MARKET POWER, PROFJTABILITY AND FINANCIAL LEVERAGE Thesis for the Degree of Ph. D. MICHEGAN STATE UNIVERSlTY TiMOTHY GERARD SULLIVAN 1972 Date 0-7639 LIBR/ RY Michigs State Univere. i , e14 This is to certify that the thesis entitled MARKET POWER, PROFITABILITY AND FINANCIAL LEVERAGE presented by Timothy Gerard Sullivan has been accepted towards fulfillment of the requirements for Finance, Business Ph'D degree in / "\ .-’ ””/’ ”I, I ‘ 2" 7 54%;” ”WM Mdaummmmn Feb. 1, 1972 1 1..» a. ' CIND'NG BY “DAG & SUN? BOOK NNDERYIND LIBRARY BINDERS QRINGPORL memes! ABSTRACT MARKET POWER, PROFITABILITY AND FINANCIAL LEVERAGE BY Timothy Gerard Sullivan A number of studies demonstrated a positive rela- tionship between market power, as measured by market con— centration and entry barriers, and firm profitability, as measured by the ratio of net income to the book value of stockholders' equity. Economic theory demonstrates that these higher profits imply higher prices and restricted out- put and consequently inefficient resource allocation. Financial leverage, however, could be a possible alternative explanation for these profits. Market power may increase the ability of firms to support low cost debt capital and therefore the higher observed profitability may be as much the result of greater financial leverage as monopoly pricing, restricted output and its related mis- allocation of resources. This study then attempted to find empirical evidence to support the hypothesis that powerful firms use greater financial leverage than other less power- ful firms. This study examined 90 firms during the period 1956 Timothy Gerard Sullivan to 1963 and concluded that powerful firms, as measured by both market concentration and entry barriers. utilized less not more financial leverage, as measured by the ratio of long term debt to total invested capital, than other less powerful firms. Therefore this study supported the tradi- tional condemnation of the higher profits associated with market power as indicating monOpoly pricing, restricted out- put and resource misallocation. The finding of an inverse relationship between mar- ket power and financial leverage questioned the ability of powerful firms to support greater debt. Did powerful firms maintain unduly conservative capital structures and inflated capital costs, and pass those inflated capital costs on to customers in the form of monOpoly prices? The above question centered upon three of the most controversial areas of finance: debt capacity, cost of capital and security valuation. This study examined three measures of debt capacity and found conflicting evidence that powerful firms should have supported greater debt. The study could not refute the charge that powerful firms inef- ficiently allocate their debt and equity capital inputs and do not minimize capital costs. Further research into the relationship of market power to financial leverage is needed. MARKET POWER, PROFITABILITY AND FINANCIAL LEVERAGE BY Timothy Gerard Sullivan A THESIS Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1972 ©C0pyright by TIMOTHY GERARD SULLIVAN 1972 ACKNOWLEDGMENTS I would like to thank the members of my dissertation committee for their assistance during the preparation of this study. Dr. Alan E. Grunewald, Chairman Dr. Richard G. Walter Dr. Bruce T. Allen ii TABLE OF CONTENTS Page ACKNWLEDGMNTS O O O O O O O O I O O O O O O O O O O 1 1 LIST OF TABLES O O O O O O O O O O O O O O O O O O C V LIST OF FIGURES O 0 O O O O O O O O O O O O O O I O 0 Vi Chapter 1 INTRODUCTION 0 O O O O O O O O O O O I O O l 2 REVIEW OF THE LITERATURE . . . . . . . . . . 13 A. Firm Size and Profitability . . . . . . 13 B. Market Concentration and PrOfitabilitY. O O O O O O O O O O O O 15 C. Entry Barriers and Profitability. . . . l6 3 FINANCIAL LEVERAGE . . . . . . . . . . . . . 20 A. The Concept of Financial Leverage . . . 20 B. cost Of capital 0 O O O O O C O C O O O 23 C. Financial Leverage and The Cost of Capital. . . . . . . . . . . . 24 D. Corporate Debt Capacity . . . . . . . . 29 E. Statement of Hypotheses . . . . . . . . 31 4 DATA ANALYSIS. . . . . . . . . . . . . . . 34 A. Sample Selection and Description. . . . 34 B. Time Period Selection . . . . . . . . . 35 C. Data Collection . . . . . . . . . ... . 36 D. Data Presentation . . . . . . . . . . . 38 E. Data Analysis . . . . . . . . . . . . . 40 F. Debt Capacity . . . . . . . . . . . . . 41 iii Chapter Page 5 LIMITATIONS AND IMPLICATIONS . . . . . . . . 46 A. Study Limitations . . . . . . . . . . . 46 B. Study Implications. . . . . . . . . . . 51 BIBLIOGRAPIIY O O O O O O O O O O O O O O 0 O O O O O O 54 APPENDIX A Average of and Variance of Leverage Ratio (D/TIC) and Average of and Variance of Profit Rates (NI/SE) for Thirty Industries, 1956-1963. Classified by Barriers to Entry. . . . . . . . . . . . . . . . . . 58 B Average of and Variance of Profit Rates (EBIT/TA) for Thirty Industries, 1956— 1963. Classified by Barriers to Entry . . . 61 C Annual Interest Coverage (EBIT/IE) for Thirty Industries, 1956-1963. Classified by Barriers to Entry. . . . . . . . . . . . 66 iv LIST OF TABLES Table Page 1 Average Profit Rates (NI/SE) and Average Leverage Ratios (D/TIC) for Thirty Industries, 1956-1963. Classified by Barriers to Entry. . . . . . . . . . . . 39 2 Average Profit Rates (NI/SE) and Average Leverage Ratios (D/TIC) for Thirty Industries, 1956—1963, Classified by Industry Concentration . . . . . . . . . 39 3 Average EBIT/TA and Average Variance EBIT/TA for Thirty Industries, 1956- 1963, Classified by Barriers to Entry . . . 43 4 Average EBIT/TA and Average Variance EBIT/TA for Thirty Industries, 1956— 1963, Classified by Industry Concentration . . . . . . . . . . . . . . . 44 Figure l 2 LIST OF FIGURES Traditional View . . . . . . MM VieWO O O O O O O O O O 0 Revised MM View. . . . . . . vi CHAPTER 1 INTRODUCTION The basic economic problem confronting any society is the allocation of scarce resources among competing and unlimited human desires. Within the united States market forces, market power. and public policy governs this econ- omic allocation. Public policy pursues objectives which society as a whole deems desirable: the attainment of effi- cient production and thereby cost minimization, the attain- ment of reasonable prices and profits. Efficient production has two aspects: allocative efficiency and productive efficiency.1 At any moment in time, society possesses only a limited stock of productive input factors, each with an associated cost and productivity. Allocative efficiency means the utilization of these limited inputs in precisely that combination to insure production of the Optimum valued social output at minimum input costs. Allocative efficiency then implies productive 1See: Harvey Leibenstein, "Allocative Efficiency VS. 'X-Efficiency'", American Economic Review, 56 (June, 1966), pp. 392—416. 2 efficiency, which has two components. Productive efficiency means that an individual firm will select the lowest cost combination of inputs necessary to produce any given level of output. Productive efficiency also means that an indi- vidual firm will employ within the productive process suffi- cient measures of managerial control, motivation and pro— ductive technique to insure that the productive process does in fact yield the highest value of output possible from a given set of inputs. In short, productive efficiency means the least cost transformation of inputs into completed out- put goods. By definition, efficiency is cost minimization. Allocative efficiency demands production of the highest valued output that society's limited input resources are capable of producing. Productive efficiency by definition requires firms to use the least cost combination of inputs capable of producing a given output, and productive effi- ciency also requires the least cost transformation of those inputs into finished output. Any conclusions concerning the relative efficiency of a given firm or group of firms implies conclusions concerning their minimization of costs. Public policy holds that the many in society and not individual producers should receive the benefits of efficient production. That is, output prices should allow 3 the producer to cover all costs, including a profit suffi— cient to compensate for risk. But, in the long run, the producer should receive only this reasonable profit. Economic theory demonstrates that competitive mar— kets better achieve these socially desirable public policy objectives than monOpolistic markets.2 Both the competitive and monOpolistic economic models assume productive effi- ciency. That is, both models assume that each market par— ticipant selects the least cost combination of inputs cap— able of producing a desired level of output and transforms that input into output at minimum cost. But when contrasted the competitive and mon0polistic models demonstrate the allocative inefficiency associated with monOpoly. Because of restricted entry and ability to determine output price, the monOpolist produces less and charges more than competi- tively determined output quantity and price. As such, monOpoly generates higher prices and profits, restricted output and inefficient resource allocation. The monOpo- list's restriction of output causes inputs to flow into other less Optimal uses, forming the basis for the classical condemnation of monopoly. Real world markets do not precisely conform to 2C. E. Ferguson, Microeconomic Theory (Homewood, Illinois: Richard D. Irwin, Inc., 1966), pp. 192-219. 4 either competitive or mon0polistic assumptions, but rather fall on some continuum between the two extremes. Diversity marks the United States economy as a delineation of firms or markets upon almost any economic variable would reveal. Certainly relatively few firms generate enormous economic activity,3 yet they coexist with a wide range of smaller firms. Many markets have few participants,4 while other markets have many participants. Some markets require little capital or technical expertise to enter and compete effectively, while others require large quantities of both. In actuality, individual real world markets contain varying elements of competition and monOpoly, and measuring these prOportions in a given case is far from an exact science. Yet careful observation leads to the belief that some firms are better able to control the major variables of their existence, as could a monOpolist, than other more competitive firms. These firms which control their envi- ronment are said to possess market power defined as "the 3In 1964, 325 non-financial corporations each held $250 million or more in assets, representing a full 42 per cent of all assets held by non-financial corporations. See: F. M. Scherer, Industrial Market Structure and Economic Performance (Chicago, Illinois: Rand McNally & Company, 1970), p. 39. 4Manufacturing industries in which the largest four firms accounted for 50 per cent or more of industry sales generated 33.1 per cent of all value added attributed to manufacturing. Ibid., p. 62. 