Assignment One CBA | Economics
A CBA OF A PROPOSED DAM AND HYDROPOWER STATION SCHEME
A Regional Authority (RA) in a developing country has been presented with an opportunity for economic development in its region. You are a consultant and have won the contract to provide a detailed analysis and a recommendation to the RA regarding this development opportunity. You are to present your findings as a report to the RA. Assignment One CBA Economics.
Background of Assignment One CBA Economics:
The land is currently used for agricultural production, with a net annual value of $41 million. The RA is keen to see economic growth in its region and this proposal is to bring a much-needed increase in electricity to the region. The proposal is to build a dam and a hydropower station on the main river in the region, the Yessam River. This dam will flood the agricultural land, removing the livelihood from many in the area. In addition, 100 households will need to be relocated and so for them, the land will need to be purchased and new housing built.
The lake created by the dam will provide recreation activities (as yet unspecified or valued) and business from outside the area is putting forward a fish farm proposal to be situated at the far end of the lake which they say will provide some jobs and a good supply of fish for the community.
All further relevant data for the project is given in the data appendix. You will need to follow Parts 1 – 4 to complete your report to the RA.
Part 1: (16 marks)
In order to provide detailed and defendable advice to the RA regarding the proposal, you need first to carry out a CBA from a regional viewpoint. Calculate the NPV and the IRR for the entire proposal. To do this you will need to decide on a discount rate, and be able to justify your choice (marks will be given for this in Part 4).
Begin with an initial 10-year analysis and then in the Data Appendix you will be instructed on how to extend this. Present a complete spreadsheet of your analysis showing the benefits, the costs, the net cash flow for each year, and the NPV and IRR for the entire combined proposal. You can do the analysis as a ‘With – Without’ analysis or you can do it all together, but remember that the current situation’s net benefits will need to be expressed as costs in your analysis (since these are benefits foregone). Complete all the CBA on one sheet of your spreadsheet.
On your spreadsheet, please state the discount rate you used and either show your working or provide your reasoning for choosing this (2 marks).
You are to make the following assumptions:
1. As is usual in an economic analysis (or CBA), do not incorporate inflation in your analysis (conduct a constant value analysis).
2. From year 2 onward all other costs and revenues occur at the end of each year.
With a spreadsheet analysis, it is important that you do all calculations in the spreadsheet, do no calculations on a calculator or in your head (even if you can). Put all your raw data in clearly labelled cells in the top few rows of your spreadsheet. Below this you set out the main table of your analysis, and make sure that every cell links (via excel formulae) to the raw data cells. The reason for this is that you will later be required to conduct a number of sensitivity or scenario analyses for which you may have to change the value of several variables (e.g. some prices or the discount rate). If set out correctly, when you do this the entire analysis will change (which is what you want).
Part 2: (4 marks)
There is also a second proposal that is smaller in scale. This proposal is for a smaller scale dam and hydropower station and will need to be done after you have done Proposal 1. Proposal 2 requires 60% of the materials used in Proposal 1, 65% of the labour costs and built over the same timeline. Only half the agricultural land will be flooded, and no households will need relocating. Electricity production will be 47% of the production for Proposal 1 and the O + M for electricity is 65% of that for Proposal 1 The fish farm would not go ahead under Proposal 2. Calculate the NPV and IRR for Proposal 2. Complete the analysis for Proposal 2 on the same spreadsheet sheet as your main analysis – do it directly below (for ease of marking).Assignment One CBA Economics.
