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close this bookAgroforestry In-service Training: A Training Aid for Asia & the Pacific Islands (Peace Corps, 1984)
close this folderAppendices
close this folderAppendix D: New directions in agroforestry: The potential of tropical legume trees
close this folder4. Economic evaluation of agroforestry projects
View the documentThe need for economic evaluation
View the documentFactors in economic evaluation
View the documentEconomic evaluation techniques
View the documentA simplified example
View the documentRecommended references

Economic evaluation techniques

Many different techniques have been developed to evaluate the discounted streams of benefits and costs. Same of these techniques are explained in texts listed in the reference section.

Commonly used approaches include the Net Present Value (NPV), the Benefit-Cost Ratio (E/C Ratio), and the Internal Rate of Return (IRR). All of these use discounted streams of benefits and costs. The Net Present Value (NPV) is the basic economic value to be measured. The NPV determines the present day value of net benefits (gross benefits minus costs of a given project with a predetermined discount rate and time horizon:


where

Bj - benefits in year j
Cj - costs in year j
i = discount rate (expressed as a decimal)
n = number of years (the time horizon)

If there are no capital or other constraints, one would undertake all projects with an NPV ³ 0; these projects would yield total benefits with a present value greater than the present value of total costs. When there are constraints-capital, management skills, or land, for example-other analytic techniques employing ratios can be used to rank alternative projects although the objective is always to maximize net present value subject to the constraints. In general, the constraining variable is placed in the denominator and a ratio is constructed of benefits and this constraining variable. In practice, costs are frequently considered as the constraint and a Benefit-Cost Ratio approach is used. In this case costs are placed in the denominator of the ratio:

B/C Ratio =


where

Bj = benefits in year j
Cj = costs in year j
i = discount rate (expressed as a decimal)
n = number of years (the time horizon).

The B/C Ratio is closely related to the NPV calculation and is an alternative way of providing information for decision making when there is a constraint on costs. The B/C Ratio does not provide information on the amount of total net benefits; it merely calculates the ratio of discounted benefits to discounted costs.

The ratio can be greater, equal to, or less than one (unity). If the B/C Ratio equals 1.0, the present value of all measured costs is just equal to the present value of all measured benefits. There is no "profit." If the B/C Ratio is greater than 1.0, the present value of benefits is larger than the present value of costs, and the project is economically "profitable" at the chosen discount rate, i. The reverse is true if the B/C Ratio is less than 1.0.

The sign of the NPV and the size of the B/C ratio are related since they are similar approaches. If an NPV is negative, this is the same as a B/C Ratio of less than 1.0; a zero NPV is equal to a B/C Ratio of 1.0; and a positive NPV is equal to a B/C Ratio of more than 1.0.

A third approach, the Internal Rate of Return, is similar to the NPV calculation, but instead of setting a discount rate, i, it sets NPV = 0 and solves for i. That is, it gives the discount rate that will set the NPV equal to 0 or define a B/C Ratio of 1.0. Once this discount rate, i, the IRR, is calculated, it can be compared to current interest rates or the social cost of money. For example, if the IRR of a project is 22 percent but the cost of money is 15 percent, the project is economically attractive since it would take an interest (discount) rate of 22 percent to make the present value of benefits equal to the present value of costs. Since the cost of capital is only 15 percent, the extra 7 percent (22 minus 15 percent) is a measure of profitability.

All of these approaches are commonly used in project evaluation, but the NPV and B/C Ratio can be more easily calculated by hand and therefore may be more useful in the field. If several projects are under consideration and funds are not sufficient to undertake all of the projects, the various alternatives can be evaluated and their B/C Ratios ranked as an aid to budget allocation. Of course, this approach depends heavily on the discount rate chosen. As discussed previously, sometimes the same project is evaluated at several discount rates (sensitivity analysis) to see how much this changes the results and the ranking among alternative projects.