You are on page 1of 6

Natural Resource Economics

Vijaya R. Sharma, Ph.D.


University of Colorado at Boulder

BENEFIT – COST ANALYSIS


I. Brief Introduction of Benefit-Cost Analysis
Benefit-cost analysis is a method of evaluating economic viability of projects. It
compares the total benefits of a project with its total costs and recommends the
implementation of the project if benefits exceed the costs. Note that the benefits and costs
of a public project are evaluated from social perspective. There are four steps in this
analysis:
1. Determine the useful life of the project: the number of years over which the
benefits and costs of the project need to be evaluated. Let the useful life be T years.
2. Estimate in physical units all benefits and all costs of the project for each year
of its useful life, irrespective of whether they are monetary or non-monetary in nature
and whether they are associated with the use or nonuse value of resources.
3. Convert physical units of benefits and costs into dollars, using appropriate
prices and values.
Table 1: Benefit and Cost Inventory of Project
Description Year 0 Year 1 … Year T
Benefits, $ B0 B1 … BT
Costs, $ C0 C1 … CT

4. Once the dollar values of benefits and costs are compiled for each year,
calculate their present values, using an appropriate discount rate. Then, add up the
present values of annual benefits to determine the total benefits (B) of the project.
Similarly, add up the present values of annual costs to determine the total cost (C).
5. Calculate the total net benefits, called the net present value (NPV), by
subtracting the total cost from the total benefit, i.e., NPV = B – C. Also, calculate the
B
benefit-cost ratio, dividing total benefit by total cost, i.e., B/C ratio = .
C
6. The decision rule is then:

a. If NPV ≥ 0, implement the project. Else, do not implement it.

or
B
b. If ≥ 1 , implement the project. Else, do not implement it.
C

II. Results may be sensitive to choice of discount rate


Conclusion of a benefit-cost analysis may be sensitive to the choice of discount rate. At a
certain discount rate, the project may be considered feasible, but at some other discount
rate it may not be feasible. Consider a hypothetical project that has a life of 2 years (see
the table below). This hypothetical project has positive NPV at 2%, but negative NPV at
5%.
Table 2: Sensitivity to Choice of Discount Rate
Description Year 0 Year 1 Year 2 Sum of the Present Sum of the Present
Values @ 2% Values @5%
Benefits $0 $50 $100 $145.1 $138.3
Costs $100 $20 $25 $143.6 $141.8
Net Benefits - $100 $30 $75 $1.5 (NPV @2%) - $3.5 (NPV @5%)
In 1959 U.S. and Canada prepared the complete benefit and cost inventory of a tidal
power project in the Passamaquoddy Bay between Maine and New Brunswick for joint
implementation of the project. In spite of the fact that both countries had the same dollar
figures for annual costs and benefits, the U.S. evaluated the project using a discount rate
of 2.5% and recommended its implementation, whereas Canada used a discount rate of
4.125% and recommended non-implementation of the project.

In 1962 the U.S. Congress authorized construction of a number of water projects based
on benefit-cost analyses that used a discount rate of 2.63%. In 1964, two economists, Fox
and Herfindahl, examined the same projects at a discount rate of 8% and found that only
20% of them were feasible.

A researcher who has a vested interest in a project may intentionally choose a discount
rate to make or break the project. Or, even for a neutral researcher it may be difficult to
correctly estimate the social discount rate. Therefore, researchers are often required to do
sensitivity analysis, i.e., to repeat the analysis for different discount rates and to report
whether the conclusion of the analysis changes with a change in discount rate. In some
countries, the government prescribes the discount rate, to avoid the arbitrary choices of
researchers. The Office of the Management and Budget (OMB) in the Unite States
prescribes the discount rate for evaluation of federally funded projects.

III. Internal Rate of Return (IRR)


Analysts often calculate the IRR, which is the discount rate at which the NPV of project
becomes zero. Generally, the NPV declines as discount rate rises. The IRR of the
hypothetical project presented in Table 2 is 2.8% (see Figure 1). A project that has IRR ≥
social discount rate is considered a good project.

Figure 1: Discount Rate and NPV


NPV, $
+1.5

0 2% 2.8% 5% Discount rate (r)

- 3.5

IRR is a measure of risk associated with the project, as to how high the discount rate can
go, without making the project infeasible (i.e., without making the NPV negative).

IV. Payback Period


Payback period of a project is the number of years it takes for the project to recover its
initial investment. The initial investment on the above-considered hypothetical project is
$100 (the cost in Year 0). In the first year, the project recovers $30 as net benefits, still
leaving $70 to be recovered from future net benefits. In the second year, the net benefit is
$75, which is more than sufficient to recover the remaining investment. Thus, the
payback period is almost two years. So calculated payback period is called the simple or
undiscounted payback period, because in the calculation the time value of benefits and
costs were ignored.1 The payback period calculated from the present values of net
benefits is called the discounted payback period. The shorter the payback period, the less
riskier the project. Remember, the farther the future, the more the uncertainties.

V. Use NPV, not B/C ratio to compare mutually exclusive projects


Project A and Project B are considered mutually exclusive if the implementation of one
excludes the possibility of implementing the other. For example, you can construct either
a large dam or a small dam at a given hydropower site. If a choice has to be made among
mutually exclusive projects, do not use B/C ratio of projects for comparison, as this ratio
can mislead the choice. Instead, use the NPV for comparison.

