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Baker Source: The Review of Economics and Statistics, Vol. 55, No. 4 (Nov., 1973), pp. 503-507 Published by: The MIT Press Stable URL: http://www.jstor.org/stable/1925675 . Accessed: 10/01/2014 15:04

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Samuel H. Baker *

T

HIS studyinvestigates the effectof finan- Hall and Leonard Weiss (1967) found that

equity/assets, which is inversely related to leverage, had a significantly positive effect on profits on equity when market structure conditions were held constant.4 They noted, ". . . a possible after-the-fact explanation is that relatively profitable firms take some of the exceptional returns in the form of reduced risks." (1967, p. 328.) Thus profitability may affect leverage, and leverage may affect profitability. On grounds that the direction of causation between leverage and profitability may run in both directions, this paper develops and tests a model consisting of two equations, one explaining industry profitability in terms of the usual market structure variables plus leverage and the other a new equation incorporating risk variables to explain leverage. I Components of the Model The two-equation model and its elements are: R f (L, F, K, C, E, G) (1) L g (R, F, P) (2) where R = average after tax profit rate of the leading firms in an industry over a ten-year period L = average leverage measured inversely as the ratio of equity to total assets for the leading firms in an industry over a ten-year period F = cost fixity K = absolute capital requirements C = four-firm concentration

'Hall and Weiss were primarily concerned with the effect of firm size on annual profit rates in a model that also included as independent variables an equity asset ratio (which we utilize), an industrial concentration ratio, a measure of growth in industrial output, and year dummies. When they utilized class interval dummies to allow for the influence of concentration, profits on equity and equity/ assets were negatively related. Richard Caves provides an interpretation of these results (1970, p. 289). The concentration dummies used by Hall and Weiss may have served as proxies for instruments correcting for simultaneous equation bias by "soaking up" industry effects.

cial leverage, or relatively greater use of debt capital, on industry profitability. Recently at least two cross-section studies have yielded the surprising result that systematically higher rates of return are earned by firms with relatively low leverage. Measuring leverage inversely as the ratio of equity to assets,' one would expect the rate of return on equity and this ratio to vary in opposite directions, lower values of equity/assets and the associated riskier bond intensive capital structures implying higher equilibriumprofit rates, ceteris paribus.2 But so far the evidence has gone the other way. Fred D. Arditti (1967) calculated expected profit rates for firms as a geometric average of past rates of return and regressed this variable on the ratio of debt to equity.3 His measure of leverage appeared with a negative sign in all of his regressions. And in a paper dealing with the determinantsof firm profitability, Marshall

Received for publication November 20, 1972. Revision accepted for publication April 19, 1973. * Roger Sherman and a referee contributed significantly in commenting on earlier drafts. Of course, any remaining errors are my own. Financial support in the form of a Faculty Grant from the College of William and Mary is acknowledged. 1Leverage commonly refers to the magnified effect fluctuations in total earnings have on a firm's common stock income due to fixed payments to bonds and preferred stock. Thus, high leverage refers to a relatively high proportion of debt which raises average return to owners while increasing the risk of financial problems. The choice of a leverage measure here is based partially on precedent (Hall and Weiss, 1967). 2Utilizing I. N. Fisher and G. R. Hall's definition, risk is ". . . the inability to predict the outcome of a forthcoming event with complete certainty" (1969, p. 80). In general, differing risks at the industry level can be expected to lead to differences in observed or actual rates of return among industries since ". . . capital . . . is transferred from low-return, high risk activities to high-return, low-risk investments until an equilibrium, characterized by a set of risk premiums reflecting differences in risk exposure is achieved" (Fisher and Hall, 1969, p. 84). 'In that part of his paper of particular interest to us here, Arditti examined the effect a firm's financial policy on its rate of return based on dividends in common stock prices over time. His financial variables were a dividend payment rate and leverage measured as the ratio of equity at market value to debt at book value.

