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Entrepreneurial ignition of the business cycle: The corporate finance of malinvestment

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Abstract

This paper provides an extension of the Austrian Business Cycle Theory (ABCT) framework by integrating corporate capital structure, the monetary policy transmission channel, and capital budgeting analyses. In this manner, the paper presents the business cycle as being exogenously set up by central bank authorities, but endogenously set off by commercial banks and enterprises making use of central bank-distorted market signals. The cyclical boom is modeled as a gradual process where both latitudinal and longitudinal investment expansions are possible with either internal or external finance. Bank credit creation, although a necessary condition for igniting the boom, is diversely transmitted to the economy because of heterogeneity in entrepreneurial misjudgment, corporate capital structure strategies, and the class of projects available to the enterprises.

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Notes

  1. Reserve ratios represent the minimum proportion of demand deposits that a bank should hold in liquidity reserves, i.e. cash. Capital ratios correspond to the minimum proportion of a bank’s risk-weighted total assets that the bank should maintain as its capital base. A bank’s capital according to the BIS Basel capital accords consists of a core (i.e., Tier-1) capital plus a supplementary (i.e. Tier-2) capital. The former is essentially composed of common stock and disclosed reserves, while the latter may include undisclosed reserves, revaluation reserves, general provisions reserves, hybrid debt capital instruments, and subordinated term debt. See BIS (2011) for more details on capital requirements.

  2. This usually involves the manipulation of an overnight rate. Since short-term rates are used as the basis of forward spot rates, manipulations of short-term rates might also have impact on long-term rates—see Fama (1976; 2006) and Fama and Bliss (1987). Moreover, announcement effects and “quantitative easing” have been directly targeting long-term rates as of lately. For more on this point, see Friedman and Kuttner (2010), Gambacorta et al. (2012), Krishnamurthy et al. (2011), and Turner (2011).

  3. Nowadays, this is usually done through repurchase agreement operations (REPOs) instead of definite purchases, though these ones might still occur given certain conditions.

  4. As long as the CB is credible and ready to massively intervene to back its announcements, the banking sector sets their lending strategies according to the interest rate announcements of the CB. If the announcement implies a lower (higher) rate than current rates paid on highly liquid securities—usually treasury bills—or on deposits held at the CB, then, banks prefer to create (reduce) credit as this might be more (less) profitable than new securities and CB-deposits at the announced lower rate. The advantage of this kind of operation for CBs is that they do not need to continuously back their interest targeting with liquidity intervention—as long as banks dispose of enough reserves and liquid market securities to respect both their reserve and capital ratios. See Borio (1997), Disyatat (2008), and Friedman and Kuttner (2010)

  5. See Borio and Disyatat (2010) for a survey of modern UMPs, which comprise what is usually referred to “quantitative easing” and “credit easing.” So-called “qualitative easing” is also included among UMPs (Farmer 2012).

  6. This is particularly true of working capital. If the present value of working capital is given by \( WK={P}_{factors}\times \left(1+\frac{r}{turnover\kern0.15em rate}\right) \), where P factors is the price of the factors of production, and r is the required return on debt, then, the percentage change in the present value of working capital is: \( \varDelta WK=\frac{r_1-{r}_0}{turnover\ rate+{r}_0} \). In this manner, a rise in the interest rate of 50 % on a working capital with a turnover rate of 4, from say 2 to 3 %, only has an impact of 0,248 % on the cost of financing working capital. For more on this, see Cwik (2008) and Machlup (1935).

  7. Banks are major participants in both quoted and private equity funds (Cendrowski, et al. 2008; Cumming 2010a), leveraged buyout partnerships (Rosenbaum and Pearl 2009), and venture capital companies (Cumming 2010b). They are also the main providers of leverage to hedge funds (McCrary 2002), mutual funds, pension funds, and insurance companies (Russell 2007). Moreover, banks are the main dealers in the commercial paper and other negotiable instrument markets (Fabozzi 2002).

