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WR Economics Tutorial

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34 views23 pages

WR Economics Tutorial

Uploaded by

tino
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Capital Recovery factor

• A Capital Recovery Factor (CRF) converts a present value into a stream of


equal annual payments over a specified time, at a specified discount rate
(interest).

• The value of an equal payment (Annuity) to be made in each of n periods


is given by:
• A = P x CRF where

CRF= capital recovery factor: =

The present value, P is then equal to 1/CRF × A. the reciprocal of the CRF is
called the Annuity factor
EAC (Equivalent Annual Cost)
To Calculate annual investment cost:

i
n
 Capital Recovery Factor
[1  (1  i ) ]
where:
i = interest rate (fraction)
n = number of years
EAC equivalent annual cost
Investment: $150 000
Life time: 8 years
OM: $7 500 / year
Discount rate: 5%
Capital Recovery factor ?

Annual capital cost: ?

EAC: ?
EAC equivalent annual cost
Investment: $150 000
Life time: 8 years
OM: $7 500 / year
Discount rate: 5%
Capital Recovery factor : 0.155

Annual capital cost: 23 250

EAC: 23 250 +7 500 = 30 750


Remember: A Capital Recovery Factor (CRF) converts a present
value into a stream of equal annual payments over a specified
time, at a specified discount rate (interest).

Total investment is $450,000 and $260,000, respectively, for the


two projects. Even though the annual O&M costs are lower for
Plan A, the annual cost comparison tells us that the extra
investment is not justified. Thus Plan B should be selected.
Calculation of NPV
• NPV =
• Where B0, B1, B2, …Bt are the benefits in years 0,1,2,…t
• C0, C1, C2, … Ct are the costs in years 0, 1, 2, … t
• i is the rate of interest
Benefit-Cost Ratio
-A project can be undertaken if B/C>1
-This implies that B-C>0, similar to the present
value calculation considered earlier

The benefit-cost ratio is poor for comparing


between projects, as it doesn’t consider
the amount of PV:

$3 net PV could have a B/C value of 1.7


while $2,000,000 net PV could have a B/C
value of only 1.1
Internal Rate of Return (IRR)
• The IRR is the discount rate at which the PV of
benefits equals the present value of costs.

• The IRR is the maximum interest rate that could


be paid for the project resources that would
leave enough money to cover investment costs
and still allow society to break even.
IRR Formula
Solve for the IRR by finding i that solves:

PV(Benefits) = PV(Costs)

• The IRR must exceed the chosen


discount rate for the project to be
accepted.
Advantages of BCA
1. Provides a framework

2. BCA is quantitative
3. BCA is based on facts
4. The methods provide clarity
5. Results allow comparability
Disadvantages of BCA
1. Requires valuation

2. Discount rate sensitivity


Each evaluation criteria yields a different answer to the
decision question
• The answer to a NPV analysis is a monetary amount ($$$)
• The IRR determines the discount rate where the PV of
benefits is just equal to the PV of costs (and the IRR is then
compared to the discount rate)
• The answer to a B/CR calculation is a ratio (a pure number,
often just less than or just more than 1.0)
• All three criteria use the same input data on benefits and
costs over a defined time period (the “time horizon”), and
with a pre-determined discount rate for NPV and B/CR. The
IRR solves for the discount rate where PV benefits is equal
to PV of costs.
BCA – Alternative Decision Rules based on the same basic inputs
– benefit and cost information

Bt  Ct
n
Net Present Value (NPV)  NPV  
t  0 1  r 
t

n
Bt  Ct
Economic Internal Rate
of Return (EIRR)
 
t  0 1  r 
t
0

n
Bt
Benefit-Cost Ratio
 1  r t

 B/C ratio  t n0


(B/CR) Ct

t  0 1  r 
t
Find the NPV (net present value)

Assume a hydroelectric project:


Building costs 28 M $
Power benefits 2 M $/year
Life time 25 years
Discount rate 6%
Project NPV $
Calculate the NPV

Assume a hydroelectric project:


Building costs 28 M $
Power benefits 2 M $/year
Life time 25 years
Discount rate 8%
Project NPV
Net Present Value (NPV)
Calculate the NPV

$100,000 $150,000 $200,000


(positive cash flows)
0 3

$500,000 (negative cash flow)

NPV = -CFo + CF1 + CF2 + CF3 + CFn


(1+r)1 (1+r)2 (1+r)3 (1+r)n

where CFX = cash flow in year x, n = number of periods (n=3), r = interest rate (say,
10%)

NPV = -500,000 + 100,000 + 150,000 + 200,000 = -$134, 861


(1+0.1)1 (1+0.1)2 (1+0.1)3

18
Cash Flow Diagram for A Proposed Water Supply System

Cash Inflows (Net annual Uniform Savings)


$4,925…………………………………………………………$4,925
0
12

$18,000 $7,500 $7,500 $7,500

Cash Outflows (Initial Investment and Replacement Cost)

Initial one-time investment = $18,000


Filter replacement cost (once every 3 years) =
$7,500
Net annual uniform savings = $4,925 / year
Project life 12 years 19
Case Study #1 – Calculation for NPV

Assuming an interest rate of 10% ( r = 10 / 100 = 0.1), PV of cash inflows


12
= 4,925  1 = $33,557
t=1 (1 + 0.1)t

PV of cash outflows
= 18,000 + 7,500 + 7,500 + 7,500 = $31,049
(1+0.1)3 (1+0.1)6 (1+0.1)9
NPV = PV of cash inflows – PV of cash outflows
= $33,557 - $31,049 = $2,508

Since the resultant NPV > 0, the project option is


financially viable.
20
Case Study #1 – Calculation for IRR

IRR would need to be solved through iteration:


12
0 = 4,925  1 – 18,000 – 7,500 – 7,500 – 7,500
t=1 (1+r)t (1+r)3 (1+r)6 (1+r)9

Taking r = 12% (i.e. 12/100 = 0.12), Left Hand


Side (LHS) = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -


152.49 21
Case Study #1 – Solving for the Exact Value of IRR

Taking r = 12% (i.e. 12/100 = 0.12), LHS = 664.63

Taking r = 13% (i.e. 13/100 = 0.13), LHS = -152.49

Solving for the exact value of IRR through interpolation:


r – 12 = 0 – 664.63
r – 14 -152.49-664.63

IRR = 12.63%

Since the IRR is greater than 10% (i.e. the rate of interest that the money would
earn in the bank, investing in this water supply project is worthwhile.

22
Calculate the present value of the net benefits

Item Project $ million


A
Cost at the beginning of Phase 1 2.8
Cost at the beginning of Phase 1 10
Annual OMR cost in Phase 1 0.2
Annual OMR cost in Phase 2 0.75
Benefits at the end of the 1st 5 years 3.2
Benefits at the end of the 2nd 5 years 10
Benefits at the end of the 3rd 5 years 15
Benefits at the end of the 4th 5 years 26

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