Public Finance (ECO3110)

Chapter 8

Kyungwoo Lee
Yonsei University

March 29, 2016

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Overview

Cost-benefit analysis
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I
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Net present value

Internal rate of return
Issues with cost-benefit analysis

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Introduction

Cost-benefit analysis
I
I

A dominant tool for decision making about various projects

You will never see a decision making by social welfare functions.

It is based on a very simple, clear, and obvious idea

I
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If the benefit from a project exceeds the cost, then do it.

With many alternatives, take one with the highest net benefit.

Unfortunately, it is too often misused and/or abused.

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To the extent that it may not be trustworthy at all!

Overestimation of benefits and underestimation of costs

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Present value
Projecting present dollars into the future
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How much is $A today worth in t years time?

Answer: A (1 + r)t
F

r : annual interest rate

Projecting future dollars into the present

I

How much is B dollars t years later worth today?

Answer:
F

(1 + r)t

= B (1 + r)

r is called the discount rate, rather than interest rate.

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Present (discounted) value (PDV or PV)

I

What is the present value of a stream of income R0 , R1 ,

F

, RT ?

Rt : income in t years later from today

PV with a constant discount rate r

PV = R0 +

R1
+
(1 + r)

RT

(1 + r)

Rt

(1 + r)t

t=0

PV with a variable discount rates

T

PV =

t=0

where

Rt
,
j = 1 1 + rj

1 + rj = (1 + r1 ) (1 + r2 )

( 1 + rt ) .

j=1

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Accounting for inflation

Situation
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Real income flow: R0 , R1 ,

, RT
Inflation rate ( ) and nominal (i) and real interest rate (r)
F

By definition: 1 + i = (1 + r) (1 + )

Present value of the income stream

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Expressed in real terms

PV R =

Rt

(1 + r)t

t=0
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Expressed in nominal terms

PV N =

Rt (1 + )t

(1 + r)t (1 + )t

t=0
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Rt

(1 + r)t

= PV R

t=0

It does not matter whether you express PV in real or nominal terms.

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Private sector project evaluation

Comparison between two alternative projects
I

Project X
F
F

X
Benefit stream: BX
, BX
0 , B1 ,
T.
X
X
Cost stream: C0 , C1 ,
, CX
.
T

Project Y
F
F

Y
Benefit stream: BY
, BY
0 , B1 ,
T.
Y
Y
Cost stream: C0 , C1 ,
, CY
.
T

Questions
I

What alternatives are admissible?

F

Admissible if net benefit > 0.

Which alternative is preferable?

F

Preferable if net benefit is greater.

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Net present values

I

Project j = X, Y
NPV j =

(1t + r)tt

t=0

Present value criterion

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Admissible project if NPV > 0

X is preferable if NPV X > NPV Y .

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Internal rate of return

Internal rate of return (IRR)
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The discount rate that would make a projects NPV zero.

Let denote the internal rate of return. By definition,
T

Bt

Ct

(1 + )t

= 0.

t=0

IRR and discount rate

I

According to the textbook, a project is admissible if > r because

T

0=

Bt

Ct

(1 + )t

<

t=0
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Bt

Ct

(1 + r)t

t=0

This argument is valid only if NPV decreases with the discount rate.
But NPV sometimes increases with the discount rate!

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Partial derivative of NPV

T

NPV =

Bt

Ct

(1 + r)t

t=0
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NPV
=
r

t=0

t ( Bt

Ct )

( 1 + r )t+1

The sign of NPV/r depends on the flow of Bt

Ct .

An example
time
0
1
2
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Bt Ct
10
11
-20

discount rate
3%
4%
-3.26%

NPV
1
2.08
0

NPV rises with r.

The project is admissible even though < r.
This case typically arises when B C is positive early and negative
later.

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IRR and the cost of capital

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Typically, projects involve large initial costs and reap benefits later.
In such a project, one has to evaluate:
T

NPV =

Bt

(1 + r)t

C0

t=0
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In this case, the NPV falls with r.

NPV
=
r

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tBt

(1 + r )t+1

<0

t=0

In this case, a project is admissible if > r.

