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Cost-Benefit Analysis

Cost-Benefit Analysis. Cost Benefit Analysis. Identify & evaluate all costs & benefits Discount Assess project(s) by calculating Benefit/Cost Ratio (B/C) Net Present Value (NPV) Internal Rate of Return (IRR). Evaluation. Identification (what are they?) Evaluation (what are they worth?)

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Cost-Benefit Analysis

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  1. Cost-Benefit Analysis

  2. Cost Benefit Analysis • Identify & evaluate all costs & benefits • Discount • Assess project(s) by calculating • Benefit/Cost Ratio (B/C) • Net Present Value (NPV) • Internal Rate of Return (IRR)

  3. Evaluation • Identification (what are they?) • Evaluation (what are they worth?) • Measurement issues: • Direct & indirect (i.e. externalities) effects • Tangible & intangible effects • Pecuniary effects

  4. Discounting • Policies & projects last a long time • Frequently costs & benefits occur at different times • Money has a time value, i.e. ceteris paribus, current dollars are more valuable than future dollars • Thus, we need to place current & future costs & benefits on an equal basis for comparison

  5. Discounting, cont. • This is done by “discounting,” that is by reducing future dollars to present value by applying a discount (or a negative interest) rate

  6. Discount Rate v. Interest Rate • $100,000 invested at a 3% interest rate today will be worth roughly $115,927 in five years • $100,000 in anticipated benefits five years from now is worth roughly $86,260 today, when discounted by 3%

  7. The Discount Rate Matters • $100,000 in anticipated benefits five years from now is worth roughly $86,260 today, when discounted by 3% • $100,000 in anticipated benefits five years from now is worth roughly $78,352 today, when discounted by 5% • The difference grows larger as • Multiple years are accounted for • Benefits accrue further into the future

  8. What To Use As A Discount Rate? • There are various approaches to selecting one • “Givens” (i.e. some authority imposes one) • Bank interest rates • Rates of return on certain investments (e.g. government bonds) • “Social” discount rates

  9. Net Present Value • The difference between total discounted benefits and total discounted costs • NPV = (PVB ‑ PVc) • NPV: decision criteria • For a single project, a positive NPV indicates acceptability • For multiple (competing) projects, the project(s) with the highest NPVs should receive highest priority

  10. Benefit/Cost Ratio • B/C = (PVB / PVC) • Benefit/Cost ratio: decision criteria • For a single project, a B/C ratio which is greater than 1 indicates acceptability • For multiple (competing) projects, the project(s) with the highest B/C ratios (greater than 1) should receive highest priority

  11. Internal Rate of Return • The discount rate at which the present value of benefits is equal to the present value of costs • Internal Rate of Return: decision criteria • For a single project, an IRR which is greater than the selected (for B/C and/or NPV analysis) discount rate indicates acceptability • For multiple (competing) projects, the one with the largest IRR is the most desirable

  12. NPV & B/C Comparison • NPV measures totals, indicates the amount by which benefits exceed (or do not exceed) costs (total benefit or loss) • B/C measures the ratio (or rate) by which benefits do or do not exceed costs (efficiency)

  13. NPV & B/C Comparison, cont. • They are clearly similar, but not identical • With multiple projects, some may do better under NPV analysis, others under B/C

  14. Internal Rate of Return • It has a certain attraction, but also has some problems • The argument that an IRR which is greater than the selected discount rate is desirable can be questioned - discount rates can be arbitrary! • Calculation (by hand) is tedious & prone to error (but modern spreadsheets are a help) • Under certain conditions there may be more than one correct solution to an IRR problem

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