ECONOMIC ANALYSIS

Lecture 4

FINANCIAL & MONETARY

ANALYSIS

Time Value of Money

Conceptually, time value of money means that the value of a sum
of money received today is more than its value received after some
time. Conversely, the sum of money received in future is less
valuable than it is today.
In other words, the present worth of a rupee received after some
time will be less than a rupee received today. Since a rupee
received today has more value, individuals, as rational human
beings, would naturally prefer current receipt to future receipts.

Techniques
In order to have logical and meaningful comparisons between cash
flows that result in different time periods it is necessary to convert
the sums of money to a common point in time. There are two
techniques for doing this:
Compounding

F = P (1 + I)n

Discounting

P=

F
(1 i ) n

Techniques (Contd)
Compounding Technique
Interest is compounded when the amount earned on
an initial deposit (the initial principal) becomes part of
the principal at the end of first compounding period.
The term principal refers to the amount of money on
which interest is received.

Evaluation Techniques
Net Present Value Method
Pay Back Method
Internal Rate of Return Method
Benefit Cost Ratio

Net Present Value (NPV)

The NPV method requires that all cash flows be
discounted to their present value, using the firms
required rate of return.
It can be expressed as

NPV
t 0

At
(1 i)

C
0
n

Net Present Value (Contd)

Example

The advantages of the net present value method are that it takes
into account the time value of money, and regardless of the pattern
of cash flows, a Single net present value is easily calculated.

Cash flows from two rural income generation

projects in Rs.:
Year

Project A:

-2,500

1,000

1,500

1,000

Project B:

-2,500

-1,000

2,500

2,000

Net Present Value (Contd)

Project A involves an initial investment of Rs. 2,500 and expected
cash flows for 3 years. Project B requires the same initial
investment, an additional cash outlay of Rs. 1,000 in the first year,
and positive cash flows in the second and third year Suppose the
required rate of return is 10%. Then the NPVs of the projects are:
C P/F, 10, 1

P/F, 10, 2

P/F, 10, 3

NPVA= -2,500+1,000(0.9091)+1,500(0.8264)+1,000(0.7513)= Rs. 400

NPVB= -2,500-1,000(0.9091)+2,500(0.8264)+2,000(0.7513)= Rs. 160

Net Present Value (Contd)

Since the NPV of A is the larger of the two, project A is
the better investment.
When the cost of a project is spread over a number of
years, the net present value of the investment is
obtained as follows:
n

NPV
t 0

At
(1 i )

t 0

Ct
(1 i ) t

Evaluation of NPV
Merits
Recognizes the time value of money
Considers the total benefits arising out of the proposal
over its life-time
A changing discount rate can be built into the NPV
calculation by altering the denominator
Particularly useful for the selection of mutually exclusive
projects
This method of the asset selection is instrumental in
achieving the objective of financial management, which
is, the maximization of the shareholders wealth

Evaluation of NPV(Contd)
De-Merits
Difficult to calculate as well as understand
Calculation of the required rate of return to discount the
cash flows is a complex procedure
This method will favour the project which has higher
present value (or NPV). But it is likely that this project
may also involve a larger initial outlay.
May also not give satisfactory results in the case of two
projects having different effective lives

Payback Period
Number of years required to recover the initial outlay of
an investment.
The payback period is found in two ways: conventionally,
and by discounting the cash flows.
Conventional payback
Discounted payback

QUIZ 1: Payback Period (5 minutes)

Project cash flows ($)
Year
0
1
2
3
4
5

A
-2,400
600
600
600
600
600

Conventional payback (years):

Discounted payback (years)
Net present value(i=10%):

B
-2,400
800
800
800
800
800

C
-2,400
500
700
900
1,100
1,300

Payback Period
Project cash flows ($)
Year
0
1
2
3
4
5

A
-2,400
600
600
600
600
600

B
-2,400
800
800
800
800
800

C
-2,400
500
700
900
1,100
1,300

Conventional payback (years):

4.0

3.0

3.3

Discounted payback (years)

5.4

3.8

4.1

-125

633

867

Net present value(i=10%):

Internal Rate of Return

The method most widely used in evaluating capital
projects is the internal rate of return method, commonly
known as IRR.
The internal rate of return for an investment is the rate of
return (i.e. interest rate) that makes the present value of
the cash flows equal to the cost of the investment.
Mathematically, it is calculated from:
n

