THE JOURNAL OF INDUSTRIAL ECONOMICS 0022-1821 S2.

00
Volume XXXVIII December 1989 No. 2

FIRMS AS PORTFOLIOS: A MEAN-VARIANCE

ANALYSIS OF UNQUOTED UK COMPANIES*

DONALD A. HAY AND HELEN LOURI

This paper adopts a mean-variance portfolio framework to model the

balance sheet behaviour of unquoted companies with respect to choice
items such as fixed investment, investment in stocks, trade credit, and
borrowing. Econometric results for a sample of 39 UK firms are
consistent with many of the restrictions implied by portfolio theory, in
particular that these balance sheet items are jointly determined.

L INTRODUCTION

THE IDEA motivating the research reported in this paper is that unquoted
firms may usefully be analysed as portfolios of assets and liabilities. The assets
are the physical capital, stocics and woric in progress, net trade credit, and
working capital of the firm; the main liabilities are loans. The "size" of the
portfolio, and hence the size of the firm, is constrained by the availability of
shareholder funds, both share issues and retained profits. This is one reason
for the focus on unquoted firms: in principle, quoted firms can resort to new
issues to increase their capital base.
Another distinction between quoted and unquoted firms makes the choice
of unquoted firms for analysis partictilarly significant. In unquoted firms the
owners' eqtiity in the firm is likely to be a major portion of their total wealth.
Hence their personal preferences and risk aversion will be major infiuences
on the overall shape and riskiness of the balance sheet. The influence will be
straightforward in the case where the owners also work in the firm and draw
a salary as executive directors or managers. The firm will represent a
substantial proportion not only of non-human wealth, but also of their
human wealth, much of which is specific to the firm. By contrast, the
shareholders in a quoted firm are likely to hold equity as part of a diversified
portfolio of wealth. In a capital asset pricing model framework they will be
interested in the covariance risk of the holding, and be much less concerned
about the risk profile of a single firm's balance sheet. This contrast may be
weakened by the fact that the managers of a quoted firm are in a situation
comparable to that of owner-managers of unquoted firms in respect of

* We are grateful to S. Holder, who assisted in the compilatioo of the company data, to J. Zour
who saved us a lot of time by guiding us through the intricacies of the use of the TSP package for
the particular applications in this paper, to G. McNamara for programming assistance and to
A. Courakis for comments and discussions. The Institute of Ecanomics and Statistics, Oxford
provided both a small grant forresearchassistance, and the use of facilities for research.

141
142 DONALD A. HAY AND HELEN LOURI

human capital, and in respect of any equity holdings or equity linked

incentives. Such quoted firm managers are also likely to be motivated by their
own risk aversion in structuring the balance sheet.
Our approach is derived from seminal papters by Dhrymes and Kurz
[1967], and Brainard and Tobin [1968]. The theoretical and empirical
insight of these papers is that dedsions about assets and liabilities are
interdependent. Thus Dhrymes and Kurz model flow decisions of firms with
respect to investment in physical capital, investment in inventories, dividend
payments, borrowing and new equity issues, and find substantial evidence of
interdependence (see also Hay and Morris [1984], pp. 206-217). Brainard and
Tobin stress the theoretical case for simultaneous determination of assets and
liabilities in the portfolios of financial institutions, and the pitfalls of ignoring
this interdependence in econometric work. But neither of these papers sets the
analysis in the context of a specific model of portfolio behaviour.
Portfolio modeis have been extensively applied to banks and other
institutions. Representative examples of the genre are Parkin et al [1970],
Parkin [1970], Sharpe [1973], Courakis [1974, 1975, 1988]. A critical
summary of the model has been provided by Courakis [1980]. There are
three key assumptions: the decision taker seeks to maximise expected utility
of wealth at some terminal date, the determinants aflfecting the choice of
alternative portfolios can be reduced to expected return and risk (proxied by
the mean and variance of returns), and dedsion-takers are quantity setters
taking as parametric the vector of stochastic )ields (costs) on different assets
(liabilities). Courakis considers the significance of these assumptions in the
analysis of finandai institutions such as banks.
Different institutional features are relevant in the context of firm behaviour
and this raises a number of questions. The first is how to justify the use of
period analysis (or discrete time) in a situation where a firm may alter its
holdings of assets and liabilities continuously. Presumably one has to appeal
to the idea of a planning period, and to the existence of adjustment
costs/discontinuities which rule out instantaneous adjustment. However,
there is no reason to believe either that the planning j)eriod or the adjustment
costs are the same across all assets and liabilities. (Nor that the planning
period is one year and that the terminal date coinddes with the annual
drawing-up of the balance sheets for accounting purposes. Yet we are
constrained to use the annual balance sheets in our empirical work.)
Secondly, as is well known, the mean-variance assumption is open to
theoretical objection, and this will be noted briefly in Section II of the
paper. The third assumption is price-taking, quantity-setting behaviour. One
objection is that a firm may have considerable discretion over the returns to
be earned on its physical investment. Pridng and marketing dedsions can
influence returns in the short run, as. can research and development in the
long run. Price-taking behaviour requires a competitive asstunption about
the markets in which the firm operates. Those markets give rise to a large
 FIRMS AS PORTFOUOS 143
number of investment opportunities, at the margin yielding a competitive
risk-adjusted rate of return. The firm picks a few projects to coincide with its
existing expertise. The reader must judge whether this view of investment
opportunities is appropriate to unquoted companies.
The unquoted companies whose behaviour is analysed in the empirical
part of this paper were the subject of previous research (Hay and Morris
[1984]). Some of the key findings are listed here, as they provide background
information. Hay and Morris undertook an analysis of 54 unquoted
companies, for the period 1967-1979. It is the same sample, with infonnation
extended into the 1980s and the Ust pruned for various reasons (e.g.
disappearance of company by merger or liquidation, radical change in
accounting conventions), which is used in this paper.' The original research
involved in-depth analysis of 19 of the 54 firms, including interviews with
management. These interviews revealed a number of features. The majority of
the companies were famUy businesses, and had been so over a number of
generations. Ultimate control of the business rested with a small family group
of major shareholders. Their overriding objective was to remain a family
company and to hand on a secure business to the next generation. The firms
were highly dependent on retained earnings to finance expansion. As
unquoted private companies they could not offer equity for subscription by
the public: and they generally avoided long term debt financing which might
pose a threat to their independence. This was confirmed by analysis of the
finandal behaviour of all 54 firms in the sample. Retention ratios were
on average high (about 90% of after tax profits in 1975), and long term debt
provided only 7% of the long term liabilities. The firms made extensive use of
short-term borrowing, especially from banks, but there was no evidence of
any binding finandal constraint in this respect. At interview most firms
foresaw no diffictJty in financing a substantial investment project, additional
to their existing plans, should an unexpected, but profitable, opportunity
arise.
This previous research feeds into the research reported here in several
ways. First, the financial base of the companies is the shareholders funds,
mainly profits retained in the firm. Second, the lack of a perceived constraint
suggests that borrowing by the firm is a choice variable at the discretion of
the owner-manager. Third, the finandal conservatism of the companies is
motivated both by the desire to retain family control, and by the fact that for
most of the owners their stake in the firm represented a very high proportion
of their wealth. While none of these features requires that their balance sheet

