Policy, Planning, and Reserch
WORKING PAPERS
Finandal Policy and Systeisn
Country Economics Department
The World Bank
August 1989
WPS 266
Policy Changes
that Encourage Private
Business Investment
in Colombia
Mansoor Dailami
To sustain expansion of private business investment, Colombia
should consider an investment tax credit, frequent forecasting of
business variables (to reassure businessmen of the favorable
climate for investment), a shift from historical cost accounting
to replacement cost accounting, and preferential treatment for
small and medium-size firms in the allocation of available
capital.
The Policy. Planning, and Research Complex distnibutes PPR Working Papers to disseminate the findings of work in progress and to
encourage the exchange of ideas among Bank staff and aU others interested in develo,-eent isues These papers carry the names of
the authors, rflea ordy their views, and should be used and cited accordingly. The futdings, interprtations, and conclusions are the
authors own.7ley should nom beaauributed totheWorld Bank. its Board ofDiractors, itsmanagement, or any of its manber countries.



Polac,Pnning, and Roa_r:h |
Financial Policy and Syatl<n
Private business investment has expanded           debt financing should lead to a more balanced
remarkably in Colombia's recent economic           corporate capital structure and possibly a lower
recovery. Sustained expansion of this invest-      overaU cost of capital. The elimination of
ment is considered crucial to continued eco-       dividend income taxes as par, of the 1986 tax
nomic growth and increases in production.          reform eliminated double taxation of capital and
thus helped reduce the cost of equity financirg.
Having analyzed demand, the cost of capital,    On the other hand, it prompited shareholders to
and the availability and allocation of investable  pressure corporate management to distribute
funds, Dailami concludes the following:            more dividends -  which limits a corporation's
ability to finance its investments internally.
Motivating firms to expand capacity is a
key requirement for continued expansion. Many         * The cost of capital could also be reduced by
firms are already operating at high capacity       shifting the tax treatment of depreciation a )w-
utilization rates. An investment tax credit        ances away from listorical cost accounting
designed to lower the effective price of capital   system toward a replacement cost accounting
goods would help to target investment expansion    system.
and hence would be desirable.
* High inflation and low savings rates keep
* Frequent forecasting of such variables as      the prevailing lending rates high in Colombia -
GDP, interest and exchange rates, and credit and   and it is generaUly easier for larger firms to get
monetary aggregates, would tend to improve the     capital than for small and medium-size firms.
climate for investment by enabling the private     There are at least two reasons why small and
sector to make informed decisions.                 medium-size firms should get preferential
treatment in allocation of available capital: (1)
* The real (marginal) cost of capital to the     they tend to be concentrated in relatively more
nonfinancial corporate sector is high in Colom-    labor-intensive activities and sectors, and (2)
bia: currently about 16 percent. Policy efforts    their existence and survival are necessary to
that induce corporations to substitute equity for  guard against increased industrial monopolies.
This paper is a product of the Financial Policy and Systems Division, Country
Economics Department. Copies are available free from the World Bank, 1818 H
Street NW, Washington DC 20433. Please contact Maria Raggambi, room N9-03 1,
extension 61696 (53 pages with charts and tables).
The PPR Working Paper Series disseminates the fiPdings of work under way in the Bank's Policy, Platning, and Research
Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished.
'Me findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.
Produced at the PPR Dissemination Center



' i,s
Table of Contents
I.  Introduction ....................................., 1
II. Aggregate Deomand and Investment           ..                              4
1. Emuirical Investigation.                                              4
2. Policy Implications.                                                  7
III. Financial Policy and Business Investment ..                .       .     10
1. Policy Framework ....    10
2. Structure of Corporate Finance   ..... 12
a) Needs for Funds                         ..                         12
b) Sources of Funds    ..16
3.  Explaining the Pattern of Corporate Finance    . . .19
4.  Directed Credit and Business investment          . . .21
a) Main Policy Issus    ..21
b)  Directed Credit:  Volume and Relative Significance ..           25
IV.  Tax Reform of 1986 and Corporate Cost of Capital .33
1. Introduction .33
2.  The Relevant Provisions of the 1986 Tax Reform .34
3. Concluding Remarks .40
V. Conclusions and Policy Suggestions .42
Demand Factors .42
Coat of Capital .43
Availability and Allocation of Investable Funds .45
Annex .47
A.1 Derivation of the Cost of Capital ........................... 47
A.2 Determination of Corporate Leverage Ratio .............. .. 49
A.3 Parameter Estimates and Assumptions .52
References .53
The author is grateful to Alan Gelb, Peter Miovic, and E. C. Hwa for helpful
comments and suggestions.



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List of Tables
Table 1.  Colombia:  Total Domestic and Private Investment,
1970-1987   ................................................    2
2.  Estimation Results for Relationship between Aggregate
Private Investment and Demand Components ....   ............. 8
3.  Colombia:  Composition of Corporate Assets:  Non-financial
Corporate Sector, 1980-1985 .............................. 13
4.  Composition of Corporate Business Assets in Selected
Countries . ........................................ 15
5.  Sources of Business Operating Income:
Billions of Pesos and Percentage of Total, 1983-1986 ..... 17
6.  Composition of Liabilitv Side of Balance Sheet for
Colombian Non-Financial Corporate Sector .....  ............ 18
7. inflation Viability in Colombia and a Selected
Number of Developing and Developed Countries .... ......... 24
8.  Directed Credit:  Recent Evolution and Relative
Significance .............................................. 26
9.  Outstanding Development Credits to Business
Private Sector . ........................................... 28
10.  Interest Rate Subsidy, 1976-1987 ......   ................... 31
11.  Colombia, Recent Changes in Key Interest Rates
Selected   Periods   .........................................  32
12.  The Impact of Inflation on Real Marginal
Cost of Debt (1970-1985)   . ................................. 37
13. The 1986 Tax Reform and The Real Marginal Cost
of Capital ................................................ 39
14. Primary Share Offering by Non-Financial
Listed Companies:  1985-1987 .......   ...................... 41
A.1. Regression Results for Determinants of Aggregate
Debt-Capital Ratio in the Non-Financial Corporate
Sector; Annual Data, 1970-1985. .......  ................... 51



I.  Introducto
1.      A striking feature of the recent economic recovery in Colombia has
been the remarkable expansion of private investment outlays. After having
declined precipitously during the recession years of 1982-1985, total private
investment, adjusted for inflation, increased at an average annual rate of
14.6 percent during 1986-1987 period and is furthermore expected to have
continued its expansion in 1988, albeit, at a slower pace. The expansion has
already broken past records in terms of durability and has led to
re-establishing the dominant position of the private sector in the country's
process of capital formation and growth (see Table 1). It has not just been
associated with certain cyclical impulses, such as the upturn in business
profitability in 1986 and buoyant economic growth, but also with favorable
developments on the fiscal side, which are expected to have a more enduring
impact. There is, thus, the expectation, if not yet the belief, that these
developments may come to mark an important turning point in the course of
Colombian macro-economic policy and performance and set the agenda for the
medium-term economic strategy and policy.
2.      The broad objective of sucb a strategy is to launch the economy on a
path of sustained long-term growth in accordance with the developmental needs
of the 1990s and in cognizance of the expected shrinkage of foreign capital
inflows. The main impetus of economic growth is to come from the expansion
of private investment with public investment resources gradually geared



TABLE 1, COLOMBIA : TOTAL DOMESTIC AND
PRIVATE INVESTMENT, 1970-1987
. .. ......   ,,....... . . . . . . . .,. . . . . . . . . ..   . . _ . . . . .. . . . . . . . .
1970-79    1980    1981    1982    1983    1984    1985    1986    1987
GROWTH RATE : PERCENT PER ANNUM
Gross
Dom.
Inv.        7.41    10.88   13.23    5.33    -2.15    -5.89    -9.64    5.14        5.5
Total
Pvt.
Inv.        6.62    -2.07   10.11   -2.26    0.27   -10.97   -14.95   13.92   15.31
PERCENTAGE OF GROSS DOMESTIC PRODUCT
Gross
Dom.
Inv.       18.72    19.07   20.62   20.49   19.89   18.96   19.04   17.95   19.00
Total
Pvt.
Tnv.       12.47    11.44   12.03   11.09   11.03    9.95        9.41     9.61    11.10
memorandum:
Share of
Pvt Sector
in tot.dom.
inv (%)    66.61   59.99   58.34   54.12   55.46   52.48   49.42    53.54   58.42
. .... ..... ................................................................ . . .. .. .
Source: Banco de la Republica; National Department of Statistics (DANE),
and National Department of Planning (DNP).



