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Net Present Value Analysis: A Primer for Finance Officers.

First, they are quantified inside the net present worth calculation. sup.8])
* cost-effectiveness analysis; and
Assuming the government's bond fascination rate is 5.3 percent as well as the forecast inflation
rates are 2.6 percent, your real discount charge regarding bond-financed tasks would be:
5) add your expected worth with regard to every scenario to get the expected benefit (or cost).
Assuming a discount charge regarding 3 % as well as that each choices get a life associated with
eight years, the actual net existing value calculation with regard to Proposal A would look like
Exhibit 8. The Particular net current worth calculation for Proposal B would seem like Exhibit 9.
Several governments are generally willing to pay an interest cost in order to borrow money to
advance richesse projects. Pertaining To example, if society extremely values forgoing present
investing pertaining to spending inside the future, then this preference will be reflected by method
of a low interest rate. Any time forecasting costs, it's important to include chance costs. Figure Out
the discount charge (r) 3. The Particular author prefers to utilize any various discount price
pertaining to projects that are usually primarily financed using taxes and also tasks which are
primarily financed with bonds. However, it really is nonetheless achievable to produce an
estimate by utilizing the strategy in Exhibit 3. [1] When the forecast will be made in "real" dollars,
future costs as well as benefits usually are generally not elevated to add the effect associated with
inflation. He holds a new master's degree throughout Public Policy from your University Or College
regarding Chicago.
(1+0.057/1+0.026)-1=0.030=3.0%
Omit non-monetary costs and also benefits. [2]
A convenient way in order to obtain forecasts of long-term interest levels and inflation may always
be the Congressional Spending Budget Workplace publication, Economic and Budget Outlook:
Fiscal Many Years 2002-2011, which could be up-to-date annually. The Particular chance costs of the
proposed project are the possible benefits that are lost by selecting it. A New $100 financial savings
bond that matures throughout 10 a prolonged time represents $100 in the future, however, it
is worth a smaller amount than a $100 bill today.
* cost-benefit analysis;
* return about investment analysis;
3) estimate the actual benefit (or cost) inside each scenario;
4) multiply the actual probability of each along with every scenario through the benefit (or cost)
within the scenario to have an expected value; and
Do not consist of sunk costs. The Particular real long-term fascination rates are such as an
"exchange rate" that reflects society's choice pertaining to exchanging existing pertaining to
future consumption. Your low cost charge converts the stream involving long term expenses and

rewards into their value today. GREGORY MICHEL can be Manager inside GFOA's Study and
Consulting Center within Chicago, Illinois. When any real discount rates are used, treatment
should be taken when you compare this rate for the rate utilized in various other
governments because other governments might always be utilizing a nominal low cost rate. The idea
is easier to make forecasts within real bucks because inflation will not complicate the forecast.
Therefore, using this building pertaining to a community middle entails an chance cost of $2.3
million. For You To display how this can cause poor decisions, suppose the small city government is
actually considering a couple of proposals for a community center. The Recreation Department
presents 2 proposals. * expected worth tables;
http://www.thefreelibrary.com/Net+Present+Value+Analysis:+A+Primer+for+Finance+Officers.-a0
72706711
-$4,003k = (-$1,000k/)+(-$3,000k/(1.03))+(-$15k/(1.06))+(-$15k/(1.09))+(-$15k/(1 .13))+($15k/(1.16))+(-$15k/(1.19))+(-$15k/(1.23))+(-$15k/(1.27))
( one + Real low cost charge ) X ( one + Long Term CPI) -1 = Nominal discount rate
CALCULATING THE NET PRESENT VALUE Right now year one Yr 2 Benefits $X $X $X Costs -$X $X -$X Net benefits () () () [down arrow] [down arrow] [down arrow] Net Existing = value ( ) (/[(1
+ r).sup.1]) (/[(1 + r).sup.2]) year three Yr 4 year 5 Benefits $X $X $X Costs -$X -$X -$X Net
benefits () () () [down arrow] [down arrow] [down arrow] Net present = Worth (/[(1 + r).sup.3])
(/[(1 + r).sup.4]) (/[(1 + r).sup.5]) Yr 6 Benefits $X Costs -$X Net benefits () [down arrow] Net
present = Worth (/[(1 + r).sup.6]) 1. Finally, nominal discount rates may be effortlessly compared
along together with other governments in which use nominal low cost rates.
