheap internal finance, but rather higher payouts to shareholders.
It’s worth emphasizing that there are two key assumptions here. First, that internal funds are perceived as a less costly source of investment finance than external funds; and second, that shareholder payouts have shifted from relatively fixed to an effective claim on each incremental dollar of earnings. Many discussions of investment power and shareholder power, it seems to me, don’t make these points clearly enough, ignoring or leaving unstated the first, and blurring the second with the fact of higher payouts. Higher fixed payouts, in a world where internal finance is cheaper than external, will indeed reduce investment; but they won’t change the functional relationship between cashflow and investment.
On the other hand, people who want to argue that payouts are irrelevant need to explicitly challenge the assumption that internal funds are preferable to external — that they’re perceived as lower cost by corporate decisionmakers. This assumption may or may not be a good description of the investment decision at a typical American firm. But one has to actually make the argument; one can’t simply ignore it, as Cochrane and Wolfers do, and claim that payout critics are making a simple logical error.
Finally, there’s the case where both the supply-of-funds and expected-return curves are steep. At the level of the individual firm, this doesn’t introduce anything new, since the firm will only be on the steep/vertical segment of one or the other of the two curves. If it’s on the steep part of the expected-returns curve, the situation will be in the same as in the second case; if it’s on the steep part of the supply-of-funds curve, the situation will be the same as in the third case. Nonetheless, it’s worth thinking about this case if we think that, in general, there are two groups of firms. There are smaller, more rapidly growing firms whose investment is financially constrained; and there are established firms whose investment is demand-constrained. Neither group will be especially sensitive to the cost of capital. Of course, there logically might be a third group constrained by neither; but this would have to be a business without significant market power that was small relative to its market, but that nonetheless was considered a very safe risk by lenders. Probably there are some such. But it doesn’t seem unreasonable to suppose that by the time a business is big enough to face a flat cost-of-funds curve, it is normally also big enough to face a steep expected-return curve.
So we now have four cases. Case one is the Cochrane-Wolfers world of a horizontal cost-of-funds curve and a shallow expected-return curve. Case two is a market-power or demand-constraints world where the expected return curve is steep and the cost-of-funds curve is relatively flat. (It doesn’t matter in this case whether the cost-of-funds curve is perfectly flat as in the first case or slopes upward, as long as it is much flatter than the expected-return curve.) Case three is the Minsky world where the cost of external funds rises as the firm borrows more. And case four is case three, but with shareholders exercising an effective claim on each dollar of incremental funds. What is the effect of tax cuts on investment in each of these cases?
We can think of a tax cut as having two effects: it shifts the expected-return curve upward, since the firm now keeps more of the sales dollars generated by additional capacity; and it shifts the cost-of-funds curve to the right, since the firm also keeps more of the sales dollars generated by its existing capacity. The exact mix of these two effects will of course depend on the specifics of the tax cut; in the extreme case of revenue-neutral tax reform, only the expected-returns curve moves. Using the figures above, we can see the effects of these changes.
In the first case, the rise in expected returns has a large effect on the volume of investment; the flat slope of the expected-return curve means that lowering the required pre-tax return on investment even slightly means a large number of additional projects qualify. The rightward shift of the cost-of-funds curve has no effect. Since internal and external funds are perfect substitutes in this world, there is no benefit to increasing firms’ retained earnings.
In the second case, neither shift will have much effect on the volume of investment. If a firm faces highly inelastic demand for its output there is no reason to increase investment in response to a higher profit margin on sales or cheaper financing. Only increased demand — a rightward shift in the expected-return curve — will lead to significantly more investment. Without that, a tax cut will lead only to some mix of less borrowing, increased financial asset holdings, and increased payouts.
In the third case, the effect of the tax cut depends where the firm is on the supply-of-funds curve. If it can already finance all of its desired investment out of internal funds, then the horizontal shift in the cost-of-funds curve will have no effect; the vertical movement of the expected-return curve may or may not have a significant effect, depending on how steep it is. Most likely, for mature firms generating substantial profits, the expected-returns curve is steep, so this effect will be small. For firms that rely on borrowing to finance investment, on the other hand, the rightward shift in the cost-of-funds curve may lead to a large increase in investment, as it allows them to substitute cheap internal funds for more costly external funds. In this case, a across-the-board tax cut will be more effective than one that only reduces taxes on earnings from new investment.
The fourth case is similar to the third case except now the horizontal movement of the cost-of-funds curve has no effect on investment, because internal funds are no longer a source of cheap financing. Instead, empowered shareholders impose a minimum return on new investment that lies above the cost-of-funds curve some distance into the borrowing segment. In this case, again, changes in the cost of funds are not going to affect investment, since the economy-wide interest rate or equivalent is no longer the relevant opportunity cost for the corporation.
So in two cases tax cuts are likely to increase investment; in two cases they are not. But the pairs are not the same. In one case of investment-boosting tax cuts, a cut targeted at new investment will be more effective than an across-the-board cut, in the other the “badly targeted” cut is actually more effective. And in one case of ineffective tax cuts, shareholder payouts are just an incidental symptom; in the other case they are the root of the problem.