-3.
towards social areas. The underlying logic is straight forward and is
predicated on the notion that an increase in allocation of national resources
towards private business investment should boost aggregate demand through the
multiplier process, dampen inflation through its positive influence on
aggregate output and productive capacity, and lead to enhance the overall
gain in productivity and efficiency of resource use. These are highly
desirable outcomes, considering inflation has reached its recent-time peak,
industrial productive capacity is at its limitation, and productivity is
lagging.
3.       But desirability is hardly a guarantee for success.  What is required
is a consistent framework of policy initiative and measures designed to
strengthen the underlying demand for expansion in capacity, to facilitate
resource transfer to the private sector in order to meet that sector's
growing financing requirements, and to influence favorably the relationship
between the return on investment and the cost of capital. These measures
relate at the macro level to three areas of economic policy; i.e. demand,
financial and taxation. Their strength in influencing private investment in
Colombia derives basically from the following observations:
a) aggregate private investment in Colombia has in the past been highly
sensitive to aggregate demand, particularly internal demand conditions;
b) the corporate sector is highly leveraged and has traditionally relied
on debt to finance its investment and growth;
c) the interaction between taxation and inflation has been crucial in
lowering the real cost of capital to match profitability and return on
investment; and



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social areas. The underlying logic is strAght forward and is predicated on
the notion that an increase in allocation of national resources towarda
private business investment should boost agqregate demand through the
multiplier process, dampen inflation through its positive influence on
aggregate output and productive capacity, and lead to enhance the overall
gain in productivity auid efficiency of resource use. These are highly
desirable outcomes, considering inflation has reached its recent-time peak,
industrial productive capacity is at its limitation, and productivity is
lagging.
3.       But desirability is hardly a guarantee for success.  What is required
is a consistent framework of policy initiative and measures designed to
strengthen the underlying demand for expansion in capacity, to facilitate
resource transfer to the private sector in order to meet that sector's
growing financing requirements, and to influence favorably the relationship
between the return on investment and the cost of capital. These measures
relate at the macro level to three areas of economic policy; i.e. demand,
financial and taxation. Their strength in influencing private investment in
Colombia derives basically from the following observations:
a) aggregate private investment in Colombia has in the past been highly
sensitive to aggregate demand, particularly internal demand conditions;
b) the corporate sector is highly leveraged and has traditionally relied
on debt to finance its investment and growth;
c) the interaction between taxation and inflation has been crucial in
lowering the real cost of capital to match profitability and return on
investment; and



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d) the degree of government intervention in the financial markets in
terms of directed credit programs has been important in influencing the
evolution ana structure of financial markets and the allocatton of credit to
firms and households.
4.      These considerations set the stage for the analysis and policy
discussion that follow. The analysis in divided into three parts: (i) the
relationship between aggregate demand and investment; (ii) the influence of
financial policy on investment; and (iii) taxation and the cost of capital.
In addition, a concluding section contains the main result and policy
suggestions, and an annex presents the technical and theoretical discussion
for determinants of marginal cost of capital under Colombia tax code.
II. Ag_g_TatT Demand and Invastment
1. .   trical Let1aAtf
5.      The basis for consideration of potential demand policy influences on
private investment behavior in Colombia is the historical relationship
between aggregate private investment and demand. This relationship has been
very strong and robust as illustrated by estimation results of equations (1)
through (7) contained in Table 2. The equations are based o&I an accelerator
model of private investment behavior, whereby investment responds to changes
in aggregate demand via changes in the desired level of capital stock. To
capture the influence of supply of credit, total outstanding loan from
financial institutions is also included, and several lag specifications were
considered to highlight the underlying dynamics between aggregate investment
and demand. Finally, aggregate demand was decomposed into domestic and
external components. Estimating the model over 1971-1987 period, several
important conclusions emerge:



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6.       First, that aggregate private investment in Colombia iBas been highly
sensltive to domestic demand conditions. Thus, changes in domestic demand
have been consistently significant and important explanation of investment
variability in Colombia. For instance, one percentage point increase in the
rate of growth of aggregate domestic demand leads to an increase of 2.8
percent increase in the level of rsal. private investment in the short run,
and 5.6 percent in the long run.1 These results remain rather robust for
various specification of the model.
7.       Second, in contrast to domestic demand, external demand has not been
an important stimulus to private investment. Statistically, aggregate real
external demand does not contribute to the explanation of past behavior of
private investment.2 This, however, is not surprising given the weight of
housing investment in aggregate private investment data3 and the well-known
characteristic of the business sector in Colombia which tends to be highly
oriented towards internal rather than external conditions.
8.       Third, considering the estimated multiple correlation coefficients of
the set of equations reported in Table 2, it is evident that the model
explains roughly one-half of variability of past behavior of private
1 This is based on equation (4) in the Table, which is statistically
considered as the most appropriate equatinn.
2 The partial correlation coefficient between changes in aggregate private
investment and foreign demand is estimated over the period 1967-1987 to be
-0.14, but is not statistically significant. It is to be noted, however,
that such correlation, or the econometric findings presented above, provides
only a partial analysis of the relationship between domestic investment and
external demand. A more detailed analysis should also incorporate the
balance of payments effect of the relationship between domestic investment
and external demand. In that case, changes in external demand would
influence domestic investment through availability and cost of import.ed
capital goods.
3 Total household investment in residential and durable goods accounted
during the period 1970-1985 for about one-third of total private investment
outlays, or about 4.2 percent of GDP.



_ 7
investment in Colombia. In other words, roughly one-half of investment
fluctuations remain unexplained, which are attributable to other factors and
presumably to the state of business confidence or "animal spirit". This th^n
suggests for certain degree of caution in relying on a private investment-led
growth strategy. The point is that such a strategy involves certain measures
of risk relating principally to the unpredictability and volatility of
private investment behavior, which, in Colombia, has in the past been
particularly pronounced.
2. Po118! Implications
9.       The above empirical investigation of the aggregate relationship
between private investment and demand provides a strong case for the proper
management of aggregate demand. It is evident that a balanced expansion of
aggregate demand, particularly domestic, is critical to the success of a
private investment-led growth strategy. Without that, firms have no reasons
or motives to expand capacity and hence tc order new machinery and equipment.
To stimulate demand, policies need to be frsmed within the broader macro
economic context, within which the inflationary consequence of such policies
are given due attention. The detailed formulation and design of such
policies and their instrumentalities and mixes are beyond the scope of this
paper, but, given the past trend of inflation in Colombia, which has shown a
high degree of sensitivity to aggregate demand conditions, there is little
doubt -hat expansionary policies need to be targeted to encourage investment
demand, rather than consumption. In this respect an investment tax credit
scheme for new investment represents a desirable option. This scheme is
desirable because it helps to offset, to some degree, the adverse impact of
the 1986 tax reform on the cost of capital.
10.      As will be detailed below, the provision regarding the gradual
elimination of deductibility of inflationary component of business interest
payments will tend to increase the cost of funds to corporate borrowers; the



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Tablo 2
Estimation R.sults for Relationship between
Aggregate Privato Investment and Demand Components
1/      1/      1/       1/
Eq.  Constant  4cn Yt  Alnyt-i  &lnzt   lnzt-.  In It  ln L    R2    DW
(1)    2.25      2.35    1.22   -0.17    0.31    0.36    0.40   0.63  2.20
(0.65)    (1.35)  (0.87)  (-0.40)  (0.76)  (0.90)  (1.99)
(2)    2.29      2.61       -   -G.14    0.19    0.48    0.29   0.60  2.18
(0.68)    (1.55)          (-0.32)  (0.50)  (1.28)  (1.88)
(3)    2.61      2.57       -   -0.14        -    0.43    0.30   0.59  2.17
(0.81)   (1.58)           (-0.35)          (1.24)  (2.05)
(4)    2.09      2.84       -        -       -    0.49    0.29   0.59  2.21
(0.76)    (2.05)                           (1.61)  (2.11)
(5)    1.06      2.75       -   -0.03    0.30    0.89         -  0.46  2,37
(0.29)    (1.47)          (-0.07)  (0.72)  (2.69)
(6)    1.50      2.69       -   -0.03        -    0.85        -  0.44  2.34
(0.42)   (1.47)           (-0.08)          (2.66)
(7)    1.38      2.76       -        -       -    0.86        -  0.44  2.35
(0.45)   (1.77)                            (3.14)
Note: The variables are defined as: I - real aggregate private investment
outlays, y - real aggregate domestic demand, z - real aggregate foreign
demand, and Lt - total outstanding loans from financial institutions.
All variables are in 1975 constant prices (millions of Col.$).
t-statistics are in parentheses and the data is annual from 1971 to 1986.
1/ a is the difference operator; i.e., & ln Yt - ln Yt - ln Yt-i.



- 9 -
impact of such increase Li the cost of funds on the overall cost of
investment can be alleviated through the proposed investment tax credit
scheme which works to reduce the price of new capital goods.
11.      The potential for encouraging private business investment through
efforts to stimulate external demand needs also to be explored. The
observation that such a channel has not been statistically important in the
pas; should not be used as evidence against consideration of its future
potential. Moreover, such strategy needs tc be viewed in light of its
favorable balance of payment implications and greater availability of foreign
exchange and hence supply of imported capital goods.
12.      Finally, in considering the potential influence of domestic demand
expansion on the evolution of private investment in the future, it is
important to take account of the favorable trend in productivity gain that
will be associated with an increased share of private investment in the
country's total capital formation. To the extent that the lagging behavior
of productivity growth in the past had been associated with increase in the
share of public investment,4 the substitution of private for public investment
in the future will lead to reduce inflationary tendencies and hence widen the
scope for expansionary demad policies.  More expansionary domestic demand
policies will feed into higher investment, and thereby increased supply
potential and faster growth.
4 In fact, the pattern of aggregate private investment in Colombia has, over
the past two decades, mirrored that of public investment. In other words,
changes f.n aggregate public and private investments have tended to offset
each other with the consequence that total domestic investment expenditures
has, in relation to GDP, remained relatively constant. Despite substantial
variation in its components, total domestic investment has shown since the
mid 1960s no time trend; it has hovered near 19 percent rf GDP throughout
this period. (The mean has been 18.9 percent, with a standard deviation
around the mean of only 1.13 percent.)



