Learning Notes 3

Discounting
- Takes over periods rather than years
- In all public-sector, discounting period = a year
Future Value Analysis
- Compares the amount the city will receive in the future if it engages in the project with the amount it will
receive in the future if it invests in money
- Future Value
o The amount the city will have in the future if someone buy’s something (e.g. land)
- The future value in one year of some amount X available today (principal amount)
o FV = X ( 1 + I )
 X = amount available today, called principal amount
 i = annual interest rate
- Interest rates are stated as percentages
o Note: one enters interest rate and includes a minus sign in front of principal amount
 First argument = interest rate
 Second term = number of periods
 Third term = annuities
 Fourth term = principal amount
- In Excel:
o = -FV(0.5,1,,1000)
o =FV (0.5,1,,-1000)

Present Value Analysis

- Compares current equivalent value of the project with current equivalent value of best alternative project
- Present Value
o Current equivalent value of the project

o
 i = prevailing annual interest rate
 Y = amount received in one year
- The present value of some future amount decreases as the interest rate increases
- In Excel:
o = -PV (.05,1,,1000)
o = PV (.05,1,,-1000)

Net Present Value Analysis

- Calculates present values of all benefits and costs of a project, and sum it up
o Includes initial investment
o Obtains net present value (NPV)
- If NPV is positive, buy it
-
 o PV(B) = present value of the benefits
o PV© = present value of costs
- Provides a simple criterion for deciding whether to undertake a project
- Positive NPV decision rule assumes implicitly that no other alternative with a higher NPV exists
- If there are multiple, mutually exclusive alternatives, then one should select the alternative with the highest
NPV.
- Analysts assume that government can borrow or lend funds ate the same interest rate
o It does not matter whether the government currently has the money or not – NPV rule still holds
o Select the project with largest NPV

Future Value over Multiple Years

- To calculate the interest in future years, know if simple interest or compound interest.
- Simple interest
o Each year interest is received only on original principal amount
o No interest is paid on the interest received each year
- Compound interest
o Interest is compounded annually
o Investment would grow
o Interest is earned on principal amount and on interest that has been reinvested (interest on the
interest)
 Process called “compounding interest”
- Always assume that interest is compounded annually, unless explicitly stated otherwise.
- Gap between compound interest and simple interest become large over longer periods
o Divergence between the two increases with interest rate
-
o X = amount
o N = years
o I = interest rate compounded annually
o FV = Future Value
o (1+i)^n = Compound interest factor
 Gives future value
 Compounded annually
- In Excel:
o To obtain compound interest
 = - FV (.05,4,,1)
 = FV (.05,4,,-1)
o To obtain FV:
 = - FV (.05,4,,10)
 = FV (.05,4,,-10)
- FV increases as interest rate increases and as number of periods increases.
Present Value over Multiple Years

- Present value of $Y received in n years with interest compounded annually at rate i is

o 1/(1 + i) ^n = present value factor or discount factor
 - In Excel
o To obtain the present value factor for PV
 = - PV (.06,3,,1)
 = PV (0.6,3,,-1)
o To obtain FV
 = -FV (.06,3,,10)
 = FV (.06,3,,-10)
- Discounting
o Process of calculating the present value for a future amount
o The present value for a future amount is less than the future amount itself
- The amount of discount increases as interest rate increases and as the number of years increases
- Effect of interest rates on PV increases with time
- The formulas that summarize the relationship between discounting and compounding:

o
o
- If project yields benefits in more than one period, compute the present value of the whole stream by adding
present values of the benefits received in each period. PV(B):

o
- If C1 = costs incurred in period t, then PV (C):

References
Anthony , B., David, G., Aidan, V., & David, W. (2018). Cost-Benefit Analysis: Concept and Practice.
United States of America: Sheridan Books, Inc.