(C&B Ch. 2, 3 Dof Ch. 4 FP Ch. 3, 4, 5) 1

Basic Concepts In Project Appr
[C&B Ch. 2, 3; DoF Ch. 4; FP Ch. 3, 4, 5] 1.

[C&B Ch. 2, 3; DoF Ch. 4; FP Ch. 3, 4, 5] 1. 2. Which Investment Criterion?

[C&B Ch. 2, 3; DoF Ch. 4; FP Ch. 3, 4, 5] 1. 2. 3. Which Investment Criterion? Investment Decision Criteria

[C&B Ch. 2, 3; DoF Ch. 4; FP Ch. 3, 4, 5] 1. 2. 3. Which Investment Criterion? Investment Decision Criteria Net Present Value
Annual User Charge / Value On Completion / Annual Value / Annuities
4.

4. 5.
Internal Rate of Return

4. 5. 6.
Internal Rate of Return B/C Ratio

4. Internal Rate of Return 5. B/C Ratio 6. Payback Period 7.

4. Internal Rate of Return 5. B/C Ratio 6. Payback Period 7. Ination 8.

4. Internal Rate of Return 5. B/C Ratio 6. Payback Period 7. Ination 8. Income Tax 9.

4. Internal Rate of Return 5. B/C Ratio 6. Payback Period 7. Ination 8. Income Tax 9. Discount Rates for Public- and Private-Secto 10.

4. Internal Rate of Return 5. B/C Ratio 6. Payback Period 7. Ination 8. Income Tax 9. Discount Rates for Public- and Private-Secto 10. Consistency of Horizon/Residual Value 11.

4. 5. 6. 7. 8. 9. 10. 11.
Internal Rate of Return B/C Ratio Payback Period Ination Income Tax Discount Rates for Public- and Private-Secto Consistency of Horizon/Residual Value Capital Rationing
1. Which Investment Criterion?

[L 2.3] Net Present Value: b(t ) c(t ) K, NPV = t t =0 (1 + r )
T
whereNPV = net present value from proje
b(t ) = benets ($) received from pro
c(t ) = costs ($) of project in year t 1 = discount factor at interes 1 + r (t ) T = lifetime of project K = initial (capital) outlay at t = 0
Questions: (These issues will take several lectures.) 1.
Questions: (These issues will take several lectures.) 1. 2.
Which benets b and costs c to inclu
Questions: (These issues will take several lectures.)
1. Which benets b and costs c to inclu 2. How are they to be valued? (i.e. shad prices?) 3.
1. Which benets b and costs c to inclu 2. How are they to be valued? (i.e. shad prices?) 3. At which rate(s) r to discount? 4.
1. Which benets b and costs c to inclu 2. How are they to be valued? (i.e. shad prices?) 3. At which rate(s) r to discount? 4. Which investment criterion to use?
2. Investment Decision Criteria
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3.
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1 Annual User Charge. 3.2
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1 Annual User Charge. 3.2 Value on Completion. 3.3
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1 Annual User Charge. 3.2 Value on Completion. 3.3 Annuity Values.
4.
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1 Annual User Charge. 3.2 Value on Completion. 3.3 Annuity Values. 4. Internal Rate of Return (IRR). 5.
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1 Annual User Charge. 3.2 Value on Completion. 3.3 Annuity Values. 4. Internal Rate of Return (IRR). 5. Benet/Cost Ratio (B/C). 6.
[C&B pp.4153; DoF Ch. 4, App. III; FP C 3. Net Present Value (NPV). 3.1 Annual User Charge. 3.2 Value on Completion. 3.3 Annuity Values. 4. Internal Rate of Return (IRR). 5. Benet/Cost Ratio (B/C). 6. Payback Period.
Opportunity Cost again ...
The basis for decisons must be opportunit or the value of options forgone.