4) Use expected worth to always be able to estimate uncertain advantages and also costs.
Net existing worth analysis involves four basic steps.
* weighted score tables;
-$3,910k = (-$1,000k/)+(-$1,500k/(1.03))+(-$5k/(1.06))+(-$5k/(1.09))+(-$5k/(1.13 ))+(-$5k/(1.16))+-$1,685k/(1.19))+(-$15k/(1.23))+(-$15k/(1.27))
NPV = (-$1,000k/)+(-$3,000k/[(1+0.03).sup.1])+(-$15k/[(1+0.03).sup.2])+(-$1
5k/[(1+0.03).sup.3])+(-$15k/[(1+0.03).sup.4])+(-$15k/[(1+0.03).sup.5] )+($15k/[(1+0.03).sup.6])+(-$15k/[(1+0.03).sup.7])+(-$15k/[(1+0.03). One proposal can be to create
use of a new vacant city-owned creating downtown (that could be sold pertaining to $2.3 million).
This is similar to converting the actual value that is written on the deal with of the financial savings
bond for you to its real value today. After converting each year's future value into a existing value,
the net rewards for each year are summed to calculate the actual total net benefit.
Since your constructing could be offered with regard to $2.3 million, its value in order to the city
government is $2.3 million. another limitation of net current worth analysis is that will there's
absolutely no universal discount price or perhaps standard approach of setting a reduction rate. by
applying this price reduction rate, a government's decisions to forgo present expenditures
regarding long term expenditures match society's preferences. However, this argument could justify
renovating the building eternally since every new renovation could possibly be justified through
the money which includes been "invested" inside the creating already. First, combine the
advantages and charges inside each year to produce any net advantage for that year. Omitting non-

monetary costs and also benefits also may make an analysis more accurate because it would
remove the danger of over or undervaluing non-monetary expenses and benefits.
(1.) The idea can in addition be feasible to create almost all forecasts within nominal dollars and
price reduction them in a nominal low cost rate. The idea can be also easier to comprehend
forecasts inside real dollars. Opponents of the brand name new facility argue that the old creating
really should not be abandoned since the actual county had just poured $1.2 million in to it in order
to deliver it straight into compliance together with EPA regulations. This is essential regarding
budgeting and financing decisions. the fact that a government chose to devote its income upon
current rather than future needs (and spend an interest expense down the road) proves which it
places a higher value on current instead of long term needs.
R. Since a new sunk price will continue to be the identical irrespective of what decision is made,
this price should be ignored throughout an analysis.
* fiscal impact analysis;
1) list the actual possible scenarios;
(2.) Presently there will additionally be positive aspects to making forecasts inside nominal dollars
along with utilizing a nominal low cost rate. Third, solve the particular formula to calculate the
actual net present value for the alternative. However, there are usually two reasonable arguments
for much less than which includes monetary benefits and costs in the net existing worth calculation:
1) the analysis is easier to always be able to perform--nonmonetary advantages and charges like
human existence and happiness take time and effort along with time-consuming to quantify as well
as 2) the overall analysis may become much more accurate if non-monetary rewards along with
costs are left out of your net existing worth calculation. This analysis exhibits which Proposal B has
got the best net current value, i.e., lowest costs.
Other Analysis Tools
Example of a net existing worth analysis. In the actual event that only monetary costs and also
rewards had been included in the calculation, then consider if the non-monetary costs and rewards
justify selecting another alternative. In the particular event that the real made in real (or current)
dollars. Use the diagram in Exhibit 6 to calculate any net present worth for each alternative. Thus,
standard analysis could offer anestimate which is inconsistent using a decision-maker's criteria.
