Lecture 5 - Discounting Costs and Benefits

Levan Pavlenishvili

ISET

2022

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Table of Contents

Today’s reading: [BGVW] pp. 201-232 (Chapter 9)

1 Basics of Discounting
2 Compounding and Discounting over Multiple Years
3 Timing of Benefits and Costs
4 Comparing projects with different time frames
5 Inflation and Real versus Nominal Dollars
6 Terminal Values and Fixed Length Projects
7 Terminal Values and Long-lived Projects
8 Sensitivity Analysis in Discounting

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The Basics of Discounting

Normally discounting takes place over periods;

Depending on the project at hand you might select different periods
for discounting;
In public policy application typically periods are calendar years.

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The Basics of Discounting

Projects with Lives of One Year

It is often useful to lay costs and benefits on a timeline.

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The Basics of Discounting

Future Value analysis

How much money will the city receive if it invests the money in Treasury
Bonds for one year?

FV = X (1 + i) (1)
where, i is an interest rate and X is an amount of money we invested.
Excel command for future value is: ” = −FV (0.05, 1, , 1000)”

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The Basics of Discounting

Present Value Analysis

How much money does the city need if it invests the money in Treasury
Bonds and wants to recieve certain amount in one year?

Y
PV = (2)
1+i
where, i is an interest rate and Y is an amount of money received in a
year. Excel command for present value is: ” = −PV (0.05, 1, , 1000)”

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The Basics of Discounting
Net Present Value Analysis

Costs and benefits taken in different time period is summed up in the net
present value analysis

NPV = PV (B) − PV (C ) (3)

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Compounding and Discounting over multiple years

Future value over multiple years

Simple interest - receive an amount on the original amount. Say 5%

on 10 mil. per year investment, i.e. 500,000.
Compound interest - receive interest every year on compounded
amount. See the Table below:

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Compounding and Discounting over multiple years

Future value over multiple years

In this case future value is calculated with following formula:

FV = X (1 + i)n (4)
where, n is number of periods over which amount of money is
compounded and (1 + i)n is compound interest factor.

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Compounding and Discounting over multiple years

Present Value over multiple years

In this case Present Value is calculated with following formula:

Y
PV = (5)
(1 + i)n
where, n is number of periods over which amount of money is
1
compounded and (1+i) n

Process of calculating the present value of a future amount is called

discounting

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Compounding and Discounting over multiple years

Present Value over multiple years

In cost benefit analysis benefits and costs might appear in more than one
period, thus we can one just simply discount one value:

B0 B1 B2 B3
PV (B) = 0
+ 1
+ 2
+
(1 + i) (1 + i) (1 + i) (1 + i)3
n
X Bt
PV (B) = (6)
(1 + i)t
t=0
n
X Ct
PV (C ) = (7)
(1 + i)t
t=0

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Compounding and Discounting over multiple years
Present Value over multiple years

This process can be summarised with following figure:

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Compounding and Discounting over multiple years

Net present value of the project

As the result net present value of the project can be calculated with
several methods:
n n
X Bt X Ct
NPV = − (8)
(1 + i)t (1 + i)t
t=0 t=0
n
X NSBt
NPV = (9)
(1 + i)t
t=0

where, NSBt = Bt − Ct

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Compounding and Discounting over multiple years
Net present value of the project

This process can represented with the following figure

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Compounding and Discounting over multiple years
Annuities and Perpetuities

Annuity - is an equal fixed amount received each year for a number of

years.

n
X A
PV = = Aait (10)
(1 + i)t
t=1
where, A is a present value of annuity, and ait is an annuity factor
Perpetuity - is an annuity that continues indefinitely.

A
PV =
if i > 0 (11)
i
You need annuities and perpetuities often to assess operating and
maintenance costs of the project.
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Timing of Benefits and Costs
We always make an assumption, that all benefits and costs occur at
the end of each period, except for initial costs, which occur
immediately;
NPV of the projects can vary considerably depending on assumptions
about timing of costs and benefits
We might also distinguish ordinary (regular) annuity and deferred
annuity
Ordinary Annuity - payments are received at the end of each year
Deferred Annuity - payments are received at the beginning of each
year
Another way is to assume that payment occur in the middle of the
year, in this case our NPV will be:
n
X NSBt
NPV = −C0 + (12)
(1 + i)t−0.5
t=1
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Comparing projects with different time frames

Alternative projects might have different time frames. Therefore, when

comparing NPV s we are not looking at actual alternatives, making ”unfair
comparison”

For example, should we build hydropower (HPP) that will last 75 years,
with NOV = 40 mil. USD with 6% discounting, or build cogeneration
plant(CGP) that will last 15 years with NPV = 25 mil. USD.

Two methods can be applied to make this assessment rollover method and
equivalent annual net benefit method

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Comparing projects with different time frames

Roll-over method

In this method we can multiply the project up to the point when their
timelines are similar:

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Comparing projects with different time frames

Equivalent annual net benefit method

Equivalent annual social net benefit method divides the NPVs by their
respective annuity factors. Thus, we are calculating what we would have
recieved every year if it was an annuity.

NPV
EANB = (13)
ain
As a result we could have two different EANBs:

EANB(HPP) = 40/16.46 = 2.43 and EANB(CGP) = 25/9.71 = 2.57

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Inflation and Real versus nominal values

In order to control for declining purchasing power of any currency we

convert nominal values of cash flow to real values i.e. constant
purchasing power

To make a conversion we might use either a GDP deflator, or an inflation

index Consumer price index

CPI can substantially overstate the rate of increase in market prices.

CPI might be effected with commodity substitution, or discount stores

effect

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Inflation and Real versus nominal values

Discounting using real or nominal values

If benefits and costs are measured in nominal dollars then analyst should
discount using a nominal discount rate; if benefits and costs are measured
in real dollars, then the analyst should discount using a real discount rate

However, it might be more intuitive to assume all benefits and costs in real
values and discount using real interest rate. The formula for real interest
rate will be:

i −m
r= (14)
1+m
where i is a nominal interest rate and m is an inflation rate

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Terminal values and fixed length projects

Many projects have the following structure:

1 initial costs up-front in period 0
2 project operating costs from period 1
3 asset liquidation at end of the final period (i.e. sale of the asset on
second hand market)
Then NPV can be calculated with following formula:
n
X RNSBt Tn
NPV = −C0 + + (15)
(1 + i)t−0.5 (1 + i)n
t=1

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Terminal values, and long-lived projects
Many projects can generate benefits long after your assessment period
consequently, we have NPV :
∞
X NSBt
NPV = (16)
(1 + i)t
t=0
In this case it is useful to split net present value into discounting period
and horizon value in this case:
k
X NSBt Hk
NPV = t
+ (17)
(1 + i) (1 + i)k
t=0

where,
∞
X NSBt
Hk = (18)
(1 + i)t
t=k+1

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Sensitivity analysis in discounting

The discount rate can substantially determine the NPV value and thus
disagreements might arise on its proper value (details to follow in next
lectures)

To cover for the uncertainty on actual discount rate, one might want to
conduct sensitivity analysis i.e. vary parameters of the discounting and
re-calculate NPV accordingly.

One might calculate internal rate of return (IRR) of the project, or

break-even discount rate. This is the value of the discount rate where
NPV = 0

IRR might be used for selecting the project when you have only one
alternative to the status quo. However, IRR might not be unique and it
represents a percentage, not a value i currency.
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