3.7 The user cost of capital

In addition to the factors examined above, companies’ investment decisions are also influenced by the average costs at which the investment can be implemented at a given point in time. The costliness of corporate investment is captured by the indicator called the user cost of capital. The user cost of capital is fundamentally determined by price changes in physical capital (real estate, machinery, equipment, etc.), the relative price of the capital compared to output, interest rates and depreciation (for details, see the box). In Hungary, the average user cost declined considerably in the late 1990s and at a slower pace from the early 2000s 50 120 % (Chart 3-18). The declining trend in interest rates and 45 110 relative prices had a favourable impact on the user cost. 40 90 100 This was partly offset by the rise in depreciation rates, 30 35 70 80 which took place as a result of changes in the composition 25 60 of tangible assets (increasing share of machines) and in accounting rules. Both led to a faster depreciation of 10 15 20 20 30 40 50 enterprises, the deterioration in market conditions for

capital stock, thus increasing the user cost. At the end of 5 10 the period, following the launch of the easing monetary cycle, all the factors lowered the user cost. 0 0 2001 2002 2003 200 4 2005 2006 2007 200 8 2009 2010 2011 201 2 2013 2014 tőkeköltség

Chart 3-18 kockázat mentes hozam (jobb tengely)

Development of the user cost of capital értékcsökkenés (jobb tengely)

(2001=100, per cent)

Per cent

120 110 100 90 80 70 60 50 40 30 20 10 0

2001 2002 2003 200 4 2005 2006 2007 200 8 2009 2010 User cost of capital Risk-free rate (right axis) Depreciation (right axis)

2011

2 201

2013 2014 50 45 40 35 30 25 20 15 10 5 0 Although the user cost of capital has been steadily declining since the mid-2000s, for the time being this has not resulted in an increase in the investment rate. In this analysis, the causal effect of the user cost on investment is not examined. However, our findings reveal that in relation to the development of Hungarian corporate investment, the effect of the user cost was weakened by the aforementioned factors: the fall in the number and investment of new entrant companies, the high number of ageing and stagnant micro Source: MNB calculations.

the companies producing for the domestic market and concentration, as a result of which the volume of aggregate investment may be affected even by a few especially large projects.

3-2. Box

THE USER COST OF CAPITAL

The user cost of capital (hereinafter referred to as the ‘user cost’) is a rate of return on capital implying the rent of a unit of new capital good. User cost plays a central role during the optimisation of corporate investment decisions because in the course of profit maximisation, inter alia, the price of capital as a factor of production must be produced.

The user cost is determined by the following factors: the cost of funds (own or external funds), the price change of physical capital, the relative price of capital compared to output, as well as depreciation, as it matters how long the given capital good takes part in the production, and how the price of the good changes during its involvement in production. In addition, the effective tax rate reduces the user cost, as the cost of external funds is accounted for by enterprises to the debit of pre-tax profit, thus reducing the tax base. For the estimation of the used cost, the following formula is taken as a basis (see, for example, Kátay – Wolf, 2004):

where indicates the company, is a sector-specific investment price index, E indicates the company’s equity capital, D means the external funds, and V denotes all funds of the company, is the effective tax rate, is depreciation, which increases the user cost through the wear and tear of the capital good. indicates the price index of the value added. The percentage change in the price of capital is denoted by ; it correlates negatively with the user cost. The average interest cost of disbursed forint loans is indicated by , adjusted for risk on the basis of size, based on available surveys concerning SMEs (MNB 2013). In the case of large companies – due to lack of other information consistent with the other size categories – we took into account the risk premium of medium-sized companies that have the best ratings. Of course, domestic lending is not covered completely by the forint loans granted, and at the same time, unfortunately, we do not have reliable information on the company-level ratio of FX loans; therefore, the cost of external funds is approximated with forint loans. The required rate of return on equity is indicated by , calculated on the basis of the one-year benchmark government security yields, also adjusted for risk by company size. 40 From the user cost estimated at company level, we calculate an aggregate average user cost; 41 this is shown in Chart 3-18.

REFERENCES:

Kátay, G. – Wolf, Z. (2004): Investment Behaviour, User Cost and Monetary Policy Transmission – the Case of Hungary MNB Working Paper, 2004/12. Magyar Nemzeti Bank (2013): Trends in Lending, May 2013, MNB publication. Reiff, Á. (2010): Firm-level adjustment costs and aggregate investment dynamics – Estimation on Hungarian data MNB Working Paper, 2010/2.

40 The cost of equity was adjusted for the size-specific risk and the market risk premium, thus the cost of equity is higher than the credit cost not only because of the effect of the tax shield (i.e. the 1-τ). 41 The aggregate user cost was interpreted as the simple average of the corporate user cost. The estimation was also conducted for the user cost weighted by capital, which showed a similar trend over time. However, based on the literature and our own estimates there is no definite weighting methodology, and at the same time, in the case of weighting by capital, due to composition effects the results were contradictory in the case of the breakdown by company size.