Liquidity, Profitability and Lon Term Survival

Liquidity, Profitability, and Long-Run Survival: Theory and Evidence on Business InvestmentAuthor(s): Trevor W. Chamberlain and Myron J. GordonSource: Journal of Post Keynesian Economics, Vol. 11, No. 4 (Summer, 1989), pp. 589-610Published by: M.E. Sharpe, Inc.Stable URL: http://www.jstor.org/stable/4538156 .Accessed: 15/02/2014 10:33

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TREVOR W. CHAMBERLAIN and MYRON J. GORDON

Liquidity, profitability, and long-run survival: theory and evidence on business investment

Introduction

When the stockholders of a corporation hold portfolios that are well diversified, management serves the stockholders by following an investment and financing policy that maximizes the current market value of the stock without regard for the risk consequences of that policy. However, with the separation of ownership and control and information that is incomplete, a corporation's management is not compelled to serve its stockholders slavishly. Indeed, management typically has considerable freedom to pursue its own interest. This interest, it will be argued, is served by maximizing the probability of the corporation's long-run survival (PLRS). A model that is consistent with this objective has the corporation's investment vary with liquidity flow, with the excess of the actual over the desired liquidity stock and with the abnor- mally profitable investment opportunities available to the corporation.

The authors are, respectively, Assistant Professor of Finance, McMaster University and Professor of Finance and Economics, University of Toronto. The authors have benefited from comments on an earlier draft of this paper by an anonymous refer- ee. All communications concerning this paper should be directed to Myron Gordon, Faculty of Management, University of Toronto, Toronto, Ontario M5S 1V4. 'The separation of ownership and control and its implications for management behavior was first recognized by Berle and Means (1932) some fifty years ago. More recently, Jensen and Meckling (1976), among others, have characterized this separation as a problem of economic agency. As such, the latter authors have focused on building constraints into value maximization models instead of rationalizing some other paradigm of firm behavior, such as PLRS maximization.

Journal of Post Keynesian Economics/Summer 1989, Vol. 11, No. 4 589


590 JOURNAL OF POST KEYNESIAN ECONOMICS

This model may be considered an extension of the liquidity flow theory of investment first advanced by Kalecki (1937).

To test the model and to compare its performance with that of the neoclassical and profitability theories, we use the domestic investment of all nonfinancial corporations in the United States over the years 1952 to 1981. Although empirical work on theories of investment is fre- quently carried out with firm or industry data, we use aggregate data for two reasons. First, a reliable theory for explaining total investment is required in order to establish public policy and assess its effects. Evidence on the performance of a theory at the macro level is only provided by testing the theory with aggregate data. Second, we are able to obtain relevant variables not previously available by combining replacement cost and market value statistics on aggregate financial position, provided by the Federal Reserve Board, with current dollar income statement information obtained from Department of Commerce publications.2

The next section of this paper reviews the methodology and findings of an earlier attempt, by Dale Jorgenson and Calvin Siebert, to compare the empirical performance of alternative theories of investment. The paper then goes on to present the investment model that maximizes a firm's PLRS and to describe the models used to represent the neoclassical and profitability theories. In the final section our empirical findings are presented and their implications considered.

We find that our model does a far better job of explaining a firm's investment than does the neoclassical model. In comparing our model with the profitability model, we first note that the two models are mutually exclusive only if the latter is looked upon as a pragmatic or empirically useful representation of the neoclassical theory. To elaborate, according to the neoclassical theory a firm's sole objective is to maximize its market value, which implies that investment varies only with those variables that convey information on profitability. The theory of long-run survival also maintains that profitability influences investment. Hence, we may compare the performance of the profitability theory with the PLRS theory by determining whether or not the

2Balance Sheets for the U.S. Economy, 1945-1981, Nonfinancial Corporate Busi- ness, Table 705 (Washington, D.C.: Federal Reserve Board, April, 1982); "The National Income and Product Accounts of the United States: 1929-74 Statistical Tables," A Supplement to the Survey of Current Business (Washington, D.C.: Bu- reau of Economic Analysis, Department of Commerce, 1976); and subsequent is- sues of the Survey of Current Business.


LIQUIDITY, PROFITABILITY AND SURVIVAL 591

addition of liquidity stock and liquidity flow to a model with profitability variables improves the model's explanation of investment. If little or no improvement occurs, the data may be interpreted as consistent with the neoclassical theory.3 Conversely, if the explanatory power of the model is enhanced, the PLRS theory would appear to prevail. Because the addition of liquidity variables did lead to a significant improvement in the explanatory power of the profitability model, we conclude that the long-run survival theory provides the more appropriate representation of a firm's investment behavior.

