Wednesday, May 23, 2012

Present discounted value, explained slowly

Suppose that you own an asset that gives you $100 per year annual income net of any costs of ownership. Would you be a fool to sell that asset and forego that revenue stream? Well, it depends on how much money you would be given for the asset and what you would do with it.

If your best possible use of any raised funds is a RaboBank term deposit at 6%, and if the net earnings flows are comparably risky, then if somebody's willing to pay you at least $1667 for the asset, you're better off selling it. Otherwise, you're better off keeping it. If somebody offered you $1000 for it, you'd get $60 per year in interest. That's less than $100 per year. If somebody offered you $2000 for it, you'd get $120 per year in interest. That's more than $100 per year. Whether you should sell off the asset depends on how much somebody else is willing to pay for it.

So, what's somebody else willing to pay for your asset? That depends on what they could do with it. If others reckon they could earn more from your asset than you are, they could bid the price up to a point above $1667. If they think they could earn less, they'd offer less. So whether you should consider selling the asset really depends on whether somebody else could make more money from it than you can. If they could, they'll pay you for the privilege, and you'll both be better off.

This has, perhaps, been overly pedantic. But when folks' main objections to asset sales are losing the flow of dividends, pedantry seems necessary. Here's Christchurch Mayor Bob Parker.
The strategy does not propose the sale of any city-owned assets, including our shares in companies such as Port of Lyttelton, Orion or Christchurch International Airport Limited. This Council has recognised the importance of retaining these assets, which provide valuable dividends each year and offer an alternative revenue stream to rates alone.
As part of our usual business practice, the Council keeps an eye on the value of our assets and the returns they yield. At this stage, when you look at the annual revenue we receive from these companies, it just does not make financial sense to consider selling them for a short-term profit.
Where an asset is more efficiently owned by the public sector, then the one-off return from selling the asset will be lower than the value of the dividend stream. But how many assets really fall into that kind of category? Christchurch Council used to think private management of Lyttelton Port was a good idea; they wanted to bring in Hutchison Port Holdings as strong minority owner and manager of the Port. It wound up being blocked, if I remember correctly, when Lyttelton's main competitor, Port Otago, acquired a blocking interest to prevent the sale; they seemed to be worried that Lyttelton would be more competitive under private management.

Before the earthquake, with a different Mayor, Christchurch thought it a really good idea to sell off just shy of a controlling interest in the Port to a foreign specialist in ports. They saw opportunities for better management with specialist interested assistance. Now, after the earthquake, when Council's a bit more desperate for money, Mayor Bob Parker thinks it short-term thinking to sell off even part of Lyttelton Port? Remarkable.

If the quake has made it more expensive for Council to raise debt financing, then surely that also makes partial divestiture of some current Council assets more attractive. Council owns 75% of the airport. Is there something magical about 75% that made it the right ownership fraction both before the earthquake and afterwards? Mightn't it make sense to trade some of Council's ownership of the Airport, Port, and Red Bus for Council ownership of improved roading, sewerage, and water infrastructure? Or to help build a park and bike paths along the Avon that don't provide a financial return but improve quality of life? Or maybe to help them rebuild the torched kid's play structure in South Brighton Park that's been sitting behind a fence since January and otherwise ignored by Council but asked about by my children every single time we go to use the swings there?* Surely there are some current quality of life issues that are worth more than having an extra 5% of the airport. Am I a heartless neoliberal because I think it just might make sense on equity grounds to fund partial temporary rates abatement in the more earthquake affected parts of Aranui and Bromley by selling off a few percent of Red Bus and canning the plans for an expensive new stadium and convention centre?

Yes, selling Council-owned assets gives us money now and less money later if we spend it on current consumption or lower rates. That's a trade-off worth making after an earthquake so long as the selling price for the assets is reasonable.

* Update: The Christchurch Mail, in my mailbox this evening, reports Council's planning on starting work on it; it might be ready for next summer.

8 comments:

  1. Well Eric, good theoretical, but New Zealanders have seen practically and directly what happens when we sell off assets.
    First of all since the eighties we create some knights, and celebrities, Roger Douglas, Michael Fay, David Richwhite, Eric Watson and various other bloody criminals, and they grab our money and never bring it back.
    And then the various Companies that suck our wallets for electricity, and then the fact that you can not buy a postage stamp any more, because there is no postal service, and then sweet jesus there is Telecom.
    New Zealanders despise selling off assets with good reason.
    I think you are on a hiding to nothing with this comparative efficiency argument Eric. Everyone knows that once Christchurch loses income stream our rates go up even worser, and the last Indian leaves town. Flee now Eric. Flee with your wife and children. Brilliance and efficiency will avail you nothing here.
    This is redneck territory for many generations.

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  2. "This Council has recognised the importance of retaining these assets, which provide valuable dividends each year and offer an alternative revenue stream to rates alone."

    And this is the most dangerous statement of them all, whether uttered by Bob, the Govt, the Greens or Labour.

