Forgetting the cost of capital

May 21st, 2011 at 2:00 pm by David Farrar

The Dom Post reports:

At a share price of $1.13 the Government has lost about $125m on its $1 billion investment.

But this was more than compensated for by $450m in dividends the airline has paid it over the past 10 years, which means taxpayers are still $325m ahead.

No we’re not. The cost of capital has been over-looked.

The Government borrows at around 6%. So if it had not sunk $1 billion into Air NZ, it would have $60 million less interest a year. And then if you compound the interest, the actual cost of the investment in Air NZ is $1.79 billion.

The current value is $875m plus $450m in divideds, which is 1.33b. So the Government is down around $460 million.

One may have a viewpoint that a loss was acceptable to keep Air NZ solvent (mind you if Cullen and Anderton had not blocked sale to Singapore Air a bailout would not have been needed), but you shouldn’t declare that the Government is $325m ahead, by ignoring cost of capital.

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26 Responses to “Forgetting the cost of capital”

  1. tom hunter (4,576 comments) says:

    The cost of capital has been over-looked.

    Not just that, but for most members of the public who have never run a business, the whole concept of a business requiring constant doses of investment to keep the machine running is over-looked. For such people these “assets” are more akin to the Magic Porridge Pot.

    Every time I hear some ordinary person yammer on about “government assets” I ask them if they know how much money has been poured into it versus how much has been generated, or what the actual Return On Capital is. Because unless they’re positive the thing is not an asset but a liability.

    Of course I don’t bother asking any politician this question – because a government’s ability to borrow or print money at zero cost is effectively infinite.

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  2. Viking2 (11,286 comments) says:

    HMM, well I guess the numbers for the train set will be even worse.
    Time to quit some of the business that Govt. owns. Metservice a good place to start, along with TVNZ and its stablemate with all the wires and stuff.

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  3. Elaycee (4,337 comments) says:

    One of the few things (positive) I recall from the bail out of Air NZ is that, with the NZ Government having a majority number of seats on the Board, there would be no more daft ideas such as the decision to purchase Ansett Australia.

    Whilst the purchase of Ansett was an opportunity for Air NZ to expand services via cabotage, the purchase was doomed to be troubled because of the unhealthy influence of the militant Australian unions.

    Anyone in doubt needs look no further than what is happening with Qantas today.

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  4. Right_Wing_Dad (62 comments) says:

    Most businesses would probably utilise a discount rate of around 8% and then another 3% for inflation when calculating NPV for an investment. On that basis, the investor (sorry taxpayer) has taken a bath.

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  5. James (1,338 comments) says:

    What Tom said……these assets are really liabilities.Can you do an expanded piece on the truth behind these so called assets DPF?…..Labours campaign to stop the sales really needs confronting with cold hard facts.

    The question also needs to be asked….if these assets were competing in an open economy against private players would they hold their own? Highly unlikely.So that also needs factoring in….

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  6. southtop (263 comments) says:

    Would be interesting to also analyse how much the state owned airline has cost provincial NZ through anti-competitive behaviour.
    My suspicion is that if the government hadn’t propped up AirNZ we would have a much more competitive air industry in NZ today, especially competition servicing smaller centre e.g. Whangarei, Hamilton, Tauranga, Gisborne, Napier, New Plymouth, Palmerston North, Nelson, Invercargill, Hokitika.

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  7. Johnboy (15,602 comments) says:

    “Metservice a good place to start,”

    Quite right V2. I bought one of those electronic weather stations. Right about 95% of the time. Beats the Metservice by a factor of at least 2. :)

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  8. Johnboy (15,602 comments) says:

    If Cullen hadn’t bought the train set Toll could have pulled the track for scrap value and JK could have had his national cycleway for bugger all. :)

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  9. Manolo (13,517 comments) says:

    Air New Zealand should’ve been acquired by Singapore Airlines, but it wasn’t because of the intervention of the odious Michael Cullen. He is sole responsible for the losses suffered.

    However, he is smiling all the way to the bank and drawing a fat salary after his appointments to NZ Post and Kiwi Rail boards by the current Labour lite, aka National, government. Disgraceful.

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  10. SPC (5,473 comments) says:

    Put it more simply – if they invested a $B and received $450M in dividends over 10 years the rate of return was 4.5%

    A little better than finance companies have done or investment in roads – the government is proposing $10B on 7 roads we can survive without. Hardly investments to future proof the economy – but just to further encourage the low wage economy with the most cars per head in the world.

    As to the cost of this capital, this has been under 6% for much of the past 10 years.

    How much advantage to tourism and continuance of cargo transport routes has been realised, it’s unquantifiable.

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  11. SPC (5,473 comments) says:

    Correction – its 9 years of dividends – so the rate of return was 5% pa.

    It was Airline of the Year in 2010 in the Air Transport World Global Airline Awards.

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  12. louie (92 comments) says:

    Aren’t there any grown ups on duty at the Dom Post when stories like this and the dairy tax payments are published? Don’t they have anyone they can run them past who will spot the stupid assertions?

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  13. Johnboy (15,602 comments) says:

    Didn’t do quite so well in 1979 SPC.

    Maybe the food wasn’t up to scratch or something?