[ 503 1

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504

THE REVIEW OF ECONOMICS AND STATISTICS correspondingpotentially high profit risk may, ceteris paribus, tend to choose financial structures that are relatively less risky (i.e., high values of equity/assets). Equation (3) demonstrates that profit risk also is a function of output variance (o-,2) (q2). The usual profit maximization model can be utilized to demonstrate that profits and output move in the same direction for changes in demand and cost conditions.5 However, this model implicitly assumes that any shift in demand or cost parametersis unanticipated. For, if all firms knew now the extent of a demand or cost change next year, they might be able to eliminate any potential profit rate change by the adjustments they would make now. However, a firm's profit rate and the deviation of output from its predicted level still could be expected to move in the same direction. We shall try to capture a measure of output predictability in the trend effect obtained as the adjusted coefficient of determination (P) when we regress industrial output on time.6 Output predictability is an admittedly naive measure of the extent to which changes in output are anticipated, a high value of P indicating that industry output is relatively predictable or that the associated oTq2 in equation (4) is low. That is, output predictability is inversely related to output risk if we define risk as the unpredictability of future outcomes.7 In equation (2) we would expect equity/assets (L) and output predictability (P) to be negatively related. Firms in industries with relatively low values of P, and with the associated unpredictable output fluctuation, may issue less debt because they face a greater risk of not having earnings every period with which to pay fixed financial charges. Conversely, firms in industries with

E = economiesof scale relative to marketsize G = growthin industryoutput P = outputpredictability. Risk variables and market structure variables will be discussed in turn. Cost Fixity and Output Predictability Examination of the leverage variable for the major firms in our sample of industries indicates that firms in the same industry tend to have similar amounts of leverage. This observation suggests that industry conditions play a role in determining the leverage ratios firms select. Since a firm's leverage choice carries with it a financial risk choice, this decision may be influenced by demand and cost risks in its industry. Roger Sherman and Robert Tollison (1972) utilize a measure of cost risk, short-run total cost fixity (or variability) that depends on the

inflexibility of ". . . technology together with

the relative prices of variable inputs" (p. 450). Technology is inflexible if relatively large amounts of time are necessary to adjust optimally to an input mix and scale when changing output. Technology tends to be inflexible as fewer inputs are variable in the short run. Cost fixity will be high when technology is inflexible, so long as relative prices and quantities of variable inputs are such that total variable cost is a relatively small fraction of total cost. Thus, cost fixity is inflexibility of total cost in response to output changes. Shermanand Tollison show that, since profit (-r) equals total revenue (pq) minus total variable cost (vq) and net of fixed cost, the variance of profit can be written as

2 = (p-V)2o(q2

(3)

where G-q2 is the variance of output. In equation (3) for a given oq2, the variance of profit 5Profits (7) can be represented as r = S(Q,a) - C(Q,b) will be larger as (p- v) is larger or as costs where total revenue, S(Q,a) is a function of output (Q) that do not vary with output are larger (i.e., and a demand shift parameter (a), and total cost C(Q,b) as we have higher total cost fixity). Given the is a function of output and cost shift parameter (b). Taking partial derivatives with respect to a and b of the familiar assumption that investors are risk averse, dif- profit maximization condition, 37r/DQ = DS/DQ - DC/DQ, fering profit risks at the industry level can be it can be shown that profits (before or after taxes) and expected to lead to differencesin observed rates output move in the same direction given that the secondis > 32S/3Q2, order condition for a maximum, 32C/3Q2 of return among industries because stockhold- satisfied. ers of riskier securities will receive greater 6 A linear function is utilized since it yields uniformly risk premiums. Thus, ceteris paribus, larger higher coefficients of determination than log-log or semi-log alternatives. amounts of cost fixity imply higher profit rates. 'Output risk here is analogous to Fisher and Hall's Also, firms with relatively high cost fixity and measure of profit risk (1969, p. 85).

