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AStudent'sGuidetoCostBenefitAnalysis

AStudent'sGuidetoCostBenefitAnalysisforNaturalResources
Lesson5ProjectSelectionCriteria

Introduction
Wehaveintroduceddiscountedcashflowanalysis.Wewillexamineinvestmentcriteriaforselectinga
project(i.e.,formulae):NetPresentValue(NPV),BenefitCostRatio(B/Cratio),InternalRateofReturn
(IRR)andforprojectsofunequallength(i.e.,EquivalentAnnualNetBenefitsandCommonMultiplesof
Duration).
NetPresentValueCriterion
TheNetPresentValue(NPV)criterionistheprincipalgovernmentinvestmentprojectevaluationcriterion.
Thecashflowsconsistofamixtureofcostsandbenefitsoccurringovertime.Netpresentvalueismerelythe
algebraicdifferencebetweendiscountedbenefitsanddiscountedcostsastheyoccurovertime.(Youmust
thinkofthetermsAnetpresentvalue@andAnetpresentbenefits@asbeinginterchangeable.)Theformula
forNPVis:

Where:NPV,t=year,B=benefits,C=cost,i=discountrate.
Twosampleproblem:
Problem#1)NPVroadrepairproject5yrs.i=4%(realdiscountrates,constantdollars)
year=

Benefits

$0

1200

1200

1200

1200

Cost

$3000

500

BC

$3000

1200

1200

700

1200

Disc.Factor

1.04^1=1.04

1.04^2=

1.04^3=

1.04^4=

1.04^5=

1.082

1.125

1.169

1.217

1109.06

1066.67

601.89

986.03

Disc.Annual
CashFlows

$2884.61

SumNPV=$879.04.Q:Goornogo?A:asingleprojectwithapositiveNPVisaAgo.@
Problem#2)NPV,5yrsi=7.8%.Beginsintime=0.
Year=

Benefit

$0

2500

2500

2500

3000

3000

Cost

$10,000

500

500

500

500

500

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Net

$10,000

2000

2000

2000

2500

2500

Disc.
Factor

1.078^0=1

1.078^1=

1.078^2=

1.078^3=

1.078^4=

1.078^5=

1.078

1.162

1.253

1.35

1.45

DiscCash
Flow

$10,000

1855.28

1721.17

1596.17

1851.85

1724.14

SumNPV=($1125.39).Decision:Resultisnegative,hencenogo.
Benefit/CostRatio
MosthaveheardofB/Cratio.Althoughnotthepreferredevaluationcriterion,theB/Cratiodoesservea
usefulpurposewhichwewilldiscusslater.B/Cformula:

Problem#3)Plantgrasstoreclaimastripminesiteanduseforlivestockgrazing.5yearproject,i=10%,
begintime0.
Year=

Benefits

$5000

20000

Disc
Factor

1.1^0=1

1.1^1=1.1

1.1^2=1.21

1.1^3=

1.1^4=
1.464

1.1^5=

PVBen

$3415

$12,422

Cost

$6,000

4000

1000

1000

1000

1000

PVC

$6,000

3636

826

763

683

621

1.331

1.61

Sumbenefits=$15,837
Sumcosts=$12,529
B/Cratio=$15,837/$12,529=1.26.Q:Goornogo?A:forasingleprojectgo.Butwe=llsaymoreonB/C
ratioandmultipleprojectcomparisonslater.
InternalRateofReturn
TheIRRisusedmoreforprivatesectorprojects,butitisimportanttoknow.
IRRisdifferentthanourotherprojectevaluationcriteria.Inourpreviousformula,iwasaknownandwe
solvedforthediscountedcashflows.WithIRR,iistheunknown.IRRistheannualearningsrateofthe
project.
TofindIRRwewanttoknow:Awhatisthediscountrate(i)thatwillequateatimeseriesofbenefitsand
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costs?@Or,otherwisestated:PVB=PVCorwherePVBPVC=0

