COST-BENEFIT ANALYSIS NPV 1 Flashcards
is the most important criterion for the financial and the economic evaluation
project’s net present value (NPV)
If incremental NPV is positive.
then this project at scale 2 is preferable to scale 1
This procedure (scale increase) is repeated until a scale is reached where the NPV of the
incremental benefits and costs associated with a change in scale are negative.
If the initial scale of the project had a negative NPV, but all the subsequent incremental net present values for changes of scale were positive,
It still would be possible for the overall project to have a negative NPV.
assuming that each successive increment of investment has a unique IRR. If this condition is met, then the optimum scale for the facility will be the one at which the IRR
for the incremental benefits and costs equal to the discount rate used to calculate the net present value of the project
the scale at which the IRR is always maximized
The scale where the IRR=MIRR
maximum net present value
where IRR is equal to the discount rate called MIRR
becomes particularly difficult for large indivisible projects such as infrastructure investments in roads, water systems, and electric generation facilities.
The decision about an appropriate time to start
If these projects are built too soon, a
a large amount of idle capacity will exist
a large amount of idle capacity will exist
In such cases, the foregone return (that would have been realized if these funds had been invested elsewhere) might be larger in value than the benefits gained in the first few years of the project’s life
Whenever the project is undertaken too early or too late
The NPV of such projects may still be positive but it will not be at its maximum
The determination of the correct timing of investment projects will be a function of
how future benefits and costs are anticipated to move in relation to their present values.
In Case A, the project should be postponed
If the present value of the benefits that are lost by postponing the start of the project from time period t to t+1 is less than the opportunity cost of capital multiplied by the present value of capital costs as of period t.
because the funds would earn more in the capital market than if they were used to start the
project.
then the project should proceed.
if the foregone benefits are greater than the opportunity cost of the investment.
Case A: Potential Benefits are a Rising Function of Calendar Time
rKt > Bt+1 ⇒ Postpone
rKt < Bt+1 ⇒ Start
Case B: Both Investment Costs and Benefits are a Function of Calendar Time
rKt > Bt+1 + (Kt+1 – Kt) ⇒ Postpone
rKt < Bt+1 + (Kt+1 – Kt) ⇒ Start
The term, (K1-K0), represents the
savings of the increase in capital costs by commencing the project in t0 instead of t1
could be abandoned at some point in time with the result that a
the one-time benefit is generated, equal to its scrap value,
five special cases regarding scrap value and change in scrap value of a project
SV > 0 and ∆SV < 0 SV > 0 but ∆SV > 0 SV < 0 but ∆SV = 0 SV < 0 but ∆SV > 0 SV < 0 and ∆SV < 0
SV > 0 and ∆SV < 0
SV > 0 but ∆SV > 0
machinery;
Land
SV < 0 but ∆SV = 0
SV < 0 but ∆SV > 0
SV < 0 and ∆SV < 0
a nuclear plant;
severance pay for workers
Clean-up costs
Case C: Potential Benefits Rise and Decline According to Calendar Time
Stop if rSVtn – Btn+1 – ∆SVtn+1 > 0
Start if rKt < Bt
it is necessary to consider the length of life of the two
or more projects.
If the mutually exclusive projects are expected to have
continuous high returns over time
The reason for wanting to ensure that mutually exclusive projects are compared over the same span of time is to
give them the same opportunity to accumulate
value over time,
Economic rent that give fixed factor of production