- 10 _
1fl. IIw~anaia1 Foltew and Rua
1. Poliey Pramework
13.      Against this background of aggregate demand expansion, the relevant
financial policy requlrements for a medium-ters investment strategy relate
basically to two issues: (i) the availabillty of funds to pay for investment
and (ii) the cost of capital relative to return on investment. Seen in a
macro-economic perspectlve, these aspects of fLiance depend on the capacity
and structure of financial markets to allocate funds to the business sector,
on the extent and nature of government intervention, and on the determinants
of profitability such as real wages and efficiency of capital use. But such
a macro perspective needs also to be supplemented by a disaggregated view of
company finance to take account of companies' specifLc characteristics which
give rise to credit rationing and quantitative constraints. It is known, for
instance, that small and medium-size firms in Colombia operete under much
tighter restrictive financial environments thmn do large and reputable ones.
For the former class of firms, it is not so much the cost of capital as it is
the sheer availability of capital which is often the operating constraint on
their investment behavior. These firms, in contrast to large ones, do not
have realistically the option of raising fresh capital through capital
markets. They are also excluded from the inter-firm market which caters
exclusively to the needs of large and reputable companies. The main sources
of funds, beside their own internal sources, are loans from financial



- 11 -
institutions and curb markets.5 Hence, they are highly vulnerable to the
impact of monetary and credit squeezes.
14.     Such characteristics of company finance, coupled with consideration
of several structural features of Colombia's financial markets such as
segmentation, and a high degree of bias towards short-term end of maturity
spectrum, provide the main rationale for the role of financial policy
affecting the availability and cost of capital to influence business
investment behavior. Such a role of financial policy is further reinforced
once it is viewed against the understanding tlat the scope for policy
influence on the profitability side seems rather limited. There is a strong
cyclical component in pattern of profitability in Colombia, which stems from
the cyclical behaviLr of real wages and rate of capacity utilization. Both
of these factors are strongly influenced by business cycle conditions.
Nominal wages in Colombia increase normally with the rate of inflation, but
5 Interestingly, by classifying firms by asset size, it becomes evident that
the very small and the very large firms are relatively less leveraged than
medium-size firms (see Figure below). The very small firms (with assets less
than Col.$200 million) have less debt mainly because they tend to be crowded
out in the credit market, and the very large firms (with assets exceeding
Col.$5000 million) resort to equity markets and have the opportunity of Sigh
internal cash generation due to their higher profitability performances.
:11tSIM94 t f 2es<4110:7 M.1.0 14;::J wt.-S
.3
0 -  M         I~~*1
1,.MO
as*wa         or" oe d.ue m



- lc -
the adjustment involves a one-year lag.6 An a consequence, profits tend to
increase during periods of high inflation. Also, to the extent that
inflation moves pro-cyclically, profits move similarly. This means that
profits are high during the upward phase of the cycle, as evident by the
experience of the 1986 - 1987 period, and low during the downturn. In this
sense, the extent to which policy can influence profitability depends on its
success in influencing the business cycle.
15.      Thus, the key to the question of how financial policy affecting the
cost and availability of funds may influence business investment decisions
and performances is the understanding of firms' capital structure; i.e., the
ways and means by which companies finance their investment and growth.
2. Struecture of Cornorate Finance
a) Needs for Fund-.
16.      But, while concern in this respect relates to the financing of fixed
investment, it is important to note that fixed investment outlays constitute
only one element of the broader corporate uses of funds. In addition to
using funds for purposes of fixed investment, i.e., plant, equipment, and
real estate corporations need funds for holding inventories, for financing
trade debtors, and for holding cash and other liquid assets, as well as for
purposes of acquiring financial assets.. These additional uses of funds which
arise from corporations' normal operating requirements, as well as from their
role as financial intermediaries, have been, indeed, quite important in the
context of Colombian non-financial corporate sector. Table 3 confirms this
assertion.
6 As implied from the Modigliani-Miller Theorem (1958), under perfect capital
market conditions and no taxes, firms' real investment decisions are
independent of their financial structure. Under these conditions, there is
no role for financial policy to influence real investment decisions. For a
criticism of the Modigliani-Miller Theorem, in the context of developing
countries, see Dailami (1988).



_ 13 -
Table 3 , Colombia : Composition of Corporate Assets: Non-ftnancial,
Corporate Sector. 1980-1985
(Percentage of total Assets)
--............ ............................. ..... ........... ............ ................................ .......... ......... ...... ................
Average
1980    1981    1982    1983    1984    1985             1980-1985
ASSETS
Fixed assets        27.18   30.38   32.13   31.43   31.73   33.74                31.10
Inventories         20.73   19.25   17.90   15.45   15.28   14.45                17.18
Accts receivable    31.68   29.93   27.14   28.61   27.58   24.55                 28.25
Liquid assets        6.72    7.10    6.81    6.53    7.10    5.66                 6.65
Subtotal           86.31   86.66   83.99   82.02   81.69   78.40                 83.18
Financial assets    13.69   13.34   16.01   17.98   18.31   21.60                 16.82
Total              100.00   100.00  100.00  100.00   100.00   100.00             100.00
~~. . ........... ... .. ..... .... ...... .. ........ ... ................. .... .. ....... ...........
Source: Staff estimates based on SuperLntendencia de Sociedades, Boletin
Estadistico, various issues.



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The Table uses consolidated balance sheet data, as reported by the
Superintendencia de Sociedades, to provide a detailed breakdown of total
corporate assets into five categories, namely, fixed assets; inventories;
accounts receivable; liquid assets; and financial assets. Fixed assets have,
on average, accounted, over the period 1980-1985, for about 33 percent of
corporate total assets, compared with a ratio of 14 percent for inventories,
24.5 percent for accounts receivable, 5 percent for liquid assets, and,
finally, 21.6 percent for financial assets.
17.      In comparison with other countries, the share of fixed assets in
total corporate assets in Colombia is not unusually low. It is, indeed,
closely comparable to the situation in other developing countries, such as
Korea, India, and Turkey, but not to the U.S. and the U.K., where the figure
is significantly higher (See Table 4). In the latter two countries fixed
assets seem to have accounted in recent years for over 50 percent of total
corporate business assets, as compared to a ratio of between 30-40 percent in
the developing countries, including Colombia. But, perhaps, more striking,
in the case of Colombia, is the relatively high share of financial assets in
corporate balance sheet. In 1983, for instance, financial assets accounted
in aggregate for about 20 percent of total assets in the non-financial
corporate in Colombia. This is about twice as high as the corresponding
ratio observed in developed countries, such as the U.S.A., Japan, and the
U.K. It is also higher than the corresponding figure in Korea, where the
non-financial sector is known to engage in a high degree of financial
intermediation.
18.      Several factors account for the relatively high share of financial
assets in Colombian corporate sector. First, access to subsidized credit
through development funds has been an important encouragement for firms to
hold financial assets and to perform financial intermediation. This reflects



Table 4:   Composition of CorDorate-Business-Assets  n Selected_Countries. 1983
(percentage of total assets)
Columbia 1/ Germany 21 India 31 Japan 21 Korea 41 Turkey 51 U.K. 21 USA 2/ Zimbabwe 61
1. Fixed Assets al    32.24       32.38      41.75    27.19    39.62       34.90   41.76   61.00    55.85
2. Inventories bi      15.38      21.18      29.97    14.01    17.72      19.80   20.39   14.62    23.15
3. Accounts
Receivable cl      26.02     29.99 f/   20.46    36.81    16.57       24.16   23.37   13.58    14.28
4. Liquid Assets dl    6.48        4.01       6.31    13.32    10.93       5.72    7.13    5.59       2.49
5. Other Assets el    19,88       12.44       1.51     8.67    15.16      15.42    7.35    5.21       4.61
6. Total              100.00    100.00      100.00   100.00   100.00    100.00  100.00  100.00   100.00
a/   Net of accumulated depreciation.
bl   Work in progress and raw materials.
cl   Trade and other account receivable.
dl   Cash, bank deposits and marketable securities.
e/   Includes investments and other deposits.
fl   Includes short term bills and bonds.
Source:   1/   Superintendencia de Sociedades.  Boletin Estadistico No. 6, 1983.
2/   OECD Financial Statistics Part 3, 1986.
Non Financial Corporations in Germany, Japan (total sample), U.K. (large companies in all
industries) and U.S.A.
3/   Reserve Bank of India Bulletin, 1986.
4/   Bank of Norea, Financial Statement Analysis, 1983.
51   Industrial Development Bank, 1987.  Consolidated balance sheets of 185 companies.
6/   Based on the 48 listed Companies in the Zimbabwe Stock Exchange, 1988.



16 -
the fact that firms engage in financial intermediation in addition to their
traditional role of producing goods and services. The exact extent and
causes of such financial intermediation are difficult to establish, given the
subsidiary grouping character of corporations in Colombia and a large amount
of gross equity holdings. Nevertheless, one important implication is clear;
financial revenues are important components of business operating income.
Over the 1983-1986 period, interest incomes averaged 150 billion pesos
compared to total operating income of Col$321 billion, or about 47 percent
(See Table 5). This reduces sensitivity of firms' fixed investment demand
towards interest rate changes.
b) ources of Ftnds.
19.      The corporate sector in Colombia has traditionally, at least over the
past two decades, relied on debt financing, including foreign debt, to a
considerable degree. Debt has increasingly become the predominant means of
company finance.   Total liabilities, including borrowing and trade payables,
accounted in 1985, for instance, for about 80 percent of aggregate
non-financial sector total liabilities, or four times as much as the total
amount of shareholders' equity (see Table 6). This confirms the generally
held view that the corporate sector in Colombia is highly leveraged. More
alarmingly, a closer look reveals that much of corporate debt is concentrated
at the short-end of the maturity spectrum; short-term liabilities accounted
in 1985 for more than one-half of total liabilities, or nearly 40 percent of
total assets. Of these, roughly one-third is accounted by trade payables,
and the rest by short-term borrowing from financial institutions. Given the
paucity of direct borrowing through bond issues, almost all of long-term
liabilities are in the form of borrowing, mostly from domestic financial
institutions. Total loans from domestic financial institutions to corporate



