Econ 4831: Cost and Benefit Analysis

Summer 2016
Problem Set 2
ANSWER KEY
This problem set is worth 100 points with extra 20 points and is due on April 20th in class.
Feel free to collaborate with your classmates to work on the problems, but everyone needs to
turn in an individual (and original) copy of the problem set. Acknowledge the people you work
with! Identical, or essentially identical, problem sets will forfeit points (up to 50) depending on the
graders discretion. Present your work clearly and succinctly. Dont skip steps and explain your
logic as you go along, it helps me give partial credit. Feel free to draw diagrams wherever you feel
it might help you explain things.
Exercise 1: Discounting Benefits and Costs (20 points)
Paul is tired of sitting in the freezing Minnesota winter and is considering insulating his home. It
would cost him $5000 this year to insulate, and the estimated reduction in his yearly fuel costs
would be $350 per year. The insulation can be installed immediately. Assume the discount rate
is 7%. Paul plans to live in the house until he retires, 23 years from today, at which point he will
sell the house and move to someplace warmer. He has already consulted a real estate agent for advice and was told that insulation will not add anything at all to the value of the house when it is sold.
(a) (5 pts) Calculate the present value of net benefits of insulation assuming that the benefits are
realized at the end of each year.
ANSWER
Consider the annuity factor formula:
n
X
t=1

1
1 (1 + i)n
=
(1 + i)t
i

So, the present value of benefits with n = 23 and i = 0.07:

P V (B) =

23
X
t=1

350
(1 + 0.07)t

1 (1 + 0.07)23
0.07
= 350 11.2721
= 350

= 3945.23
So, the net benefits of insulation is:
N P V = P V (B) P V (C)
= 3945.23 5000
= $1054.77
(b) (5 pts) Calculate the present value of net benefits of insulation assuming that the benefits are
realized at the beginning of each year.
ANSWER
If the benefits are realized at the beginning of each year, we should discount each dollar as:
22
X
t=0

22

X
1
1
=
1
+
t
(1 + i)
(1 + i)t
t=1

So, the present value of benefits is:

P V (B) = 350 +

22
X
t=1

350
(1 + 0.07)t

1 (1 + 0.07)22
0.07
= 350 + 350 11.0612
= 350 + 350

= 350 + 3871.42
= 4221.42
So, the net benefits of insulation is:
N P V = 4221.42 5000
= $778.58

Suppose the real estate agent is wrong, and that insulation does, after all, add to the value of a
house when it is sold, adding then the present discounted value of the reduction in fuel costs over
all later times (that is, forever). The price of Pauls house will be $600,000 in 23 years from today
(without insulation).
(c) (5 pts) Calculate what the house will be worth 23 years from today with insulation. Assume
the benefits are realized at the end of each year.
ANSWER
Consider the perpetuity formula:

X
t=1

1
1
=
t
(1 + i)
i

Given that insulating adds to the value of the house its benefits, the liquidation value is just the
present value of benefits. So, the present value of benefits:
P V (B) =

X
t=1

350
(1 + 0.07)t

350
0.07
= $5000

So, the price of the house 23 years from today will be:
N P V = 600, 000 + 5000
= $605, 000
(d) (5 pts) What is the net present value of insulating the house today, allowing for both the
reduction in costs and increased value of the house when sold. Assume the benefits are realized at
the end of each year.
ANSWER
Notice that the benefits will just be the present value of all future benefits forever:
P V (B) =

X
t=1

350
(1 + 0.07)t

350
0.07
= $5, 000

Since the P V (C) = $5000, N P V = $0.