Consider the diagram below. Here, a choice has to be made between two alternative
sizes of a project: Q1 or Q2.

Figure 2: Comparison of Mutually Exclusive Projects (Size Q1 and Size Q2)

$/unit Social MC in Present Value

a c

b d Social MB in Present Value


Q (the size of project)
0 Q1 Q2 Q*

Theoretically, we know that Q* is the optimal or best size, as this size would maximize
the total net benefit possible from the project. But, assume that this size is not available
for some reason. The available sizes are Q1 and Q2. We know from economic theory that
Q2 is better, as it is closer to the efficient size Q*. The total net benefit (NPV) of Q2 is
Area (a + c), whereas the total net benefit (NPV) of Q1 is Area a; the NPV of Q2 exceeds
that of Q1.

NPV of Q1 size = B - C = (a + b) - b = a
NPV of Q2 size = B - C = (a + b + c + d) - (b + d) = a + c

But, if the B/C ratios of the two sizes are compared, it turns out that B/C ratio of Q1 is
higher than that of Q2:
a + b a
B/C ratio of Q1 size = = 1 + > 1
b b

1
Wouldn't it be better if the project recovered $70 in the first year and $30 in the second year, instead of
$30 in the first year and $70 in the first year?
(a + b ) + (c + d ) a + c
B/C ratio of Q2 size = = 1 + > 1
b + d b + d
a a + c
Both projects have B/C ratio higher than 1, but note that > , because c < d (see
b b + d
the diagram). To summarize, it is safer to use NPV, instead of B/C ratio, to compare
mutually exclusive projects.

VI. Incremental B/C Ratio


If B/C ratio must be used, as is required by law in the USA for obtain federal funds for a
project, use the incremental B/C ratio. Incremental B/C ratio is the ratio of incremental
(additional) benefit of higher investment alternative (on and above the benefit of lower
investment alternative) divided by the incremental cost of the higher investment
alternative (on and above the cost of the lower investment alternative). In the above
example, Q2 is the higher investment alternative and Q1 the lower investment alternative.
The incremental benefit of Q2 over Q1 is (c + d), whereas the incremental cost is d;
c +d c
thereby, the incremental B/C ratio of Q2 is = 1 + > 1 . The higher incremental
d d
B/C ratio suggests that Q2 is a better investment than Q1.

VII. Use Incremental IRR, not IRR, for mutually exclusive projects
Similar to B/C ratio, use of IRR for comparison of mutually exclusive projects can be
misleading. Consider the diagram below.

Figure 3: Comparing IRR of Projects


NPV, $
A

+ NPV Project A
B
Project B

0 f e a b B Discount Rate (r)


A
- NPV

Let Project A and Project B be two mutually exclusive projects, with AA and BB their
respective NPVs at different discount rates. As can be seen from the above figure, the
IRR of Project A is a and that of Project B is b. Project B has a higher IRR (b > a); yet, it
should not be considered necessarily better than Project A. If the true social discount rate
were f (less than e, the point of intersection of the two NPV curves), Project A would
yield a larger NPV than Project B; in this case, Project A would actually be considered
better. But, if the social discount rate were higher than e, Project B would yield a higher
NPV and hence would be better than Project A. Thus, comparing mutually exclusive
projects based on IRR can be misleading. Instead, use incremental IRR, which is the
discount rate at which the incremental benefit of a higher investment alternative (over
and above the lower investment project) is equal to its incremental cost. In other words,
to compare Project Q2 with Project Q1, find the discount rate at which the incremental
benefit of Q2 become equal to the incremental cost of Q1. Suppose that happens at
discount rate s; if this incremental IRR is above the true social discount rate r, then
Project Q2 should be preferred over Q1.

VIII. Do not use Payback Period for comparison


Payback period also should not be used to compare projects. Calculation of payback
period focuses only on net benefits of a project in the initial few years. A project may
have a longer payback period, but it may be a better alternative than another shorter
payback period project, if the former project is expected to return a lot more net benefits
in the years beyond the payback period.

IX. National NPV versus Regional NPV


Often projects are susceptible to political pressures, especially when their benefits are
localized to a region or group, whereas the costs are shared or spread out among a larger
population in many regions or the whole nation. To the beneficiary region or group, the
project may appear economic, but it may not be economic from the national benefit-cost
perspective. In situations like this, it is conceivable that the local residents and politicians
exert political pressure on the national legislature to implement the project.

X. Clearly explain any nonquantified benefits and costs


In spite of the best efforts of analysts it is possible that there remain some benefits and
costs of a project that cannot be quantified or cannot be monetized. The decision makers
should be made aware of such unquantified and nonmonetized benefits and costs,
because their inclusion could have changed the NPV and B/C ratio calculations and
hence the conclusion about the project, so that the decision makers can make some
subjective evaluations of those benefits and costs.

XI. Include distributional consequences of project in the analysis


The NPV and B/C ratio analysis ignores the distributional consequences of project, as to
who – rich or poor, males or females, majority or minority ethnic group – shares what
proportion of benefits and costs of the project. It is desirable to add the distributional
analysis to help decision makers. The Environmental Protection Agency (EPA) requires
such a distributional analysis in all benefit-cost analyses done for it.

You might also like