Tfaie5:         Soures of  kssinvis It Olpeailng  ltw                 Bllilons of Pe se and
Petrrnta"w of Total. I t11 le6.
year                          aperatIng  Profit                               Interest Inee_                                  Operating  Incee
...-  --              --------------------------                     -------------------------          -            --_-_-_-_-_-.-_-_-_---..-----
Statio   Peso           Poreeot                Sllon  Poe.             Percent                 Pillion Feso             Pereent
1963                       96)                                            i        it  16          3 2. 51                201.19                  100.00
1966                      196.83                   53.0                   129.15                    6. e3                 2S1.U8                  j0o0.0
191s                      1to.16                   so.e06                 a.Is                     69.99                  360   0                 i00o.0o
1466                      261.29                   18.33                  169.&9                   *1.6?                  619.12                  100.00
Avor,eo                   111.25                   52. 2                  1W.9                     91. is                 321.                    100.00
...._._._........         ....................... I   -----------------------------------------------------------------------                             ---
Sot, WAd Sources
It Roless to mon-Iinasewpl. corp.rauo sector as a whol.!.
Smarcc: Staff estimates bsed" em Suporimtendooci. do Soeeiodds. Selotim
1-4                  Isra92tdistlco,  various issuos.
IWet                 "t 



- i3 -
Table 6: Composition of Llabillty Slde of Islance Sheet
for Colombian Non-Financial Corporate Sector
Year End 1983, Percentage of Total Assets
1.  Short Term Liabilities                     37.65
a. Trade Payables                          12.18
b. Short term borroving                    23.03
c. Other liabilities                        2.43
2.  Long Term Liabilities                       34.73
a. Bonds                                    0.15
b. Long term borrowing                     34.58
3.  Other Liabilities                           7.91
4.  Total Liabilities                           80.29
5.  Shareholders Equity                        19.71
6.  Total Liabilities and
Shareholders Equity                       100.00
Source: Staff estimate based on data from Superintendencia de Sociedades



- 19 -
sector have accounted for about 40 percent of total corporate liabilities.
The high degree of corporate indebtedness in Colombia is noteworthy. It is
also of recent origin. Indeed, even in the early 1970s, the ratios of debt
to assets were much lower, averaging 40 percent for the non-financial
corporate sector.
3.   Ialning   a Pattern of Corporate liane
20.     What has caused corporations in Colombia to increase their
indebtedness over the past two decades? In addressing this question, two
factors are considered: (i) that the growth of corporate sector has generated
needs for funds much in excess of its own capacity to supply internally and
(ii) that government policy with regard to int3 rest rate subsidy associated
with development credit lines (fondos financimros) and taxation have
considerably lowered the real effective cost of debt to corporate borrowers.
21.     With regard to the first factor, the underlying premise is the basic
fact that the supply of internally generated funds - retained earnings and
capital consumption allowances - imposes, inevitably, a ceiling on the growth
of corporate investment and assets. To see the logic of this argument, it is
only necessary to understand the dynamics of asset accumulation of a purely
self-financing firm, which under the Colombian tax regime is determined by
two basic parameters: the rate of the firm's operating profits and its income
tax rate. Accordingly, based on the assumption of a corporate profit rate of
40 percent and statutory corporate tax rate of 39 percent, which corresponds
to the average of 1976-1985 period, it follows directly that the highest rate
of growth in total assets that could have been achieved under a
self-financing strategy (i.e. if firms paid no dividends or interest) would
have been about 24.4 percent per year. In redlity corporations in Colombia
were paying substantial dividends and were highly leveraged and,



- 20 -
interestingly, grew at an average annual rate of 42 percent during that time
period. In other words, if the firms had been only financed through earning
retentions, they would have grown at roughly one-half of the ra.e that they
actually did.
22.      Regarding the impact of the government policy on the real effective
cost of debt to corporate borrowers two observations are relevant:
23.      First, loans advanced to priority sectors such as exports,
agriculture, and industry are partly subsidized through rediscount facilities
at the central bank. These loans which are administered by comercial and
development batks are formally regulated through the operation of several
development funds (Fondos Financieros). The degree of subsidization varies
from fund to fund and from year to year. In 1987, for example, the combined
credit extended to the business sector through these funds accounted for 19
percent of total outstanding loans of formal credit market to the business
sector. The average lending rate on these loans were 31.4 percent, as
compared to an average market lending rate of 41 percent.
24.      Second, in addition to this particular feature oa  credit allocation
in Colombia, there are other institutional, structural anI policy factors
which have worked to make debt financing cheaper than equity financing. One
important factor, in this context, has been the taxation of corporate capital
income in the Colombian environment of high inflation. Until the tax reform
of 1986, corporations were allowed to fully deduct interest payments against
their income taxes. But presumably, part of such interest payments were
attributable to the inflationary component of interest rates, and in that
case were, in essence, payments of the principal rather than payments for the
use of debt. In this sense, the higher the rate of inflation, the hiigher the



- 21 _
servicing of principal which benefited from tax deductibility of interest
expenses. Given the relatively high rate of inflation in Colombia, the
magnitude of such tax-cum-inflation related reduction in the cost of
borrowing has been sizeable, as will be elaborated below.
4. Directed Credit and Business Investment
a) main Policy Issues.
25.      Against this background of corporate pattern of finance and real
investment in Colombia, the question of how government-directed intervention
in credit allocation process may affect private business investment behavior
revolves around two issues: First, how important are government credit
programs in relation to the total availability of loanable funds to corporate
borrowers. And second, how significant are interest rate subsidies
associated with government directed credit programs in the overall cost of
debt and capital to corporate borrowers. These questions need to be
approached bearing in mind the various needs and policy objectives which have
historically motivated the government to take an active role in the credit
market. Three sets of such needs have been instrumental in Colombia: (i) to
supplement the capacity of financial institutions to supply medium- and
long-term capital to the industrial and agricultural sectors; (ii) to
reallocate resources towards priority sectors and activities, snd (iii) to
deploy finance as a tool of advancing certain social/regional and political
objectives. Some aspects of these needs have, of course, changed through
time and the links between the original policy objectives and the specific
form of credit programs have become increasingly questionable. There is, in
particular, a growing concern whether the programs themselves have not been
important causes of Colombia's financial market imperfection and structural
imbalances.



- 22 -
26.     There is no argument that financial intermediaries in Colombia are
relatively biased towards the short-end of maturity spectrum. Signs of this
"short-termism" are readily visible in many aspects of financial system,
including the low maturity of banking system loan portfolio, the virtual
absence of long-term debt instruments, the small size of the equity market,
and the dominant share of short-term debt in corporate capital structure.
The average maturity of banking system's loan portfolio is estimated for the
period of 1970 - 1986 to be about 4.2 years when housing sector loans are
included and to be the 2.1 when these loans are excluded.7 In the same vein,
the market capitalization of corporate equity in relation to GDP averaged in
Colombia over the period of 1980 - 1986 to 3.96 percent as compared to values
of 24.13 percent in Chile, 13.7 percent in Brazil, 48.6 percent in Malaysia,
or an average of 31.2 percent in developed countries.
27.     These are clear expressions of the degree of short-term bias in
financial intermediaries.  The causes of this phenomenon are several, as will
be demonstrated below. But before engaging in this investigation, it is
important to note that "short termism" entails real economic costs, both in
terms of higher cost of intermediation brought about as a consequence of
higher administrative and operational cost of financial intermediations, and
in terms of failing to diversify risk. From the latter perspective, a
two-year loan contract on a project with gestation period of two years, for
instance, is not equivalent to a one-year loan contract which, in principle,
can be rolled over. Under the second arrangement, the issuing bank has the
option of rolling or not rolling at the end of the first year, and hence
concentrating the risk of investment with the borrower.
7 Based on a classification of loan portfolio of bankings systems into short,
medium, and long-term, and assigning one year for short-term, three years for
medium, and five years for long-term values. For the loans to the housing
sector, long-term loans were assumed to have an average maximum of 12 years.



- 23 -
28.      With regard to the causes of short-term bias of financial
intermediation in Colombia, it needs to be noted that the traditional
explanations of "short-termism" of financial intermediaries, which have, in
the context of Latin American countries, emphasized the role of inflation, do
not hold in the case of Colombia, at least not with equal force.8
29.      Indeed, in contrast to most other Latin American countries, the rate
of inflation in Colombia has not historically been very high, neither has it
been highly volatile. This follows immediately from causal observation, and
more formally from the econometric investigation of inflation variability in
Colombia and its comparison with other countries reported in Table 7.   Thus,
when inflation volatility is measured by the standard deviation of the
unexpected component of inflation process (i.e. inflation shock), the
estimate for Colombia, based on quarterly data from 1980 to 1986, yields a
value of 6.2, which is significantly lower than a corresponding value of
121.8 for Argentina, or 15.5 for Mexico. Interestingly, such a low estimate
of inflation volatility in Colombia is striklngly close to that in Korea.
Moreover, this similarity holds when inflation variability is measured by the
estimated coefficient on lagged inflation in a first-order autoregressive
scheme. These estimates are 0.63 and 0.51 respectively for Colombia and
Korea.
30.      The above discussion and empirical evidence, thus  helps to cast
doubt on the conventional belief that inflation variability has been in
8 High and variable inflation is viewed, according to this line of argument,
to increase overall uncertainty and to obscure the identification of
different sources and nature of risk. For example, the conventional
decomposition of risk associated with financial transactions into various
components of interest rate risk, business risk, regulatory risk, is rendered
meaningless when inflation exceeds a certain threshold and when its
variability swaps other dimensions of risk. Under these circumstances,
financial instruments tend to be overwhelmingly concentrated in the short-end
of maturity spectrum