or

OncetheunknownAi@hasbeendetermined,youcancompareitothebestavailablealternativerateof
return.Ifthecalculatedi(IRR)isgreaterthantheminimumacceptablerateofreturn(MARR)(i.e.,you
won=tacceptanearningratelessthantheMARR)thenyouwillAgo@withyourproject.Note:Calculated
Ai@=internalrateofreturnMARR=externalrateofreturn.
Awordoncomputationaldifficulties:OneproblemwithIRRisthatitcannotbesolvedforinadirect
algebraicfashion.Why?Recallfromalgebra,youneedoneequationforeachunknowninordertosolve.
WithIRRyouhavemoreunknownsthanequations.Thus,youcannotsolvefori.
Hence,IRRmustbesolvedforiniterativeAtrialanderror@fashion.
Procedurefortrialanderror:
1)setupyourannualbenefitsandcostsseparately
2)putinaninitialdiscountrate,discountallbenefitsandcost,
3)examinetoseeifB=C
4)ifnot,repeatcalculationswithanewdiscountrate,
5)repeatcalculationswithanewiuntilBC(tofirstdecimalplace).
IRRProblem#4)Wetakeaseriesofannualcashflows,beginwith7%discountrate:
Year

Cost

$85,000

5000

5000

5000

5000

DiscFact.

1.07

1.14

1.22

1.31

1.4

PVC

$79,439

4385

4098

3816

3571

Benefits

$0

20000

25000

35000

50000

PVB

$0

17534

20491

26717

35714

At7%discountrate:sumPVB=$100456sumPVC=$95309=$5147.
Decision:increaseordecreasei?AifB>C,theincreaseiandtryagainat8%BC=$2710.at9%BC=
$586at9.3%benefits=costs,thusIRR=9.3%
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IRRistheannualearningrateoftheproject.Rule:acceptprojectifIRR>MARR.
ProjectsofUnequalDuration
Thusfar,wediscussedprojectswithoutmuchdiscussionregardingtheprojectduration.
Thedurationofprojectsisimportant,however,whenyouarecomparingalternativeprojects.Therule:you
cannotcomparetheNPVsofprojectswithunequaldurations.Youmustmakesomeadjustmentforduration
tomakethecomparable.
Forexample:
1)projectAis10yrs.w/NPVof$45,000i=6%
2)projectBis15yearsw/NPVof$50,000i=6%
ProjectBwouldseemtobethechoice,butwecannotsaybecausetheyareofunequalduration.Youcannot
compareprojectsofunequalservicelength.
TwoMethodsforComparingProjectsofUnequalLength:
1.EANBcomputeequivalentannualnetbenefits(EANB).EANBrestatesNPVasaseriesofequivalent
annualpayments.Itcomputestheamountneededtopayoffaspecifiedsum(NPV)inaseriesofequal
periodic(e.g.annual)payments.Thus,2AEAprojects@aremadecomparablebecausetheirreturnsare
annualized.Theformula(NPVxAcapitalrecoveryfactor@):

Problem:2projectsA&B.
A:projectNPV=$45,000,t=10,i=6%
B:projectNPV=$50,000,t=15,i=6%
Question:whichoneshouldyouundertake?
BseemsbetterwithhigherNPV,butthe2projectsareofunequallengthsoyoucannotcomparejustyet.You
mustusetheEANBmethod.Workthroughthisexample.YouwillseethatprojectAhasthehighestEANB,
thusisthefavoredproject.

2.CommonMultiplesofProjectDuration:Asecondmethodofcomparingprojectsofunequaldurationisto
computetheNPVusingcommonmultiplesofprojectduration.Sameproblem:
1)projectAis10yrs.w/NPVof$45,000i=6%
2)projectBis15yearsw/NPVof$50,000i=6%
Steps:
1)findthecommonmultipleinyearsofthe2projectlengths(inthiscase30years).
2)commonmultiple=30years.Thus3projectAs=2projectBs
3)forprojectA,theNPVof$45000willcoverthefirst10years.Another$45000willbereceived10years
hence,another$45000isreceived20yearshence.These3projectscoverthe30years.
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4)Discountasfollows:
ProjectA:NPV=$45,000+$45,000/(1.06)10+$45,000/(1.06)20=$84,158
5)ProjectBNPVis$50,000forfirst15years.Another$50,000isreceived15yearshenceandthiscovers
thelast15years.
6)Discount:
ProjectB:NPV=$50,000+$50,000(1.06)15=$70,863
Decision:
ProjectA:NPV=$84,158>ProjectB:NPV=$70,863
Conclude:acceptprojectA.
Q:areEANBandcommonmultiplesmethodsconsistent?Yes,theyareconsistentlyintheirrankingof
projects.

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