Scott Herriott, Ph.D.
Co-Chair of the Department of Business Administration Professor of Management
Dean of the College of Arts and Sciences
Expansion Council Chair
B.A. summa cum laude, Dartmouth College
M.A., Ph.D., Stanford University
Professor Herriott’s research interests include issues of cooperative strategy in business policy. Specific projects include studies of electric utility power pools, cooperative advertising, risk pooling, partial acquisitions, information channels in markets, and the implications of Maharishi Vedic Science for theories of motivation, job design, and management decisions.
3. Wholeness of the Lesson
The Great Law of the Iroquois instructed
council members to make decisions with an
eye to their consequences 7 generations into
the future. The theory of finance has at its
heart a consideration of the trade-offs
between the present and the future. What kind
of decision rule does the 7th Generation
principle call for in financial terms, and what
does that imply as the characteristics of a
sustainable economy?
4. The Duration of a Discount
Rate
In the theory of discounted cash flow
analysis, the discount rate defines
the trade-off between money now and
money in the future.
A high discount rate “discounts” the
value of events happening in the
future. So a low discount rate
suggests a longer-term perspective in
decision making.
5. The Duration of a Discount
Rate
We formalize that concept as the
duration of a discount rate, analogous
to the duration of a bond or other cash
flow, which is the PV-weighted average
of the times at which cash is received.
The discount factor applied to any cash
at time T in the future is e-rT.
Define d(r) =
6. The Duration of a Discount
Rate
This simplifies to
Which calculates to a remarkably
simple formula
d(r) = 1/r
This is the “average” time taken
into consideration when using the
discount rate r.
7. The Duration of a Discount
Rate
r Duration
0.5% 200 y
1.0% 100 y
2.0% 50 y
3.0% 33 y
4.0% 25 y
6.0% 17 y
8.0% 13 y
10.0% 10 y
So we would have to use a discount rate of
0.5% to look out 200 years, on average.
8. Sustainable Growth
The financial model for sustainable growth is
given by the Gordon formula for the price of a
company’s share of stock, assuming that
dividends start next year at D1 ($) and then
grows at a rate of “g” (percent per year) for all
eternity. If “r” is the discount rate applied to
the cash flow for the purpose of valuation,
9. Sustainable Growth
If the growth rate equals the discount rate (g = r), then
this model predicts an infinite price for the stock of
the company. If g>r, the price is nonsense (negative).
Why? Because if a company could reliably grow
eternally at a rate faster than its cost of capital (r), it
would immediately attract so much capital that it
would absorb the entire economy.
Therefore the sustainable growth rate must be less
than the company’s cost of capital (discount rate).
10. The 7th Generation Paradox
Therein lies the paradox.
For sustainability, a long-term view is
needed, which means a very low
interest rate (discount rate).
Yet sustainable growth must be at a
rate lower that the discount rate.
A sustainable economy is a stagnant
economy.
11. The 7th Generation Paradox
This is troubling, because we would
like to think that a sustainable
economy is an enlightened economy—
functioning in alliance with natural law,
exhibiting the effulgent creativity of
nature.
Is there a way off the dilemma of
sustainability versus creativity?
12. Attempts to Resolve the
Paradox
1. Which interest rate (discount rate)?
2. Shorten the time horizon?
3. What about risk?
4. Creativity in a sustainable knowledge
economy
13. Which Interest Rate?
We are dealing with a real (inflation-
adjusted) discount rate, not the
nominal rate that governments can
manipulate through the money supply.
US nominal 10-year T-bond is 2.5%
US 10-year forecast inflation is 2.2%
So the real T-bond rate is 0.3%.
14. Which Interest Rate?
US nominal 30-year T-bond is 3.5%
US 30-year forecast inflation?? 2.0-2.5%
So the real 30-year T-bond rate is 1.0-
1.5%.
That has a duration of 67-100 years.
Should we settle for 1-2 generations?
“Don’t try to value farther than you can
15. Risk-Bearing Rates
US long-term real risk-free rate is
about 1.5%
The market (S&P 500) risk premium is
historically about 7-8%.
So the real, risk-bearing discount rate
is about 8-9%. That has a duration of
11-12 years, violating the 7th
Generation Principle quite severely.
16. Risk-Bearing Rates
How to Bring Down the Risk Premium?
Reduce the volatility of the market
(coherence in collective consciousness
through the practice of the Transcendental
Meditation program)
Reduce investors’ fear of loss
(enlightened awareness, “inner happiness,”
less dependent on possessions for a sense
of stability in life)
17. Creativity in a Sustainable
Knowledge Economy
Apple Computer: From Garage to Fortune
500, but with a substantial infusion of
capital.
Facebook: Harvard student to billionaire in
less than 4 years.
The growth rate for wealth in an economy
is not the same as the return on capital to
investors.
18. Creativity in a Sustainable
Knowledge Economy
Returns to Creativity
Entrepreneurship. Start your own
company.
Intrapreneurship. Contract with your
employer to “carve out” your ideas and
pay a percentage of revenues or profits.
Employee Stock Option Plans. For all.
19. Creativity in a Sustainable
Knowledge Economy
Returns to Creativity
These forms of return to creativity, which
respect individuals rights to their
intellectual property, are not addressed
in current metrics for sustainability, such
as the GRI or SA8000, nor even the
Global 100 nor B-Corp.
Rights to created property should be a
component of sustainability metrics.
20. Summary
The paradox is real, at least now.
We need low discount rates to direct the
flow of capital with a long-term vision.
The return to capital is an upper bound for
discount rates.
Enlightened awareness will lower rates.
Proper treatment of intellectual property
will help, but how to direct R&D to the
long-term?
Editor's Notes
The sustainable firm does not violate the natural environment, engages relevant stakeholders in its governance, serves its stakeholders effectively, and makes a profit doing so. Deep sustainability implies an enlightened management that uses a broad awareness to make more effective decisions.
The response from purists would likely be that the point of the 7th Generation Principle is to make us look out 200 years, and decision theorists would add that while we may not be able to see there with clarity, we see there in terms of probability distributions whose expected values enter our calculations of value.Realists would then add that even a 1-2% discount rate will not now apply to the risky investments that seem to be the bane of the 7th Generation Princple.
The growth of wealth reflects the return to creative intelligence (entrepreneurship) as well as to capital.
The growth of wealth reflects the return to creative intelligence (entrepreneurship) as well as to capital.
The growth of wealth reflects the return to creative intelligence (entrepreneurship) as well as to capital.