So far, I think, there is nothing here that John Cochrane would disagree with. My goal up to here is not to argue for or against any of these perspectives, but simply to clarify the key assumptions that drive different views about tax cuts and investment. I think all of us, on all sides, would do better to be more explicit about the logic of our arguments. People who think that the level of investment depends varies in a straightforward way with changes in the cost of funds and/or expected return (as from interest rate and tax changes) need to recognize that doubters are not just economically illiterate, but probably have a vision of the investment decision something like cases two, three or four here. To convince people that a fall in the cost of capital should, in general, lead to higher investment, you need to make an affirmative case that there is a large population of firms that face neither demand constraints nor credit constraints. On the other side, for people who are skeptical of these links, it’s not enough to point to econometric evidence that investment isn’t sensitive to taxes or interest rates. We need coherent stories about investment that rationalize this insensitivity, and are consistent with what else we know about the investment process. And it probably is stories, plural!6
* * *
If the world looks like Figure 5b, then most firms will be on the vertical segments of one of the two curves. Large, established firms will normally be on the vertical part of the expected-returns curve; they don’t care much about changes in expected returns or the cost of capital because they don’t expect to be able to sell additional output, or at least not without unacceptably large price reductions. Smaller, newer firms don’t care much either, because they can’t borrow more at anything like the market interest rate, or at all, so they require more internal funds (or a more tolerant attitude from lenders) to undertake even very high-return investments. One thing to note: the effect of greater market power is ambivalent here. For the first group of firms, it will limit desired investment, but in the second case it will allow more investment to be financed. It seems to me that the history of, for instance, 19th century US railroads illustrates the way in which both too much and too little competition can be inimical to high levels of investment. But again, this is only if the world does in fact look like Figure 5b.
But now I want to bring up a reason to doubt that the Cochrane-Wolfers story works even if the world looks like Figure 2, the most favorable case for it. Does a tax cut really move the curves in the required way? At first glance, the answer might seem obvious: If the tax on corporate profits is cut from, say, 50 percent to 40 percent, then the after-tax return on any project with positive earnings has now increased by 20 percent. This would be a reasonable way to think about it if we were imagining a representative wealth owner considering whether to consume their income or to invest it in some some project – if investment normally took the form of free-standing, one-off projects, that were dissolved at completion, like a long-distance merchant voyage in the 15th century.
The problem is, investment today is carried out by ongoing enterprises. It is financed not directly by contributions from wealthy households, but either by incurring new liabilities — normally debt — or else by spending down assets. And the tax cut also affects the terms of that financing. Suppose that a firm would finance additional investment by issuing debt. The interest payments on that debt are deducted from the firm’s income for tax purposes. So a tax cut raises the after-tax cost of debt payments by exactly the same proportion as it raises the after-tax return on new investment. Of course, if the expected return on the investment is higher than the interest rate faced by the firm, the effects will not exactly cancel out. But by hypothesis in the Cochrane-Wolfers world, these two rates must be very close, so the net effect must be very small. On the other hand, suppose that the firm pays for additional fund out of retained earnings. In this case, the opportunity cost is whatever earnings it would get on those funds if it held them in financial form. And these earnings are also benefiting from the tax cut, so again there the opportunity cost rises by just as much as the after-tax return on new investment does. And Cochrane’s money-flows-to-returns assumption implies that firms’ earnings on cash should not be much lower than the marginal return on new investment. In which case, again, the tax cut effectively shifts the cost-of-funds curve up by nearly as much as the expected-return curve, meaning there is no reason for investment to respond either way.
It’s easy to come up with reasons why these counteracting effects won’t apply. If the subjective cost of borrowing to corporate management includes substantial elements beyond the interest rate itself (because of the danger it creates of loss of control, because of covenants and other legal restrictions, etc.) these other elements will not be affected by the tax cut, so the effective cost of funds will rise by less than the expected return. Or, if the firm holds cash at returns substantially below the expected returns on new investment, then the tax cut will raise the opportunity cost of spending cash by less than it raises the expected return. Both these claims probably have an important element of truth. The problem is, you have to believe them consistently. If you think a firm’s cost of borrowing may be much higher than the market interest rate, or that firms hold large amounts of cash at less than the market interest rate, then you’ve landed squarely in Minsky world. Here pervasive financial frictions mean that the investment decision is no longer a straightforward matter of comparing a smoothly declining expected-return curve to an economy-wide cost of capital.
Another way to think of this: The Cochrane-Wolfers vision is a set of investment projects with smoothly declining expected returns, with the firm picking every investment project with expected earnings above the economy-wide cost of capital. In this framework the investment decision is not going to be affected by taxes on income from projects that earn above the cost of capital, which is what a corporate income tax does. The marginal project will be exactly the same whether the firm keeps 100 percent of the income from infra-marginal projects or only 10 percent of it.