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  14. Adolf Fiinkensein (2,834 comments) says:

    And to add to the critique of this slovenly reporting, the gummint has NOT lost a penny because it has not sold the shares. When they are sold it will discover whether there is a profit or a loss to be booked. I see the shares were selling at over $1.50 not so long ago so one would expect an intelligent vendor to maximize the price.

    Mind you, the sort of reporting we see here is appropriate for a newspaper whose readership predominantly comprises drones within the public service.

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  15. SPC (5,473 comments) says:

    Fair point Adolf, thus far the rate of return on the investment of 5% pa is all that is known.

    And any owner of an asset is best advised to keep themselves in the position where they sell assets at the time of their choosing, so that they maximise the return.

    It’s unwise to declare an intention to sell an asset within a time period because buyers will under-bid looking for a bargain – much better to invite offers and state that all offers too low will be rejected.

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  16. tom hunter (4,576 comments) says:

    It was Airline of the Year in 2010 in the Air Transport World Global Airline Awards.

    Never mind the width, feel the quality!

    How much advantage to tourism and continuance of cargo transport routes has been realised, it’s unquantifiable.

    The business equivalent of Pascal’s Wager then – but with an American televangelist approach to pitching the offer.

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  17. Blue Coast (165 comments) says:

    After the kick the Dairy Farmers got earlier this week what else do you expect from the Pinko Dim Post. I used to send $25k pa on advertising with this rag but quickly learn to find otherways to spend my hard earned than give it to a dead loss outfit.

    And my new approach is even more profitable which confirms my view of the “believers” following the Dim Post.

    I find it hard to believe that at least someone with 6th form Accounting/Economic’s in their business area would not have the balls to have a chat in the editors ear.

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  18. freedom101 (481 comments) says:

    Twice in one week. First the economically illiterate report on dairy farmer tax and now this on Air New Zealand. I’ll soon have to reconsider my DomPost subscription. What’s the point of buying this tosh?

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  19. reid (16,111 comments) says:

    So where has been the Nat’s vigour with respect to ejecting and rejecting this uneconomic investment?

    Is it cause it would make it more difficult for the PM to be popular, if the govt said over Key’s objections was unfortunately by circumstance forced to say: for good and reasonable economic reasons, Air NZ has to be sold down, completely?

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  20. aquataur (56 comments) says:

    For all you non corporate finance types

    Airlines are volatile investments – and I would guess the risk adjusted cost of equity for an airline should be in excess of 10%

    Air NZ has returned to the govt around 5-6 % p.a. (combination of dividends and capital growth)

    Govt therefore has been losing at least $40-$50m on an investment of around a $bn

    hardly a great investment or a poster child for the ‘mixed ownership model’

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  21. elscorcho (153 comments) says:

    I must have missed the memo where the sole purpose of government was to beat the market in capital investments?

    What’s the ROI on the Police? The NZDF?

    Can’t wait till the rightists get their way, because if they’re going to be consistent they will abolish all government services as being collectivist artifacts.

    Most rightists, of course, have never read Hobbes, and if they had would probably fap quite hard at the thought of a state of nature – forgetting that as soon as anybody gathers any wealth (food for 5 people?) they’d get brained with a thighbone.

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  22. Elaycee (4,337 comments) says:

    Elscorcho says: “Most rightists, of course, have never read Hobbes, and if they had would probably fap quite hard at the thought of a state of nature – forgetting that as soon as anybody gathers any wealth (food for 5 people?) they’d get brained with a thighbone.”

    Errrr… WTF??

    Are you (long) overdue for your meds?

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  23. elscorcho (153 comments) says:

    Meds? I am referring to something most people are quite familiar with: the rightist paradise where nobody can tell you what to do with your own precious private property: the state of nature.

    You cannot deny the logical extension of rightist, individualist thought is the state of nature.

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  24. Elaycee (4,337 comments) says:

    Elscorcho says “I am referring to something most people are quite familiar with: the rightist paradise where nobody can tell you what to do with your own precious private property: the state of nature. You cannot deny the logical extension of rightist, individualist thought is the state of nature”.

    Sure. Of course. Whatever you say, Elscorcho… Now be sure to swallow this nice white pill….

    Pfffftttt.

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  25. hubbers (230 comments) says:

    Seriously how dumb do you have to be to be a reporter?

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  26. virtualmark (1,522 comments) says:

    DPF, you’re confusing the Government’s cost of funds with Air New Zealand’s cost of capital. Yes, the Government can loan money at around 6% pa. But it is an equity investor in Air New Zealand, and the cost of equity for an airline is much higher than 6%. I’d expect the cost of equity for Air New Zealand to be about 12% pa post-tax.

    So that makes the picture even worse, in terms of it being a financial investment. Of course, the Government is unique in being able to extract a number of other genuine benefits from owning Air New Zealand, besides just the straight financial returns. So the Government may still consider Air New Zealand a rational investment for them.

    Also, I’d be careful about placing too much weight on a potential Singapore Airlines bailout of Air New Zealand back in 2002. I was there, and I can tell you that Singapore Airlines did not have the means or the will to bailout Air New Zealand. Yes they were on the scene. But they were blinking in the headlights and it was clear they couldn’t have pulled off a bailout.

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