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PRESENT VALUE
Outline
• Cash Flow Diagrams
• Discounting
• Present Value and Future Value
• Net Present Value
• Internal Rate of Return
• Appropriate Time Horizon
• Timing of Cash Flows
Readings
• Dixon and Meister, chpt. 7
• Chapter 9 and Appendix 2 of Sinden and
Thampapillai)
• World Bank pp. 127132
Main Points
• 1. Time value of money and discounting
• Money received in different time periods
has different values
• Discounting is essentially a technique that
allows comparing the value of dollars in
different time periods.
Main Points
• 1. Time value of money and discounting
• 2. Present value
• Value in present time period of stream of
benefits and costs received in different
time periods
• PV is used to analyze the profitability of
an investment or project
Main Points
• 1. Time value of money and discounting
• 2. Present value (PV)
• 3. Net present value (NPV)
• NPV is traditional valuation technique and
key investment criteria
Main Points
• 1. Time value of money and discounting
• 2. Present value (PV)
• 3. Net present value (NPV)
• 4. Internal Rate of Return (IRR)
• IRR is rate of return on money invested in
project
• A second investment criteria
Main Points
• 1. Time value of money and discounting
• 2. Present value (PV)
• 3. Net present value (NPV)
• 4. Internal rate of return (IRR)
• 5. Benefitcost ratio
• Gives discounted benefits per dollar of discounted cost
• Third investment criteria
Cash Flow Diagrams
Typical Time Stream of Project
Net Benefits
Net Benefits ($)
Time
The Issues
• Projects generate stream of costs and
benefits over time
• How can a stream of net benefits be
converted to a single value at a point in
time?
• What is the present value of these net
benefits received as a cash flow?
The Issues
• Consider constant NB
• NBt ≠ NBt+1
• Weighting device required to convert NBs in
different time periods into common units in
present time period
• Convert NB stream into its present value
• Present value converts benefits and costs from
different time periods into a common unit, their
present value
• Otherwise, comparing apples and oranges
Famous quotes on discounting
• Keynes: “In the long run we’re all dead”
• Ramsey (1928): discounting is “ethically
indefensible”
• Harrod (1948): discounting is “a polite
expression for rapacity”
Discounting
• Discounting is essentially a technique that
enables us to compare the value of
dollars in different time periods.
• All benefits and costs of different time
periods made comparable by converting
into their equivalent dollar present value
• Gives a single number present value
Rationale for Discounting
• Would you rather receive $100 today or
$100 in 3 years?
• Why?
Rationale for Discounting
• $100 received today is preferred to $100
received 3 years from now
• Individuals prefer receiving dollars sooner
rather than later
• Why?
• Because we can increase our
consumption today, whereas the dollar
received in the future can increase only
future consumption.
• Having to postpone consumption makes
tomorrow's dollar less valuable than
today's
Rationale for Discounting
• Alternatively, receiving money sooner is better,
because can reinvest money at interest rate r
• Allows greater future consumption
• The declining value of money over time has
nothing to do with inflation, only with the
postponement of consumption.