C0
t 0

At

(1 r )
t

Internal Rate of Return(Contd)

where C0 is the initial capital outlay, At is the cash flow in
period t, and r is the internal rate of return, IRR, of the
investment.
The initial investment is $100,000, and the expected
cash flow is $30,000 annually for 5 years then

30,000 30,000 30,000 30,000 30,000

100,000

2
3
4
5
(1 r ) (1 r ) (1 r ) (1 r ) (1 r )
or

100,000 30,000

P / A, r , 5

Internal Rate of Return(Contd)

In other words, what interest rate makes the right side of
the equation equal to the left side ? The unknown we
must solve for is the P/A factor.

100,000
P/ A
3.3333 for , n 5, r ?
30,000
From the interest rate table interest rate is between 15%
and 16%. 15.175% or about 15.2%. Note that if the cash
flows were discounted at 15.2%, the NPV of this
investment would be zero.

Internal Rate of Return Method

Consider the time value of money
In the case of the present value method, the discount rate is the
required rate of return and being a pre-determined rate, usually the
cost of capital, its determinants are external to the proposal under
consideration
The IRR on the other hand, is based on facts which are internal to
the proposal of the project
IRR depends entirely on the initial outlay and the cash proceeds of
the project which is being evaluated for acceptance or rejection. It
is, therefore, appropriately referred to as internal rate of return.

Evaluation of IRR
Merits
It considers the time value of money
It takes into account the total cash inflows and outflows
The IRR is easier to understand
It does not use the concept of the required rate of return
(or the cost of capital)
It is consistent with the over-all objective of maximizing
shareholders, wealth

De-Merits
It involves tedious calculations
It produces multiple rates which can be confusing

Benefit - Cost Ratio

Benefits - Disbenefits - Cost
Investment
Benefits
Costs

Benefit-cost analysis of three mutually

exclusive proposals
A group 0f 600 summer-home owners on the
Atlantic coast of the United States is concerned
with the erosion of the shoreline and periodic
flooding of their properties from the ocean. They
engaged a consultant engineer to conduct a
feasibility study to solve their problem. After
establishing the objectives of the home-owners
and the physical and zoning constraints of the
area, the engineer prepared the following three
proposals:

a) Reconstruct the shoreline and provide all

necessary protection measures to prevent erosion for
20 years at a cost of $350,000. In return the
insurance company would reduce its annual premium
to each home-owner by an average amount of $100.
b) Combine the work of Proposal (a) with the
construction of a beach suitable for swimming and
sunbathing and construct a refreshment stand and
toilet facilities at a total cost of $500,000. The
expected annual income from the refreshment stand
would be $30,000 and the maintenance cost of the
beach $10,000 per year.

c) Combine the work of Proposal (b) with the

construction of a beach suitable for swimming
and sunbathing and construct a cafeteria, toilet
facilities, and a parking lot to accommodate
twice as many people as Proposal (b) and
charge the non-residents an entrance fee, at a
total cost of $950,000. The estimated annual
income from the restaurant concession plus the
entrance fees would be $80,000. The annual
cost of operation and maintenance of the beach
would be $35,000.

Proposal (a)
Benefits:
PV of savings from
insurance premiums

P/A, 10, 20
$100 (600)(8.5136)

Costs:
PV of capital investment

= $ 510,816

= $350,000

Proposal (b)
Benefits:
PV of savings from
premiums
PV of income from
concession

= $ 510,816
P/A, 10, 20
$30,000 (8.5136)

= $ 255,408

Disbenefits:
Increased noise and air
pollution for homes near
beach

Costs:
PV of operation and
maintenance

N.Q.

$10,000 (8.5136)

PV of capital investment

= 85,136
= 500,000

Proposal (c)
Benefits:
PV of savings from
premiums
PV of income from
concession and fees

= $ 510,816
P/A, 10, 20
$80,000 (8.5136)

= $ 681,088

Disbenefits:
Increased noise and air
pollution for homes near
beach
Increased traffic through the
area
Costs:
PV of operation and
maintenance
PV of capital investment

N.Q.
N.Q.