Neither IRR nor B/C can be adequately use choose between two mutually exclusive pro
In general, we want to compare two (or mo projects and choose one (mutually exclusiv
Consider two projects, A and B.
Each costs $100 in year 0. Project A returns n year 1, and $121 in nal year 2. Project B retur in nal year 1, and nothing thereafter.
Project A Project B
Year 0 $100 $100
Year 1 0 $115
Year 2 $121 0
Project A Project B
Year 0 $100 $100
Year 1 0 $115
Year 2 $121 0
At a zero discount rate, Project A is more attract
Project A Project B Year 0 $100 $100 Year 1 0 $115 Year 2 $121 0
At a discount rate of 5.2% pa the two projects ar
attractive (and have a positive NPV).
attractive (and have a positive NPV). At a discount rate of 10% pa Project A has an NP its IRR is 10% pa. Why?
attractive (and have a positive NPV). At a discount rate of 10% pa Project A has an NP its IRR is 10% pa. Why? At a discount rate of 10 Project B has a positive NPV.
attractive (and have a positive NPV). At a discount rate of 10% pa Project A has an NP its IRR is 10% pa. Why? At a discount rate of 10 Project B has a positive NPV. At a discount rate of 15% pa Project B has an NP its IRR is 15% pa. Why?
attractive (and have a positive NPV). At a discount rate of 10% pa Project A has an NP its IRR is 10% pa. Why? At a discount rate of 10 Project B has a positive NPV. At a discount rate of 15% pa Project B has an NP its IRR is 15% pa. Why? At a discount rate of 15 Project A has a negative NPV.
So, choose Project A if the market rate is less than Project B otherwise, if the criterion is maximizing th Choose Project B if the criterion is maximizing IRR 20 NPV 10 0 NPV B NPV A 0 5 10 15 Discount rate r %
10
Find r 1 where two projects have equal NPV by solv NPV A (r 1 ) = NPV B (r 1 ): r 1 = 5.2%
115 where NPV B = 100 + and NPV A = 100 1+r
3. Net Present Value
[C&B pp.4143; DoF Ch. 4; L. 2.3; FP
Calculate NPV (or NPB) of each project usi (the appropriate market rate or ratesthey vary through timeof return) (Using the fo Lecture 3-2, above.)
3. Net Present Value
[C&B pp.4143; DoF Ch. 4; L. 2.3; FP
Calculate NPV (or NPB) of each project usi (the appropriate market rate or ratesthey vary through timeof return) (Using the fo Lecture 3-2, above.)
if NPV
> 0 then the project is OK = 0 indifferent < 0 then the project is not OK, be return (the appropriate marke is higher than the return from project. The opportunity value negative.
Many projects?
If there are many projects, mutually exclusi there is no budget constraint, then rank by positive NPV > 0 and go with the largest NPV, since this project maximises the size o Yes, if only 1 chosen. No, if can choose several.
Three types of decision: 1.
Three types of decision: 1. accept or reject: accept if NPV > 0 reject if NPV < 0 2.
Three types of decision: 1. accept or reject: accept if NPV > 0 reject if NPV < 0 2. ranking a.
Three types of decision: 1. accept or reject: accept if NPV > 0 reject if NPV < 0 2. ranking a. If no capital budgeting, (or oth rationing), then accept all projects with N b.
Three types of decision: 1. accept or reject: accept if NPV > 0 reject if NPV < 0 2. ranking a. If no capital budgeting, (or oth rationing), then accept all projects with N b. If there is capital budgeting, (S below) then rank: by B/C, not by NPV
3.1 Annual User Charge (AUC)

