Cost-Benefit Analysis for Investment Decisions Chapter 5 PDF

COST-BENEFIT ANALYSIS FOR INVESTMENT DECISIONS, CHAPTER 5: SCALE, TIMING, LENGTH AND INTER-DEPENDENCIES IN PROJECT SELECTION Glenn P. Jenkins Queen’s Universi...

COST-BENEFIT ANALYSIS FOR INVESTMENT DECISIONS, CHAPTER 5: SCALE, TIMING, LENGTH AND INTER-DEPENDENCIES IN PROJECT SELECTION Glenn P. Jenkins Queen’s University, Kingston, Canada and Eastern Mediterranean University, North Cyprus Chun-Yan Kuo Queen’s University, Kingston, Canada Arnold C. Harberger University of California, Los Angeles, USA Development Discussion Paper: 2011-5 ABSTRACT It is generally agreed that a project’s net present value (NPV) is the most important criterion for the financial and the economic evaluation of a project from either the owner’s or economic perspective.. The NPV criterion requires that a project analyst recommend only projects with positive NPV. The next step is to endeavor to maximize the NPV. The reason for trying to maximize the NPV is to extract as much value from the project as possible. Ideally, we should strive to maximize the NPV of incremental net cash flows or net economic benefits. Of course, optimization cannot be pursued blindly; there may be repercussions for other stakeholders that need to be considered in the final decision making. There are other important considerations project analysts often encounter. These considerations include changes in project parameters like the scale of investment, the date of initiation of a project, the length of project life or interdependencies of project components. Each of them is addressed in this chapter by using the criterion of a project’s net present value. This chapter explains how project analysts use the criterion of a project’s net present value to make such decisions. To be Published as: Jenkins G. P, C. Y. K Kuo and A.C. Harberger, “Scale, Timing, Length and Inter-Dependencies in Project Selection” Chapter 5, Cost- Benefit Analysis for Investment Decisions. (2011 Manuscript) JEL code(s): H43 Keywords: Project Selecting, Economic Evaluation, Financial Evaluation CHAPTER 5: CHAPTER 5 SCALE, TIMING, LENGTH AND INTER-DEPENDENCIES IN PROJECT SELECTION 5.1 Introduction In the previous chapter, we have concluded that a project’s net present value (NPV) is the most important criterion for the financial and the economic evaluation. The NPV criterion requires that a project analyst recommend only projects with positive NPV. The next step is to endeavor to maximize the NPV. The reason for trying to maximize the NPV is to extract as much value from the project as possible. Ideally, we should strive to maximize the NPV of incremental net cash flows or net economic benefits. Of course, optimization cannot be pursued blindly; there may be repercussions for other stakeholders that need to be considered in the final decision making. There are other important considerations project analysts often encounter. These considerations include changes in project parameters like the scale of investment, the date of initiation of a project, the length of project life or interdependencies of project components. Each of them is addressed in this chapter by using the criterion of a project’s net present value. 5.2 Determination of Scale in Project Selection Projects are rarely, if ever, constrained by technological factors to a unique capacity or scale. Thus one of the most important decisions to be made in the design of a project is the selection of the scale at which a facility should be built. Far too often the scale selection has been treated as if it were a purely technical decision, neglecting its financial or economic aspects. When financial or economic considerations have been neglected at the design stage, the scale to which the project is built is not likely to be the one that would maximize the 1 CHAPTER 5: NPV. Thus, in addition to technological factors the size of the market, the availability of project inputs, the quality of manpower, etc. will also have a role to play. The most important principle for selection of the best scale of a project (e.g., height of an irrigation dam or size of a factory) is to treat each incremental change in its size as a project in itself. An increase in the scale of a project will require additional expenditures and will likely generate additional expected benefits over and above those that would have been produced by the project at its previous size. Using the present value of the incremental benefits and the present value of the incremental costs, the change in net present value, stemming from changing scales of the project, can be derived. In Figure 5.1 the cash flow profiles of a project are shown for three alternative scales. C1 and B1 denote the expected costs and benefits if the project is built at the smallest scale relevant for this evaluation. If the project is built at one size larger it will require additional expenditure of C2. Therefore, the total investment cost of the project at its expanded scale is C1 + C2. It is also anticipated that the benefits of the project will be increased by an amount of B2, implying that the total benefits from this scale of investment will now equal B1 + B2. A similar relationship holds for the largest scale of the project. In this case, additional expenditures of C3 are required and extra benefits of B3 are expected. Total investment costs for this scale equal (C1 + C2 + C3) and total benefits are (B1 + B2 + B3). Figure 5.1 Net Benefit Profiles for Alternative Scales of a Facility Bt - Ct B3 B2 B1 0 Time C1 C2 C3 2 CHAPTER 5: Our goal is to choose the scale that has the largest NPV. If the present value of (B1 - C1) is positive, then it is a viable project. Next, we need to determine whether the present value of (B2 - C2) is positive. If incremental NPV is positive, then this project at scale 2 is preferable to scale 1. This procedure is repeated until a scale is reached where the NPV of the incremental benefits and costs associated with a change in scale is negative. This incremental net present value approach helps us to choose a scale that has maximum NPV for the entire investment. The NPV is the maximum because the incremental NPV for any addition to the scale of the project would be negative. If the initial scale of the project had a negative NPV, but all the subsequent incremental net present values for changes of scale were positive, it still would be possible for the overall project to have a negative NPV. Therefore, in order to pick the optimum scale for a project, first we must make sure that the NPV of the overall project is positive and then the NPV of the last addition to the investment to increase project’s scale must also be non-negative. This is illustrated in Figure 5.2 where all project sizes between scale C and scale M yield a positive NPV. However, the NPV of the entire investment is maximized at scale H. After scale H, the incremental NPV of any expansion of the facility becomes negative. Therefore, the optimum scale for the project is H, even though the NPV for the entire project is still positive until scale M. Figure 5.2 Relationship between NPV and Scale NPV (+) NPV of 0 Scale of Project A B C D E F G H I J K L M (-) 3 CHAPTER 5: The optimum scale of a project can also be determined by the use of the internal rate of return (IRR), assuming that each successive increment of investment has a unique IRR. If this condition is met, then the optimum scale for the facility will be the one at which the IRR for the incremental benefits and costs equal to the discount rate used to calculate the net present value of the project. This internal rate of return for the incremental investment required to change the scale of the project will be called marginal internal rate of return (MIRR) for a given scale of facility. The relationships between the IRR, the MIRR, and the NPV of a project are shown in Figure 5.3. Figure 5.3 Relationships between MIRR, IRR, and the NPV Percent MIRR>ρ NPV (+) Maximum NPV Maximum IRR (14%) NPV@10% IRR>ρ MNPV@10% Discount Rate (ρ) = Opp. Cost of Funds MIRR