Table 7: lnlALln VariAbillty 4      ColonhiA and aSgerin
Number of Developlng *nd Deloped CounLries
Uev.i-Usanq ICottnirt e                             Developed Co entrios
Auti.orPeression Lcaelaclent I1   Inflation Shocls "' Aut.nregrCiits                  ---lC------t -t Infl-i--n Shock-s 27
5eae atsIt I.        ".9            121.8.)         Canada               ".79              1.9.01
IWa;Al               1.24            14.60          frante      *u.75                      . 1.9t
C:h I e              8...79          90.30          Germany              "0 . 1.20)
4:uou.b I -I. 6                       6.20)         Italy                t..12            3.40
Isds a              '*.24             7.10         Japan        *.58                     4.10
Ijirael             0.97             56.50         Nether I and%    *b  .61               1.9C*
# ,w *a     t.5l                     6.90          Spain                * s.'.'k         3.20
".mIay 1a.          *V. 4.'           3. Ott        Swedeh..             ".66             2. 3'
Pk-:: E*     z       IPun4     I S .t         O     Wl eubH.6..                           4. 28 
III I a gpaIe-.      I's. oil        11.5.)         titA                 '. 6U3           2.30
venez Il            *'. t,           3. 6Lu
I ahabde            *.. 51 S          5. 6t 
A v   h"67                           ?9.62         AvgihAGE      * J .72                  2. 64
Notes:   1/ This is the estimated coefficient (aA on  lagged Inflation in a
first-order autoregression scheme of the form.4X, - A0*A1X,-1*U  where X' is
rate of Inflation In CPI, and U  is an error term.  Thus. tAe Ligher the value
of Al the higher the degree of inflation variability. In the extreme case
that Al - 1, Inflation follows a random walks.
2/ Inflation shock Is the standard deviation of the residual of the
error Lerm in the autoregression on equation described above.
Sources: Based on data from 1F, Interl ational FinanciAl Statistica



- 25 -
Colombia the cause of short-term bias of financial intermediaries. There
appears no compelling evidence, at least in a comparative perspective, to
link inflation volatility to short-termism phenomeron in Col4mbia's financial
institutions. The sources and causes of the problem seem to reside somewhere
else, and in particular, in three areas: (i) general uncertainties facing
economic agents which are not necessarily associated with inflation; (ii)
high interest rates; and (iii) discriminatory regulatory p.:actices and wide
disparities among different financial institutions with regard to reserve
requirements and forced investment, which have led to impede competition and
innovative efforts to offer longer-term deposit instrument and facilities.
Under the first category, the broader degree of uncertainty associated with
security conditions in the country and the traditional short-term orientation
of macro policy in Colombia, and the lack of a clear long-term strategy and
indicative planning are obvious candidates. These are mutually reenforcing
while the nature of the interaction and direction of causality cannot easily
be established.
b)  Directed Colume and Relative Significance.
31.      Table 8 puts the recent evolution of the directed credit programs in
Colombia in a quantitative perspective. The table presents data on end-year
(1980-1987) outstanding credit, both in volume and in relation to GDP,
extended to the business and agricultural sector for the purpose of financing
investment (both working capital and fixed assets) and for export expansion.
Institutionally, these programs include credit extended through the Fondo
Financiero Agropecuario (FFAP), the Fondo Financiero Industrial (FFI), and
the Fondo Para Inversiones Privadas (FIP), all administered by the Banco de
La Republica, and through the Fondo de Promocion de Exportaciones (PROEXPO),
which is administered by another government agency and funded by an earmarked
tax on imports. Included under the rubric of directed credit programs are
also external credit lines



TableJ3:  Directed Credit  Recent Evolution and Relative Significance
I In SIIIIons of Colomblan Pesos and In percent I
End of Year 1910 1937
19n       10111     19n2      19on     1393       13n%      14n36     393
1. Total Pirected Credit                                         64 5      el B    115 9    141 8    188 1    230 9    299 2           n a.
I 1. Development Credit  (Fondos Flnancleros)                  52.3      67.3      94.0    122 5    157.5    106.7    216 6    305.1
*  FFI                                                    3 9       1 8       4.8       5.9       *6 *        .*       7.'9     *.7
b. FIP                                                    31         3.5      5 2        1.7        6        7        82         9 .6
c. PROEXPO                                               22.5      31.9      *5 3      57.4      73 4      S7 1      311  2    n a.
d. FFA                                                   22.9      28.2      38.7      S1 6      67.7      84 0    102.3    123.4
1.2. Esternat Credit                                           12 2      14.3      21.9      25.3      30 6      44.2      62.6      na.
2  Total Ranking System Credit                                  343.9    480.3    59.s9    734.9    640.8   1021.3  1362.5   1034.2
3. Directed Credit/Tot. 5kg Synte  Credit (1)                    18.8      17.0      19.4      20 1      22.4      22 6      22 0      n a
4. DIr,eted CreditiCDP (1)                                        4.1       4.1       A 6       4 8       4.9       * 6       * S      na.
5  Dltrectd Credit In Constant 1980 Ptlces                       64.5      66 4      75.7      80.2      63 5      82 1      82 *      n a
Notes and Sourceos
I1 Total Directed CredLt-Development Credit (Fondos Financetros) plus external credit
21 Deflated by CDP Implicit price deflator
Source: Staff *stliates based on data from The Banco d4e la Republics.



27 -
supported by the World Bank and IDB loans which have also been administered
by the BR and channelled primarily through Corporaciones Financieros (CFS).9
The outstanding volume of these credit lines amounted at the end of 1986 to
Col$300 billion (4.5 percent of GDP), which accounted for 22 percent of total
outstanding credit of formal financial markets. Of this amount roughly 50
percent is accounted for by the development credits (Fondos Financieros),
which are financed by various forms of taxation levied on imports or on
financial institutions through excessive reserve requirements or forced
investment. It is, thus, this component of government credit programs which
has been the subject of policy controversy and debate. The balance of this
section will, hence, concentrates on two aspects of these programs: (i)
their volumes, and (ii) the degree of interest rate subsidization involved.
32.      Table 9 sets the tone; it describes the evolution of development
credits (Fondos Financieros) from 1976 to 1978, and reveals two important
facts. First, that the volume of total credit facilitated through official
funds (Fondos Financieros) has increased in nominal term from Col$15.4
billion in 1976 (2.9 percent of GDP) to Col$305.1 billion (3.4 percent of
GDP) in 1987. In relation to total credit market activity, however, the
volume of official funds has tended to decline during this period, from an
average of 24.1 percent in the second half of the 1970s to 16.5 percent in
1987. Second, more than 40 percent of total volume of official funds has
been channeled to the agricultural sector through the FAA.
33.      In addition to its dominant position in the total supply of
development credits, the FFA is distinguished also by its high degree of
9 The data excludes credits through the Fondo de Capitalizacion Empresarial
(FCE) on the grounds that this line finances individuals purchase of company
shares and, hence, is not comparable with other official credit lines such as
FFAP, FFI, FIP, and PROEXPO, which are in essence debt capital, whether they
originate from foreign or domestic sources.



Tahl   9   Oititandfia   Dewtopint Credit   to Eutivin.   Prt e S.-t
I In Sillbona of Coilihlan P.ioa and In pwrcent
End of Tears  1396-1i11.
-- -  - -  -  -  - -  -  - -  -  - -  -  - -  -  - -  - -  -  -  - -  - -   ...   _... ..  ,,,,,,,,,,,,,,_.. ... . . . ...........  ...  ... . . . . ..   ..               ..   ..   .. .  . .  .  . .  . .  .  . .  . .  .  .
1976       19??        iqi         1979        1000       1"I         le"?        10011       14004      1gq5         ells       I"R?
1  DCV 9lol_nt Credit   (FandoA   finanet.ros)                             IS.4       27.1        13  A       Al s       S2 1        6t 1         a a       W   s 177..5 156                   2i1  a      lo S.I
to. IVA                                                                  * S        1f.6       21 1        29 5        2?         701 I       1in         51 6        a? t          36      192 1       121 .
2. DO      _nt  CroltCreditCwI l )1 2.9                                                  .                       O.        1 1         1 a                      * D      4 o        1.76        3 51        1 a?
1  Deelopmnt Creditt?ot Instltutlonal Credit (2                           a It 0      21              1 259 PR6           is? IS .0 15 i                     Jr 1      to 71       10 2b        17 1       t o S
Source: Staff eatlmtee based on data from The Banco d.t Is Republira



- 29 _
politicization, higher degree of subsidization, and its rigid interest rate
s aicture. The administered borrowing rate on loans secured through the FFA
in 1985, for instance, was 21 percent, as compared to corresponding rates of
33.8 percent and 32.3 percent applied to loans directed to industry through
the FIP and FFI respectively. This favored position of agriculture relative
to industry, both in terms of its higher share of directed credit allocation
and higher degree of interest rate subsidization, is an interesting feature
of Colombian political economy. There is also the belief that the
agricultural sector has been traditionally discriminated against in other
areas of macro policy, particularly trade policy. Motivated by this belief
and pressed by the fact that the agricultural sector relies on credit as its
primary source of finance and its virtual exclusion from the resources of
capital markets, have led the agricultural community to rally its political
power and to resist any changes in the status-quo. IJI a sense, the sector
views its more favorable treatment in the finance area as a compensatory and
corrective policy, balancing of the discriminatory treatment that it is
subjected to in other areas of macro policy. There may be some valid
justification for such a position. In any event, the fact remains that no
policy reform in the areas of development credit programs can be
realistically expected to succeed unless it is firmly grounded in the
political economy of the agricultural sector and the peculiarities of its
credit demand.10 These peculiarities include the relatively high degree of
agricultural sector in development credits and the inelastic nature of its
loan demand. The outstanding credit facilitated through the FFA accounted in
10 It is an important characteristic of agricultural finance that loan demand
in that sector tends to be very inelastic. This means that higher interest
rates typically lead to financial distress and bankruptcy, rather than to
lower demand. The farm crisis in the U.S; in the wake of high interest rates
of the 1980s provides a convincing illustration of this fact, so does the
enormous political pressure exerted by the agricultural community for an
interestink study of the farm crisis in the U.S. (see Calomiris, Hubbard and
Stock [198Z)



