Cost Benefit Analysis L5

Cost Benefit analysis L5
Discounting Future Impacts

• To compute net present value of a project
• Assuming that the social discount rate is known
• And ignoring uncertainty and risks
Discounting
• Public projects usually span across multiple years
• For a proper comparison, we discount future benefits or costs by presenting everything in
terms of their present value
• Aggregate the present value of all costs and benefits and propose a project with highest
net present value
Discounting 1 period - diagram

10000 in t=0 11000 in t=1 cost = 10000 benefit =1000 implement project?
10000 today is not exactly equal to 10000 tomorrow. Opportunity cost of 10000 dollars.
Method 1: Future Value Analysis

• Compare it with the alternative of investing in risk-free bills
• If risk-free interest rate is 5%, the $10, 000 will amount to $10, 500 in a year
• This is the future value of $10, 000
• FV (X) = X(1 + i), where i is the annual risk-free rate of interest
Method 2: Present Value Analysis

• Compare its current value with the current value of the alternative of investing in risk-free
bills
• If risk-free interest rate is 5%, the $11, 000 at t = 1 is same as having $10, 476 = (11,
000/1.05) now
• This is the present value of $11, 000
• PV (Y ) = Y/ 1+i , where i is the annual risk-free rate of interest
Y$ you will receive in future.
Method 3: Net Present Value Analysis

• Compute present value of all benefits and costs and sum them to compute the net present
value (NPV)
• Choose a project with highest NPV
• NPV = PV (benefits) − PV (costs)
Adopt project if NPV is positive, or if it has highest NPV

Diagram - shows discounting of 11000 to the present value.
PV(B)=10476
PV(C)=10000
NPV = 476
Future Value – multiple periods
• Compare it with the alternative of investing in risk-free bills
• Let
– risk-free interest rate, i
– number of years, n
– initial investment, X
• With simple interest: FV (X) = X(1 + ni)
• With compound interest: FV (X) = X(1 + i) n
• Compound interest factor = (1 + i) n • It is the value of $1 after n years with interest rate i
compounded annually
Depends on type of interest.

X t=0
Xi -> X(1+i) t=1
Xi^2 t=2
To show how to get formula
Present Value – multiple periods

• Compare its current value with the current value of the alternative of investing in risk-free
bills
• Let
– risk-free interest rate, i
– number of years, n
– future investment, Y
• With compound interest: PV (Y ) = Y /(1 + i) ^n
• Present value factor or discount factor = 1 /(1+i) ^n
• It is the present value of $1 received after n years with compound interest rate of i
Discounting
• Discounting is the process of computing present value of a future amount
• FV = PV (1 + i) n
• PV = FV /(1+i) n
If Bt is the benefit after t years where t = 0, 1, · · · , n, then

PV (B) = B0 /(1 + i) ^0 + B1 /(1 + i) ^1 + B2 /(1 + i) ^2 + · · · + Bn /(1 + i) ^n
• If Ct is the cost after t years where t = 0, 1, · · · , n, then
PV (C) = C0 /(1 + i) ^0 + C1 /(1 + i) ^1 + C2 /(1 + i) ^2 + · · · + Cn /(1 + i) ^n
Benefits and costs happening at the end of the year in formula.

Net present value of a project is equal to the sum of present value of net social benefits
E = aggregate.
Net benefit in year t = Bt - Ct
NSB = net social benefits
Diagram showing PVs on timeline generated from costs and benefits. Different approaches
illustrated - should get same answer from both.
Comparing projects with different time frames

• Projects should always be compared over the same discounting period
• Consider project A lasting for 75 years with NPV of $40 million versus project B lasting for
15 years with NPV of $25 million.
• Is project A preferable as its NPV is larger?
• No. The are not directly comparable
• Project A is comparable to 5 back-to-back project B
Real versus Nominal Dollars

