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.

Sell it already

Christchurch Council is again being encouraged [see also NBR] to consider selling off some of its holdings to help pay for the earthquake rebuild. Labour is predictably outraged:

Labour Party SOE spokesman and Christchurch-based MP Clayton Cosgrove said Carter's comments on Sunday "proved beyond doubt central government’s intention to see Canterbury’s assets sold off."

“This issue was raised over a year ago when the CERA legislation was before Parliament. This was not a part of the deal. The Minister’s rationale - that councils should sell down infrastructure to survive - is ludicrous," Cosgrove said.

“These are revenue generating assets which have sizable returns for the whole community. Selling these off to fulfil National’s agenda is foolish," he said.

"This is a nationwide issue. Selling revenue generating highly profitable assets which are providing a solid rate of return at a local level is about as logical as National’s plan to sell our revenue generating state-owned assets.

“Canterbury’s profitable assets have kept local rates in check. To hear the Minister say that he would rather give up that revenue stream to pay for the disaster that has befallen our City makes a mockery of the Government’s commitment to Canterbury’s recovery," Cosgrove said.

Cosgrove can only be right where the asset is more efficiently owned by local council, or where there are serious problems in IPO markets, or where the Council has a particular kind of stupidity.

If the asset is best owned by government, then the selling price will be less than the discounted value of the dividend flow. Otherwise, local Councils can do better by selling off the asset and taking the cash.

If there are serious problems in IPO markets, then things sell for less than fundamental value at IPO. But there's no particular evidence of this.

The last one might be more of a worry. Imagine a guy who has a trust fund that pays him a modest annual income. He generally is foolish in how he spends it, but he's always able to pay his bills. If he is given the investment as a lump sum, he blows it all on pop rocks and bungee jumping and has no income flow for the next year. That guy is probably better off not being able to sell off the dividend-paying asset. Is Christchurch Council that guy? Hopefully not. But post-quake, unless they're dumb enough to blow it all on stadiums, there are tons of productive ways they could be spending the money - roads, sewers, turning Red Zone into useful parks.

And, if Council is dumb enough to blow any divestiture returns on pop rocks and stadiums, are they smart enough to handle the asset properly if they own it in the first place? Note that an asset like the Lyttelton Port of Christchurch isn't like a hands-off trust fund; it requires annual decisions about asset maintenance versus dividends. Cosgrove talks about how the revenue stream from assets helped kept rate rises in check; what reports I'd heard on maintenance standards at the Port as of a few years ago suggested that Council was putting a fair bit more weight on current dividend flow than on maintaining the assets. Divestiture may be a bad idea if Council is prudent enough to manage the asset properly while they own it, but profligate if they're handed a lump sum of cash; under the current circumstances, with plenty of really pressing financial needs, I'm less worried about this one.

Previously:

• Perils of partial asset sales
• Selling assets to pay for the quake
• Optimal quake financing
• Don't sell the lines company, sell the Port.

Idiotic? Perhaps not.

Optimal financing for the Christchurch rebuild involves a mix of spending cuts elsewhere, debt now, and future tax increases. But what about asset sales? Gordon Campbell says forcing Council to divest assets would be idiotic: you'd only get fire-sale prices in the current environment. 

Big picture, he's almost right. Unless privatization comes with an increase in firm profitability, there's an equivalence between the value of the flow of dividends coming from the asset and the selling price of the asset. In that case, fire-sale prices reflect the real reduction in value that comes from holding a damaged asset: it's worth less either to Council or to a private firm. So it doesn't make much difference whether Council borrows against the flow of earnings from its holdings or sells its holdings. It's not idiotic to sell off assets, but it doesn't do a lot of good. Unless the privatization increases value. Or, unless Council faces financial market constraints on borrowing. I'd explored things in more depth a year ago.

So I'm not sure there's much case for selling off the Council's power lines company, Orion. We'd have to replace monopoly Council ownership with regulation of a natural monopoly; I can't see a whole lot of gain to be had either way. It's sure not the first place I'd look for potential privatization.

But what about Lyttelton Port of Christchurch? An insurance-funded rebuild of the Port's capital stock could put it in better shape than it was prior to the earthquake; there's a good case to be made for privatization bringing efficiencies to port operations. It's (as best I understand things) the threat of those efficiencies that had Port Otago block Christchurch Council Holdings' attempt to sell the port to Hutchison Port Holdings five years ago. It wouldn't be crazy to argue that Council might never get a better price for the Port than when it's all bright and shiny with fresh infrastructure, so long as LPC is able to get insurance settled. If the Port can earn greater returns under private ownership than under Council ownership, then privatization is far from idiotic. At latest share prices, it's worth about $200 million.