    The more profitable the assets and the more ownership a council or Govt has, the less control the tax/ratepayers have over the assets' dividends, maintenance deferred and how surpluses are used.

    Typically the council/govt can say "We built that statue to Bob with profits from the Port.. no ratepayer money was involved".. in this example Bob and the Council control the narrative on how the money was spent and can placate criticism with "no ratepayer money was spent".

    Its nice to have profitable assets, particularly when you control the price flowing from the asset, but the downside is the council/govt is less reliant on the tax/ratepayer when purchasing the bling you feel you are entitled to.

    On balance, I prefer councils and govt to be more dependent on rates and taxes to fund their operations.. that way they have to increase taxes and rates to buy the bling and are more openly accountable for it.

    JC

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  3. JC. A nice point. Having politician who are financially independent of taxpayers/ratepayers is a recipe for disaster. But politicalisation of firm helps politicians not just via profits. Politicians can take profits in forms other than money. Say, over manning, payments/gifts to politicians or their re-election complains, contracts being given to political supports, low prices for some groups and not other etc. So paper "profits" of a firm may look small but that doesn't mean politicians are not taking advantage of control over firms. Thus having no control over firms helps accountability on more than one dimension.

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  4. If the income received from asset sales was actually put into an interest bearing fund and was able to provide greater returns than the dividend from the asset itself then I'd agree with you. Or even if the sum total was used to pay down the current debt loading it would be worth doing, because the interest on the debt would probably be greater than the dividend return. But we all know, if we are to be honest with ourselves, that the politicians don't do that. At least some of the money goes into general expenditure and gets spent elsewhere. Once the windfall is gone we end up being in the position of having the same or similar expenses and less income to fund them, leading invariably to government or council needing to look at other ways to increase revenue.

    Maybe I'm just a bit dumb and don't get it. I'm the first to admit I'm no economist, I headed down the science path at school, so avoided econ and accy classes. But my memory of our experience with privatising the power companies here is that it led only to increased power prices for consumers, and, aside from the short-term windfall, reduced revenue for government. I fail to see how this is a public good.

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    1. Lats, the point is that the current dividend returns are irrelevant. You're compensated for them in the price you get when you sell the asset. Even if they yielded a billion percent returns, so long as you've a reasonably functioning stock market, you shouldn't care whether you keep the asset or take the cash-in-hand equivalent via divestiture.

      Seamus will disagree with you on the power companies. First, recall that they are state owned enterprises; they've not (yet) been even partially privatized. Power prices are far more a function of supply and demand here - the electricity trading market is really rather good. We've just let DoC, Forest & Bird, and The Greens decide that we can't have any more new power stations unless they're really really high cost generators.

      But you are entirely right on one bit: if Council takes any lump sum and spends it on magic beans, we're worse off.

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    2. Yep, you're correct on the power companies, I should have said splitting supply and distribution rather than privatisation. My bad. Bradford at the time went on and on about how this would lead to greater efficiencies and lower prices for consumers. It was all smoke and mirrors of course, all it did was introduce another level of management into the mix which was required to turn a profit. How that was ever expected to reduce prices on the consumer baffles me. And in the long run, shouldn't a large part of government's job be to do what most benefits the people? Or am I just being a naive idealist?

      Regarding the recent decision on the Coast, I agree with you. We know that we need to invest in more generation capacity, and environmentalists are dead against increased use of fossil fuels. My understanding is that hydro is one of the greener forms of energy generation, and that while wind farms are nice to have you can't really beat a dam when it comes to bang for your buck. It seems like the greenies are determined to prevent any expansion of our generation capacity, protesting against all manner of new ventures. Tidal generation = unfriendly to iwi & harms fish, windfarms = ugly blot on the landscape, coal & nuclear = evil, dams = kill snails. What the hell are we supposed to do?

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  5. Lats,

    At the time of the breakup of ECNZ, it was clear to anyone who analysied the electricity market that prices were going to rise and rise quite sharply, as a consequence of a) demand rising while the cheap options for generation were exhausted, and b) a legacy of previous over investment implying that electricity prices didn't come close to covering the cost of capital. The policy wonks who did the hard work putting the electricity market together were very careful to write the Press release speeches for Bradford claiming only that the market would result in prices that would be lower than would eventuate under the existing model. It was a policitcal choice to remove the counterfacutal based on the belief, I understand, that complicated sentence structures don't make good sound bites. The fact is that, despite the increase in demand with barely any increase in supply, the market parts of the electricity network are delivering reliability of supply and prices that don't imply an excess return on the capital cost of marginal generation capacity.

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    1. Thanks for that Seamus. The unfortunate downstream effect of the political word-smithing was that many of us in the general public who weren't actively analysing the market felt that we had been lied to by Bradford et al. Not that this should have come as any surprise, politicians are one of the less trusted bunch of people for a pretty good reason. Why we continue to vote for them mystifies me sometimes.

      If I am translating your last sentence correctly, are you saying that power prices are set at a rate such that they are covering generation/distribution costs, and returning very little margin to the vendors, i.e. they don't make much profit on power?

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