Lawrence D. Schall

Book-to-market ratios as predictors of market returns

Abstract The book-to-market ratio of the Dow Jones Industrial Average predicts market returns and small firm excess returns over the period 1926–1994. The DJIA book-to-market ratio contains information about future returns that is not captured by other variables such as interest yield spreads and dividend yields. The DJIA book-to-market ratios predictive ability is specific to the pre-1960 sample. In contrast, the S&P book-to-market ratio provides some predictive ability in the post-1960 period, although this relation is dramatically weaker than the Dow Jones pre-1960 findings. The predictive ability of book-to-market ratios appears to stem from the relation between book value and future earnings.

Problems with the Concept of the Cost of Capital

The cost of capital concept has for some years permeated both finance theory and textbook treatments of capital structure and business investment decisions. This has been due, to a major extent, to the important works of Modigliani and Miller [10,11] and Solomon [16], among others. In recent years, however, the concept has been the subject of some controversy. A number of authors have shown that the cost of capital, as usually computed, can produce errors except under highly restrictive assumptions and that there continues to be some debate over its proper definition and use. Our purpose in the present paper is to explicate more fully the source of the difficulties with the cost of capital and to suggest that, despite the initial usefulness of the concept, the field of finance would be better off now if it were relegated to history. Both the perfect and imperfect market cases will be considered. We propose that the term “cost of capital†be eliminated from textbooks and research papers and be replaced by superior concepts.

Technological Externalities and Resource Allocation

This paper is an examination of the effects on resource allocation of technological externalities within a given industry. A competitive equilibrium in the presence of technological externalities in production is compared with a Pareto optimum in terms of input use and final outputs of the economy. Resource allocation with technological externalities and imperfect competition is also compared with the competitive and Pareto-optimal solutions. It is shown that standard theorys approach for comparing resource use requires extremely restrictive assumptions and, in general, can lead to significant errors.

Commodity chain systems and the housing market

Abstract A system of gross substitutes, referred to here as a chain system, is analyzed and the results applied to the housing market. The stability conditions and comparative statics properties of the system are examined in detail. One of the results is that a specific numerical magnitude is of special importance to the systems stability and comparative statics behavior. Implications of the analysis for the housing market and for government policy are discussed.

Firm Financial Structure and Investment

The relationship between capital market equilibrium and firm financial policy has received extensive attention in recent years. Until recently, accepted theory was generally consistent in its view that the diversification effect of new investment on firm earnings is a necessary consideration in project selection. In arguing this position, no distinction was made between the perfect market situation exemplified by the models of Modigliani and Miller (M-M) [9, 10, 11] and those of Sharpe [19], Lintner [6, 7] and Mossin [12] (LSM model) and the traditional case in which firm value is not independent of debt policy, e.g., as might be the case if individual investors cannot lever on terms comparable to those available to firms. In a recent article, Mossin [13] examines the implications of the former case of perfect markets. Using a single period model with riskless rate borrowing and lending by individuals and firms, homogeneous expectations, mean-variance portfolio selection, and no taxes, Mossin shows that the effect on the investing firms value of a new project is independent of the stochastic properties of the other income earned by the firm. This conclusion and the M-M [10] Proposition I follow from the statistical property of Mossins model that any income stream has the same value regardless of how that stream is divided into the equity or debt streams of one or more firms; or, equivalently, firm value and financial structure are independent. Schall [18] presents a general proof that firm value and financial structure are independent and that firm investment diversification effects are irrelevant in perfect capital markets.

The investment tax credit and the leasing industry

The microeconomic and macroeconomic effects of the investment tax credit (ITC) on leasing are analyzed. It is found that under certain specified conditions a) even if the lessor and lessee pay sufficient income taxes so that either can fully take the ITC on a leased asset, the optimal strategy is for the party (lessor or lessee) in the higher tax bracket to take the credit, and b) the ITC favors leasing relative to sales to users.