COST-BENEFIT ANALYSIS NPV 2 Flashcards
additional loss
caused by postponement equal (K1 - K0), as shown by
FGHI
CASE areas
The rule shows a comparison of the area t1DEt2 with t1ACt2 plus FGHI
if investment costs are expected to rise in the future, it will be optimal for the project to be undertaken
earlier than if investment costs remain constant over time.
Case C: Potential Benefits Rise and Decline According to Calendar Time, example
the growth in demand for a given type of electricity
generation plant in a country is expected to continue until it can be replaced by a cheaper technology.
NPV formula for Case C: Potential Benefits Rise and Decline According to Calendar Time, example
the area under the B(t) curve minus K1
NPV= -K /(1+r) + sigma[Bt /(1+r)^t ]
In case of c it only pays to keep the project in operation so long as
Bt n+1 > rSVtn - ∆SVtn+1
Case D: Both Costs and benefits do not change systematically with calendar time
In this case, the optimal date to start the project
is determined by
estimating the net present value of the project in each instance and choosing the time to start the project which yields the greatest net present value
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 for fixed factor of production.
in order to equalize or adjust two project lives two condition have to met
both projects must be supra-marginal (i.e., have positive NPVs) and should be repeatable at least a finite number of times.
repeat, repeatable projects until
The construction of the repeated projects is initiated so as to maintain a level of service
Projects with Interdependent and Separable Components
The analyst should attempt to break the project down into its various components and examine the incremental costs and benefits associated with each of the components to determine whether it increases or decreases the NPV of the project
to maximize the NPV of the whole package, it may mean that
the efficiency of some of the components will be reduced. In this case, the overall project might be improved if one or even two of the components were dropped from the investment package.
To appraise such an integrated investment package
we should begin by evaluating each of the components as an independent project.
The technology and operating plans will have to be designed
to maximize the net benefits from the combined facilities
Frequently, the project which ends up with the greatest NPV is one containing
fewer components that were initially proposed by its sponsor.
A common investment problem of the type which involves separable component projects arises
when a decision is being made as to whether or not existing equipment should be replaced.
existing equipment decision
(a) Keep the old asset and do not buy the new asset now;
(b) Sell the old asset and purchase the new one; or
(c) Keep the old asset and in addition buy the new one.
B0
present value of all future benefits that could be generated by the old asset (evaluated net of operating cost)
SV0
liquidation or scrap value of the old asset if sold
Bn
present value of future benefits (net of operating costs)
from the new asset
Cn.
the present value of the investment costs for the new asset
In order that alternative (a) be feasible
present value of the future benefits from the old asset exceed its liquidation value, i.e., Bo-SVo>0
In order for alternative (b) to be feasible
it is necessary that the present value of the future benefits from the new asset are bigger than the present value of its investment costs, Bn-Cn>0.
For alternative (c) to be feasible
The total benefits produced by both assets combined
must be greater than the costs of the new investment plus the liquidation value of the old asset.
Bn+o-(Cn+SVo)>0
