Why the CBO Would Fail Finance 101
For the past decade, I have toiled as a finance professor, teaching hundreds of students—primarily MBAs—how to perform capital budgeting. Like almost every major corporation around the world, we use a tool known as Net Present Value (NPV), which is perhaps the most important tool in finance. As I listen to the health-care debate, especially the CBO cost estimates, I cringe because the CBO has violated just about every rule for performing capital budgeting using NPV.
As finance professionals, why do we like NPV for valuing a project? Primarily for three reasons: (1) It values only the incremental cash flows relevant to the project (2) it values all of the relevant cash flows relevant to the project and (3) it discounts all of the relevant cash flows relevant to the project properly using a risk-adjusted discount rate. Now, let us use these three reasons to examine how the CBO values the project known as health-care reform, and why I, and most finance professionals, assign the CBO a grade of “F” in Finance 101.
First, the CBO includes cash flows that are irrelevant to the project. The most obvious of these are the cash flows associated with the student loan program and Medicare. These projects are irrelevant because they occur whether or not we do the project known as health care reform. This old trick allows bad managers to hide bad projects by tying them together with good projects.
Second, the CBO includes only the cash flows from the first ten years of the project; it fails to include all of the relevant cash flows. In many projects like health care reform, the majority of the value comes from cash flows after ten years. We include these by capitalizing the cash flows in year ten and discounting them back to the present. CBO fails to do this. Instead, CBO includes ten years of costs but only about four years of benefits.
Third, CBO appears to be ignorant of the most fundamental concept in all of finance—the time value of money. The time value of money simple states that a dollar received today is worth more than a dollar received next year. We relate the two by the annual interest rate. When dealing with cash flows across ten years, as the CBO does, it is critically important to account for the time value of money. At an interest rate as low as 4%--the current rate on a ten-year Treasury Bond rate—a dollar received in ten years is worth only 67 cents today. At 12%—the 1981 rate on ten-year Treasury Bonds in 1981 that we are likely to see in coming years if we do not reign in the national debt—a dollar received in ten years is worth only 32 cents today. Yet the CBO treats a dollar received in ten years as exactly equal to a dollar received today. Compounding this problems is the fact that much of the cost comes during the early years, whereas the benefits only come much later during the project, when they are worth less. So much for the most important concept in all of finance.
Beyond these three points, another critical part of the NPV valuation process is what is known as sensitivity analysis, which is where we test how sensitive are our estimates of value to our assumptions. Of special interest are assumptions about growth rates. The CBO makes a number of heroic assumptions that drive its analysis, including changes in the growth rates of health costs with and without the reform project, yet it does so without doing any analysis of how different costs would be if it’s assumed growth rates are wrong (as they most probably are). What if growth in future medical costs don’t decline as the bill assumes? What if we can’t “save” $500 billion from Medicare? Is it still a good project? No.
So we see, on al l four of these counts, the CBO earns a failing grade in its approach to valuing health-care reform—and everything else. How am I, as an educator, supposed to teach my students the right way to value a project when our government’s “watch dog” violates virtually every rule I am trying to teach. Let’s reform the CBO’s arcane and inaccurate costing methodology before it bankrupts our country. Finance 101 is a good place to start.
