Chairman's Page (Immediate Past Chairman)Author(s): Harold GoldSource: Public Contract Law Journal, Vol. 7, No. 1 (October 1974), pp. xiii-xvPublished by: American Bar AssociationStable URL: http://www.jstor.org/stable/25753842 .

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Chairman's Page (Immediate Past Chairman)

For some years now discussion and

consideration of the values of return on investment has received in

creased attention. The increased em

phasis on the subject motivates me to recommend that the appropriate committees of the Public Contact Section undertake to study the ques tion and hopefully develop some constructive suggestions.

DPC 107 issued on December 11, 1972 undertook to consider return on investment in pricing, but we have no published experience as to the effectiveness or value of DPC 107. The Logistics Management Insti

tute, the GAO Profit Study, a study performed by George Washington University for NASA, the Commis sion on Government Procurement,

all have emphasized the importance of the subject. The subject should not be abandoned to the govern ment for an unilateral solution which

may or may not be equitable. It is a timely subject and perhaps an ex

pression of some of the problems is

appropriate at this time. From the standpoint of pricing

and excessive profits for renegotia tion purposes, should the govern

ment be concerned as to the source of private capital, i.e., capital or fi nancial assistance not provided by the government? That question was

recently posed by a member of the

Renegotiation Board in an academic

discussion and can be demonstrated

by the following example: A contractor with total capital of

ten million dollars, represented by nine million dollars supplied by creditors and one million dollars

by shareholders as equity capital, realized a pre-tax profit of one mil lion dollars or a return of ten per cent on total capital and one hundred percent on equity capital. Assume the return on equity capital is deemed extremely high, but that the return on total capital is deemed reasonable or low.

From the standpoint of pricing and of excessive profits for renego tiation purposes, it seems to me the

question is whether the contractor realized a windfall at the expense of the government, and not whether the contractor realized a windfall at the expense of creditors who pre sumably profited from the contrac tor's business.

The argument that the creditors incurred the risk of capital is at least in part offset by the manage

ment risk of borrowing and of hav

ing creditors. Frequently creditors obtain rights to acquire an equity interest at the possible risk of losing

management control or ownership control. Furthermore, it may be dif ficult to differentiate between equity capital and creditor capital.

It seems to me that the Defense

Industry Profit Study by the Gen eral Accounting Office, B-159896, March 17, 1971, has great merit in

concluding that the government should not.be so concerned with the

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Chairman's Page (Immediate Past Chairman)

source of capital, provided it is from

private sources. For as stated above,

the windfall, if any, was not at gov ernment expense.

This raises the question as to

whether the return on capital or the return on equity investment should

be a measuring device for determin

ing an excessive price or an excessive

profit. Reference to the importance of the return on capital and equity investment is, from an investors

point of view, generally to deter mine the attractiveness of the invest

ment, i.e., whether the investor is

realizing enough to attract his in

vestment, and not whether the in vestor is realizing too much. This is not intended to mean that the return on capital and on equity investment is not a fair measurement as to whether the contractor received

enough or whether the contractor

may have received too much. I am

inclined to concur with the view noted in Spaulding v. Douglas Air

craft Co. (IV Cir. 1946) 154 F.2d

419, 424, N.4 which sets forth para

graph vii of the principles, policy and procedure to be followed in re

negotiation, August 10, 1942:

Under existing war conditions more

reliance should be placed on the ratio

of profit to sales or to adjusted costs, and the ratio of profit to net worth should be used only as a

check[,] . . .

to determine whether the company is

making a fair return on its investment.

[Emphasis added.]

Regulations under the Renegotia tion Acts of 1942 and 1943 were to the same effect, not so as to the Re

negotiation Act of 1951.

There are many problems which

complicate the accurate determina

tion of the return on book capital and book net worth. One difficult

question is that of valuation. Assets

may have been undervalued or over

valued due to the method used for

depreciation and amortization or to

changes in market value, or equip ment and facilities may have been

leased, which some argue should be

capitalized. Another question is whether book

value should be used in determining return on capital investment, as

suggested by GAO, among others.

This problem is demonstrated by the example of two entities doing identical work, using identical equip

ment of identical age and condition.

Both entities, over the years, through

depreciation reduced book value to

a negligible amount. However, the

market value is considerably higher. One of the two entities is acquired

in a taxable transaction resulting in a stepped-up basis so that its book and market value are the same.

Should it be allowed a much more

favorable price or profit level than

the other entity? Among still other problems is (1)

the difficulty of isolating income

with related capital when the aggre

gate profits are attributable to oper ations where capital is a major in come producing element and also where it is not a significant income

producing element, and (2) the com

plication of making comparisons between companies whose financial needs have become stabilized and also those which have not, as in the

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Chairman's Page (Immediate Past Chairman)

case of giant entities as opposed to

small but growing businesses. It may be extremely difficult to al

locate investment and capital solely to any particular portion of business or to determine the extent to which excessive or inadequate capitaliza

tion of an entity resulted in too low or too high a return. Competition may influence prices but it rarely dictates the amount of capital or

equity investment used or the man ner of its use.

As I have stated in the past, the

capital employed factor should be used at most as a check that a con

tractor has not been or is not being treated harshly and possibly as a

crude barometer to indicate whether the profit realized or to be realized is excessive so as to justify further

investigation into the reasons for the

high return.

Harold Gold

Immediate Past Chairman Public Contract Law Section

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