The Jorgenson-Siebert comparative study A number of papers authored or coauthored by Dale Jorgenson have offered evidence in support of the neoclassical theory's ability to explain investment.4 Of particular interest is a comparative study of the performance of alternative theories, with Calvin Siebert (1968), the principal conclusion of which was stated as follows:

The neoclassical theory of investment behavior is superior to theories based on capacity utilization or profit expectations and ... these theories are superior, in turn, to a theory based on internal funds available for investment. (p. 708)

The sophistication of the econometric methods used by Jorgenson, the prominence of the journals in which his papers have appeared, and the substantial decline in empirical research on investment following his work all suggest that Jorgenson's conclusions have gained wide acceptance.5

Since the PLRS theory of investment is related to the liquidity flow theory, we felt obliged to look carefully at the empirical research that

3The relevance of liquidity variables to the investment decision is sometimes presented in a neoclassical framework by invoking market imperfections. See, for example, Ungar (1978). However, doing so presupposes that such imperfections are important enough to alter the predictions of the model. 4See the comprehensive review article by Jorgenson (1971) and references 60 to 69 of that article for other papers authored or coauthored by Jorgenson on the performance of the neoclassical theory. 5The only prominent development in the theory of investment since the work of Jorgenson has been Tobin's q ratio, which has been offered as an empirically useful representation of the neoclassical theory. See Tobin and Brainard (1977) and von Furstenberg (1977).



gave rise to the Jorgenson-Siebert (J-S) conclusion quoted above. We found that they so misrepresented the liquidity flow theory that their work provides no evidence on the performance of that theory.

To demonstrate, let us first summarize the general framework employed by J-S to test alternative theories of investment. If Kt is the actual capital stock net of the reserve for depreciation at the start of period t, and K* is the desired net capital stock for period t, net investment during t is6

(1) It = Kt+I - K, = (1 - X) (K* - K),

where 0 < X < 1. J-S included a partial adjustment coefficient, X, on the grounds that it is not feasible to move from the actual to the desired capital stock within one period.

Next, they noted that actual capital can be represented as a weighted average of all past levels of desired capital, so that

0o

(2) Kt+l= ES xjK*j, j=o

where .j is the weight for period t-j.7 Making the substitutions indi-

cated by (2) for K,+l and Kt in (1) gives 00

(3) It= E /j(K*j-K*j_l) j=0

6In J-S, It and Kt refer to gross investment and gross capital stock, respectively, and the depreciation on capital is an additional variable. Because the various theories of investment are concerned with changes in the capital stock, we believe it is more instructive to focus on the net values of these variables. 7In fact, Equation (2) follows directly from Equation (1). That is, from (1),

K+i = (1-X)Kt* + XKt; XKt = X(1-X)K*i + X2Kt_ , and so on. Thus,

00oo K,_-= (1-X) E XKt-j,

j=0

which equals 00 E tjKt*j for tj =(l -X)Xi.

j=o



Finally, J-S arrived at the investment model used to test each theory of investment by successively replacing K* in (3) with an affine function of the appropriate variable for each of the theories of investment. For example, under the neoclassical theory the desired capital stock equates the marginal rate of return on capital with the cost of capital. Consequently, J-S tested the neoclassical theory by substituting into the variable for the desired capital stock as follows:

(4) K* = 13rQtIct, where f is the elasticity of output with respect to capital, 7r, is the ratio of the price level for output to the price level for capital in t, Qt is the output in t, and c, is the price of capital services in t. The further development of (3) and (4) required to test the neoclassical theory is described below.

Our earlier statement that J-S misrepresented the liquidity flow theory is confirmed by the following passage from their paper:

In the Liquidity theory of investment behavior, desired capital is proportional to liquidity,

Liquidity: K* = aLt,

where ao is the desired ratio of capital to the flow of internal funds available for investment. (pp. 694-695)

Their assumption that desired capital stock is proportional to internal funds implies that investment is proportional to the change in internal funds. Why they would represent the liquidity flow theory in this way is unclear. Kalecki (1937, 1954), Meyer and Kuh (1957), Kuh (1963) and, to our knowledge, all other writers on liquidity flow make investment-not capital-proportional to the flow of internal funds. Hence, their finding that the change in liquidity flow did a poor job of explaining investment tells us nothing about how well the liquidity flow theory explains investment.

The long-run survival of the corporation Gordon (1983) established the investment decision that maximizes the probability of long-run survival for a portfolio investor. Under reason- able assumptions this decision reduces to the allocation of net worth



between a risk-free bond and a diversified portfolio of risky stocks. Gordon found that an investor's PLRS is maximized by placing in the risky portfolio a fraction of net worth that varies directly with the excess of the expected rate of return on the stock portfolio over the interest rate, inversely with the variance of the stock portfolio's return, and inversely with the investor's net worth. He also determined that a necessary condition for a high PLRS is a consumption-portfolio policy that provides a high expected rate of growth in net worth. In fact, the PLRS is close to the probability that the rate of growth in net worth will be positive.

