Lecture4_3509 - Last Class Economic viability of projects:...

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Last Class Economic viability of projects: - Whether to go ahead with a project - Choice between mutually exclusive projects 1
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2 Criteria for accepting/rejecting projects Net present value, NPV Benefit – Cost Ratio Payback period Internal rate of return (IRR) Wealth Maximizing Rate (WMR)
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B/C ratio: the problem of scale Consider one hectare of land. Mutually exclusive projects: Crop 1: Costs: $100 Revenue after a year: $150 Crop 2: Costs: $10 Revenue: after a year: $20 Discount rate: 10% Which to choose? 3
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Making Projects comparable Must have the same PV C Crop 1: Costs: $100; Revenue after a year: $150 B/C ratio: 1.37 Crop 2: Costs: $10; Revenue: $20 Borrow $90, invest for a year, gain $90(1+r) next year Cost: $100 Benefit: $20+$90*(1+0.1): $119 4
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Making Projects comparable For project 2: PVC = 100 PVB = 119/1.1 = 108.2 B/C ratio: 1.08 Choose project 1 Consistent with NPV 5
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B/C ratio Remember: always discount your cash flows Appropriate for determining to go ahead or not with a single project Can lead to wrong choices when comparing projects of different scale. To be able to compare projects, adjust the scale (same PV C ) 6
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7 Payback Period The payback period is defined as the time required for a project's total benefits to exceed its total costs. At that time, the project can be said to have “paid back” its initial cost, hence the name payback period. It is popular for some applications (and sometimes for politicians) since it allows projects to be judged by how rapidly they pay off. It has a logical appeal understood by non- economists However, as the C/B ratio, it can lead to poor financial decisions.
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8 Examples Energy conservation investments: Government advertise: if you replace your light bulbs with energy efficient lights, it will pay back in xxx years. Water conservation investments Buy a water-efficient toilet and after YY years you have paid it Buy a hybrid vehicle
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9 Estimating the payback period Let X t be any cash flow in period t (the difference between benefit and costs in period t). Let p be the payback period The “undiscounted” payback period, p is found when : X 0 + X 1 + X 2 +.. X p ≥ 0 Example: -100, 10, 10, 10, 10, 10, …. What is the payback period?
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Estimating the payback period Undiscounted version is flawed because it does not considers the time value of money. By discounting, the payback period is
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This note was uploaded on 05/27/2010 for the course ECON ECON 3509 taught by Professor Pablo during the Winter '09 term at Carleton CA.

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Lecture4_3509 - Last Class Economic viability of projects:...

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