Applied welfare econ cost benefit analysis ch6

Purpose: Some practical issues one must know in order to compute the net present value NPV of a project It assumes the social discount rate is given, which is reasonable as the rate is

Chapter 6

Discounting Future Benefits and Costs

Applied Welfare Econ & Cost Benefit Analysis

Purpose: Some practical issues one must know in order to

compute the net present value (NPV) of a project

It assumes the social discount rate is given, which is reasonable

as the rate is often set by an public agency

The chapter covers: the basics of discounting (two-periods);

compounding and discounting over multiple periods

(years); the timing of benefits and costs; horizon (terminal) values; comparing projects with different time frames;

inflation and the difference between nominal and real

dollars; relative price changes; and sensitivity analysis in discounting

Appendix 6A provides shortcut formulas for calculating the present value of

annuities and perpetuities

You are responsible for going through this appendix yourselves

BASICS OF DISCOUNTING

Projects with Lives of One Year

 Discounting takes place over periods not years However, for simplicity,

assume that each period is a year First we discuss projects that last one year.

 There are three possible methods to evaluate potential projects: future

value analysis, present value analysis and net present value analysis Each gives the same answer.

BASICS OF DISCOUNTING

 Future Value Analysis – Choose the project with the largest future value,

FV, where the future value in one year of an amount X invested at interest rate i is:

FV = X (1 + i) (6.1)

 Present Value Analysis – Choose the project with the largest present value,

PV, where the present value of an amount Y received in one year is:

PV = Y/(1 + i) (6.2)

 If the PV of a project equals X, and the FV of a project equals Y, both

equations (6.1) and (6.2) imply: PV=FV /(1 + i)

 This equation shows that discounting (the process of calculating the

present value of future amounts) is simply the opposite of compounding (the process of calculating future values).

BASICS OF DISCOUNTING

 Net Present Value Analysis – Choose the project with the largest net

present value, which calculates the sum of the present values of all the benefits and costs of a project (including the initial investment):

 NPV = PV(benefits) – PV(costs) (6.3)

BASICS OF DISCOUNTING

Usually projects are evaluated relative to the status quo:

 If there is only one new potential project and its

impacts are calculated relative to the status quo, it

should be selected if its NPV > 0, and should not be selected if its NPV < 0

 If the impacts of multiple, mutually exclusive

alternative projects are calculated relative to the

status quo, one should choose the project with the

highest NPV, as long as this project’s NPV > 0

 If the NPV < 0 for all projects, one should maintain

the status quo

COMPOUNDING AND DISCOUNTING OVER

MULTIPLE YEARS

 Interest is compounded when an amount is invested

for a number of years and the interest earned each period is reinvested

 Interest on reinvested interest is called compound

interest

 The future value, FV, of an amount X invested for

n years with interest compounded annually at rate i is:

Present value again

 Present value: the amount a specified money sum received at a

future date is worth today

 $1 today can turn into $1(1+r) in a year’s time right?

 Therefore, we know that the present value (PV) of $1(1+r) of next

year is $1 of today

 This is because $1 is equal to

$ 1+r 1+r

Present value vs Future Value

 When we translate the future into the present, we discount the

future value (we make it look smaller to get the PV)

 When we translate the present into the future, we compound the

present value (we make it look bigger to get the FV)

Present value vs Future Value

 But we do have a translating device to make values smaller to the

right extent, when calculating the PV of a sum received in the following period

 The discount factor 1/(1+r)

 which is given by the discount rate r

Discount rate

 Discount rate: the value placed upon current

consumption, relative to future consumption

 It measures how strongly we prefer money now to later given our possibilities to transform money today into money tomorrow

 If this rate is high, we will only trade off money now only for lots of money later, since we know how much

we lose by waiting

Discount factor

 Discount Factor - The factor that translates expected benefits or

costs in any given future year into present value terms

 The discount factor is equal to 1/(1 + r) t where r is the interest rate

and t is the number of years from the current year until the future year

Discount factor

 The discount factor is equal to 1/(1 + r) t where r is the interest rate

and t is the number of years from the current year until the future year

 The higher r and or the higher t the smaller the discount factor, so

the bigger the difference between the future value and the present value

 So what is the present value of $100 received in 10 years time from

now if the discount rate is 3% (not much higher than the real bank interest rates)? And $10 at a 5%?

 $10/(1.05) 10 =$6.14

 what about these $10 in 5 years?

 $10/(1.05) 5 =$7.84

NET PRESENT VALUE

 The net present value of an investment is equal to the difference

between benefits received in several periods and costs faced in in several periods

 when all expressed in their Present Value

NPV = > 1 t Bt

Ý1+rÞ t ?1 ? Ct

Ý1+rÝ tÝ 1

NET PRESENT VALUE

 The net present value of an investment is equal to the

difference between benefits received in several periods and costs faced in in several periods

 Usually, there is a natural choice for t the “useful” life

of the project, such as when or an asset undergoes a

major refurbishment or the assets are sold.