For a corporation, the capital structure variable that influences its PLRS is its debt-equity ratio rather than the fraction of net worth placed in risky assets. This difference, however, is merely a matter of convention;8 the important difference between an investor and a corporation is in the nature of the risky assets held. An investor holds shares of stock, which are traded in secondary markets at a modest transaction cost and have rates of return that are independent of the quantity held. In contrast, a corporation holds tangible productive assets (real capital), which have neither of these properties. Consequently, while an investor is able to move at will at the start of each period to any desired allocation of net worth, a corporation is only able to move toward its desired debt-equity ratio over the period. Thus, a corporation maximizes its PLRS by making its growth rate in capital during each period equal to the expected rate of growth in its net worth plus some fraction of the difference between its actual and its desired debt-equity ratio.

There is also considerable support in the literature for the proposi- tion that a corporation's management serves its own interest with an investment and financing policy that maximizes the probability of long- run survival. Marris (1971), Williamson (1966), and Herendeen (1974) are among those who have recognized that the compensation, prestige, and job satisfaction of a corporation's management are posi- tively related to the corporation's rate of growth. In the long run, growth rates in sales, assets, and debt cannot depart materially from the growth rate in net worth, and the latter is best achieved with a high rate of return on capital and the retention of a substantial fraction of earn- 8The difference reflects the assumption that an investor is normally a creditor on balance, while a firm is normally a debtor. For both, risk increases with the ratio of risky assets to net worth.



ings. As these authors and others have observed, the welfare of management also depends on the corporation's survival, since bankruptcy results in unemployment and a sharp curtailment in the alternative job opportunities available to the management. What may not have been recognized, however, is that the probability of avoiding bankruptcy in the long run varies with its liquidity flow-that is, with the expected rate of growth in net worth and capital. Moreover, as demonstrated by Gordon (1980, 1987), the likelihood of the firm's survival is enhanced by taking advantage of investment opportunities that offer abnormal rates of return.

In order to describe precisely an investment model that captures the objective of maximizing the PLRS the following variables will be employed:

Xt = Il/Kt = rate of growth in capital during period t; It = net investment in capital at current prices during t; Kt = net capital (inventory plus net fixed assets) at replacement cost at

the beginning of t; Yt = (1 -rt)[xt + (Xt-rt)Bt/Et] + AtBt/Et = expected rate of return

on net worth for t; dt = DtlEt = dividend rate during t; Dt = dividends paid during t; E, = net worth at replacement cost at the beginning of t;

=t = BtlSt = debt-equity ratio at the beginning of t; Bt = net debt at the beginning of t; St = net worth at market value at the beginning of t; at = desired value of Vt at the beginning of t; Zt = Xt-rt + At = excess of the expected return on capital over the

real interest rate for t; x = XtlKt = expected rate of return on capital for t; Xt = earnings before interest and taxes during t; rt = nominal interest rate on debt at the beginning of t; At = expected rate of inflation embedded in the cost of capital for t; and Tt = tax rate on corporate income during t.

In addition, xt and At are arrived at in the empirical work that follows on the assumption that they are exponential averages of actual values. For example,



(5) Xt = Xxt + (l-X)t_-l,

with 1 = .3 assumed for both xt and At and initial values assigned for 1946, the first year for which data are required.

The model that we employ to represent the firm's investment behavior under the assumption of maximizing the PLRS is as follows:

(6) Xt = ao + ui(Yt-dt) + a2( t-Ct) + a3(Zt-Zt-l)

Broadly speaking, (6) states that the rate of growth in capital varies directly with liquidity flow as represented by expected retained earnings, y - d,; inversely with the shortfall in liquidity stock as represented by the excess of the actual over the desired debt-equity ratio, , - t,; and directly with the profitability of investment as represent-

ed by the increase over the prior period in the excess of the expected return on capital over the real interest rate, Z - Zt-1. The values of the parameters are ao > 0, 0 < ai < 1, -1 < a2 < 0 and 03 > 0.

The rationale for this representation of the firm's investment behavior requires some explanation. When t= - dr-that is, when capital and net worth grow at the same rate-ao =0, a = 1 and the balance sheet identity K,=Bt+Et ensures that the debt-equity ratio remains unchanged.9 However, this implies that the firm's investment policy would perpetuate a zero rate of expected growth in net worth notwith- standing the fact that the PLRS would be very low when the expected rate of growth in net worth is zero. With ao >0 and 0 < a < 1, an increasing fraction of the growth in net worth is devoted to reducing the corporation's debt-equity ratio as Yt - dt rises above ao/(l - a1). Con- versely, as Yt-dt falls below ao/(l-a1), the debt-equity ratio is increased in order to moderate the decline in investment.

