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Coups, discount rate dragons, and mahogany

13/03/2012

[The Fiji Times, 31 Dec 2000.]

There has been much speculation in the media that the May 19 coups and other disruptions were associated with disagreements over the distribution of benefits fromFiji’s mahogany plantations.

 If there is any truth in the speculations, it is tragically ironic that the coups themselves (and the subsequent army mutiny) have reduced the value of the mahogany plantations by hundreds of millions of dollars.

Foreign (and local) investors in a mahogany plantation expect revenues to continue 20, 30, 40 years into the future.  When risks go up, all future revenues are “discounted” (reduced in value) even more than normal, by the use of higher “discount rates”.

You may not understand the theory, but the cartoon tells it all.  The higher the “discount rate” used by investors, the greater the loss in value.

If the discount rate rises from 9% to 15%, today’s value of all future mahogany plantation revenues will plummet from about $760 millions to $440 millions- a loss overnight of $320 millions,  or some 42%.

With costs between 10% and 20% of revenues, the above would represent a loss in net value of more than $250 millions.

And were the mahogany logs to be processed locally into value added products, the financial losses may be counted in the billions.

Discount Rates

These “discount rates”- 9%, 15%- these tiny percentages, look so simple, so innocent, don’t they?  But their effects are deadly and draconian, especially over long periods.

Why do economists and investors “discount” future revenues?  One could use fancy terms, such as “opportunity cost of capital”, “risk aversion”, costs of borrowing etc., etc. But there are two simple ideas.

First, for most people, money “grows” over time.  $1 today becomes more in the future.  Perhaps it grows at different rates for different people.  But money grows over time.

Second, money expected in the future is “risky” given the “uncertainties” of life.  You may not get your money on time; or only a part of it; or maybe none of it.  Hence the saying, “a bird in the hand is worth two in the bush”.

One dollar expected in 10 years time, is worth much less to you today.  One dollar

expected in 20 years time, has to be  worth even less.

If the investor asks “what is the discounted value of that $1 expected in 10 years’ time”, the answer depends on the “discount rate” used, easily understood as the opposite effect of compound interest rates.

Money Grows

If someone borrows $1 from you and gives you back $1 in ten years time, you know that would not be very fair, because you would have lost all that interest. (of course, if it was kerekere, you might not getting anything back!)

$1 invested at the bank, paying 9% interest (hey, I know that’s a joke) becomes $1.09 after one year (interest of 9 cents).  If you keep re-investing the interest earned (i.e. your money “compounds” at 9%) then your $1 will become $2.37 after 10 years.  (Get your kid to check all this arithmetic on a calculator- keep multiplying $1.00 by 1.09).

So proportionately, $1 in 10 years’ time, is worth 42 cents today (divide 1 by $2.37). Check: your 42 cents today, earning 9% compound interest rate per annum, will become $1 in 10 years’ time (multiply 42 cents by 1.09, ten times).

The “discount rate” effects are more draconian the higher the interest rate.  If you earned 15% interest per annum on the $1 (as most good businesses do), then your $1 grows to $4.05 cents in 10 years’ time (multiply by 1.15 ten times).

So proportionately, $1 to be received in 10 years’ time, at a discount rate of 15%, is today worth only 24.7 cents (equal to $1 divided by $4.05.   Check: 24.7 cents, at a compound interest rate of 15%, becomes $1 after 10 years).

The “discount rate” effects are more draconian, the further into the future you expect the revenue.  At 9% discount rate, $1 to be received in 20 years’ time, is worth only 18 cents today; and at 15% discount rate is worth a miserable 6 cents.

What, you ask?  $100 millions to be received in 20 years’ time is to be valued today at only $6 millions (at 15% discount rate)?  Are economists and financial experts crazy?

Indeed, many economists feel strongly that using high discount rates (which grossly devalue future revenues) makes our societies very short-sighted, and less concerned about the benefits to future generations.   They advocate discount rates of around 3% to 5%.

But unfortunately, it is the corporate giants who decide on the discount rates, not minnows like the Fiji Government or socially conscious economists.  So what is the effect of discount rates on the value ofFiji’s mahogany plantations?

Fiji’s Mahogany Plantations

There are many valuations around.   One set of estimates suggest that Fiji’s mahogany plantations can generate revenues of around $66 millions per year for the first ten years, and then $100 millions per year thereafter (assuming a farm gate price of $700 per cubic meter of log, and sustainable harvesting).  Huge sums, hey!

So, what total value today would a foreign investor place on  these future revenues expected to extent beyond the year 2030?

Normally for forests,  a discount rate of 9% could be  used, giving a present value of around $760 millions.   But following the May 19 coups investors would be forced to use much higher discount rates.

The Risk Factor

Some investors use higher discount rates because their own capital earns that high return, or that is the return normally expected in that line of business.  But discount rates also rise with higher risks.

Investors now worry about future revenues being disrupted; disputes over land ownership stopping the harvesting; villagers mounting road blocks over jobs;  disruptions to electricity (because of continuing conflict over compensation issues) stopping the milling;  another coup, another army mutiny, a new government reneging on previous agreements; or irresponsible budgets, inflation, devaluation and cost escalation?

Increased risks force investors (foreign and local) to increase their discount rates, thereby reducing the present value of all revenues expected in the future.

At a discount rate of 15%, the present value of the mahogany plantation revenues would drop to roughly $440 millions- a massive reduction of $320 millions in present day dollars.

With costs of 10% to 20% the loss in net value would be above $250 millions.

Unfortunately forFiji, such depreciation of asset values through rising discount rates, affects any revenue-generating assets, like the planned Namosi copper mine, or the new Natadola tourist resorts.  This does not encourage investors.

Currently, most investment projects are on hold, suggesting that the effective discount rate is way above 15%.

The discount rates will not come down until there is long-term political and social stability, built around a generally acceptable constitution.

In the meantime, we continue to lose hundreds of millions in the value of most of our national assets.

Costly coups indeed.

 

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