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

[Kevin Chisholm]

Dear Lewis

Thanks for your "financial and evaluating overview."

Certainly, there are problems with the various relevant techniques. 
Probably many of the problems can be traced back to the phenomenon: 
"Figures never lie, but liars often figure." I would guess that the 
potential for problems would be greatest when the Evaluator has a vested 
interest in the outcome AND other peoples money is being spent. However, 
if the Evaluator is sincerely looking for guidance on the best way to 
proceed AND if it is his own money at stake, then the likelihood for 
bias or error is much less, unless the Evaluator is incompetent or 
dishonest to himself.

Other factors of relevance could include Size, and Seriousness. 
Evaluating an investment costing say $1,000 does not justify the level 
of effort and the thoroughness that would be justified if $100,000 was 
at stake. On the other hand, where a $100,000 loss may destroy a small 
Investor, a large Company may be able to afford such a loss with as 
little consequence as a $1,000 loss to a Small Player. A Small Player 
contemplating a $100,000 investment would have to be very thorough and 
complete with such an analysis, in that an unfavourable outcome could 
have disastrous consequences.

Best wishes,

Kevin



MMBTUPR at aol.com wrote:
>           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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