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 measure present value of the future cash inflow and outflow. The discount rate uses the time value of money in the cost benefit analysis and helps the firm in investment decision.

NPV is used to measure the net present worth of any project. NPV is used in investment planning to analyze the profitability of a project. In cost benefit analysis, if NPV is positive, then project is desirable and if the NPV is negative, then the project is not desirable.

it may prove impractical to input values for each and every year for all costs and benefits that continue to occur, especially if some of the costs and benefits continue far into the future. In this case we use horizon value. it considers costs and benefits arising close to the beginning of the project, and then separately considers costs and benefits occurring into the far future .

The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. In cost benefit analysis, it is used to determine the attractiveness of the project.

Sensitivity analysis determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that depend on one or more input variables. It is a method for examining how the result of benefit cost analysis will change if any of the assumptions or inputs are changing for the project.