No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 399 So the conclusion we can draw from the application of this formula is that any asset’s value is directly related to how much cash flow it can yield in the future, and inversely related to the expected interest rate. In making capital investments, entrepreneurs have to make assessments as to how they can make an investment that will yield higher future cash flows, and they form expectations as to the interest rates that will prevail during their investment period. In Figure 16.3 , we compare a series of 3 cash flows of $135 to a series of five $100 annual cash flows when interest rates are 30%. Without doing a present value calculation, most of us would likely prefer five $100 payments to three $135 payments—but our preference is likely driven by the fact that U.S. interest rates have always been relatively low. When interest rates are higher, the situation reverses: you prefer earlier receipt of cash flows. Therefore, projects that yield earlier cash flows are preferred when interest rates are higher, and projects that yield cash flows later become relatively more valued as interest rates fall. This helps us return to our discussion of business cycles and monetary management. If the central bank reduces interest rates, longer-lived projects with more cash flows become more profitable. At the margin, more long-term projects will be viable when the Federal Reserve stimulates the economy with “easier” money. Yet consumer consumption preferences have not changed just because the central bank is stimulating the economy; the demand for current goods is just as high as before. So projects that would satisfy current consumption desires are not met. This tends to bid up resources for current goods, ultimately forcing the central bank to raise rates. When interest rates increase, these long-term capital projects will no longer be viable and will be abandoned. The boom is followed by the bust, as these long-term investments will be shown to be malinvestments. Not overinvestment, or too much investment, but malinvestment — the wrong kind of investment. Present value calculations help us see how valuation of those investments changes as interest rates change. Figure 16.3, Present Value comparison of five $100 payments to three $135 payments. When interest rates are high, the out-year cash flow contribution to the overall present value is samll, such that higher cash flows over a shorter period become more valuable than slightly lower cash flows over longer periods. CF/(1+i ) CF/(1+i ) 2 CF/(1+i ) 3 CF/(1+i ) 4 CF/(1+i ) 5 Present Value $103.85 $79.88 $61.44 0 0 $245.17 CF=$100, i=30% CF=$135, i=30% $76.92 $59.17 $45.52 $35.01 $26.93 $243.55 Malinvestment: Investment that is made not because of consumer preferences but because of government manipulation of markets (usually interest rates)