The willingness of the firm to adjust its debt-equity ratio will depend upon the extent to which the actual ratio varies from the desired or PLRS maximizing ratio. The actual ratio, ~t, may vary from infinity, in which case the firm is bankrupt, to minus one, in which case the firm's entire net worth is in risk-free loans. As /t approaches infinity the probability of bankruptcy in the near future approaches one, and as \t

9In principle the growth in net worth can be affected by both the retention of earnings and the issuance of shares. However, as pointed out by Gordon and Gould (1978), corporations use stock financing infrequently and, if they do, it is mainly as a complement to, rather than as a substitute for, retained earnings. It is for this reason that we treat yt-dt as the expected rate of growth in net worth.


LIQUIDITY, PROFITABILITY, AND SURVIVAL 597

approaches minus one a hostile takeover or bankruptcy arising from an inadequate return on capital becomes increasingly likely. The desired debt-equity ratio, it, will thus fall somewhere between minus one and infinity. Unfortunately, we cannot observe ~t, so we shall assume that it remains constant and focus on the behavior of 't.

With regard to the third term, we noted earlier that the firm's willingness to undertake investment opportunities will also depend upon their expected profitability. Unfortunately, the expected profitability of investment opportunities is very difficult to measure. Hence, we employ, as a proxy, the excess of the expected return on existing capital over the real rate of interest. The expected excess return, rather than the expected return itself, is used because the firm, insofar as it assesses its opportunities from the standpoint of their expected profitability, will do so with reference to the cost or saving associated with a complementary adjustment in its debt position. In turn, Z, - Zt- is substituted for z in order to allow for the possibility that the excess return variable experiences secular change.

The neoclassical and profitability theories

In testing the neoclassical theory of investment, the J-S model will be followed as closely as seems appropriate. In their model the desired capital stock is given by Equation (4), and the price of capital services is

(7) Ct = [(l-rtOt)dt + Qt]/(l-Tt),

where wt = ratio of depreciation allowed for tax purposes to depreciation at

replacement cost during period t; 5t = depreciation rate for capital based on replacement cost for t; Qt = (1 -t)xt/qt = a measure of the cost of capital during t; and qt = (Bt + St )/(Bt + E) = ratio of market value to replacement cost for

capital at the beginning of t.

The other variables are as defined previously. Equation (3) cannot be used in its stated form to examine the hypoth-

esis that the variable K* = i3rtQtlct explains investment. Thus we truncate the distributed lag, and include only the current and two immediately past values for the change in desired capital as indepen-



dent variables. All prior values are represented by It-3. Accordingly, the model becomes

(8) Xt = ao + al(ntt--nt-i) + a2(nt-.l--tt-2) + e3(nt-2 -nt-3) + a4(It-3/Kt-3),

where nt = KtKt. Equation (8) differs from the original J-S model in three respects.

First of all, they did not attempt to avoid heteroscedasticity by deflating investment and the independent variables by Kt-j. Secondly, whereas in our model I, is net investment in plant and equipment plus inventory investment, in their model it is gross investment in plant and equipment, with Kt included among the independent variables to capture replacement investment. Finally, J-S selected from a class of distributed lag functions the lag distributions on change in desired capital and on past investment that minimized the residual variance,10 whereas we simply let the data determine the coefficient of each change in desired capital and restrict the role of past investment to that described above.

As indicated earlier, J-S also tested theories of investment based on profit expectations and on capacity utilization. For the former they used the market value of the firm as a measure of profit expectations. However, following Brainard and Tobin (1968), the ratio of market value to replacement cost has gained wide acceptance as the appropriate index of profit expectations. This ratio, often referred to as Tobin's q, is used in the present study. 1 For the capacity utilization (or accelerator) theory, J-S used the level of output as a proxy for the rate of capacity utilization. We choose, instead, to rely directly on the Federal Reserve Board (FRB) capacity utilization index for the manufacturing sector. 'J-S described and justified their method as follows:

Misspecification of the lag distribution for a given theory of investment behavior may bias the results of our comparison. Accordingly, we choose the best lag distribution for each alternative specification of desired capital from among the class of general Pascal distributed lag functions. Differences in the result- ing explanations of investment behavior may then be attributed to the specification of the desired level of capital rather than to the specification of the lag distribution. (p. 688)

Inasmuch as the actual rate of investment does not depend upon the model used in its estimation, we believe that in comparing alternative models the number of lags should be fixed. Hence, we adopted the maximum number of lags used by Jorgenson and Siebert. 'A survey of the ratio's use in empirical research can be found in Chirinko (1986).


LIQUIDITY PROFITABILITY, AND SURVIVAL 599

To test the accelerator theory we simply substitute ut for nt in Equation (8), with ut the FRB index of capacity utilization during period t. In testing the profit expectations theory, we should, to follow J-S, also substitute qt for nt in Equation (8). However, doing so would seem to have no more theoretical justification than the J-S treatment of the liquidity flow theory, since the profit expectations theory maintains that investment varies with the level of, and not with the change in, expected profits. Therefore, our test of the profit expectations theory will substitute qt for nt-nt-i, instead of for nt, in Equation (8).

