Introduction to
Financial Management
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Easter Revision guide based on analysis of Past Papers for
ES3D4 and ES4D5
2010
2011
Concrete pressure (lectures 29 and 30 by Paul Markham)
Q1
Q1
Waste management (lectures 23 & 24 by Martin Fairlie, chapter 5 in
Operations Management for Construction by Chris March)
Q2
Q2
Safety regulation in the context of CDM (lectures 17 to 19 by Martin
Fairlie, chapter 4 in Operations Management for Construction by
Chris March)
Q3
Q3
Project appraisal - whole life costs and Net Present Value
(lectures 26 to 28 by Karen Bradbury)
Q4
Types of procurement contract (lectures 9 and 10 by George Webb)
Q4
2011-12 Surveying added (lectures 1 to 4 by Tony Price & Nicki
Meads)
Equipment productivity and selection
Q5
ES4D5 only – project management networks
Q6
Q5
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Project Appraisal
Financial Models
Comparing the
value of
different
contracts
Choosing new
equipment
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Financial Models for Project Selection
•
•
•
•
Payback period
Return on investment (ROI)
Net present value (NPV)
Internal rate of return (IRR)
• All these techniques are limited
because they rely on forecasted
cash-flow.
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Payback Period
• The time taken to gain a financial
return = the original investment.
Year
Cash-flow m/c A
Cash-flow m/c B
0
(£35, 000)
(£35, 000)
1
£20, 000
£10, 000
2
£15, 000
£10, 000
3
£10, 000
£15, 000
4
£10, 000
£20, 000
Payback
period
2 Years
3 years
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Payback Period cont.
Advantages
• Simple
• Uses readily available
accounting data
• Shortest payback =
lowest risk
• Faster payback has
favourable short-term
effect on earnings per
share
Disadvantages
• Ignores time value of
money
• Indifferent to the
timing of the cash-flow
(if payback time equal)
• Takes no account of
what happens after
payback period
• Does not quantify risk
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Return on Investment
Average Annual Profit
ROI 
%
Original Investment
AAP 
(Total gains)  (Total outlay )
Number of years
Year
Cash-flow m/c A
Cash-flow m/c B
0
(£35, 000)
(£35, 000)
1
£20, 000
£10, 000
2
£15, 000
£10, 000
3
£10, 000
£15, 000
4
£10, 000
£20, 000
Total gains
£55, 000
£55, 000
AAP 
20000
 £5000
4
ROI 
5000
 14%
35000
For both
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Compound growth
• Invest £1 today at interest rate of 10%per annum,
compounded annually
Time (T)
1
2
3
Value
after T years
£1 x (1+0.10)
= £1.10
£1 x (1+0.10)2
= £1.21
£1 x (1+0.10)3
= £1.33
• In general, £1 invested today for T years at R%
per annum, compounded annually, will grow to:




£1  1 R
100
T




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Discount Factors and Present Value
• Conversely, in order to end up with £1 at
the end of T years, today we need invest
only:
£1 
1
T
1 R 


 100 
• This is the present value of £1 that we
expect to receive T years from now
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Discount Factors and Present Value cont.
• The discount factor that multiplies £1 in the
above expression reflects the time value of
money
– £1 expected T years from now is not as
valuable as £1 for sure today
– if we had £1 today, we could invest it for
T years at R% per annum
• the interest forgone is the opportunity
cost of having to wait T years to receive
£1
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Discounted Cash Flows cont.
• Present value of expected future cash flows:
PV  20000  15000 2  10000 3  10000 4
A
1  0.10
1  0.10
1  0.10
1  0.10






PV  10000  10000 2  15000 3  20000 4
B
1  0.10
1  0.10
1  0.10
1  0.10






assuming company’s cost of capital = 10% per
annum
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Net Present Value
• In return for some initial investment I, a typical
capital project is expected to generate a stream
of future cash flows Ct , t = 1, 2, … T
C1
C2
C3
CT
…
1
2
3
T
I
• Net Present Value of project equals:
C3
C1
C2
CT
NPV   I 



T
2
3
1 R 1 R  1 R 
1 R 






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Net Present Value cont.