Concepts:
Opportunity Cost: The opportunity cost of a pr what is forgone by undertaking the project i value of resources in next-best use.

Concepts:
Depreciation (economic): The change (fall) in m value of an asset.

Concepts:
Depreciation (economic): The change (fall) in m value of an asset.
Implicit rental cost: The opportunity cost of ho (owning) an asset. (e.g. a machine) = the implicit rental cost = the sum of: the interest forgone on outlay + depreciation + any operating costs.
(Dont use straight-line depreciation: use annu
Example of Annual User Charge (AUC): Purchase of vehicle.
Bought for $2 Sold at $1 one year later. i = 10% p.a.; costs $0.30 to run for one year
Bought for $2 Sold at $1 one year later. i = 10% p.a.; costs $0.30 to run for one year Interest charge = $2 0.1 = Depreciation charge = $2 $1 = Operating cost = AUC =
Bought for $2 Sold at $1 one year later. i = 10% p.a.; costs $0.30 to run for one year Interest charge = $2 0.1 = Depreciation charge = $2 $1 = Operating cost = AUC = Marginal cost: How much more does it cost to produce unit of output? Average cost: What does it cost per unit of output?
3.2 Value On Completion A project involves:
3.2 Value On Completion
A project involves: cash investment outlays = x t withou receipts over the rst T years of the p
A project involves: cash investment outlays = x t withou receipts over the rst T years of the p followed by net operating revenues x t the operating life of the project repres by L (t from T + 1 to T + L)
A project involves: cash investment outlays = x t withou receipts over the rst T years of the p followed by net operating revenues x t the operating life of the project repres by L (t from T + 1 to T + L)
The NPV of the project can be assessed as x1 x2 xT ... NPV 0 = x 0 2 1 + r (1 + r ) (1 + r )T xT +1 xT +L ... + + + T +1 (1 + r ) (1 + r )T +L
VOC Criterion.
An equivalent but simpler method is to com the Value On Completion (VOC): VOCT = x 0 (1 + r )T + x 1 (1 + r )T 1 + . . . + xT
That is: accumulate forward your investme outlays at the cost of capital, to the last dat which the completed project costs.
VOC Criterion.
An equivalent but simpler method is to com the Value On Completion (VOC): VOCT = x 0 (1 + r )T + x 1 (1 + r )T 1 + . . . + xT
That is: accumulate forward your investme outlays at the cost of capital, to the last dat which the completed project costs.
Then: Compare VOCT with NPVT , where bo evaluations refer to the same date. So we compute: xT +1 xT +2 xT +L ... + NPVT = + + 2 1 + r (1 + r ) (1 + r )L
VOC Criterion: NPVT VOCT NPV 0 = > 0 if NPVT > VOCT T (1 + r ) Note:
VOC Criterion: NPVT VOCT NPV 0 = > 0 if NPVT > VOCT T (1 + r ) Note:
Accept the project if the VOC is less than o to the NPV of cash ows over the operating the project. Moreover,
VOC = Direct Capital Outlays + Interest During Co
Example 1 of VOC:
$1 is outlaid at the beginning of each of 3 p (T = 2). The asset operates for two years, y a net revenue stream of a (L = 2). The discount rate r = 10% p.a. Diagrammatically:
VOC 2 T=0 1 T=1 1 T=2 1 NPV 2 a T=3 a T=4
Calculating various values, forwards and b
NPV 0 VOCT =2 NPVT =2
1 1 a = 1 + + 2 3 (1. 1) (1. 1) (1. 1) (1. = (1. 1)2 + 1. 1 + 1 = 1.21 + 1.1 + 1 a 2. 1a a + = = 1.736a = 2 2 (1. 1) 1. 1 (1. 1)
1 1 a = 1 + + 2 3 (1. 1) (1. 1) (1. 1) (1. = (1. 1)2 + 1. 1 + 1 = 1.21 + 1.1 + 1 a 2. 1a a + = = 1.736a = 2 2 (1. 1) 1. 1 (1. 1) Is VOCT =2 < NPVT =2 ?
1 1 a = 1 + + 2 3 (1. 1) (1. 1) (1. 1) (1. = (1. 1)2 + 1. 1 + 1 = 1.21 + 1.1 + 1 a 2. 1a a + = = 1.736a = 2 2 (1. 1) 1. 1 (1. 1) Is VOCT =2 < NPVT =2 ?
Accept if 3.310 < 1.736a, or if a > 1.9072.
The annuity equivalent of VOCT =2 = 3.310 is 1.9072. Hence the net revenue must excee a > A.
Example 2 of the VOC Approach The (early 90s) Very Fast Train (VFT):
Investment Outlay: $900m p.a. for each of 5
Cost of capital (assume 9.06% p.a.) (from d of CRIF, AGSMs Centre for Research in Fin Direct capital cost Value On Completion Annual User Charge
= $4.5 billion = $5.393 billion ( return on cap = $591 m p.a. (20
($5.393 bn is the present value of an annuit $591 m over 20 years.)
The VFT continued ...
Operating and maintenance costs = $218m
Total annual costs = $591 + $218 m = $80
Equivalent to 6 million passengers each p $129 per trip. NPV when rst dollar is outlaid is zero.
The VFT continued ...
Operating and maintenance costs = $218m