J-S treat the various theories tested as mutually exclusive explanations of investment. A similar approach was followed in an earlier study by Kuh (1963) and in later work by Bischoff (1971), Clark (1979), and Kopcke (1985).12 On the other hand, Kalecki (1954), Meyer and Glauber (1964), Eisner (1967), Bernanke (1983) and most other empirical research on investment employed models that included two or more variables which J-S treated as being mutually exclusive. Although Kalecki explicitly rejected the neoclassical theory, the other empirical work has either attempted to explain investment in an ad hoc fashion without identifying the underlying arguments or has tested what might be called a "pragmatic version" of the neoclassical theory.

To elaborate on what constitutes a test of the pragmatic version of the neoclassical theory, it can be argued that the problems involved in measuring the variables in the strict version of the neoclassical theory, as tested by J-S, severely limit the usefulness of such a test. A reason- able alternative is to make investment a function of profitability, since the neoclassical theorem that the firm maximizes its current market value implies that investment depends solely on its profitability. There is still a problem, however, in that no single variable provides a precise measure of the profitability of investment. Thus a pragmatic interpreta- tion of the neoclassical theory should embrace a number of variables believed to be closely associated with profitability. An appropriate form for the model might be as follows:

(9) xt = oO + alqt + a2(Zt-Zt-1) + O3Zt + Ct4Ut The rate of capacity utilization is included in Equation (9) because it is profitability and not simply the satisfaction of demand for output that 12Kuh found that as between output and retained earnings the former provided a better explanation of investment. The other researchers obtained a variety of different results. We note that in the long-run survival model investment should vary with both output and retained earnings.



provides the motive for making investment vary with capacity utilization. We also note that xt rather than Zt might be used as a measure of the expected rate of profit.

We now have a clear and simple basis for using empirical work to examine the truth of the neoclassical and long-run survival theories of investment. Under the neoclassical theory the firm is motivated by profitability in its investment decision. Hence, if we add the liquidity variables to Equation (9) and find that they contribute nothing to the explanation of xt, we obtain support for the neoclassical theory.

It may be noted that the long-run survival, profitability, and J-S models represent different approaches to the explanation of investment and call for different methods of estimation. According to J-S, each theory may be represented by one variable, that variable can be measured free of error, and the difficult problem is to determine correctly the lag distribution for each theory. By contrast, in the long-run survival and profitability models we impose an arbitrary lag structure on the estimation of Xt and Ai since we do not believe that a different lag structure for either variable would materially improve the performance of the models. The important problem in each of these models is the contribution of each variable to explaining the investment rate.

Empirical findings

As stated at the beginning of this paper, the basis for evaluating each of the theories of investment considered above is its ability to explain the annual domestic investment of all nonfinancial corporations in the United States between 1952 and 1981. In order to conduct our tests we combined replacement cost and market value data on the financial position of nonfinancial corporations, obtained from the Federal Re- serve Board's Balance Sheets for the U.S. Economy, with income statement and other flow information reported in the Survey of Current Business and its "National Income and Product Accounts" Supple- ment. Interest rate information was taken from successive editions of Moody's Industrial Manual.

Annual data were utilized to measure all variables. Although quarterly and monthly observations are sometimes employed to estimate models of investment, the balance sheet data provided by the Federal Reserve Board are presently only available on an annual basis. In any event, the use of annual information allowed us to avoid seasonal variations in the values of certain variables.



The details of the measurement rules adopted for the variables in this study are summarized in the Appendix. In keeping with the origins of the bulk of the data, the variables are defined in customary accounting terms unless otherwise indicated. In addition, as will be seen below, the flow variables utilized in this study are estimated using both current and one-period lagged data. Our interest in lagged data derived from the fact that a firm's investment expenditure will be largely, if not completely, determined at the beginning of the period in which it is to occur. Current flow variables, in contrast, will not be known with certainty and, as such, may have little effect on the rate of investment.

Table 1 presents ordinary least squares regression results for the long-run survival model, Equation (6), and for the neoclassical, capacity utilizations, and profit expectations theories, represented by Equa- tion (8). The results for the survival model are very good, with R2 = .738 and with each of the three estimated slope coefficients highly significant.13 In contrast, the results for the neoclassical model are quite unsatisfactory, with R2 = .206 and with none of the coefficients significant at the five percent level. The capacity utilization model did reasonably well, with an R2 of .512 and with all but one of its coefficients having t-statistics greater than the critical value of 2.04. The profit expectations model (using current and lagged values of q, instead of changes in q) has an R2 of .410, but only the coefficient for the current value of q is significant at five percent. Thus we see that under the J-S method of comparison the survival model outperforms all others by a wide margin, while the neoclassical theory appears to be of little use in explaining investment. The poor performance of the neoclassical theory does not appear to be due to the particular form in which we implemented the theory. We obtained similar results when we attempted to adhere strictly to the methodology employed by Jorgenson and Siebert.14

The results in Table 1 may be criticized on the grounds that our tests assume that firms know the current values of flow variables such as Y, - d, and u, when the value of xt is determined. Since the value of x,

'3ai, however, is greater than one and, as such, exceeds its predicted value. This may be a consequence of the fact that we ignored new stock financing in our measurement of the rate of growth of net worth. See Tables 2 and 4 for similar results. '4It may also be noted that Elliott (1973) attempted to confirm the J-S conclusions by faithfully applying their methodology to a much larger sample of firms (184 as compared with 15 in the J-S study). He similarly found that the neoclassical model failed to outperform the others.