* - 30 -
1986, for instance, for 52 percent of total institutional credit extenved to
the agricultural sector. In contrast, the share of industry in development
credits relative to its total demand for credit amounted in the same year to
5.7 percent excluding PROEXPO and 47.6 percent when PROEXPO was totally
allocated to industry.11
34.      Interest rate subsidy has been one other important aspect of directed
credit programs in Colombia which has generated a great deal of policy
controversy and debate. There is no doubt that the extent of interest rate
subsidy has been relatively large, averaging for the period 1976 - 1978 to
about 19.6 percentage (see Table 10). Recent measures, however, to link
lending rates applied to development credits to DTF (a market-determined
composite deposit rate), have led to reduce significantly the magnitude of
such subsidy. In 1987 this has fallen to 10 percentage points for the
development credits as a whole. The main reason has been the sharp increase
in lending rates applied to PROEXPO and to industrial funds. It is essential
that this policy direction be followed, and to the extent possible, to bring
credits channeled through the FFAP under the same rule and treatment. It is
also essential to lower the currently high lending rates; such efforts need
to address both sides of lending rate equation, i.e., the deposit and margin
rates. The official ceilings imposed on August 29, 1988, seem hardly to
provide a long-term solution. They could only alleviate temporarily the
pressure or interest rates. But as table 11 shows, there has not yet been
any sign ot downward movement in the pattern of deposit and lending rates.
11 This is of course not valid given the fact that PROEXPO finances
agricultural exports also. The exact distribution of PROEXPO funds between
industry and agriculture is, however, not clear.



- 31 -
Table 10: INTEREST RATE SUBSIDY, 1976-1987
Market Lending          Development          Subsidy
Year               Rate                    Funds
1976                    38.1                    21.0                 17.1
1977                    38.1                    17.6                 20.5
1978                    36.5                    17.4                 19.1
1979                    36.6                    20.9                 15.7
1980                   40.2                     22.7                 17.5
1981                    47.3                    22.7                 24.6
1982                    47.9                    22.6                 25.3
1983                   43.7                     21.5                 22.2
1984                    44.7                    22.6                 22.1
1985                   45.3                     22.6                 22.7
1986                   41.2                     22.6                 18.6
1987                   41.4                     31.4                 10.0
Average                 41.8                    22.1                 19.6
Source: Staff estimate based and data from Banco de la Republica.



- 32 ^
TABLE  1_; COLOKBIA. RECENT CHANGES IN KrY INTEREST RATES
SELECTED PERtODS
(ANNUAL RATES IN PERCENTAGE)
Before Ceilln                  after  a'-
July    July      Aug. Sep.  Sep.       Sep.
Instrumcnts                     15 - 22  2     9 22 * 2    12 * 16  .;   :
1. Denosie Rates (90-day CDT)
Banks                         35.0    34.9        31.5        31.5   31.3
CF.                           36.5    37.0        34.0        33.4   33*
2. Lnding Rates
Banks                         47.9    43.3        39.0        39.9    3*99
CFs                           45.7    45.3        45.5        43.2    42.3
CFCs                          46.5    45.9        44.9        44.0    ,3.3
3. Government Paper
(JAN CtASS A 180-dav)            35.6    35.5        29.5        31.5    29.2
Source:  Asoclaclon Bancaria de Colombia. Inform* aseadistico semanal,
various issues.



- 33 -
IV.   X Refor   f 1986 and Corporte cost gf capital
1. Intzgditgn
35.       This section analyzes the impacts of the 1986 tax reform on the real
cost of capital in the nonfinancial corporate sector of the Colombian
economy. The analysis concentrates on the marginal cost of capital, which
refers to the rental or user cost of capital and is defined as the real cost
of funds (both
debt and equity), adjusted for the impact of accelerated depreciation and
cost of asset decay. This yields a measure of the real cost of capital which
is most relevant for the analysis of business investment incentives. To
finance their new investment expenditures, firms are assumed to draw first on
their internally generated sources of funds, secondly, on loans obtained from
subsidized official funds, and lastly on loans secured from financial
institutions. For this reason, the marginal cost of debt is measured by the
market lending rate. 2 And the cost of equity is measured as the average
(expost) real return on equity after making proper adjustment for inflation -
induced depreciation in real the value of debt and economic depreciation of
underlying capital base. This combined measure for the aggregate
non-financial corporate sector is used as a basis for assessing the impact of
the tax reform.
12 This applies more realistically to large firms. For small and medium size
firms, it is the informal market rate which represent their marginal cost of
debt.



- 34 -
2.  T  ftn1va: P --ta  ia of The 1096 Tax Reform
36.     The three provisions of the tax reform of 1986, which are thought to
have bearing upon the cost of capital are: (i) the gradual elimination of
the deductibility of the inflationary component of interest payments; (ii)
the elimination of dividend income taxes; and (iii) the reduction in the
corporate income tax rate from 40 percent to 30 percent. These measures are
adoptad to eliminate the long-standing bias against equity financing, and
thereby, to bring about a more balanced corporate capital structure. By
shifting tax incentives towards equity financing, the authorities are hoping
to reverse the trend in corporate leverag, ratios which, as noted previously,
have increased dramatically over the past two decades. But success is by no
means assured, and the chief reason relates to the expected limited supply of
equity capital. The supply of external equity is likely to be scarce due to
companies' reluctance to issue new shares. The family-based structure of
corporate ownership and the desire to maintain operating control over
corporation activi.y, are strong forces in Colombia which operate to make
company management very hesitant to resort to outside equity financing, even
if relative cost considerations favor such a financing strategy. Also, the
supply of internal equity is likely to be adversely affected by the
elimination of dividend income taxes. Expectations that this provision of
the tax reform may be reversed or changed have already prompted company
shareholders to exert considerable pressure on management to increase the
proportion of company earnings distributed in the form of dividend income.
37.     Thus, the danger exists that the increase in the cost of capital
associated with the gradual phasing out of deductibility of inflationary
component of interest payments may hamper real investment activity and,
hence, growth and profitability. The lower level of real investment may



- 35 -
reduce the overall demand for funds including also debt, but this outcome
would be far from the *uthorities' objective of promotLng substitution of
equity for debt financing at a rising level of real investment.
38.      Yet, one thing is certain; ti.. gradual elimination of the
inflationary component of interest expenses from corporate taxable income
will help to break the linkage between inflation and the real cost of debt,
which in the past has been crucially important. As it is generally known, in
the presence of full tax deductibility of interest expenses, inflation
directly affects the real cost of debt to corporate borrowers.13 This happons
because interest payments (in inflationary environments) are partly payments
of principal. The treatment of the inflationary component of interest
payments which are in the nature of capital expenditure as current expenses
for tax purposes, thus confers a subsidy in the form of tax savings to equity
holders. The higher the rate of inflation, the higher the value of this tax
savings, and hence the lower the real cost of debt.
39.      The significance of this inflation related tayr shield for the period
prior to the tax reform of 1986 in Colombia is demonstrated in Table 12. The
calculations are based on the average lending rates on loans secured from
financial institutions' own resources, which account for roughly 50 percent
of total credit extended to the business sector in recent years.14
13 See, for instance, Cohn and Modigliani, (1985).
14 In 1985, for instance, loans from financial institutions accounted for
about 48.5% of total formal market credit extended to the non-financial
business sector, See Table A.1 for more detail.



- 36 -
40.      Table 12 shows that without the inflation tax shield, the real cost
of debt would have been much higher (column 1). In 1985, for instance, the
real cost of borrowing from financi-l instLtutions would have been 12.25%, as
compared to the actual rate of 2.3 percent.
41.      Under the tax reform of 1986, however, interest expenxes are only
partially deductible. The deductibility of the inflationary component of
interest payments is to be gradually phased out over a ten-year period. In
fact, by 1996, only real interest payments will be eligible for deduction
against income taxeu.15 By that time the increase in the real cost of debt
would amount to 8.1 percentage points, assuming the current inflation of 27
percent per year.
42.      Of course, the cost of debt is only one component of the overall cost
of capital which is relevant for investment decisions. For investment in
fixed assets, i.e. plant, machinery, and equipment, the other main components
of the cost of capital are: cost of equity, the acquisition price of
capital, i.e., the cost of acquiring one unit of machinery and equipment,
taxation, depreciation allowances, and the cost of asset decay; i.e , real
depreciation in terms of wear and tear and the obsolescence of fixed assets.
15 To formalize the scheme let the parameter "a" denote the allowable
proportion of inflation which is tax deductible in a particular year, and let
the real cost of debt in that year be denoted by "'"; it can be shown, that,
Or" is given by:
r - (l-u)r-a.u.x.                     (1)
where "u" is the corporate tax rate, "r" is the real rate of interest and "x"
is the rate of inflation.
It will be seen from equation (1) that when a - 1, that is, under the
previous tax regime, the real cost of debt would be reduced by the full value
of the inflation tax shield, i.e., u.x. But after the tax reform of 1986,
"a" will gradually decline by 10% each year to reach zero in 1996. At that
time, the real cost of debt will be r-(l-u)r indicating an overall increase
of u.x.