Second, figure out the value of every along with every of those resources for you to the government
or possibly the greatest advantage which the federal government would obtain by using each as well
as every source inside yet another way, then record this advantage like a cost of your proposal.
2) estimate the actual probability of each scenario;
* The Actual second step is to determine a discount rate.
To find out how which includes sunk costs can easily lead to bad decisions, suppose a county
government will be thinking about demolishing its 52-year-old high school and also constructing a
new facility around the same site. Throughout particular, benefits in many cases are non-tangible
(but real) improvements to always be able to the community. Forecast the benefits along with
costs 2. in other words, which includes the particular sunk cost with the asbestos removal would
lead your county to be able to invest $900,000 a lot more of computer features to for a secondary
school facility associated with equal quality.

The next instance exhibits how an individual can calculate a real low cost rate using the method
demonstrated in Exhibit 4. Analysts should follow five general guidelines when forecasting expenses
along with benefits.
* decision trees;
(3.) The Federal Government Finance Officers Association dots not get access to a recommended
practice in setting a discount rate.
A New FORECAST OF a PROJECT'S COSTS AND BENEFITS Currently 12 Months one Yr 2 Yr three
12 Months 4 year 5 12 Months 6 Benefits $ 0 $32,000 $47,000 $47,000 $47,000 $47,000
$47,000 Costs -$950,000 -$40,000 -$ 5,000 -$ 5,000 -$ 5,000 -$ 5,000 -$ 5,000 year 7 year 8 Yr 9
Yr 10 Benefits $47,000 $47,000 $47,000 $500,000 Costs -$65,000 -$ 5,000 -$ 5,000 -$ 5,000
INCLUDING VS. The $1.2 million for asbestos removal is a sunk cost and should end up being
ignored because it can not really be recovered no matter the particular selection that's made. If the
price of renovating and expanding the old constructing is actually $4.3 million and the price of
demolishing the existing constructing and also building a fresh facility is $3.4 million, the actual
county would save $900,000 b y selecting any new facility. Since the baseball diamonds would be
located about metropolis property, an opportunity cost of $1 million is included since the initial
price regarding both proposals. Although a traditional analysis gives dollars within the long term
exactly the actual same worth as us dollars today, governments, and society like a whole, implicitly
location a new lower value upon long term dollars than current dollars, the concept known as the
occasion worth of money. Second, plug the actual net advantage of each 12 months to the system
beneath it. The Particular expense in the survey is a new sunk price as it will continue in order to be
the identical regardless whether the pool is built. to estimate an uncertain advantage or cost:
* selection tables;
CALCULATING THE NET PRESENT VALUE OF PROPOSAL B
The flaw in the classic method regarding analysis is always that it assumes that dollars within long
term a long time have the exact same worth as bucks today and can simply be additional together.
For example, in case a city were thinking about building any public pool in vacant city-owned
property, the actual metropolis would lose your possible income it would generate through offering
the particular terrain in order to an exclusive developer. Forecasts inside nominal dollars in addition
make it easier to recalculate your analysis in a future date because the forecasts are made in
relation to the worthiness of the dollar inside each year instead of the value of a dollar inside the 12
months the analysis was made. Many times it is difficult to estimate the huge benefits or expenses
simply because they will are dependent with an unpredictable environment or since the result
regarding a project can be uncertain. The Particular 12 months before the county had spent $1.2
million to satisfy an Environmental Protection Agency (EPA) deadline pertaining to asbestos
removal. Alternatively regarding having for you to pay an interest cost to always be able to borrow
money, any government could have saved funds year by 12 months to meet long term capital needs.
To compare any real price reduction charge to a nominal price reduction rate, make use regarding
the formula in Exhibit 5 in order to transform a new real discount charge to a nominal low cost
rate.