This might seem obvious. I think one reason it’s not as obvious as you think, is the ambiguous meaning of “profit” in economics. In both everyday and business usage, profits are income in excess of all costs of production, including costs incurred for the use of capital goods — interest and depreciation. But in economic theory, profit is used to mean the payments to capital, just as wages are the payments to labor. Models are set up in terms of the rental price of capital. The vision is of a world in which the current services of capital are paid for in each period just as the current services are paid for with a wage. The payments to capital are normally labeled profit. This leads to various (hopelessly confused, in my opinion) efforts to separate out the rental payments in this notional market for capital services from the profits we observe in the data. More to the current point, it leads economists to think of a tax on profits as a tax on capital. If there really was a market for capital services, and the corporate income tax really was a tax on purchases in that market, then the link between corporate taxation and investment would be as straightforward as Cochrane suggests. But in the real world there is no such market, and the corporate income tax is not a tax on purchases in that nonexistent market. This is one of many cases where what economists justify as a convenient simplification gives rise to very misleading intuitions.
So it seems to me that if you want to make an argument for the investment-boosting effects of tax cuts, the strongest one would be based on the exact opposite of Cochrane’s premise: Tax cuts work not because capital freely flows to wherever the return is highest, but precisely because it does not do so. Higher investment may require higher cashflow for the firms that themselves will be doing the investing. This a corporate tax cut could deliver.
I think this argument would also be more consistent with the evidence. In this post I’m just trying to lay out an analytic framework. But for what it’s worth, my read of the empirical literature is that it is very hard to find evidence that investment responds much, or at all, to shifts in returns or the cost of capital. There is more support for the idea that some firms — including younger and rapidly-growing firms whose investment is plausibly especially socially valuable — do sometimes face credit constraints. Implying you can raise investment not by changing incentives, but just by handing the constrained firms money.
UPDATE: I had thought I’d based these figures on Minsky and was a bit puzzled that I couldn’t find them in the obvious places. But it turns out I actually got them from Hubbard, Fazzari and Petersen (1988).
 |
- It’s enough that the people making the investment decision have some subjective beliefs about these values – they do not have to exist in reality. More precisely, it’s enough that there are projects that managers will undertake when funds are readily available, that they will not undertake when funds are more costly. And if not, fine, then the curve is vertical. As will be seen, I am not making any assumptions about the shape of the curves.
- Cochrane walks this back a bit later on: “Let me also quickly grant that there are second-order effects and frictions. Perhaps due to ‘agency costs,’ internally generated cash is a cheaper source of investment funds than cash obtained by issuing stock or borrowing. In that case, financing decisions do matter. Tracking down this sort of thing is what makes economics fun. But good economic analysis always starts with the relevant budget constraint or neutrality theorem, and then adds the frictions. Neither Ms. Guthrie nor Ms. Noonan had such a second order financing friction in mind.”
This is an interesting passage for two reasons. First, because Cochrane, who is both a very smart person and a close observer of finance in the real world, is well aware of the tensions between his finance-doesn’t-matter view and the concrete phenomena he is trying to explain. But second, because this passage gives an admirably clear statement of a key part of “thinking like an economist.” One must never start from the concrete phenomenon. One must always start from the “general” case, i.e., the one particular model used by academic economists.
- A cynic might say: It’s certainly convenient for the masters of finance to be able to argue that money is cheap and abundant when they’re taking it out of businesses, and that it’s valuable and scarce when they’re putting it in.
- The fact that Minsky used diagrams like this will, I hope, mollify some of my brethren in heterodoxy who might say that the whole supply-demand apparatus is illegitimate.
- In Minsky’s original version there’s a second step where debt finance is exhausted and the firm turns to equity finance. I don’t think this makes sense for most US firms today.
- Another set of explanations, outside of this scope of this post, is various reasons that an increasing fraction investment-like activities from the point of view of the firm don’t show up as investment in the national accounts. This includes spending on intangible assets that don’t show up in official investment measures, investment overseas, etc.
These micro stories clarify my thinking around corporate taxes and stock buybacks.
One quibble: “technology” can indeed explain a downward-sloping expected return curve (in Figure 1). When a firm like Starbucks decides whether to invest, they presumably consider the profitability of their marginal establishment. Although every establishment uses the same coffee-serving technology, establishments earn different profits because each establishment is a different location with different populations, tastes, infrastructure/technology, and competitors. I suspect these factors constraint the number of Starbucks much more than “entrepreneurship”.
Sorry, I wasn’t clear. I was trying to explain why you can have a downward sloping expected returns curve even in the absence of market power. Part of starting with the most orthodox story. I agree your story is more realistic.
“The natural way to think about this, as an economist, is in terms of two curves – one the expected return on each incremental dollar of investment, the other the cost of each incremental dollar of financing. If the firm is maximizing profits, they will pick the level of investment at which these two values are equal. Even if they are not strictly maximizing (expected) profits, the analysis doesn’t change in any fundamental way – we can just think of a region around the intersection instead of a precise point. Investment is still more likely to proceed when the expected return is high relative to the cost of funds as perceived by the decision maker.”
It’s been a long time since I thought about such things in any depth. So I have an elementary question:
Does “expected return on each incremental dollar of investment” refer to the expected return on common equity capital?
Does “the cost of each incremental dollar of financing” refer to the cost ( or “hurdle rate” ) of common equity capital?
