[Terrapreta] Net Present Value and Net Future Value of TP Benefits

[MMBTUPR at aol.com]

          from               Lewis L Smith

The related techniques of cost/benefit ratios, future value, internal rate of 
return, net present value et cetera can be applied to any activity [ project 
or program ] which can be described in monetary terms and which also requires 
a layout of $$$ up front, in expectation of net benefits in the future over a 
specified period of time. 

So these techniques are very useful in comparing projects of different 
characteristics, locations, sizes, time periods et cetera. Moreover, they are 
grounded in the very human tendency to prefer [ like Alice in Wonderland ] "jam 
today" as opposed to "jam tomorrow". 

[ In the jargon of the trade, these techniques are part of what is often 
referred to collectively as "cost-benefit analysis". ]

However, there are also problems in using these techniques. For example   >>>

[1]     It is hard to express many environmental "goods" and "bads" in money 
terms, in part because no organized markets exist for them, and there is no 
agreement among economists as to the appropriate techniques for estimating the 
"missing" values.

[2]     The techniques of cost-benefit analysis may be manipulated to give 
the "right" answer. 

For example, projects involving large dams, mass transport or solid waste 
typically require heavy upfront expenditures and take a long time to pay off. So 
use a low rate of discount to make the project "look better" !   Nuclear-steam 
electric-generating plants have big environmental cleanup costs at the end of 
their useful lives. So use a high rate of discount !   And so on.

[ The history of Federal "pork-barrel" public-works projects is replete with 
good examples. ]

[3]     Consumers often discount events in near years at a higher rate than 
events in far years, while economists and investors tend to use the same rate 
of discount for all years. 

[ In the "jargon of the trade", the former practice is called "hyperbolic 
discounting". ]

[4]     The rate of discount or return used for a specific year should be 
related to the risks in that year. However, pattern of risk for many projects is 
"U shaped". That is, risk is higher when the project is young and particularly 
vulnerable to the factors which cause the high "juvenile mortality" of new 
ventures. It is also higher in the last years, when the project is increasingly 
subject to technological obsolescence from competitors, changes in 
environmental regulations et cetera. 

[ This problem is usually ignored by economists. ]

[5]     In establishing the appropriate rate of discount to use for 
cost-benefit calculations, rates observed in the market may not be good guides. 

Market rates reflect existing technologies, past mixes of financing, past 
expectations of inflation et cetera, none of which may be relevant to a new 
project embodying new technologies. In fact, British energy economists have 
concluded that every energy project requires a different target rate of return !   In 
brief, there is no one "cost of capital" or "price of money" generally 
applicable to all environmental and/or energy projects.

[6]     For reasons such as taxes, the target rate for a public-sector 
project should be different from that for a private-sector project. But economists 
are not agreed on how to make this distinction !   

[ This difference is sometimes known as "the wedge". ]

[7]     For example, the IRR, derived for a specific project depends on the 
net benefits in each year, which in turn depends on the estimates of inflow and 
outgoes. However, outgoes in particular may be calculated by "rule of thumb" 
methods, of dubious validity in the case of specific projects or a large class 
of projects. 

For example, many estimates of maintenance expense for equipment and 
machinery [ before inflation ] are based on a constant percentage of the original 
investment in same. [ I plead guilty to having done this ! ]

However, it is common that even with "tender loving care", this item will 
begin to increase continuously in the third or fourth quarter of an   
investment's useful life. Steam boilers are a good example, because of the nonlinear 
effect of repeated startups and shutdowns on the structural stability of the metal 
from which they are made, increasing the risk of cracks and blowouts.

[8]     The medium and long-run futures are no longer predictable beyond a 
sophisticated type of scenario planning, where one creates a number of scenarios 
which hopefully cover most of possibilities of what could happen in the 
future.

Taken altogether, the foregoing eight points suggests that we should forget 
about trying to forecast the future, throw the matter of returns into the 
sensitivity analysis of an activity's prospects and ask ourselves the following 
question, instead of the traditional of "Will the project make enough money or 
return more benefits than cost ?   >>>

Will the activity produce an acceptable rate of return [ or cost-benefit 
ratio ] under most of the scenarios [ and possible variations thereof ] ?   In 
particular, is the project robust in the face of misfortune and/or misestimation 
?

In doing the foregoing calculations, we should remember the following, which 
I have distilled from long experience   >>>

It is almost impossible to correctly evaluate a program or a project if one 
does not get most of the numbers right. 

However, getting the numbers right is seldom [ if ever ] the whole story. 

Some of the most important factors to consider may not be amenable to 
numerical characterization, such as those in the domain of uncertainty [ no 
probabilities can be calculated ] and the domain of off-the-wall phenomena. The latter 
are   phenomena with a low but unknown probability of ocurring but big 
consequences if they do. 

[   For example, a Chernobyl, Exxon-Valdez or Three Mile Island type 
accident. ]

So getting the numbers right is not only necessary but also very useful. It 
enables us to reduce an unruly herd of variables to four or five factors [ some 
numerical, some not ] on which experienced managers, professionals and 
technicians can exercise their considered judgment. 

[Beyond four or five, there is a tendency for human beings to unconsciously 
omit a factor or misweight some or all. ]

Cordially.   ###     






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