Table 1

Regression results for the long-run survival model and the Jorgenson-Siebert models with current values for flow variables*

Long-run survival model**

xt = -.020 + 1.710(t-dt) - .090(%t-t) + .779(zt-zt-1) (-1.65) (5.35) (-5.79) (4.09)

R2 =.738 SER =.0087 D-W= 1.078

Neoclassical model

xt = .039 + .014(nt-nt-1) + .010(nt-1-nt-2)- 006(nt-2-nt-3) - .131xt-3 (5.19) (1.61) (1.24) (-.74) (-.81)

R2= .206 SER =.0155

Capacity utilization model

xt = .025 + .002(ut-ut-1) + .002(ut-l-Ut-2) + .002(ut-2-ut-3) + .330xt-3 (3.57) (4.20) (4.16) (2.60) (1.96)

R2 = .512 SER = .0122

Profit expectations model based on Tobin's q

xt = .018 + .052q + .017qt-1 - .039qt-2 -.147xt-3 (1.64) (2.50) (.60) (-1.85) (-1.03)

R2 = .410 SER = .0133

*The numbers in parentheses under the equations are t-statistics, R2 is the square of the multiple correlation coefficient, SER is the standard error of the regression, and D-W is the Durbin-Watson statistic. **In computing Yt-dt and Zt, the current values of the return on capital, xt, and of the inflation rate, At, are used.

is largely (if not completely) determined at the start of t, the flow variables for t, such as Xt and ut, which are not known at the beginning of the period, may have little effect on the rate of investment.15 In

'5Stock variables such as BtISt, in contrast, will be known or, at least, reasonably estimable at the beginning of t.



Table 2

Regression results for the long-run survival model and the Jorgenson-Siebert models without current values for flow variables*

Long-run survival model**

xt = -.001 + 1.169(yt-dt) - .075(t-t) + .890(2t-zt-i) (-.06) (2.72) (-3.60) (4.39)

R2= .576 SER =.0111 D-W=1.416

Neoclassical model

xt = .041 + .012(nt_ --nt-2) - .008(nt-2-nt-3) - .005(nt-3-nt-4) - .092xt-3 (5.35) (1.39) (-.94) (-.52) (-.52)

R2=.132 SER=.0162

Capacity utilization model

Xt = .035 + .001(Ut-1-Ut-2) + .0005(ut-2-ut-3) - .00002(ut-3-ut-4) + .056xt-3 (3.95) (2.08) (.70) (-.03) (.25)

R2 = .166 SER = .0159

Profit expectations model based on Tobin's q***

xt = .018 + .052q + .017qt- - .039qt-2 - .147xt-3 (1.64) (2.50) (.60) (-1.85) (-1.03)

R2 = .410 SER = .0133

*The numbers in parentheses under the equations are t-statistics, R2 is the square of the multiple correlation coefficient, SER is the standard error of the regression, and D-W is the Durbin-Watson statistic. **In computing Yt -dt and Zt, the current values of the return on capital, xt, and of the inflation rate, At, are not used. ***Carried over from Table 1, since q is a stock variable.

addition, at the macro level, output and profits vary with investment, so that, for example, the correlation between x, and ut in the capacity utilization model may reflect the causal relation xt-ut rather than ut- xt. To investigate this possibility, we regressed xt on current and lagged values of ut and obtained R2 = .768, with only the current value of ut statistically significant. Hence, if we were to ignore the possibility



that investment determines capacity utilization, the level of capacity utilization during t explains investment better than any of the models in Table 1, including the long-run survival model.

Table 2 presents the same regression results as Table 1, except that current values for the flow components of the independent variables are excluded. For the long-run survival theory, the adaptive expectations expression, Pi = Xvt-_ + (1-X))t-1, vt = xt,At, was used to calculate yt and Zt, and the dividend rate employed was that prevailing at the beginning of t rather than the average for the year. For the neoclassical and the capacity utilization theories we deleted nt- nt1 and Ut - ut-i and added nt-3 - nt-4 and Ut-3 - Ut-4, respectively.16 The regression results for the profit expectations theory in Table 1 can be retained because qt is a beginning of period value for a stock variable.

