Friday, December 19, 2008

The Bailout: Coming to Automakers Near You!

To the tune of $17.4B. Oh yeah, and those union concessions? In the by and by.

From the Fox Fact Sheet:

Viability Requirement: The firms must use these funds to become financially viable. Taxpayers will not be asked to provide financing for firms that do not become viable. If the firms have not attained viability by March 31, 2009, the loan will be called and all funds returned to the Treasury.

Definition of Viability: A firm will only be deemed viable if it has a positive net present value, taking into account all current and future costs, and can fully repay the government loan.

Help me out here: is "positive net present value" the same thing as "profitable?" I think that a company must be profitable if the difference between its expected earnings earnings and its expected liabilities, discounted to the present, is positive. But who knows what the future holds? This sounds like a number begging to be gamed. I'd have preferred something like actually earning more in sales than in spends. Actually, I still would have preferred no bailout.

Let the record reflect that Φ has lost patience with the Bush Administration.

UPDATE: In the comments, Bobvis explains that, yep, "net present value" can indeed be gamed:

A firm can certainly be unprofitable and still have a positive expected net present value. A company that loses $1000 every year for the next 100 years and makes $100,000,000 the year after that and closes will have a positive net present value despite ceasing operations and being unprofitable less than 1% of the time.

Of course it's hard to say what 2108 will look like though. That is why some poor financial analyst will be sitting in the administration next year under tremendous psychological and social pressures to make rosy assumptions of the far off future to justify additional loans today.

1 comment:

bobvis said...

But who knows what the future holds?

The wizard...

A firm can certainly be unprofitable and still have a positive expected net present value. A company that loses $1000 every year for the next 100 years and makes $100,000,000 the year after that and closes will have a positive net present value despite ceasing operations and being unprofitable less than 1% of the time.

Of course it's hard to say what 2108 will look like though. That is why some poor financial analyst will be sitting in the administration next year under tremendous psychological and social pressures to make rosy assumptions of the far off future to justify additional loans today.

The basic illustration of how critical assumptions are is to look at the present value of a perpetuity.
http://en.wikipedia.org/wiki/Perpetuity
It is
present value = Earnings / discount rate.

Obviously, the present value above depends a lot on the discount rate you use above, which actually has nothing to do with the company itself.

It gets worse though. For a growing perpetuity (which all companies that expect growth are) it is
Present value = Earnings / (discount rate - growth rate)

If you raise the growth rate by 1%, it can really pump up the present value.

Remember that it was easy for financial analysts to argue that hemorrhaging dot coms would soon be worth billions and billions of dollars.

Let the record reflect that Φ has lost patience with the Bush Administration.

And it only took 7 years and 11 months! Welcome to the dark side. :)