Chapter 5

Cost-Benefit Analysis
Prepared and Taught by Lecturer: YIN SOKHENG, Master in Finance

INTRDUCTION
Cost-Benefit Analysis is the meaning of the costs of a project and the benefits of a project to help decide whether to undertake the project and what the scale of the project should be. Cost-benefit analysis is a set of practical procedures for guiding public expenditure decisions.

Instructed by YIN SOKHENG, Master in Finance

The Basic Principle of Cost-Benefit Analysis

A project should be undertaken if its benefit to society exceeds its cost to society. The scale of such a project should be increased as long as the marginal social benefit (MSB) exceeds the marginal social cost (MSC) so that the optimal scale occurs where MSB equals MSC.

Instructed by YIN SOKHENG, Master in Finance

Figure 5.1 The Optimal Scale of an Investment Project

$

The scale where MSB equals MSC is socially optimal

Q* Scale of the Project

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A PRIVATE FIRM
Present Value, PV One period Multiperiod

PV

C1 1 r

PV

C1 C2 CT (1 r ) (1 r ) 2 (1 r )T

Where: - PV: Present value ( of cash flows) - C1 : Cash flow at 1 year - r : Interest rate - T : Number of periods over which the cash is invested.
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Building a factory with Borrowing

Suppose the firm must borrow $100,000 today to pay for construction cost, and will repay the loan in year 1. If the profit in year 1 would be $110,000.
Should the firm build it if the interest rate is 5%? Should the firm build it if the interest rate is 15%? Table 5.1 Correct Decision Rule
Description PV of profit Cost of project Correct decision r = 5% $ 104,762 100,000 Build r = 15% $ 95,652 100,000 Dont build

Instructed by YIN SOKHENG, Master in Finance

Building a factory without Borrowing

Suppose the firm has the cash from past profit $100,000 to build another factory without borrowing. If the profit in next year would be $110,000. Should the firm build it if the interest rate is 5%? Should the firm build it if the interest rate is 15%?

Instructed by YIN SOKHENG, Master in Finance

Building a factory without Borrowing

Result: If r = 5%, the PV of the profit will be $104,762 so the factory should be build. If r = 15%, the PV of the profit will be $95,652 so the factory shouldnt be build. If r = 15%, the bank account would grow to $115,000 next year, so it would be better not to build the factory.

Instructed by YIN SOKHENG, Master in Finance

GOVERNMENT (Building a Highway)

While private firms invest in factories, government invests in infrastructure, such as roads and bridges. The cost of the highway has two components: Construction costs: Labor, equipment, and asphalt Future maintenance (repair) costs Cost of Highway = Construction costs + PV of future maintenance costs
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The Benefit of Highway

The benefit is how much drivers would be willing to pay to use the highway in all future years. Estimate the benefit of highway Discounting each years benefit and summing Estimate the benefit of highway: Highways save drivers time Put a dollar value on time saved
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The Cost-Benefit Analysis

There are at least three ways for the cost-benefit analyst to estimate the benefit to commuters: Increased output Actual market behavior (revealed preference) Hypothetical questions and answers (contingent valuation)

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Increased Output
One approach to measuring the benefits of time saved is to estimate how much more output commuters could produce at work. If the commuter works the hour instead of driving and is paid a wage of $20 an hour, economists estimate that the highway has enabled $20 more output to be produced.

Instructed by YIN SOKHENG, Master in Finance

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Actual Market Behavior (Revealed Preference)

Another approach to measuring the benefits of time saved is to look at commuter location preference. Economists recommend using a actual data to try to quantify the relationship between all these factors and home price. Assume that the commuter in the home closer to the city actually paid $20,000 more for her home than the other commuter. Dividing $20,000 by the number of hours saved
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Hypothetical Questions and Answers (Contingent Valuation)

Another way to put a dollar value on time saved is to ask drivers hypothetical questions. The following four ways of asking about the dollar value of saving an hour commuting:
1. How much would you pay to reduce your daily commute one hour? 2. Considering traffic, how much would you pay to reduce your daily commute one hour? 3. Considering what you could earn at work, how much would you pay to reduce your daily commute one hour? 4. Considering the time you could spend with your children, how much would you pay to reduce your daily commute one hour?
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Benefits of Improving the Safety of a Highway

Not all benefits can be measured by time saved. Compare the safety of highways. The safer the highway, the greater the cost of building. The benefit of building the highway safer is the reduction in death and injuries. We must determine how this benefit can be valued so it can be compared to the cost.
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The Value of Statistical Life

Estimate a project would save lives Estimate the value of statistical life (VSL) in dollar If a highway safety project is estimated to save 10 lives per year and VSL is estimated to be about $8 million, then the projects benefit from lives saved can be estimated as about $80 million per year.

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Mistakes to Avoid
Objective analysts should be on guard to avoid several mistakes. Mistakes to avoid when doing cost-benefit analysis include: Counting jobs created as a benefit Double counting the same benefit Counting secondary benefits

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RDUCING GLOBAL WARMING

Cost-benefit analysis can also be applied to a broader issue like global warming. Uncertainty and the risk of catastrophe The social discount rate Cost-effectiveness analysis

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PAYING FOR A COSTLY MEDICAL TREATMENT

One of most difficult and important application of cost-benefit analysis concerns whether the government should pay for a costly medical treatment. One way to measure the benefit in this situation would be to ask hypothetical questions and answers (contingent valuation method).

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INTERVENING MILITARILY
A military intervention should be subjected to cost-benefit analysis. Although an estimate of the benefit must rely on the disciplines of history, international relations, political science, and military science, economists can provide an estimate of the cost. The economics cost of a military intervention is much larger than the military budgetary cost that is incurred during the war.
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