^ Sample selection is described in Hay and Morris [1984] Section 6.6. The pnimitg of the list
from the original 54firmsto 39 raised the familiar problem that a sample of firms that survive
will inevitably involve unknown biases by eliminating those that have failed or been taken over.
Radical restnictudng of the accounts, which was a reason for pruning a number offirmsfromthe
sample, may also reflect perfonnance, and hence give ri^ to bias. We know of no simple means to
assess how serious the% biases might he.
144 DONALD A. HAY AND HELEN LOURI

behaviour be modelled as portfolios, it is evident that such models might be

expected to capture at least some of the aspects of that behaviour.
The objective of the paper is therefore to determine whether treating the
balance sheets of firms as portfolios of assets and liabilities can increase our
understanding of behaviour with respect to such variables as fixed investment,
investment in stocks, borrowing and trade credit. In Sections II and III we
explore the theoretical and econometric issues involved in the specification of
portfolio selection models. Section IV presents empirical results for our
sample of 39 unquoted companies.^ In Section Y we evaluate the perfonnance
of the model.

n. MEAN VARIANCE PORTFOLIO SELECTION MODELS

The portfolio choice problem has the agent maximising the expected utility of
profits (and hence wealth) at a given terminal date, given the constraint of his
initial wealth. Writing the objective function as max £[C/(JI)], it is con-
8U d^U
ventional to assume that ^— > 0, and that - r - j - < 0. Risk averse
dit oil
behaviour is implied by -^—j- < 0, in the empirically relevant case of
stochastic returns. It is difficult to make progress with the solution of general
portfolio problems, unless one is prepared to specify the precise form of the
utility function 17{ •), and the characteristics of the stochastic returns. The
mean-variance approach is the most popular. It gives some economically
interesting insights into widely observed portfolio behaviour, particularly the
phenomenon of diversification. The disadvantage is that the assumptions are
very particular.
Underlying the approach is the assumption that the determinants of
portfolio choi£» can be reduced to expected retum, and to risk, which is
proxied by the variance of the distribution of retums. Portfolios are
partitioned into choice and non-choice items. The agent can freely determine
only the stock of choice set items. But the allocation decision is based on a
consideration of the whole portfolio including the non-choice items. The
exposition of the model which follows will be brief. For further discussion the
reader is referred to Courakis [1974,1980].
Assume that the preferences of the agent over altemative feasible portfolios
are described by the negative exponential utility function in profits:
U(n) = a —cexp( —tm)
where n = profits, and a, b, c (all > 0) are parameters. If the stochastic rates of
* There is oo previous work with which to compare our results. Jackson [1984] and
Chowdhury, Green and Miles [1986] have analysed the short term financial decisions of the
aggregate UK company sector within a portfolioframework.Both the level of aggregation and
the narrower focus of these studies makes comparison difficult.
 FIRMS AS PORTFOLIOS 145