I fear but expect that the answer to at least one if not both of these questions is no.
Which would be weird also, because that’s how investment decisions are made.
I was conceiving expected return as dollar of (appropriately discounted) earnings per dollar of capital expenditure. But sure, it could be percent of equity expected earnings per percent of equity capital outlay.
I admit I don’t see how this would change anything, given that equity capital is not a decision variable for the firm. Still, I’m happy to stipulate that any numbers on the axes will be in units of percent of common equity capital, if that makes you happier.
I feel like I’m missing your point somehow.
I’m trying to relate those economic curves to an idea of real world finance.
Consider the cost of funds curve:
Suppose a firm has the option of using retained earnings for investment – as opposed to distributing RE to shareholders via a share buyback. In the first case, that firm would project its balance sheet and income statement to take into account the full capital structure that it wants to back up such an investment. Very firm firms would default into a pure equity financing choice – which is what the exclusive use of retained earnings would imply. Many firms would issue debt on top of retained earnings – in order to optimize the use of leverage. Leverage properly used is prudent financing in the interests of delivering returns to shareholders. Such a balance sheet projection then produces a return on equity that presumably meets the hurdle rate for acceptable capital projects. Firms don’t simply use retained earnings alone to fully fund new capital projects. They actively manage the capital structure of their balance sheets. Retained earnings is one input to that process. There is more.
I think the consideration of the two choices includes an asymmetry of balance sheet choices and outcomes. Buying back shares is an easy balance sheet simulation. The firm simply uses the liquid cash it has built up to buy them. No other changes are required, because cash is risk free. It’s been diluting equity returns but that’s why the buyback choice has a purpose. Using retained earnings for investment is more difficult. The full balance sheet projection in almost all cases would include capital structure assumptions that incorporate more than just the retention of earnings – i.e. the possible issuance of debt as well. In other words, “internal funds” as a source in this context are internal equity funds from retained earnings. Yet the investment choice in full typically includes more than just the internal equity funds that can otherwise be jettisoned cleanly in the case of a share buyback.
So I don’t know how the cost of funds curve in the economic diagram translates to that sort of choice. And so far I can’t make any sense out of such a cost of funds curve concept unless I translate it to a hurdle rate for the cost of equity capital. The target capital structure in full (which almost certainly includes some evolution of the debt structure in addition to the retention of earnings) then lies beneath that representation in the assumptions underlying the cost curve.
If you don’t disagree with all that, then perhaps it is implicit in the economic diagrams.
But I’m having trouble discerning that.
Once again:
“The natural way to think about this, as an economist, is in terms of two curves – one the expected return on each incremental dollar of investment, the other the cost of each incremental dollar of financing.”
I don’t know what “incremental dollar of financing” means. Because, whether firms use retained earnings or external equity financing, the decision to invest typically includes more than the cost of equity financing, and more than just incremental equity financing.
And I find this confusing:
“First, cheaper finance (lower interest rates, for example) shifts the cost of funds curve downward … In this framework, vertical movements in the curves represent price changes – the price of additional funds (measured as an interest rate or equivalent)”
I find it confusing because of the reference to interest rates and the lack of reference to the cost of equity capital. But all this said, I imagine I’m missing something pretty basic in term of the way these problems are typically framed in economics as opposed to finance. And perhaps my question can be assumed away because of this. But for now, I can’t get past this in trying to absorb the more interesting content of the argument. Otherwise, I find the post well written and interesting. I also find Cochrane’s piece interesting.
Quick thoughts – as I said, its been some time since I thought about this sort of thing. Maybe I’m not making total sense because of that.
SO helpful. Thanks. (And without saying it quite explicitly, shows how childishly simplistic Cochrane/Wolfers are in their “it’s obvious”isms. They actually don’t even understand what they’re saying—or are being intentionally obtuse by assuming Figure 2 and ignoring the true, larger picture depicted so well here.)
This is on par with SRW’s great five-part series on potential pareto.
One slightly peripheral item that really helped me: the muddled confution of firm profits and “payments to capital”—the latter being incoherent IMO cause it really means returns to owners/ownership/wealth. Marx continues to plague our thinking.
(Ducking…)
Thanks.
Reading this, I realise that I take for granted that most if not all businesses are demand constrained, however I’d say that the opposite option is nonsensical:
“This is the case for a firm that faces perfectly competitive markets both for its output and for funds. It can sell as much as it wants to at the going price…”
The idea that in a perfectly competitive market a firm can sell any quantity of stuff at the prevailing price is IMHO bonkers. I’m quite sure that any shopkeeper would be delighted to know that, in a situation of perfect competition with other shopkeepers, whathever quantity of stuff he buys he can be sure to sell at the prevailing price, just because.
My understanding is that pricing goes this way: I buy/produce a certain quantity of items, each item having a cost of X to me. I then try to sell adding a markup of Y. The higher the Y, the higher unitary profits, but the lower quantity of sales.
