Appendix 1

The Nature of Interest

The following discussion parallels a similar discussion in the FASB discussion memorandum Present Value-Based Measurements in Accounting, No. 098-A December 7, 1990. The purpose of this discussion is to provide background and substance to what might otherwise be considered an artificial and unnecessary accounting measure. 

Interest is an economic fact. It is compensation that lenders demand and borrowers are willing to forgo, in exchange for the use capital that borrowers demand and lenders are willing to forgo. Interest is the agreed-to free market price that maximizes capital market efficiency. Interest rates vary depending on a number of factors. These factors may be considered determinants or components of interest. They include, 

1. Time Preference Component It is generally thought that current capital is preferred over future capital and that time preference is positive. 

2. Liquidity Preference Component The lender won’t freely surrender immediate access to his capital. The borrower must forestall immediate access. The liquidity component is the price of access rights. Access rights are important when needs or new opportunities (such as higher interest) arise and require capital. This component increases with longer duration commitments. 

3. Loss of Principal Component The lender may never have access to some or all of his capital if there are failures, bankruptcy or default. This component may be large for companies that are new or untested, highly debt leveraged, not diversified, not profitable, growing too fast, or are otherwise at risk. 

4 Inflation Component Capital is generally returned in nominal amounts of lower purchasing power. This component is designed to provide a return of real amounts. 

5. Variability Component In many capital investments the amount or timing of capital repayments depends on future results or conditions, so that repayments are sometimes higher or lower that expected, or sometimes sooner or later than expected. This uncertainty, even though balanced, is shunned. This component is the price of uncertainty. It is often viewed only as an adverse deviation.

 6. Supply / Demand Factors Demographics, economic conditions, central bank policies, regulatory pressures, capital productivity are all environmental factors as opposed to the above more fundamental components. They affect the general price of capital by changing the supply or demand for capital.


We are not interested in assessing or assembling the above components since the capital markets do so unequivocally. We will use the market cost of capital as the discount rate. In theory, this market cost of capital would be based on the spot price of the company’s shares and the market’s spot projections of its dividends or equivalently the market’s spot expectations of the company’s future net operating cash flows. Markets prices are available, but market cash flow projections are unavailable. In practice, we will use the historic cost of capital based on the share prices over the prior 5-years and the company’s expected cash flows as validated over the same period. This practical approach has the advantages of feasibility, stability, and reliability compared with the theoretical spot market cost of capital. This definition produces company valuations expressed in stock market units; actual stock prices will oscillate about the company valuations. 

There are other formulations of the cost of equity. One very simple one emerges from the Gordon Growth Model as outlined at the end of Chapter 5, 

Where RI is the required interest or equity cost of capital, D(0) is the current dividend, G is the constant growth rate of dividends, and PV(NCCF) is the stock price. Solving for RI we obtain,

 

Hence the cost of capital is the current dividend yield plus the growth of dividends. The higher the stock price the lower the cost of capital (other things being equal); the higher the growth rate the higher the required interest (other things being equal). Equation A1.1 assumes a current dividend and a known constant growth rate thereon. This expression has the advantage of visibly relating the cost of capital to the market price of capital, PV(NCCF).

 

Another formulation of the equity cost of capital emerges from the Capital Asset Pricing Model (CAPM). The cost of capital of a company (Required Interest RI) is expressed as a risk free rate (including expected inflation) plus a risk premium as follows,

 

Where Rf is a risk free cost of capital representable by government bond rates, Rm is an average rate of return on a diversified stock portfolio and b is the relative volatility of the company price movements compared to a diversified stock portfolio. This formulation seems reasonable and is correct for the market as a whole for which b =1. But it seems unlikely that a company’s relative stock price volatility captures all the aspects of a company’s risk. It may be true that one component of a company’s cost of capital is volatility, but there are surely other components and other factors. One major flaw with the CAPM is that the cost of capital does not depend on the price of capital. Another flaw is that the formula assumes uniform risk aversion for all shareholders. Some investors, in particular companies, or at a particular time, may seek out the upward volatility and require less, not more, interest compensation. Another problem is defining, coordinating and determining the three terms of the right hand side of Equation A1.2. 

We have seen that a company can add value if its cost of capital or required interest is less than the earned interest rate. If the earned interest is fixed then value will be added if the required rate is decreased. Part of the required rate is compensation for risk. Part of the risk compensation is for variability of company reported results. With AFTF there will be a greater stability due to the long-term nature of the company valuations. Although value added is a residual and hence is highly variable, it will, in general, be small. It is expected that on a per share basis value added will be small in relation to the share price. Hence AFTF will tend to stabilize the market valuations. The elimination of traditional accounting adjustments may stabilize results. The excellent AFTF matching of asset and liability flows will tend to offset fluctuations in assets or liabilities. AFTF provides cash flow forecasts; future cash flow disruptions may be more easily anticipated and disarmed.

 

Part of the risk compensation is compensation for lack of confidence in management’s ability to assess the future (estimate probabilities). By carefully creating cash flow models based on reasonable expectations the AFTF actual-to-expected ratios will be stable at about 100% and management credibility and shareholder confidence will be enhanced. 

With AFTF, value creation and a focus on the future will be encouraged. There is likely to be an increase in the number, variety, and quality of investment proposals. A greater number and diversity of projects will tend to stabilize overall results. The careful explicit use of expected cash flows should reduce the normal discount shareholders apply to uncertain outcomes, i.e., the use of probabilities in determining expected cash flows already discounts the future. In addition, discounting using of a cost of capital severely decreases the importance of more distant and more uncertain cash flows. Shareholders may come to trust expected cash flows more than actual cash flows as an indication of underlying or long-term value. AFTF will provide mechanisms for lowering the perceived and actual risks a company faces and can lower the cost of capital.

   

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