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RISK, LEVERAGE AND PROFITABILITY more predictable output and hence potentially lower profit risk may be expected to issue relatively more debt and have lower values of equity/assets. Thus, we assume that cost fixity and output predictability affect leverage in equation (2), and thereby affect profit rate in equation (1) through leverage. However, since there is evidence that cost fixity affects profitability directly (Sherman and Tollison, 1971, 1972), this variable is also explicitly included in equation (1). Market Structure Variables The profit rate equation (1) includes familiar market structure variables: four firm concentration (C), growth in output (G), measures of economies of scale (E) and absolute capital requirements (K) barriers to entry. An advertising-sales ratio is not included in equation (1) as a separate market structure variable. Although advertising has often been treated as a market structure variable that has a separate positive effect on profitability, perhaps because it discourages entry, Sherman and Tollison (1971) point out that high levels of advertising can result from high levels of cost fixity. The reason is traced to Robert Dorfman and Peter Steiner (1954), who show how profit maximizing conditions for a firm require that the marginalvalue product of advertising, [, equals p/(p-mc), the reciprocal of Lerner's index of monopoly power (where mc is marginal cost). Sherman and Tollison note that mc is smaller as total costs are relatively inflexible with short-run output variation, and thus y will be smaller as cost fixity is higher. Lower values of y will be associated with higher levels of advertising as long as the marginal value product of advertising is decreasing, so higher advertising outlays can be expected as cost fixity increases. Thus, a high level of cost fixity can result in a high level of advertising. Intuitively, the firm advertises more when added sales will make a higher marginal contribution to profit. In an attempt to determine whether advertising is the result of cost fixity or profits are the result of advertising, Sherman and Tollison regress industry profitability on cost fixity and advertising and other market structure variables in our equation (1). They find that cost

505

fixity, but not advertising, has a separate significant impact on profitability and that advertising and cost-fixity have a significant positive simple correlation. Since cost fixity is technologically determined, they conclude that this

variable ". . . would seem to be the genuine

explanatory variable, making advertising a dependent variable" (1971, p. 404). Thus, the omission of an advertising variable in equation (1) has both theoretical and empirical support. II The Data This study utilizes the data that Sherman and Tollison reported (1971) for 25 of H. Michael Mann's industries. The Sherman-Tollison data on cost fixity are particularly useful since profits and advertising have been purged from their measure in an effort to avoid spurious correlations with profitability. Their measure of total cost fixity (or variability) is one minus the ratio of variable costs to total revenue net of advertising and profit. In equation (1) above, average profit rate (R), four firm concentration (C), capital requirements (K), and economies of scale (E) are also obtained from Sherman-Tollison (1971, p. 407) who give primary sources. Leverage (L), measured inversely as the ratio of equity to total assets for the leading firms in an industry over the ten-year period, is calculated with firm data from Moody's Industrial Manual.8 The output predictability variable (P) is obtained by regressing industrial output on time.9 The measure of growth in industry output (G) is the ratio of 1959 output to 1950 output. III Empirical Results Equation (1), estimated with two-stage least

squares, is 10

8 For larger firms L can be obtained indirectly as the ratio of net income to total assets divided by the ratio of net income to net worth. For some smaller firms L has to be calculated directly. 'Data for calculated output predictability and growth in output are from Industrial Production, 1957-1959 Base (Federal Reserve Board: 1962) and the Annual Survey of Manufactures (Bureau of the Census: various issues, 19501959). A complete list of all variables and sources is available from the author upon request. 10 Logarithmic specifications of equation (1) and (2) yield similar results and thus are not reported. Bartlett's

506

THE REVIEW OF ECONOMICS AND STATISTICS with larger growth rates, ceteris paribus, can

.111 F 18.82 L + R = 27.76 be expected to have higher profit rates and may (1.87) (-2.11) (3.37) take some of their exceptional profits in the .346 E .0087 C + .0062 K+ (4) form of reduced risks through higher ratios of (2.07) (-.37) (1.29) equity to assets. + 1.84 G where t-scores are in parentheses and R_2 = .18. (1.29) IV Conclusion The leverage variable (L) is significant at the