• Individual preferences count
Rationale for Discounting
Present Value Future
Value
0 1 2 3
Rationale for Discounting
• Suppose P0 dollars were reinvested for
one year at interest rate r, compounded
annually
• Sum received at end of one year = P1
• P1 composed of principal P0 and interest
earnings rP0
• Then:
P1 = P0[1 + r] = P0 + rPo
Rationale for Discounting
• Thus, P0 dollars now worth same as P1
= P0[1 + r] dollars received at end of year
• Hence:
• P1 = P0[1 + r]
• Rearranging gives
P1
P0 = = present value of P1
[1 + r]
Rationale for Discounting
• If P0 dollars invested for two years:
• In one year, P0 grows to P1 = P0[1 + r]
• In second year, P1 grows to
P2 = P1[1 + r]
= P0[1 + r][1 + r]
= P0[1 + r]2
Rationale for Discounting
• Rearranging gives
P2
P0 =
[1 + r]2
= present value of P2 receivable in two years
Rationale for Discounting
• Similarly, discounted present value of PT
dollars receivable in T years is:
PT 1
P0 = = PT
[1 + r]T [1 + r]T
Discount Factor
• Discount Factor in time t
1
[]t = ρt
1 + r
Discount Factor in time t=0
1
[]0 = ρt = 1
1 + r
Discount Factor
• Discount Factor time t=1
1 1
[]1 = ρ1 = ----
1 + r 1 + r
Discount Factor
• Discount factor in time t=3
1
[]3 = ρ3
1 + r
• Discount factor in time T (terminal time)
1
[]T = ρT
1 + r
Discount Factor Example
• Discount Factor in time t=3
1 1 1 1
[]3 = x x
1 + r 1 + r 1 + r 1 + r
1 1 1 1
[]3 = x x = 0.8638
1+0.05 1.05 1.05 1.05
Discounting Example
Time Value at Discount Discount Discounted
Period (t) time t ($) rate (r) factor ρ in Value
time t Bt x ρ t
t=0 100 0.05 1 100
Present Value (PV)
• Value in present time period of stream of
benefits and costs received in different
time periods
• Period t=0 value
• PV is used to analyze the
profitability of an investment or
project
Present Value
• Present Value of Income Stream (Cash
Flow)
P0 P1 P2 PT
PV = + + + ∙∙∙ +
[1+r]0 [1+r]1 [1+r]2 [1+r]T
T Pt
= ∑
t=0 [1+r]t
Present Value
• Using discount factor rather than discount
rate
T Pt T
PV = ∑ = ∑ ρT Pt
t=0 [1+r]t t=0
Future Value
• FV = PV x (1 + r)t
• FV (t=3) = PV x (1 +r)3
• FV = $100 x (1 + 0.05)3
= $100 x (1.05) x (1.05) x (1.05)
= $100 x 1.157625
= $115.7625
Present Value and Future Value
• FV = PV x (1 + r)t
FV
• PV =
(1 + r)t
Present and Future Value
• r or ρ is assumed constant in each time
period
• No inflation assumed
• Constant or real dollars
Net Present Value
• Traditional valuation methodology
• Expresses how much value an
investment will result in
• Provides investment criterion
• Sum of discounted cash flow expected
from investment less investment costs
Net Present Value
• Formula for NPV
B0 – C0 B1 – C1 B2 – C2
NPV = + +
(1 + r)0 (1 + r)1 (1 + r)2
BT CT
+ … +
(1 + r)T
Net Present Value
• Formula for NPV
T Bt – Ct T NBt
NPV = ∑ = ∑
t=0 (1 + r)t t=0 (1 + r)t
where:
Bt = dollar value of benefits at time t
Ct = dollar value of costs at time t
NBt = dollar value of net benefits at time t
r = discount rate
T = terminal time (last period of project)
Net Present Value
• Note that:
T Bt Ct T Bt T Ct
NPV = ∑ = ∑ ∑
t=0 [1 +r]t t=0 [1+r]t t=0 [1+r]t
NPV Investment Criterion
• Maximize present value of net benefits
accruing over life of project:
T Bt Ct
max NPV = ∑
t=0 [1 +r]t
NPV Investment Criterion
• NPV > 0
• Positive contribution to economic welfare
• Alternative with highest NPV is best
• Contributes most to goal of economic welfare
Version A Version B B-A: Incremental
Investment
Year K Cost Net Benefits K Cost Net Benefits K Cost Net Benefits
1 20 4 40 8 20 4
2 4 8 4
3 4 8 4
4 4 8 4
5 4 8 4
6 4 8 4
7 4 8 4
8 4 8 4
9 4 8 4
10 4 8 4
Discount Rate r
r*
Internal Rate of Return
• Keynes called IRR marginal efficiency of
capital
• IRR is rate of return on money invested in
project
• IRR sometimes called critical discount
rate
Internal Rate of Return
• Discount rate that makes NPV = 0
• Solve for r in:
T Bt – Ct T Bt T Ct
∑ = 0 or ∑ = ∑
t=0 [1 + r]t t=0 [1+r]t t=0 [1+r]t
Internal Rate of Return
NPV T Bt – Ct T Bt T Ct
∑ ----------- = 0 or ∑ ------- = ∑ ------
t=0 [1 + r]t t=0 [1+r]t t=0 [1+r]t
Discount Rate r
Internal Rate of Return
• Decision Criterion
Undertake investment if IRR > social
discount rate
Problems with IRR
• (1) IRR doesn’t preclude problem of