retum are normally distributed, it is well known that

max {U{n}} is equivalent to max {n^—^ba^}
where fi^ and a.^ are the mean and variance of retums.
We need to define fi^ and a^ in terms of the retums to the various assets
that make up the portfolio (liabilities are treated as negative assets). Let V be
a vector of the stocks of the n different assets that the agent decides to hold.
Let m be the associated vector of rates of retum on those assets. Since the
agent is not free to determine the stocks of every asset in his portfoho
(some are non-choice items, at least during the period under consideration)
the vectors V and m can be partitioned into z choice items and k non-choice
items (where n = z + k).
Assume that the yields, m, are random variables, distributed with the
following expected retums and variance-covariance matrix:
£(m) = fft = [i

cov (m,m') = £[(m-rfj)(m'-rfj')] = S =

The end-of-period profit can be defined as:

11 = tn V =^ ffij V^ + wtjt K^

Expected profit is given by:

with variance:
a^ = £{(7t-£(jr))^) = E{{m:-rh')Vf} = V'SV
Given the stocks of the non-choice assets, V^, the agent chooses the
beginning of period stocks of choice assets, V^, so as to maximise

subject to the balance sheet constraint on both assets and liabilities

where /^ and I^ are vectors of ones.

Solving the agent's constrained maximization problem yields the following
asset demand equations:

(1) V, = \Gih,-HV^

where G and H are matrices of coeflBcients.

The linear form of these asset demand equations (1) is a striking feature of
146 DONALD A. HAY AND HELEN LOURI

the analysis, and probably does much to explain the popularity of the model.
However, the results are highly dependent on the particular utility function,
and on the assumptions about the distribution of retums.''
Equation (1) has an important economic interpretation. The demand for
each choice asset is a function of the expected retums on all the choice assets,
and the stocks of all non-choice items in the balance sheet. The latter form
the "base" on which the rest of the portfolio is built. The response of
choice set items V^ to changes in their expected yields ih^ is captured by the
matrix, G, which depends on the covariance matrix of returns on all choice
assets, S^. The effect on V^ of the stocks of non-choice items is described by
the matrix H which is a function of the covariance matrix of returns between
choice and non-choice items. This implies that the composition of the stock of
non-choice items will be significant: but the level of yields on these items does
not enter the determination of the rest of the portfolio.
Examination of the mathematical properties of the model (see Appendix I)
indicates some propterties of the G and H coefficient matrices which are
important for empirical apphcations of the model:
(i) S3rmmetry: G is symmetric;
(ii) homogeneity: an equal change in the rates of retum on all choice set
assets leaves the relative demands for these assets unchanged;
(iii) Coumot aggregation: all asset adjustments following a change in
retums must be consistent with keeping the balance sheet in balance;
(iv) non-negative own rate coefficients: an increase in expected yield on an
asset, ceteris paribus, will never lead to a decrease in the stock of that
asset held;
(v) Engel aggregation: this property is another consequence of the balance
sheet constraint. A change in the stock of a non-choice set asset brings
about changes in the demand for the different choice set assets which
add up to the total amount of the initial change.
These properties represent restrictions which should be tested as part of
any evaluation of the empirical perfonnance of the model. Conditions (iii)
and (v) are automatically satisfied by the balance sheets and are not testable.

^ As Courakis [1974] has shown, if we had assumed a quadratic utility function of the fonn

then the asset demand equations for choice set assets would have the form:

a
where X, = ih^ih^V^ and Xi = *,*;»;. It is evident that draoand for assets in this
formulation depends in a complex Eashion not only on the returns to choice assets, but also the
returns to non-choice assets. In the context of the econometric work to be discussed later in the
paper, this is a distinct disadvantage. To estimate the demand e q u a t i ^ requires estimates of the
nit, and sobstantially more data.
 FIRMS AS PORTFOLIOS 147

However, homogeneity and symmetry can be tested by comparing restricted

and unrestricted versions of the model.

m. DATA AND ECONOMIC METHOD

The data consisted of standardised profit and loss accounts and balance
sheets for 39 unquoted UK companies in 14 two-digit SIC sectors over the
period 1967-84. (Data were not always available over the entire period: on
average there were 16 annual observations for each firm.) Published balance
sheets contain a great deal of detail about different assets and liabilities. To
reduce the analysis to manageable proportions we consolidated items, and
netted out similar items on both sides of the balance sheet to arrive at the
following highly simplified balance sheet for each firm:

Assets Liabilities
Net physical capital {K +1) Shareholders funds (SH)
Stocks and work-in-progress (S) Revaluation reserve {RR)
Net trade credit (T) Loans (L)
"Working capital"