Include chance costs. Pertaining To example, in the wedding the government determines that three
money projects supply approximately the identical NPV (e.g., new bus, new train, highway
widening), then other non-monetary elements could tip the balance inside favor of 1 proposal.
Throughout this example, the government would incur huge upfront costs yet enjoy a new stream of

rewards in later on years.


* The Particular initial step is often to forecast the advantages and costs in each year.
Limitations associated with NPV Analysis
Note the total cost of proposal The ($0.7 million) appears for you to be $1 million under the actual
total expense involving proposal B ($1.7 million). However, in the event the opportunity price is
included, the expense as well as benefits look like the bottom box inside Exhibit 2.
* breakeven analysis;
Using this method, tasks that are financed by simply taxes are provided a discount charge equal
towards the real, long-term curiosity rate. It is available from GFOA for $15 member/$20
nonmember. This publication is available in www.cbo.gov.
The main limitation regarding net current worth analysis may become the difficulty of accurately
forecasting future expenses as well as benefits. (Although the diagram in Exhibit 6 merely extends
out to some six-year period, it could be extended for you to any length regarding time.)
Use expected worth to become able to estimate uncertain benefits as well as costs. In the particular
event that the actual opportunity cost of using the area building were ignored, the expenses and
advantages of each proposals within the 1st year would appear like the best box inside Exhibit 2.
NPV = (-$1,000k/)+(-$1,500k/[(1+0.03).sup.1])+(-$5k/[(1+0.03).sup.2])+(-$5k /[(1+0.03).sup.3])+($5k/(1+0.03))+(-$5k/[(1+0.03).sup.5])+(-$1,685k/ [(+0.03).sup.6])+(-$15k/[(1+0.03).sup.7])+-$15k/[(1+0.03).sup.8])
Step 1: Pertaining To every alternative, forecast the advantages and costs in each year. Excluding
inflation from the forecast can help make it distinct that the increase in costs or perhaps benefits is
actually an actual increase, rather than simply an increase credited for you to inflation. Government
discount rates furthermore needs for you to be low for you to reflect this preference.
For tasks that are financed by simply bonds, the discount rate is set equal for the real interest
charge on the government's bonds of similar maturity. [3] Tax-financed projects must have the
discount rate which is distinct coming from bond-financed tasks because tax financing displaces
private consumption, whereas bond financing mostly displaces private investment.
* The Particular final step would end up being to compare the particular net present values
associated with the alternatives.
This specific article demonstrates how anyone can use a determination tool known as netpresent
worth (NPV) analysis to gauge a new project's long-term monetary costs along with benefits.
A standard analysis of a project's long-term costs and benefits simply adds together each and also
every year's price or even benefit consequently that the total price will be the sum involving the
costs within each year, as well as the total benefit may be the sum of the benefits within each along
with every year. Proposal Any would end up being to develop the entire park within the very first
year. However, forecasts in real money are usually less difficult to make as well as realize than
forecasts within nominal dollars. Exhibit 7 exhibits the actual forecasts regarding the expenses as
well as advantages of each proposals.

Governments also place an increased worth on dollars nowadays rather than dollars inside the
future. Inside fact, it is not unheard of for public policy studies to put any monetary worth about
human life. This kind of curiosity price reflects the particular chance cost of the private investment
us dollars that could have gone to various other uses.
Forecast advantages and charges in today's dollars. Get Throughout Touch With GFOA in 312/9779700 or Publications @gfoa.org for further information.