• If NPV > 0, then the project adds value for
the company’s shareholders
– provided capital is not rationed, company
should undertake the project
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Year
Cash-flow m/c A
Discount factor
PV
0
(£35, 000)
0
(£35, 000)
1
£20, 000
0.9091
£18, 182
2
£15, 000
0.8264
£12, 396
3
£10, 000
0.7513
£7, 513
4
£10, 000
0.6830
£6, 830
Total NPV
£9, 921
Year
Cash-flow m/c B
Discount factor
PV
0
(£35, 000)
0
(£35, 000)
1
£10, 000
0.9091
£9, 091
2
£10, 000
0.8264
£8, 264
3
£15, 000
0.7513
£11, 270
4
£20, 000
0.6830
£13, 660
Total NPV
£7, 285
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Net Present Value cont.
Advantages
• Introduces time value
of money
• Expresses future cashflow in today’s values
• Allows for inflation and
escalation
• More accurate profit &
loss forecast
• Used for simulation
Disadvantages
• Accuracy limited by
predictions of cash-flow
and inflation
• Biased towards shortterm projects
• Excludes non-financial
data, e.g. market
potential
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Hurdle Rate
• The hurdle rate for a project is the
minimum rate of return that the providers
of the firm’s capital require from the
investment
• Also known as opportunity cost of capital
– how much providers of firm’s capital
could earn from investing the money
instead in a well-diversified portfolio of
financial securities of same risk as
project
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Hurdle Rate cont.
Alternative definition:
“The required rate of return in a discounted
cash flow analysis, above which an investment
makes sense and below which it does not.
Often, this is based on the firm's cost of
capital or weighted average cost of capital,
plus or minus a risk premium to reflect the
project's specific risk characteristics. “
www.investorwords.com/2362/hurdle_rate.html
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Hurdle Rate cont.
• Hurdle rate is provided by financial markets:
Hurdle
Rate
Market
Risk-free
Return
Market
Risk Premium
Risk
i.e. the greater the risk the higher the required
rate of return.
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Internal Rate of Return
• Internal rate of return, IRR, is the value of the discount
rate R that makes NPV = 0
• If a project is expected to generate a stream of positive
future cash flows in return for some initial investment I,
then graph of NPV vs. R looks like:
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Internal Rate of Return cont.
• The “NPV > 0” rule for accepting capital projects is then
equivalent to the rule:
IRR  hurdle rate
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Year
Cash-flow m/c A
Discount factor 24%
PV
0
(£35, 000)
0
(£35, 000)
1
£20, 000
0.8065
£16, 130
2
£15, 000
0.6504
£9, 756
3
£10, 000
0.5245
£5, 245
4
£10, 000
0.4230
£4, 230
Total NPV
£361
Year
Cash-flow m/c A
Discount factor 25%
PV
0
(£35, 000)
0
(£35, 000)
1
£20, 000
0.8000
£16, 000
2
£15, 000
0. 6400
£9, 600
3
£10, 000
0.5120
£5, 120
4
£10, 000
0.4096
£4, 096
Total NPV
(£184)
Therefore 24% <IRR<25% (for m/c B 18% <IRR<19% not shown)
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• Net present value (NPV) is when we subtract
initial investment from present value of cash flow
– Positive NPV means that the project created
value
• Internal rate of return (IRR) is the discount rate
that makes NPV zero
– If the IRR is equal or greater than the company
“hurdle rate” then the project creates value
• Payback period is the time it takes to cover the
investment
• Return on investment measures the profitability
of an investment
Massood Samii, MIT OpenCourseWare
Summary
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Meehan corp. is a civil engineering company
with annual revenue of £8 billion per year. The
company is a multinational with operation in
Latin America and South East Asia. Meehan
was established in 1962, and since then it has
experienced a high rate of growth. The
company is involved in infrastructure
development, commercial property development
and oil exploration and development. The
company is currently considering whether or
not to accept a road construction project.