Three items call for definition. First, physical capital is identified as the sum of
the net capital stock inherited from the previous period (K), and additions to
that capital stock investment during the accounting period (/). The point of
this distinction is that K is not a choice variable of the firm in the period
under consideration, while / clearly is. The second is "working capital".
Recall that a balance sheet is a "snap shot" of the firm taken at a particular
day. On that day the accountants take note of the level of current assets like
short term deposits and securities and cash, and of the company's immediate
liabilities like dividends declared but not yet paid, and tax which is due. The
recorded size of any one of these items is an accident of the circumstances on
the day the audit was undertaken. However, the net value (current assets less
current liabilities), or "working capital", is more likely to be a choice variable
of the management, since it is an indicator of the capacity of the firm to meet
its immediate obligations. The third item is the revaluation reserve. It was
necessary to adjust the data for inflation, particularly the data pertaining to
capital stock. Given that different adjustments were made to the two sides of
the balance sheet, the effect was to unbalance the two sides. This was rectified
by adding in a revaluation reserve as a liability, to restore the balance. The
inflation adjusted value of the assets of the company net of loans usually
exceeded the inflation adjusted value of shareholders funds (both original
equity capital and accumulated reserves from retentions). The revaluation
reserve therefore represents a "capital gain" to shareholders which is entered
as a liability of the firm.
All the accounts were inflation adjusted to 1980 prices. Details of the
148 DONALD A. HAY AND HELEN LOURI

methods used are given in Appendix II. The inflation adjusted capital stock
was derived by calculating gross investment in each year at constant prices,
and by assuming that the true rate of depreciation in each year is given by the
ratio of actual depredation to book value of assets in that year. With the
further assumption that the book value of physical assets shown in the first
set of accounts for each firm (usually 1967 or 1966) was an accurate base
value, the rest of the series was built up by deducting depredation and adding
gross investment in each year (both at constant prices).
The theoretical analysis of Section II requires that choice and non-choice
items be distinguished in the econometric specification. After some ex-
perimentation, K, SH and RR were identified as predetermined or non-choice
items. All three are carried forward from the previous period, and are unlikely
to be choice variables for thefirmin the current period. Choice variables were
identified as /, S, L, T and WK: the reasoning is that the level of each of these
is, in prindple, open to determination by the firm over the accounting year.
Thus stocks and work in progress (S) can be substantially increased or
decreased by the firm in the light of market conditions. Trade credit (T) can
be built up or reduced over the year. The same applies to loans (L), virtually
all of which are short term bank borrowings in the case of the firms in the
sample, and to working capital {WK).
From Section II we have the following equation system (2)

Gl2 G 13 '14

s G22 G2 3 ^24

L G32 G 33 '34 35

T G42 G4 3 G44 G4

WK G52 G53 ss

^12 H 13 SH' •'11 •'12

Ii22 23 RR .^21 J22

H32 33 K + J3I •'32

H42 43 ^41 ^^42

^52 53 JSI JS2

Note that balance sheet variables are always entered with the appropriate
sign: positive for an asset, negative for a liability. Where the data set consisted
of pooled observations from a number of firms (usually three), firm spedfic
dummies [f>i, Dz] are entered.
Our choice of definitions for the rates of return [mj,..., mj] is constrained
by the data available. We used:
m^: retum on investment: the ratio of the aveiage increase in post
 FIRMS AS PCMITFOLIOS 149

tax profits over two subsequent years to investment in the current year
(all appropriately deflated).*
m^: retum on stocks and work in progress: the forward inflation rate of the
producers' prices for the respective sector less the general inflation rate, on
the assumption that the return on keeping stocks is the expected rate of real
price increase for the goods in question. These "holding gains" are measured
net of corporate tax.*
m^: cost of loans: minimum lending rate net of corporation tax relief less
inflation.* While the lending rate to business by banks is typically at a
premium over the base rate, there was no means of making an appropriate
adjustment.
m^. retum on net trade credit: the annualised three month certificate of
deposit rate less inflation.
^ 5 : retum on working capital: the retum on cash assets is the negative of
the inflation rate.
The lack of sophistication in these definitions should be bome in mind
when the results of the econometric estimation are considered.
To estimate the equation system (2) we used the multivariate seemingly
unrelated regression technique. This technique minimises a criterion Q which
is the negative of the log-likelihood function i.e. minimisation of Q gives
maximum likelihood estimates. For multivariate regression the log-likehhood
function includes the log of the determinant of the covariance matrix of the
disturbances. Given that we expect disturbances to be correlated across the
equations of our system then multivariate regression is more effident than
single equation estimates.
Our theoretical discussion showed that the model imposes restrictions on
the matrices of G, H and J coeffidents in the equation system (2). These were
dealt with as follows:
Cournot aggregation and Engel aggregation arise as a consequence of the

