Negative interactions mean that the sum of the parts is worth less than the parts individually. In this case, projects have negative influences on one another, and thereby decrease one another’s value. Economists sometimes call negative externalities diseconomies of scale. Here are a few examples.
Pollution and Congestion If there is only one major road to two divisions, and the traffic of one division clogs up the traffic to the other division, it can cause a loss of cash flow in the other division. A division that wants to expand and thereby clog up more of the existing infrastructure will not want to pay for the congestion cost that its own expansion will impose on the other divisions. (Of course, it is the overall firm’s headquarters that should step in and allow the expansion only if the NPV is positive after taking into account the negative externalities imposed on other divisions.)
Cannibalization If a new Apple computer can produce $100,000 in NPV compared to the older Windows machine that only produced $70,000 in NPV, how should we credit the Apple machine? The answer is that the Apple would eliminate the positive cash flows produced by the existing Windows machine, so the cash flow of the project “replace Windows with Apple” is only the $100,000 minus the $70,000 that the now unused Windows machine had produced.
Bureaucratization and Internal Conflict If more projects are adopted, project management may find it increasingly difficult to make good decisions in a reasonable time frame. This may require more cumbersome bureaucracy and reduce cash flows for all other divisions.
Resource Exhaustion Perhaps the most common source of negative externalities—and often underestimated—is limited attention span. Management can only pay so much attention to so many different issues. An extra project distracts from the attention previously received by existing projects.
Although costs always include opportunity costs, in the case of negative project externalities, they are more obvious. If your project cannibalizes another project or requires more attention, it’s clearly an opportunity cost.
Tags: cash flow, Credit, loan, mortgage
The historic default rates on mortgages have been generally much lower than on other consumer and corporate loans. They have also generally remained low even when borrowers have significant levels of negative equity. There are a number of reasons why this should be the case:
People have to live somewhere. Negative equity represents an unrealized loss. There is no incentive to realize this loss provided the borrower can service the loan. The advantage of moving to cheaper rented accommodation has to be balanced against the disadvantages of defaulting. Bankruptcy avoidance. If a borrower defaults on a property with significant levels of negative equity they are likely to face bankruptcy proceedings. In addition to the stress and loss of assets that such proceedings bring they are also likely to make it impossible for the borrower to ever own their own property.
Long dated option. A mortgage can be viewed as a long dated option. Given long enough most property markets eventually recover, even though it may take years. Option holders do not simply throw away an option that is out-of-the-money for the simple reason that it also has a “time value”. Given the typical term of mortgages the time value is significant, particularly as the “premium” they have paid (the down payment) represents a significant portion of their accumulated savings.
The level of defaults in the UK rose sharply after the residential property market crashed in 1986. A close examination of the problem showed that many defaulters had not actually made any down payment on their mortgage. Instead the lending bank had sold indemnity policies to them issued by an insurance company. These policies protected the banks from the first 20% of losses. Having paid very little for the option and being well out-of-the-money borrowers had little incentive to stay current and simply dropped off the keys after moving out.
The actual losses experienced by banks were relatively modest and the insurance companies simply responded by increasing the premiums charged for these policies. Few banks went through formal bankruptcy proceedings and, in the absence of a central register of defaulters, borrowers were able to go to another bank and took out a new mortgage on a different property. It’s a wonderful world.
Tags: Credit, interest, loan, mortgage