(Townley Chapter 7) in ppt

Townley Chapter 7
Problems in Project Evaluation
• This lecture discusses some of the practical
problems involved in a cost benefit analysis.
• This highlights some of the potential pitfalls as
well as the errors that should be avoided
when conducting a cost benefit analysis
• Always treat discount rate that is used in
evaluation projects as “real”
• Social discount rate is net of inflation
• Nominal interest rate has two components a real
rate of return and an adjustment for price level
• In cost benefit analysis all benefits and costs are
measured in real (constant) dollars and net
present values are computed using a real
discount rate
Starting Dates, Planning Horizons and
Scrap Values
• Example 1 : consider a dam, which can be started in
any of the next 3 years, it will have same economic life
regardless of when it is built.
– No change in value of project
• Example 2: Suppose population changes and there is a
change in aggregate willingness to pay out that could
change net present value; e.g., suppose as the
population ages there are more preferences for health
care and benefits for seniors
• Example 3: Suppose technological change reduces
costs associated with a project then this could affect
present value
• Termination date of project is not usually an issue but
can be sometimes (for example, on text p. 146, a
private sector firm would operate/collect tolls on a
bridge for 35 years, after which it transfers control to
the Federal government who would operate it for the
rest of its economic life; the project has an economic
life of 100 years, but the private sector firm might use a
planning horizon of 40 years (5 years to build + 35
years it operates ) if not aligning termination date with
economic life of project scrap values – determined by
its worth in its next-best alternative use.
• For a steel bridge, can use girders as scrap metal
Depreciation and Interest Charges
• In evaluating a project only concerned with
resource costs, not with how it’s financed.
• Interest payments and transfers between
borrowers and lenders and shouldn’t be part
of the calculation.
• Depreciation allowances are the same sort of
issue, used for tax purposes.
Spillovers and Secondary Effects
• Easiest to illustrate these with an example.
• Suppose a multipurpose dam is built which will provide
flood protection, irrigation, recreational water use. Other
potential impacts might include:
Enhancing productivity of nearby agricultural land and increases
farm profits.
Increase in agricultural production would lead to increases in profits
to firms that supply farmers.
Increased recreational facilities might expand tourist industry in a
Altered flow of water might cause more downstream dredging to be
used more frequently than otherwise for navigation
Altered flow of water will be conducive to fish breeding
Increases in demand for construction workers will raise wages of
other workers
• Which Impacts should count?
– Only 1, 4, and 5 should be counted in a costbenefit calculation. The rationale for this is
discussed below.
• Only impacts which result in changes to
physical production should be counted.
• Impacts that result in redistribution of income
should be ignored.
Impacts to Count
• Benefits
– Direct impacts
• (1) is an increase in farm
output that is directly
attributable to enhanced
water supplies; it is a change
in physical output should
count (changes in profits or
value of land induced by this
– Positive Technological
• 5) increases the productivity
of downstream fishing
industry and is an
improvement in the real
output of the economy.
• Costs
– Negative Technological
• 4) Dredging the river is a real
resource cost to the economy
Impacts to Count
• All of the impacts on the previous slide are
direct effects
• Only direct effects should be counted in a cost
benefit analysis
Impacts That Should Not Be Counted
• Secondary impacts that are purely
redistributive, or are accounted for
somewhere else or are offset in the analysis
should be excluded, i.e., (2), (3), (6)
Multiplier Effects
• Multiplier effects should not be included in a cost
benefit analysis
• Why?
– Multiplier effects are basically like secondary effects
except they are not specifically identified.
• A multiplier is applied to the aggregate project
expenditure to capture aggregate secondary effects
• Almost all of the effects captured by the multiplier will
be redistributive and not involve real resource costs.
• As above only costs/benefits should be included in an

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