Reference no: EM13118188

Benefit-cost Analysis

The objectives of the assignment are to gain further experience in calculating net present values with an excel spreadsheet, in distinguishing private benefits and costs from social benefits and costs, and in distinguishing between benefits and costs that occur within and outside of national boundaries.

Problem:

A company that is completely foreign-owned invests in a tree plantation in Australia. Harvesting is to commence in year 5 and continue until year 20. The value of output of logs in year 5 of the project is estimated to be $10 million, increasing by $2 million per year until year 20 when the gross annual revenue is $40 million. The export price received will remain constant throughout the 20-year period. Assume also that the output of logs is marginal compared with existing output, all logs are exported, and Australia is a price taker in the export market.

The company will employ 20 people for years 1 to 4, and 50 people in years 5-20. Harvesting begins in year 5. There is high unemployment in the region where the project is to take place, and 60 per cent of the workers will be unemployed at the time of hiring. Their unemployment pay is equal to the value of their leisure. Wages are $50,000 per worker per year (see note iii).

Capital investment is funded fully from domestic sources. It is $15 million in each of the first three years of the project.

Operating costs are $2 million per year from year 1 until the end of the project. All operating and start-up expenditure is spent on locally purchased equipment and materials, and is funded domestically.

The salvage value of plant and equipment at the end of the project is predicted to be $4 million and is not subject to taxation. Assume the salvage value is received at the end of year 20. There are no other benefits or costs. All profits to the company accrue to overseas shareholders.

When net revenues before payment of royalties and taxes are positive, the company is to pay 5 per cent of its gross revenue as royalties. When net revenues after payment of royalties are positive, the company is also to pay 30 per cent of its net revenue as taxes. There is no carryover of losses for taxation purposes. The relevant social discount rate is 5 per cent per annum. And the relevant private rate is 7 per cent per annum.

Requirements:

(a) Calculate the net private benefits of the project to the foreign-owned company, as a net present value.

(b) Calculate the net social benefits of the project from the viewpoint of the Australian economy, with the same criterion.

(c) Make a recommendation to the government whether the project should be accepted on the basis of these results.