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

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Author Info

  • 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.

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Bibliographic Info

Paper provided by JDI Executive Programs in its series Development Discussion Papers with number 2011-08.

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Length: 40 pages
Date of creation: Aug 2011
Date of revision:
Handle: RePEc:qed:dpaper:201

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Keywords: discounting; discount rate; economic cost of capital; rate of time preference; gross of tax rate of return;

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  1. Glenn P. Jenkins, 1985. "Public Utility Finance and Economic Waste," Canadian Journal of Economics, Canadian Economics Association, Canadian Economics Association, vol. 18(3), pages 484-98, August.
  2. 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, Economic Society of South Africa, vol. 71(3), pages 523-543, 09.
  3. 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.
  4. 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.
  5. Sjaastad, Larry A & Wisecarver, Daniel L, 1977. "The Social Cost of Public Finance," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 513-47, June.
  6. 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.
  7. Glenn Jenkins, 1973. "The Measurement Of Rates Of Return And Taxation From Private Capital In Canada," Development Discussion Papers, JDI Executive Programs 1973-02, JDI Executive Programs.
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