Part 3: (10 marks)
a) On the same spreadsheet sheet, set up a table with varying discount rates and the NPVs for both proposals. Now use this table to plot a graph showing the changing NPVs for both proposals to demonstrate the impact on the analysis of varying the discount rate. Based solely on the CBAs, for what discount rates (correct to 2 decimal places) would you recommend one proposal over another? ‘Goal Seek’ is a great tool to use. Write these in your spreadsheet. For what discount rates would you not go ahead with either proposal? Again write in your spreadsheet. Save and keep your spreadsheet, as it is to this point, ready to submit for Assignment 1. (5 marks)
b) Now I suggest that you re-save your spreadsheet with a new filename. You will not submit this file to me, but I recommend that you do your sensitivity analyses here so that you do not make changes (that you may forget to reverse) to your main analysis. Carry out an investigation into key variables that, if changed, will alter the recommendation you would make based on the CBA alone. Do not just change every variable but make informed choices. Again I recommend ‘Goal Seek’. Make a note of these and the outcomes (in terms of the overall NPV and IRR) as you will be reporting on these in your final report. (This is also where the marks are allocated for this, i.e. in Part 4). Between each change you make, you may wish to revert your spreadsheet back to the original analysis (so that these sensitivities are made independently of each other). I also suggest you carry out a ‘best case’ and ‘worst case’ scenario to report on – you could do these in Scenario Manager if you wish. (5 marks)
Part 4: (30 marks)
You are now required to write a report of your findings and make your recommendations to the RA. Your recommendations must take into consideration all the information at hand.
So far, you have carried out CBAs for Proposals 1 and 2, which will provide you with recommendations based on your CBA and sensitivity analyses alone. Also explain the sensitivities and scenarios you chose to do (changes to the variables you made) and the outcomes from each of these (in terms of NPV and IRR) and how these would impact your overall decision if based solely on the CBA (6 marks).
In addition, you need to identify any social, environmental and cultural issues that should be taken into consideration when making a decision on this overall project. List and discuss fully the importance of each of these. Now choose two of your environmental issues and outline the method or approach you would use to estimate the monetary value of each of these environmental issues and how you would incorporate them into a CBA (20 marks).
Taking all of the above into consideration, make your final recommendations to the Regional Authority Clearly justify your reasoning (4 marks).
Note: Remember that you are being paid to make a decision, so suggesting that more analysis be undertaken is not an acceptable recommendation.
Note that all prices quoted are in local currency ($) unless otherwise indicated.
A. Capital Costs
Capital costs include all costs required to complete each component of the project. It is estimated that 55 percent of the materials needed for the dam and hydroelectric power plant are imported from the US.
B. Labour costs associated with building and relocation
Labour is required to build the dam and hydropower station (both in the 1st and 2nd year), labour costing $2.56mill. In addition labour costing $850,000 is required to build the new housing. Unemployment is currently at 11%.
C. Electricity generation
It is expected that the hydropower station will generate 3.2 billion kWh each year beginning in year 2 and the price of electricity is expected to be 9 cents/kWh.
Operating and maintenance costs begin in year 2 and from years 2 – 6 (inclusive) are
$36mill. From year 7 onward operating and maintenance increase to $59 mill each year.
Note: 1 billion = 1000 million
D. Fish farm
A start-up business has approval from the local authority to set up a fish farm at the far end of the lake. The business has done research on this and these are the expected capital costs:
Power & Maintenance costs are estimated to be $11,000 at the end of the first year and then twice this amount for subsequent years.
Fingerlings cost 40cents each and 170,000 are purchased each year. The survival rate is 90%. The first purchase is at the beginning of year 1 and after this the cost of fingerlings (as well as other costs) can be recorded as the end of each year (unless otherwise specified). Other fish-related operating costs (including feed etc) are estimated at $590,000/year. Staff costs are $270,000.
Time until harvest is one year and in the first year 80,000 fish are harvested and then 153,000 each year after this. The average weight of a fish sold is 2.0kg and they sell at $3.50/kg
E. Macroeconomic Parameters
The country still has import controls and tariffs, and economists have estimated that the exchange rate is overvalued. Currently, the official exchange rate is Local$1.00=US$0.64. A more realistic (or shadow) exchange rate is Local$1.00=US$0.49. Government policy is directed to remove import control and tariffs, and so move to a free trade situation.
Ten-year government bonds are currently yielding 7.5 percent.
The current market rate is 8.5 percent and inflation is at 2.1 percent.
F. Beyond the 10-year time horizon
The capital equipment is unlikely to have been worn out after 10 years, and we can assume that the project will continue beyond the 10-year analysis. One way we can incorporate this into our CBA (instead of having salvage values for plant and equipment sold off at the end of the project), is to value the proposal on into the foreseeable future by valuing the stream of net benefits on beyond the 10 years. We can do this by considering the stream of net benefits as a particular type of an annuity called a perpetuity. Then as long as the cash flow each year (for the later years) is likely to stay constant, then this is an annuity.