~ 37 -
Table 12   Th: -%pact of Inflation on Real Marginal Cost of Debt
(1970-1985)
Year                 After Tax          Inflation      Real Effective
Real Rate of       Tax Shield          Rate.(3)
Interest (1)           (2)
1970
1970                    7.71                3.53             4.18
1971                    9.26                3.71             5.55
1972                    1.28               4.70              -3.42
1973                    -3.09               7.12            -10.21
1974                    0.74               10.19             -9.44
1975                    9.13                9.15             -0.02
1976                    7.54               10.21             -2.67
1977                    4.65               11.58             -6.93
1978                   12.93               6.90              6.03
1979                   11.61                9.62             1.99
1980                   10.95               11.02             -0.07
1981                   14.82                9.12             5.70
1982                   13.89                9.90             3.98
1983                   14.00                8.15             5.85
1984                   13.57                8.87             4.70
1985                   12.24                9.96             2.28
Notes: More formally, the above columns are defined as:
(1) - (1-u)r
(2) - u*x
(3) - (1) - (2)
Where u is corporate tax rate, r is real rate of interest, nominal bank loan
rate minus rate of inflation in GDP implicit price deflator; x is rate of
inflation (GDP price deflator).



- 38 -
The procedure for incorporating the influence of these factors on the cost
of capital under the Colombia tax code is described in the Annex, where a
general expression for the real cost of capital for the non-financial
corporate sector is derived. The Annex also contains the various assumptions
underlying our estimates of real cost of capital for corporations in
Colombia. The final simulation results, however, are reported here in Table
13. The Table also contains the historical estimates for 1981-1985 period to
serve as the reference points to which the two altornative simulated results
of 1996 are compared. The two scenarios are defined assuming (i), that the
aggregate debt-capital ratio remains constant at its historically estimated
value of 0.86 and (ii), that it declines by 5 percent per year. In the first
scenario, the real cost of capital increases from an average value of 14.6
percent in 1981-85 period to 22.5 percent in 1996. In other words the real
cost of capital increases by roughly 8 percentage points. Such an increase
is somehow moderated in the second scenario by the posited reduction in the
corporate debt ratio. Under this scenario, the increase in the real cost of
capital amounts to 6.7 percentage points by 1996, which is still quite
considerable.



- 39 -
Table 13 The 1986 Tax Roform and the Real Marginal Cost of Capital
(Percent per Annum)
XAU Hist2rte&I Values
1981                       16.4
1982                       13.6
1983                       16.1
1984                       16.0
1985                       11.1
Simulated Results
_Constant Debt RAtio      Changing Debt Ratio a/
1986                        8.8                         8.8
1987                       14.5                        14.5
1988                       15.3                        15.3
1989                       16.6                        16.7
1990                       17.6                        17.7
1991                       18.6                        18.6
1992                       19.6                        19.4
1993                       20.5                        20.1
1994                       21.5                        20.7
1995                       22.5                        21.3
* Based on the assumption that aggregate corporate debt capital ratio
declines by 5 percent a year, starting in 1989.



_ 40 o
3. Concluding 10marks.
43.      The authorities in Colombia have undertaken a comprehensive tax
reform which contains several provisions that are often advocated for high
inflation countries. This note has briefly examined the implications for
real corporate cost of capital of three of the provisions contained in the
tax form,. i.e., (i) the gradual elimination of the deductibility of the
inflationary component of interest payments, (ii) the reduction in the
corporate income tax rate from 40 percent to 30 percent, and (iii) the change
in depreciation allowances to a more generous scheme, (40, 40, 20 percent).
The analysis is still at a preliminary stage, so the findings need to be
interpreted accordingly. Bearing this in mind, the main conclusions can be
summarized as follows:
i) The reform will tend to increase the real cost of capital for
corporate borrowers. The increase, based on current trends in inflation and
interest rates, is estimated, for the aggregate non-financial corporate
sector, to be in the order of 8 percentage points by 1996. Such an increase
is quite considerable and it seems inconceivable that profitability could
increase to an extent as to leave investment incentives unchanged.
Therefore, the likelihood exists that fixed investment will be adversely
affected.
ii) The reform will be effective in breaking the linkage between
inflation and the real cost of borrowing, a phenomenon which has, in the
past, been directly responsible for lowering the real cost of debt and
presumably for encouraging leverage financing.
iii) It is too early to see the impact of the tax reform on the
development of capital markets. It is true that the primary equity market
has experienced an impressive growth over the past three years. The primary
shares offered by listed companies increased by 53 percent and 72 percent in
1986 and 1987, respectively (see Table 14). It is not, however, clear,
whether such an increase reflects the influences of higher tax incentives for
equity financing, or the sheer pressure of credit shortages, which have
compelled companies to consider alternatives to bank borrowing.



- 41 -
Table 14 Primary Share Offering by Non-Financial Listed
Companies: 1985-1987
(In Billions of Colombian Pesos & Annual Percent Change)
In Billions of ColoMbian _esos       Annual Pereant
1985      1986     1987          1986/85      1987/86
1. Shares                 8.71      13.34    23.03          53.09         72.66
2. Convertlble           4.53        4.88     2.08           7.73        -57.48
Bonds
3. Total                13.24       18.22    25.10          37.57         37.80
Source:  Staff Estimate Based on Data from Comision Nacional de Valores de
Colombia,  nfia Laboras 1987-1988.



- 42 -
V.       lslona and poliew Ruagati
44.      A strong expansion in the pace of private business investment has
been a remarkable feature of recent economic recovery in Colombia. The
sustainability of this investment expansion is currently perceived to be
critically important to the prospects for economic growth and productivity
gain over the next few years. This paper (chapter) has concentrated on three
areas of economic policy, demand, financial and taxation, and their potential
influences on private business investment. The main result and policy
suggestions are summarized below.
mahiand Factors
45.      On the demand side, the key requirement is the continued expansion of
domestic demand to motivate firms' desire for capacity expansion. The
initial condition is favorable since many firms are already operating at high
capacity utilization rates. Policy, thus, needs to build upon this favorable
condition by encouraging demand towards investment and away from consumption.
A desirable policy option in this respect would be an investment tax credit
scheme designed to lower the effective price of capital goods to the business
sector.
46.      Yet, business investment decisions are as much governed by current
realities as driven by future expectations. And here, there is a strong case
for macro stability, policy transparency, and credibility. There is no way
of exaggerating the importance of a predictable environment for investment
performance; business investment decisions are, by nature, forward looking,
and they are often irrevisible. This means that, when faced with high.
uncertainty, firms respond by simply not investing or just waiting, or by
investing in financial and liquid assets. In this context, policy has an



- 43 -
important role to play in casting light on the evolution of main economic
variables, such as GDP, interest and exchange rate, and credit and monetary
aggregates. Frequent forecast of these variables would tend to provide
useful anchors for private sector expectations.
Coat of Capital
47.      The starting point for consideration of potential policy influence on
the cost of capital, and through that, on investment, is tho observation that
the real cost of capital in Colombia is high in real terms, even for a
developing economy. The real (marginal) cost of capital to the non-financial
corporate sector is currently about 16 percent. This could further increase
as the gradual elimination of inflationary component of business interest
payments takes its effect. Unless interest rates are reduced, the complete
elimination of inflationary component of interest payments, could, by 1996,
add an additional 6 percentage points to the current high levels. Such an
increase, however, could be moderated by extending the period over which the
tax deductibility provision is scheduled to be phased out.
48.      What does this trend in the real cost of capital suggest for the role
of policy? Clearly, either profitability has to be increased or other
component of cost of capital has to be brought under control if investment
incentives are not to be adversely affected. Three areas of policy options
are considered below:
49.      First, there seems limited scope for policy influence on the
profitability side; there is a strong cyclical component in pattern of
profitability in Colombia, which stems from the cyclical behavior of real
wages and rate of capacity utilization. Thus, profitability tends to be high
during the upward phase of the cycle, as evi'sat by the experience of the



- 44 -
1986 - 1987 period, and low durlng the downturn. In this sense, the extent
to which policy can influence profitability depends on its success in
influencing the business cycle.
50.      Second, efforts to induce corporations to substitute equity for debt
financing should lead to a more balanced corporate capital structure and
possibly to a lower overall cost of capital. Indeed. an important provision
of .1986 tax reform, i.e., the elimination of dividend income taxes, was
particularly designed to that end. This has resulted in eliminating the
double taxation of capital in Colombia, and thus has helped to reduce the
cost of equity financing. This may have been also partly responsibi for the
impressive growth of the primary equity market observed over the past three
years. The primary shares offered by listed companies increased by 53
percent and 72% in 1986 and 1987 respectively. But given the very small size
of the market, its rapid growth of the past three years is likely to have
marginal impact on the cost of capital, or on the pattern of corporate
finance. On the other hand, the elimination of dividend income taxes and the
expectation that it may be reversed, prompted shareholders to exert
increasing pressure on corporate management to increase the proportion of
corporate earnings that is distributed in the form of dividend. As a
consequence, retained earnings are adversely affected and, through that,
corporations' ability to finance their investment internally.
51.      Third, there is potentially some room for policy influence on the
cost of capital through tax treatment of depreciation allowances. The
prevailing tax code for capital consumption allowances is based on historical
cost accounting system. This system tends to understate the economic value
of a portion of fixed assets which is used up during the process of



