Time Horizons and Technology Investments (1992) / Chapter Skim
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Appendix A: Cost of Capital - The Managerial Perspective
Appendix A: Cost of Capital - The Managerial Perspective
Pages 79-104
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From page 79... ...
Another eight executives (Group 2) expressed a roughly opposite view, arguing that the cost of capital is not one of the primary competitive factors in their businesses.
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From page 80... ...
And two factors in particular appear to account for the different views: the firms in Group 2 tend to be in better financial condition than those in Group 1, and are technology leaders in their respective markets. While there is heated dispute about whether or not the cost of capital in the United States is higher than it is in Japan, there is a growing consensus that Japanese firms behave as if their cost of capital is lower.
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From page 81... ...
We explore not the economic meaning and measurement of the cost of capital, but the way it is perceived by and influences senior executives in a range cuff American firms. We begin with the following premise: whether or not the cost of capital is lower in Japan than it is in the United States, many Japanese firms appear to approach their investment decision making with longer time horizons than their U.S.
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From page 82... ...
We attempted to ensure diversity by selecting industries that differed along such broad technology-related dimensions as length of product life cycle, research intensity, and nature of manufacturing process (e.g., chemical process versus component assembly and fabrication)
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From page 83... ...
Texas Instruments Pfizer Small Analog Devices Amgen Chips & Technologies Centocor THE INTERVIEWS Question 1: Is the Cost of Capital an Important Source of Competitive Disadvantage? 83 We approached this question by focusing on specific investments that each firm is reported to have made recently or to be planning.
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From page 84... ...
These executives point to other factors as more important determinants of their ability to remain competitive. All eight suggested that their decision making about specific investments is tempered by considerations other than strict financial projections of rates of return which should in no way be taken to suggest that they are not driven to earn overall rates of return that exceed hurdle rates-and six specifically explained that the uncertainties associated with their businesses make financial projections about specific investments too unreliable to serve as the driver for decision making about them.
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From page 85... ...
cost of capital thus becomes a critical issue, and as with Inland, governs the specific investments that are and are not made. Purdum distinguishes between three sets of investments-those that lead to zero or negative return but are required by government regulation; those that clearly satisfy hurdle rates; and those that are strategically important but that fail to satisfy hurdle rates.
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From page 86... ...
This is consistent with the importance that these companies attach to the high cost of capital and their selection of important public policy issues. Luerssen and Junkins cited interest rates and capital formation as their top policy concerns; Purdum cited trade policy, reasonableness of environmental regulations, and policies that would lower the cost of capital, in that order; Geier emphasized overall policy on competitiveness, arguing that policies that influence the cost of capital would follow once the larger problem of competitiveness was confronted; only Ryker did not mention policies that influence capital formation, focusing instead on policies that promote exports.
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From page 87... ...
. Merck & Co., Pfizer: These two pharmaceutical companies do not view the relative cost of capital as an important competitive factor.
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From page 88... ...
"Finance is the biggest barrier to entry into the pharmaceutical business." Nonetheless, neither executive views the relative cost of this much needed capital as a major competitive factor. As Rathmann described, "when you are in the creation business, it doesn't really matter whether the cost of capital is 4 percent, 9 percent, or 12 percent....
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From page 89... ...
Before that point, given the uncertainties associated with new product development, it would be "lunacy in our business to decide that we know exactly what's going to happen to a Product once it gets out." A . continuing effort is made to develop and apply financial analysis tools which, rather than govern decision making, can help decision makers deal with the high uncertainties in new drug development in ways that are consistent with "the construct of returning the cost of capital." · George B
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From page 90... ...
· Hurco Companies: Brian D McLaughlin, CEO, argued that for a small machine tool company like Hurco Companies, which faces competition from the likes of the Fanuc-GE joint venture, Mitsubishi, and Siemens, the key to remaining competitive is to avoid competing on a capital-intensive basis (i.e., on the manufacturing of mechanical and microelectronic hardware)
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From page 91... ...
