ECON 3650 Lecture Notes  Lecture 5: Federal Aviation Administration, National Highway Traffic Safety Administration, United States Treasury Security
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Published on 11 Nov 2020
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ECON 3650: Policy Analysis
Hennadige N. Thenuwara
Lecture 5 – Tools of Policy Analysis
Financial Accounting Analysis and Cost Benefit Analysis
Resources: Chapter 8 : Jonathan Gruber
In many cases of policy analysis, current and future costs of policies are to be compared
against current and future benefits. Financial accounting analysis and costbenefit analysis
are two major tools of analysis.
5.1 Financial Accounting Analysis
● Time Value of Money
Example 1:
i. A $100 received next year (year 1) is worth less than $100 this year (year 0).
This is because money loses its value over time.
The discount factor = 1/(1+market interest rate) interest rate = price of money
If the market interest rate is 5%, then the discount rate = 1/(1+5/100) = 0.95
a. $100 to be received in 2021 is worth = 100/(1+5%) = 100*0.95 = $95
b. $100 to be received in 2022 is worth = 100/(1+5%)2 = 100*.95*.95 = 90.25
ii. A $100 received in this year (year 0) is worth more than $100 next year (year 1).
This is because value of money is greater this year than next year.
The compounding factor = (1+5%) = 1.05
a. Thus, $100 received in 2020 is worth 100*(1.05) = $105
Money can’t just be added together over time because it is discounted
Example 2
● Use the time value of money concept to evaluate these two projects
Project 1:
Cost  1000 in year 0, 2000 in year 1 and 500 in year 2
2
Benefits  1000 in year 3, 5000 in year 4, and 6000 in year 5.
Project 2 :
Cost  1000 in year 0, 1500 in year 1 and 1200 in year 2
Benefits  500 in year 3, 3000 in year 4, and 7000 in year 5.
Pure Financial Analysis:
Use the market interest rate to discount future stream of costs and benefits.
Choose the project with highest net benefits.
(Market interest rate – say 10%)
Discount factor = 1/(1+10%) = 1/1.1 = 0.91
Project 1
Present Value of Costs of Project 1
Year
0
1
2
Sum
Cost
1000
2000
500
Present Value
1000
2000/1.1
500/(1.1)2
1000
1818
413
3231
Present Value of Benefits of Project 1
Year
3
4
5
Sum
Benefit
1000
5000
6000
Present Value
1000/(1.1)3
5000/(1.1)4
6000/(1.1)5
751
3415
3726
7892
Net Present Value from Project 1 = 78923231 = USD 4661
Project 2
Present Value of Costs of Project 2
Year
0
1
2
Sum
Cost
1000
1500
1200
Present Value
1000
1500/1.1
1200/(1.1)2
1000
1364
992
3356
3
Present Value of Benefits of Project 2
Year
3
4
5
Sum
Benefit
500
3000
7000
Present Value
1000/(1.1)3
5000/(1.1)4
7000/(1.1)5
376
2049
4346
6771
Net Present Value from Project 1 = 67713356 = USD 3415
Based on Financial Analysis Project 1 is better.
5.2 Internal Rate of Return = when net percent value becomes 0
Internal rate of return of a project is the rate of interest at which the net present value
becomes zero.
Example 3
If you invest $1000 in a project that lasts just one year, and receives $1100 in return at the
end of the year the internal rate of return is 10%.
The above figure was achieved by using the following procedure.
Assume that the internal rate of return is x.
The cash flow of the project is as follows.
Year
0
1
Cost
1000

Benefits

1100
Present Value of Cost
1000

Present Value of Benefits

1100/(1+x)
Net Present Value = 1100/(1+x) –1000
Net Present Value is zero when x=10%
Example 4