Massood Samii, MIT OpenCourseWare
Example
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Meehan has collected the following information
about the project; which will take four years to
complete and Meehan must initially invest about
£64 million on equipment and £26 million on
buying the necessary property, for a total of £90
million. The annual operation cost is £20 million a
year, which includes labour cost, and other
operational costs. The company uses straight line
8 years depreciation. The salvage value of
equipment is calculated as the cost. The tax rate
is 34%.
Massood Samii, MIT OpenCourseWare
Example cont.
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The contract calls for payment of £32 million at the end
of each of first three years and £100 million upon
completion at the end of the four year period. The project
will commence in January 2010. Therefore all initial
expenses such as purchase of land and equipment must
take place prior to the start of the project. However,
operational revenue and costs are calculated for the end
of each subsequent year.
• Should Meehan accept this project, if the discount rate
is 10%?
• What if Meehan used 8% discount rate?
• What if Meehan needed a £5 million working capital that
it would recapture at the end of the project?
Massood Samii, MIT OpenCourseWare
Example cont.
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Massood Samii, MIT OpenCourseWare
£ million
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Massood Samii, MIT OpenCourseWare
£ million
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Exam Question 4, 2010 –
Whole Life Cost
Type A Windows
Type B Windows
• £900,000 to install
• £20,000 to decorate
every 5 years
• Replace after 25 years
for £1,200,000
• £1,250,000 to install
• Repair at 20 years and
40 years for £300,000
each time
Discount factor at 4%
0 yrs = 1, 5 = 0.8219, 10 = 0.6756, 15 = 0.5553,
20 = 0.4564, 25 = 0.3751, 30 = 0.3083, 35 =
0.2534, 40 = 0.2083, 45 = 0.1712
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Recommend which windows
and what factors might
influence the decision?
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Which to use; IRR or NPV?
• Why not all?
• Accountants prefer NPV to IRR because the
interest rate can be varied with NPV
• NPV is a measure of profitability based on the
transaction
• IRR is a measure of profitability established by
the capital markets (hurdle)
• In a capital drought use NPV because the
fundamental objective of financial analysis is to
maximise the PV of the company’s investment
portfolio.
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Determining the Discount Rate
C1
C2
C3
CT
…
0
1
2
3
…
T
C3
C1
C2
CT
PV 



T
1 R 1 R 2 1 R 3
1 R 






But … how do we determine the discount rate R?
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Discount Rate
• Discount rate R is the opportunity cost of capital
– i.e. return that investors could obtain for
themselves by investing instead in a well-diversified
portfolio of financial securities with same level of
risk as project
• What do we mean by “risk”, and how do we measure it?
• How do we adjust discount rate R for risk?
• Financial markets provide the answer
– highly efficient at pricing securities
– only risk that cannot be diversified is rewarded by
financial markets with additional return
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What determines the discount rate R?
Where:
R is the discount rate
Rf the risk free interest rate. Normally government bond
Ri Rate of inflation. It is measured by either by consumer price
index or GDP deflator.
Rr Risk factor consisting of market risk, industry risk, firm
specific risk and project risk
Example: If risk free interest is 5%, inflation 3% then nominal
rate of interest is 8%. In addition if we add 5% risk premium
then our discount rate is 13%
Later we argue that weighted average cost of capital would make a
good indicator for discount rate
Massood Samii, MIT OpenCourseWare
R = Rf + Ri + Rr
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Beta
“A quantitative measure of the volatility of a
given stock, mutual fund, or portfolio,
relative to the overall market. Specifically,
the performance the stock, fund or portfolio
has experienced in the last 5 years as the
market moved 1% up or down. A beta above 1
is more volatile than the overall market, while
a beta below 1 is less volatile.”
www.investorwords.com/4378/SP_500.html
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Beta cont.
