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Introduction
Private sector test for a project investment is Invest if Present Value of the investment > 0,
where present value is given by the formula:
PV = (Rt-Ct)/(1+dt)t
t
with
indicating the sum over time (t) for the length of the projects time horizon,
th
R being the revenue generated by the project in the t time period, (or for public investments B
t
for benefits),
th
C being the costs generated by the project in the t time period, and
t
th
d being the discount rate (%), the cost of funds invested in the project in the t time period.
t
Public sector investment decisions are more complicated (and sometimes made more
complicated than they should be) because:
Interest rates that are normally quoted in the marketplace are nominal rates that
compensate investors for both the use of their funds and the loss of purchasing
power associated with inflation. The relationship is the following:
.
(1+ n) = (1+r) (1+ p )
where n is the nominal rate of interest,
r is the real rate of interest, and
.
p is the inflation rate,
all expressed as a percentage.
Thus if funds cost 6% in the marketplace and the rate of inflation is 2%, the real
rate of interest can be calculated (1.06/1.02 = 1.039) as 3.9%. (Note that for small
values only, a reasonably close estimate of the real rate can be obtained by
subtracting the inflation rate from the nominal or market rate.)
If the inflation rate is expected to vary substantially over the time horizon of the
project and/or vary significantly between major cost and benefit items, then price
changes should be worked into the cost-benefit calculation with estimates of
future (current) dollar values and the nominal rate(s) of return being employed.
E. The Discount Rate
In a private sector cost-benefit analysis, the discount rate is the cost of funds,
often the cost of borrowing through a bond or debenture issue or, for smaller
amounts, a bank loan. Firms may sell equity (shares) to finance projects,
especially small start-up firms; the cost of such funds involves the loss of some
share of future earnings for current owners and is thought to be the most
expensive financing method. Going concerns may use retained earnings (the
share of profits not distributed as dividends to owners); this may be the cheapest
financing method.
In the public sector, major projects are typically financed by government debt
(usually at rates somewhat below corporate borrowing costs in the market) and by
tax revenue (perhaps foregoing a tax reduction or a pay-down of existing debt).
Crown corporations may have some retained earnings but usually their borrowing
costs are the same as the governments and the retained earning are employed at
the expense of increased government revenue.
Alternative theories of the discount rate for public sector projects:
Use the social rate of time preference (Marglin) the premium that
society requires to defer a dollars worth of consumption to next year.
The argument is that private investors are myopic, not considering the
interests of future generations. More interested in near-term returns they
discount future benefits more heavily than they should. Thus concerns
for future generations are not reflected in the market rates of interest.
Governments should consider future generations and, therefore, use a
discount rate that is less than the market rate of interest. The difficulty is
determining this social rate of time preference: how much is it less than
market rates?
Marglin has suggested that a trade-off between these two theories might be
to use the social rate of time preference as the discount rate to avoid the
myopic view but then require a benefit-cost ratio somewhat greater than
one to ensure more efficient uses of capital by the private sector are not
squeezed out. But what ratio is appropriate?
The difficulty with picking and choosing among the various approaches is that the
competing analysts can justify very different conclusions with relatively small
variations in the discount rate. But then this perhaps points to a weakness in this
whole methodology.
F. Decision Criterion
Three competing criteria or tests are often identified for deciding whether a
project or program should proceed or for selecting which eligible projects should
be undertaken:
1) Present value > 0
2) Benefit-cost ratio >1
3) Internal rate of return > the cost of funds.
[ Bt/(1+dt)t] / [ Ct/(1+dt)t]
t
PV = (Bt-Ct)/(1+r) = 0
t
While the rate of return test is often cited as the private sector test, it is in fact flawed. If a
project does not have a stream of early negative net benefits (i.e. costs), followed by a
consistent stream of positive net benefits, then the equation above can have more than
one solution. Regardless, the rate of return test can result in different choices than the
first two, valid rules if the solution, r, differs significantly from the cost of funds, d.
The appropriate rules are the following:
1. If funds are unlimited, or at least sufficient to fund all available projects, then
undertake all that have a present value greater than 0 (or B-C ratio greater than 1).