* The problems arising from the use of accounting profit rates to measure economic retums are
now well documented (Edwards, Kay and Mayer ([1987]). The measure m^ is used to proxy the
unobservable economic rates of return. We have tried to minimise the diflBculties by modelling
net investment in each period, so that m, is defined as the incremental profit rate. It is by no
means a perfect proxy for the economic rates of retum: but it does avoid the need to value the
capital stock of the firm.
' The tax treatment of holding gains on stocks is complex (Kay and King [1986], pp. 200-201).
Until 1973 stock appreciation was taken into accounting profits and taxed accordingly. In the
early 1970s high inflation rates gave rise to high accounting profits based on stock appreciation:
butfirmslacked thefinancialresources to pay the tax on these paper profits. In 1974 (and made
retrospective to include 1973), stock relief was introduced. Under this scheme taxable stock
appreciation was limited to 10% of gross trading profits. Stock relief was abolished in 1984.
* The cost is defined as:
Interest rate (1 —corporate tax rate)—inflation rate.
We assume that the firms in the sample expected to eam sufficient profits to be able to benefit
firom the tax relief on interest payments. It was not possibie to asoertain whether any of the firms
was in fact "tax exhausted" for any part of the period of the analysis.
150 DONALD A. HAY AND HELEN

balance sheet constraint. The implication for the estimation of (2) is that the
five equations are not independent, so one has to be dropped. The working
capital {WK) equation was omitted. Its coeffidents can be calculated from the
coeffidents of the other four equations e.g. G51 = — Gn—Gjj—G31—G41
and Jfji = —1—Hji—H21—H31—/f^j. The balance sheet constraint also
implies that the column sums of the J matrix of coeffidents on the dtmimy
variables are zero. So we calculate, for example, J51 = —Jii—J2t~Jii~J4.i-
Symmetry and homogeneity. S)fmmetry requires that the G matrix of
coeffidents be symmetric, homogeneity that the row sums of the G coeffidents
be zero. These restrictions can be imposed by setting Gij = Gjt in the
estimation, and by setting Gjj = ( —G,, —Gfj —Gi3-GjJ for each row i of
the G matrix. We test for these restrictions, by comparing restricted and
unrestricted regressions. With the restricted version there are ten fewer
coeffidents to be estimated: Gj j G25 G35 G45 (homogeneity) and Gji G31 G32
G41 G42 G43 (symmetry) are dropped. The test is to compare the likelihood
ratio test statistic (computed as twice the difference in the sample log-
hkelihood) with a Chi-square critical value (see Courakis [1975], pp. 644-646)
for ten degrees of freedom.

TABLE I
CoMPAJusoN OF CONSTRAINED AND UNCONSTRAINED VERSIONS OF THE POKTFOLIO MODEL

Log likelihood ratios:

SECTOR (i) (2) (3) H)

21 Food 21.80 143.86 29.96 10.60
23 Drink 18.48 30.92 21.66 4.00
27 Ckemcais 27.76 39.28 34.02 32.28
33 Meckanica} engineering 20.56 136.36 22.60 29.76
36 Electrical engineering 17.64 67.02 23.66 20.70
41 Textiles 40.14 87.22 37.30 16.12
43 Leather 20.72 150.88 21.36 13.26
44 Clothing 16.72 98.36 11.58 11.42
45 Footwear 10.62 97.02 9.42 1.14
46 Bricks etc. 39.26 53.44 31.96 10.58
47 Furniture 20.84 130.40 11.18 36.86
48 Paper 8.34 61.52 18.58 10.96
50 Construction 19.38 93.28 22.66 7.44
81 Wholesale distribution 24.10 192.76 31.54 5.46

' Compar^n of unconstramed version of model with version with restrictions of symmetry and
homogeneity imposed. The appropriate test for statistically significant differences between the two versions is
Chi-squared with 10 degrees of freedom (23.20 at 0.01 level of significance, 18.31 at 0.05 level).
' Comparison of model witb non-choice items (SH, RR, K) entered separately as oplanatory variables, and
model in which they are aggregated. Test statistic is Chi-squared with 8 degrees of Cneedom (20.10 at 0.01 level
15.51 at 0.05 level).
' Comjrarison of model with non-choice items SH and RR entered separately as explanatory variables, and
model in which they are aggregated. Test statistic is Chi-squared with 4 degrees of &eedom (13.28 at 0.01 level,
9.49 at 0.05 level).
^Comparison of model with or without a constant. Test statistic is Chi-squared with 4 degrees of freedom
(13.28 at 0.01 level, 9.49 at 0.05 level).
 FIRMS AS PORTFOLI(» 151
Non-negative own rate coefficients. This condition is not imposed, as we
believe that the perfonnance of the model in giving non-negative own rate
coeffidents is an important indication of its explanatory power.