I’ll try to get the correct Y that maximizes total profits. Since total profits are (quantity of sales) * (unitary profits), it follows that I will also pick a certain quantity of produced stuff, and, as to increase that quantity I have to lower unitary profits, I’m not going to invest in more capital equipment (with the purpose of increasing the quantity of stuff produced) unless I expect demand to go up too.
My understanding is that the difference between more or less competitive markets is that in a market with small competition players don’t try to undercut each other with price competition, so the optimal Y will be high, whereas in more competitive markets sellers are supposed to undercut each other more or less to death, which would lead to a very low optimal Y (actually to an Y of 0, so obviously market cannot be perfectly competitive otherwise there would be no profits).
But I really don’t understand what has perfect competition to do with the quantity of stuff produced, since in both cases firms are demand constrained: in small competition because, to increase sales, they would still have to reduce Y so that total profits would fall, in perfect competiton they are in the same situation and in addition Y is already close to 0, so they can’t sell more stuff even if they wanted.
So I think that a tax cut can increase investiment only to the degree it increases aggregate demand.
However a tax cut on profits could keep employment up also in the case that we somehow misprice the cost of business, so that what is taxed is gross profits instead of net profits (for example if businesses are forced to buy more modern capital because of competition, in addition to the devaluation of their own capital). In this case, some businesses that appear in the green but in reality are in red could be in the green again with lower taxes, thus keeping employment high, not because of new investiment but because firms that are failing (negative net profits) at a certain tax rate are kept afloat at the newer tax rate.
Apologies if this is a tangent, but had to reply to this on how producers set prices.
I may not be representative, but as an entrepreneur (with a partner in my biggest biz who was a finance/econ major), we were constantly if not in so many words trying to suss out the demand curve we were facing, and base prices on our (largely intuitive) sense of that.
If you can raise your prices by 10% with no loss of sales, that 10% is pure, cash-in-your-personal-bank-account profit. The incentive here is incredible. I don’t think we were unique in perceiving that, or in setting our prices based on that.
The problem is that it’s almost impossible to know the demand curve. You can see some prices and quantities out there for similar products, hold up your thumb and squint at your past prices/sales, but…
And very few business can test price. You just have to choose one based on what your competitors are charging, what you know about your customers, past experience, etc. etc. And find excuses to discount/price-discriminate, working your way down the demand curve if you’re not selling all you could be.
Even that biz of ours, which was obsessively analytics-, direct-mail driven, eg tracking promotion costs vs customer lifetime values over many years — we tried A/B testing price a few times (print multiple brochures with different prices, track everything as well as you can…). But 1. You still only see a few points on the demand curve, often with very limited statsig, and 2. as soon as your product changes slightly, or market conditions change, you have to do it again. The curve’s always changing.
I deeply envy (and resent) Amazon. Their ability to test the demand curve, base prices on it, product by product. Plus do real-time, per-customer price discrimination…
“If only some firms are in the position of Figure 3a, then the paid-out or lent-out cash flow will eventually make its way to the firms that face a flatter expected-returns curve. But if market power and/or demand constraints are ubiquitous, then the cash will simply circulate until it is held by someone who wants a more liquid balance sheet. (This includes paying down debt – the old law of reflux revived by Richard Koo under the name balance-sheet recession.) In this story, shareholder payouts aren’t the reason for the failure of investment to respond to tax changes (or interest rate cuts). But, along with increased corporate cash holdings, they are an important symptom.”
Either way, these arguments track the eventual use of the cash purportedly freed up by increased profits due to the effect of the tax cut.
But it should also be remembered that at the macro level the tax cut is offset by increased bond issuance (other things equal), totally absorbing the aggregate cash otherwise created by the increased deficit.
It should also be remembered that at the macro level the tax cut is offset by increased bond issuance (other things equal), totally absorbing the aggregate cash otherwise created by the increased deficit.
Yes. The post was focused on the micro (firm-level) logic. This is part of the macro story, which would be the subject of a hypothetical followup post.
It is striking that someone like Cochrane is happy to totally ignore the additional government borrowing implied by the tax cut. There are reasonable perspectives in which changes in borrowing by the federal governmnet have no implications one way or the other for financing conditions for private units; but I’m pretty sure Cochrane wouldn’t say this in other contexts.
Will reply to your other (very helpful) comments in a bit.
@JKH: “at the macro level the tax cut is offset by increased bond issuance”
From the perspective of change in total private-sector balance-sheet assets, the bond issuance is pretty immaterial.
Assuming unchanged spending, the tax-cut-hence-deficit results in 1. more private-sector “cash” assets, and 2. a private-sector portfolio that’s “overweight cash” (assuming unchanged portfolio preferences).
Treasury then swapping newly-issued bonds for cash (which as you say, it “absorbs”/burns) also affects the PS portfolio mix (#2), but it doesn’t “offset” #1. The private sector has more assets and (since def spending adds no private-sector liabilities), more net worth.
The idea that internal funds are cheaper than external funds is called the “pecking order” theory in financial economics. I don’t know the history of it, but the usual explanation (from Myers-Majluf 1984) is in terms of information asymmetry, rather than liquidity preference. The same story fits venture capital, since venture capitalists have lower information asymmetry than a retail investor — they can just show up at the workplace and look around. There’s a whole academic field, known as “corporate finance”, dedicated to looking at questions like this. It’s well-understood that many firms are financially constrained, that Miller Modigliani doesn’t hold, and looking at how firms decide to invest and how they fund it is a subject of active research.