choosing a discount rate to discount and
obtain NPV
Because IRR endogenously determined
However, still have to choose discount rate
to compare IRR with discount rate in decision rule
Problems with IRR
• (2) Multiple Roots
In computing IRR, possible to obtain more
than one solution (more than one value)
Because IRR is solution to polynomial
equation
If polynomial of degree n, there are n
possible solutions
Problems with IRR
• (2) Multiple Roots
B1 – C1 B2 – C2 Bn Cn
+ + ∙∙∙ +
[1 + r]1 [1 + r]2 [1 + r]n
Negative and imaginary numbers discarded
and only positive roots remain
Negative root has no meaning
What is meaning of 2% ?
Problems with IRR
• (2) Multiple Roots
• Number of positive roots found by
Descartes’ “Rule of Signs”
• Cash flow stream of signs + + + + ∙∙∙ has
one positive root since one sign change
• Cash flow stream of signs + + + may
have two roots since two signs changes
Problems with IRR
• (2) Multiple Roots
• Fairly common sequence with initial
expenditure ( sign) followed by positive
returns (+ sign), followed by negative
returns ( signs) at end of project when it
is dismantled and scrapped
Problems with IRR
• Which solution root to use?
(2) Multiple Roots • Complex rules available to
choose
NPV
• But difficult to handle all possible
cases
0
Discount Rate r
Two solution roots
Problems with IRR
• (3) IRR provides no information about
relative and absolute sizes of NPVs for
different investment alternatives
With no budget constraint, decision criterion
for both independent and mutually exclusive
projects is maximize NPV
Gives maximum potential Pareto
improvement
Problems with IRR
• (4) IRR cannot be applied to mutually
exclusive projects
IRR cannot be used when project alternatives
preclude one another
Problems with IRR
(4) IRR cannot be applied to mutually exclusive projects
NPV • Two mutually exclusive projects, A and B
A • NPVs at different discount rates represented by
curves A and B
• IRR criterion implies choose B
NPVA • But at current discount rate q, NPVA > NPVB
NPVB
B Critical discount rate = IRR
Discount rate r
IRRB IRRA
q
Problems with IRR
• (5) Sensitivity of IRR to length of project
Can have high IRR for shortlived project, but
low NPV of total net benefits
Can high lower IRR for longerlived project
with higher NPV
Goal is to maximize NPV of net benefits, not rate
of return
Problems with IRR
• (6) Sensitivity of IRR to phasing of costs
and benefits
IRR may give higher ranking to projects
which bunch benefits into early part of
economic life
Problems with IRR
• (7) IRR cannot be used to choose among
portfolio of projects subject to budget
constraint
IRRs are ordinal, not cardinal
IRRs cannot be summed
IRRs don’t put projects on common basis
E.g. IRR per dollar of cost
BenefitCost Ratio
• Third of three basic decision criteria
• Definition
T Bt
∑
B t=0 [1 + r]t
=
C T Ct
∑
B t=0 [1 + r]t
BenefitCost Ratio
• Gives discounted benefits per dollar of
discounted cost
B Discounted gross benefits
=
C Discounted total costs
Costs include capital plus operation,
maintenance, and replacement costs
Problems with BenefitCost
Ratio
• (1) Not correct ranking criteria
• Smaller of two projects may have higher
B/C but smaller total NPV
• Example
• Two projects, A and B, each with economic
life of one year
• Discount rate of 5%
Problems with BenefitCost
Ratio
• Project A has higher B/C but lower NPV
• Higher NPV preferred, because yields greater
increase in society’s total net benefits
A 0 1 2 0 1.9 0.9
B 0 5 8 0 1.5 2.6
Problems with BenefitCost
Ratio
• (2) Value of BenefitCost Ratio depends on
where netting out of different costs and benefits
occurs in time stream of costs and benefits
• Affects values in numerator and denominator, and
hence B/C ratio
• Different conventions for netting out benefits and
costs
o Can move a cost from denominator and subtract it
from numerator
Conclusion
• NPV is preferred investment criterion
• Gives correct ranking of projects
• Want largest net benefits
• Should not discriminate against costly
investments (which may also have largest net
benefits)
Appropriate Time Horizon
• Issue
• For how long of a period should an economic
analysis be conducted?
