CAPITAL BUDGETING_LECT 091 The Concept of Opportunity Cost The concept of opportunity cost is used in CBA to place a dollar value on the inputs required to implement policies –The opportunity cost of using an input to implement a policy is its value in its best alternative use It measures the value of what society must forgo to use the input to implement the policy Example: –A police dept decides to pay tuition for police officers –To pay for tuition, the dept might have to keep its patrol cars an extra two months each –Opportunity costs = additional repair cost because of the older automobiles

CAPITAL BUDGETING_LECT 092 Opportunity Cost and Pareto Efficiency Following the same 3-people policy example –Recall that the aggregate willingness-to-pay was $50 –Assume that the policy requires inputs that have an opportunity cost of $75 If so, some other members of society would have to give up goods valued at $75 In this case, the policy does not generate enough benefits to the 3 persons to allow them to compensate those who must forgo the $75 –The net benefits to society are negative 50 + (-75) = -25 –The policy is not Pareto efficient –If opportunity costs were only $20…

CAPITAL BUDGETING_LECT 093 The Link between Net Benefits and Pareto Efficiency As long as analysts value all impacts in terms of willingness-to-pay and all required inputs in terms of opportunity costs, then the sign of the net benefits indicates whether or not it would be possible to compensate those who bear costs sufficiently so that no one is made worse off –Positive net benefits indicate the potential for compensation to make the policy Pareto efficient –Negative net benefits indicate the absence of this potential Adopting only policies that are actually Pareto efficient is impractical Bounded rationality / too costly to administer / people would overstate their costs and understate their benefits

CAPITAL BUDGETING_LECT 094 Potential Pareto Efficiency—an alternative decision rule Based on the Kaldor-Hicks criterion –A policy should be adopted if and only if those who will gain could fully compensate those who will lose and still be better off Adopt only policies that have positive net benefits –If policies are always adopted on the basis of net positive benefits, society maximizes aggregate wealth Richer societies more willing to redistribute wealth –Costs and benefits would tend to average out across society –Minimizes concentrating benefits on interest groups at the expense of unorganized groups

CAPITAL BUDGETING_LECT 095 (6) Discount Benefits and Costs to Obtain Present Values –Needed because capital projects incur cost in the present and benefits in the future—the net benefit stream will be negative for a period of time and then positive to produce a summary measure of the net benefits of a project all values are converted to values at a common point in time (usually the present) Recall that PV = FV n / (1 + r) n –The present value amount (PV) invested at discount rate r will grow to future value FV n at the end of n years –Both benefits and costs are converted to their present value

CAPITAL BUDGETING_LECT 096 (7) Compute the Net Present Value of Each Alternative Present value of the benefits = PV(B) Present value of the costs = PV(C) The net present value of an alternative, NPV, equals the difference between present value of the benefits and the present value of the costs NPV = PV(B) – PV(C)

CAPITAL BUDGETING_LECT 097 Decision Rules A single alternative to the status quo –Adopt the project if NPV > 0; which means PV(B) > PV(C) More than one alternative to the status quo –Select the project with the largest NPV Assuming that at least one alternative is positive In the highway example, the no-tolls alternative has higher NPV than the tolls alternative –The largest NPV rule recommends the more efficient of the alternatives compared; but there’s no assurance that the most efficient alternative is being recommended

CAPITAL BUDGETING_LECT 098 Other Criteria—Benefit Cost Ratio Benefit-Cost Ratio (BCR) –The present value of benefits divided by the present value of costs –When BCR = 1; the present value of benefits are equal to present value of costs As the ratio increases, the benefits accruing have increased –An analyst would recommend A BCR > 1 if comparing one alternative to status quo The largest BCR if comparing more than one alternative to the status quo –BCR could be the wrong choice When alternatives are of different scale (some cost a lot more than others) Depending on whether negative willingness-to-pay amounts are subtracted from benefits or added to costs When the benefits stream changes signs more than once

CAPITAL BUDGETING_LECT 099 Other Criteria—Internal Rate of Return The discount rate at which the NPV is zero is also called the internal rate of return –Is that rate of discount applied to benefit and cost streams which sets PV(B) = PV(C), or NPV = 0

CAPITAL BUDGETING_LECT 0910 (8) Perform Sensitivity Analysis Recognizing that predicting and monetizing impacts is difficult, sensitivity analysis reassesses the appropriateness and quantification of: –the discount rate selected –The level of standing selected (whose benefits and costs really count?) –Other relevant questions: How accurate is the estimate of the lives saved by the shorter and safer proposed highway? How accurate is the dollar value placed on a statistical life saved?

CAPITAL BUDGETING_LECT 0911 (9) Make a Recommendation Generally, the alternative with the largest NPV is recommended –In the highway example, Option A is better than C Option B is better than D –The no-tolls alternative is superior Option D has a negative NPV –Compared to the status quo, It would be more efficient not to build the highway –The tolls lower the NPV because they deter people from using the highway, and so fewer people enjoy the benefits

CAPITAL BUDGETING_LECT 0912 Strengths and Weaknesses of CBA Strengths –Versatile Applies to many project types –Provides a useful framework in which to consider issues A systematic approach Uses economic principles Weaknesses –Empirical difficulties Data availability Reliability of data sources –Monetizing difficult –Methodological difficulties Still used as efficiency analysis and not as distributional tool Still an incremental approach –Does not account for all possible alternatives Utilitarian in nature –Places monetary value on all aspects of life May pre-empt political decision making

CAPITAL BUDGETING_LECT 0913 Practicality of Efficiency Analyses Impractical if –Required technical procedures are beyond the scope of the evaluation project –Required resources too high –Methodological requirements may be outside the staff’s expertise –Political or moral controversies by placing economic values on outcome measures –The methodology may be too confusing for the stakeholders –Data may not be available Private entities conduct cost-benefit analysis on a purely financial objective—profit maximization –Issues relevant to government are not applicable to the private sector