  8. The WACC is given here as: WACC = k ex  × r ex  + k ei  × r ei  + k d  × r d ; where k ex stands for external equity capital, k ei for internal equity capital, k d for debt, while r ex stands for cost of external equity, r ei for cost of internal equity (usually an opportunity cost), and r d for cost of debt. For simplicity’s sake, the WACC is not detailed on the different kinds of external equity (e.g. ordinary and preferred stock, classified shares) and debt (e.g. bonds, negotiable instruments) that an enterprise can issue.

  9. Although not all enterprises actually use formal capital-budgeting techniques to evaluate investment opportunities, it is fairly plausible to assume that, in general, investment evaluation can be likely described by those techniques. In fact, those techniques consist in more refined profit and loss calculations accounting for the cost of time—calculations and a cost that even informal entrepreneurs pay attention to. Here follows the five main NPV-based investment evaluation formulae most currently in use:

    3.1 \( NPV={\displaystyle {\sum}_{t=0}^n\frac{C{F}_t}{{\left(1+ WACC\right)}^t}} \)

    3.2 \( DPP= ln\left(\frac{1}{1-\frac{WACC\times Investment\ CF}{Periodic\ Operating\ CFs}}\right)\div ln\left(1+ WACC\right) \)

    3.3 \( 0={\displaystyle {\sum}_{t=0}^n\frac{C{F}_t}{{\left(1+IRR\right)}^t}} \)

    3.4 ∑FV operating CFs  = ∑PV investment CFs  × (1 + MIRR)

    3.5 \( PI=\frac{{\displaystyle \sum P{V}_{operating\ CFs}}}{{\displaystyle \sum P{V}_{investment\ CFs}}} \)

    The investment decision criteria implied by these techniques and involving the WACC are: NPV (equation 4.1), choose the highest positive NPV among all alternatives; Discounted Payback Period (DPP, equation 4.2), choose the project that more rapidly recovers investment cash flows relative to a target period; Internal Rate of Return (IRR, equation 4.3) and Modified Internal Rate of Return (MIRR, equation 4.4), if (M)IRR > WACC, then, choose project with highest (M)IRR among all eligible alternatives; Profitability Index (PI, equation 4.5), choose the project with the highest PI among all alternatives.

  10. This effect is of importance for both Keynesians (Hicks 1937; Keynes 1964; Taylor 1995) and the Austrians (Hayek 1967; Rothbard 2004), though while the Keynesians consider the resulting real effects to be lasting, Austrians see them to be unsustainable and destabilizing.

  11. Market interest rates, be them CB-influenced or not, are nonetheless an important element of the WACC. The greater the proportion of debt capital used, the greater the direct impact of market interest rates on a firm’s WACC. But interest rate levels also impact the required return rate of equity, since this is commonly calculated through techniques like dividend evaluation models (Gordon and Shapiro 1956; Gordon 1959), CAPMs (Sharpe 1963, 1974), and arbitrage asset pricing models (Burmeister and Wall 1986; Ross 1976), all of them measuring risk premia relative to the current level of risk-free interest rates. Consequently, accommodative monetary policies tend to directly lower the cost of debt capital, while indirectly lowering the cost of equity capital, thus lowering the total WACC.

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Acknowledgments

We would like to thank Prof. Renaud Filleule, Stéphane Couvreur, Maximilien Lambert, Jason Lermyte, Benjamin Le Pendeven, and two anonymous reviewers for their insightful critiques, comments, and suggestions that helped improve previous versions of this paper.

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  1. Finance, Economics, and Law Department, Groupe ESC Troyes en Champagne, 217, avenue Pierre Brossolette, 10002, Troyes, France

    Gabriel A. Giménez Roche

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Giménez Roche, G.A. Entrepreneurial ignition of the business cycle: The corporate finance of malinvestment. Rev Austrian Econ 29, 253–276 (2016). https://doi.org/10.1007/s11138-014-0298-0

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