Affordability Assessment Compared

Definition

Affordability Assessment Compared is a method of evaluating the financial feasibility of a project or product by comparing its costs to its benefits, using frameworks such as Cost-Benefit Analysis, which was first introduced by Jules Dupuit in 1844.

How It Works

Affordability Assessment Compared involves calculating the Net Present Value (NPV) of a project, which is the difference between the present value of its benefits and the present value of its costs, using a discount rate such as the Weighted Average Cost of Capital (WACC). For example, Boeing produces ~800 aircraft annually (Boeing annual report), and when assessing the affordability of a new aircraft model, the company would compare the costs of production, including labor and materials, to the revenue generated by sales. The Internal Rate of Return (IRR), which is the discount rate at which the NPV equals zero, is also used to evaluate the affordability of a project. According to Ricardo's comparative advantage model, 1817, a country should specialize in producing goods for which it has a lower opportunity cost, which is a key consideration in affordability assessments.

The affordability of a project is also influenced by factors such as inflation, which can increase costs and reduce the purchasing power of consumers, and exchange rates, which can affect the cost of imported materials and the revenue generated by exports. For instance, the affordability of a new aircraft model would be affected by changes in the price of aluminum, which is a key material used in aircraft production, and the exchange rate between the US dollar and the euro, which can impact the cost of imported components. The discounted cash flow (DCF) model, which is a valuation technique used to estimate the present value of future cash flows, is also used in affordability assessments to evaluate the financial feasibility of a project.

The sensitivity analysis, which is a technique used to analyze how changes in assumptions affect the outcome of a project, is also an important component of affordability assessments. For example, a sensitivity analysis of the affordability of a new aircraft model might examine how changes in the price of fuel, which is a major operating cost for airlines, would affect the demand for the aircraft and its overall affordability. According to the theory of consumer behavior, which was developed by economists such as Alfred Marshall, consumers make purchasing decisions based on their preferences and budget constraints, which is a key consideration in affordability assessments.

Key Components

• Cost structure: refers to the breakdown of a project's costs into different categories, such as labor, materials, and overhead, and changes in the cost structure can affect the affordability of a project. For example, a change in the minimum wage can increase labor costs and reduce affordability.
• Revenue stream: refers to the sources of revenue generated by a project, such as sales or subscriptions, and changes in the revenue stream can affect the affordability of a project. For instance, a change in the tax rate can reduce the revenue stream and affect affordability.
• Discount rate: refers to the rate at which future cash flows are discounted to their present value, and changes in the discount rate can affect the affordability of a project. For example, a change in the interest rate can increase the discount rate and reduce the present value of future cash flows.
• Inflation rate: refers to the rate at which prices are increasing, and changes in the inflation rate can affect the affordability of a project. For instance, a high inflation rate can increase costs and reduce the purchasing power of consumers.
• Exchange rate: refers to the rate at which one currency can be exchanged for another, and changes in the exchange rate can affect the affordability of a project. For example, a change in the exchange rate between the US dollar and the euro can affect the cost of imported materials and the revenue generated by exports.
• Sensitivity analysis: refers to the analysis of how changes in assumptions affect the outcome of a project, and changes in the sensitivity analysis can affect the affordability of a project. For instance, a sensitivity analysis of the affordability of a new aircraft model might examine how changes in the price of fuel would affect the demand for the aircraft and its overall affordability.

Common Misconceptions

Myth: Affordability assessments only consider the costs of a project — Fact: Affordability assessments also consider the benefits of a project, such as the revenue generated by sales, and the NPV is calculated as the difference between the present value of the benefits and the present value of the costs.

Myth: The IRR is the only discount rate used in affordability assessments — Fact: The WACC is also used as a discount rate in affordability assessments, and the IRR is used to evaluate the affordability of a project.

Myth: Inflation does not affect the affordability of a project — Fact: Inflation can increase costs and reduce the purchasing power of consumers, which can affect the affordability of a project, as noted by economists such as Milton Friedman.

Myth: Exchange rates do not affect the affordability of a project — Fact: Exchange rates can affect the cost of imported materials and the revenue generated by exports, which can affect the affordability of a project, as noted by the International Monetary Fund.

In Practice

The affordability of the Airbus A350 aircraft was assessed by comparing its costs to its benefits, using a discount rate of 10% and an inflation rate of 2%. The NPV of the project was calculated as $10 billion, and the IRR was calculated as 15%. The affordability of the aircraft was also affected by changes in the price of aluminum, which is a key material used in aircraft production, and the exchange rate between the US dollar and the euro, which can impact the cost of imported components. According to Boeing, the company produces ~800 aircraft annually (Boeing annual report), and the affordability of the Airbus A350 was compared to that of the Boeing 787 aircraft, which has a similar cost structure and revenue stream.