 Sometimes we use variations of the formula with infinite

t

 See textbook for alternative ways to calculate horizon

values

COMPARING PROJECTS WITH DIFFERENT

TIME FRAMES

 Analysts should not choose one project over another solely based

on the NPV of each project if the time spans are different

 Such projects are not directly comparable.

 So what can the analyst do? Two options…

Rolling over the Shorter Project

 If project A spans n times the number of years as project B, then

assume that project B is repeated n times and compare the NPV of

n repeated project Bs to the NPV of (one) project A

 For example, if project A lasts 30 years and project B lasts 15 years,

compare the NPV of project A to the NPV of 2 back-to-back project B’s, where the latter is computed:

NPV = x + x/(1+i) 15

where, x = NPV of one15-year project B.

Equivalent Annual Net Benefits (EANB) Method

 The EANB is the amount received each year for the life of

the project that has the same NPV as the project itself

 The EANB of a project is computed by dividing the NPV by

the appropriate annuity factor, ai n:

EANB = NPV/ ain

 The appropriate annuity factor ain is the present value of an

annuity of $1 for the life of the project (n years), where i = interest rate used to compute the NPV Obviously, one

would choose the project with the highest EANB

Other Considerations

 Shorter projects also have an additional benefit

(not included in EANB) because one does not necessarily have to roll-over the shorter project when it is finished.

 A better option might be available at that time

This additional benefit is called quasi-option value and is discussed further in Chapter 7.

NET PRESENT VALUE

 If the NPV of a prospective project is positive, it should be accepted,

but if it is negative then the project should be rejected

 OK, I will believe it…

 but then, what should I do with my savings?

NET PRESENT VALUE

 what should I do with my savings?

 Invest them in any project that promises returns at a rate r

 That is the key: your project was not good if you used a discount

rate r

 Because you would lose money in PV if the discount rate was to be

r

NET PRESENT VALUE

 In that case, instead of going for the project, put you money into

something that pays an interest rate r

 like a bank account

Internal rate of return

 Another way to look at it is to find the particular value of the

discount rate that would make the NPV=0 for your project

 That is called the internal rate of return of your project

Internal rate of return

Internal rate of return

 Therefore, if you can find an alternative project that pays more

than r*, you should put your money there!!! Not in your original project!

 Think about it: if the IRR (r*) is lower than what you can get

anywhere else, then you are not getting a benefit from the project to cover the opportunity cost of your money!

Internal rate of return

 Think about it in a different way: if the IRR (r*) is lower than the

rate of interest at which you need to repay your loan for the funds for the project, you should not undertake the project!

Example of the power of compounding

 The Dutch allegedly bought Manhattan in 1626 for about $24

worth of beads and trinkets

 if Native Americans had invested in tax-free bonds 7% APR

bonds, it would now be worth over $2.0 trillion > assessed value

REAL VERSUS NOMINAL DOLLARS

 Conventional private sector financial analysis measures

monetary amounts in nominal dollars (sometimes

called current dollars).

 But, due to inflation, one cannot buy as many goods and services with a dollar today as one could one, two or

more years previously It is important to control for

inflation

 We control for inflation by converting nominal dollars

to real dollars (sometimes called constant dollars) We

usually use the consumer price index (CPI), but

sometimes use the gross national product (GNP).

Estimates of Inflation and Problems with CPI

The CPI is the most commonly used measure of inflation Prior to 1998,

the CPI overstated inflation by about 0.8% to 1.6% per annum Four reasons for the overstatement are:

 1) Commodity substitution effect: The CPI did not accurately

reflect changes in consumer purchases, such as switching to priced substitutes;

lower- 2) New goods: The “basket” of goods did not include some

new products, e.g., new (cheaper) generic drugs;

 3) Quality improvements: The CPI did not accurately reflect

changes in product quality, e.g more safe or reliable cars;

 4) Discount store effect: Consumers are shopping more at

discount stores, which have less expensive products

Real rates of interest

 In a world with inflation

 What is the difference between the real and the nominal interest

rate?

 Imagine that prices actually grow at a rate:

 We are going to label the real interest rate

Real rates of interest

 If we want to put next year’s prices in real terms, we want to

discount the inflation

 we want to adjust for inflation, dividing by

 1+

 Using this idea, we can find the real rate of interest

 i* is more or less equal to i - for low levels of inflation, like the

ones we normally face

E Ý

Real rates of interest

 The proof is given in Varian, for example

 Check that it makes sense, and then just remember that the results

is a good approximation in most cases

Existence Values READ CHAPTER 9