Discounting It is the conversion of future values into present values called discounting and requires a rate know as discounting rate . Basic principle is that US $ or other currency now is worth more than a dollar to be received sometime in future because that present US $ received can be invested at interest to accumulate more than its original value
PV =Xi/(i+r) tPV= present valueXi= amount of money in year Tr=rate of discount expressed as aproportionT= number of years from thepresent data
Example :Receiving US $ 100,000 now is betterthan receiving US$ 100,000 in a yearstime, reason is , it would not beworthful in future.
To compare costs and benefits thatoccure in different years it is necessaryto convert their value into present value.It can be done with the help ofdiscounting. When all cost and benefits areconverted to present value it is possibleto compare them. This is done by using three decisionmaking criteria .
Net present valueInternal rate of returnBenefit cost ratio
NET PRESENT VALUE It is diffrence between sum of the present value of the benefits and the sum of the present value of the cost.NPV= Ƹ Bt/(1+r)t – Ƹ Ct/(1+r)t If NPV is negative the investment is not worth while , while a positive NPV indicates only that the investment might be considered.
Internal rate of returnIn simpler term the IRR is the interest ratethat will make the investment just break even.NPV= Ƹ Bt/(1+r)t – Ƹ Ct/(1+r)t=0If IRR exceeds the minimum acceptablediscount rate is the opportunity cost ofmoney the project is worth for futureconsideration.
Benefit cost ratio It is calculated by dividingthe sum of the present value of benefits by sum of the present value of cost. /BCR=Ƹ Bt/(1+r)t Ƹ Ct/(1+r)tAn investment is worth considering if the BCR is greater than 1.
ConclusionCarrying of cost benefit analysis ofinvestment in any project requires aprocess by which analyst examine where toinvest.