Benefit-Cost Analysis: Financial and Economic Appraisal Using Spreadsheets

By Harry F. Campbell; Richard P. C. Brown | Go to book overview

2
Investment Appraisal: Principles

Introduction

This Chapter provides a simple introduction to the principles of investment appraisal. It starts with an outline of the logic of the investment appraisal process from the viewpoint of an individual considering a very simple type of project. During the course of the discussion of this process such concepts as the discount rate, discount factor, present value, benefit/cost ratio, marginal productivity of capital and internal rate of return are developed. The discussion then shifts to the economy as a whole and the role of investment appraisal in allocating resources between investment and the production of goods for consumption. The simple algebra of various investment decision-rules applied in the latter part of the Chapter is then presented, followed by a numerical example. Following this, some special concepts, such as annuities, economic depreciation, inflation and risk, are discussed in the context of investment appraisal.

In the following chapter (Chapter 3), the discussion shifts to applications of the various investment decision-rules. Some of the applications rely on the simple algebraic concepts already discussed in Chapter 2, while some are developed using the basic tool of the benefitcost analyst – the spreadsheet. Some issues already raised in this Chapter, such as the time value of money and the calculation of present value and internal rate of return, are explored further, while new concepts, such as comparison of projects and capital rationing are introduced and discussed.


Investment Appraisal from a Personal Viewpoint

Economists start from the proposition that an individual's economic welfare in a given time period is determined by the quantity of goods and services she consumes in that time period; consumption of goods and services is taken to be the ultimate goal of economic activity. However sometimes it pays to use scarce resources – land, labour and capital – to produce capital goods in the present so that the flow of consumption goods and services (hereafter referred to as [consumption goods]) can be augmented in the future. Two important processes are at work here: saving – which is refraining from consumption so that scarce resources are freed up for a use other than producing goods for current consumption; and investing – which is the process of using scarce resources to produce goods for future consumption. Sometimes an individual undertakes both activities – for example, instead of spending all of her income on

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