Methods of Discount

[Haech]

This is just a random thought that I want to throw out there. Does anyone else think that discounting the future by interest rate is too dependent on the completeness of the market economy and less on the assumptions of utility? Assumptions should be made, but perhaps this one is a little far fetched. Are there more appropriate methods of discounting future than the interest rate?

 

(don't be afraid to put me in my place with this one)

[Theory5]

Does anyone else think that discounting the future by interest rate is too dependent on the completeness of the market economy

 

HAHAHAHAHAHAHAHAHAHAHAHA :esmoking::lol:

 

Yes, of course it is dependant on the completeness of the market economy. Most financial projects that are dependant on the future rely on the market. This is risky but apperantly vital for companies and projects to rely on the future of the market. There should be better ways but I do not know of any.

[Haech]

See, I should clarify this a little. In terms of discounting, if you're measuring the opportunity cost of making an investment versus putting it in a risk-less bank deposit, then the interest rate as the method of discount is probably appropriate. However in terms of many other situations, this is not very clear to me. Consider natural resources, say a body of forest, I really am not sure whether a market interest rate (which is mostly determined by the central banks and security traders) work in terms of capturing the dynamics of opportunity cost. In this case, the discount rate should be based on the utility of forest to the present population measured between the present and far into the future.

[lawcat]

See, I should clarify this a little. In terms of discounting, if you're measuring the opportunity cost of making an investment versus putting it in a risk-less bank deposit, then the interest rate as the method of discount is probably appropriate. However in terms of many other situations, this is not very clear to me. Consider natural resources, say a body of forest, I really am not sure whether a market interest rate (which is mostly determined by the central banks and security traders) work in terms of capturing the dynamics of opportunity cost. In this case, the discount rate should be based on the utility of forest to the present population measured between the present and far into the future.

 

 

I think that you may be confusing opportunity cost of goods with opportunity cost of money. Goods are just goods. Money, on the other hand, is labor.

 

Opportunity cost of goods is embedded in the price of goods. Goods are sold in today's market for today's money, and that is the end of it. If goods have useful life over one year, then goods can be depleted or depreciated over the life of goods. (which is not the discount rate).

 

Money on the other hand is discounted. Say, you receive payment of $100,000 for lost opportunity to work for the next 20 years. The $100k payment includes money that should be received 3, 5, 11 years from today. Yet, you are receiveing money today. If the payor was to pay you annually, the payor could put the money in the bank and receive interest, and then pay you 11 years from now. Thus payor loses opportunity, and you receive the opportunity to grow the money from today. You must then receive the $100k at a discount.

 

There are 4 ways discount is generally calculated. One is to take $100k and multiply it by inflation coeeficient, and then reduce that amount by prevailing interest rate. Second, prevailing interest rate is reduced by the rate of inflation, and than the $100k is reduce by that rate. (same results in both cases.)

 

Third, and this is the mehtod which would support your argument that we do not know about the future, is that we assume that the difference between inflation and interest rate is always between 1.5-2.0 percent (arbitrary selection); and then we discount the $100k by that number.

 

Fourth method is we do not do anything. We presume that labor, interest rate, inflation, etc., will wash out and todays purchasing power is equal to future purchasing power.

[lemit]

I think that you may be confusing opportunity cost of goods with opportunity cost of money. Goods are just goods. Money, on the other hand, is labor.

 

Opportunity cost of goods is embedded in the price of goods. Goods are sold in today's market for today's money, and that is the end of it. If goods have useful life over one year, then goods can be depleted or depreciated over the life of goods. (which is not the discount rate).

 

The example Haech gave was of a forest. That's agriculture. My late brother traded agriculture futures on the CBoT for several years. He tried to explain to me how that worked but didn't have the time. He was one of those guys who ran a string of grain elevators in Kansas and dominated the feed that went to the Arkansas chicken farms while working the grain futures, so his heart gave out when he turned 60. I was always fascinated that part of his control of grain futures lay in the rolling stock he kept around in Kansas, Missouri, Arkansas, and Oklahoma, but I never understood exactly how he did what he did.

 

I think that's what Haech's question is about. If not, I'll ask my question somewhere else.

 

Thanks.

 

--lemit

[LaurieAG]

Are there more appropriate methods of discounting future than the interest rate?

 

Nearly 20 years ago I wrote capital expenditure evaluation software based on the Australian governments accounting methods then.

 

While we used development forecasting back then, predicting the future is iffy (as well as future Internal Rate of Return, IRR) at best so (after my program produced the report based on a fixed discount rate) it plotted the respective project alternatives discount rate (y axis 1-75%) verses the projects Net Present Value (NPV calculated for the different discount rates, x axis) to give a better understanding of the impacts of varying discount rates over time when IRR is uncertain.

 

It's interesting to note that at this time our interest rate was nearly 20% and legislated future income tax reductions were never provided because the plot of discount rates shows the same IRR at 2 distinct Discount rates, particularly if the expenditure is in the not near future and interest rates are high. If the interest rate drops there is no capacity to generate the much larger amount of money eventually required to pay for the promised cuts.

 

While it's easy to tell, since most of our public assets have/are being sold, that the commercial in confidence agreements covering public asset were designed to deliberately hide from the public the missing component in the algorithm used today vs 1990 in Australia, surely these agreements subvert the publics right to know about these hidden costs on the public purse.