• Required return on any asset (or portfolio of assets)
reflects the component of risk that cannot be
diversified away i.e. the risk that is related to the
economy as a whole
– this component of risk is known as systematic risk
• Systematic risk is measured by the beta of the asset
(or portfolio of assets)
– beta of market portfolio equals 1
• So … in order to determine the rate of return
required of an investment, we need to be able to
estimate the beta of that asset
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Securities Market Line cont.
• The risk-free rate RF is the return that we
expect from investing in an asset that has no
risk
– e.g. short-dated Treasury bills issued on
behalf of UK or US Government
• The market risk premium E[RM]-RF is the
extra return that we expect from investing in
a well-diversified portfolio that tracks the
market
– by definition, this portfolio has a beta of 1
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Capital Asset Pricing Model
• The Securities Market Line is the graph of the
Capital Asset Pricing Model (CAPM)
• In words, the CAPM says that:
Expected return on asset i
 risk - free rate  (beta of asset i)  (market risk premium)
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Cost of Equity vs. Cost of Debt
• Most companies are financed partly by
– equity (owned by shareholders)
– debt (owned by lenders)
• In general, equity is more risky than debt
– interest payments on debt must be paid,
whereas dividends can be cut or not paid
• As a result, shareholders demand a higher rate
of return from their investment than do lenders
– cost of equity is higher than cost of debt
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Cost of Equity vs. Cost of Debt
cont.
• Weighted Average Cost of Capital (WACC)
reflects the split (by market value) in company’s
financing:
WACC  (proportion of debt)  (cost of debt)
 (proportion of equity)  (cost of equity)
or in symbols:
WACC 
D  E[R ]  E  E[R ]
D
E
D E
D E
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WACC
• WACC represents the overall return on the firm’s
assets required by providers of capital
• WACC provides a benchmark
– return required on “average risk” project
undertaken by company
• Need to use a higher (lower) rate to discount cash
flows from projects of higher (lower) risk than
“average-risk” project
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Summary
• Time value of money
– expected future cash flow of £1 T years from now
is not as valuable as receiving £1 for certain now
– present value of expected future cash flow is
obtained by multiplying cash flow by discount factor
1/(1+R)T
• Discount factor reflects both timing and risk of
expected future cash flow
– the higher the risk, the greater is discount rate R
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Summary cont.
• Net Present Value, NPV, of stream of expected future
cash flows equals the sum of the present values of
individual expected future cash flows, net of initial
investment I
• If capital is not rationed, company should accept all
capital projects with NPV > 0
– if capital is rationed, company should rank projects
according to profitability index NPV/I
• Internal rate of return IRR is the value of the
discount rate R that makes NPV = 0
– break-even rate
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Summary cont.
• Cost of capital is rate of return required by providers
of finance
– shareholders expect to earn cost of equity on their
shareholdings
– lenders expect to earn cost of debt on their loans
• CAPM quantifies the relationship between expected (or
required) return and (systematic) risk for any asset (or
portfolio of assets):
E[Ri ]  RF  bi (E[RM ]  RF )
where systematic risk is measured by asset’s beta bi
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Summary cont.
• WACC is weighted average of cost of debt and
cost of equity
– weights equal the proportions (by market
value) of equity and debt financing in the
company’s capital structure
• WACC is a key input to corporate financial
decision-making
– return on firm’s assets required on average by
providers of capital
– reflects overall risk level of firm’s operations
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Summary cont.
• Cost of equity also reflects financial risk
associated with company having debt in its
capital structure
– “hidden cost” of equity financing
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Cost Benefit Analysis
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• Public projects are those that are undertaken by government.
Their objective is not necessarily to maximize profit or NPV as
discussed earlier
• The main objective of public projects is to maximize social
benefits and return to the society
• The problem arises regarding quantification of benefits and
costs. Often there is no tradable market for public goods (parks,
environmental clean up, non-toll road) or even if there is, it does
not reflect the true value to the society (public education, public
transportation).