Net current worth analysis is merely among many beneficial analysis tools. a sunk price is truly a
cost in which previously has occurred along with will carry on to always be able to be the identical
irrespective of what decision is made. An instance of the sunk cost is the price regarding conducting
a new survey to determine resident interest in an outdoor pool. If a forecast is manufactured
in nominal dollars, the particular analyst knows the actual real variety of dollars that will always be
spent as well as received each year. Then, following the net present value system recommends a
certain choice because the best alternative, choice makers have a propensity to not necessarily
entirely believe in the recommendation so they will really reconsider the worth of non-monetar
y factors such as the human lives saved or even the political ramifications. For this reason, it may
always be easier to separate monetary and non-monetary considerations and possess a distinct
picture of the monetary payoff along with then compare it towards the non-monetary
considerations. Simply Because there is simply no regular on this area, net present value analysis is
actually susceptible to manipulation through selecting a high or lower low cost rate, however, each
of those weaknesses might be addressed simply by conducting a sensitivity analysis.
Making accurate forecasts of future costs and rewards may be the most difficult step within net
existing value analysis. Netpresent value analysis closely matches the actual criteria that will
governmentsimplicitly use when creating long-term decisions--meaning in which it provides alower
value to end up being able to money inside the future.
Instead of merely adding with every single other each as well as every year's expense or perhaps
benefit, net current worth analysis 1st converts value of long term expenses and benefits to their
actual value today. Including this opportunity price exhibits that the initial cost associated with
proposal The will be $1.3 million greater than proposal B.
* sensitivity analysis.
* The Actual third step is to help make use of a new system to be able to calculate the particular net
present value.
How to become able to Perform the NPV Analysis
1) Forecast rewards and costs in today's dollars.
Step 4: determine which in turn alternative has got the highest net present value. Calculate your
NPV FORECASTED COSTS AND BENEFITS OF BOTH PROPOSALS Proposal Any Right now 12
Months one 12 Months 2 Yr three year 4 12 Months 5 12 Months six year 7 Benefits $0 $0 $25k
$25k $25k $25k $25k $25k Costs -$1,000k -$3,000k -$40k -$40k -$40k -$40k -$40k -$40k Net
Advantage -$1,000k -$3,000k -$15k -$15k -$15k -$15k -$15k -$15k Proposal B Benefits $0 $0 $15k
$15k $15k $15k $ 15k $25k Costs -$1,000k -$1,500k -$20k -$20k -$20k -$20k -$1,700k -$40k Net
Advantage -$1,000k -$1,500k -$ 5k -$ 5k -$ 5k -$ 5k -$1,685k -$15k Proposal Annually 8 Benefits
$25k Costs -$40k Net Advantage -$15k Proposal B Benefits $25k Costs -$40k Net benefit $15k Opportunity cost of terrain Construction expenses Maintenance costs

CALCULATING THE NET PRESENT VALUE OF PROPOSAL A


To convert long term money to existing dollars, net current value analysis runs about the number
called any "discount rate." A New discount rate reflects the government's price associated with
borrowing or even a community's choice for current versus future consumption. Although there is
simply no regular government discount rate, your interest rates in the nation's economic markets
really are generally a great source for determining a reduction rate.
If chance costs aren't included as costs, then some proposals may appear to be much better just
since they use active government resources. This would consist of "hard" expenses requiring out-o-pocket expenditures and "soft" costs for example employee time. IGNORING OPPORTUNITY
COST Proposal A--Use Area Building Ignoring Chance Cost Land purchase expense $0.0
m Construction expense $0.7 m Total expense $0.7 m Including Chance Cost Opportunity expense
associated with building $2.3 m Construction expense $0.7 m Total expense $3.0 m Proposal B-Purchase Land Land purchase price $0.5 m Construction cost $1.2 m Total price $1.7 m Land
obtain price $0.5 m Construction price $1.2 m Total cost $1.7 m AN EXAMPLE OF FORECASTING
BENEEITS WHEN IT IS DIFFICULT TO PREDICTTHE THE FUTURE Step 1 Step 2 3 Step 4 Step
5 List feasible Estimate Estimate Calculate scenarios probability advantage expected
benefit Recession 10% X $ 50 = $ 5 Moderate growth 70% $100 $70 High Growth 20% $200 +
$40 $115 PREFERRED METHOD OF CALCULATING A New GOVERNMENT DISCOUNT RATE
for tax-financed Real long-term = (1+Forecast 10 year Treasury bond/ projects: interset price 1+