Total annual costs = $591 + $218 m = $80
Equivalent to 6 million passengers each p $129 per trip. NPV when rst dollar is outlaid is zero.
(So VOC equivalent to NPV (when costs & b are discounted to T = 0). Instead, the VOC costs & benets to a date after investment begun.)
3.3 Annual Value (Equivalent Annuities) [C&B pp.3031; DoF pp.46]
GPB equivalent annuity AB : PV (AB ) = GP GPC AC : PV (AC ) = GPC Benets Costs AB AC
Time
> 0 accept accept/reject: AB AC < 0 reject rank by (AB AC ) But AV: NPV
GPC AC GPB AB
rank by (AB AC )
NPV
Annuities and All That [C&B pp. 313
(1 + r )t 1 FV = F n = F 0 (1 + r )n = F r where FV is the future value of an amount F 0 and discount rate over n periods; where F is an annu over t periods.
When n is innite, we have a perpetuity. In prese terms: Fn PV = (1 + r )n 1 (1 + r )t PV = F r annuity, and PV = PV F = 1 (1 + r )t r F r
pe
4. Internal Rate of Return
[C&B pp.4549; DoF pp.114; L. 2.4; F
IRR is the interest rate which makes the NP project zero.
[C&B pp.4549; DoF pp.114; L. 2.4; F
Example: a cost of $1 now, a return of $1.1 period. 1. 1 NPV = 1 + = 0 at some i , the IRR. 1+i Internal rate of return = 10% = i
[C&B pp.4549; DoF pp.114; L. 2.4; F
Example: a cost of $1 now, a return of $1.1 period. 1. 1 NPV = 1 + = 0 at some i , the IRR. 1+i Internal rate of return = 10% = i xt In general, NPV = = 0 i * = IRR t t (1 + i *) Rule:
[C&B pp.4549; DoF pp.114; L. 2.4; F
Example: a cost of $1 now, a return of $1.1 period. 1. 1 NPV = 1 + = 0 at some i , the IRR. 1+i Internal rate of return = 10% = i xt In general, NPV = = 0 i * = IRR t t (1 + i *)
Rule: undertake the project if its internal ra exceeds the external yield (the market rate)
But not if several and mutually exclusi Note:
But not if several and mutually exclusi
Note: if projects are mutually exclusive, we rank them by their internal rates of ret Why?
Note: if projects are mutually exclusive, we rank them by their internal rates of ret Why? Because the IRR is independent of th or scale of the project: a minute projec have a much larger IRR than a project times bigger: scale-independence.
Note: if projects are mutually exclusive, we rank them by their internal rates of ret Why? Because the IRR is independent of th or scale of the project: a minute projec have a much larger IRR than a project times bigger: scale-independence.
IRR solves for the rate r which makes the p value of net benets equal zero, or GPB(r *) GPC (r *). bt IRR = r * : = t t =0 (1 + r *) includes K 0 )
T T
ct (1 + r *)t , (wher t =0
IRR is compared to the Market Rate
We compare the IRR with r m , the appropria market rate:
if IRR > r m then OK on opportunity co grounds if IRR < r m then not OK if IRR = r m indifferent
If there exist many mutually exclusive proje then rank in terms of their IRRs and go with highest?
IRR is compared to the Market Rate
We compare the IRR with r m , the appropria market rate:
if IRR > r m then OK on opportunity co grounds if IRR < r m then not OK if IRR = r m indifferent
If there exist many mutually exclusive proje then rank in terms of their IRRs and go with highest? No. But there are problems with IRR. (See Luenberger in the Package.)
Criticisms of IRR:
1.
Criticisms of IRR:
1. Lack of uniqueness (may be several IRR 2.
Criticisms of IRR:
1. Lack of uniqueness (may be several IRR 2. Different time proles of costs and bene result in ambiguous ranking. NB:
Criticisms of IRR:
1. Lack of uniqueness (may be several IRR 2. Different time proles of costs and bene result in ambiguous ranking. NB: Neither IRR nor B/C can be adequately u choose between two mutually exclusive Benets 0 investment Costs clean-up
(a common prole) IRR = 4% and 17
5. Benet/Cost Ratio
[C&B pp.4344; DoF pp. 112; FP p. v. of benefits B Calculate the ratio of = o p. v. of costs C bt (1 + r )t t =0 m T ct (1 + r )t + K t =0 m
T
B C
B If C > 1, then the project is OK, according t criterion. NPV B C > 0.
Mutual Exclusivity [C&B pp.4749]
If there are many mutually exclusive projec B rank in terms of C ratio and choose the pro with the largest ratio? No its scale independent.
This doesnt guarantee that NPV is maximi so the best project chosen.
There is, however, a role for B/C when ther capital rationing. (See 11. below.)
5.1 Net Benet Investment Ratio, NBIR, or Protability Ratio [FP pp.8082; C&B p.50] T B OC t t (1 + i )t t =0 NBIR = T IC t (1 + i )t t =0