• The method used for the evaluation of a project from the public
point of view ( as opposed to a private firm which looks purely for
private value creation for owner/stockholders) is called CostBenefit Analysis ( value creation for society).
Massood Samii, MIT OpenCourseWare
Public Projects
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Definition
Guide to Cost-Benefit Analysis of Major Projects, In
the context of EC Regional Policy, 1997 edition,
European Union
Massood Samii, MIT OpenCourseWare
“Cost-Benefit Analysis is a procedure for evaluating
the desirability of a project by weighting benefits
against costs. Results may be expressed in different
ways, including internal rate of return, net present
value and benefit-cost ratio.”
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1. Project identification
2. Definition of objectives (unemployment, economic
growth, reduce regional income inequality)
3. Feasibility and option analysis
4. Financial analysis
5. Socio-economic costs
6. Socio-economic benefits
7. Discounting
8. Economic rate of return
9. Other evaluation criteria
10. Sensitivity and risk analysis
Massood Samii, MIT OpenCourseWare
EU CBA for major projects
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• Objective of investment may not necessarily
be profit, but other factors such as job
creation.
• In public goods, for example non-toll highway,
since no payment is taking place, evaluation
must be based on another alternative.
• For public goods, evaluation of benefits is in
terms of non monetary returns. The gain from
an investment is for the society and not for
investors.
Massood Samii, MIT OpenCourseWare
Why Cost-Benefit Analysis
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• The issue is how best to quantify the
benefits other than monetary benefits
from particular investment. Yet all those
benefits must be put in a monetary term
for comparison purposes
• In NPV and IRR costs are both explicit.
However, implicit cost and benefits, namely
social costs are not taken into account.
Massood Samii, MIT OpenCourseWare
Why CBA cont.
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• How do we decide on the return on public goods if they are not traded
(can we find a similar trade-able good such as a similar toll road ?)
• If the government charges a fee for the use of public goods, what
should be the fee? ( for example, what is the proper level of toll that
government collects?). After all in many cases government or the
owner of public goods (even in the case of privatized toll road) has a
monopoly power and therefore it can exploit this power.
• What is the distributive effect of the government subsidizing the use
of public goods (or taxing it)? For example if a motorway is built with
tax money, but I never get to use that motorway, why should I pay for
it?
• What is the externality of public goods (construction of a motorway)?
That is the businesses around the highway benefit from an increase in
activities leading to an increase in tax revenue.
Massood Samii, MIT OpenCourseWare
Key questions
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• What rate of discount should be used in the calculation?
Some of the decision on public goods could be politically
motivated. The two critical issues are prices and
decision to investment.
For example, price of water, electricity, toll and
bridges, tuition in public universities are all political
decisions and are not fully driven by market forces.
• But while decisions are politically driven, they must also
have economic justifications. How do we measure the
economic benefits?
Massood Samii, MIT OpenCourseWare
Key questions cont.
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Impact of Large Projects
– A large project may in fact raise the labour cost for
other sectors
– It could also effect over all economic growth of
country with its positive impact on the economy as a
whole, leading to increase in demand for output of
other sectors
– From social point of view, government decisions must
take into account these and a number of other
impacts
Massood Samii, MIT OpenCourseWare
• Mega projects absorb a large amount of
resources with substantial impact over a long
term on the prices and outputs of other sectors
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• Most of the public projects have a feed back system. For
example, a highway to reduce traffic congestion may lead
to increase in economic activities in that region, which
cause migration to the area which in turn leads to more
traffic and congestion.
• Also, in many cases project A would effect project B
either directly or sometimes indirectly through project
C. For example, building of a highway may speed up
traffic, but could lead to congestion in the feeder road,
if they are left unimproved
• While it is possible to see relationships mentioned above,
their quantifications are not trivial and are quite
difficult to estimate.