Forecast CPI) - 1 For bond-financed: Real bond local government's bond interest rate projects:
curiosity rate for a bond with smilar naturity (1 + since the life in the project/ 1 + Forecast CPI)
REAL TO NOMINAL CONVERSION FORMULA
* net present value analysis; . The 2nd proposal would always be to purchase vacant land in a
residential area. Unfortunately, there isn't any consensus on how governments should determine
their particular discount rate. programs may get unanticipated expenses or perhaps produce
less revenue than expected. The idea can always be done to set a monetary figure upon intangible
items. Any typical forecast associated with expenses and also rewards may well look some thing
like Exhibit 1. Within traditional analysisof richesse projects, cash inside the future emerges the
same worth asmoney today; however as proven above, money in the future emerges a new
lowervalue than cash today. Each proposals create revenue from concession sales. after calculating
any net current worth with regard to each alternative, determine which in turn alternative gets the
highest net present value. Any time any non-monetary cost or advantage is included in the net
existing worth analysis, there is the tendency to consider these non-monetary factors twice. for
example, if an analyst forecasts the long run revenues regarding a swimming pool throughout
nominal dollars, the forecast pertaining to each year must take into account each the particular
number of users of the pool and the impact of inflation. For You To present an illustration of a net
existing worth analysis, suppose a tiny area is contemplating building a pair of public baseball
diamonds upon vacant terrain owned through the city. using a new forecast inflation price of 2.6
percent and a forecast 10-year Treasury bond price of 5.7 percent, the real discount charge with
regard to tax-financed projects would be:
2) Do not include sunk costs.
3) Consist Of opportunity costs.
(1+0.053)/1+0.026)-1=0.026=2.6%

Step 3: Calculate the actual net current worth of every alternative. Such factors might consist of
improved service to the public or environmental benefits.
Step 2: Decide the particular price reduction rate. in some other words, if a advantage associated
with $100,000 is forecast for that fifth 12 months of the project, which $100,000 may have
the same acquiring energy as $100,000 today.
5) Omit non-monetary expenses along with benefits.
To discover opportunity costs, first think about almost all with the government resources that will
are utilized by the proposed project-land, employee time, facilities, etc. With Regard To a private
firm, the particular discount rates are merely your price of return on an investment with a similar
danger because the proposed project. Proposal B is often to build 50 % of the particular park in the
initial 12 months as well as expand the particular park in the sixth year at a higher cost. Thus, they
ought for you to be employed along with forecasts of costs and rewards produced in real (or
current) dollars. It is important in order to treat inflation consistently throughout a new net present
value calculation, therefore most forecasts associated with long term expenses along with
advantages ought to be made in today's dollars, i.e., real dollars, and discounted in a real low cost
rate. Subtracting the total cost from the total benefit calculates any project's total net benefit.
NOTES
It is extremely important for you to keep throughout mind that your formulas above calculate
real, not nominal, price reduction rates. One simple instance that will proves this can become a
financial savings bond. Any new publication in the GFOA, Choice tools for Budgetary Analysis,
provides practical, step-by-step methods for utilizing 12 analysis equipment including:
Since conventional analysis offers a new mistakenly quality value to dollarsin the future, it might
supply poor information. To End Up Being Able To begin, forecast your total advantages and total
expenses inside each year. This potential tax revenue loss will end up being the opportunity
expense of the pool, and it should be included as an expense of the pool.
* activity-based costing;
As an alternative solution to creating forecasts inside real dollars, it is also possible to create most
forecasts within nominal money along with price reduction all of them from a nominal low cost rate.
in possibly case, inflation should always be handled consistently.
This publication will always be the third inside the GFOA Budgeting Series that shows how to
implement the actual advised procedures in the National Advisory Council upon State and also local
Budgeting. In your event that the same forecast can be made in real dollars, just the number of
users (or real increase in revenue) needs being projected