Here’s the thing — there is no way that John Cochrane doesn’t know this. It’s not his research area, but I would guess that over half of financial economists are in corporate finance.
Of course you are right. This post certainly will not tell Cochrane anything he doesn’t know. I think this is an intereting illustration of how economics discourse works. You go from Cochrane saying that we should always start our analysis from Modigliani-Miller, even tho we know it doesn’t hold, and then add frictions/constraints etc; to Wolfers in effect saying that Modigliani-Miller is a correct desctiption of the facts. The esoteric version of the theory is it’s a radical simplification that we adopt as a starting point for analysis. The exoteric version is that it is just true. It’s the same as Krugman on trade.
You might find this article about capital investment, cash flow, and reinvestment options (vs repurchase of shares or distribution of profits to owners) of interest even though it does not specifically discuss the impact of taxes on investment decisions:
http://basehitinvesting.com/buffetts-three-categories-of-returns-on-capital/
The article uses a letter by Warren Buffet to classify three types of investment which consume cash to generate future cash flows for further investment.
I’m not familiar with the Minsky fixed dividend business, but it seems like an artificial construct. Moreover, it seems to me that the “rentier constraint” is a standard feature in real world finance. Firms have some sense and often a specific objective for the kind of ROE that they want to deliver to shareholders. This really becomes the firm specific cost of equity capital. In different years, they may exceed it or fall short. I think it gets pretty mushy when trying to relate this to an “economy wide” cost of capital. It is of course, a function of balance sheet structure and credit risk, which goes to the Minsky theme more generally and is the reason why we have diversified capital markets with highly developed credit risk assessment.
I think firms assume/state a firm-specific cost of equity capital and this becomes the effective cost of capital curve – or line. That curve – or line – can change from time to time as a matter of policy. The question is whether investment projects generate an expected return than meets or exceeds that hurdle rate.
Something not in your piece is the nature of the academic finance theory around cost of equity capital – theory which in itself I think is bit mushy when compared to the observable cost of an interest rate. Using things like the capital asset pricing model (as I recall). This is far different than an observed interest rate. It is much more interpretational than observable. That’s what I mean by “mushy”.
Again, I think the cost of capital that matters here is the cost of common equity capital, and that the cost of the interest rate slips in via back door of that calculation – in the case of both internally retained equity capital and newly issued equity and the associated capital structure in full assumed in both those cases. Although the firm may choose to issue debt in order to finance an investment – instead of passing on that opportunity and buying back shares with excess capital – it is not the interest rate on the debt that should be used on the cost of capital curve in my view. It should still be the return on common equity hurdle rate. This is what I mean by asymmetric – the decision at the margin may well be between buying (back) equity versus selling new debt (and retaining equity) – with the resulting capital structure aligning according to the resulting asset risk in both cases. So the cost of capital curve should be clear on which cost of capital it is. It obviously shouldn’t mix up the cost of common equity and the cost of debt.
Maybe I belabor this point – perhaps it is implicit in what you’ve written.
One other point – the differential cost of external equity finance versus internal equity finance can be observed in one way through the discount to market price that is typically involved in new equity issues. Although – this is fleeting stuff – the stock market could be up a week later and down again a year after that.
Cochrane’s basic idea seems to be that the effect on after-tax investment returns dominates the effect on after-tax retained or distributed earnings. That seems valid enough. But he expresses this in a somewhat questionable, even contradictory fashion:
First, he suggests or at least describes that the earnings created are some kind of hot potato money looking for investment:
“Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.”
That logic is brittle. The firms that do the investing create a financing requirement – be that in the form of internal funds or external funds. If external, the financing obviously doesn’t have to depend directly on what has been distributed by other firms that have done share buybacks as a result of the tax cut. Things are a lot more complex than that. In fact, the first order macro connection is that all earnings directly created by a tax cut are matched by the issuance of government bonds to finance the associated increase in the government deficit. The aggregate money supply effect of the tax cut and increased earnings is nil because of this, other things equal. So there is at least no aggregate hot potato money effect directly resulting from share buy backs, as he seems to describe. It’s all a redistribution of existing money after taking into account the required government deficit financing. There is an immediate private sector net wealth effect, but it is represented at the macro level through financial wealth held in the form of government bonds. The distribution of retained earnings and share buybacks merely rearranges the existing aggregate money supply that is kept in check through government bond financing required by the tax cut. In fact, it is the knock effect of tax cuts on new investment that results in new saving and wealth – investment creates saving – and that is in addition to the private sector saving effect created by the increased government deficit. This is a type of multiplier effect.
And this is a kind of contradictory statement:
“The larger economic point: In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by “giving companies cash” which they may use, individually, to buy new forklifts, or to send to investors.”