Benefits and costs across years are expressed in same units (for example, in dollars)
• This is referred to as nominal dollars
• However, we know that a $10 bill in 1900 had more value than a $10 bill in 2020
• This is because of price inflation
• Purchasing power decreases with price inflation
• To account for inflation, we need to convert nominal dollars into real dollars
A Deflator is used to convert nominal dollars into real dollars
• It is a measure supposed to capture the extent of price inflation across range of goods and
services
• It is based on the market price of a basket of goods and services purchased by consumers
• For example, Consumer Price Index - Urban (CPI-U) is a commonly used deflator for US-
based CBA studies
• CPI-U of year t is the ratio of income needed to purchase a standard basked of good in
year t to the income needed to purchase the same (or similar) basket in the base year
(1982-1984)
• If CPI in 2020 is 300, it means that we need 3 times more money than needed in 1982-84
to buy a similar basket of goods
• real dollars in base year = nominal dollars in year a /CPI of year a × 100
• Can you think of any potential problems in using CPI?
– substitution effect
– discount stores effect
– ”new goods” problem
Even though income doubles cannot buy double the amount of goods, comparing nominal to
real values = how much you can really buy with your income.
Convert nominal to real need a deflator.
Prices of basket of goods and services = prices change over time.
What income you need next year to buy the same basket of goods - ratio of the two incomes
is deflator.
Substitute for less expensive goods when there is inflation - substitution effect
CPI does not take into account consumers change their basket of goods
When prices increase - go to other supermarkets with discounts - discount stores effect.
Basket itself changes over the years - quality of products increase for instance - safer
products - new products such as phones and ipads everyone uses now.
Discounting using real or nominal dollars

• Use either real or nominal dollars
• Depending on that discount using real or nominal interest rate
• Important to be consistent
• To convert nominal costs and benefits into real dollars, we need expected inflation rate m
• Real cost or benefit = Nominal cost and benefit/ (1+m) ^t
• Let i = nominal interest rate and m = expected inflation rate
• Can you derive a real interest rate in terms of i and m?
r = i−m/ 1+m
Sensitivity analysis in discounting

• We assumed the discount rate is known to the analyst
• Difficult to determine
• Important to perform sensitivity check of the NPV with respect to the value of discount rate
Diagram X axis real discount rate Y axis NPV showing IRR points as real discount rate
increases NPV decreases - negative slope - cost at t=0 benefits come after.
As the discount rate increases - give less weight to the worth of the project.
At IRR you are indifferent between taking the project or not.
The social discount rate

Let wt be the weight we want to assign to impacts of tth year
wt : social discount factors

• Weights help in comparing benefits and costs that are realized in different times
Usually,
• SDR : real social discount rate
• Why discounting?
1. possibility of investing
2. Impatience
Specific case:
Wt is directly proportional to wt-1

Weights are decreasing over time.
Shown in diagram with 3 lines red, yellow and green. Geometrically decreasing over time.
When the discount rate is high, the graph is steeper. Higher value, more impatient - less
value on things in the future. Patient = red - impatient = green
Example - table project ABC initial investment 80000 5 years; A benefit is uniformly
distributed B - big benefit in the beginning and little payments after C- no benefit till year 5.
Computed NPV for different discount rates - Highest NPV is C for 2%
Highest NPV is B for 10% - more impatient at 10 %
When is there no doubt about the SDR?

• Policy makers aim to maximise social welfare
• Social welfare is driven by consumption
• Individuals tend to prefer consuming today than to consuming same thing in future
• Preference for now as compared to later is known as time preference
• Marginal rate of time preference (MRTP): rate at which individuals trade-off consumption at
t versus at t + 1
• Consumers’ MRTP can help in determining appropriate SDR
Maximise social welfare use MRTP as discount rate

Example = need 20% extra income to be indifferent between two options
Reduced gap between present and future income MRTP is now below 20% - would prefer to
have 1200 later - less indifferent
MRTP and interest rate

• If consumers are free to take loan, they will adjust their consumption from future to present
until their MRTP equals market interest rate i
• If MRTP > i: borrow now and shift consumption from future to now
• If MRTP < i: save now, invest and consume in future
• If market is efficient and borrowing is unrestricted, consumers will adjust their MRTP until it
is equal to i
• If everyone has MRTP equal to interest rate, we can use i as the discount rate

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Cost Benefit analysis L5

Discounting Future Impacts

Discounting 1 period - diagram

Method 1: Future Value Analysis

Method 2: Present Value Analysis

Y$ you will receive in future.

Method 3: Net Present Value Analysis

Adopt project if NPV is positive, or if it has highest NPV

Depends on type of interest.

Present Value – multiple periods

If Bt is the benefit after t years where t = 0, 1, · · · , n, then

Benefits and costs happening at the end of the year in formula.

Comparing projects with different time frames

Real versus Nominal Dollars

Discounting using real or nominal dollars

Sensitivity analysis in discounting

The social discount rate

wt : social discount factors

Wt is directly proportional to wt-1

When is there no doubt about the SDR?

Maximise social welfare use MRTP as discount rate

MRTP and interest rate

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