The Cost of Capital in the Defense Industry: Managerial Incentives and the Economic Impact of Mandatory Debt Accounting

Abstract

We examine managerial incentive factors and the economic implications of mandatory debt accounting on the firm's cost of capital in the defense industry, a significant sector of the economy. In fiscal year 1999 alone, the Department of Defense awarded $124 billion to contractors for goods and services. We consider a unique mandatory accounting treatment and its resulting cash flow or debt subsidy in this industry, the Facilities Capital Cost of Money (FCCOM). To capture a defense-contracting spending cycle, we use 1988 as the study's base year and expand our test-years to include 1982 and 1994. We include 134 firms and examine 349 firm-year observations in the study. Using a control sample of commercial firms, we first document that mandatory debt accounting impacts managerial incentives and differentially influences the use of debt covenants restricting dividends in the defense industry. We also find that incentive factors explaining debt covenants restricting dividends and additional borrowing are decidedly different for defense firms than for commercial firms. In addition, we report a significant negative relation between FCCOM and the existence of dividend covenants suggesting that, consistent with agency theory, the cash flow subsidy mitigates the need for these covenants. Finally, in a debt equity trade-off, we also demonstrate that the FCCOM debt subsidy leads to a lower cost of debt but an increased cost of equity capital within the defense sector. Our results suggest if firms face mandatory accounting that provides debt holders with a cash flow subsidy and a lower cost of debt capital, with a resultant increase in the cost of equity capital, investors seeking to minimize their risk posture may prefer to be debt holders in defense firms rather than in commercial firms, ceteris paribus.