Of course investment has to do with financial decisions. If firms want to make an investment, they have to think about how to finance it, whether through available retained earnings or otherwise. Somebody must use cash to invest or obtain cash in financing investment. I think the correct point to be made really is that not all investment must be financed directly by the retained earnings of the firm doing the investing – not that investment has “nothing to do” with financial decisions. Perhaps that’s being picky, but his description is a tad too hot potato monetarist to ring accurate.
Nice paper by Minsky – it boils down to a discussion of finance, banking, leverage, and the Kalecki profit equation. The Kalecki profit equation is a twist on GDP equals income. Investment is a component of GDP and profits are a component of income. Strip out the noise by “heroic” assumption and you have the relationship as seen in an expansion. The greats who made the big contributions (Keynes, Kalecki …) depended on accounting and finance as subsets of economics. Apparently mainstream academy still hasn’t learned the lesson.
(interesting language – financing veil versus bartering veil)
“The implication is that internal funds are cheaper than external funds, that the next dollar of borrowing will be more costly than the last, and that past a certain point further funds may not be available at all.”
Not trolling – just adding thoughts on an interesting post that has puzzled me inordinately.
I think it would help to be quite precise on what you mean by the cost of funds. The only way I can make sense of it is if the cost of funds means weighted average cost of debt and equity capital. Then, it may make sense to speak of the case where internal funds may be cheaper than external funds at the margin. But it makes no sense to speak of a case where internally generated equity is cheaper than external debt at the margin.
JKH-
Apologies for my very slow response to your very thoughtful comments.
Does “expected return on each incremental dollar of investment” refer to the expected return on common equity capital?
I don’t think this matters for the argument being made in this post. You are considering an outlay of x dollars — on a new Starbucks outlet, on a new container ship, whatever. You have some belief about y – the additional dollars of revenues, net of operating costs, that this new sset will generate. The ratio of x to y is what matters, and that will be the same whatever units we measure them in.
If there’s a reason that an analysis in terms of return on equity will yield a different result than in some other terms, I’d like to hear it.
that’s how investment decisions are made.
This is an interesting question. I defer to your expertise, but I’m not convinced that it’s always the case.
it seems to me that the “rentier constraint” is a standard feature in real world finance. Firms have some sense and often a specific objective for the kind of ROE that they want to deliver to shareholders.
Right. My argument is that this is a change from the situation in the 1940s-1970s. I’d also suggest that the degree to which this is the binding constraint on investment depends on the concrete relations between shareholders and management. Do you think this is how Elon Musk approaches investment decisions?
I think firms assume/state a firm-specific cost of equity capital and this becomes the effective cost of capital curve
Right. The relevant question is, (how much) does this cost vary with the level of investment? The orthodox view is not at all — the line is flat. Minsky says no, it rises with the level of investment. Everyone agrees that investment projects are undertaken only if the expected return exceeds that cost.
Something not in your piece is the nature of the academic finance theory around cost of equity capital – theory which in itself I think is bit mushy when compared to the observable cost of an interest rate.
It’s not explicitly there. But again, I’m just saying in a very general way that there is a cost of capital. Obviously this is a huge issue in the academic finance literature. My impression — and I’m happy to be corrected — is that that literature doesn’t have much contact with the way these decisions are made in practice.
I think the cost of capital that matters here is the cost of common equity capital
Here I think we disagree. But tell me: how is this operationalized? How do we observe it in practice?
here is at least no aggregate hot potato money effect directly resulting from share buy backs, as he seems to describe. It’s all a redistribution of existing money after taking into account the required government deficit financing.
Agreed. The macro story is much less favorable to Cochrane than the micro story discussed here.
Of course investment has to do with financial decisions. If firms want to make an investment, they have to think about how to finance it, whether through available retained earnings or otherwise.
This is the whole point the post is trying to make.
I think it would help to be quite precise on what you mean by the cost of funds. The only way I can make sense of it is if the cost of funds means weighted average cost of debt and equity capital.
Fundamentally what I mean is the subjective cost to the relevant decisionmakers. I certainly take your point that, in reality, a corporation doesn’t simply reduce its cash holdings or increase debt by the amount of investment, but makes a more complex set of balance sheet adjustments. The assumption here, which may or may not be defensible, is that we can reduce that to a single number, which I am calling the cost of funds. Where we may disagree is on the extent to which it’s useful to think of this number in terms of the cost of equity.
Thanks for responding.
You may be right that the common equity perspective doesn’t matter for the generality of the analysis you present. Perhaps I am too much into the weeds of finance. I think your framework is logically constructed. But there are a couple of points on which we seem to disagree, and which may be relevant to the case for the common equity perspective.
My own approach to this sort of thinking starts from a bank-centric framework, which results from experience. But I think this can generalize to a broader case of reasonably sophisticated non-bank corporations.
In the case of banks, capital management has been highlighted since the first Basel regulations in the late 1980’s. Since then, big banks in particular have developed highly analytic approaches to both capital adequacy and disciplined cost of capital assumptions. And they are pretty transparent about how this translates to shareholder expectations for return on common equity. Just run through the risk management section of any big bank annual report. Capital adequacy, risk weighted capital requirements, and target returns are all prominent. I expect this sort of framework translates to reasonably sophisticated risk management systems in non-bank corporations with an equal emphasis on shareholder returns.