where: OC t are the projects operating costs in pe IC t are the projects investment costs in pe B t are the benets in period t , i is the appropriate discount rate.
NBIR separates the projects operating costs investment costs, to enable calculation of th operating prot per present-value dollar inve
6. Payback Period
K , implicitly r = 0 bt
[DoF pp. 115; FP C
6. Payback Period
K , implicitly r = 0 bt not necessarily consistent with NPV
[DoF pp. 115; FP C
6. Payback Period
K , implicitly r = 0 bt
[DoF pp. 115; FP C
not necessarily consistent with NPV bias towards projects with front-end r (i.e., if recover costs in t then OK
7. Ination
[C&B pp.6466; DoF pp. 52; L. 2.6; FP Ch.4.9]
(Ination: An increase in the general price level) NPV is invariant to the ination rate!
7. Ination
[C&B pp.6466; DoF pp. 52; L. 2.6; FP Ch.4.9]
(Ination: An increase in the general price level) NPV is invariant to the ination rate! Let R = nominal interest rate i = real interest rate g = rate of ination of all prices 1 + R = (1 + i )(1 + g ) = 1 + ig + i + g R i + g , or i R g .
7. Ination
[C&B pp.6466; DoF pp. 52; L. 2.6; FP Ch.4.9]
(Ination: An increase in the general price level) NPV is invariant to the ination rate! Let R = nominal interest rate i = real interest rate g = rate of ination of all prices 1 + R = (1 + i )(1 + g ) = 1 + ig + i + g R i + g , or i R g . looking ahead: expected ination rate? 1.
7. Ination
[C&B pp.6466; DoF pp. 52; L. 2.6; FP Ch.4.9]
looking ahead: expected ination rate? 1. In NPV analysis we can project price increas future and use nominal interest rate R (curre or 2.
7. Ination
[C&B pp.6466; DoF pp. 52; L. 2.6; FP Ch.4.9]
looking ahead: expected ination rate? 1. In NPV analysis we can project price increas future and use nominal interest rate R (curre or 2. Can forget about future general price increas use real interest rate i . (adjusted for ination 3.
7. Ination
[C&B pp.6466; DoF pp. 52; L. 2.6; FP Ch.4.9]
looking ahead: expected ination rate? 1. In NPV analysis we can project price increas future and use nominal interest rate R (curre or 2. Can forget about future general price increas use real interest rate i . (adjusted for ination 3. We get the same answer in both cases.
Example with Ination:
Cost of $1 now, a real return of $1.10 in one nominal return 1.10 (1+g ). 1. 1(1 + g ) NPV 1 + (nominal) 1+R 1. 1(1 + g ) = 1 + (1 + i )(1 + g ) 1. 1 = 1 + (real) 1+i
If real interest rate i = 10%p.a., then NPV = regardless of ination rate g .
NPV is not a function of the ination rate
8. Income Tax
[FP
If capital income and interest receipts are t rates c and i respectively (with payments deductible), then:
8. Income Tax
[FP
pre-tax interest rate = i
8. Income Tax
[FP
pre-tax interest rate = i post-tax interest rate = i (1 i )
8. Income Tax
[FP
i is used to discount pre-tax cash ow
8. Income Tax
[FP
i is used to discount pre-tax cash ow i (1 i ) to discount after-tax cash ow
Example with Taxes: Taxi Plate Net cash ow real interest rate i tax rates c = i
= $10,000 p.a. pre-ta = 10% p.a. = 50%
Example with Taxes: Taxi Plate Net cash ow real interest rate i tax rates c = i NPV (pre-tax)
= $10,000 p.a. pre-ta = 10% p.a. = 50%
$10, 000 = 0. 1 = $100,000 for a per
Example with Taxes: Taxi Plate Net cash ow real interest rate i tax rates c = i NPV (pre-tax)
= $10,000 p.a. pre-ta = 10% p.a. = 50%
$10, 000 = 0. 1 = $100,000 for a per
NPV (post-tax)
$10, 000 (1 c ) = 0. 1 (1 i ) $10, 000 (1 0. 5) = 0. 1 (1 0. 5) = $100,000 (perpetu
What if the two tax rates are not equal?
Classical tax system versus Imputation sys Suppose: Nominal interest rate R Expected ination rate g Real interest rate i Risk premium on equity Corporate tax rate (nominal effective) Debt:equity split = = = = =
Classical (pre-1987) cost of capital: Pre-tax (nominal) basis: debt + equity 15% + 7% 1 1 15% 2 + 1 39% 2 = 25.5% nominal
since the required 22% nominal return on e grossed up by the corporate tax factor (1
Pre-tax (real) basis: 25.5% 10% = 15.5%
With the Australian tax imputation system dividends (post-1987):
Company tax at the rate of 39% was effecti abolished for Australian taxpaying owners Australian companies, so that the weighted average discount rate (nominal) is: 15%
1 2
+ (15% + 7%)
1 2
= 18.5% nomin
8.5% real (for such a personal inves
9. Discount Rates for Private (and Sector Projects:

Four concepts: [C&B pp.112113, 221229; DoF 1.

Four concepts: [C&B pp.112113, 221229; DoF 1. 2.
Social Rate of Time Preference (SRTP) peoples valuation of the future (consumpt

Four concepts: [C&B pp.112113, 221229; DoF 1. 2. 3.
Social Opportunity Cost of Capital (SOCC) competing investments

Four concepts: [C&B pp.112113, 221229; DoF 1. 2. 3. 4.
Project-specic use Capital Asset Pricing Model for th

Project-specic use Capital Asset Pricing Model for th Cost of Funds debt borrowing equity owning (See the example in 8 on Tax above.)
5.

Project-specic use Capital Asset Pricing Model for th Cost of Funds debt borrowing equity owning (See the example in 8 on Tax above.) Special Cases
5.
9.1 Social Rate of Time Preference (SRTP)
Societys preference for present consumpt versus future consumption. or:
9.1 Social Rate of Time Preference (SRTP)
Societys preference for present consumpt versus future consumption. or: the additional future consumption re to exactly compensate for postponem a unit of present consumption now. SRTP individuals RTP necessarily
Estimating SRTP:
The exchange of government bonds b
Estimating SRTP:
The exchange of government bonds b long term (up to 50 years)
Estimating SRTP:
The exchange of government bonds b long term (up to 50 years) certain nominal costs and returns: say, buy at $100, receive $110 after
Estimating SRTP:
The exchange of government bonds b long term (up to 50 years) certain nominal costs and returns: say, buy at $100, receive $110 after small units
Estimating SRTP:
The exchange of government bonds b long term (up to 50 years) certain nominal costs and returns: say, buy at $100, receive $110 after small units available to all
At the margin, the return is equal to all (M say, 10% p.a. nominal (or lower?)
Estimating SRTP:
The exchange of government bonds b long term (up to 50 years) certain nominal costs and returns: say, buy at $100, receive $110 after small units available to all
At the margin, the return is equal to all (M say, 10% p.a. nominal (or lower?) Adjust for ination: 10 3 = 7% p.a. (real) Adjust for taxation: 7(1 1 ) = 4.7% p.a. 3
But: some seek higher returns, while some nothing. Net: is SRTP an upper bound?
9.2 Social Opportunity Cost of Capital (SOC
The return on the investment that is displac the marginal project.
With fully competitive markets: SOCC SR But with tax etc.: SOCC > SRTP Estimate:
Net benets are consumption, not investm
9.2 Social Opportunity Cost of Capital (SOC
The return on the investment that is displac the marginal project.
With fully competitive markets: SOCC SR But with tax etc.: SOCC > SRTP
Net benets are consumption, not investm
Estimate: bond rate of 10% p.a. nominal, be + risk premium 2% real = 12% expected ination of real = 9%
tax adjustment of 9(1 1 ) = 6% effec 3
9.3 Project-Specic Rates
Use CAPM to get market premium (2.1 7.9 (Use AGSM Centre for Research In Finance database.)
9.3 Project-Specic Rates
Use CAPM to get market premium (2.1 7.9 (Use AGSM Centre for Research In Finance database.) 9.4 Cost of Funds
If the government is borrowing, then the lo bond rate.
If private borrowing, see examples in 8 on T above.
A Bias Towards Government Projects? If we use the lower SRTP, then government
A Bias Towards Government Projects? If we use the lower SRTP, then government projects face a lower hurdle, private
A Bias Towards Government Projects?
If we use the lower SRTP, then government projects face a lower hurdle, private projects (SOCC or higher) face a h hurdle.
If we use the lower SRTP, then government projects face a lower hurdle, private projects (SOCC or higher) face a h hurdle. a bias towards government projects
If we use the lower SRTP, then government projects face a lower hurdle, private projects (SOCC or higher) face a h hurdle. a bias towards government projects infrastructure bonds (lower discount private projects in order to lower the cost, PPPs, Public-Private Partner
If we use the lower SRTP, then government projects face a lower hurdle, private projects (SOCC or higher) face a h hurdle. a bias towards government projects infrastructure bonds (lower discount private projects in order to lower the cost, PPPs, Public-Private Partner SOCC or project-specic rates for th government DoF: 8% p.a. as benchmark (real) = 2% margin + 6% risk-free
(Probably too high for a risk-free rate n 2006.)
SRTP versus SOCC

Time preference SRTP Goal Achieve a preferred ow of net benets over time. Long termas long as individuals plan (say, one to two generations) ... government bonds
Opportunit SOCC
Increase ne to society.
Time span
Short term as the life o private inve (say, up to
Estimation can start from ...
... governm plus a risk
Typical real 4% to 7% Above 7% rates, after adjustment for taxation (from Sinden & Thampapillai, p.134)
10. Consistency of Horizon Choice

[C&B pp.5153; L p. 25,26,29] The plantation costs $1 to establish. Two choices: A.

[C&B pp.5153; L p. 25,26,29] The plantation costs $1 to establish. Two choices: A. cut it down after one year to receive $2, or B.

[C&B pp.5153; L p. 25,26,29]
The plantation costs $1 to establish. Two choices: A. cut it down after one year to receive $2, or B. wait until the end of the second year and rea Compare the two projects using NPV and IRR: Net Present Value @ 10% p.a.: A.

[C&B pp.5153; L p. 25,26,29]
The plantation costs $1 to establish. Two choices: A. cut it down after one year to receive $2, or B. wait until the end of the second year and rea Compare the two projects using NPV and IRR: Net Present Value @ 10% p.a.: A. B. 2 NPV of cutting sooner is $0.82 = 1 + 1. 1

