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Cost Benefit Analysis

# Cost Benefit Analysis

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05/22/2013

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Cost Benefit Analysis
Cullis and Jones chap 6

Future benefits and costs discounted at present value.The individuals are not indifferent between certain sum omoney today and the receipt the same in future.If r is interest rate and n is number of years the discount factor is 1/(1+r)nAssume that there are monetary benefits received each yearsare converted into present value and added, the PV is thestream of earnings:The costs are split into initial cost I
0
and current costs C1,C2,…..which occur during the lifetime of projectThe net benefits are discounted to evaluate
net present value
The projects are ranked according to their NPV.The best project are with highest NPV. .Project are selected if NPV>=0
nn
B B B PV
)1(...)1()1(
221
++++++=
nn
B B B I  NPV
)1((...)1()()1()(
2210
+++++++=
=
++=
niii
B I   NPV
10
)1()(

The Internal rate of return
is the value of r that makesthe stream of discounted net benefits equal to initialcapital cost.The projects with high NPV have also high IRR.It is preferable to rank projects according to NPVBecause there is no unique solution of IRR, there aremore than one discount rate make stream of earningequal to zero.Mutually exclusive projects, IRR will select the projectnot chosen by NPV.In public sector project different benefits, costs anddiscount rate are calculated. Based on welfareeconomics.When for public expenditure project NPV is positive itmeans that if the project is undertaken the beneficiariesfrom the investment will gain more than the losers
=
+=
n
B I
10
)1()(