5 ability of a market participant or group of participants . . . to influence price, quantity, and the nature of the product in the marketplace."5 Market power is then a nebulous yet pervasive concept, and important to an under- standing of the performance of modern economic markets and the conduct of the firms that participate in them. A number of studies have examined the relationship between market power, or more precisely certain more easily measured proxies for market power such as number of sellers and ease of entry, and firm profitability. This literature, reviewed in Chapter II, concludes that greater market power generates higher rates of profitability, and the existence of this higher profitability over time is condemned because it implies higher prices, restricted output and consequently allocative inefficiency. Because of entry barriers, the managements of power— ful firms presumably set output prices in excess of those which a competitive market would permit, and by so doing only satisfy a restricted demand. Hence the total value of society's output is lower than its stock of inputs could have produced, since inputs now produce other less Optimal 5William G. Shepherd, Market Power and Economic Welfare (New York, New York: Random House, Inc., 1970), p. 11. 6 outputs. And entry barriers prevent these higher profits from being bid away by new market entrants. The role of number of market participants is intui- tively apparent. If sellers are few, each can inflict identifiable harm upon the others and expect retaliation in kind. Accordingly, each seller may choose to play safe, keeping its output restricted and its prices high. If sellers are few, any firm that cuts prices will be dis- covered quickly, with the result that no firm has an incen— tive to do so. In fact, each may trust the others to main— tain prices at super—competitive levels. This recognition of mutual dependence reaches its greatest effect under con— ditions of few sellers, identical costs, and the acceptance by each firm of a fixed market share (irrespective of market price). Under these conditions, individual firm profit maximization will produce a level of prices and a distribu— tion of outputs that maximize joint industry profits, i.e. the monOpoly solution. Relaxation of any of these condi— tions or alternative behavioral assumptions will produce results ranging between this outcome and the purely compe— titive one. Besides the above condemnations of market power for fostering allocative inefficiency, powerful firms stand accused of productive inefficiency as well. Practical 7 measurement of such a charge is difficult, but the reason- ing behind it is straight forward. One attribute of the large modern corporation is the separation of ownership, as represented by a diverse group of stockholders, and control, as represented by a unified group of professional managers.6 The managements Of powerful firms freed from the pressures of a competitive market and the scrutiny of ownership interests simply do not have to be productively efficient.7 Powerful firms can still earn superior profits in spite of inflated expenses. If correct, the higher observed profits associated with market power reveal only a portion of the inefficiency caused by market power. 0. E. Williamson8 has moved this analysis a step further: powerful firms incur excess expenses not out of unplanned inefficiency but because of the preferences of management for certain types of expenses. These higher 6R. J. Larner found 169 of the 200 largest U. S. corporations in 1963 were management controlled with no individual or discernible family or business group owning 10% or more of its voting stock. See: R. J. Larner, "Ownership and Control in the 200 Largest Nonfinancial Corporations, 1929-1963," American Economic Review, 56 (September, 1966), pp. 777-787. 7For examples of such productive inefficiency see: Leibenstien, Op. cit. 8O. E. Williamson, "Managerial Discretion and Business Behavior,“ American Economic Review (December, expenses take two basic forms: those that personally bene- fit management,9 and those that make the job of managing . . . . . 10 the firm ea51er by increa31ng its market power. Williamson calls this notion expense preference: The essential notion that we prOpose in order to connect motives with behavior is that of expense preference. That is, the management does not have a neutral attitude toward costs. Directly or in- directly, certain classes Of expenditure have posi— tive values associated with them.11 If Williamson's notion of eXpense preference is a reasonably accurate description of the conduct of powerful firms, then market power leads to serious inefficiencies, both allocative and productive. Powerful firms can charge sufficiently high prices as to report superior profits in spite Of inflated expenses. These inflated expenses are not unintentional, and may reinforce the very market power which permits the higher prices to exist over time. In addition, the management of powerful firms receive inflated compensation for managing less risky enterprises. Certainly 9Williamson found a positive relationship between entry barriers, concentration and executive compensation, adjusted for job responsibility. See: Ibid., p. 1045. 10Dorfman and Steiner found relative advertising activity positively associated with firm size. See R. Dorfman and P. 0. Steiner, "Optimal Advertising and Optimal Quality," American Economic Review, 44 (December, 1954), pp. 826-836. llWilliamson, OE. cit., p. 1032. 9 such conduct would violate both objectives of public policy: efficient production and the attainment of reasonable prices and profits. Productive processes have two basic types of input: fixed and variable usually represented by capital and labor. Modern firms have the option of financing their stock of capital assets by some combination of debt funding and equity funding. This is the problem of financial leverage or Optimum capital structure and that literature is reviewed in Chapter III. General agreement exists that the use of financial leverage can effect a firm's capital costs and its overall level of risk. Financial leverage is a means by which cor- porate management can trade higher risk for higher profits. As such, financial leverage would appear to be an excellent device for the managements of powerful firms to employ ex- pense preference. These managements could employ ineffi- ciently low financial leverage with its associated low financial risk and high capital costs. High output prices could absorb these high capital costs and still permit the earning of superior profits, and management would have the personal advantages of directing a lower risk Operation. Consider the potential advantages to the management of a powerful firm for utilizing less than the Optimum 10 amount of debt. The firm's fixed interest charges would be reduced, thereby reducing its overall level of risk. Man- agement could presumably raise money quickly and at favor- able rates to meet new Opportunities. This strong financial position would reinforce entry barriers by providing funds for advertising campaigns, research and development acti- vities, or whatever else would be needed to discourage poten- tial competitors from entering the industry or matching the outlays of those which might enter the industry. In addi- tion, monopoly output prices would permit above average returns on stockholders' equity thereby satisfying stock— holders' desires and attaining for management the prestige associated with Operating a consistently profitable firm. This is a possible explanation of the influence of market power on financial leverage. There is also an alternative explanation of that relationship. Because of their ability to control the major variables of their existence, powerful firms may have the ability to support large amounts of low-cost debt, debt which would lower their overall capital costs. If true, the higher observed profits associated with market power could be the result Of lower capital costs and not monOply prices and restricted output, thereby breaking the direct link between those profits and allocative inefficiency. In ll fact, market power may have the socially desirable prOperty of permitting firms to reduce capital costs. F. M. Scherer clearly stated this possibility in a recently published text. It is possible that the high Observed returns on stockholders' equity in concentrated industries have been due as much to financial leverage as to greater success in realizing monOpoly gains on the total amount of capital employed. That is, firms in concentrated industries may have elected a capital structure with an unusually high ratio of low-cost but inflexible debt obli- gations, so that returns above interest charges were magnified in relation to the relatively small quantity of equity capital. Stigler found that concentrated industries had significantly more stable returns over time than unconcentrated industries, and this may put them in a better position to accept high leverage without incurring excessive risks. The possibility of interactions among concentration, leverage, and profitability has not yet been subjected to thorough empirical analysis. Further research is clearly needed.12 The Objective of this study then is to examine the relationship between market power and financial leverage. Toward this end, a sample of firms and a time period will be selected in Chapter IV to empirically test the hypothesis that powerful firms do indeed utilize greater financial leverage than other less powerful firms. And if they do not utilize greater financial leverage, whether to 12F. M. Scherer, Industrial Market Structure and Economic Performance (Chicago, Ill.: Rand McNally & Com- pany, 1970), p. 185, George J. Stigler, Capital and Rates of Return in Manufacturing Industries (Princeton, N. J.: Princeton University Press, 1963). 12 attribute that to managerial decisions not to minimize capital costs. Chapter V presents the limitations and implications of this study. If powerful firms do utilize greater amounts of debt, then serious rethinking of the Opposition to market power in the legal and economics professions would be in order. For if market power grants the socially desirable ability to reduce capital costs, then Opposition to it must result from a balancing of its advantages and disadvantages. If powerful firms do not utilize greater amounts of debt, then such findings would support and strengthen the tradi- tional Opposition to concentrations of market power for causing allocative inefficiency. It would further raise questions concerning the minimization of capital costs by the managements of powerful firms. CHAPTER 2 REVIEW OF THE LITERATURE A. Firm Size and Profitability Recognition of the importance of imperfect competi- tion and the related concept of market power fostered many theoretical and empirical studies considering the various aspects of market power, market conduct and market perform- ance.1 One thrust of this research effort attempted to relate firm size, number of sellers and ease of entry, variables thought to be related to market power, and firm profitability. These studies are reviewed in this chapter. One method of market power classification involves the division of firms into market power groups according to relative size as measured by either sales or assets. For example, 60 firms might be divided into three market power groupings according to total assets below $250,000,000, total assets between $250,000,000 and $500,000,000 and total assets over $500,000,000, then examine the 1This literature is indeed enormous. For an excellent review see: F. M. Scherer, Industrial Market Structure and Economic Performance (Chicago, Illinois: Rand McNally Company, 1970). 