2.6 Present value and discounting

Introduction

The community places a higher value on benefits and costs that occur in the near future, compared with those that occur at a later date. Thus it is not possible to directly combine amounts occurring at different times

Example

A present amount may be invested and is worth more than the same amount at some future time by its return on investment in the interim. For example, if it is known that $1.00 invested today will return $1.10 in a year's time, then we can say that $1.10 in a year's time has a present value of $1.00

Treatment in cost benefit analysis

The time value of money is treated in cost benefit analysis by discounting benefits and costs to present values to provide a common unit of measurement. The discount rate represents the rate at which present benefits and costs can be exchanged for future benefits and costs

Benefits and costs may occur at various times over the duration of a project and beyond.

Benefits and costs are discounted to take this timing into account using appropriate present-worth factors from appendix A1.

Present value

The present value (PV) or present worth of a future benefit or cost is its discounted value at the present day. For a series of annual benefits or costs, the discounted values for each future year are summed to give the present values of the series

Discount rate

The discount rate shall be 10 percent per annum. This is a rate established by The Treasury for all public sector project evaluations.

Use of discount factors

The discount factors for single payments, uniform series payments and arithmetic growth series payments in appendix A1 shall be used to calculate the PV of future costs and benefits. Appendix A1 also gives a detailed explanation of how the discount factors shall be applied. The single-payment discount factors in table A1.1 are in time steps of one year, and therefore part-year benefit and cost flows must be assigned to either the start or end of the financial year in which they occur, whichever is the nearer

Particular care shall be taken with amounts occurring in the first five years of the analysis period to allocate them to the correct time. Table A1.2 provides single-payment discount factors in time steps of one quarter of a year, which allows improved accuracy. It is important to accurately define the start timing of the benefit flow after completion of construction/implementation

Inflation

Price inflation is a different concept from discounting. In general, all benefits and costs should be calculated in present-day (constant) dollars.

The discounting of future values reduces the significance of any future inflation that might be expected to occur between various categories of benefits and costs, and therefore no adjustment for inflation is required in the evaluation