Question

******PLEASE COMPLETE ALL PARTS*****

1. The EPA is considering an application from the state of Colorado for a large dam project on the Colorado River. The basic costs and benefits of the project (in inflation-adjusted dollar values) are as follows:

Costs			$900 million/year first three years
Construction costs:
Operating costs:			$80 million/year
Agricultural product lost from flooded lands:			$65 million/year
Forest products lost from flooded lands:			$40 million/year
Benefits
Revenues from Power Generation
	Hydropower generated:		4 billion Kilowatt hours/year
	Price of electricity:		$0.125/Kilowatt hour
Revenues from Irrigation Services
	Irrigation water available from the dam:		200K Acre-Feet
	Price of water:		$700/Acre-Foot

1. Do a formal Cost-Benefit Analysis (CBA) using the quantifiable factors listed above. Assume that the operating lifespan of the dam is 30 years. Assume construction begins in year 1. All other impacts start when the dam is completed (at the beginning of Year 4) and continue for 30 years, which implies the full lifespan for the project is 33 years.
2. Using the same parameters and results from part (a.), adjust the interest rate to determine the level of discounting necessary to just break even. (Hint: I would start by changing the interest rate in 1% increments and then refine the changes as you get close to the break-even point.) What does this increase or decrease in interest rate imply about the relationship between costs and benefits over time?
3. (Return to the setup from part (a.) with a 7% discount rate.) In addition to the components of the project listed above, what other costs and/or benefits do you think are missing that should be included? How do you think they will impact the overall conclusion regarding the profitability of the project? (Hint: I would suggest thinking about this in terms of existence values – i.e., based on our discussion in class surrounding the development of ANWR what values may need to be built into this analysis and how would you go about getting them. There isn’t one right answer – you just need to defend your reasoning for what you come up with. I would suggest starting by thinking about how many households there are in the US and how much each would pay per year to protect the ecosystems associated with the dam.)
4. Finally, holding constant the analysis you did in part (c.) what happens when you increase the acre-foot price of irrigation water from $700 to $1500 and/or the price per kilowatt hour of electricity from $0.125 to $0.15?

Answer 1

Discount rate	7.00%
CBA-
Year-	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20	21	22	23	24	25	26	27	28	29	30	31	32
Cash flows- ($ Mn)
Costs
Construction costs	900	900	900
Operating costs				80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80	80
Agricultural product lost from flooded lands				65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65	65
Forest products lost from flooded lands				40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40	40
Total costs	900	900	900	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185	185
Benefits
Revenues from Power Generation (4000*0.125)				500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500	500
Revenues from Irrigation Services (0.2*700)				140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140	140
Total benefits	0	0	0	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640	640
Net cash flow (total benefit- total cost)	-900	-900	-900	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455	455
Total net cash flow	10,950
PV of cash flow	(900.00)	(841.12)	(786.09)	371.42	347.12	324.41	303.19	283.35	264.81	247.49	231.30	216.17	202.03	188.81	176.46	164.91	154.12	144.04	134.62	125.81	117.58	109.89	102.70	95.98	89.70	83.83	78.35	73.22	68.43	63.96	59.77	55.86	52.21
NVP of cash flow	2,404

a
It can be seen from the above table that the project is overall profitable. The net benefit accrued from the project over its full lifespan at present value adjusted for inflation is $2.404Bn.

b
The question is asking to find out the rate which the project reached a breakeven. This is also called as the IRR (Internal Rate of Return) for the project. Since the net cash flow is +ve at a discount rate of 7%, we can continue to increase the discount rate till we reach a NVP of cash flow as 0. Alternatively, we can use excel function IRR. I will solve by both methods.

IRR=

14.385%

c

In addition to the costs and benefits mentioned above there are some tangible and intangible factors that need to be considered.
Tangible costs
Cost of rehabilitating the human settlements in the catchment/ flooded area
Intangible costs
Lost forest cover and damage to existing ecosystem, loss of livelihood and sentimental value of the human settlement in the catchment area
Tangible benefits
Additional revenue from constructing a wildlife reserve in the catchment area, possible boost to agriculture and industry from reliable and cheaper power availability
Intangible benefits
Reliable and possibly cheaper power availability to human settlements, industry and agriculture

The net impact in $$ terms appears to be positive. However, there are intangible costs and benefits associated with this project. They are difficult to put a $$ value on them. In the end, the question boils down to the choice between development and conservation

d

Note- As per the general convention, beginning of current year is ending of previous year. Hence, project begins at the beginning of year 4 which is also equivalent to ending of year 3. Also, had to upload image for some parts due to space constrains.