13 l4 profitability of each group. These studies have reached conflicting conclusions. Alexander2 examined all manufacturing corporations submitting balance sheets with their 1937 federal income tax returns and found a positive relationship between firm size and the ratio of net income to the bOOk value of stock- holder's equity (NI/SE). Hall and Weiss3 worked with 341 firms for the period 1946 to 1962 and found a positive rela— tionship between firm size and both NI/SE and the ratio of net income to the book value of total assets (NI/TA). H. O. Stekler examined all firms filing income tax returns for the period 1947 to 1949 and found medium sized firms were more profitable, profitability as measured by both NI/SE and NI/TA. That is, the returns of firms with total assets between $500,000 and $10,000,000 were higher than larger or O 4 O I smaller firms. Osborn examined income tax returns for 2Sidney S. Alexander, "The Effect of Size of Manu- facturing Corporation On the Distribution of the Rate of Return," Review of Economics and Statistics, 31 (August, 1949), pp. 229-235. 3Marshall Hall and Leonard Weiss, "Firm Size and Profitability," Review of Economics and Statistics, 49 (August, 1967), pp. 319-331. 4H. O. Stekler, Profitability and Size of Firm (Berkeley, Calif.: Institute of Business and Economic Research of The University of California at Berkeley, 1963), p. 74. 15 manufacturing corporations during the period 1931 to 1946 and also found medium sized firms more profitable, profit- 5 Samuels and Smyth6 examined ability as measured by NI/SE. 186 United Kingdom companies during the ten years from 1954 to 1963 and found size of firm and NI/TA were inversely related. Sherman examined corporate income tax returns for the period 1931 to 1961 and found medium sized firms with higher NI/SE than other firms. But differing patterns emerged within four subperiods studied.7 Conclusions con- cerning the relationship between firm size and profitability seem to depend heavily upon the sample of firms selected, the time period studied and the determination of size groups. B. Market Concentration and Profitability A second market power classification method consists of the so-called concentration ratios. These ratios calcu— lated by the Bureau of the Census of the Department of 5Richard C. Osborn, Effects of Corporate Size on Efficiency and Profitability (Urbana, Ill.: University of Illinois, Bulletin NO. 72, 1950), p. 58. 6J. M. Samuels and D. J. Smyth, "Profits, Vari- ability Of Profits, and Firm Size," Economica, 35 (May, 1968), p. 127. 7Howard J. Sherman, Profits In The United States (Ithaca, N. Y.: Cornell University Press, 1968), p. 41. Also see Chapter One of Sherman's work for an excellent literature review of corporate size and profitability. 16 Commerce,8 indicate as an example the percentage of output within various industries shipped by the largest four or eight firms. There have been a number of studies9 which have examined the relationship between concentration and NI/SE. with one exception,10 which in turn has been criti- , ll . . Cized, the results have demonstrated a con31stent, p051— tive relationship between these factors. C. Entry Barriers and Profitabilipy A third method of market power classification con- sists of the analysis of entry conditions into various 8 U. S. Bureau of the Census, Annual Surveypof Manu- facturers: 1966, "Value-Of-Shipment Concentration Ratios by Industry," M66 (AS)-8 (Washington, 1968). 9Joe S. Bain, "Relation of Profit Rates to Industry Concentration," Quarterly Journal of Economics, 65 (August, 1951), pp. 293-324; Victor Fuchs, "Integration, Concentra- tion, and Profits in Manufacturing Industries," Quarterly Journal of Economics, 75 (May, 1961), pp. 278-296: Stigler, Op. cit.; Hall and Weiss, Op. cit.: Joe S. Bain, Barriers to New Competition (Cambridge, Mass.: Harvard University Press, 1956); H. Michael Mann, "Seller Concentration, Barriers to Entry, Review of Economics and Statistics, 48 (August, 1966), pp. 296-307; Sherman, Op. cit., p. 100: Leonard W. Weiss, "Average Concentration Ratios and Indus- trial Performance," Journal of Industrial Economics (July, 1963), pp. 237-253. 10Stigler, Op. cit. 11Robert W. Kilpatrick, "Stigler on the Relationship Between Industry Profit Rates and Market Concentration," The Journal of Political Economy, 76 (May/June, 1968), pp. 479-488. 17 industries. Economic theory demonstrates that the condi- tion of entry into a given industry has strong influence upon the maintenance of competitive conditions within that industry, and some real world markets appear easier to enter than others. The expectation is that blockaded mar- kets would have higher prices than competitive markets, and that these higher prices could lead to some combination of higher profits and higher expenses. Two researchers have examined the proposition that high market entry barriers imply high profitability for market participants. Bain examined the relationship between entry condi- tions and NI/SE for the leading firms in 20 oligOpolistic12 industries during the periods 1936 to 1940 and 1947 to 1951. From various published sources and interviews with industry executives, Bain estimated the extent to which four factors impeded entry into each of the 20 industries. The four factors were: (1) the existence of economies of scale,13 (2) product differentiation advantages of established firms,14 (3) control of scarce productive resources by 12The lowest four seller concentration ratio in Bain's sample of firms was 27 per cent. See: Bain, Barriers to New Competition, p. 45. 13Ibid., Chapter 3. pp. 53-113. 14Ibid., Chapter 4, pp. 114-143. 18 established firms,15 (4) ability of potential entrants to raise capital to enter the industry.16 With the extent of each factor upon each industry determined, Bain placed each industry and the leading firms within that industry into one of three categories of overall entry condition: high entry barrier, substantial entry barrier, and moderate-to-low entry barrier.l7 Bain presented two major conclusions. Industries in the high entry barrier group earned higher average NI/SE than industries in the other two groups, but these latter two groups showed no difference in average NI/SE.18 Indus- tries in which the largest eight firms accounted for over 70 per cent of industry sales had higher average NI/SE than industries in which the largest eight firms accounted for less than 70 per cent of industry sales.19 Mann replicated Bain's study for the period 1950- 1960, increasing the number of industries included in the 20 study from 20 to 30. He divided the 30 industries and 15Ibid., Chapter 5, pp. 144-166. 16Ibid., Chapter 5. pp. 144-166. IAEELQ-. Chapter 6, pp. 167-181. 18Ib1d.. p. 196. 19Ibia.. p. 196. 20All of Bain's industries retained their classifi- cation with the exception of cement which Mann moved to the substantial entry barrier group: Mann, Op. cit., p. 297. 19 their leading firms into the same three market power classi- fications groups as Bain, using the same determinants of entry condition.21 Mann, like Bain, found a significant difference between the NI/SE of the high entry barrier group and the two others, but no such difference between the substantial and moderate-to-low entry barrier groups.22 Mann, again like Bain, found that industries in which the largest eight firms accounted for over 70 per cent of sales had higher NI/SE than industries in which the largest eight firms accounted for less than 70 per cent of sales.23 If there is a consensus regarding entry barriers, it is that they must be "very high" to influence market conduct and per- formance. Interestingly, all of the Bain and Mann indus— tries that could be so characterized were also highly concentrated. ZlIbid., p. 297. 221bid., p. 299. 23Ibid., p. 300. CHAPTER 3 FINANCIAL LEVERAGE A. The Concept of Financial Leverage The concept of financial leverage is fairly simple. A corporation raises a portion of its total required capital by means of fixed payment securities, usually debt, in the expectation that the return earned on those funds will ex- ceed their cost. As a result, this differential between return and cost will magnify the return of the residual security holder. Thus "non—equity financing adds to the earnings stream as long as the explicit costs of financing are less than the returns from the capital invested." An example may prove helpful. Assume a tax free world in which a firm issues only two types of securities, common stock and bonds. If a given firm earns 10 per cent on its total invested capital (TIC) which was raised entirely through stock, then its return on stockholders' equity (SE) would be 10 per cent. If this same firm raised lRonald F. Wippern, "Financial Structure and the Value of the Firm," Journal of Finance, 21 (December, 1966), p. 615. 20 21 half its total capital through 8 per cent interest debt (D), then its return on the smaller equity base would have risen to 12 per cent. Financial leverage, then, possesses a powerful advantage. A given firm can increase its return on equity provided that it can obtain debt financing at a cost lower than its return. But financial leverage also has disadvan- tages. JUst as debt can magnify gains in return on equity, so it can magnify losses. If the above cited firm with 50% debt in its capital structure had earned 6% on its total invested capital instead of 10%, then its return on equity would have declined to 4%. Debt financing involves the risk of default since interest on debt is a contractual obligation. The directors of a corporation may pass common dividends without legal difficulty but failure to meet interest payments gives creditors the Option of forcing the firm's bankruptcy. Financial leverage thus provides a direct mechanism for the trade-off of higher returns on stockholders' equity for higher risk. And this trade-off mechanism is under mana- gerial control. The degree of usage of financial leverage by indi- vidual firms will influence the results of studies such as those reviewed in Chapter II. Since the usual measure of 22 profitability in such studies was the ratio of net income to stockholders' equity, two firms could have similar assets, sales, prices and expenses, yet have differing profitability measures dependent upon the amounusof financial leverage utilized. The objective of this study is to examine the relationship among market power, profitability and financial leverage. Specifically, the purpose is to determine if powerful firms utilized large amount of debt in their capital structures, debt which may explain their superior returns on stockholders' equity. And if they did not use large amounts of debt in their capital structure, whether that failure could be attributed to managerial decisions not to minimize capital costs. The tOpic of financial leverage is closely related to the very difficult topic of cost of capital, which in turn is related to the valuation of securities by capital markets. Financial leverage decisions of individual firms are of interest to this study to the extent they influence capital costs. This chapter will discuss the cost of capital, its relationship to financial leverage and present testable hypothesis concerning market power and financial leverage. 