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Net Present Values

2.8.1In appraisals, we generally need to compare options that will impact over a period of years into the future. This raises the question of how future cost and benefits should be valued in today's terms. Normally people prefer to receive cash sooner rather than later, and pay bills later rather than sooner. This is true even after allowing for inflation. For an individual this time preference may be indicated by the real interest rate on money lent or borrowed.
2.8.2In the public sector, likewise, we reflect social time preference by giving more weight to earlier than to later costs and benefits. This is usually given effect by applying a "discount rate" to future costs and benefits. The discount rate defines how rapidly the value today of a future real pound declines through time, just as a real rate of interest determines how fast the value of a pound invested now will increase over time. Guidance on the practical application of the discount rate is given in Basics of Discounting - including Discount Tables.
2.8.3The standard discount rate is 3.5% per annum in real terms. This rate also serves as the Resource Accounting and Budgeting Cost of Capital Charge (RABCCC). This rate should be applied in all but a few exceptional cases. The main exception concerns assistance to industrial and commercial activities (See 2.8.18 below).
2.8.4The 3.5% rate should be applied to all costs and benefits expressed in real terms up to and including the 30th year of an appraisal. However, current practice is to discount longer term impacts less heavily. This is because uncertainty about the future can be shown to cause declining long-term discount rates over time. Thus, instead of applying 3.5% to all future years, the following schedule should be used:
  0-30 31-75 76-125 126-200 201-300 300+
Discount Rate 3.5% 3.0% 2.5% 2.0% 1.5% 1.0%

2.8.5In 2008, HM Treasury produced separate guidance providing for heavier discounting in projects with very large long-term effects on welfare of future generations. See http://www.hm-treasury.gov.uk/d/4(5).pdf for details. Such cases are likely to be relatively rare in Northern Ireland, but where they arise, the following schedule of annual discount rates is recommended:
  0-30 31-75 76-125 129-200 201-300 300+
Discount rate 3.0% 2.57% 2.14% 1.71% 1.29% 0.86%

Treatment of Inflation
2.8.6The standard discount rate is defined in real terms, and should therefore be applied to values which are also expressed in real terms, as opposed to nominal or cash values. This means that the anticipated effects of general inflation should be removed from all the figures before discounting.
2.8.7The most common assumption is that inflation will affect all prices equally, in which case all values are expressed in constant prices at a given date. This is adequate in a majority of appraisals. The effect of expected future inflation in the general price level should be removed by deflating future cash flows by forecast levels of the relevant deflator. The GDP Deflator is usually the most appropriate measure of prices to use as a general deflator in appraisals. See HM Treasury's Gross Domestic Product (GDP) Deflators for latest figures and examples of use.
2.8.8

In some cases, it may be anticipated that a certain cost or benefit item, for example wage earnings or oil prices, will experience inflation at a significantly different rate to that of general inflation. In such circumstances, the cost or benefit stream for that item should be adjusted accordingly before discounting. Specialist advice should be sought about how to do this if necessary.

Adjustment for Optimism Bias
2.8.9

The adjustment for optimism bias (OB) explained under STEP 6 above is usually made before the calculation of NPVs. The base case for each option is the best estimate of its costs and benefits after allowance for appraisal optimism. Thus the base case NPV for each option is its OB-adjusted NPV.

Net Present Value
2.8.10Appraisals should generally include, for each option, a calculation of its Net Present Value (NPV). This is the name given to the sum of the discounted benefits of an option less the sum of its discounted costs, all discounted to the same base date. Where the sum of discounted costs exceeds that of the discounted benefits, the net figure may be referred to as the Net Present Cost (NPC). Alternatively, the term 'negative NPV' may be used.
2.8.11The NPV is the key summary indicator of the comparative value of an option. It not only takes account of social time preference through discounting, but also, by combining capital and recurrent cost and benefits in a single present day value indicator, enables direct comparison of options with very different patterns of costs and benefits over time. For instance, it solves the problem of how to compare a low capital cost / high running cost option with that of a high capital cost / low running cost alternative.
2.8.12The decision rule is to select the option that offers to maximise NPV, or minimise NPC. This is subject to account being taken of those impacts which can not be valued in money terms. Conceptually, these also have an NPV or NPC, but inability to express them in money terms means that they must be judged by other means, as indicated at STEP 7, and weighed alongside the monetary values in coming to a decision.
2.8.13The time horizon for NPV calculations should reflect the economic life of the services being appraised, or the useful life of relevant key assets, and should be sufficiently distant to cover all the important cost and benefit differences between options. For projects expected to have a very long life, the effect of shorter horizons should be illustrated for key years.
2.8.14

Discount calculations should be shown in detail. Net Present Value (NPV) calculations should show a breakdown of the main cost/benefit items covered, and how their incidence is distributed over time. All calculations should be conducted at up-to-date prices. In addition, DFP generally expects the calculations to show:

  • the discount factors used, year by year;
  • the total NPV (or NPC) for each individual year; and
  • the cumulative total NPV (or NPC), for each year of the calculations.
2.8.15

Appraisal reports should record both:-

  • the price basis of the money values (i.e. the date at which prices have been held constant); and
  • the base date for discounting (i.e. the date corresponding to start of the appraisal - usually the beginning of Year 0 in the NPV calculations).
2.8.16

Discount calculations are facilitated by the use of software packages or a calculator. Departmental economists can advise about this and can normally supply spreadsheets suitable for adaptation to the needs of individual cases. A basic NPV speadsheet is available on the DFP appraisal web pages.

Basics of Discounting
2.8.17

The basic principles of discounting are explained further in Basics of Discounting - including Discount Tables, which also provides tables giving discount factors, equivalent annual cost factors and annuity factors.

Discount Rate for Commercial and Industrial Activities
2.8.18The main exception to the use of the 3.5% discount rate is where Government is selling goods or services commercially, or is providing support to industrial or commercial activities. Where government is acting in a competitive environment, it should achieve a rate of return set neither to advantage nor disadvantage it against its competitors. Similarly, when it is supporting industrial or commercial activities, for example through financial assistance, the viability of the proposed activities needs to be assessed by reference to current commercial rates of return.
2.8.19

This requires the use of rates that reflect the commercial returns achieved by comparable businesses facing a similar level of risk. Currently the normal range of rates is 5-10% but rates as high as 15% may be appropriate for the very highest risk businesses.

Required Rates of Return and Pricing Rules
2.8.20Some central government bodies sell goods or services commercially, including to the government itself. These activities may be controlled by requiring prices to be set to provide a required rate of return (RRR) on the capital employed by the activity as a whole. Government policy is generally to set charges for goods and services sold commercially at market prices, and normally to recover full costs for monopoly services, including the cost of capital as explained in Managing Public Money NI (see discussion of financial objectives at A.6.2.5 in the annexes).

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