GOVERNMENT INVESTMENT DECISIONS, PRIVATISATION AND THE APPROPRIATE DISCOUNT RATE
Michael C. Crowley
School of Commerce
Flinders University of South Australia
GPO Box 2100
Adelaide, South Australia 5001
Telephone: +61 8 8201 2882
Facsimile: +61 8 8201 2644
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SCHOOL OF COMMERCE RESEARCH PAPER SERIES: 00-20
ISSN: 1441-3906
GOVERNMENT INVESTMENT DECISIONS, PRIVATISATION AND THE APPROPRIATE DISCOUNT RATE
ABSTRACT
This paper enlarges upon the debate regarding the impact on the assessment of risks in regard to Government investment decisions, by focussing on its significance in the privatisation of Government assets. Previous papers focus on two possible outcomes in the assessment of Government investment risk[1]. Firstly, Government risk associated with investment decisions is the same as for the private sector, therefore, it should be discounted in the same way as the private sector. Secondly, investment risk is lower for the Government than it is for the private sector, therefore, the discount rate used for Government should be lower than the discount rate used for the private sector.
This paper expands on a third possible alternative; that the risk associated with Government investment decisions are different to that of the private sector, however, this difference could lead to the discount rate for Government that is evaluated to be higher than that assessed for the private sector. It is acknowledged that the three possible alternative discount rate scenarios can lead to very different investment decisions when assessing the privatisation options for Government.
The paper concludes by proposing suitable methods for measuring the appropriate discount rate for Government investment decisions in privatisation. It is suggested that using either multi-factor Capital Asset Pricing Model (CAPM) or multi-factor models via analysing and pricing individual risk factors can provide the most accurate measurement of risk.
KEY WORDS: – Discount rate, Privatisation, Risk, Government risk, Risk-free rate, Risk factors. Investment risk factors.
1.0 INTRODUCTION
The assessment of risks associated with Government investment decisions has always raised considerable controversy[2]. Government investment decisions have attracted more attention over the last two decades with the increase in Privatisations worldwide[3].
The proceeds from privatisation in Australia have totalled in excess of $70 billion[4]. By international standards, Australia’s privatisation program has been extensive. In terms of dollars netted it runs second in the OECD after the UK, while relative to economic size it is also second, but this time to New Zealand[5]. Therefore, Government investment decisions through their impact on privatisation have been extremely important to Australia.
A Government investment decision, like any private capital market investment decision, is to maximise the present value of returns properly adjusted for risk[6]. Therefore, the Government, like any other investor, will base its investment decision around its ability to maximise expected value from its assets. In assessing potential investment options through privatisation an important factor for Government to consider is whether the value of an asset is maximised with Government ownership or private sector ownership. Thus, the Government has the option to maximise the value of an asset by maintaining Government ownership or through a sale of the asset to the private sector.
Should the value of an asset be different, if held by the Government or the private sector, remains controversial. The assessment of risk when determining this value is where there is particular contention amongst academics. The assessment of investment risk has the capacity to affect the determination of the discount rate used in investment decisions. Government investment decisions, particularly privatisation investment decisions, are no exception to this. Thus, accurately determining an appropriate discount rate is critical when considering the Privatisation of a Government owned asset.
Previous debate on Government investment risk, and its effect on the discount rate to be used, has focussed on two possible outcomes. Firstly, Government risk associated with investment decisions is the same as for the private sector, therefore, it should be discounted in the same way as the private sector. Thus, it is irrelevant if the Government or private sector owns the asset[7].
Secondly, investment risk is lower for the Government than it is for the private sector, therefore, the discount rate used for Government should be lower than the discount rate used for the private sector. This argument therefore provides for the option of two different values for the same asset, one, higher, value if retained by Government and another, lower, value if privatised.
A third possible alternative that has not been seriously considered in the academic debate is that the risk associated with Government investment decisions are different to that of the private sector. However, this difference is that risk is assessed to be higher for Government ownership than private sector ownership. This, in turn could lead to a discount rate for Government that is evaluated to be higher than that assessed for the private sector. Therefore, the value of an asset may possibly be higher with private sector ownership than Government ownership.