Massood Samii, MIT OpenCourseWare
Definition of project
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• Public investment projects should take into account the
external effect of their action so far as it alters the
physical production possibilities of other producers or
satisfaction that consumers get from resources. It should
not take into account side effects if the sole effect is via
prices of products or factors. For example, a dam has its
main objective of irrigation and electricity generation, but
it also may provide, free of charge, a possibility for people
to use the area around it for a picnic. The benefit to users
of a picnic area is the externality. But, if there is a charge
for the park, only the charge should be included in the
estimation.
• Therefore externalities are when other benefits without
payment are taking place as a result of a particular
investment.
Massood Samii, MIT OpenCourseWare
Externalities
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Secondary Benefits
For example an irrigation system will lead to more
grain production which in turn leads to a series of
other related activates down stream. There is a
debate as to whether we should use the secondary
benefits. General consensus is that if the market
price reflects the benefit of secondary effects
we should use that, otherwise we must impute the
value of secondary benefits .
Massood Samii, MIT OpenCourseWare
• Inducement to create other activities is
considered to be secondary effect. These should
be taken into account.
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• Use of social rate of discount presents a number of
difficulties.
• Role of time and preference. Private investor preference is
toward a quicker return (short term) than public
investment.
• The weighted average cost of capital used by the private
sector as the discount rate is not applicable in the case of
public projects. This is because of the structure of
government financing through taxes and government bonds.
• Government has the advantage in terms of having a lower
rate of interest than the private sector. This implies that
the social rate of discount for the same project is lower for
the government than for private sector.
Massood Samii, MIT OpenCourseWare
Choice of Discount Rate
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• The issue of distributive effect is highly theoretical.
– The argument is the following: since government is
the agent of society it should take the interests of all
equally into account. Therefore, by its decision it will
impact some people negatively (by taxation) and
others positively by investment. This kind of decisions
are not “Pareto Optimal”.
– The counter argument is that if the net gain is
greater than the net loss, the gainers can compensate
losers and society is left with a net positive result.
– However, this is problematic since valuation of gain
and loses by individuals in the society is difficult.
Massood Samii, MIT OpenCourseWare
Distributional Constraints
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• Implication for infrastructure is that taxing and
investing in infrastructure is not “Pareto Optimal”,
while privatised development of infrastructure is,
since those who use the facility pay for it and are
better off, whilst not taxing others .
• Alternatively it is argued that if the decision
improves the overall social benefit, even if it makes
some worse off, it is still an acceptable decision.
e.g. Government involvement in infrastructure using
tax, which makes some tax payers worse off but
increases the benefit to society is acceptable if
the social benefits exceed the social cost.
Massood Samii, MIT OpenCourseWare
Social Choice
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• A government has a limited budget, therefore it
must allocate its resources among various uses.
The issues therefore include:
– Does the project provide net benefit (benefit
over cost)?
– Does it provide the highest net benefit among
various projects government can undertake?
– For whom does it create benefit (allocation
issue)?
Massood Samii, MIT OpenCourseWare
Budgetary Constraint
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A CBA is conducted for a simple highway improvement and
extension. The improvement in highway leads to more
capacity resulting in time saving. Data indicates that for
rush hour the time cost of a trip is £5 without and £3
with the project . It is assumed that operating cost of a
vehicle is unaffected by the project (£4). The project
lowers the cost of each trip leading to an increase in the
number of trips. For rush hour the cost saving is £2 and
for non rush hour it is £0.8. The project is also expected
to reduce fatalities from 12 per year to 6. We assume
value of time to be £0.1 per minute during rush hour and
0.08 during non-rush hour.
Massood Samii, MIT OpenCourseWare
Example
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Example cont.
Massood Samii, MIT OpenCourseWare
Assume cost of right of way is £100 million that can
be recovered at the end of the project and that the
construction cost is £200 million over four years
(£50 million a year) and maintenance £1 million per
year. Calculate whether this project makes sense if
the life of the project is 30 years and the bond rate
is 4% with 2% inflation rate (2% real interest).
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Massood Samii, MIT OpenCourseWare
Data for Highway Project
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Determining Consumer Surplus
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Massood Samii, MIT OpenCourseWare
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Massood Samii, MIT OpenCourseWare
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