23 B. Cost of Capital Like any productive factor, capital has a cost (k0) associated with its use. Theoretically considerable agree- ment exists as to the precise nature of k0, but in practice its measurement is surrounded with difficulty. The cost of capital is perhaps the most diffi- cult and controversial tOpic in finance. In theory, most would agree that it is the opportunity cost Of the funds employed in an investment project--the rate of return on the project--that will leave un— changed the market price of the firm's stock. In practice, there are widespread differences as to how this cost should be measured.2 As noted in the previous section, firms raise capital from two general sources, debt and equity. Since the future costs associated with issuing debt are contrac- tually stated, determining their cost (ki) to the firm is reasonably simple. The future costs of equity (ke) are on the other hand variable, that is, contingent upon future events. In order to determine its ke, a particular firm must know the price at which it can sell its common shares and the future benefits that investors who purchase the shares expect. Since the firm presumably knows the former but not the latter, the solution is indeterminant. Two unknowns present themselves, k and the expectations of e 2James C. Van Horne, Financial Management Policy (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1968), p. 110. 24 investors, and consequently no precise solution is possible. Cost of capital then depends not only upon the actions of the firm, but also upon the evaluation of those actions by capital markets. As such, its practical determination is most difficult.3 C. Financial Leverage and The Cost of Capital Traditional financial theory holds the relationship between the cost of capital and financial leverage approxi- mates the situation depicted in Figure 1. Over some initial Figure l TRADITIONAL VIEW % /ke _ k0 \/;ki / j D/TIC X* 3For a discussion of the difficulties involved in the computation of cost of capital see: Michael Keenan, "Models of Equity Valuation: The Great Serm Bubble," The JOurnal of Finance, 25 (May, 1970), pp. 243-273. 25 range of leverage, k1 is constant. That is, creditors demand a constant interest payment provided the level of debt stays within some limit. Presumably, creditors view risk over this range as constant. As D/TIC rises, ke also rises but at a slower rate since common stock investors view moderate leverage as only slightly increasing the risk of their investments. Consequently as the firm increases leverage k0, the weighted average of ki and ke, declines. This decline in the overall cost of capital demonstrates the judicious use of leverage. As D/TIC increases, the firm eventually reaches a point X* where both classes of investors become alarmed over its ability to meet its interest obligations. Beyong that point both ki and ke rise sharply,as consequently does k0. Therefore over the entire range of D/TIC, k0 is U shaped, and an optimum capital structure exists. Tradi- tional financial theory holds that a corporate financial manager should strive for that combination of debt and equity indicated by X*. This would achieve the minimiza- tion of capital costs. Determining this Optimum amount of debt in the financial structure of a given firm is the problem of corporate debt capacity. 26 In 1958, F. Modigliani and M. Miller4 (MM) ques- tioned the validity of the traditional view of leverage with its Optimum financial structure. By assuming perfect capital markets and rational investors, MM demonstrated that ko was independent of financial leverage. That is, changes in financial leverage could not effect a firm's cost of capital. The MM position is presented in Figure 2. Every effort of corporate management to obtain advantage through leverage was exactly Offset by the reactions of investors FIGURE 2 MM VIEW % ke k0 1‘1 ------~-— D/TIC 4Franco Modigliani and Merton Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review, 48 (June, 1958): reprinted in: Stephen H. Archer and Charles A. D'Ambrosio, editors, Egg Theory_of Business Finance: A BoOk of Readings (New YOrk, N.Y.: The Macmillan Company, 1968), pp. 125-159. 27 who substitute their own personal leverage. The amazing conclusion was not what MM showed to happen under their highly idealized set of assumptions, but rather their con- tention that their assumptions were reasonable approxima- tions of the real world. According to MM the actual ko of real world firms was in fact independent of their capital structures. They presented some preliminary evidence to support that conclusion.5 On this latter conclusion, MM received severe criticism. Durand questioned the MM assumed identity of corporate and financial leverage, noting the restrictions on margin borrowing.6 In addition, Durand7 noted the existence of other market imperfections, most notably brokerage commissions and tax considerations. Since interest payments are deductible tax expenses for corporations and dividends are not, governmental taxing policy favors the use of corporate debt. MM came to agree 5Ibid., p. 283: for empirical data in support of the traditional approach see: J. Fred Weston, "A Test of Cost of Capital Pr0positions," The Southern Economic Journal, October, 1962, pp. 105-12. Reprinted in: Archer and D'Ambrosio, Op. cit., pp. 202-212. 6David Durand, "The Cost of Capital, Corporation Finance, and the Theory of Investment: Comment," American Economic Review, 53 (June, 1963), pp. 433-43: reprinted in: Archer and D'Ambrosio, Op. cit., pp. 160-176. 7Ibid., p. 166. 28 that corporate income taxes reduce the cost of debt, but . . . . 8 except for this tax effect their pos1tion was unchanged. The revised MM position is presented in Figure 3. FIGURE 3 REVISED MM.VIEW ‘% D/TIC The deductibility of interest payments for corporate income tax purposes has reduced ki' now defined as the after tax cost of debt. By combining ke with the cheaper ki' k 0 declines with every increase in debt. 8Franco Modigliani and Merton H. Miller, "Corporate Income Taxes and The Cost of Capital: A Correction," American Economic Review, 53 (June, 1963), pp. 433-43: reprinted in Archer and D'Ambrosio, Op. cit.. pp. 192-202. 29 D. Corporate Debt Capacity In Spite of the practical difficulties associated with the determination of cost of capital and Optimum capital structure, businessmen cannot escape the problem. A number9 of researchers have studied the attitudes, prac- tices and justifications of corporations and their manage- ments toward the use Of debt financing. In general these studies demonstrate that corporate 10 and risks managements are well aware of the advantages associated with financial leverage. In addition, they demonstrate wide variations in the amount of debt utilized by any given firm and wide variations in the methodology of determining and the justification for the amount of debt utilized. In addition, managements have considerable lati— tude in determining debt policy. Businessmen appear to shun the direct computation of cost of capital and tend to rely upon a wide range of decision rules to determine the prOper level of debt financing. The debt to equity ratio itself is an important 9Edwin P. Harkins and Francis J. Walsh, Jr., Corporate Debt Management (New York, N.Y.: The National Industrial Conference Board, 1968). Gordon Donaldson, Copporate Debt Capacity_(Boston, Mass.: Harvard University, 1967). 10Donaldson, 6p. cit., p. 68. 3O decision rule.11 Firms evidently through tradition or by comparison to other firms determine an appropriate level of debt for their Operations. Using the debt to equity ratio of one firm to determine the debt to equity ratio of another firm could lead to non-Optimal financial decisions. Another pOpular decision rule is the earnings coverage standard.12 By this rule the net income or the income before interest and taxes, the amount available for interest payments, of the firm must be at least a certain number of times the interest payments. Such a standard has the advan- tage of focusing attention upon the payment of interest, but shares the disadvantage of any arbitrary standard in possibly fostering non-optimum decisions. As Donaldson13 points out, the risk associated with the use of financial leverage is the risk of being unable to meet fixed interest payments when due. Therefore profitability, or more precisely cash flows, and their predictability play a large part in determining corporate debt capacity. All things equal, firms with higher earnings llHarkins and Walsh, Op. cit., pp. 18-24, and Donaldson, Op. cit., pp. 100-102. 12Harkins and Walsh, Op. cit., pp. 25-26. Donaldson, 6p. cit.. pp. 103-105. 13Donaldson, Op. cit., pp. 6-9. 31 and cash flows and more stable earnings and cash flows can and should support greater amounts of debt. E. Statement of Hypotheses General agreement exists that at least over some initial range increases in D/TIC cause kO to decline. The traditionalists argue that ko declines until X*, while MM argue that ko declines with every increase in corporate debt. This study assumes that significant imperfections exist not only in capital markets but in output markets as well. Although Modigliani and Miller contributed sig— nificantly to an understanding of the theoretical effects of perfect capital markets upon capital costs, the assump- tions of perfect markets are simply too rigorous to approxi— mate observed financial and output markets. This study, then, assumes that capital markets are sufficiently imper- fect to enable firms to affect their capital costs by changing their capital structures: changes which cause the traditional U shaped cost of capital curve with its Optimum capital structure represented by X* Ideally this study should deal directly with the cost of capital. Not only should it measure a given firm's present cost of capital, but also its marginal cost of capital for every possible change in financial leverage. 32 It would then be possible to determine which firms were and were not minimizing capital costs. Clearly this would be an enormous task: one that the literature of cost of capital indicates may not be possible. Consequently this study will not examine cost Of capital directly but rather will examine the D/TIC of firms with different market structure characteristics. D/TIC will serve as an imperfect substi— tute for cost of capital. Chapter Four will consider evidence to support or refute the following null hypothesis and its alternative. H Null Hypothesis: Firms with great market 0' power have relatively more debt in their capital structures than firms with less market power. H1, Alternative Hypothesis: Firms with great market power do not have relatively more debt in their capital structures than firms with less market power. If the data analyzed in Chapter Four of this study support the null hypothesis, the study will conclude that these higher levels of debt supported by powerful firms are strong evidence, although indirect, of lower capital costs. This result would thus at least challenge the 33 traditional condemnation of market power for necessarily causing allocative inefficiency. At most it would call into question the identification in the literature of high rates of return on stockholders' equity with the exercise of monopoly profits by oligOpOlists. If on the other hand the alternative hypothesis were supported and powerful firms did not support greater levels of debt, this study will seek to determine whether powerful firms did not support greater debt because they did not have the capacity, or because they did have the capacity but chose not to use it. The second of these results would of course imply production inefficiency. CHAPTER 4 DATA ANALYSIS A. Sample Selection and Description H. M. Mann demonstrated a positive relationship between market power, as measured by both market concentra- tion and entry barriers, and firm NI/SE.1 He examined 92 firms in 30 industries for the period 1950 to 1960. Mann assigned each of these 30 industries into one of three groups which indicated difficulty of entry: very high barriers to entry, substantial barriers to entry, and moderate-to-low barriers to entry. He then assigned the leading firms of each industry into the entry barrier group for that industry. He cross—classified the 30 industries and 90 firms into two groups dependent upon whether the industry's largest eight firms had above or below 70 per cent of industry sales. This study will use the same firms as Mann for several reasons. Mann's study provided valuable information 1H. Michael Mann, ”Seller Concentration, Barriers to Entry, and Rates of Return in Thirty Industries, 1950- 1960," Review of Economics and Statistics, August, 1966, pp. 296-307. 