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The Color of Money – Part III

February 29, 2012

In my post of February 27th, The Color of Money—Part I, I provided the big picture answer. In yesterday’s follow-up post we delved into the details of depreciation. Today we will deliberate discounting—muse over money’s time-value.

A dollar earned or saved today has a greater value than a dollar earned or saved in a future time period for two reasons. First, inflation—we all experience its pernicious penalty. In cell B6 illustrated nearby, the annual replacement inflation is assumed to be 2.4%. The inflation of replacement is due primarily to the increasing cost of labor, secondly to the increasing cost of the commodities that make up a new cable, but thirdly both increases are mitigated by increases in the productivity of the people and tools performing replacement. Inflation then, is the composite of these three effects. Notwithstanding claims by the Federal Reserve Chairman, nobody can predict what future inflation will be, but that shortcoming is not as onerous as one might expect.

For individual large and stable firms, such as most utilities, the spread or difference between the discount factor in cell B3 and the inflation rate in cell B6 is quite stable. If inflation increases, discount factors increase too. The 5.9% spread in the example is typical for the power distribution industry in North America.

The second component of the discount factor involves a dispassionate assessment of the future financial risk—taking into account the financial expectations of the firm’s capital sources. The capital sources might include public debt and equity markets, they might include the ratepayers of a cooperative, or they might be taxpayers of a government-owned distribution firm. With the exception of some improperly functioning government entities, no capital source makes an investment without an expectation of a return. Further, the greater the perceived risk of the investment, the greater the expected return.

In yesterday’s post on depreciation, we also touched upon the rate of return on capital, and here again there is a generally stable historical spread between the rate of return and the discount factor. Thus modelers must generally move these three values together for any sensitivity analysis. Inflation is less than the discount factor, which in turn is less than the rate of return. The spreads are fairly stable for individual firms and are typically about 6% and 1% respectively. Check with your finance folks to determine the discount factor, inflation, and rate of return. Let me know of any values that differ substantially from the norms.

In my next post in this series we will examine the remaining assumptions required to compare two rejuvenation options.