0.05 level and has the theoretically correct negative sign. Thus, relatively large amounts of leverage (low values of L) tend to raise industry profit rates, more leverage implying greater risks. For comparison we also estimated equation (1) with ordinaryleast squares, with the result

R= .070F -1.30 +27.71L+ (1.24) (3.63) (-2.29) .364 E .0092 C + .0055 K+ (2.20) (-.40) (1.16) + 2.67 G where R 2 = .45. (1.77)

(5)

Here we have a positive effect of leverage similar to those in previous studies that have found a strong leverage effect but with the "wrong"

sign.

The variables in the leverage equation (the first stage used to estimate equation (4)), followed by corresponding t-values, are F, 1.04; P- -1.54; K, .72; C, .18; E, .18; G, 1.47. Cost fixity (F) has a modest influence on leverage, larger amounts of cost fixity leading to higher values of equity/assets and less average. Thus, more cost structure risk apparently leads a firm to take less financial risk, in terms of leverage. The simple correlation coefficient between cost fixity and equity/assets is 0.31. Relatively low output predictability (i.e., low values of P) also leads to high values of equity/assets, indicating that firms in industries REFERENCES with more unstable or less predictable outputs Arditti, F. D., "Risk and the Required Return on have relatively less debt. The correlation coEquity," Journal of Finance, 22 (Mar. 1967), efficient between P and equity/assets is -.22. 19-36. Capital requirements,concentration, and econ- Caves, R. E., "Uncertainty, Market Structure and Performance: Galibraithas Conventional Wisdom" in omies of scale do not have strong separate J. W. Markham and G. F. Papanek (eds.), Induseffects on leverage. Largerpercentage increases dustrial Organization and Economic Performance in industry output do lead to higher values of (Boston: Houghton Mifflin Company, 1970), 283equity/assets, although the coefficient of the 302. growth in output variable (G) is not quite Dorfman, R., and P. 0. Steiner, "Optimal Advertising and Optimal Quality," American Economic Review, significant at the usual 0.05 level. Industries

64 (Dec. 1954), 826-836.

test indicates that heteroscedasticity is not present in our sample. "See Sherman and Tollison (1971, p. 448) for a similar

Previous authors who have found an association between profitability and financial leverage have found it with a "wrong"sign. This study utilizes a simultaneous equation approach and finds that leverage measured inversely by the ratio of equity to assets has the theoretically correct negative sign and is significant as well. We also find that the predictability of output fluctuations and the effect of output changes on total cost and hence on profit fluctuations may separately influence financial leverage decisions in expected ways, although their effects here are not significant at ordinary test levels. Since leverage is correlated with some of the elements of market structure, particularly cost fixity, it is desirable to include leverage in equations explaining profitability. Thus, the tacit separation of industrial organization from finance seems undesirable as risk continues to be introduced into models in both fields." Leverage is positively correlatedwith cost fixity but does not seriously weaken the importance of this variable. Since leverage is not significantly correlated with the other elements of market structure (such as concentration), the omission of this financial variable in some previous studies of the rate of return on equity capital should not cause any doubt to be cast upon the associations found.

suggestion.

Fisher, I. N., and G. R. Hall, "Risk and Corporate Rates of Return," Quarterly Journal of Economics, 82 (Feb. 1969), 79-92. Hall, M., and L. Weiss, "Firm Size and Profitability," this REVIEW, 49 (Aug. 1967), 319-331. Mann, H. M., "Seller Concentration, Barriers to Entry, and Rates of Return in Thirty Industries, 1950-

507

1960," this REVIEW, 48 (Aug. 1966), 296-307. Sherman, R., and R. Tollison, "Advertising and Profitability," this REVIEW, 53 (Nov. 1971), 397-407. , "Technology, Profit Risk, and Assessments of Market Performance," Quarterly Journal of Economics, 86 (Aug. 1972), 448-462.

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