Thursday, September 8, 2011

Why Businesses Aren’t Hiring

The continued high levels of unemployment have sparked a growing amount of criticism of corporate America. The argument goes something like this: “In these days of record high corporate profits and stock market performance, it is irresponsible for companies to sit on the sidelines of the economy and not employ more people.”

It is certainly reasonable to ask the question of why companies seem to be choosing to refrain from hiring. My intuition is that there are many reasons, which probably vary from company to company. As such, it is not likely that there is a simple explanation that applies to all firms. Nevertheless, there is a relatively straightforward explanation of this phenomenon that is grounded in one of the most basic principles of finance, Capital Budgeting.

Capital budgeting is the process by which firms analyze potential investments (like starting a new product line or opening a new factory) and then decide which ones should be pursued. In a nutshell, most decisions that would result in hiring more workers are either an expansion of existing operations or the start of a new venture. Either way, it’s a capital budgeting decision.

So how are capital budgeting decisions made? There are many analytical techniques that managers use to evaluation the financial worthiness of new projects, including Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), Payback Period, etc. etc. I will not attempt to explain the workings of any of these techniques here, since those details are available in any finance textbook (or by doing a search on the web). They all share a common attribute, however. They all require a reasonably accurate estimate of the future cash flows of the proposed project.

If, for example, the proposed project is the building of a new widget factory that has a life-span of ten years, the start of any capital budgeting analysis is the estimation of the up-front investment costs and then the yearly cash flow from the new factory. Cash flow in a future period, simply stated, is the revenue from the project minus the costs in that period. Ongoing costs include things like materials, labor, equipment maintenance, utilities, taxes, regulatory compliance, etc.

And there’s the rub. Right now there is a great deal of uncertainty regarding some of these costs. Healthcare costs are a growing piece of overall labor costs, but since many of the details of the Patient Protection and Affordable Care Act (commonly known as Obamacare) remain to be decided by regulators, it is not possible to accurately estimate future labor costs. There is similar uncertainty concerning environmental regulations, financial regulations, and tax policy.

The cumulative effect of all this uncertainty is the inability of financial analysts to be able to comfortably estimate future costs, and thus it is extremely difficult to engage in meaningful capital budgeting activities. The unfortunate result is that since managers cannot make an informed “go” or “no-go” decision on new projects under consideration, they will default to “no-go” until better information is available.

This is not a commentary about the relative merits of any particular regulation or policy. The fatal error of the current administration is that by leaving so many legislative “loose-ends,” they have created an unacceptable level of uncertainty about future costs, thus making capital budgeting decisions nearly impossible. The tragic result is that the growth engine of the United States economy, private-sector business investment, has been stopped in its tracks.

The good news is that once some degree of certainty has been restored, regardless of the details, the growth engine will start to resuscitate. Of course, certainty in the direction of lower costs will result in more new project approvals than certainty in the direction of higher costs, but ANY certainty is better than none at all.

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