DIGEST 2006 - Sabita

we can economically test a
possible investment:
• The discount rate captures
the opportunity cost of
capital. In a sound
investment, this must be less
than the discount rate at
which the present value of
benefits and costs are equal,
i.e. the internal rate of return
(IRR).
• We subtract the discounted
costs from the discounted
benefits so as to
estimate the net
present value
(NPV) of the
contemplated
investment. This
is the most
direct way of
comparing two
types or
instances of
asset, such as a
gravel road and
a paved road:
which has the
higher NPV? It is
immediately obvious that this
form of comparison must be
highly sensitive to the period
of time over which we choose
to estimate costs and
benefits. One asset might pile
up costs earlier than another
but then deliver a better ratio
of benefits to costs at later
stages. How many of these
later stages are factored into
the calculation of NPV will
then crucially influence the
conclusion of our comparison.
The key to effective economic
analysis of any investment
decision is finding a way to
account for all consequences that
have value to people or impose
costs on them, even where the
values and costs in question don’t
have prices assigned to them
directly by markets. Such
non-traded cost and benefit
streams must be assigned
so-called ‘shadow prices’, that is,
monetary amounts people appear
willing to pay to avoid the costs
and acquire the benefits.
The key to
effective economic
analysis ... is
finding a way to
account for all
consequences that
have value to
people or impose
costs on them
For example, if someone whose
time can be sold
on the consulting
market for R1,000
per hour spends
two hours per
month polishing
their car, we can
shadow price the
value of a shiny
car to that person
at R24,000 per
year.
Bearing in mind
that surfaced
roads are
relatively costly to build but
relatively cheaper to maintain than
gravel roads, we can identify the
two general factors that have
mainly contributed to overestimations
of the economic value
of gravel roads as compared to
paved ones. The first is failure to
consider long enough periods in
calculating NPVs, or implicitly
assuming too steep a discount
rate (which amounts to the same
thing). The second is failure to
incorporate shadow prices for a
range of non-traded benefits that
flow from paved but not from
gravel roads, or flow from gravel
roads only to a lesser extent.
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