• Time horizon of analysis is comparable to
economic life of project
Appropriate Time Horizon
• Two Factors Important in Selecting Appropriate
Time Horizon
• (1) Expected Economic Life
• When beneficial project outputs become very
small or end, effective project life is over
• Technical life of project could be longer than
economic life
• Due to technological obsolescence
Appropriate Time Horizon
• (1) Expected Economic Life
• Examples
• Tree Crops (rubber, palm oil, fruit, cocoa)
• Yields are zero for initial period, rise rapidly, continue for
some years, then decline but still provide yield
• But declining yield in later years combined with new, higher
yielding varieties makes later years technologically obsolete
• Economic life shorter than technical life due to technological
obsolescence
Appropriate Time Horizon
• (1) Expected Economic Life
• Examples
• Information Technology: Personal Computers
• PCs may continue working for many years
• But technological advances make PCs incapable
of running new software and operating systems or
at too slow of speed
• Economic life shorter than technical life due to
technological obsolesence
Timing of Cash Flows
• Issues
1. Designation of initial year of project
2. Assumptions are required on timing of
cash flows (benefits and costs)
In which part of year do cash flows occur?
Beginning or end of year?
3. All costs (capital and operating) and
benefits treated same way as cash flows
Timing of Cash Flows
• 1. Designation of Initial Year of Project
In principle, the initial year of any project can
be designated as year 0 or year 1
In practice, initial year is designated as year
0
Then cash flow ranges from t = 0 to t = T
T = terminal period or end of project
Timing of Cash Flows
• 2. Timing of Cash Flows
Do cash flows (costs or benefits) take
place at beginning or end of year?
Cash flows can be discounted
beginning with the first project year or
only with the second project year.
Timing of Cash Flows
• 2.1. Cash flows take place at end of year
Any cost or benefit occurs at end of year
Any cost or benefit occurring during a year is
discounted for entire year
Example:
Cost incurred any time in year 5 is discounted for
entire 5 years
Timing of Cash Flows
• 2.1. Cash flows take place at end of year
With this assumption, begin discounting only
with second year of project
Rationale is that investment must be made before
first year is ended
First year is not discounted
Some international agencies and most
private firms adopt this approach
Timing of Cash Flows
• 2.1. Cash flows take place at end of year
This assumption introduces a small error,
since actual expenditures or receipts should
theoretically be discounted from time when
they actually occur
These errors overlooked in interest of
simplicity
If desired, all cash flows can be discounted
from exact time they occur
Timing of Cash Flows
• 2.1. Cash flows take place at beginning of
year
Any cost or benefit occurs at beginning of
year
Costs and benefits occurring in first year are
discounted
Can potentially lead to present value less
than actual value
World Bank sometimes adopts this approach
Discounting from Project Year 1 and from Project
Year 2 Compared