Lecture Notes on Cost Assessment Methods

Key Concepts in Cost Assessment

• Understanding and assessing costs is complex, with various tools and methods available.

Main Methods to Assess Costs

1. Net Profit

   • Definition: Total income during the project life cycle minus total costs and resources expended.
   • Key takeaway: Represents the bottom line of profit from a project.

2. Payback Period

   • Definition: Time taken to recover the initial investment from the income generated by the project.
   • Important Factors:
     • Investments are typically higher at the start of a project.
     • Income is often zero initially, then increases over time.
     • Closer the break-even point is to the start, the better the project.

3. Return on Investment (ROI)

   • Definition: Total gain from an investment minus the total cost of that investment.
   • Example: Buying a book for 100 pounds and renting it for 10 pounds per week. ROI is calculated by deducting the book cost from total rental income over a period.

4. Net Present Value (NPV)

   • Definition: Current worth of future cash flows generated by an investment, discounted at a specific interest rate.
   • Key Points:
     • Value of money changes over time (e.g., 1000 kroner today is worth more than 1000 kroner in a year).
     • Example of interest effect:
       • Investing 1000 kroner at a 10% interest results in 1100 kroner after one year.
       • Compounding interest: 1000 kroner grows to 1331 kroner in three years at the same interest rate.
   • Formula:
     Present Value = Future Value / (1 + r)^n
     Where:
     • r = interest rate
     • n = number of years.
   • Example of calculation:
     • 5000 kroner in 3 years at 15% interest equals approximately 3285.50 kroner today.
     • Comparison of cash flows:
       • Investing 3000 kroner now to receive future payments (500 kroner/year for 3 years and 2500 kroner in the fourth year).
       • Calculating present values of future cash flows to determine if the investment is worthwhile.

Summary of Cash Flow Calculation Example

• Initial Investment: 3000 kroner
• Future Cash Flows:
  • Year 1: 500 kroner discounted to 455 kroner
  • Year 2: 500 kroner discounted to 430 kroner
  • Year 3: 500 kroner discounted to 376 kroner
  • Year 4: 2500 kroner discounted to 1708 kroner
• Total Present Value: 455 + 430 + 376 + 1708 = 1969 kroner
• Result: 3000 - 1969 = -1031 kroner (indicating a loss of value, thus not a good investment)

Conclusion

• Understanding these cost assessment tools is crucial for making informed decisions in projects. Each method offers different insights into the financial viability of investments.