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Cost-Benefit Analysis for Investment Decisions: Chapter 8 (The Economic Opportunity Cost of Capital)

Author

Listed:
  • Glenn Jenkins

    (Queen's University, Canada and Eastern Mediterranean University, Cyprus)

  • Chun-Yan Kuo

    (Queen's University, Canada)

  • Arnold C. Harberger

    (University of California, Los Angeles, USA)

Abstract

An investment project usually lasts for many years, hence its appraisal requires a comparison of the costs and benefits over its entire life. For acceptance, the present value of the project's expected benefits should exceed the present value of its expected costs. Among a set of mutually exclusive projects, the one with the highest net present value (NPV) should be chosen. This criterion requires the use of a discount rate in order to be able to compare the benefits and costs that are distributed over the life of the investment. The discount rate recommended here for the calculation of the economic NPV of projects is the economic opportunity cost of capital for the country. If the economic NPV of a project is greater than zero, it is potentially worthwhile to implement the project. This implies that the project would generate more net economic benefits than the same resources would have generated if used elsewhere in the economy. On the other hand, if the NPV is less than zero, the project should be rejected on the grounds that the resources invested would have yielded a higher economic return if they had been left for the capital market to allocate them to other uses. This chapter explains how the economic opportunity cost of funds to an economy is derived and how it is used in the appraisal of an investment to calculate its economic present value.

Suggested Citation

  • Glenn Jenkins & Chun-Yan Kuo & Arnold C. Harberger, 2011. "Cost-Benefit Analysis for Investment Decisions: Chapter 8 (The Economic Opportunity Cost of Capital)," Development Discussion Papers 2011-08, JDI Executive Programs.
    • Handle: RePEc:qed:dpaper:201
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    References listed on IDEAS

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    1. Chun‐Yan Kuo & Glenn P. Jenkins & M. Benjamin Mphahlele, 2003. "The Economic Opportunity Cost Of Capital In South Africa," South African Journal of Economics, Economic Society of South Africa, vol. 71(3), pages 523-543, September.
    2. Harberger, Arnold C & Wisecarver, Daniel L, 1977. "Private and Social Rates of Return to Capital in Uruguay," Economic Development and Cultural Change, University of Chicago Press, vol. 25(3), pages 411-445, April.
    3. Glenn P. Jenkins, 1981. "The Public-Sector Discount Rate for Canada: Some Further Observations," Canadian Public Policy, University of Toronto Press, vol. 7(3), pages 399-407, Summer.
    4. Sjaastad, Larry A & Wisecarver, Daniel L, 1977. "The Social Cost of Public Finance," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 513-547, June.
    5. Glenn P. Jenkins, 1985. "Public Utility Finance and Economic Waste," Canadian Journal of Economics, Canadian Economics Association, vol. 18(3), pages 484-498, August.
    6. David Burgess, 2008. "Removing Some Dissonance From the Social Discount Rate Debate," University of Western Ontario, Economic Policy Research Institute Working Papers 20082, University of Western Ontario, Economic Policy Research Institute.
    7. SANDMO, Agnar & DREZE, Jacques H., 1971. "Discount rates for public investment in closed and open economies," LIDAM Reprints CORE 98, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    8. David F. Burgess, 1981. "The Social Discount Rate for Canada: Theory and Evidence," Canadian Public Policy, University of Toronto Press, vol. 7(3), pages 383-394, Summer.
    9. Glenn Jenkins, 1973. "The Measurement Of Rates Of Return And Taxation From Private Capital In Canada," Development Discussion Papers 1973-02, JDI Executive Programs.
    10. Harberger, Arnold C, 1997. "New Frontiers in Project Evaluation? A Comment on Devarajan, Squire, and Suthiwart-Narueput," The World Bank Research Observer, World Bank, vol. 12(1), pages 73-79, February.
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    More about this item

    Keywords

    discounting; discount rate; economic cost of capital; rate of time preference; gross of tax rate of return;
    All these keywords.

    JEL classification:

    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate

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