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
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| 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.
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| 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.
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| 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.
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| "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.
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| "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.
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