What methodology is used to determine the best options of two competing “projects”

The Petro Caribe buy back is a good deal

The Petro Caribe buy back is a bad deal

In my opinion, the deal is a good one because it reduces our Debt/GDP ratio by 10%

In my view the deal is a bad one because its going burden tax payers.

Jamaica got a good deal on the international capital market.

All the above are various statements that we have heard from economist, financial analyst, commentators, politicians, bloggers, the man in the street, but who is correct, because they all cannot be.

Let us first examine, what was the intent of the debt buy back before looking at anything else.

The foremost thing in the mind of Dr Peter Phillips and supported by the IMF is a reduction in the debt/GDP Ratio, this is one of the most fundamental part of the entire EEF arrangement between the IMF and Jamaica.

By all accounts this debt buy back has or will reduce the debt/gdp ratio by some figure, which is yet to be determined given the various Debt/GDP ratio that are floating around and the % of the Petro Caribe debt that is included in this debt/gdp ratio.

If this is the sole measurement, then yes, the debt buy back has achieved its objective, end of story.

In the accounting world however, this is NOT how things are done. I will use an example to demonstrate my thought process.

Let’s say I am an Engineer and Devon Chang happens to be my Chief Accountant /Financial Controller.

I need to replace an old AC unit, with a new one and I have the following information. I need to use the information below to justify my purchase decision and submit same to Mr Chang for approval, so let’s examine how that will be done.

One unit cost $2.65m, while the other cost $1.8m. I plan to borrow all the money to fund the purchase. I can obtain a loan and 10% to purchase the $1.8m unit or I can get the $2.65m at a slightly higher interest rate of 12%.

Which unit would Mr Chang approve of, the lower cost unit at the lower interest rate or the higher cost unit at the higher interest rate.

Lets see how the numbers work out.

Option #1 Option #2 Existing Unit
Standard AC  Unit Inverter AC unit End of useful life
Cost  $              1,800,000  $            2,650,000
Energy Cost /annum  $                 375,000  $               150,000  $          450,000.00
Maintenance Cost/annum  $                   45,000  $                 45,000  $          180,000.00
Life Span (Yrs) 12 12
Borrowing Rate 10% 12%
Energy Savings/YR  $              75,000.00  $          300,000.00
Maintenance Cost Savings/Yr  $            135,000.00  $          135,000.00
Total Savings/yr  $            210,000.00  $          435,000.00
ECONOMIC ANALYSIS
Payback (yrs) 8.6 6.09
NPV  $           (369,060.00)  $            44,390.00
P|Ain 6.814 6.194
Life Cycle Cost (LCC )  $              4,661,880  $            3,857,830
Benefit/Cost Ratio        ( BCR) 0.795 1.017
Internal rate of return (IRR) 5.60% 12.36%

What do these numbers mean and which unit would be approved.

The unit which would have been approved, would be the one that actually cost the most and for which the borrowing would be higher, but why ?

Using the five main economic analysis factors this is what we found

  1. This unit has the shortest payback period, but this is not sufficient alone to select this unit.
  2. The net present value of the project is positive; You always want project with a positive NPV
  3. The life cycle cost if lower, which means you save money over the life of this project, when compared to the other unit.
  4. The benefit to cost ratio is a above one, the higher the BCR the better the value of the project.
  5. The internal rate of return IRR is 12.36%, which is greater that the borrowing rate of 12%.

So Mr Chang does not arrive at his decision on which unit he will approve on the basis of an opinion or a feeling from the Engineer. His decision is grounded in a group of various economic analaysis variable, which when put togther shows that despite the higher purchase price and higher interest rate, this particular project is of better value than the lower cost unit and the lower borrowing rate.

This is the type of discourse I would have loved to see on the Petro Caribe deal vs the opinionated reports that I have been seen thus far.

I am still calling out the lecturers   and professors at UWI, UTECH and UCC to run the numbers and show us, so we can form our own opinion, is that really too much to ask.?

If this deal was in the USA you would have seen reports from professors at  Harvard, Columbia, Stanford, Yale and Princeton from last week, but no so in Jamaica, why ?

In fact I bet if one professor from one of these were to write on the buy back, you would have a local guy criticizing and correcting him 🙂

Bless

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