Introduction
This unit reviews basic financial analysis techniques. The issue involved is fundamentally this:
investment in a project requires giving up consumption or other benefits in the current period, in
exchange for consumption or other benefits in the future. How do we evaluate this trade-off
between present and future values? This is what investment analysis is all about. We cannot
simply sum up the future net-returns and compare this sum with the project’s initial costs,
because people have a bias in favor of benefits received in the present period. Hence, future
benefits or costs must be weighted, or discounted, to convert them into current-period
equivalents. Once future returns are converted into “present value equivalents”, everything can
be summed up, allowing a comparison of the “present value” of the project’s net-benefits against
its costs.
As a terminological note, the term “economic cost” has a very specific meaning to economists:
it’s the opportunity cost of resources given up to do something. This may or may not be the same
as financial expenses or outlays, e.g., a hour of donated labor imposes an opportunity cost in the
form of what the time could otherwise have been doing, even though there is no financial charge
for the labor. (See week 1 lecture notes: “A Substantive Course Overview”). In this handout,
however, I will assume away the distinction between economic cost and financial outlays and
expenditures, assuming that financial outlays do represent economic costs and thus speak
interchangeably of financial outlays and economic costs. But note that this is very specific to the
context; namely, it requires a shadow pricing assumption that financial outlays do equal
resource costs. (This equivalence between financial cost and resource opportunity cost will
change later, when we consider the “shadow pricing” issue formally.) As mentioned in the week
1 lecture notes, we abstract from the shadow pricing issue in this unit in order to focus
exclusively on the fundamental features of investment analysis that arise whether or not there is
a shadow pricing issue.
Another important qualification is also needed at this point. In the previous handout, the
“Fundamental Theory of Discounting,” we focused on the relationship between MRTPs and the
market rate of interest, R. In that context, individuals were simply borrowing and loaning the
funds they had to reallocate their mix of present and future consumption to better optimize their
consumer choice. This is essentially the story of a trading economy in which no production
takes place. For example, if I have $x of funds and you have $y, we might arrange a loan
between us to better optimize our consumption opportunities between future and present
periods, just as if I have a bushel of apples and you have a bushel of oranges, we might swap
some apples and oranges to better optimize our consumption of apples and oranges. No
production is involved in either case.
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