Table 2 indicates that the R2 values for all the models decline when current information is excluded, but the best performance is again obtained using the survival model, with an R2 of .576, even when compared with the profit expectations model. Moreover, its estimated coefficients have the correct signs and its t-statistics are well above 2.04. As before, the neoclassical model does very poorly, with an R2 of .132 and with no significant coefficients. The results for the capacity utilization model are also disappointing, with the R2 falling quite dramatically, from .512 to .166, and with only the coefficient of the first lagged value remaining significant at five percent.

Earlier it was suggested that Equation (9), in which investment is a function of all variables that convey information on profitability, might be considered a pragmatic representation of the neoclassical theory. Table 3 presents the regression results for alternative versions of the profitability model, with the current values of the flow variables excluded in all cases. In the first set of regression results, excess return on

'6All previous values of the change in desired capital variable continue to be represented by Xt-3 = It-3/Kt-3. The need to use Xt-3 can be demonstrated by consider- ing the case of the neoclassical model, where

Xt = CO + Cl(nt-n-rt-2) + a2(nt-2-nt-3) + Co3(nt-3f-nt-4) + -(4Xt-3 and Xt-3, in turn, is equal to

a' O + as(nit-4 - nt-5) + a6(5t-5-nt-6) + C7(nt-6-nlt-7). If Xt-4 were to be substituted for xt-3, nt-4- nt-5 would be omitted from the re- sulting investment equation.



Table 3

Regression results for alternative versions of the profitability model*

Models based on excess return on capital**

xt = .039 + .029qt + .680(zt-zt-i)- .0842t + .0007ut (17.59) (2.84) (2.47) (-.59) (.91)

R2 = .552 SER = .0116 D-W = 1.414

xt = .040 + .030qt + .829(zt-zt-1) (18.51) (3.18) (3.96)

R2 = .538 SER = .0114 D-W = 1.548

Models based on return on capital**

xt = .040 + .029qt + 1.653(xt-xt-) - .087xt + .0007ut (18.10) (2.62) (2.78) (-.35) (1.82)

R2 = .576 SER = .0113 D-W = 1.593

xt = .040 + .027qt + 1.965(-t-xt-1) (19.08) (2.89) (4.27)

R2 = .563 SER = .0111 D-W = 1.636

*The numbers in parentheses under the equations are t-statistics, R2 is the square of the multiple correlation coefficient, SER is the standard error of the regression, and D-W is the Durbin-Watson statistic. **The constant term in each equation is based on values of q, z, and u that are differences between the observed values and their respective means. Also, flow variables exclude their current values.

capital is the explicit profitability variable, and we see that when all four variables are included only the coefficients for q and the change in excess return are significant at the five percent level. Dropping capacity utilization and the level of excess return lowers the value of R2 only slightly and the standard error of the regression is actually reduced. Similar, though slightly better, results are obtained in the second set of regressions, where return on capital replaces excess return as the explicit profitability variable. This is somewhat surprising in that the willingness of a firm to undertake risky investment should depend not on the expected return on capital, but on its excess over the real interest



Table 4

Performance of the long-run survival model*

With flow variables that exclude their current values**

xt = -.015 + 1.328(t-dt) - .085(%t-t) + .932(zt-2t-1) (-.70) (2.51) (-2.24) (3.44)

+.004qt - .2882t + .00003ut-1 (.22) (-1.25) (.03)

R2 =.653 SER =.0107 D-W= 1.462

xt = -.002 + .995(t-dt) - .045(t-t) + .802(2t-2t-)+.022qt (-.10) (2.33) (-1.69) (3.96) (1.71)

R2= .620 SER= .0107 D-W= 1.379

With flow variables that include their current values**

xt = .0007 + .939(y-dt) - .037(0t-t) + .364(2t-2t-1) (.07) (3.35) (-1.64) (2.50)

+ .005qt -. 1592t + .002ut (.56) (-1.89) (6.19)

R2 =.906 SER =.0056 D-W= 1.371

*The numbers in parentheses under the equations are t-statistics, R2 is the square of the multiple correlation coefficient, SER is the standard error of the regression, and D-W is the Durbin-Watson statistic. **The constant term in each equation is based on values of q, z, and u that are differences between the observed values and their respective means.

rate. We can only speculate on the reason(s) for this anomaly. Perhaps our measure of expected inflation is inappropriate, in that a large proportion of actual inflation during the 1970s was unexpected. Alternatively, in their investment decisions, corporations may not have fully recognized the gain that resulted from the erosion in the value of debt due to inflation.