When Chips & Technologies was starting up, the only way to raise enough capital to build its own fabrication facilities would have been "to give away 80 percent of the company." So the general approach became to "do anything you can to avoid becoming capital intensive." Just as Hurco Companies views the machine tool as a "shipping crate," Chips & Technologies views semiconductor fabrication capability as "a commodity." Its devices are now fabricated at about a dozen foundries worldwide. From a policy perspective, Campbell was much more concerned about the general problem of a lack of a cohesive policy regarding the competitiveness of U.S.
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From page 92... ...
Texas Instruments, as it struggles to regain leadership in the capital intensive DRAM business, has taken a variety of steps that in Junkins' words, "simulate access to a low cost of capital environment." For example, TI has entered into a series of joint ventures that have in effect made an additional $1 billion available to the company over the next several years.
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From page 93... ...
In the steel industry, Armco and Inland Steel Industries have engaged in a not dissimilar set of tactics. Perhaps the most dramatic example is a series of agreements between Inland and Nippon Steel, agreements that have grown into a $1-billion joint venture to build and operate two worldclass steel-making facilities one that manufacturers cold-rolled sheet-steel products and the other that produces coated steel products.
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From page 94... ...
The "capital structure of the joint venture looks like that of a Japanese firm." Otherwise, "we never could have gone ahead with the deal." Armco has taken similar measures. It has entered into several joint ventures, the most dramatic being a joint venture with Kawasaki Steel Company, into which Armco has spun off its carbon steel facilities, which represent about 40 percent of its total capacity.
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From page 95... ...
How then do we account for the difference? Why do some executives view the relative cost of capital as fundamental to their ability to compete, and others not?
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From page 96... ...
All the executives from the pharmaceutical industry believe that differences in the cost of capital are not a critical issue, whereas all the executives from the machine tool industry take the reverse point of view (although Hurco Companies' point of view is a bit more complicated)
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From page 97... ...
In Figure A.2 we have attempted to control for size by dividing capital investment and R&D expenditures by sales. The data again confound our expectations and suggest that capital intensity is not particularly related to executive views on the competitive importance of the cost of capital.
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From page 98... ...
have been more capital intensive than the machine tool companies (Group 1 and 34.
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From page 99... ...
This appears to be why Inland and Armco, for example, have joined with Japanese firms to build their next generation of plants, and have turned to Japanese sources to raise the capital needed to finance their portion of the joint ventures! In theory, capital is always available for a price, but in practice, in these instances, the capital needed to remain competitive simply would not have otherwise been available.
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From page 100... ...
In contrast, our two Group 1 steel makers, Inland and Armco, while they are among the strongest of the domestic integrated steel makers, face formidable foreign competition. · In Machine Tools, our two Group 1 companies lost their market leadership over the course of the past decade, except in the area of plastic injection molding equipment, where Cincinnati Milacron is acknowledged to be the world leader.
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From page 101... ...
Intel and Analog Devices are technology leaders in microprocessors and analog signal-processing devices, respectively; Nucor has long been a pioneer in the steel industry and recently invested $270 million in building the world's first continuous thin-slab cast flat-rolled steel-making facility, while Worthington Industries is the U.S. leader in the application of advanced steel processing technology developed in Europe; Merck & Co.
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From page 102... ...
The simplest and most general conclusion from our survey is that the way to remain competitive against firms that behave as if they had a lower cost of capital is to stay ahead! This seems simplistic, yet the firms in our survey that do not perceive relative cost of capital as a critical competitive factor are those that have succeeded in preserving leadership in their respective markets.
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From page 103... ...
firm can compete successfully over the long run on these terms. On such an uneven playing field, all that is left as a basis for competition once technology leadership is lost is access to domestic markets, and it is not surprising in these circumstances to see a growth in the number of joint ventures between Japanese firms with capital and U.S.
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From page 104... ...
Why U.S. manufacturers are at a competitive disadvantage.
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