Cost Effective Analysis: The Role of Discounting in Government Investing
Methods and Models I Track
In order for the government to best fulfill its obligation to efficiently spend tax dollars, it uses various analysis methods to determine which investment to choose. Cost effectiveness analysis is often the preferred analysis method when an investment is not being judged as to the value added but to determine the least expensive spending alternative. According to the Office of Management and Budget (OMB) in circular A-94, an investment is cost effective when, comparing competing alternatives, its cost are the lowest as expressed in present value terms for a given amount of benefits (OMB, 2011). This is because cost effectiveness analysis can only be used when the benefits are the same for each alternative. It is the value of properly discounting estimated costs that is most important—besides accurately estimating the costs, which is assumed to be known here – when conducting a cost effectiveness analysis.
The discounting relationship with cost effective analysis is that a lower discount rate will actually have a higher current cost than an investment with a higher discount rate. In terms of present value, when evaluating a cost effective investment, one would prefer a higher discount rate as it provides a lower cost in today’s dollars. With this known, using a rate higher than what OMB guides will cause an undervaluation of the optimal alternative. This will lead the decision maker to believe he is spending less than what really needs to be spent. The reverse is true in an overvaluation scenario.
However, the process of discounting extends beyond plugging numbers into the present value equation and requires a more detailed understanding. Experience has shown that an analyst needs to avoid the lifecycle—bond maturity mismatch, ineffective use of nominal or real rates and incorrect discounting based on timing of cash flow. For example, taking the twenty year treasury rate for a program lifecycle of fifteen years is inappropriate and can lead to an under or overvaluation of the optimal alternative. The fifteen year interpolated discount rates would need to be calculated between the ten and twenty year treasury rate. In order to arrive at an appropriate valuation through discounting one must understand the use of matching lifecycle to bond maturities, when to apply nominal or real rates, and whether beginning of the year, middle of the year or end of the year discount factor should be applied.
A financial model on cost effective analysis will be discussed and provided in detail at the ICEAA workshop in order to gain a better understanding.
Federal Aviation Administration