Follow the Numbers and Peel the Onion: Finance & Economics in Public Administration
A strong background in Finance and Economics is a highly desirable quality in elected officials and public administrators. While terms and acronyms such as NPV, IRR, ROA, ROE, ROI, FCF, Discount Rate, Amortization Rate, Economic Multiplier Effect, etc. may seem to be overcomplicated concepts in small to medium scale projects, they have a clear purpose in understanding the value generated for a community when a direct investment in a Capital Improvement Project occurs. Decisions are not achieved without proper analysis, and it is an unrealistic expectation for any elected official to obtain all the answers from the staff of a public agency. Knowing how to run your own numbers is advantageous. The concept of NPV (Net Present Value) is a necessary calculation to ensure that a project is generating value for the community; because such calculation doesn’t take into account the residual value past the period of time calculated. A positive result in an NPV calculation will show that value will be generated. Conversely, a negative result would indicate that value will not be generated unless the project has substantial residual value at the end of its intended purpose. It is also important to account for the amortization of the project as the one-time investment needs to be depreciated over the project’s useful lifetime. The calculation of the NPV is critical for another function: finding the IRR (Internal Rate of Return). Let’s apply these concepts to a practical example. Let’s say that a city is contemplating the investment of $500,000 on a sidewalk (an improvement providing public benefit) to retain three car dealerships. At face value, this would seem to be a banal subsidy because the dominant logic is that in ten years car dealerships will be obsolete. Perhaps; but as Yogi Berra once said: “It is difficult to make predictions, especially about the future.” Hence, rather than making predictions, economic and financial scenarios need to be constructed and evaluated. When numbers are analyzed, a holistic picture does emerge. The three dealerships combined generate $960,000 per year in sales tax revenue to the city. A quick calculation on straight-line depreciation over ten years will reveal that, ceteris paribus (meaning all things remaining equal), the potential revenue generated is $9.6 million or a net of $9.1 million. On the surface the project is intuitively compelling, however, the longer we go into the future, the more unstable the financial modeling becomes. With an NPV calculation, we can easily see if the project is viable over a shorter period and calculate the IRR. If we take the $500,000 investment and load it with a 6% interest rate (as in the case of borrowed capital), and then we enter four years of revenue for the city with a variance of approximately 8% to account for changes in market conditions; we will see that the NPV (Net Present Value) of the project is roughly a positive $2.8 million, and the IRR (Internal Rate of Return) will be approximately 180%. It is the ability to run financial models that sets apart the quality of the decision making process from the knee-jerk reaction forming an opinion. As opinions are like belly buttons, my philosophy is to arrive to an assessment by following the numbers and peeling the onion, even if it takes much more of my time to do so. Happy numbers hunting!