 

While depreciation may be defined as compensation for the loss of value of an asset over time, and one would expect that the consolidated value of the depreciation would be saved in a sinking fund to actually replace the asset when it has no value (I'm not going to argue about financial value and economic value apart to say that as this financial benefit is derived from public largess to business, the 2 should be the same) should the government declare to the public that the $100 million dollar asset sold will mean that over the next 20 years, the business buying the asset can deduct the value of the asset from their expenses, pre tax, meaning that the asset is actually worth 100-(100*business tax rate) (simplistically) to the public purse over those 20 years.

 

Arguments that our government would have worn the depreciation expenses anyway don't wash when you consider that our government would have also owned the asset! Then also consider accelerated depreciation, another hidden stimulus expense, i.e 100 million depreciated over 10 years, sold, then depreciated again in its entirity is very dangerous especially if the value of the asset increases (real or artificial). And I'm not going to get into the shysters who have blown the NPV of their asset because it was a component of their financial deal to buy the asset and was stripped off at the start as such, and the asset then blows up because market conditions drop and they cannot afford to maintain their asset. If I had a go at those dirty shysters I'd also have to have a go at those dirty underhanded congenital criminal politicians who set up a system that allows this to happen, and then doubles it and hides the real cost from the public.

 

I hate to tell you that Australia's economic miracle is based on public usury.

 

Our big banks generate approx 10 billion in profits per year and also bring in around 10 billion of user paid fees and charges (unless you owe them heaps of money or go to primary school you pay, I am not kidding) each year too. In 1992 when I studied Maths of Finance at uni fees and charges were just starting to creep in.

 

Just to do some v quick calcs, say Australia's population is 20 million and fees and charges are 10 billion, if this userous system were applied in the US (England has laws against this abuse) the big banks would make approx 180 billion dollars per year from the people who don't owe money through loans from those banks.

 

Yes there probably are appropriate ways as long as responsible government blocks off the inappropriate ways from deliberate abuse and doesn't try to hide any hidden expenses from public scrutiny.

[lemit]

Gee, thanks, Laurie! That was really interesting!

 

Uh, do you suppose you could explain it again, maybe using sock puppets?

 

No, I'll reread it a few more times. I think I saw a couple of cognates in there somewhere. I'll try to work outward from them. (Of course we all know that, once terms are established, all economists say pretty much the same thing. That's why so few of them even bother to publish.)

 

So I'll keep working on that, and I'll get back to you later.

 

--lemit

[LaurieAG]

Hi Lemit,

 

(Of course we all know that, once terms are established, all economists say pretty much the same thing. That's why so few of them even bother to publish.)

 

So I'll keep working on that, and I'll get back to you later.

 

The interface between politics, economics, business and finance is a place not of this real world, a place where things like perpetual motion machines happen.

 

Consider depreciation of PC's when they were completely written off over 3 years (now 3.5) with a business tax rate of 33%. If you replace one third of your PC's each year and depreciate all of your PC's by one third each year then the savings in profit from the depreciation (deducted from business profits before tax) will be equal to the original cost of buying the retired PC's 3 years ago.

 

If you combine all of the various aspects of the downsides outlined in my previous post with the perpetual motion machine you end up with something that I call the Leveraged Depreciated User Paid Leasing System. I won't go into real detail but the system involves a wholly owned subsidiary providing 3x leveraged PC's on lease to a parent company (a real world application (and there was one) would involve a partnership of large members of the same industry, who all owned a share of the 'subsidiary' proportional to their industry requirements, but would still be equivalent).

 

A 3xleveraged depreciated User paid leasing system with a 10% Goods and Services Tax (GST) would return 1.36 to the Government as tax, 2.56 in profit to the userers and the poor old useree will pay 6 for something that chould have been done entirely internally and only cost 1 to the user through their government.

 

This Crony Capitalist system is the basis for a mathematical proof I call the 'Godellian disproof of global unregulated leverage', I'll dig it up if you like. Basically the results change when you change all of your OR's in your original equation to AND's. i.e. x= a OR b OR c and x = a AND(+) b AND(+) c are totally different.

 

And then we can get onto kickbacks vs vendor comissions, later.

[LaurieAG]

And then we can get onto kickbacks vs vendor comissions, later.

 

Put simply, a kickback is a secret payment/commission agreement between the seller/buyer and a third party that is not declared at the time of the sale. Things become complicated when the buyer is aware of the secret payment as this payment can be a success fee if the third party is a lobbyist paid by either buyer or seller.

 

On the other hand Vendor commissions are more appropriate when the third party/parties provide declared services to the buyer (free of charge) while having an agreement with the seller to be paid a certain amount for the services rendered at a later date.

 

Considering the complexity involved with lobbyists, a quantum superposition, it's probably easier to say that kickbacks are illegal when they are hidden from the buyer and are official corruption when politicians and/or public servants and/or political officers become involved.

[LaurieAG]

Hi Lemit,

 

Gee, thanks, Laurie! That was really interesting!

 

Australia's largest bank, the NAB, dropped a high proportion of their fees and charges last week.

 

They didn't need sock puppets.

[LaurieAG]

One final thing, if your state politicians value the land under your roads to bring their budget into balance, start warming up the tar and collecting feathers.