3

Exercise 2: Projects with Different Time Length (20 points)

A towns recreation department is trying to decide how to use a piece of land. One option is to
put up basketball courts with an expected life of 8 years. Another is to install a swimming pool
with an expected life of 24 years. The basketball court would cost $180,000 to construct and yield
net benefits of $40,000 at the end of each of the 8 years. The swimming pool would cost $2.25
million to construct and yield net benefits of $170,000 at the end of each of the 24 years. Each
project is assumed to have zero salvage value at the end of its life. Using a real discount rate of 5
percent, which project offers larger net benefits? Approach the problem using the Roll-Over and
the Equivalent Annual Net Benefit methods.
ANSWER
Consider first the NPV of each project separately:
N P V (court) = $180, 000 +

8
X

40, 000
= $78, 529
(1 + 0.05)t

t=1
24
X

N P V (pool) = $2, 250, 000 +

t=1

170, 000
= $95, 769
(1 + 0.05)t

Notice that since the projects have differetn length, it is not appropriate to choose based on NPV.
First, use the Roll-Over method; that is, one could choose between one swimming pool and three
successive basketball court projects.
N P V (3court) = $78, 529 + $78, 529/(1 + 0.05)8 + $78, 529/(1 + 0.05)16
= $78, 529 + $53, 151 + $35, 975
= $167, 655
Thus, three successive basketball court projects offer a higher NPV of benefits than the swimming
pool, and based on the Roll-Over one should build the basketball court. The other possible approach
to the problem is using the Equivalent Annual Net Benefits. Remember that the annuity factor is
equal to
ani =

1 (1 + i)n
i

So, the appropriate annuity factors are:

1 (1 + 0.05)8
= 6.4632
0.05
1 (1 + 0.05)24
=
= 13.7986
0.05

a80.05 =
a24
0.05

The EANB are

$78, 529
= $12, 150
6.4632
$95, 769
EAN B(pool) =
= $6, 940
13.7986
EAN B(court) =

The basketball court offers net benefits equivalent to an annuity paying $12,304 each year over its
life. The swimming pool offers net benefits equivalent to an annuity paying $6,942 each year over
its life.
Exercise 3: Expected Benefits and Costs (20 points)
The government is considering constructing a dam that will last for 5 years. If the dam is constructed the annual benefit of the dam is $50 million. Assume that the benefits will start accruing
at the end of the first year and accrue at the end of every year that the dam operates thereafter.
In order to construct the dam, there is an initial cost of $25 million that must be paid at the
beginning of the first period. In addition, there is an annual maintenance cost that must be paid at
the beginning of the year for all 5 years. This cost depends on the amount of rainfall. Every year
can be a rainy year with probability 0.7 and a dry year with probability 0.3. In a rainy year, the
maintenance cost is $5 million and in a dry year, the cost is $3 million. What are the net benefits
of the dam? The real discount rate is 5% and all amounts are measured in real dollars.
ANSWER
The PV of benefits is:
P V (B) =

5
X
t=1

50
= $216.5 million
(1 + 0.05)t

Expected cost of maintenance:

E(Cm ) = 0.7 5 + 0.3 3 = $4.4 million
If the expected cost of maintenance is discounted at the beginning of the period:
P V (E(Cm )) = 4.4 +

4
X
t=1

4.4
(1 + 0.05)t

4.4 + 4.4 3.5459

= 4.4 + 15.6021
= 20.0021
PV of costs:
P V (C) = 25 + 20.0021 = $45.0021 million

PV of net benefits:
N P V = 216.5 45.0021 = $171.4979 million

If the expected cost of maintenance is discounted at the end of the period:

P V (E(Cm )) =

5
X

t=1

4.4
= $19.05 million
(1 + 0.05)t

PV of costs:
P V (C) = 25 + 19.05 = $44.05 million
PV of net benefits:
N P V = 216.5 44.05 = $172.45 million

Exercise 4: Option Price and Option Value (40 points)

Consider the project of constructing a dam. The only person affected by this project is a farmer,
with utility U (I) where $I is his income. There are two possible contingencies: it rains a lot (wet)
or it does not rain a lot (dry). With the dam, his income is $180 if wet and $120 if dry. Without
the dam, his income is $100 if Wet and $80 if dry. The probability of raining a lot is 50%.
(a) (5 pts) What is the expected surplus of the farmer?
ANSWER

POLICY
DAM

NO DAM

PROB

WET

180

100

0.5

DRY

120

80

0.5

The surplus if a wet contingency happens:

U (180 Sw ) = U (100) Sw = 80
The surplus if a dry contingency happens:
U (120 Sd ) = U (80) Sd = 40
Expected surplus is:
E(S) = 0.5 80 + 0.5 40 = 60
6

(b) (5 pts) What is the variance of income with the dam and without it?
ANSWER
The expected income without the dam is:
E(IN O ) = 0.5 100 + 0.5 80 = $90

The variance of income without the dam is:





var(IN O ) = 0.5 (100 90)2 + 0.5 (80 90)2
= 100
The expected income with the dam is:
E(IDAM ) = 0.5 180 + 0.5 120 = $150

The variance of income without the dam is:





var(IDAM ) = 0.5 (180 150)2 + 0.5 (120 150)2
= 900
(b) (10 pts) Assume U (I) = ln I. What is his expected utility in case the dam is not constructed?
What is his option price? Compare its option price to its expected surplus.
ANSWER
In case the dam is not constructed, farmers expected utility:
E[UN O ] = 0.5 U (100) + 0.5 U (80)
= 0.5 ln(100) + 0.5 ln(80)
0.5 4.6051 + 0.5 4.3820
= 4.493
Option price is the maximum an agent would accept to pay for the dam; that is, the farmer would
accept to pay a value that makes him indifferent between the dam or not, E[UOP ] = E[UN O ] where
E[UOP ] = 0.5 U (180 OP ) + 0.5 U (120 OP )

So, we have,
0.5 ln(180 OP ) + 0.5 ln(120 OP ) = 0.5 ln(100) + 0.5 ln(80)
ln(180 OP ) + ln(120 OP ) = ln(100) + ln(80)
ln[(180 OP ) (120 OP )] = ln(100 80)
(180 OP ) (120 OP ) = 100 80
21600 180OP 120OP + OP 2 = 8000
OP 2 300OP + 13600 = 0
To apply Bhaskara formula, let = b2 4ac. So,
= (300)2 4 13600 = 90000 54400 = 35600
Then, we find that:
OP =

300

35600

2
300 188.68

2
OP1 = 55.66

or

OP2 = 244.34

The solution is OP = 55.66. Notice that OP = 224.34 would lead the farmer to have negative
income. Then we have that,
OP = 55.66 < 60 = E(S)
Farmers option price is lower than the expected surplus of the project. This is a consequence of
the increase in risk (in terms of a higher variability in the income stream).
(c) (10 pts) Assume U (I) = I. What is his expected utility in case the Dam is not constructed?
What is his option price? Compare its option price to its expected surplus.
ANSWER
In case the dam is not constructed, farmers expected utility:
E[UN O ] = 0.5 U (100) + 0.5 U (80)
= 0.5 100 + 0.5 80
= 50 + 40
= 90

Also, consider the utility:

E[UOP ] = 0.5 U (180 OP ) + 0.5 U (120 OP )
= 0.5 (180 OP ) + 0.5 (120 OP )
= 90 OP/2 + 60 OP/2
= 150 OP
To compute the option price, make E[UOP ] = E[UN O ]:
150 OP = 90
OP = 60
Then, we have that OP = 60 = E(S). Farmers option price is the same as the expected surplus
of the project. This happens because the farmer does not value the increase in risk (in terms of a
higher variability in the income stream). The farmer does not lose utility from increased consumption variability and only cares about expected income.
(d) (10 pts) Calculate the option value for each case above. Compare them. How would you explain
their difference?
ANSWER
For the risk averse famer, option value is:
OV = 55.66 60 = 4.44
and for the risk neutral farmer:
OV = 40 40 = 0
The difference is due to the effects of risk for each type of farmer. While the risk averse loses utility
from the increase in risk, the risk neutral is indifferent to it.
Extra Points Exercise: Sensitivity Analysis (20 points)
Reproduce Figure 7.3 and Figure 7.5 in the book. Together with the figures, explain the methodology to compute them; i.e., the idea behind the method and how you did it. The explanation should
have about ten to twelve lines for each method.