Once again I sat through a meeting about NPV calculations and the assumptions behind them. This time NPV's are being used to calculate sales bonuses. Huh? You assign the loan to the gal who sold it: every month the loan instalment is paid, she gets a percentage, just like a regular salesman does. Who needs NPV's?
There is one circumstance when you do. That's when you want to sell a commercial building with a known and reliable rental income from a tenant who isn't going anywhere until the end of the lease. Then the NPV of the cash stream is the capital sum you would need to invest now in a quarterly-paying bond at the discount rate you chose to generate a cash flow with the same NPV. (Quarterly because commercial rents are usually payable on quarter-days.) And that is only possible because the cash flow from a commercial lease is basically the same as from a bond.
In this example, the forecast of the net income stream can be done accurately and has a high degree of probability of being true; while the NPV itself has a real interpretation, as the value of a bond, and as the purchase price of the building.
Now consider a mortgage or personal loan. This has a net income stream, payable monthly. It is much more difficult to forecast: loans are closed early, the default rate is very high (banks make loans to people with a 30% chance of defaulting and think it's good business – the people who financed your neighbour's sofa live with default rates of 50%) and the timing of a repayment or default is erratic. The bank can calculate averages, but the variances are high and the tails correspondingly fat.
But here's the real difference: for a commercial building, the net income stream repays the capital amount, but for a loan, the capital is repaid by the gross income. So if you discount the net income from a loan and call that the NPV, whatever meaning it has, it is not the amount you would pay for the loan. If you wanted to own the net income stream from the loan, you would have to buy the whole of the outstanding capital at the time of purchase, less a discount equal to the expected default on the remaining term of the loan. So if the discounted net income isn't the purchase price, what is it? It turns out to be the amount the shareholders would need to invest in a monthly bond offering the rate of return used in the discounting calculation to yield a cash flow with the same NPV as the loan. So it's the value now of the net income stream to the shareholders. It's what the loan is “worth” to the shareholders.
Or at least that's what everyone around me keeps saying. It sounds convincing. Except it isn't what the loan is worth to shareholders. What the loan is worth to shareholders is the contribution it makes towards their annual dividend payments, and that is measured by the gross margin (net income minus variable costs) of the loan taken year by year. As a rough guide, most of the value of any reducing-balance instrument is in the first half of its life.
Do not ask me why they calculate the NPV – I suspect it's because they're in banking and calculating NPV's is what you're supposed to do when you're in banking, like taking ecstasy when you go clubbing. That the discount rate they use is around 12% - good luck getting that in the money markets – makes the whole exercise silly.
So aside from the fact that it's the wrong measure, what else is wrong with using NPV's? It's a distraction from the job of finding the right measure for the job; it gives them the undeserved feeling that they are being sophisticated and clever; and it soaks up analysis time doing monthly lifetime factorisations of all sorts of things that should be left as totals: defaulting, bad debt, early closures. It creates an air of utterly spurious accuracy. But hey, get with the programme. This is, after all, the same industry who thought that lending money to people with no incomes was a good idea.
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