$35,000 (8.5136)

= 297,976

= 950,000

BCR = B-D-C
I
Proposal (a):

BCR = $510,816 = 1.46

$350,000

Proposal (b):

BCR = $766,224-$85,136 = 1.36

500,000

Proposal (c):

BCR = $1,191,904-$297,976 = 0.94

950,000

Benefits and costs of upgrading power substation

(amounts in 1975 dollars).
Capital investment
$500,000
Economic life
Appropriate discount rate
Case 1:
Reduction in recurring annual costs:
Maintenance personnel compensation

25 years
10%

Operation costs
Case 2:
Total recurring annual benefits
from elimination of blackouts

$10,000

$20,000

$30,000

Source: U.S. Naval Facilities Engineering Command, Economic

Analysis Handbook, 1978, pp. 53-4.

Case 1: Direct savings increase

A naval base has experienced repeated blackouts due to
outmoded and over-loaded transformer transmissions. A
technical feasibility study recommends that the only
alternative is to upgrade the power substation because
the local power company is unable to provide the power
required by the base. Although this is the only alternative
possible, the Public Works Officer recognizes certain
benefits potentially occurring from this project and has
decided to do a benefit-cost analysis.
The estimated cost of upgrading the power substation is
$500,000 for an economic life of 25 years. The result will
be a reduction in maintenance costs by eliminating two
positions costing the navy, in salary and fringe benefits,
$10,000 per person/year. Operating costs will decline by
$10,000 per year.

In this case, the benefit-cost ratio is:

BCR =

$30,000
=
$500,000 (0.1102)

0.55

The ratio indicates that the project amortizes 55% of its

investment in savings relative to the current operations
over its anticipated economic life.
The information is useful for decision making, even
though it is the only alternative available.

Case 2: Efficiency

or productivity increase

The public works planners at the naval base of the previous case
have identified additional efficiency or productivity benefits
occurring from the upgrading of the power substation.
Since the existing substation serves the industrial area of the base,
every time a power blackout occurs most industrial functions of the
base come to a standstill. An officer conducted a time and motion
study to determine the impact of blackouts on industrial output.
The study revealed that the economic impact of industrial downtime
due to blackouts averaged 2.5 man-years per year. Given the
existing work backlog, by eliminating the recurring blackouts, the
upgrading of the substation would provide an additional 2.5 manyears of industrial capacity with no increase in personnel. The value
of this benefit is equal to the cost of hiring additional workers to
provide 2.5 man-years of work per year at $12,000 per worker or
$30,000 per year.

Using the annual equivalent formulation of the

benefit-cost ratio,
BCR=

$60,000
$500,000(0.1102)

1.09

.
The benefit-cost ratio indicates that the value of the
proposed project's benefits is $1.09 per dollar
invested.

Table 11.5 Benefits and costs of construction alternatives for naval

facility (amounts in 1975 dollars).
Item

Capital investment

Modify
Demolish old and
existing
construct new
hangar space
hangar space
$2,000,000
$2,600,000

Appropriate discount rate

10%

10%

Recurring annual costs

(personnel, 0 & M, etc.)
Benefit/output (maintenance
jobs performed)

$100,000

$85,000

300/year

375/year

Expected economic life

25 years

25 years

Source: U.S. Naval Facilities Engineering Command, Economic

Analysis Handbook, 1978, pp. 55-4.

Case 3: Quantifiable output measure

Due to a proposed regional consolidation, the Naval Air Rework
Facility at a Naval Air Station has been assigned the responsibility
of providing all the corrosion-control maintenance for Atlantic Fleet
P-3 Orions in the Northeast. The public works planners have
undertaken a detail feasibility and concept study and have
determined that there exist only two reasonable alternative methods
of satisfying this operational requirement:
(a) Modify existing non-used hangar space to accommodate the
corrosion-control function.
(b) Demolish old hangar space and construct new, highly efficient
semi- automated corrosion control facility.
The appropriate basis of comparison for the two alternatives is the
ratio of annual output benefits to annual equivalent costs:

Modify hangar: BCR=

New hangar:

BCR=

300 jobs
$2,000K (0.1102) + $100K
375 jobs
$2,600K (0.1102) + $85K

=0.94
=1.01

Notice that even if both ratios were less than unity, the alternative
with the larger BCR is acceptable, because the benefit output per
equivalent annual, dollar expended is higher for the new facility. In
this case the BCR ranks the alternatives in terms of completed
maintenance jobs per year per $1,000.

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