IV. RESULTS

A test of equation system (2) was attempted with pooled data across all 39
firms. The equations included dummies for each firm to identify fixed effects
at the firm level. The results were not satisfactory: in particular only one of
the G coeffidents was statistically significant at the 5 percent level. The need
to disaggregate did not come as a surprise: Firms and sectors differ in risk
(which will affect the choice of finance), in production (the length of the
production process, which will affect the level of work in progress), and in
marketing (compare production to order and production for stocks, which
will affect the level of stocks differently).
Results for the 39 firms grouped into 14 sectors, with two or three firms in
each, are presented in Appendix III. Here we report the main features of those
results:
(a) The restrictions of symmetry and homogeneity are rejected in four
sectors (Chemicals, Textiles, Bricks, and Wholesale Distribution) by the
log-likelihood ratio test (see column (1) in Table I). In the remaining ten
sectors the restrictions cannot be rejected at the 1 percent level. ^
(b) Inspection of the 70 own rate coeffidents (the diagonals of the G
matrices) in Table II shows that 36 were positive with 13 of these significant at
least the 5 percent level. Of the 34 negative coeffidents, 5 were statistically
significant at the 5 percent level. There is therefore only weak support for the
requirement that these rates should be non-negative. 43 out of a total of 140
off-diagonal coefficients in the G matrices are significant at the 5 percent leveL
We have no prior expectations about the pattern of signs, but certain features
merit attention. Recall that the restriction of symmetry implies that Gy = Gji.
The most consistent coefficients in terms of sign and significance are
Gi3 = G31, G24 = G42, G25 = G52 and G45 = G54. The first refiects the
expected linkage between physical investment and the borrowing. The
negative sign implies that a higher cost of borrowing reduces investment, and
that higher returns to investment will lead the firm to borrow more. The other
consistent coeffidents link investment in stocks, the giving of trade credit and
the level of working capital. Thus G24 = G42 implies that higher retums to

^This conclusion shotild be evaluated in conjunction with the following discussion of the
statistical significance of the individtial coeffidents of the G matrices. If only a few of the
coeffidents are significantly differetit from zero, than it is relatively easy to satisfy the
homogeneity and symmetry constraints; but it gives us ao confidence in the model generally. In
this regard, it should be noted that the 1% test is quite stringent: at the 5% level the hypothesised
restrictions of symmetry and homogeneity are rejected in 10 sectors.
152 DONALD A. HAY AND HELEN LOURI

TABLE II
CcMFHCffiNTS: SIGNS AND STATISHCAL SIGNIFICANCE

Independent variables
Dependent
variables mi m* ms SH RR K

I +ve 7(2) 7(1) 6(0) 8(2) 6(1) 0 <0) 6 (2) 5 (0)

7(0) 7(1) 8(4) 6(2) 8(2) 14(11) 8 (5) 9 (9)
S+ve 5(3) 9(1) 10(5) 3(1) 0 (0) 1 (0) 6 (4)
9(2) 5(1) 5{1) 11(4) 14 (12) 13 (12) 8 (5)
L +ve 7(3) 8(2) 8(2) 7 (2) 4 (1) 2 (1)
—ve 7(2) 6(3) 6(2) 7 (6) 10 (7) 12 (7)
T +ve 8(5) 6(1) 9 (7) 14 (14) 13(11)
— ve 6(1) 8(7) 5 (1) 0 (0) 1 (1)
WK +ve 9(-) 2 (1) 1 (1) 1 (1)
—ve 5(—) 12 (8) 13(11) 13 (12)

Notes: (i) Numbers in parentheses indicate number of coefficients with tbe given sign which are significant at
at least the 5% level.
(ii) Thefirstfivecolumns are the G matrix coef&cients: the restriction Gij = Gj^ applies. The last three columns
are the H matrix coefficients.

trade credit encourage the firm to increase its stocks, and higher returns to
holding stocks are assodated with a greater willingness to extend credit. The
interpretation is that when firms are expecting a higher level of activity and
increases in the relative prices of their products, they build up stocks and
become more willing to extend credit. The negative signs of G25 = G52, and of
G45 = G54 imply that a higher inflation rate increases the willingness to hold
stocks and extend credit at the expense of working capital. These qualitative
results suggest a partitioning of the portfolio in a majority of sectors, between
physical investment and loans on the one hand, and investment in stocks,
trade credit and working capital in the other.
(c) In virtually every equation the coefficients on SH, RR and K are well
determined (see Table II): 152 out of 210 estimated coefficients are significant
at the 5 percent level. With the exception of the equation for trade credit (T),
the majority of the coeffidents are negative. The negative signs on SH and
RR arise because they are entered with negative signs, as liabilities. The
interpretation is that these "sources" of funds (net of those represented by
existing capital K) form the base for new holdings of physical assets
and stocks. However aggregation of SH, RR and X as a single variable
{SH + RR-K) was rejected in all sectors (see column (2) of Table I) and
aggregation of SH and RR was rejected in all but three sectors (see column (3)
of Table I).* The coeflBdents on SH, RR and K in the loans equations (L) are