34 35 on entry conditions; data which would have required sub— stantial effort to duplicate. The industries in Mann's 2 and this avoided the serious sample were oligopolistic, problems of measuring the profitability of smaller firms. In smaller firms, where ownership and control are united, owners serving as managers may take profits in the form of higher wages thereby avoiding corporate income taxation. From a statistical point of view, Mann selected his sample in a non-random manner. As such, no statistical inference from relationships within the sample to relation- ships within the entire economy was possible. However, the 92 firms selected by Mann held combined assets in 1962 in excess of $89 billion comprising over 30%.of all assets 3 held by manufacturing corporations in the United States. As such, a study of these firms as a unit was significant. B. Time Period Selection Mann examined the profitability of the firms in his sample in the eleven year period from 1950 to 1960. Examin- ing profitability over a number of years was wise. First, 2The lowest 10 firm concentration ratio was 29.1 per cent for bituminous coal in 1955; Ibid., p. 298. 3U. S. Senate, Committee on the JUdiciary, Subcom— mittee on Antitrust and Monopoly, Hearings, Economic Concentration, Part 1 (Washington: 1964), p. 115. 36 economic theory demonstrates that even perfectly competitive markets may endure short run adjustment periods during which profits and prices above the competitive are possible. Second, corporate managements have discretion under modern accounting procedures in timing the recognition of revenues and expenses. Although management does not have the ability to create income through selection among various accounting techniques, management does have the ability within limits to shift reported income from period to period. Averaging profitability measures over a number of years minimizes any potential short run fluctuations attributable to the above factors. This study covers the period 1956 to 1963. The assumption is that it is a sufficiently long period to achieve the benefits outlined above. In addition it over- laps Mann's study by five years and as such maintains the strength of his market power classifications. The period also avoids the early 1950's with its Korean War related dislocations, and is sufficiently long to include periods of general economic prosperity and decline. C. Data Collection Data for 79 of the 90 firms came from the Compustat 37 Data Tapes of Standard and Poor Corporation.4 Data for the remaining 11 firms came from the apprOpriate Moody's Industrial Manual. The following data was compiled for each firm for each year from 1956 through 1963. ‘NI Net Income--income after all Operating and non-Operating income and expense and minority interest, but before preferred and common dividends. It is stated after extraordinary items which are listed in the company's pub- lic reports as being net of taxes. IE Interest Expense-—all interest paid plus the amortization of debt discount or premium and the amortization of debt flotation expenses. Taxes--actual and deferred federal and state Ia corporate income taxes. .EEEI Earnings Before Interest and Taxes—-the sum of NI, IE and T. TA Total Assets—-all recorded assets of the firm including current assets, net plant and equip- ment, deferred items and intangibles. ID Long Term Debt--debt obligations due after one year. 4Mann used 92 firms in his study, but two, American Chicle and American Viscose, merged out Of existence during 1960-1963. Hence only 90 firms pOpulate this study. IO 38 Preferred Stock-~the number of preferred shares outstanding times the involuntary liquidation value per share. Stockholders' Equity--the sum Of the capital stock, capital surplus and retained earnings accounts. Total Invested Capital-—the sum of D, P and SE. In addition to the above raw data, the following ratios were calculated for each firm for each year from 1956 through 1963. NIZSE EBITZTA DZTIC EBITZIE Net Income to Stockholders' Equity Earnings Before Interest and Taxes to Total Assets. Debt to Total Invested Capital. Times Interest Earned. D. Data Presentation Table 15 presents a summary of average NI/SE and D/TIC for the 30 industry sample divided into the three entry barrier groups: very high, substantial, and moderate- tO-low. 5Appendix A contains a more complete data presenta- tion. 39 TABLE 1 AVERAGE PROFIT RATES (NI/SE) AND AVERAGE LEVERAGE RATIOS (D/TIC) FOR THIRTY INDUSTRIES, 1956-1963, CLASSIFIED BY BARRIERS TO ENTRY Average Average Entry Barriers ~ Profit Rates Leverage Ratio 1956-1963 1956-1963 very High 13.67 8.82 N=8 Substantial N=9 9.89 16.06 Moderate-to-Low N=13 9.03 19.99 Table 2 presents a summary of average NI/SE and D/TIC for the 30 industry sample divided into two market 6 concentration groups: industry concentration rates above 70 per cent, industry concentration, industry concentration ratio below 70 per cent. TABLE 2 AVERAGE PROFIT RATES (NI/SE) AND AVERAGE LEVERAGE RATIOS (D/TIC) FOR THIRTY INDUSTRIES, 1956-1963, CLASSIFIED BY INDUSTRY CONCENTRATION Average Average Concentration Profit Rates Leverage Ratio 1956-1963 1956-1963 Above 70% N=21 11.54 14.38 Below 70% N=9 8.15 19.22 6Percentage of industry shipments by the largest eight firms. 40 E. Data Analysis The information on profitability presented in Table l and Table 2 corresponds closely, as expected to Mann's profitability results. The average profitability of the very high entry barrier group (13.67) was significantly higher than the average profitability of the substantial (9.89) and moderate-to-low (9.03) entry barrier groups, but no such significance existed between these latter two groups. Similarly the average profitability of the over 70 per cent market concentration group (11.54) was sig- nificantly higher than the average profitability of the below 70 per cent market concentration group (8.15). The statistical technique of analysis of variance tested for, and confirmed, the significant differences at the .05 confidence level. Once again consider the null hypothesis and its alternative. Ho' Null Hypothesis: Firms with great market power have relatively more debt in their capital struc- tures than firms with less market power. H1, Alternative Hypothesis: Firms with great market power do not have relatively more debt in their capital structures than firms with less market power. 41 An analysis of the financial leverage data presented in Table l and Table 2 refutes the null hypothesis and supports its alternative. In fact, in contrast to the positive rela- tionship between market power and financial leverage con— jectured in the null hypothesis, the relationship was inverse. The average financial leverage of the very high entry barrier group (8.82) was significantly less than the average financial leverage of the substantial entry barrier group (16.06) which in turn was significantly less than the average financial leverage of the moderate-to-low entry barrier group (19.99). Also the average financial leverage of the over 70 per cent market concentration group (14.38) was significantly less than the average financial leverage of the under 70 per cent market concentration group (19.22). Once again the statistical technique of analysis of variance tested for, and confirmed the significant differences at the .05 confidence level. F . Debt Capacipy Since the above data clearly supported the alterna- tive hypothesis, this study attempted to measure the rela— tive debt capacity of the differing market power groups. Three measures of debt capacity were examined: the ratio 42 of earnings before interest and taxes to total assets (EBIT/ TA), the variance Of EBIT/TA over time, and the ratio of earnings before interest and taxes to interest eXpense (EBIT/IE). The ratio Of earnings before interest and taxes to total assets measures the rate of return on a firm's total asset base independent of the effects of taxation and financial leverage. As such this measure of profitability provides a good indication of debt capacity since the higher the EBIT/TA the greater the ability of a firm's operations to support debt. In addition to the absolute value of EBIT/TA, its variance over time is also a measure of debt capacity. Operationally, this was calculated for each firm over time and then an industry average taken. Since not only earnings and cash flows but their predictability influence debt capacity, the more stable EBIT/TA over time presumably the greater debt capacity. The variability of EBIT/TA over time measures Operating or business risk, the risk resulting from the firm's Operations. As such the greater Operating risk a firm sustains, the less financial risk expected. Table 37 presents a summary of average EBIT/TA and 7Appendix B contains a more complete data presenta- tion. 43 average variance of EBIT/TA for the 30 industry sample divided into three entry barrier groups: very high, sub- stantial and moderate-to-low. TABLE 3 AVERAGE EBIT/TA AND AVERAGE VARIANCE EBIT/TA FOR THIRTY INDUSTRIES, 1956-1963, CLASSIFIED BY BARRIERS TO ENTRY Average Average Entry Barriers EBIT/TA Variance EBIT/TA 1956-1963 1956-1963 Very High , N=8 18.19 19.42 Substantial 12.49 10.82 N=9 Moderate-to-Low 11.57 8.07 N=13 Table 4 presents a summary of average EBIT/TA and the average variance of EBIT/TA for the 30 industry sample divided into two market concentration groups: industry con- centration rates8 above 70 per cent, industry concentration ratio below 70 per cent. 8Percentage of industry shipments by the largest eight firms. 