Thus the assessment of investment risk in three ways provides for the use of different discount rate determination. Using different discount rates could lead to very different investment decisions when assessing the privatisation options for Government.
Section 2 of the paper discusses the importance of investment risk assessment in the privatisation process. The paper continues in Section 3 by focussing on previous investment risk arguments. Section 4 expands on the debate by discussing a third possible alternative, that risk, and therefore the discount rate, could be higher for the Government than for the private sector. The paper concludes in Section 5 by proposing suitable methods for measuring the appropriate discount rate for Government investment decisions in privatisation. It is suggested that using either multi-factor CAPM or multi-factor models via analysing and pricing individual investment risk factors can provide a more accurate measurement of risk which, in turn, will lead to the use of a more accurate discount rate.
2.0 GOVERNMENT AND PRIVATE SECTOR OWNERSHIP: OBJECTIVES, INVESTMENT APPRAISAL AND PRICING.
The prevailing ideologies behind public verses private investment decisions differ dramatically. Governments undertake investment decisions for a variety of reasons. They seek to promote equity by aiding the poor and the disadvantaged and they provide a variety of services, such as education, health, defence, infrastructure, police and postal services. Thus, these investment decisions relate to economic, social, and political objectives. These objectives may themselves vary considerably over time as Governments change or political priorities alter. Frequently changing objectives of course create confusion, indeed, how to determine the benefits of these investment decisions in this environment is open to much controversy.
On the other hand, while there may also be multiple objectives in private sector investment decisions they can be united under a broadly defined, but generally accepted, objective of wealth maximisation. Although the actions involved to achieve this objective may be complex, the objective itself is well defined and unchanging, and it has a clear observable measurement indicator of performance, namely the stock market or share price. This contrasts sharply with the often confused and conflicting multiple objectives, and subsequent measurement, for Government investment decisions.
Likewise, the objectives for the privatisation process itself can be just as diverse as any other Government investment decision. For example, the objectives for privatisation around the world have varied. Many Governments view privatisation as the solution to resolving all the problems of Government owned enterprises. While no one has defined a comprehensive list of objectives, ranked by priority or weight for privatisation, Vickers and Yarrow (1988) list what they believe to have been the principal objectives of privatisation;
1. improving efficiency;
2. reducing the public sector borrowing requirement;
3. easing problems of public sector pay determination;
4. reducing government involvement in enterprise decision making;
5. widening ownership of economic assets;
6. encouraging employee ownership of shares in their companies; and
7. redistributing income and wealth.
However, while the objectives for privatisation may be many and varied, it is generally accepted that the fiscal objective for privatisation is quite clear-cut[8]. That is, to maximise shareholders/taxpayers wealth. This objective has a measurable counterpart in the private sector.
The basic problem in pricing Government investment decisions is having to price something that has never existed in the commercial world. This pricing involves having to uncover and value the effects of Government investment risk.
From a modern finance view of the world it is generally accepted that private sector investment decisions and the subsequent contribution to shareholders wealth is done by discounting an investments expected cash flows back to a present value using a risk adjusted discount. A process known as discounted cash flow (DCF) analysis.
An adaptation of the DCF analysis is shown in Figure 1[9]. This model provides a framework for privatisation pricing. The model shows valuation as a process of determining the future free cash flow of the asset facing privatisation. In this model, value is based upon future free cash flow, which is discounted back to a present value using a discount rate that reflects the business and financial risk of the enterprise. The main elements of value in the model are cash flow, growth in cash flow and risk. The latter element, investment risk, is usually built into the discount rate used to value the assets to be privatised. It is this issue that this paper considers, recognising that much of the previous debate over privatisation has focused on the former elements, in particular, the cash flow growth generated by efficiency gains.
FIGURE 1.
Not only can Figure 1 be used as a framework for privatisation analysis, it can also be used as a platform for discussing the main factors creating investment risk in Government investment decisions. The recent focus on Privatisations worldwide have brought attention to these issues and other associated topics such as; which assets should be owned by the public sector, whether assets have different values in the public and private sectors and how to price assets that are transferred between the two sectors. The crux of each of these questions is critical on the correct determination of investment risk.
