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Appendix A

Economic Analysis

Dr. David Pratt

Editor’s Note: Appendix A provides the foundations of economic anal-
ysis and the time value of money (“A dollar today is worth more than
a dollar tomorrow.”) For folks who are new to financing terminol-ogy,
this appendix is a good reference. Near the end of this appendix there
are 38 examples about how to do economic analyses of projects!

A.1 OBJECTIVE

The objective of this appendix is to present a coherent, consistent ap-
proach to economic analysis of capital investments (energy related or oth-
er). Adherence to the concepts and methods presented will lead to sound
investment decisions with respect to time value of money principles. The
appendix opens with material designed to elevate the importance of life
cycle cost concepts in the economic analysis of projects. The next three
sections provide foundational material necessary to fully develop time
value of money concepts and techniques. These sections present general
characteristics of capital investments, sources of funds for capital invest-
ment, and a brief summary of tax considerations, all of which are impor-
tant for economic analysis. The next two sections introduce time value of
money calculations and several approaches for calculating project mea-
sures of worth based on time value of money concepts. Next the measures
of worth are applied to the process of making decisions when a set of po-
tential projects are to be evaluated. The final concept and technique sec-
tion of the appendix presents material to address several special problems
that may be encountered in economic analysis. This material includes,
among other things, discussions of inflation, non-annual compounding
of interest, and sensitivity analysis. The appendix closes with a brief sum-
mary and a list of references which can provide additional depth in many
of the areas covered in the appendix.