[C&B pp.5153; L p. 25,26,29]
The plantation costs $1 to establish. Two choices: A. cut it down after one year to receive $2, or B. wait until the end of the second year and rea Compare the two projects using NPV and IRR: Net Present Value @ 10% p.a.: 2 A. NPV of cutting sooner is $0.82 = 1 + 1. 1 3 B. NPV of cutting later is $1.48 = 1 + 1. 12 So (B) later looks more attractive using NPV.
Internal Rate of Return (irr ): A.
Internal Rate of Return (irr ): A. B.
1 Solve 1 + 2c = 0 where c = , then irr = 1 + irr 100%.
1 Solve 1 + 2c = 0 where c = , then irr = 1 + irr 100%. 3 B. Solve 1 + 3c 2 = 0, so irr = 1 = 0. 73 or 73
So (A) earlier looks more attractive using IRR.
1 Solve 1 + 2c = 0 where c = , then irr = 1 + irr 100%. 3 B. Solve 1 + 3c 2 = 0, so irr = 1 = 0. 73 or 73
So (A) earlier looks more attractive using IRR. But the time horizon isnt OK: A takes only 1 year, versus 2 years for B. If we repeat (A) twice, its NPV is given by: NPV(A twice) = 0. 82 ( 1 +
1 1.1
) = 1. 5654 > 1.48 (of B)
So choose A (= earlier) repeated.
Continues ...
The IRR of twice A is unchanged: 100% per year fo Or: Solve 1 + 2c + c ( 1 + 2c ) = 0, gives c = 1 or , gives irr = 1.0 or 100%, (ignoring the negative root Another reason for choosing project A:
if the projects are repeated and the principal is rein then (A) leads to doubling of principal every year, w 3 (B) only grows at = 1.73 every year.
Note that the growth rate with reinvestment of princ = 1 + irr always.
11. Capital Rationing
[C&B pp.5051; FP Ch. 5-App. 1; S&W, C
Aim of agency or rm: to maximise its na surplus, subject to its capital budget. e.g.
11. Capital Rationing
[C&B pp.5051; FP Ch. 5-App. 1; S&W, C
Aim of agency or rm: to maximise its na surplus, subject to its capital budget. e.g. A public agency may spend up to $1.8 year 0. Four independent, divisible (w means that fractional ( 1) projects ar possible) projects are under consider
Project
A B C D
Cost in year 0 Net returns Life of project (to be paid from per year: (number of years capital ration) year 1 onwards which net return $m $m occur) 1.0 0.14 20 1.0 0.13 50 2.0 1.00 3 1.0 0.25 8
Capital Rationing
Choose projects with the highest present v capital used. At r = 10% pa, the NPVs are calculated:
Project NPV of project in year 0 $m 0.19 0.29 0.49 0.33 Present value per unit of capital $ 0.19 0.29 0.24 0.33 = NPV /K B C K = K = a B/C ratio
Int o
A B C D
Example of capital rationing:
The most efcient investment is $1.0m in P and the remaining $0.8m in Project B. This produces a total NPV of $0.56m (= $0.33 + 0 $0.29).
If another $1 is available for investment, the should invest further in Project B, increasin NPV of the agencys nancial surplus by $0
So one unit of capital, of a nominal value o at the margin a value of $1.29 with capital r We refer to this as a shadow price (greater nominal price of $1 because of the capital constraint).
The marginal opportunity cost of capital is
Capital Rationing Diagram
We can interpret this constraint with a simple supplydemand-for-capital gure: [S&W, Fig. 6.1
0.4 NPV $ per unit of capital K supply of capital
0.3 demand for capital 0.2
0.1
0 2 4 Units of capital K (millions $) Areas = NPV of projects. 0 6
Summary
[DoF p.54]
Summary
[DoF p.54] Cost and benets occurring at different tim different values. The present value of that s costs or benets is the value in todays doll calculated using the method of compound i with the discount rate as the exchange rate future dollars and todays dollars.
Summary
[DoF p.54] Cost and benets occurring at different tim different values. The present value of that s costs or benets is the value in todays doll calculated using the method of compound i with the discount rate as the exchange rate future dollars and todays dollars. Subject to budget constraints, and where a projects are not under consideration, a proj should be accepted if the sum of its discou benets exceeds the sum of its discounted that is, where its net present value (NPV) is
Summary
[DoF p.54] Cost and benets occurring at different tim different values. The present value of that s costs or benets is the value in todays doll calculated using the method of compound i with the discount rate as the exchange rate future dollars and todays dollars. Subject to budget constraints, and where a projects are not under consideration, a proj should be accepted if the sum of its discou benets exceeds the sum of its discounted that is, where its net present value (NPV) is Where alternative projects are under consid the project which maximises NPV should be selected.
Where budget constraints limit the number
projects which can be undertaken, the appr decision rule involves choosing that subset available projects which maximises total NP
projects which can be undertaken, the appr decision rule involves choosing that subset available projects which maximises total NP Provided that future budget constraints can forecast, it is possible to work out the optim timing of projects; sometimes the combined be greater if projects with lower NPVs are undertaken rst.
projects which can be undertaken, the appr decision rule involves choosing that subset available projects which maximises total NP Provided that future budget constraints can forecast, it is possible to work out the optim timing of projects; sometimes the combined be greater if projects with lower NPVs are undertaken rst. Other decision rules, such as the benet/co and the internal rate of return (IRR) may be in the analysis alongside the NPV criterion, since these rules can be misleading except restricted circumstances, they should not b instead of the NPV criterion.
When it is expected that projects of short li
lead to further projects which yield above-n returns, it is necessary to adjust the alterna investments so that they span about the sa of time.
lead to further projects which yield above-n returns, it is necessary to adjust the alterna investments so that they span about the sa of time. Evaluations should normally be undertaken values that is, the price level of a given y this assumes that future ination will affect and benets equally. Where this is incorrec ows should be separately adjusted for in the assumptions regarding relative price ch made explicit.
lead to further projects which yield above-n returns, it is necessary to adjust the alterna investments so that they span about the sa of time. Evaluations should normally be undertaken values that is, the price level of a given y this assumes that future ination will affect and benets equally. Where this is incorrec ows should be separately adjusted for in the assumptions regarding relative price ch made explicit. Do not confuse real and nominal prices and rates in the same analysis: where the analy terms of nominal prices, the discount rate m adjusted up to account for the expected in rate.
Alternative Decision Rules [DoF pp.117]