Partial responses to several points you raise:
Expected ROE is in fact “how investment decisions are made” (i.e. asset allocation decisions) in the case of big banks and I expect others. ROE number crunching is central to such decisions. And indeed it really is the case that the literature “has contact with the way these decisions are made in practice”. Those people charged with framing the cost of capital conceptual approach within large banking organizations incorporate key elements of finance literature as inputs to their cost of capital and ROE hurdle rate proposals – along with additional “real world” considerations of course. The academic literature is definitely an input (e.g. CAPM, Sharpe, etc. – and/or more recent updates of such models). Such academic models are taken in stride, of course. The staff would be thrown out of the room if academic purity was presented to excess in making the proposal for an appropriate cost of equity capital assumption. Yet such an assumption is always built into the overall risk management framework in such institutions. So it requires a disciplined intellectual process. Finally, the cost of common equity capital is operationalized and observed in practice roughly as I have suggested. It is observed as central to an extensive analytical framework used to allocate of capital to risk, to define the required hurdle rate on such capital, and then to measure the ROE actually achieved business by business within the bank. And this is all done by necessity for common equity capital because common equity calculations by their nature subsume other assumptions and calculations above the line.
I note this system perspective in the broader context of your post largely because of the question of share buybacks. Bank share buybacks are consummated with what has been formally designated and temporarily positioned on the balance sheet as excess capital – including a formal assignment of the excess capital to the risk free assets it is presumed to fund (by process of elimination since all other capital is assigned to risk assets).
The existence of excess capital and its corresponding allocation as funding for risk free assets must be in place before a share buyback can be executed. Those risk free assets can be sold (e.g. treasury bills) or used (e.g. existing balances at the central bank) in order to fund the buyback. The ultimate reason for share buybacks is that the bank can’t identity prospective risky assets that would generate the target ROE. Again, I imagine a comparable process in non-bank corporations of threshold sophistication.
Perhaps all this is obvious.
But I include it because you frame a comparison between the cost of internal funds and the cost of external funds. I think the important point here is that internal funds are de facto equity funds. I think the internal/external continuum requires consistent framing for the type of funds under consideration. What I have suggested so far is that the cost of funds might represent equity funds and the relevant cost of funds must be the cost of common equity capital.
What is not consistent is a cost of equity capital (internal funds) that jumps discontinuously to a cost of debt (external funds). This comes to mind when I read some of the language in the post. Where I get stuck on your analysis is the inflection point where internal funds are exhausted and external funds start and where the corresponding costs of funds stop and start as well – that being part of the process of identifying sources of funds and making go/no go decisions around that inflection point. For example, I do not understand how an internal cost of equity can suddenly flip to an external cost of interest paying debt at that graphical inflection point. Yet this is what I infer from reading some of the language in the post, understanding that internal funds can only be equity funds.
Again, I don’t think you can overlook identification of the type of funds and the corresponding cost of funds along with associated balance sheet adjustment when constructing a coherent cost of funds curve. It seems the post defaults into an interest rate proxy for the cost of funds in the case of external funds, which is obviously different from a cost of internally generated equity funds. And the cost of internal equity is what is most relevant in choosing whether or not a share buyback is preferred to a new investment project.
There is an alternative to the cost of common equity assumption for the cost of funds curve. It could be constructed as the weighted average cost of capital (i.e. the weighted average cost of the entire liability and equity side of the balance sheet). But in both cases there should be embedded the assumption that the capital structure of the balance sheet should be kept on target – i.e. that capital adequacy and leverage ratios be kept consistent with those assumptions made when establishing ROE hurdle rates. So it still comes back to the question of ROE.
In fact, the case of using internal equity to invest in risky assets requires funding such assets with a combination of available internal equity and assumed new external debt – in order to keep capital structure on target and consistent with the ROE hurdle rate and associated capital requirement assumption (and corresponding leverage permission/assumption). For example, a bank would never allocate internal equity to a new investment project requiring less than a 100 per cent equity capital underpinning. Instead the bank would project and manage a more general balance sheet expansion that includes new debt (and/or deposits in the case of banks), which is what allows the bank to leverage excess equity capital into an investment project of larger scale than the actual excess equity capital position. (Perhaps your Minsky graph update alludes to something along these lines.)
Maybe this is all obvious too.
An underlying capital structure assumption can be made continuous in such a cost of funds curve – whether it represents the cost of common equity or the weighted average cost of capital. And when the graph inflects from internal to external funds, it must retain its definition – either the cost of common equity (internal and external) or the weighted average cost of capital (with external debt raising assumption throughout the curve.) It can’t flip from pure internal funds (cost of equity capital) to debt and retain a consistent meaning.
In the case of internally generated excess equity capital, the decision to invest or buy back shares must be made under the discipline of a coherent analytical framework, given that excess capital lays fallow before such a decision can be agreed and implemented, generating a negative margin between risk free asset revenue and the presumed cost of equity capital. That’s a drag on overall ROE. The purpose of either investment or a share buyback is to put an end to that ROE drag.