Question

Imagine a project that has benefits that accrue over a long period of time. You are in charge of conducting a cost-benefit analysis for the project. Describe what considerations you would take into account when choosing the discount rate for the project.

subject: environmental and natural resource economics

Answer 1

Answer :

A fiscal impact analysis will identify costs and benefits over a period of time accruing to a city or county from an economic development project. Since the timing of the individual costs and benefits is important, the analysis should take into account the time value of money. The way to account for the time value of money is to discount the flow of revenues and costs and evaluate them based on their present value. The present value is a way of expressing dollars to be paid or received in the future, in today’s dollars. A dollar today is worth more than a dollar a year from now, since an invested dollar would yield a rate of return or interest over the year.

Discount Rate
The connection between future dollars and today’s dollars is the discount rate. The discount rate represents the decision maker’s patience – the lower the discount rate the more patient one is, the higher the discount rate the more impatient. We recently evaluated energy efficiency investments which included significant upfront costs and incremental savings each year during the 20-year life of the efficiency measure. Only with a discount rate below 1% would the present value of benefits exceed the present value of costs. In this case the organization would have to be extremely patient.

So what is the right discount rate?
Theory suggests the discount rate should be the opportunity cost of the project relative to other investments. Since a city or county may invest in other projects or capital investments, municipal bond rates are a good measure of this opportunity cost.

Main Factors to Consider

Their are countless factors to consider when accessing the appropriate discount rate. The overall consideration is how comfortable is a buyer likely to be with the following:

• The ability to meet or exceed the projections
• The value and marketability of tangible assets which could be recovered if the operations failed
• Cost to duplicate operations/ barriers to entry

Specific Factors to Consider

In accessing the discount rate the following factors should be considered

• Quality of earnings
• Consistency
• Portion created by recasting
• Cushion in margins to weather hard times
• Diversity of revenue base
• Aggressiveness of projections

Quality of Balance Sheet

• Are any assets under or over valued
• Receivables current & collectable
• Inventory obsolescence
• Level of net tangible assets
• Fair market value of assets
• Strength of,current ratio
• Degree-of-leverage

Cash Flow Requirements

• Magnitude of future capital expenditure requirements
• Working capital requirements

Indirect Financial considerations

• Barriers to entry
• Patents
• Diversification (product, customers, suppliers, region)
• Niche vs. commodity type product

Industry Considerations

• Outlook for industry
• Competitive environment