following conditions apply: 1.
The IRR will only provide a correct result whe

following conditions apply: 1. no budget constraints 2.
following conditions apply: 1. no budget constraints 2. project alternatives are not mutually exc 3.
following conditions apply: 1. no budget constraints 2. project alternatives are not mutually exc 3. the net benet stream is rst negative, positive for the remainder of the projec vice versa).
following conditions apply: 1. no budget constraints 2. project alternatives are not mutually exc 3. the net benet stream is rst negative, positive for the remainder of the projec vice versa). Similarly the benet-cost ratio is only as reliab NPV rule when there are no budget constraint project alternatives are not mutually exclusive
following conditions apply: 1. no budget constraints 2. project alternatives are not mutually exc 3. the net benet stream is rst negative, positive for the remainder of the projec vice versa). Similarly the benet-cost ratio is only as reliab NPV rule when there are no budget constraint project alternatives are not mutually exclusive While the discounted payback period (PBP) ru superior to the undiscounted PBP rule, and w analysts may learn to select a cut-off which re risk of bad choices, the PBP rules are not as r the NPV rules, and so should be avoided.
following conditions apply: 1. no budget constraints 2. project alternatives are not mutually exc 3. the net benet stream is rst negative, positive for the remainder of the projec vice versa). Similarly the benet-cost ratio is only as reliab NPV rule when there are no budget constraint project alternatives are not mutually exclusive While the discounted payback period (PBP) ru superior to the undiscounted PBP rule, and w analysts may learn to select a cut-off which re risk of bad choices, the PBP rules are not as r the NPV rules, and so should be avoided. Conclusion: The NPV rule should be the primary bas decision-making, and should always be
Discount Rates [DoF pp.57]

Two main concepts of the discount rate:
1.

1.
the social rate of time preference (SRTP corresponding to societys preference f as against future consumption; and
2.

1.
the social rate of time preference (SRTP corresponding to societys preference f as against future consumption; and 2. the social opportunity cost of capital (S corresponding to the rate of return on i elsewhere in the economy.
Generally the SRTP is lower than the SOCC.

1.
Generally the SRTP is lower than the SOCC. A project-specic discount rate can be determ the SOCC, using the CAPM framework.

1.
Generally the SRTP is lower than the SOCC. A project-specic discount rate can be determ the SOCC, using the CAPM framework. A fourth measure uses the direct or observed funds the cost of borrowing for a governme

1.
Generally the SRTP is lower than the SOCC. A project-specic discount rate can be determ the SOCC, using the CAPM framework. A fourth measure uses the direct or observed funds the cost of borrowing for a governme The SOCC is preferred, to reduce the risk that investment displaces higher-yielding private investment.

1.
Generally the SRTP is lower than the SOCC. A project-specic discount rate can be determ the SOCC, using the CAPM framework. A fourth measure uses the direct or observed funds the cost of borrowing for a governme The SOCC is preferred, to reduce the risk that investment displaces higher-yielding private investment. A CAPM approach is preferred, but not always
Summary of Week 2
Q:
Summary of Week 2
Q: How to decide? Which criterion is the best? A:
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities).
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return.
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects.
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects. Problems with the Payback method.
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects. Problems with the Payback method. Ination issues use either real (ination-ad nominal, but dont mix them.
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects. Problems with the Payback method. Ination issues use either real (ination-ad nominal, but dont mix them. Income tax issues.
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects. Problems with the Payback method. Ination issues use either real (ination-ad nominal, but dont mix them. Income tax issues. Which discount rate to use? Social discount Social opportunity cost of capital?
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects. Problems with the Payback method. Ination issues use either real (ination-ad nominal, but dont mix them. Income tax issues. Which discount rate to use? Social discount Social opportunity cost of capital? Make sure that time horizons are comparable projects.
Summary of Week 2
Q: How to decide? Which criterion is the best? A: In general, NPV and its derivatives (AUC, VOC Value, Annuities). The weaknesses of Internal Rate of Return. Problems with the Benet/Cost ratio, but its use when there is capital rationing in order maximise net value added across projects. Problems with the Payback method. Ination issues use either real (ination-ad nominal, but dont mix them. Income tax issues. Which discount rate to use? Social discount Social opportunity cost of capital? Make sure that time horizons are comparable projects. Rank projects using the B/C ratio when there rationing.

(C&B Ch. 2, 3 Dof Ch. 4 FP Ch. 3, 4, 5) 1

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(C&B Ch. 2, 3 Dof Ch. 4 FP Ch. 3, 4, 5) 1

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Basic Concepts In Project Appr