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

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 401 Since the cash flows in present value calculations are net, they include a measure of all costs. There may be an initial outlay of cash for any capital investment’s fixed costs such as the building of a new Walmart building as in our example, and then there are recurring variable costs such as labor and material expenses. The fixed costs would be assigned in the time period where cash is expended in the firm’s present value calculation. This is the true economic cost, but it is not allowed for tax or accounting purposes. Depending on the particular investment, fixed costs are usually depreciated according to a schedule based on the useful life of the capital asset. For example, a personal computer may be depreciated over 5 years, so a $2,000 computer would be allowed a $400 per year expense to a firm for tax purposes (using a straight line depreciation—IRS often allows accelerated depreciation for many assets). So even though a firm has a cost of $2,000, they are only allowed to recover those costs against revenues by $400 per year in their tax bill. Part of the rationale is that even though the firm experiences the full $2,000 cost when they make the purchase, they now have a valuable asset that could be sold. Depreciation is intended to roughly compensate for the loss in value over time as the asset’s value is consumed in use. Nevertheless, when a firm or entrepreneur is considering whether to make a capital investment, the present value calculation will always include the costs as they are accrued—not when the government says they experience the cost. INTEREST, RISK & INFLATION In chapter 12 we learned that the phenomenon of interest was due to time preference since people prefer consumption today to a promise to consume in the future. This is in large part a natural outcome of the uncertainty of life, the proverbial “a bird in the hand is worth two in the bush.” We ultimately identified an equation for the interest rate that depended on three variables: [Equation 5] i = r + π e + RP The nominal interest rate (i) is the interest rate a borrower will have to pay, and it is equal to the sum of the real interest rate (r), the expected inflation rate (πe), and a risk premium (RP). Real interest rates over long periods of time seem to be pretty stable, ≈2-3%. So entrepreneurs have to develop expectations for the inflation rate as well as any possible risk premium. We’ve previously covered the cause of inflation in our chapter on money (excess money creation), and there is little an entrepreneur can do to affect that as well, although it must be factored in. The entrepreneur does, however, have much to do with the risk premium. You may say “didn’t you teach us that what governs economics is not risk, but uncertainty?” That would be correct, but we’ll press ahead with the distinction anyway. Depreciation: the accounting process of allocating costs to the time period when an asset is consumed.