Civil Engineering Reference
In-Depth Information
and progressively less in each future year. The project's NPV now falls into
the negative: the present value of the cost now exceeds the present value
of the benefit by over $4 million. (See the bottom of the rightmost data
column in table 7.2.) The mayor's next lesson, then, is that he should not
take the analyst's discount rate as given, because the rate expected now may
not turn out to be the actual rate. An increase in discount rate necessarily
decreases the project's NPV.
Take note, though, that the purpose of the bridge project is not to
have a high NPV, just a positive one. At a toll of one dollar per crossing,
assuming the lower discount rate, we achieve that positive NPV. And if the
travelers are by and large willing to pay the one dollar, then the project is
worthwhile (on internal grounds only—we have not yet gotten to external
effects). After all, the purpose is to provide bridge services at reasonable
cost, not to maximize toll receipts, which the city could do anyway just by
installing toll booths at street intersections.
For decades now, the NPV technique for cost-benefit analysis has
been a standard method by which to analyze an infrastructure project and,
even more importantly, compare proposed projects. Several US presidential
administrations have maintained an executive order requiring federal agen-
cies to perform the analysis for federally sponsored infrastructure projects.
The method does provide a logical and convenient framework by which to
compare proposed projects. Yet the method is in no way a substitute for
good judgment. Each cost-benefit analysis is only as good as the data and
underlying assumptions on which it is based.
SENSITIVITY ANALYSIS AND RISK
The method we have discussed has a powerful additional application: it
allows us to look at NPVs under alternative assumptions. We have already
illustrated the project's sensitivity to an increase in discount rate from 3.5
percent to 5 percent: the net present value drops from a positive $1 mil-
lion to negative $4 million. How sensitive is our bridge to other changes
in assumptions?
Consider a scenario in which the digging of the ramps on one shore
reveals a previously unknown Indian village site. This launches the state's
procedures for reviewing archeological sites. It also gives legal ammunition
to a group that wants to reduce development on riverfront land. Its lawsuit
holds up construction for three years (during which there is a $1 million
yearly expenditure to maintain the site) until a negotiated resolution that
forces the city to move the ramps at an additional cost of $5 million. Under
this scenario (table 7.3), with the discount rate remaining at 3.5 percent,