- 45 -
production and, hence, over state taxable earnings. A shift towards a
replacement cost accounting system should lead to eliminate this distortion
and, furthermore, to enhance corporations' internal cash generation capacity.
52.      It would, however, seem sanguine to assume that the policy measures
listed above could lead to reduce the cost of capital sufficiently if
concerted efforts were not undertaken to lower the prevailing high lending
rates. The problem, here, has both macro and financial sector origins.
Under the first category, high inflation and low savings rates are among
prime candidates. Under the latter category, the source of the problem is
the high cost of financial intermediation in Colombia. The current margin of
around 9 percentage points, between average lending and deposit rates in the
financial sector (Bancos and Corporaciones Financieros), Is rather high by
international standard. This is in part due to the short-torm bias of
financial intermediaries, which imposes a high administrative cost on
financial institutions, and in part, due to the cost of financing the
official funds. While these funds provide below market loans to priority
sectors, they also entail costs to the financial sector, which are, in turn,
passed on to corporate borrowers.
3. Availability and Allocation of Investabloe Funds
53.     Of course, for small and medium size firms, it is not so much the cost
of capital as it is the sheer availability of capital which is often the
operating constraint on their investment behavior. These firms are very
vulnerable to the risk of monetary and credit constraints. They are likely
to be crowded out during periods of credit crunch. These characteristics of
these firms, thus, suggest an important role for government intervention in
the financial sector. Such an intervention, however, should, in principle,
be directed to counteract any undue credit rationing imposed on them by



- 46 -
financial instltutions. To the extent that these firms' Lnvestment and
productive activity can be regarded, from a social welfare point of viow, at
higher value than equivalent investment by large firms, there is some
justification for their preferential treatment. In the case of Colombia,
there are at least two reasons that argue for such a treatment: (i) that
these firms toed to be concentrated on relatively more labor-intensive
activities and sectors; and (ii) that theit existence and survival are
necessary to guard against increased monopolistic industrial structure.



- 47 -
ANNE
The Tax Reform of 1986 and the Real Cost of Capital
Derivation of the Cost of Capital
A. 1. Derivation of the Cost of Cagital.
54.      This annex draws on the modern theory of optimal business investment
behavior to derive an equation for the cost of capital services (rental price
of capital) for the non-financial corporate sector of the Colombian economy
to be used as a basis to evaluating the impact of the 1986 tax reform. The
cost of capital services refers to the cost of using one unit of capital for
a specified period of time, i.e., one year. It depends not only on the cost
of funds and the cost of asset decay, but also on the benefits of tax
provisions for businesses' depreciations and for deductibility of interest
expenses. Also, the determination of the cost of capital relies on the
interaction between inflation and taxes. To the extent that interest
payments which are deductible against corporate income taxes are in part
payments of the principal, the real cost of capital is reduced. This
positive aspect of inflation is, however, offset in Colombian tax regime by
the historical cost base depreciation rules, which do not fully compensate
the companies for higher replacement cost of capital.
55.      Analytically, the derivation of the cost of capi.tal is facilitated by
focusing on the investment decision from the perspective of the equity
holder.  Consider then an investment in a project costing Pk at the time of
acquisition. If a proportion, b, of that investment is financed through
debt, and if the statutory corporate income tax rate is u, the shareholder's
share of the original investment outlays, under the prevailing tax



_ 48 _
depreciation allowances ln Colombia, will be (l-zu-b) Pk, where z is the
present value of depreciation allowances. For the project to be viable, thLs
must be equal to the present value of the stream of net income; more
formally,
Pk(l-zu-b) - Iexp(-(p.)e)((-i)q?y-((l-,)R.(l-a)ux.(6-*)bP+ UZPk] dt
where:
q - real user cost of capital
Pk - purchase prlce of capital
Py - price of output, GDP price deflator
- real required rate of return on equSty
8 - rate of depreciation
b - target debt capital ratio
R - nominal rate of interest
and other variables are already defined.
Solving equation (A.1) for the real cost of capital, q, yields:
RPkr    l1-uz p-(l-u)R+x   u(l-a)x b
' nyt(P  6) l-u      l-u     b   (l-u) b
56.      It is apparent from equation (A.1) that the elimination of the tax
deductibility of inflationary componentp of business interest payments will
increase the real cost of capital, and that this increase is captured by the
additional term.
u(1 - a)x b
1-u
57.      This term vanishes when a-l, which corresponds to the usual full
deductibility of interest expenses; in that case, equation (2) takeai the



- 49-
familiar form [see, for instance, Bosworth (1985)]. Furthermore, when the
inflationary component of interest expenses are fully phased out, i.e., when
a-0, the overall increase in the real cost of capital will be equal to
-b
1- 4
which is independent of the interest rates and depends only on the corporate
income tax rate, "u", rate of inflation, "x", and corporate debt-capital
ratio, "b".
A. 2. .Rexmrnatton of Cornorate Leverage Rat.
58.      This, however, yields only a partial view of the impact of the tax
reform on the real cost of capital. A more precise view should take account
of the impact of the reduction in the corporate tax rate, which works to
lower the real cost of capital to corporate borrowers. To that end, it is
necessary to return to equation (2) and compare its estimates under the two
tax regimes, i.e., before and after 1986. There remains, however, one
obstacle; there is great uncertainty as to how the firm's debt policy, i.e.,
their debt leverage ratio, may react to the changes introduced in the tax
reform. 16 The associated increase in the real cost of debt should, in
principle, discourage debt financing. Econometric analysis of past
determinants of corporate leverage ratio in Colombia, does not support this
16 In a broader perspective, this uncertainty about the impact of tax changes
on corporate debt leverage ratio reflects the more fundamental uncertainty
about the determinants of corporate financial structure. Questions
concerning firms decisions as to how much to draw on retained earnings to
finance their investment expenditures and how much to raise externally,
through debt or equity, or what portion of their earnings to distribute as
dividends and what portion to re-invest, have, unfortunately, still remained
unsettled even in the context of industrial countries and even in theory.
Anomalies, paradoxes, and puzzles are more often used to describe the state
of knowledge, than rigorous understandings. See, for instance, Black (1976),
Myers (1984), and Mayer (1P88) for a critical assessment of the state of the
art.



- 50 -
assertion, however.17 Indeed, as apparent from the estimated equations
reported ln Table A. 1., the results indicate that the corporato sector in
Colombia seems to have followed a constant, desired, or targeted,
debt-capital ratio strategy with some adjustment lags involved. Such a
desired debt-capital ratio can be extracted from equation (3.2) to yield an
estimate of 0.86, which appears consistent with the historical pattern of
corporate finance in Colombia.
17 In addition, given the prevailing wide differential between interest rates
and loans secured through official funds, which are re-discountable at the
Central Bank, and loans obtained from financial institutions (own resources),
the higher overall cost of debt could shift demand towards official funds.
This, in conjunction with government policy of gradually raising rates on the
resources of official funds is likely to put increasing pressure on lending
rates.



- 51 -
Table A.1.: Regression Results for Determinants of Aggregate Debt-Capital
Ratio in the Non-Financial Corporate Sector; Atwual Data,
1970-1985.
(A2.1)   dt - 0.254 - 0.007rt + 0.724dt-
(2.2)     (1.2)       (4.3)
R2 - 0.60
(A2.2)    dt - 0.237 + 0.239yt + 0.728dt4_
(2.2)     (1.6)       (4.3)
R2 - 0.63
(A2.3)    dt - 0.224 - 0.003rt + l.9lyt + 0.74ldt-,
(2.0)     (0.5)       (1.1)      (4.3)
R2   0.64
(A2.4)    dt - 0.268 - 0.005Rt + 2.396(utxt) + U.62ldt4_
(2.6)     (0.5)       (1.2)      (1.7)
R2 - 0.61
t- ratios are in parentheses.
Notes and Notation; The variables are defined as follows:
dt - aggregate debt-capital ratio, where debt is measured as total outstanding
loans from financial institutions, including resources facilitated
through official funds, to the NF corporate sector; and capital is
measured as sum of total fixed assets and inventories.
r - real rate of interest, bank lending rate minus rate of inflation (GDP)
Yt - deviation of real GDP from its linear time trend.
R - nominal bank lending rate.
utxt - inflation tax shield.



- 52 _
A. 3.               tam and AIaUgVXiona
59.     The remaining variables were estimated or assumed as follows:
(i) P. the real required return on equity taken to be 9.3 percent
which is the average over the 1970-85 period of real return on equity after
making adjustments for inflation-induced depreciation in the real value of
debt and economic depreciation in underlying capital base.
(ii) 6, economic depreciation, assumed to be 5 percent.
(iii) z, the present value of depreciation allowances was estimated
to be 0.231 and 0.579 for the pre- and post-tax reform period respectively.



- 53 -
REFERENCES
Black, F. (1976), "The Dividend Puzzle", Journal of Portfolio Management,
Winter, pp 5-8.
Bosworth, B. P. (1985), "Taxes and the Investment Recover", Rrookinag EapMr
on Economin Acrtvity, No. 1, pp 1-45.
CalomLris, C. V., R. G. Hubbard and J. H. Stock (1986), "The Farm Debt Crisis
and Public PolLcy", Brookings Papers on Economic Activity, No. 2, pp
441-479.
Cohn, R. A. and F. Modigliani (1985), "Inflation and Corporate Flnancial
Management", in E. I. Altman and M. C. Subrahmanyam, eds., Rsenn
Advances in Corporate Finanee, Richard Irwin, pp 341-370.
Dailami, M. (1988), "Corporate Capital Structure and Cost of Capital in
Developing Countries: The Case of Colombia," Forthcoming.
Mayer, C. (1988), "New Issues in Corporate Finance," European Economic
Ravi , No. 5, pp 1167-1183.
Modigliani, M. And M. Miller (1958), "The Cost of Capital Corporate Flance,
and th9 Theory of Investment," American Economic Review, No. 48, pp.
261-297.
My,ars, S. C. (1984), "The Capital Structure Puzzle," Journal of Finance,
July, pp 575-592.



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