If IRR exceeds the cost of capital, i.e., the OC of funds, then a
project is admissible.

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Other problems with the internal rate of return

Example
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Project X
F
F
F

Project Y
F
F
F

BX = 100 today.
CX = 110 a year from today
IRR of X = 10%
BY = 1000 today.
CY = 1080 a year from today
IRR of Y = 8%

The IRR criterion favors X though net benefit is greater for Y!

Project selection using the IRR may lead to bad decisions.

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It only focus on the rate of return.

It ignores the size of the net benefit.

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Benefit-cost ratio

Benefit-cost ratio (BCR): B/C with

T

B=

Bt

(1 + r)t

and C =

t=0
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Ct

(1 + r)t

t=0

Admissible if B/C > 1.

The BCR is also improper for comparing admissible projects.

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Because reduction in benefit = increase in cost.

The BCR, however, will change in a different way.

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Example
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Original comparison
F
F

Then, it is realized that additional cost 40 is not accounted for X.

F
F

X : B = 250, C = 100 ! B/C = 2.5

Y : B = 200, C = 100 ! B/C = 2
If 40 is counted a fall in B ! B/C = 210/100 = 2.1
If 40 is counted a rise in C ! B/C = 250/140 = 1.79

Depending on the methods, X may or may not be preferred.

Note that NPV criterion is immune to this problem.

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The discount rate for public projects

The discount rate for private project: the OC of funds
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Conceptually, easy to determine the OC.

Practically, however, it might not be easy.

The discount rate for government projects

I
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What is the OC of funds used for government projects?

Difficult to determine, even conceptually.
Before-tax return or after-tax return (of private investment)?
F
F

Social discount rate

F
F

Before-tax return: Fund comes at the expense of investment

After-tax return: Fund comes at the expense of consumption

Paternalism (myopic individuals)

Market inefficiency (positive externalities of investments)

Reasonable approach
F
F

Take the discount rate between before- and after-tax return.

Then, conduct a sensitivity analysis

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Valuing public benefits and costs

Calculation of benefits and costs

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Market prices sometimes do not reflect social benefits or costs.

F

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I

Consumer surplus as a measure of benefits

Inferences from economic behavior
F
F

Adjusted market prices

The value of time

The value of life

What about intangibles?

F
F

Bush argued that space exploration "is a desire written in the human
heart."
National park gives the thrill of enjoying beautiful scenery.

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Games cost-benefit analysts play

The chain reaction game
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Making a project look attractive by counting secondary profits as

part of benefits.
Example: government wants to build a road.
F
F

Benefit: the reductions in transportation costs

Secondary benefit: profits of local gas stations, motels, etc.

Transfers are not benefits.

The labor game

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Viewing employment a project creates as benefits

Wages belong to costs, not benefits.
Example: A public project hires 100 workers.
F
F

Wages to those workers are costs.

Often advertised as "creating" 100 jobs.

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The double-counting game

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Counting the same benefits twice

Example: Irrigating some land yields benefits
F
F

The increase in value of the land

The present value of the stream of net income obtained from farming
it.

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Distributional considerations
Hicks-Kaldor criterion
I

Undertake a project as long as it has a positive NPV,

F

Regardless of distribution consequences.

The gainers could compensate the losers.

F
F

Potential Pareto improvement

Often, such a compensation, however, is not possible.

Distributional considerations
I

Need to take into account distributional implications to maximize

social welfare
F

One dollar is not the same one dollar to everyone.

Potential problem
F

Political concerns may come to dominate the cost-benefit exercise.

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Uncertainty

Uncertainty about costs and benefits

I

Impossible to predict costs and/or benefits with certainty.

F
F

Assign subjective probabilities to each event,

which will almost surely turn out false.

Certainty equivalents may be helpful.

I
I

Impractical.
The shape of the utility function is needed.

Uncertainty in actual projects

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Politicians overstate benefits and understate costs.

Example
F

Seoul-Pusan KTX: 5.8 trillion ) 18.4 trillion wons.

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