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Making decisions having significant future net benefits or costs. CAPITAL BUDGETING Infrastructure & Project Evaluation. JUSTIFYING PUBLIC SPENDING. Spending/Proposing agencies are responsible for justifying their proposals (I.e., presenting the case for spending in ABC terms)
(I.e., presenting the case for spending in ABC terms)
If this proposal were consistent with executive priorities, we would stop here:
The following is also true:
If teams would counsel 4000 battered spouses a year, they would pay for themselves if they reduced future assistance by $100 on average.
Public Sector Project Assessment should take all benefits and costs to public into account
Federal Gov. treats consequences to itself as costs
Consequences for citizens as benefits
Hence, revenues are negative costs and payments by citizens negative benefits
REVENUE TO GOVERNMENT
≤ COST TO CITIZENS
Timing of benefits or costs accruing from a policy choice is generally of no importance -- so long as benefits/ costs are properly discounted.
The source of financing does not matter -- shouldn’t influence capital budgeting decisions, value will be the same regardless of whether an activity is financed with debt, fund balances, or taxesTWO ASSUMPTIONS
Together these two assertions imply that all capital budgeting decisions should be governed by cost-benefit analysis, which says:
do it whenever benefits exceed costs
Making decisions having significant future benefits or costs means looking at consequences from where we are right now: converting future benefit/cost flows to
Future values are converted to present values by means of a discount rate.
That is, future nominal benefits are worth less than present benefits of equal magnitude -- the WIMPY principal
PV = FV in yeart / [1+r]^t
Where PV = Present Value
FV = Future Value (real or nominal)
t = Year
r = Discount Rate (real or nominal)
For a Stream of Benefits from year 1 to year t, SUM [add up] all the present values for all net future values
Where t = 3
PV = (FV in year1/ [1+r]^1) + (FV in year2/ [1+r]^2) + (FV in year3/ [1+r]^3)
Finding PVs is discounting; it’s the reverse of compounding.
PV = ?
= PV(Rate, Nper, Pmt, FV)
= PV(0.10, 3, 0, -100) = 75.13
A B C D E
1 0 1 2 3 4
2 100 300 300 -50
Excel Formula in cell A3:
PV = NBF / r
Where NBF = a specified annual net-benefit flow
$186k / .03 = $6.2m
Where r = real, risk-free rate
i = the expected rate of inflation
b = project specific (nondiversifiable) risk
y = income tax adjustment
WHAT NOMINAL RATE SHOULD
Borrowing rate on tax-exempt,
general-purpose bonds of similar
Annual Cost of a Capital Asset
= P [r + d - a]
Where P = Purchase Price [replacement cost]
d = Depreciation rate
[wear and tear + obsolescence]
a = Appreciation rate