' The separation of SH and RR calls for some cotnment. A referee bas pointed out that the
current measure of shareholders wealth committed to the enterprise is & aggregate of these two
valties, and that bdmviowally it is diffictilt to jtistiiy their separation. Ia prindple this is correct;
 FIRMS AS PORTFOLIOS 153

negative in the majority of cases indicating that they are treated as substitutes
for loans rather than as complements. The corresponding coeffidents in the
trade credit (T) equations are mainly positive, implying that net trade credit is
positively associated with the inherited capital stock of the firm, and
negatively with shareholders funds. The interpretation of this result is not
obvious.
(d) As in more aggregate studies our results reveal that (firm specific)
intercept terms are important and often indicate major differences in the
balance sheets of firms within the same industry. A version of the model
including a common intercept term was tried. The likelihood ratio statistics
in column (4) of Table I suggest that constraining the common intercept to
have zero value is accepted in nine out of the fourteen sections.
(e) On the assumption that conventional R^ statistics can be used as an
indicator of the explanatory power of the equations, the equations for trade
credit (T) and for stocks and work in progress (S) are generally better
determined than the equations for loans (L) and investment (J). Inspection of
the inddence of significant coeffidents in Table II suggests that the better
performance of the former equations can be attributed to the contribution of
the rates of return variables. The implication is that stocks and trade credit
are more sensitive to rates of return than either loans or investment.
Durbin-Watson statistics indicated a statistically significant problem of
serial correlation in 9 out of the 56 equations: it is difficult to adjust for this
without violating the portfolio constraints of the model. ^

V. DISCUSSION

The exercise reported above has distinct limitations from the point of view
of econometric methodology. At best we have compared restricted and
unrestricted versions of a very specific model, and, somewhat to our surprise,
we have found ourselves accepting the restrictions in two thirds of the cases,
admittedly on the basis of a fairly stringent test applied to the unrestricted
version. Apart from that we have only tested the model, and particular
coefficients, against the null hypothesis. We need to consider what competing
hypotheses might be. One possibility is a general portfolio model without the

in practice however, RR cannot be measured directly, and is a statistical artefact inserted on the
liabilities side of the balance sheet to account for various adjustments on the asset side
(see Section 11). In the drcutnstances it is more appropriate to keep RR separate, so that its
independent contribution to the overall results can be assessed. The empirical results appear to
confirm the correctness of that dedsion.
' Lagged values of the depettdent variables such as can be fotrnd in the models of Tobin and
Brainard [1968] and Sharpe [1973] can also be a way to handle serial correlation problems.
Nevertheless, given the fact that queries can arise as to how the lags in adjtistment shotild be
modelled, our approach to the problem, namely separating K as a predetermined variable and I
as a choice variable, not only has the virtue of dealing with the problem of serial correlation, but
also seems to be more appropriate behaviourally.
154 DONALD A. HA Y AND HELEN LOURI
restrictive assumptions of Section II. Such a model might allow for (a)
non-normal distributions of retums on assets, (b) a general risk-averse utility
function, and (c) more complex behavioural relationships arising from the
covariance of the returns on choice and non-choice assets. However, any
portfolio theory will give rise to asset demand equations in which the own
rates of retum, and the quantities of non-choice assets and liabilities are
features. This corresponds to an unrestricted version of (2) with perhaps
further explanatory variables on the right hand side. Nevertheless, our results
in ten of the fourteen sectors suggest that the restrictions implied by the
spedfic theory cannot in fact be rejected. Taking our cue from models of
investment in physical capital and in stocks, we could introduce the level of
sales and changes in sales as explanatory variables on the right hand side.
However, it is arguable that the level of sales is a choice variable determined
jointly and simultaneously with investment capital and stocks on the basis of
expected returns.'**
Another option is to specify a model in which the relationships of different
assets and liabilities in the balance sheet are "technologically" determined
with "fixed coeffidents". For example, production factors might predominate
in the relative sizes of physical assets and stocks and work-in-progress.
Relative retums on assets and costs of loans would be of no significance in
determining the shape of the balance sheet. In the equation system (2), the G
coeffidents would not be significant, and the H and J coefficients would
represent the "fixed coeffidents" applicable to different industries and firms.
Although we have not formally tested for their joint significance, a quarter of
the 210 G coefficients were independently significant at the 5 percent
level. That would seem to count dedsively against the "fixed coefficients"
hypothesis: there is a response of balance sheet items to relative retums on
different assets.
To conclude, our aim has been to show that it is appropriate to model the
balance sheet of behaviour of unquoted companies as portfolios of assets and
liabilities. Using the well known mean-variance portfolio theory we have
illustrated the nature of the theoretical interdependence of firm dedsions with
respect to physical investment, investment in stocks, borrowing, trade credit
and working capital. This interdependence is reflected in constraints on
portfolio behaviour that may, in prindple, be tested econometrically. Our
empirical results suggest that these implied constraints are empirically valid
in ten out of the fourteen sectors. Previous empirical work has often
concentrated on only one of the constituent equations of (2), thus ignoring the
portfolio constraints. The results of such work should be treated with some
sceptidsm. Future work must take portfolio effects seriously. A further
feature of our results is that portfolio effects only emerged as significant at the

'"Despite this objection we hope in future to explore these varial^s in a flexible portfolio
model without the constraints imposed by tbe mean-variance framewoA.
 FIRMS AS PORTFOLICK 155

level of sectors, and not when the data were pooled across all sectors. While
differences in behaviour between sectors are not unexpected, this indicates
the desirability of working with disaggregated data to obtain consistent
results.
DONALD A. HAY, ACCEPTED APRIL 1989
Jesus College,
Oxford, 0X1 3DW.
HELEN LOURI,
Athens School of Economics,
16 Patission Street,
Athens 10434,
Greece.

