1. Finance: Net Present Value & Benefit/Cost Analysis Lecture 10.1a ECON 201 Jun 9, 2009

2. Evaluating Projects Expansion project –Requires an initial investment, I o –Yields a flow of benefits and costs over time: B t, C t

3. The Net Benefits from an Investment The net benefit of an investment project is the difference between the revenue generated by the project and the project’s cost, including opportunity cost.

4. Interest Interest is an important part of the investment decision for two reasons: –First, interest must be paid to borrow funds. –Second, interest is the opportunity cost of using money to pay for an investment project. Money used to purchase capital could have been deposited in a bank to earn interest.

5. Interest (cont’d) Lenders charge interest: –To compensate themselves for not being able to use their own money to buy the things they want –To compensate themselves for the risk they assume when they make a loan –Because rising prices will reduce the purchasing power of the money when it is repaid

6. Present and Future Value The present value (PV) of money received in the future is equal to its value today. –In other words, it is the maximum amount that someone would pay today to receive the money in the future.

7. Net Present Value Firms focus on the net present value (NPV) of an asset when making investment decisions. –NPV = PV of the asset minus the PV of the expenditures on the asset. If NPV > 0 then the investment is profitable. –All else equal, the sooner the benefits are received and the lower the interest rate, the higher the NPV.

8. Other Decision Criteria Payback –Determine the number of years until revenues = costs –Choose project with shortest payback period Accounting Rate of Return – average annual profit / initial outlay

9. Have to Choose 1 Project Projects are mutually exclusive –E.g., SPU & Taylor Creek Several options to improve drainage; but can only do 1

10. NPV Decision Rules If only 1 project, or not capital constrained –NPV > 0 If more than 1 project and capital constrained –If the same initial investment Choose project(s) with highest NPV –If different investment levels Choose project(s) with highest (NPV) Benefit to Cost Ratio

11. Interest and the Demand for Capital The interest rate represents the opportunity cost of purchasing capital. Therefore, as the interest rate increases, the quantity of capital demanded will fall.

12. Figure 14.1 The Demand Curve for Physical Capital

13. Other Applications Evaluating benefit/cost of medical care that increases longevity (stop smoking) –Found that NPV of increased life-span < increased costs of medical care Army Corp of Engineers –Always uses B/C analysis to evaluate projects Government Accounting Office –Required to evaluate congressional proposals Insurance premiums –B/C analysis + actuarial analysis

14. Other Applications How do we determine the value of the firm –Flow of revenues and costs –B t = “expected” revenue stream –C t = “expected” expenses Stock price –NPV/(#shares)

15. Closer to Home Mortgage Payments

16. Closer to Home Decision to refinance –Cost of refinancing Loan origination fees (~2% of the loan): -I o NPV of monthly payments at new interest rate –Cost of Current loan NPV of remaining payments at old (higher) interest rate

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