The impact of implied facilities cost of money subsidies on capital expenditures and the cost of debt in the defense industry

We examine the public policy effects of a cash flow subsidy unique to the government contracting industry, on defense contractors’ capital expenditures and cost of debt over a relatively long time-period, 1978–2009. Because the Department of Defense found evidence of a shrinking defense industrial base in the early 1970s, it wanted to encourage capital spending by defense firms. The result was a cost accounting standard that reimbursed contractors for an imputed facilities capital cost of money (FCCOM) that has remained in effect, virtually unchanged, for almost 30 years, despite structural changes in the defense industry. Our results, using a sample of 628 defense firms, suggest that the standard met its intended objective of increased capital spending within 10 years of its promulgation. However, we also find that the FCCOM subsidy may have contributed to a decreased cost of debt within the defense sector over the long-term. Finally, further analyses indicate that the long-term persistence of this subsidy may have encouraged defense contractors to overinvest in capital goods. Our findings suggest that public policy makers should consider both direct and indirect effects of regulation embedded in accounting standards.