RDP 2005-12: Financial Constraints, the User Cost of Capital and Corporate Investment in Australia Appendix B: Measurement Issues

A measure of the stock of capital at current replacement cost (Ki,t) was estimated using the perpetual inventory method:

The first term on the right-hand side is the capital stock remaining from the previous period, that is, after depreciation revalued at current prices by multiplying by the ratio of capital stock prices (pKt/pKt−1). The current capital stock is obtained by adding to this the newly invested capital stock (Ii,t).

The initial value of the capital stock is calculated by multiplying the firm's book value of net capital stock by the ratio of net capital stock at replacement cost to net capital stock at historical cost for the economy as a whole. See Mills et al (1994) for further details. In any case, the initial value of the capital stock plays only a minor role in the estimation procedure, which requires differencing the capital stock variable. I use industry-specific depreciation rates with industries classified according to the Global Industry Classification System (GICS). Experimentation with firm-specific depreciation rates did not appreciably affect the results.

The user cost of capital formulation used in the paper incorporates a measure of depreciation allowances, which companies may claim against investment in machinery and equipment in Australia. Following Sekine (1999), the present value of depreciation allowances (per dollar of investment) for industry s at time t is as follows:

where D(n,t) is the depreciation allowance at time t for an asset of age n, T is the life of the asset for tax purposes and rt is the 10-year government bond rate at time t. For a firm using exponential depreciation, D(n,t)=δ(1−δ)n, so that:

For a firm using straight-line depreciation, D(n,t)=1/T for an existing asset and D(n,t) = 0 for a retired asset so that:

As we cannot identify a given firm's method of depreciation, we simply take an average of the two methods to obtain the present value of depreciation allowances for each industry in each year.