Governments are concerned primarily with real prices rather than “shadow prices,” or prices that have been “assigned” to intangible costs and benefits. A major budget management function is a cost-benefit analysis. When coupled with the use of time-value formulas, decision making related to operational expenditures is facilitated. Cost-benefit analysis is a means of evaluating all costs on a dollar basis, even those costs that do not have a dollar value attached to them. After all other calculations have been made, the analysis needs to conclude with the calculation of the ratio between costs and benefits. The results aid decision makers in considering multiple avenues for expenditure. This week, you practice the principles and related formulas of time- (present) value and cost-benefit analysis.

Scenario 1: Present-Value Calculation

Using the present value time-value formulas to calculate the future cost of goods and services is one way to produce more realistic prices. In this Application, you practice using a time-value formula to determine future prices.

The following simple, present-value formula shows the effect of discounting on the cost of a public policy. In the formula, the discount rate will be set at:

(1 + r)time where:

1= a constant

r = a selected interest rate

time = a period of time, usually a year

The formula is:

Cost or Benefit

(1+r)time

The calculation occurs like this example of $1,000 over 2 years discounted at 10%:

$1,000

(1+10%)2

=

$1,000

(1.1)2

=

$1,000

1.21

=$826.44

Consider the following scenario:

A city wants to open a recycling center aimed at reducing waste. The total benefits of the program are valued at $1,000,000. Three different discount rates are estimated at 5%, 6%, and 7%. The time period for receiving the benefits of the program is two years.

Scenario 1 tasks:

Scenario 2: Cost-Benefit Analysis

Note: Scenario 2 is a separate calculation. Scenario 2 is not influenced by the results of Scenario 1.

In doing the following exercise, please refer to the discussion in pages 319–333 of Chapter 7 from Mikesell’sFiscal Administration on cost-benefit and cost-effectiveness analysis. Cost-benefit analysis is a technique that assumes all costs and benefits can have a dollar value attached to them. It is a tool and should not be used as the sole basis for decision making. The result of a calculation is a ratio between costs and benefits. After all other calculations have been made, the analysis needs to conclude with the calculation of the ratio between costs and benefits. If the ratio costs exceed benefits, the project advice is to not accept the project and to consider accepting the project if benefits exceed costs. Consider the following example from the fictitious Swobodaville’s efforts to build a Community Windmill Renewable Energy Project. The following has been agreed upon:

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