In Australia, with the exception of Grant and Quiggin (1999), Klein (1997), Quiggin and Officer (1999), the debate on the assessment of risk used in the discount rate in assessing privatisation options has been scarce. Thus, Government investment decisions relating privatisation to the valuation or pricing of the assets has been paramount.
3.0 THE INVESTMENT RISK ADJUSTED DISCOUNT RATE
Debate over the appropriate discount rate to use for Government investment decisions dates back to the 1970s when the issue was one of deciding the appropriate rate to be used in evaluating Government investment projects. In determining this discount rate a number of different opinions have been put forward:
I. the private rate, reflecting current market saving, investment and consumption preferences[10],
II. the social rate which corrects for the market’s “faulty telescope”[11],
III. the opportunity cost or rate of return forgone by private sector investments displaced by public sector ones at the margin[12].
The discount rate used in assessing privatisation investment alternatives is critical in that it has a direct bearing on whether the Government should maintain the ownership of an asset or privatise it. A central question is whether the discount rate used in this assessment should reflect a discount rate that is applicable to Government investment decisions, or a discount rate that is applicable to private sector investment decisions. Conceptually, if the risk associated with the discount rate is different for Government investment decisions than it is for private sector investment decisions, ceteris paribus, free cash flow then as a matter of pure valuation mechanics will be valued differently for the Government and the Private sector. For example, if capital employed by the Government has a lower assessed investment risk than that of the private sector then assets will be more valuable if retained by Government[13]. The outcome would suggest that, at least in part, privatisation programmes are erroneous.
In the history of this debate the following issues in assessing Government investment risk are briefly discussed.
3.1 POOLING OF PUBLIC PROJECTS
Early Overseas support for the use of a lower Government discount rate when evaluating Government investment decisions proposed the use of a risk-free discount rate[14]. The basis of their arguments focused on the proposition that the risk associated with a particular public venture is inevitably pooled and averaged along with the risks of other projects, and this pooling or averaging of risk for public projects is accomplished without any cost of extra financial transactions.
Contrary to this line of thinking, it could be argued that pooling reduces risk only if the outcomes of Government assets are independent both of each other and of outcomes of private investments. The vast majority of Government projects will have outcomes correlated with national income[15]. For instance, Government projects, such as highways, electrical power etc., that facilitate commerce will produce greater benefits when national income is high than when it is low. To this end it cannot be considered that covariance between Government assets does not exist and therefore Government risk cannot be diversified away to zero.
In addition, the private sector and individual investors can also pool risks. Any advantage that Government may have in pooling diverse risks could be transferred to the private sector or to private investors. Accordingly, risk affects Government and non-Government entities equally. Therefore, according to this argument Government and private sector investment risks are assessed to be equal.
3.2 THE LAW OF LARGE NUMBERS
A corollary to the argument that ‘pooling of public projects’ leads to the elimination of Government investment risk is the notion that the Government has the ability to spread risk associated with a public investment among a large number of people so that the ‘total’ cost of risk-bearing for an investment is insignificant[16]. As the number of investors, or in this case, taxpayers, becomes large the total cost of risk-bearing approaches zero[17]. Crucial to this argument is the Government’s ability to draw on a large number of taxpayers so that the level of investment with respect to the total wealth of each taxpayer is only small.
It is argued that the private sector on the other hand does not enjoy the same ability to spread risks. Some shareholders, in order to control a firm, may hold a large stock of shares that represent a significant part of their wealth.
Once again a contrary view could be expressed. Why could not large corporations achieve the same result? For instance, modern finance theory is based upon the premise that markets will not reward investors who fail to hold an efficient portfolio, and therefore, large block shareholders are expected to hold a diversified portfolio like any other investor. Also, in some cases the major shareholder could be an equity fund consisting itself of many shareholders, thus spreading the costs of risk-bearing over an even greater number of shareholders.