Session 4

Present Values and Decision Rules

Magister Perencanaan Ekonomi dan Kebijakan Pembangunan

Fakultas Ekonomi Universitas Indonesia
Introduction
• Both private and public decisions can have important consequences
that extend over time.
• When consumers or government allocate fund for an action , they
generally expect to derive benefits and incur costs over a number of
years.
• Analysts have to compare projects with benefits and costs that arise
in different time periods (intertemporal comparison).
• To do this, analysts discount future costs and benefits so that all costs
and benefits are in a common metric—the present value, so they can
use this criterion to measure and compare alternative projects
Time Value of Money
• The cash you have today has a higher value than cash that you are
anticipating in the future.
• Which one do you prefer, IDR 1 Mio now or IDR 1 Mio next year?
• It must be IDR 1 Mio now! Why:
• You can use the money available today to make an investment and earn
interest.
• The effect of inflation
• Resources are becoming scarce, things are getting expensive
• So we must have a common ground in evaluating the value of future
benefits and cost, which is the present value
3 Concepts related to Time Value of Money
Given, FV is future value, PV is present value, r is interest or discount rate, and t is
time/year
1. Future value: how much your investment today will worth in the future
𝐹𝑉 = 𝑃𝑉(1 + 𝑟)!
2. Present value: how much your future benefit/cost will worth today
𝐹𝑉
𝑃𝑉 =
(1 + 𝑟)!
3. Net present value: the difference between present value of benefit and
present value of cost
𝑁𝑃𝑉 = 𝑃𝑉 𝐵 − 𝑃𝑉(𝐶)
Net Present Value as Decision Rule
• The NPV method provides a simple criterion for deciding whether to
undertake a project.
• Decision rule:
• 𝑁𝑃𝑉 > 0 means GO;
• 𝑁𝑃𝑉 < 0 means NO GO
• If there are multiple, mutually exclusive alternatives, then one should
select the alternative with the highest NPV.
 Discounting Benefits and Costs in Future Time Periods

represented in equation (3). Substituting equations (6) and (7) into equation (3) gives
the following useful expression:

NPV = a a
n Bt n Ct
t
- (8)
t=0 (1 + i) t=0 (1 + i)t

Discounting Over Multiple Years

To illustrate the mechanics of computing the NPV of a project using this formula,
suppose a district library is considering purchasing a new information system that
would give users access to a number of online databases for five years. The benefits of
this system are estimated to be $100,000 per annum, including both cost savings to the
library and user benefits. The information system costs $325,000 to purchase and set up
• If a project runs for several years, the benefits and costs will incur over the periods of the project.
initially, and $20,000 to operate and maintain each year. After five years, the system
would be dismantled and sold, resulting in a net cash inflow of $20,000. Such amounts
that arise at the end of a project are sometimes referred to as a terminal value or
• So, the NPV will have a general formula of:
liquidation value. Assume that the appropriate discount rate is 7 percent and there are
no other costs or benefits.
$ this project is shown
A time line for $ in Figure 4. It shows$ the timing of each benefit
𝐵 !
and cost, their present values, the 𝐶present 𝑁𝐵
value!of all the benefits, the!present value of
𝑁𝑃𝑉 = % −% =%
all the costs, and the NPV of the project. The present value of the benefits is $424,280;
the present value of the costs is!$407,004; and the NPV
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) ! of the project is $17,276.
! As the
NPV is positive,!"# !"# the new information
the library should purchase !"# system.

Benefits 85,558
($) 76,290
81,630
87,344
93,458
PV (B ) = 424,280 20,000
100,000 100,000 100,000 100,000 100,000

Time
0 1 2 3 4 5 (years)

325,000 20,000 20,000 20,000 20,000 20,000

18,691
17,469
16,326
Costs
15,258
($)
14,260
PV (C ) = 407,004
NPV = 17,276

FIGURE 4 Time Line of the Benefits and Costs of the Library Information
System
Decision Rule Involving Present Value
• Benefit Cost Ratio (BCR): a ratio between PVB over PVC
𝐵!
∑$!"#
𝐵! = (1 + 𝑟)! 𝑃𝑉𝐵
𝐶 =
$ 𝐶! 𝑃𝑉𝐶
∑!"# !
(1 + 𝑟)
• Decision rule:
• If %⁄& > 1, then GO
• If %⁄& ≤ 1, then NO GO
• Pro:
• Another way to say that benefits are larger than costs
• Cons:
• BCR are in percentage value, they should not be used to select one project from a group of
projects that differ in size
Sensitivity Analysis in Discounting
• Previous section assumes that interest/discount rate is known when
we are calculating the PVB and PVC
• Because the discount rate and the horizon value often determine the
sign of the NPV, therefore analysts frequently conduct sensitivity
analyses with respect to these two parameters (r and NPV).
• Internal Rate of Return (IRR) is the discount rate at which the NPV is
zero
Internal Rate of Return as Decision Rule
• The IRR may be used for selecting projects when there is only one alternative to
the status quo.
• The decision rule:
• If 𝐼𝑅𝑅 > 𝑆𝐷𝑅 𝑜𝑟 𝑂𝐶𝐶, then GO
• If 𝐼𝑅𝑅 < 𝑆𝐷𝑅 𝑜𝑟 𝑂𝐶𝐶, then NO GO
• Pro:
• if IRR is unique, it conveys useful information to decision makers who want to know how
sensitive the results are to the discount rate.
• Cons:
• IRR may not be unique, there may be more than one discount rate at which the NPV is zero
(when annual net benefit change more than once from positive to negative)
• IRRs are in percentage value, they should not be used to select one project from a group of
projects that differ in size
Discounting and dynamic efficiency
• Assume three time periods: now, 40 years and 100 years
• Path A produces flow of NB: $500 billion, $1000 billion, $100 billion
• Path C produces flow of NB: $500 billion, $800 billion, $1000 billion
• Discount rate = 3%
• PV = Vt / (1+r)t

Year Actual NB of A Actual NB of C PV A PV C

0 500 500 500,0 500,0

40 1.000 800 306,6 245,2

100 100 1.000 5,2 52,0

NPV 811,8 797,3

Discounting and dynamic efficiency
• If the discount rate is 2%, project C is preferred!
• The discount rate is critical in dynamic efficiency and controversial.

Year Actual NB of A Actual NB of C PV A PV C

0 500 500 500,0 500,0

40 1.000 800 452,9 362,3

100 100 1.000 13,8 138,0

NPV 966,7 1.000,3

Discount rate
• High discount rates do make future values insignificant and
consequently considerations about the welfare of future
generations
• What is the appropriate discount rate?
• In principle, the opportunity cost of capital could be
§ Interest rate of government bond
§ Interest rate of deposit
§ Interest rate of commercial loan
Discount rate
• Private investors typically know their opportunity cost
• What about public investments for society at large?
• Concern that the social rate of time preference is not related to the
private rate
• Social rate of time preference remains elusive