APPENDIX i: PROPERTIES OF THE ASSET DEMAND EQUATIONS

Tbe matrices of coeflBdents G and H are:

—1 "^22 ^Z^T ZZ

where

The following are demonstrations of the properties (i) to (v) stated in the texL
(i) G is a symmetric matrix: this follows directly from the symmetry of the
covariance matrix S^.
(ii) The row sums of G are zero

G/, = s,;^/.-^"]^^^!f^''^' = s,;'/,-s,;4, = o

(iii) the column sums of G are zero
i;s-^i,i;s,-^ _ , _j , - i _

(iv) all diagonal elements of G are non-negative: this follows directly from the
second order conditions for a maximum,
(v) the sum of the elements of vector B is unity

hence, the column sums of matrix H are unity

I:H = KGS,,+KBii = 0+4' = li
 156 DONALD A. HAY AND HELEN LOLTR!

APPENDIX n: DATA

We bave 41 different variables for eacb year for each firm. Most of these are
accounting variables relating to standardised profit and loss and balance sheets. These
are used to construct tbe variables used in the analysis as follows:
(i) Net capital stock at 1980 prices (K)
F5 = fixed assets at historic cost
F24 = depredation.
y
Define the depreciation rate in each year: D = —^. Following standard accounting
practice V^ is built up as

where (— 1) is a one year !ag, and GI is gross investment. Hence

Using this formula, we calculate GI in each year and use a capital goods price index
(PIK) to get a series for gross investment at constant 1980 pdces. Assuming that the
first Kj observation is an accurate measure of net capital in that year, we have
!966: K(66) =
1967: K ( 6 7 ) =
1968: K{6S) = (1 -D)K{6T) + G/(68) etc...
(ii) Stocks {S)
Stocks and work in progress are given in the balance sheet, and are deflated by the
producer price index {P sector) for the sector the firm belongs to.
(iii) Loans (L)
We aggregate Fjj (long term loans) and Fjj (bank loans), and deflate by the
appropriate pdce index to get a series at 1980 prices.
(iv) Net trade credit (T)
Defined as (debtors less creditors) deflated by the producer price index.
(v) Working capital {WK)
Defined as (short term securities plus casb less deferred tax/tax equalisation less
current tax less dividends) deflated by tbe producer price index appropriate to tbe
sector to obtain a series in 1980 pdces.
(vi) Share capital and reserves {SH)
Defined as (issued share capital plus reserves and secudties less trade investments)
deflated by tbe producer pdce index. Trade investments, which are in practice quite
small, are netted out so as to focus attention on tbe balance sheet of the firm's main
operations.
(vii) Revaluation reserve (RR)
As explained in tbe text, this was introduced to rebalance the balance sheets after
the adjustments to other items descdbed above. It is a residual given by
RR= -(K + S + WK + SH + L)
where liabilities are entered witb a negative sign. RR itself has a negative sign as a
liability.

Price indices and interest rates

(i) Producer pdce indices are available in the Monthly Digest of Statistics for the
following sectors: Food and Ddnk, Chemicals, Electdcal Engineedng, Textiles,
 HRMS AS PORTFOLIOS 157

Leather, Clothing and Footwear, Bdcks and Pottery etc., Timber and Furniture,
Paper and Pdnting, Construction.
(ii) A pdce index for capital goods is available in Economic Trends up to 1982. For
1983-85, there is only an index for investment goods.
(iii) In the absence of a producers' pdce index for services we used tbe index of retail
pdces for services from the Department of Employment Gazette.
(iv) The inflation rate is taken as tbe rate of change of the retail pdce index.
(v) The interest rate vadable is the bank rate, MLR or base rate of tbe commercial
banks. Source: Bank of England Quarterly Bulletin.
(vi) Three month certificates of deposit (CD) rate: average on an annual basis.
Source: Bank of England Quarterly Bulletin.
Taxes on corporate profits
(i) Corporation tax rates. Source: Inland Revenue Statistics, 1987, Appendix A.4.

APPENDIX ni: RESULTS

The basic results of tbe seemingly unrelated multivadate regressions are listed below
for tbe 14 sectors. In each case the results are for tbe restdcted version, though the
restdctiotis are in fact rejected in four sectors. Commentary on tbe detailed results for
each sector is not attempted.
158 DONALD A. HAY AND HELEN LOURI

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 FIRMS AS PORTFOLIOS 159

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160 DONALD A. HAY AND HELEN LOURI

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162 DONALD A. HAY AND HELEN LOURI

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