44 TABLE 4 AVERAGE EBIT/TA AND AVERAGE VARIANCE EBIT/TA FOR THIRTY INDUSTRIES, 1956-I963, CLASSIFIED BY INDUSTRY CONCENTRATION Average Average Concentration EBIT/TA Variance EBIT/TA 1956-1963 1956-1963 Above 70% N=21 15.08 13.39 Below 70% N=9 10.18 8.50 The data contained in Tables 3 and 4 present con- flicting measures of the debt capacity of different market power groups. On the basis of average EBIT/TA powerful firms, as measured by both entry barriers and market con- centration, could have supported more debt than less powerful firms. But on the basis of the average variance of EBIT/TA over time, powerful firms should have supported less debt than less powerful firms. Variance, however, is affected by both the variability of observations about their mean and by the magnitude of the quantities involved. In an attempt to correct for the effect of absolute magnitudes upon average variance, the average variance of EBIT/TA for each market power group was divided by the average EBIT/TA of that market power group. The results of this adjustment 45 were: moderate—to-low entry barrier group (.6974), substan- tial entry barrier group (.8662), high entry barrier group (1.024). The high entry barrier group had greater adjusted variability and therefore lower debt capacity than the sub- stantial entry barrier group which in turn had lower adjusted variability than the moderate—to-low entry barrier group. But the over 70 per cent concentration group (.8879) had ap— proximately the same adjusted variability and therefore debt capacity as the below 70 per cent concentration group (.8349). The third measure of debt capacity was the number of times earnings before interest and taxes covered interest expense (EBIT/IE). This debt capacity measure was difficult to compute since a number of firms had no or very little debt and EBIT covered interest eXpense an infinite number of times. Therefore no tabular summary of EBIT/IE for each market power group is presented in the body of this study, but rather Appendix C contains a cOmplete listing of EBIT/IE for all firms in the study.' Examination of Appendix C re— veals that powerful firms as measured by both entry barriers and market concentration covered their interest expense more times than other less powerful firms. On this basis powerful firms could have supported greater amounts of debt than they actually did with little danger of debt payment default. CHAPTER 5 LIMITATIONS AND IMPLICATIONS A. Study Limitations Ideally this study should have measured the actual and marginal, for any given change in the prOportions of debt and equity financing, costs of capital for a number of randomly selected competitive firms. Then each firm would acquire increased measures of market power and the effects of that increased market power upon their actual and marginal costs of capital noted. Clearly such a design would produce concrete answers to many important contro- versies in finance and economics, and just as clearly social science research does not lend itself to such con— trolled experimental designs. Each necessary deviation from this idealized design placed limitations upon the findings of this study. These interrelated limitations dealt with problems of inference, measurement and com— parison. Mann's sample selection process was non-random and as such statistical inference of characteristics of the sample to characteristics of all firms within the economy 46 47 is not possible. Hence the significance of this study rests upon the importance of the firms selected1 and any conclusions of this study refer specifically to them. Mann clearly selected firms for his study which he could place into single industry classifications. As such, the sample was free of firms which Operated within several industries. It is entirely possible that powerful firms of a greater conglomerate or inter-industry nature utilized greater financial leverage than other firms. For the less correlated the cash flows of two firms over time, the lower the total variability of those flows over time if combined.2 In short, powerful firms of a more diversified nature may, utilize more debt than other less powerful firms, although this was not true for the powerful firms examined in this study. Data for this study came from published financial 3 statements prepared in accordance with generally accepted accounting principles. As such the data possessed several lSupra, Chapter Four, Section. A. 2For a discussion of the reductions in the vari- ability of cash flows and earnings over time by combining varied economic activities into one unit see: ‘William W. Alberts and JOel E. Segall, Editors, The Corporate Merger (Chicago, Ill.: The University of Chicago Press, 1966), pp. 262-272. 3Supra, Chapter Four, Section C. 48 limitations for the measurement requirements of this study. Although corporate managers do not have the ability to create income over the life of the enterprise by selecting from among varying accounting procedures, they do have a degree of control over the timing of the recognition of revenues and expenses and consequently a degree of control over income reporting and asset valuation. Inter-company comparisons of income or asset values could, in the short run, draw bias from the income recognition and asset valu— ation procedures employed by particular firms. By assump- tion, eight year averages minimized the effects of this limitation. Corporations carry assets at historical costs which may or may not represent current values. Clearly some firms, particularly older firms and firms with large hold— ings of non—depreciable land, have understated asset values. These differences in asset valuations limit the conclusions of this study with its inter—company comparisons, but no less biased asset valuation system was readily apparent.4 Generally accepted accounting principles can 4See: Ralph Coughenour Jones, Price Level Changes and Financial Statements (Evanston, Ill.: American Account- ing Association, 1955). The Staff of the Accounting Research Division of the American Institute of Certified Public Accountants, Reporting The Financial Effects of Price-Level Changes (New York, N.Y.: American Institute of Certified Public Accountants, 1963). 49 understate some long term corporate liabilities, most notably future payments due under executory lease con- tracts.5 This fact may cause the understatement of the long term liabilities of firms which heavily utilized leased capital, and therefore could be a limitation upon this study which concerns itself with measurements of long term debt. Unfortunately, no system for adjusting financial statements to reflect lease liabilities was discovered which would have resulted in less biased data. This study used the ratio of the book values of long term debt to total invested capital as the measure of finan- cial leverage. It did not use market values as the market value of common equity could reflect the capitalized value of future monOpoly profits, the precise value to isolate. Independently determined input values of equity and debt financing were desirable to measure inputs of equity and debt capital, but as such precluded a direct measure of cost of capital. Therefore this study can make only general conclusions concerning market power, cost of capital and security valuation. The valuation of a firm's security 5See: JOhn H. Myers, Reporting of Leases in Finan- cial Statements (New York, N.Y.: American Institute of Certified Public Accountants, 1962). Accounting Principles Board of the American Institute of Certified Public Accountants, Opinion No. 5, "Reporting of Leases in the Financial Statements of Leases," September, 1964. 50 and therefore its cost of capital is a function of the actions of the firm and the evaluation of these actions by security markets. Financial leverage can increase both the profitability of a firm and the level of risk it sustains, and consequently sharp increases in leverage may not decrease capital costs. Two firms could have similar Operationsand differing levels of debt and both be Operating efficiently since imperfect capital markets evaluate them differently. Once one admits the existence of imperfect markets, one must admit the possibility that differences between firms are not the result of inefficiency but of individual firms adjusting to imperfect market forces. As such, this dissertation deals directly with market power and financial leverage and precinds from direct measure— ments of the effects of market power through financial leverage upon security valuation and cost of capital. Because of the difficulties associated with measur- ing net income, asset values and long term liabilities for any given firm and the lack of agreement upon the proper measures of cost of capital and Optimum debt capacity, inter-firm comparisons are difficult. It is entirely possible that differences observed between firms could be the result of these difficulties of measurement. This is clearly a limitation of this study. 51 B. Study Implications The powerful firms examined in this study, as mea- sured by both market concentration and entry barriers, earned a greater return on their stockholders' equity (NI/SE) than other less powerful firms. These powerful firms used relatively less debt in their capital structures which refutes the suggestion that their higher observed profitability could be the result of great amounts of financial leverage. The results of this study therefore support the traditional condemnation of higher oligOpoly profits as indicative of allocative inefficiency. The higher profit- ability of these firms presumably came from restricted out— put and non-competitive pricing--practices made possible by the entry barriers and the small number of market partici- pants. Powerful firms then violate the dual objectives of public policy: efficient production and reasonable prices and profits. By powerful firms restricting output, society did not receive the highest valued output its limited input stock was capable of producing and the prices and profits of powerful firms were greater than those competitive mar- kets would permit. Powerful firms could earn these exces- sive returns since entry barriers prohibited them from being bid away. As such this study supports the theoretical 52 economic predictions that market prices, profits and output are a function of the structure of the market-~particularly the number of sellers and ease of entry into the market. The finding of an inverse relationship between mar- ket power and financial leverage and the academic literature accusing powerful firms of productive inefficiency raise an even more serious question. Did powerful firms not support greater financial leverage because they did not have the capacity to do so, or did powerful firms have the capacity to support greater financial leverage and choose not to do so? The question becomes whether powerful firms are guilty of unproductive debt and equity allocation (productive inefficiency) as well as contributing to allocative ineffi- ciency by their pricing and output decisions. The determination of a definite answer to the above question is difficult because of the lack of agreement upon a precise measure of debt capacity; the measurements ex- amined also gave conflicting results. The evidence examined in this study cannot refute the charge that powerful firms should have supported greater debt within their capital structures, greater debt which presumably would have lowered their capital costs. In general, if the powerful firms examined in this study could have predicted their earnings before interest and taxes, then they could have supported 53 more debt without default of debt interest payments. Had they done so their NI/SE and their earnings per share would have been higher and more variable. If the conservative capital structures of powerful firms are less than optimal, then they present important public policy implications. The output prices of powerful firms would be sufficiently high to produce superior profits in spite of inflated expenses. As such these superior profits would represent only a portion of the inefficiency associated with market power. The managements of powerful firms could maintain the benefits and flexibility associ- ated with a conservative capital structure and pass the cost of that conservatism to their customers in the form of excessive prices. Clearly these conservative capital struc- tures require additional research. BIBLIOGRAPHY Books Alberts, William W. and Segall, Joel E. The Corporate Merger. Chicago, Ill.: The University of Chicago Press, 1966. American Institute of Certified Public Accountants. Repprting the Financial Effects of Price-Level Changes. New York: The American Institute of Certified Public Accountants, 1963. Archer, Stephen H. and D'Ambrosio, Charles A. (Ed). The Theory of Business Finance. New York: The Macmillan Company, 1967. Bain, Joe S. Barriers to New Competition. Cambridge, Mass.: Harvard University Press, 1956. Bain, Joe S. Industrial Organization. New York: Wiley, 1959. 