Question

Briefly define each of the following concepts and briefly discuss the significance/relevance/use of each in cost benefit analysis:

- discount rate

- replication method

- net present value

- horizon value

- internal rate of return

- sensitivity analysis

Answer 1

Discount rate refers to interest rate used to determine present value. Discount rate takes into consideration the effects of opportunity cost, risk from defered returns from investment and future costs. The discount rate incorporates the time value of money in the cost benefit analysis.

The cumulative present worth of positive and negative cash flow using a specified rate to look for time value of money is Net present value (NPV). In cost benefit analysis, if thr calculated NPV for a project is positive, then the project is satisfactory and if the NPV is negative, then the project is not satisfactory.

Horizon value represents all future cash flows in asset valuation model. In cost benefit Analysis,it will reflect returns that will occur to far in future that they are impossible to predict.

Internal rate of return is the interest rate at which the net present value from all cash flows of a investment is zero. In cost benefit analysis, it is used to determine the attractiveness of an investment or the project. It excludes external factors such as inflation, cost of capital etc. It is also called discounted cash flow rate of return.

Sensitivity analysis is a response to the inherent uncertainties and costs which are present there in cost benefit analysis. It is a method for examining how the result of benefit cost analysis will change if any of the assumptions, inputs and methodology are changing for the project.