Thoughts on Asset Valuation

The question is often asked: Why do ownership structures create different prices and asset values? Following Alchain and Allen's line of thought in their "Fishland" article (see- Chapter 8 Exchange & Production: Competition, Coordination, & Control, Armen A. Alchain & William R. Allen, 3^rd Edition UCLA, Wadsworth Press, 1983) in their text: "Exchange and Production," the answer, according to Alchian and Allen appears to be lie in how governments involve (control) themselves in commercial pursuits.

In the real world of water and wastewater systems, this control manifest itself in actual control-ownership, tax treatment, pricing, and ratemaking. Alchain and Allen argue that private firms and governments are driven by different objective functions. They see this objective function dichotomy between wealth maximization versus (private firms) "…maximize the public welfare…" (public entities).

The complexities of this objective function debate, are integral to the structure of water and wastewater systems in the US and abroad. The debate as to who (and how) should run the water and wastewater systems continues. The impact of private versus public ownership/control has serious ripple implications throughout the entire community. In an earlier study, I suggested that electric utilities with large depreciation accounts, declining core markets, and experience with regulatory authorities would have a comparative advantage in acquiring and effectively running public water companies. Another argument, from the prospective of the consumer, could be that privatization by an electric utility of an existing public water system may be less odious to some consumers.

In an historic paper, extolling the advantages of private property rights and market solutions, Alchian and Allen argue that individual wealth maximization (see Table 3, below) leads to society wealth maximization. Table 3, is a reproduction of the Alchain and Allen Table 8-1 page 164.

In this "Fishland" model, these authors assume that the marginal and average product on an isolated island are each four fish. They also assume that there are 1,000 workers. Total output, without any other productive input (a boat) is 4,000 fish. Alchain and Allen assume a boat is washed ashore (introduced/appears). On Table 3, Column 2, total catch on board is quantified. The marginal cost of an additional productive unit on the boat is 4, by the definition of opportunity cost. In this example - where marginal product on board equal marginal cost (MC=MR), profit on board the boat is maximized. Also, using this rule (MC=MR), profit maximization on board the boat leads to societal maximization (boat and the island output summed), as shown on Table 3, Column 8.

Alchain and Allen do not suggest that this state is attained without cost. They acknowledge shirking and hence the need for anti-shirking activities, or managers. Since resources, in the market place, are theoretically paid their marginal value in use, it is inferred that managers have an incentive to minimize shirking and thus maximize their marginal value in use. In essence, the question is simply does this system work more effectively than a public run system. Many public sector firms have acknowledge the need for greater output from their resource base and have initiated competitive managerial systems. The intriguing conclusion of the authors is that renting, owing, or leasing, under a situation where anti-shirking activities are equally as effective, will lead to the same wealth maximizing output decision. However, they also show that an equal share cooperative - formed solely on the boat's output (ignoring the wider societal implications) - will increase average boat member (cooperative) output, but decrease societal out overall.

One problem that has manifest itself in studying water and wastewater privatization has been the impact on the work force. Some unions have fought privatization on the grounds that it will change the size and quality of the labor force. Interestingly enough, in the above-mentioned "Fishland" article the issue of inter-specific resources is raised. An inter-specific resource is identified, for illustrative purposes, as a winch, specially designed for a particular boat. Alchain and Allen contrast this with the generalized fishing lines (as contrasted with the specialized winch), which can be used on the boat or on shore.

They analogize that certain skills are inter-specific in varying degrees. The latter reason, it is argued, can form the basis for unions or more structured relationships between employees and employers. The concept of marriage - a specialized type contract is referenced in this context: "… although people do not own each other, which might appear to be unusual or otherwise inexplicably restrictive contracts or arrangements may be a means of restricting potentially exploitative behavior." Likewise, unions and other labor groups may see the need to counter potentially exploitative behavior by banding together and/or resisting a change in ownership structure. These actions may or may not be rooted in the concept of an inter-specific resource. Some actions could be to protect economic rents, derived from artificially contrived barriers to entry.

In theory, the cost of capital, salvage, and removal costs (See Table 1) cover the "sunk" cost items. However, if such items are not valued at market, the question of imputing a value to historical costs becomes important in the bookkeeping context. This latter consideration overrides, in degree, the exhortations of economic theory on sunk costs being irrelevant costs. There are numerous methods for assessing asset valuation. Above and in the following tables, the idea of net present worth has been presented. In addition to the market constraints of evaluating revenues and costs, already noted, there is the problem of assigning an appropriate discount rate. Discount rates vary between individuals, firms, governments, and in fact, all planning entities. Three other suggested methods are to (1) sum historical costs, (2) sell the asset, and (3) compare it with an asset of similar size that recently was acquired by privatization or condemnation. The market price, assuming a free "bidding" process with no search or buyer barriers, meets the market criteria. However, it may not meet the political social welfare goals.

Below, I have presented the revenue requirements equations for both an Investor Owned Utility and a Public Owned Utility. In theory, the net present worth of the income stream - allowing for all explicit and implicit costs - should provide an accurate evaluation of the value of the asset.