Yesterday we looked at the notions of a distributist economist whom we’ve been calling “Tom Steele” and his associate, “Joe Wide,” regarding their assumption of absolute certainty of future events (future cash flows) and the existence of an ideal value of something that completely removes the opinion of the buyer and the seller as to the utility of what is exchanged in a transaction. In short, Wide and Steele take a “Platonic” view of the universe that assumes that ideas have an existence independent of the human mind, when the real world is Aristotelian.
Error Number Three
|Are ROI, the discount rate, and the interest rate the same thing?|
Now we need to move out of the realm of ideas and get down to the specific error, the reason Wide and Steele seem to think that workers can never repay an acquisition loan because all earnings go to pay the interest. In other words, Wide and Steele believe that ROI, the discount rate, and the interest rate are all the same thing. We are not going to paraphrase here. We took these definitions straight out the “Investopedia” a website that, among other things, gives common definitions of financial terms. Fortunately, Investopedia presents material in the form of question and answer:
What is “Return On Investment — ROI”?
A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI measures the amount of return on an investment relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.
The return on investment formula:
ROI = (Gain from Investment minus Cost of Investment)/(Cost of Investment)
In the above formula, “Gain from Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another.
Our Comments on ROI
|ROI is just the rate of profit, not what money is worth.|
Most simply put, ROI is just the rate of profit a project or company is making. A company with a cost of investment of $1 million that makes $300,000 a year has a 30% ROI.
What is a “Discount Rate”?
. . . . The discount rate also refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate. . . .
Our Comments on Discount Rate
Note: the ellipses in the above paragraph are two other definitions of “discount rate” that have no relevance here.
As can be seen, the textbook definition of “discount rate” has nothing to do with the rate of an investment’s profitability or ROI. It has to do with how much the money itself is worth, not how much money there is. All other things being equal, a company with a 30% ROI and a company with a 5% ROI would use exactly the same discount rate for the discounted cash flow analysis, whichever discount rate is selected.
|Government induced inflation changes the value of money.|
For example, take two companies, each with invested capital of $1 million. Company A has a 30% ROI, and Company B has a 5% ROI. Both realize their returns on the last day of the year, December 31. Company A will get $300,000 on December 31, while Company B will get $50,000 on December 31.
Making things very simple, we just happen to know on the preceding January 1, the first day of the year, that the government is going to inflate the currency during the year by doubling the money supply on July 1. Consequently, one dollar on January 1 will buy twice as much as that same dollar on December 31. Put another way, a dollar on December 31 will only be worth half what it was on January 1. What is the discount rate we should use for the discounted cash flow method?
Fifty percent (50%), because the $300,000.00 Company A receives on December 31, and the $50,000 Company B receives on the same day, are only going to be worth $150,000 and $25,000, respectively, in terms of January 1 dollars.
But Company A has an ROI of 30%, and Company B has 5%! . . . so we necessarily conclude that how much the money is discounted, 50%, and how much money there is to discount, 30% and 5%, are two different things. Wide and Steele have been mixing apples and oranges.
What is “Interest”?
Interest is the charge for the privilege of borrowing money, typically expressed as annual percentage rate.
Our Comments on Interest
We think that this definition is a little inadequate, but it’s a good place to start. It gets the basic idea across. We should, however, use the legal definition. In law, “interest” is defined in general as “a right to have the advantage accruing from something.” Specifically for money, “Interest is the compensation allowed by law or fixed by the parties for the use of forbearance or detention of money.” (“Interest,” Black’s Law Dictionary.)
|A lender is due a market-determined rate of interest, not all the profits.|
That means if you have a sum of money and lend it to someone to use in producing a marketable good or service, you are due interest (“the advantage accruing” to lending money, i.e., “the compensation”), plus the return of your principal. How much are you due? In today’s financial system, usually starting with some rate determined or manipulated by the government or central bank controlled by the government as a base, the market sets a rate of return taking into consideration the type of loan, the credit history of the borrower, the riskiness of the investment itself, and so on.
For example, a borrower who just wants money to spend on wine, women, and song may pay 18-24% on his credit card balance. That same borrower acting on behalf of his company may be able to borrow money for the company at 3%. The house he’s buying may have a mortgage at 5%. And so on. It all depends on what the market (the aggregate opinions of lenders and borrowers) has decided a loan for that purpose in that amount is worth in interest charges, adjusting for whatever interference the government has carried out or allowed.
It is important to note that the lender to a business is not entitled to all the profits of the business simply because he lent the money to buy the capital and operate the company. No, he is only due a reasonable, market-determined rate of return based on the type of loan.
|Everybody benefits from growth, if they participate through ownership.|
It is true that a borrower may not make sufficient profit to meet the debt service charges and other expenses. In that case, a lender may very well be due far more than the amount of profit a company makes. That, however, is because the borrower didn’t make enough money, not because the lender is suddenly due everything. That is why loans to risky businesses carry a higher interest rate: the lender is gambling that the borrower will make a go of it and they both come off well. If not, both lender and borrower lose.
Here again we see that there is no necessary link between the ROI and the interest rate. A company that borrows $1 million to go into business may pay 10%, $100,000, on that $1 million because that’s what the market has decided is a fair return to a lender under those circumstances. If the borrower makes an ROI of 30% — $300,000 — on the invested funds, well and good. The lender receives $100,000 in interest and the borrower retains $200,000 in net profits.
Then if the borrower uses half his net profits to pay down the principal and makes 30% ($300,000) again the next year, the lender gets $90,000 in interest, the borrower pays down another $100,000, and pockets $110,000, and so on. The lender will get $10,000 less each year in interest, but the same amount of principal ($100,000), while the borrower’s net profits after debt service will increase by $10,000 each year.
Of course, if the borrower only makes 5% ROI, he is in trouble. He can’t pay the interest or the principal, defaults on the loan, and everybody loses.
|"Islamic" (actually Aristotelian) banking: a share of profits instead of fixed interest.|
The only way Wide and Steele can justify using an interest rate that is the same as the ROI is 1) if they use “Islamic” banking techniques where the lender is due a pro rata share of the profits plus his principal back, AND (and this is important) 2) if the capital purchased with the borrowed funds is solely responsible for ALL production.
This is a problem, because some people believe that labor, not capital, is the sole factor of production and therefore entitled to all profits. They don’t take into account the contributions of labor and capital to profits. Wide and Steele will have to make the case to “labor-only theorists” that capital is the sole factor of production.
At the same time, however, this would contradict certain statements Steele, a follower of the agrarian socialist Henry George, has made in the past asserting that labor is the sole factor of production and that capital at best only enhances labor. The owner of capital, or the lender of the money to purchase the capital, would at best be due only a small fee . . . if labor is the sole factor of production.
|"The lion's share" = everything. Object, and get eaten.|
Wide and Steele, therefore, must prove that capital is the sole factor of production if they want to maintain that the lender of the money to purchase capital is entitled to all profits. At the same time, in order to maintain Steele’s claim that labor is the sole factor of production, they will have to insist that labor, not the lender of the financing for capital, is entitled to the lion’s share of profits.
Only by contradicting themselves, then, can Wide and Steele justify their claim that ROI and the interest rate are both the same rate. They want to have their cake and eat it, too, by insisting that both labor and capital are the sole factor of production.
At the same time, they still wouldn’t be able to fit the discount rate into their paradigm. Why? Because ROI and the interest rate have to do with how much money is made, while the discount rate has to do with how much that money as money is worth, which has no connection with how much is made — apples and oranges again.
Which leads us into another area: future savings versus past savings. We will address this tomorrow.#30#