Cost-Benefit Analysis for Investment Decisions: Chapter 8 (The Economic Opportunity Cost of Capital)
AbstractAn 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.
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Bibliographic InfoPaper provided by JDI Executive Programs in its series Development Discussion Papers with number 2011-08.
Length: 40 pages
Date of creation: Aug 2011
Date of revision:
discounting; discount rate; economic cost of capital; rate of time preference; gross of tax rate of return;
Find related papers by JEL classification:
- H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate
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- 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, 09.
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- 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.
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- Glenn Jenkins, 1973. "The Measurement Of Rates Of Return And Taxation From Private Capital In Canada," Development Discussion Papers 1973-02, JDI Executive Programs.
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