2. If funds impose a limit, select projects so as to maximize the sum of present
values for the projects undertaken.
Note: if two projects are interdependent and their present values vary depending if they
are done alone or as a pair, then treatment as three separate projects: Project A, Project B,
and the two projects together, A+B.
G. What Constitutes a Benefit and a Cost?
Benefits are new goods, services or amenities created for society by the project.
Costs are opportunity costs, the real goods, services and amenities that have to be
foregone because of the project.
Transfers from one group to another or one geographic area to another within a society
are not benefits or costs. For example, tax receipts or welfare payments simply transfer
the ability to call on a societys resources from one economic agent or group of agents to
another. They are redistribution, not a creation. They should not be included in a costbenefit calculation, although if they advance a social goal such as income equity could be
included in an impact assessment that looks at additional outcomes, i.e. a costeffectiveness analysis.
Thus, benefits may include reduced traffic congestion and time savings from a bridge or
highway or new land created by a dyke or drainage project, but not the savings in
gasoline taxes for motorists in the first example or new property taxes received by a
municipality in the second.
Analysts should take care not to fall into the trap of double-counting benefits, e.g., a dyke
may generate anticipated reductions in property damage from averted flooding, which
can be estimated. But the benefits ought not to also include savings on insurance
premiums for affected home-owners and increases in home values, as well.
As well, benefits and costs are those associated directly with the project: if the dyke
creates new land that can be built upon, include the increase in land values but not the
costs and benefits of subsequent construction those come from a different project.
Also, the incomes of those employed on the project are not a benefit (they are costs!)
unless they would have been otherwise unemployed. But dont both discount the cost
(see above) for the employment of previously unemployed and include their income
thats double-counting again. Similarly, use of a multiplier to calculate income benefits
generated by successive rounds of spending from the direct spending on the project is
inappropriate unless the services employed in second, third, etc. rounds of spending
would also have been significantly unemployed.
H. Point-of View
When multiple levels of government are involved in funding a project, the more local
governments are often tempted to treat funding from the other government(s) as free, i.e.,
not a cost. This treatment implicitly assumes that the funds would not benefit the citizens
of the local jurisdiction except through the project being evaluated. This is unlikely since
the funds might well be spent on another project within the local jurisdiction, or on a
project in a neighbouring jurisdiction with some benefits for citizens of the local
jurisdiction, or a national project, or if unspent result in lower taxes. As well, this
treatment implicitly assumes that all of the spending will stay in the local jurisdiction: but
what if labour or materials are imported for the project? In addition, more than local
residents may benefit from the project: tourists, commuters from outside the city,
neighbours who benefit from reduced air pollutions, etc.
It is generally preferable to adopt the largest point-of-view reasonable for a project, e.g.
the national perspective if federal funding is involved, and recognize that public funding
comes from all taxpayers within that largest jurisdiction who all have an interest in the
efficiency of public spending.
I. Base-line
A common error in cost-benefit analysis is the failure to employ a consistent base-line for
alternative, competing versions of a project. Analyst should ask: What is the zero, noaction case. Then all alternatives to this case should be examined to identify how costs
and benefits vary from those associated with this base-line case.
J. Cost-Effectiveness Analysis
Cost-benefit analysis is the preferred technique for evaluating public investments since it
allows a single calculation of the efficiency implications of each alternative version of a
project or program.
If it is not possible to quantify or value the quantification of all benefits and costs, then
the analyst may try reasonable estimates and test the extent that the results of the costbenefit analysis vary as these estimates are varied: this is called sensitivity analysis. It
determines how crucial various assumptions or alternative estimates are to the
conclusions of the analysis. If the results are not particularly sensitive to estimates that
have a low confidence level, the analyst can still have confidence in the analysis.
If reasonable estimates cannot be generated or other goals than efficiency are important to
the decisions about a proposed project, then cost-effectiveness analysis in its various
forms should be employed. See Weimer and Vining, ch. 14, especially pp. 338-343 and
p. 351.