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4. Once the dollar values of benefits and costs are compiled for each year,
calculate their present values, using an appropriate discount rate. Then, add up the
present values of annual benefits to determine the total benefits (B) of the project.
Similarly, add up the present values of annual costs to determine the total cost (C).
5. Calculate the total net benefits, called the net present value (NPV), by
subtracting the total cost from the total benefit, i.e., NPV = B – C. Also, calculate the
B
benefit-cost ratio, dividing total benefit by total cost, i.e., B/C ratio = .
C
6. The decision rule is then:
or
B
b. If ≥ 1 , implement the project. Else, do not implement it.
C
In 1962 the U.S. Congress authorized construction of a number of water projects based
on benefit-cost analyses that used a discount rate of 2.63%. In 1964, two economists, Fox
and Herfindahl, examined the same projects at a discount rate of 8% and found that only
20% of them were feasible.
A researcher who has a vested interest in a project may intentionally choose a discount
rate to make or break the project. Or, even for a neutral researcher it may be difficult to
correctly estimate the social discount rate. Therefore, researchers are often required to do
sensitivity analysis, i.e., to repeat the analysis for different discount rates and to report
whether the conclusion of the analysis changes with a change in discount rate. In some
countries, the government prescribes the discount rate, to avoid the arbitrary choices of
researchers. The Office of the Management and Budget (OMB) in the Unite States
prescribes the discount rate for evaluation of federally funded projects.
- 3.5
IRR is a measure of risk associated with the project, as to how high the discount rate can
go, without making the project infeasible (i.e., without making the NPV negative).
Consider the diagram below. Here, a choice has to be made between two alternative
sizes of a project: Q1 or Q2.
a c
Theoretically, we know that Q* is the optimal or best size, as this size would maximize
the total net benefit possible from the project. But, assume that this size is not available
for some reason. The available sizes are Q1 and Q2. We know from economic theory that
Q2 is better, as it is closer to the efficient size Q*. The total net benefit (NPV) of Q2 is
Area (a + c), whereas the total net benefit (NPV) of Q1 is Area a; the NPV of Q2 exceeds
that of Q1.
NPV of Q1 size = B - C = (a + b) - b = a
NPV of Q2 size = B - C = (a + b + c + d) - (b + d) = a + c
But, if the B/C ratios of the two sizes are compared, it turns out that B/C ratio of Q1 is
higher than that of Q2:
a + b a
B/C ratio of Q1 size = = 1 + > 1
b b
1
Wouldn't it be better if the project recovered $70 in the first year and $30 in the second year, instead of
$30 in the first year and $70 in the first year?
(a + b ) + (c + d ) a + c
B/C ratio of Q2 size = = 1 + > 1
b + d b + d
a a + c
Both projects have B/C ratio higher than 1, but note that > , because c < d (see
b b + d
the diagram). To summarize, it is safer to use NPV, instead of B/C ratio, to compare
mutually exclusive projects.
VII. Use Incremental IRR, not IRR, for mutually exclusive projects
Similar to B/C ratio, use of IRR for comparison of mutually exclusive projects can be
misleading. Consider the diagram below.
+ NPV Project A
B
Project B
Let Project A and Project B be two mutually exclusive projects, with AA and BB their
respective NPVs at different discount rates. As can be seen from the above figure, the
IRR of Project A is a and that of Project B is b. Project B has a higher IRR (b > a); yet, it
should not be considered necessarily better than Project A. If the true social discount rate
were f (less than e, the point of intersection of the two NPV curves), Project A would
yield a larger NPV than Project B; in this case, Project A would actually be considered
better. But, if the social discount rate were higher than e, Project B would yield a higher
NPV and hence would be better than Project A. Thus, comparing mutually exclusive
projects based on IRR can be misleading. Instead, use incremental IRR, which is the
discount rate at which the incremental benefit of a higher investment alternative (over
and above the lower investment project) is equal to its incremental cost. In other words,
to compare Project Q2 with Project Q1, find the discount rate at which the incremental
benefit of Q2 become equal to the incremental cost of Q1. Suppose that happens at
discount rate s; if this incremental IRR is above the true social discount rate r, then
Project Q2 should be preferred over Q1.