Table 4 presents the regression results for the long-run survival model when liquidity flow and liquidity stock are added to the variables of the profitability model. Only the results for which the excess return on capital serves as the explicit profitability variable are presented


LIQUIDITY PROFITABILITY, AND SURVIVAL 607

because, as was the case in Table 3, almost identical results are obtained when the return on capital is so used. In the first equation, which includes all of the profitability variables, the t-statistics for both liquidity flow and liquidity stock are well above the critical level of 2.04. In the second equation, where capacity utilization and the excess return on capital are deleted, the t-statistic for the liquidity stock variable is reduced to a significance level of approximately ten percent. Although we do not believe that using current values of flow variables to obtain the independent variables is appropriate, the final equation in Table 4 is included to provide an indication of the results obtainable when this widely adopted practice is followed. Here again the coefficients for both liquidity variables have the expected signs and are significantly different from zero. Finally, it may be noted that the results in Table 4 are consistent with ao = 0 and a1 = 1, rather than with ao > 0 and al < 1.

We conclude with a brief comment on the evidence in support of the long-run survival model of investment. We have seen that the neoclassical and survival models are both consistent with having investment vary with surrogates for its profitability. However, liquidity variables would only appear in models based upon neoclassical theory if market imperfections were thought to be such that their effects could not be fully captured by the firm's cost of capital. In the long-run survival model, in contrast, liquidity variables play an essential role inasmuch as they capture the firm's desire to avoid bankruptcy. Hence, the significant improvement in the explanation of investment obtained in Table 4 by the addition of the liquidity variables to the profitability variables of Table 3 may be interpreted as providing direct support for the long-run survival model.

REFERENCES

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Appendix

Detailed Measurement Rules

It = net nonresidential private fixed investment in current dollars, less investment in religious, educational, and other institutional structures, plus the change in inventory, measured at replacement cost, during t

Kt = inventory plus net fixed assets of nonfinancial corporations, measured at replacement cost, at the beginning of t

Dt = total dividends paid by nonfinancial corporations during t

Et = net worth of nonfinancial corporations, less U.S. direct investment abroad, measured at replacement cost, at the beginning of t

St = net worth of nonfinancial corporations, measured at market value, less U.S. direct investment abroad, at the beginning of t

Bt = long-term debt plus current liabilities and U.S. direct investment abroad less monetary assets and foreign direct investment in the United States, at the beginning of t

Xt = earnings before interest and taxes at replacement cost during t

rt = yield on Moody's Aa-rated bonds at the beginning of t

At = (PQ,t/PQ,t-1)-1, where PQ,t is the implicit price deflator for the gross domestic product of nonfinancial corporate business for t (1972 = 1.00)

of t = (PI tPI t-1) - 1, where PI t is the implicit price deflator for gross private nonresidential fixed investment for t (1972 = 1.00)

AtBtlEt = the Modigliani-Cohn inflation adjustment, to recognize that the firm can borrow AtBt/Et times its total capital and pay the proceeds in dividends without increasing its debt-equity ratio



rt = current income taxes paid by nonfinancial corporations divided by earnings before taxes and extraordinary items during t

Qt = gross domestic product of nonfinancial corporate business in constant 1972 dollars during t

Ut = FRB capacity utilization index for the manufacturing sector for t


Article Contentsp. 589p. 590p. 591p. 592p. 593p. 594p. 595p. 596p. 597p. 598p. 599p. 600p. 601p. 602p. 603p. 604p. 605p. 606p. 607p. 608p. 609p. 610

Issue Table of ContentsJournal of Post Keynesian Economics, Vol. 11, No. 4 (Summer, 1989), pp. 497-668Volume Information [pp. 665-667]Projected Long-Term Demographic Trends and Aggregate Personal Saving in the United States [pp. 497-508]The Natural Rate of Unemployment: Concept and Critique [pp. 509-521]Support for Worker Participation [pp. 522-530]Determinate Solutions and Valuational Processes: Overcoming the Foreclosure of Process [pp. 531-546]The Dual-Decision Hypothesis in Light of Recent Developments [pp. 547-560]Stage-of-Fabrication Inventory Behavior in Durable Goods Manufacturing Industries [pp. 561-588]Liquidity, Profitability, and Long-Run Survival: Theory and Evidence on Business Investment [pp. 589-610]On the Post Keynesian Challenge to Neoclassical Economics: A Complete Quantitative Macro-Model for the U.K. Economy [pp. 611-629]The Doctrine of Inherent Productivity: Keynes, Sraffa, and Kalecki [pp. 630-640]CommentGovernment Deficit Spending Is Not Incompatible with the Cambridge Theorem of the Rate of Profit: A Reply to Fleck and Domenghino [pp. 641-647]Cambridge (U.K.) versus Cambridge (Mass.): A Keynesian Solution of "Pasinetti's Paradox" [pp. 648-653]Editor's Comment on the Debate between Dalziel, Pasinetti, and Fleck-Domenghino [p. 654]

Editor's CornerFinancing Social Security: Who Pays? [pp. 655-660]

Erratum: Global Accumulation with a Dual Southern Economy [pp. 661-662]Back Matter [pp. 663-668]

Liquidity, Profitability and Lon Term Survival

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