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Chicago, Ill.: The Univer- sity of Chicago Press, 1951. Osborn, Richard C. Effects of Corporate Size on Efficiengy and Profitability. urbana, Ill: University of Illinois, Bulletin No. 72, 1950. Scherer, F. M. Industrial Market Structure and Economic Performance. Chicago, Ill.: Rand McNally and Company, 1970. Sheperd, William G. Market Power and Economic Welfare. New YOrk: Random House, 1970. Sherman, Howard J. Profits In The United States. Ithaca, N.Y.: Cornell university Press, 1968. Stekler, H. O. Profitability and Size of Firm. Berkeley: Institute of Business and Economic Research of The University of California at Berkeley, 1963. Stigler, George J. Capital and Rates of Return in Manu— facturing Industries. Princeton, N.J.: Princeton University Press, 1963. Van Horne, James C. Financial Management and Policy. Englewood Cliffs, N.J.: Prentice-Hall, 1968. Articles Alexander, Sidney S. "The Effect of Size of Manufacturing Corporation on the Distribution of the Rate of Return," Review of Economics and Statistics, Vol. XXI (August, 1949), 229-235. Bain, Joe S. "Relation of Profit Rates to Industry Con- centration,"'guarterly_Journal of Economics, Vol. LXV (August, 1951), 293—324. 56 Dorfman, R. and Steiner, P.O. "Optimal Advertising and Optimal Quality," American Economic Review, Vol. IVL (December, 1954), 826-836. Durand, David. "The Cost of Capital, Corporation Finance, and the Theory of Investment: Comment," American Economic Review, Vol. LIII (June, 1963), 433-443. Fuchs, Victor. "Integration, Concentration and Profits in Manufacturing Industries," Quarterly JOurnal of Economics (May, 1961), 278—291. Hall, Marshall and Weiss, Leonard. "Firm Size and Profit- ability," Review of Economics and Statistics, Vol. IL (August, 1967), 319-331. Keenan, Michael. "Models of Equity Valuation: The Great Serm Bubble," The Journal of Finance, Vol. XXV (May, 1970), 243-273. Kilpatrick, Robert W. "Stigler on the Relationship Between Industry Profit Rates and Market Concentration," The Journal of Political Economy, Vol. LXXVI (May/June, 1968), 479-488. Larner, R. J. "Ownership and Control in the 200 Largest Nonfinancial Corporations, 1929-1963," American Economic Review, Vol. LVI (September, 1966), 777- 787. Leibenstein, Harvey. "Allocative Efficiency vs. 'X-Efficiency,'" American Economic Review, Vol. LVI (June, 1966), 392-416. Mann, H. Michael. "Seller Concentration, Barriers to Entry, and Rates of Return in Thirty Industries, 1950-1960," Review of Economics and Statistics Vol. XLVIII (August, 1966), 296-307 Modigliani, Franco and Miller, Merton. "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review, Vol. XLVIII (June, 1958), 261-297. Modigliani, Franco and Miller, Merton. "Corporate Income Taxes and The Cost of Capital: A Correction," American Economic Review, Vol. LIII (June, 1963), 57 433-443. Samuels, J. M. and Smyth, D. J. "Profits, Variability of Profits, and Firm Size," Economica, Vol. XXXV (May, 1968), 127. Stekler, H. O. "The Variability of Profitability With Size of Firm, 1947-1958," JOurnal of the American Statistical Association, Vol. LIX (December, 1964), 1183-1193. Weiss, Leonard W. "Average Concentration Ratios and Industrial Performance," JOurnal of Industrial Economics, (July, 1963), 237-253. Weston, J. Fred. "A Test of Cost of Capital Propositions," The Southern Economic Journal (October, 1962), 105-112. Williamson, 0. E. "Managerial Discretion and Business Behavior," American Economic Review, Vol. LIII (December, 1963), 1032-1057. Whippen, Ronald E. "Financial Structure and the Value of the Firm," The Journal of Finance, Vol. XXI (December, 1966), 615. Government Documents U. S. Bureau of the Census, Annual Survey of Manufacturers: 1966, "Value-of-Shipment Concentration Ratios by Industry," M66(AS)-8 (Washington, 1968). U. S. Senate, Committee on the Judiciary, Subcommittee on Antitrust and MonOpoly, Hearings, Economic Concentration, Part 1 (Washington: 1964). 58 APPENDIX A AVERAGE OF AID VAllAlC! O, LZVDIAG! IAIIO (DITIC) AID AVIIAG! OF AID VAIIAIC! 0' PIDFIT IATES (II/8!) '08 THIRTY INDUSTRIES, 1956-1963. CLASSIFIED DY DAIIIIII TO INTI! yp/rxc 1936:1263 8i Int Iarriera nrlgifieso-iees Average Variance Average Variance Auto-obilee“ General Motora Corp. 5.677 1.090 19.004 10.793 Ford Motor Co. 7.654 4.924 13.408 12.830 Chryaler Corp. 25.002 2.725 5.885 58.714 Industry Averagea 12.778 2.913 12.766 27-4‘6 Chewing Cult. Urialey (UH.) Jr. 0.000 0.000 13.668 .925 Induatry Averagea 0.000 0.000 13.668 .925 Cigarette-u Reynolda Inc. 14.996 18.426 19.350 .839 A-erican Tobacco 20.806 43.465 13.264 .235 nggett 6 flayere. Inc. 22.024 13.084 10.328 1.340 Philip Harrie. lnc. 22.568 27.376 12.255 .206 lnduatry Averagaa 20.098 25.588 13.799 .655 Ethical Drugs“. Merck 6 Coupany .335 .007 17.626 3.840 Pfizer Inc. 7.947 31.793 16.795 1.357 Scherin; Corp. .085 .007 23.194 75.615 Parke, Davie 6 Co. 0.000 0.000 18.060 17.876 Abbott Laboratoriea 2.322 4.674 14.633 3.283 lnduatry Averages 2.138 7.296 18.062 20.394 Flat Glaae“ Pittabur‘ 7.094 8.722 10.149 6.974 Libby-Owene-Ford 0.000 0.000 19.623 20.093 Induatry Averagee 3.547 4.361 14.886 13.533 Liquor“ Seagral 18.032 4.728 6.915 .093 National Distillate 31.627 8.669 8.395 l.034 Schenley Induatriee 35.346 18.032 4.016 2.464 Hire. Halter 1.781 2.376 ll.s47 .066 lnduatry Averagea 21.696 8.45] 7.668 .914 Hickel“ Intl Nickel 0.000 0.000 15.770 13.480 Falconbridge 20.63] 301.679 17.23] 26.586 Induatry Averasea 10.315 150.840 16.500 20.033 Sulphur“ Iexaa Gulf Sulphur 0.000 0.000 l2.960 27.782 Preaport Sulphur Co. 0.000 0.000 11.138 [6.014 Induetry Averagea 0.000 0.000 12.049 21.898 Averagaa for Entry Barrier Group 8.822 24.93! 13.675 13.225 ‘1nduatriea with eight fire concentration ratioa below seventy percent. "Induetriee with eight fire concentration ratioa above seventy percent. 59 annual: A.—-Continued 9111c 1956-1963 Subetential Iota Barriere 111751: 1956-1963 Average Variance Average Variance alt-inu- Production“ Alcoa 34.317 10.326 8. 794 11.925 Ieynolde htale Co. 47.977 11.699 11. 722 25.124 laieer 49.669 14.578 13.488 12.676 Indmtry Averagee 43.988 12.201 11.335 16.575 Iiecuite“ Ietional liecuit Co. 4.187 50.384 15.098 2.225 Swahine Iiecuite 0.000 0.000 11.037 1.105 United Iiecute 22.124 3.146 6.576 5.220 Iednetry Averagee 8.770 17.843 10.904 2.850 ’082'0106- leaning. 8mdard 011 (I.J.) 10.081 .183 11.560 5.015 Texaco Inc. 11.661 6.112 14.955 .959 Mobil Oil Corp. 7.416 3.600 8.048 2.780 8tndard Oil (1nd.) 14.831 4.224 6.917 .439 ledutry Averagee 10.997 3.511 10.370 2.298 Heel“ 0. 8. 8tee1 Corp. 13.633 24.852 9.549 11.439 lethldee 8teel Corp. 9.188 9.340 8.613 6.229 laptlic 8tee1 Corp. 15.603 38.177 8.645 6.680 Jonee 6 Leo‘lin 21.201 .994 7.067 4.065 Indoetry Averagee 14.906 18. 341 8.468 7.103 ea Proctor 6 Cefile Co. 14.363 10.508 15.203 .483 Colgate Palmlive Co. 17.346 5.414 10.825 .636 Iedutq Averagee 15.854 7.961 13.014 .559 Vere Machinery and Tractore“ International Iarveeter 12.300 2.520 6.662 1. 339 Allie Ciel." 22.107 1.205 4. 544 4.481 Deere 6 Co. 24.480 19.744 10.132 8.340 ledutry Averagee 19.629 7.823 7.113 4.840 Caper” Innecott Copper Corp. .739 .238 10.093 14.818 Anaconda Co. 9.275 3.252 6.070 10.576 Phelpe Doha Corp. 0.000 0.000 11.573 23.728 6.- 8-1t 6 lelin. 1.818 14.759 8.086 8.072 lndutry Averagee 2.958 4.562 8.955 14.298 Cenent“ Ideal Ce-eet Co. 21.635 76.469 14.066 5.651 Lone Itar Conant 18.284 19.080 12.055 7.920 Lough Portland 23.570 25.602 6.958 7.046 Cenerel Portland 13.398 51.228 14.867 18.947 Indutry Averagee 19.222 43.095 11.986 9.891 8hoe Machinery“ United 8tetee 8hoe .501 .009 8.046 2.197 00.0 hoe Iachieery 16.032 8.719 5.829 12.716 Induetry Averagee 8.267 4. 364 6.938 7.457 Averagee (or Intry lorrier Crow 16.066, 13.302 9.898 7. 319 '1ndmtriee with eight fire concentration ratioe below eeventy percent. “indoetriee with eight tir- concentretion ratioe above aeventy percent. 60 APPENDIX A.--Continued D/TIC 1956-1963 Hoderate-to-Low Entry Barricre N1/SE 1956—1963 Average Variance Gleae Containere“ Owene-lllinoie lnc. 15.951 1.266 Anchor flocking Corp. 0.000 0.000 Thatcher Glaae 32.365 27.648 Induetry Averagee 16.105 Tiree and Tune” Goodyear Tire 29.097 13.728 Fireatone Tire 14.626 10.466 0. 5. Rubber 32.595 9.539 Goodrich (8. 7.) Co. 13.874 15.319 Induetry Averagae 22.548 Shoee. International Shoe 31.439 6.613 8rown Shoe Co.. Inc. 28.939 10.708 lndicott Johneon Corp. 18.212 46.469 Indutry Averagee 24.172 Rayon.9 Calaneee Corp. 29.545 1.967 leaunit Corp. 21.857 6.747 lnduetry Averagee 25.701 Gypeu-nrroducte 0. 8. Gypeun Co. 0.000 0.000 Iational Gypeua Co. 12.530 11.590 lnduetry Averagee 6.265 Canned Fruite and Vegetablea' California Paching 26.015 22.368 Libby. Icleill 31.114 2.047 Stately-Van Canp 18.339 23.936 Induetry Averagee 25-156 lent Packing. Swift 6 Conpeny 18.247 18.634 Areour 6 Co. 44.512 2.797 Uileon 9.671 1.981 Induetry Averagee 24.143 Flour. General Kille. lnc. 20.741 4.715 Pillabury Co. 22.271 8.089 Induetry Averagea 21.506 Intel Containere' Aeerican Can Co. 28.628 29.630 Continental Can Co. 25.880 3.154 Induetry Averagee 27.254 8rewere9 Anheuaer lueh. Inc. 14.597 10.925 Pabet 8rewing Co. 16.460 24.663 laleteff Ire-ing Corp. 20.700 11.782 Induetry Averagee 17.252 Iating‘ Continental baking Co. 20.735 33.998 Aeericen leheriee Co. 2.515 5.304 General labing 26.432 5.778 lnduetry Averagee 16.561 lituldnoue Coal. Coneolidetion Coal Co. 5.517 .686 Peabody Coal Co. 31.305 32.724 laland Creek Coal Co. 1.183 9.801 1nduetry Averagee 12.668 Textile Hill Producte' lurlington 1nduetriee 32.691 12.075 Stevena (J. P.) 6 Co. 21.970 6.624 Cone Hille Corp. 12.265 13.526 Dan liver lilla Inc. 15.272 3.553 lnduetry Averagee 20.549 Averagee (or lntry Iarrier Group 19.991 Average Variance 9.210 2.740 12.564 5.098 11.078 8.546 9.638 10.951 5.461 12.297 1.652 11.147 2.369 10.811 5.900 8.001 3.843 12.263 10.564 3.441 7.557 3.675 10.301 6.117 -2.486 115.678 21.293 7.209 31.850 13.824 1.270 8.126 13.313 4.357 10.975 7.291 14.470 5.959 10.332 1.946 5.795 12.401 3.953 9.624 1.440 5.135 7.881 8.046 4.143 16.117 7.602 4.488 3.885 .486 6.241 5.927 3.990 1.450 7.804 4.705 2.621 10.260 2.926 8.571 1.096 6.402 9.416 2.011 9.499 .978 9.486 3.919 16.392 9.493 2.448 9.342 1.029 2.690 22.635 14.805 2.774 15.790 8.946 8.813 13.449 9.715 10.639 20.441 5.376 17.514 15.027 9.821 15.880 6.958 1.065 12.962 1.944 7.981 13.000 14.404 9.30 5 336 8.613 3.964 5.642 1.965 3.449 .884 6.475 .790 8.944 6.045 1.901 11.864 0.033 7.346 “Induetriee eitb eight lire concentration ratioe below eeventy percent. 99lnduetriee with eight firn concentration ratioe above eeventy percent. 61 APPENDIX B AVERAGE OF AND VARIANCE 0F PROFIT RATES (EBIT/TA) FOR THIRTY INDUSTRIES, 1956-1963, CLASSIFIED BY BARRIERS TO ENTRY High Entry Barriers EBIT/TA 1956-63 Average Variance Automobiles** General Motors Corp. 23.840 21.321 Ford Motor 17.080 17.075 Chrysler Corp. 6.077 50.805 Industry Averages 15.666 29.734 Chewing Gum** Wrigley (Wm.) Jr. 23.670 2.339 Industry Averages 23.670 2.339 Cigarettes** Reynolds Inc. 23.957 4.178 American Tobacco 16.903 .987 Liggett 6 Myers, Inc. 15.125 2.190 Philip Morris, Inc. 13.212 1.622 Industry Averages 17.299 2.244 Ethical Drugs** Merck 8 Company 24.245 3.734 Pfizer Inc. 18.474 8.007 Schering Corp. 28.990 122.234 Parke, Davis 6 Co. 24.073 42.160 Abbott Laboratories 18.732 4.213 Industry Averages 22.903 36.070 Flat Glass** Pittsburg 14.731 13.507 Libby-Owens-Ford 32.957 41.730 Industry Averages 23.844 27.618 Liquor** Seagram 10.746 .494 National Distillers 9.601 1.931 Schenley Industries 5.604 1.917 Hiram Walker 19.269 .596 Industry Averages 11.305 1.234 Nicke1** Intl Nickel 20.599 19.818 Falconbridge 14.946 10.632 Industry Averages 17.773 15.225 Sulphur** Texas Gulf Sulphur 15.449 57.214 Freeport Sulphur Co. 10.771 24.711 Industry Averages 13.110 40.962 Averages for Entry Barrier Group 18.196 19.428 62 APPENDIX B.--Continued Substantial Entry Barriers EBIT/TA 1956-63 Average ‘_ Variance Aluminum Production** Alcoa 8.369 12.295 Reynolds Metals Co. 8.589 11.836 Kaiser 7.655 9.714 Industry Averages 8.204 11.282 Biscuits** National Biscuit Co. 21.408 1.826 Sunshine Biscuits 18.845 5.094 United Biscuits 8.894 4.909 Industry Averages 16.382 3.943 Petroleum Refining Standard Oil (N.J.) 12.693 3.067 Texaco, Inc. 13.554 1.360 Mobil Oil Corp. 9.597 2.228 Standard Oil (1nd.) 6.599 .800 Industry Averages 10.611 1.864 Steel** U.S. Steel Corp. 11.901 18.503 Bethlehem Steel Corp. 12.457 8.052 Republic Steel Corp. 11.997 21.315 Jones 6 Laughlin 8.617 5.381 Industry Averages 11.243 13.313 Soap** Proctor 6 Gamble Co. 20.503 1.042 Colgate Palmolive Co. 13.259 .810 Industry Averages 16.881 .926 Farm Machinery and Tractors Intl Harvester 8.764 2.121 Allis Chalmers 6.406 8.391 Deere 6 Co. 13.067 14.084 Industry Averages 9.412 8.199 Copper** Kennecott Capper Corp. 18.678 37.935 Anaconda Co. 10.059 23.049 Phelps Dodge Corp. 16.334 42.453 Amer. Smelt 6 Refin. 8.635 9.924 Industry Averages 13.426 28.340 Cement** Ideal Cement Co. 18.016 18.362 Lone Star Cement 15.983 5.422 Lehigh Portland 9.735 13.544 General Portland 21.480 41.628 Industry Averages 16.303 19.739 63 APPENDIX B.--Continued Substantial Entry Barriers EBIT/TA 1956-63 Average Variance Shoe Machinery** United States Shoe 11.758 3.659 Gompo Shoe Machinery 8.196 16.029 Industry Averages 9.977 9.844 Averages for Entry Barrier Group 12.493 10.828 64 APPENDIX B.--Continued Moderate-to-Lov Entry Barriers EBIT/TA 1956-63 Average, Variance Glass Containers Owens-Illinois Inc. 10.947 3.176 Anchor Hocking Corp 18.425 10.123 Thatcher Glass ‘12.789 9.346 Industry Averages 14.054 7.548 Tires and Tubes** Goodyear Tire 14.598 .594 Firestone Tire 14.899 1.417 U. 8. Rubber 9.975 2.770 Goodrich (B.F.) Co. 11.801 8.994 Industry Averages 12.818 3.444 Shoes* International Shoe 10.098 5.042 Brown Shoe Co., Inc. 18.394 1.069 Genesco 10.277 4.920 Endicott Johnson Corp. 1.163 46.016 Industry Averages 9.983 14.262 Rayon** Celanese Corp. 10.721 2.627 Beaunit Corp. 11.266 16.084 Industry Averages 10.993 9.355 Gypsum Products U. S. Gypsum Co. 23.708 12.059 National Gypsum Co. 15.564 3.042 Industry Averages 19.636 7.550 Canned Fruits and Vegetables* California Packing 11.224 2.443 Libby, McNeill 6.684 6.477 Stokely-Van Camp 8.955 3.823 Industry Averages 8.954 4.248 Meat Packing* Swift 6 Company 5.255 1.373 Armour 6 Co. 6.736 4.575 Wilson 10.203 8.886 Industry Averages 7.398 4.945 Flour* General Mills, Inc. 11.766 4.656 Pillsbury Co. 11.491 3.779 Industry Averages 11.628 4.218 Metal Containers** American Can Go. 11.852 1.883 Continental Can Go. 11.942 2.797 Industry Averages 11.897 2.340 APPENDIX 65 B.--Continued Moderate;to-Low Entry Barriers EBIT/TA 1956-63 Average Variance Brewers* Anheuser Busch Inc. 15.188 3.702 Pabst Brewing Co. 4.544 43.505 Falstaff Brewing Cor. 18.723 3.088 Industry Averages 12.818 16.765 Baking* Continental Baking Co. 15.212 6.805 American Bakeries Co. 16.205 36.501 General Baking 6.081 13.660 Industry Averages 12.499 18.989 Bituminous Coa1* Consolidation Coal Co. 8.088 1.625 Peabody Coal Co. 11.616 .454 Island Creek Coal Co. 8.685 20.630 Industry Averages 9.463 7.570 Textile Mill Product8* Burlington Industries 10.537 8.143 Stevens (J.P.) 6 Co. 7.766 3.090 Cone Mills Corp. 5.997 1.855 Dan River Mills Inc. 8.959 1.735 Industry Averages 8.315 3.706 Averages for Entry Barrier Groups 11.574 8.072 *Industries with eight firm concentration ratios below seventy percent. **Industries with eight firm concentration ratios above seventy percent. 66 APPENDIX C ANNUAL INTEIEST COVERAGE (EBIT/IE) POI THIRTY INDUSTRIES. 1956-1963 CMSSIYIED DY “”1885 1‘0 011'" Iiigh Entry larriere Annual EDIT] lb 1956 1957 1958 1959 1960 1961 1962 1963 Autonobilee" General Intern Corp. 100.170 79.435 75.461 161.735 166.654 99.552 115.897 190.380 Pord Motor Co. O 89.056 23.455 82.059 76.397 70.973 85.174 103.646 Chryelar Corp. 8.256 31.726 -6.817 -0.080 8.010 3.286 15.415 33.085 Chewing Cult. Wrigley (0..) Jr. O O O O O O O - Cigarettee" Reynaldo Inc. 28.475 21.118 32.500 30.695 27.025 36.713 30.229 39.935 Anericen Tobacco 13.196 12.884 16.605 24.024 21.995 23.850 28.088 39.836 Liggett 6 Myere. Inc. 12.513 10.887 17.935 26.622 27.799 27.767 27.453 27.751 Philip Merrie. Inc. 8.764 8.903 11.159 10.147 13.781 15.893 12.897 10.715 Ethical Druge" March 6 Coepany O O O O O O O O Pfizer Inc. O 83.293 38.622 21.471 19.589 24.735 11.486 28.733 DCHOI’ED. COPP- I u c n «- o - - Parke. Davie 6 Co. 273.692 288.526 343.750 177.029 190.742 117.813 61.922 48.446 Abbott Laboratoriee O O O O O O O O Flatt Glenn. Pitteburg 60.276 57.100 38.535 52.371 56.416 66.520 104.253 55.503 Libby-Mee-Pord O O o . I c o . Liquor“ Seagraa 23.407 17.860 18.707 14.032 12.790 f2.160 12.311 13.370 National Dieti11ere 13.212 10.588 7.807 9.581 8.559 8.810 6.059 6.182 Schenley Induetriae 5.338 5.452 6.103 6.443 1.813 3.813 2.965 3.630 Biran walker 85.229 83.037 71.883 73.954 96.151 168.219 319.722 244.600 lickel" Intl Michal . . - . _ . . Falconbrtda- 5.692 7.696 6.596 9.836 17.798 25.883 47.553 66.111 Sulphur“ Texae Gulf Sulphur O - Freeport Sulphur Co. -... --...- -— .Induetriee with eight lire concentration retioe below eeventy percent. 'Olndutriae with eight fire concentration r'atioe above eeventy percent. O > 500.000 67 MIX C.-—Continued Stbetantial Entry Iarriere Annual EBIT/1! 1 56 1961 11762 1963 Alt-im- Productionn Alcoa 19.631 10.875 5.215 6.325 3.883 4.768 6.421 6.283 leynolde Metale Co. 8.274 6.839 5.542 5.122 3.161 2.887 3.108 2.874 Kaiaer 12.076 5.228 4.143 3.794 3.511 3.448 3.855 3.045 Diecuite“ National 8iecuit Co. 387.000 O O O O O 52.224 41.850 Smehine 8iecuite United liecuita 16.529 18.490 10.745 12.289 12.556 12.488 14.116 9.w0 Petrolet- Refining. Standard Oil (N.J.) 39.729 33.822 24.31 24.604 24.615 26.106 19.303 23.301 Texaco Inc. 45. 754 34.269 30.119 29.444 32.827 33.938 41. 774 50.578 Mobil Oil Corp. 37.663 31.729 26.623 25.658 27.009 31.585 28.423 18.164 Standard Oil (1nd.) 20.967 20.677 11.398 9.837 10.958 10.278 11.n8 14.429 Steel” 0. 8. Steel Corp. 91.344 121.083 53.099 29.083 35.449 12.946 9.005 11.525 uthlehee Steel Corp. 32.126 50. 757 44.565 62.995 79.542 66.911 46.709 61.046 Iapxblic 8tee1 Corp. 125.235 121.421 46.173 28.497 18.832 11.223 7.308 11.998 Jonae 6 Laughlin 26.404 19.504 9.964 11.642 10.921 11.784 7.266 12.055 50.9.. Proctor 6 Indie Co. 63.335 34.775 32.501 36.606 46.894 49.971 45.782 46.007 Colgate Pal-olive Co. 13.955 14.110 14.361 17.657 15.273 16.906 15.727 16.275 Pare Machinery and Tractore“ _ Intl Diameter 25.713 23.438 22.020 20.335 12.045 10.505 13.877 11.542 Allie Chaleere 10.147 7.081 10.663 13.211 5.748 4.048 3.771 2.950 Deere 6 Co. 16.009 18.109 20.713 14.290 4.160 7.465 9.162 12.042 Copper“. ' lennecott Copper Corp. 229.862 O O 345.571 398.537 401.788 255.118 178.941 Anaconda Co. 47.082 19.534 15.049 ”.205 24.251 27.115 37.532 20.303 Phalpe Dodge Corp. A-r Seelt 6 leiin O O 63.083 43.250 ”0.500 206.313 O 127.053 Cenent“ Ideal Caeent Co. O 49.739 22.032 17.365 14.847 13.849 13.136 12.936 Lone Star Cnant 47.015 16.681 15.636 17.627 14.036 15.937 17.013 24.761 Lehigh Portlnd 118.471 12.881 8.154 11.610 8.887 4.328 5.642 L3” General Portland O O 22.93 25.634 25.554 32.540 11.224 Shoe Machinery“ United Stetee Shoe O O O O O O 121.333 103.500 Coepo Shoe Machinery 3.“ 8.167 13.500 20.000 13.333 18.000 1.293 1.500 '1nduetriee with eight fire concentration retioe below emty percent. “IndI-triee with eiflat tire concentration ratioe dove eeventy percent. O < 500.000 68 armor: C. OOCOII 821.0 Mrate—to-Low Entry Iarriere Annual EDIT I! "1W 1337 133T 959 1960 ‘119 1 11962 1963 Clean ContaineenO9 0wene-111inie Inc. 27.522 23.797 14.836 23.169 18. 718 17. 795 16.222 18.492 “Ch“ ”‘8... Cal). . C C C O I c . Thatcher Glaee 14.4” 17.107 28.520 14.175 6.621 6.239 7.779 7. 705 Tiree and Tina“ Goodyear Tire 15.088 15.762 15.676 17.824 16.6” 18.037 15. 313 16.117 Pireetone Tire 28.538 26.229 24.717 33.263 36.570 36.079 ”.995 26.214 0. 8. nan: 11.081 10.442 8.591 13.295 11.725 8.952 8.5” 7.110 Goodria (8. P.) Go. 48.720 43.408 43.299 38.846 25.682 14.743 12.394 11.512 Sheen. International Shoe 10.649 9.339 8.663 9.954 7.587 4.000 6.”1 5.847 brown Shoe Co., Inc. 21.174 20.031 23.679 25.667 26.183 27.214 33.679 38.265 Ganeeoo 10.049 8.275 10.960 17.683 14.720 6.148 6.642 4.513 Iayon“ Celeneee Corp. 9.”6 8.343 10.213 14.091 9.116 9.056 11.522 12.463 Seat-it Corp. 35.436 15.400 8.922 7.449 16.157 8.685 14.590 12.472 prat- Producte "a 8. 0’”- c0. . I I O a u . . letioeal Gypeu Co. 28.037 24.542 29.823 36.310 36.800 37.224 39.610 43. 755 Cal-ed Pruite and Vegetablee9 Celitornia Packing 9.260 4.298 7.599 8.530 11. 340 10.727 6.916 7.169 Libby. McIeill 10. 718 3.393 2.762 5.052 3.528 2.858 2.846 1.966 8toke1y-VanC. 4.425 3.329 6.204 4.246 7.233 3.748 3.843 4.976 Meat Paching9 8wi2t 6 Conny 8.228 5.271 5.713 8.555 8.387 5.353 7.087 7.587 Arnoer 6 Ge. 3.652 1.243 2.227 5.318 6.140 5.265 5.126 5.470 Hilaoe 16.933 13.481 14.000 16.804 3.907 15.610 15.857 16.192 Pl “5:116:61 111119. he- 50.093 33.010 25.421 13.387 14.306 11.560 16.923 19.136 Pillebery Co. 4.819 7.416 13.942 7.509 10.061 7.708 6.148 7.020 lhtal Containere'9 A-PIC. Can Co. 23.565 13.483 11.574 9.524 7.336 10.036 11.272 10.576 Continental Can Co. 17.047 12.728 14.061 11.969 8.295 9.674 11.113 11.745 ere-rare. Adler-er Inna. Inc. 19.848 22.011 23.949 33.674 38.596 42.456 47.158 51.984 Pabet Irowieg Co. -2.472 ~11.026 0.397 2.088 2.890 11.495 16.860 22.148 Pelatatt Irwing Corp. 23.974 21.463 20.311 29.024 33.838 32.676 18.656 22.590 Ian-6' Continual leung Go. 19.477 20.732 36.434 37.698 41.796 32.898 15.571 17.775 nericn Inheriee Co. 69.588 133.222 127.250 155.429 O O 84.500 72.400 General eating 21.636 13.047 9.043 7.197 3.549 —0.427 1.744 4.338 lituinoue Coal. Coneolidetion Coal Co. 53.117 63.283 43.017 28.040 27.914 34.090 31.258 31.597 PM Coal Co. 8.371 7.484 6.51 7.687 8.191 10.663 10.852 12.332 Tel-d Creek Coal Co. O O O O O O O 25.117 Textile Mill Producte' eurliegton Indutriee 5.590 5.966 4.983 11.445 12.006 8.813 10.951 12.033 Steven (.1. P.) 6 Co. 8.515 6.003 4.”1 8.503 8.097 6.036 8.325 6.169 Cone Mille Corp. 24.938 10.874 5.944 13.488 6.326 3.856 3.949 5.649 Dan River Milla Inc. 21.172 10.752 7.404 13.958 10.704 6.090 7.631 8.500 91ndrntriee with eipt [in concentration ration below eemty percent. “Indutriee with eight fire concentration ration drove eeventy percent. O>5W.0W