Benefit cost Analysis Cost Benefit Analysis or cba is a relatively* simple and widely used technique for deciding

whether to make a change. As its name suggests, to use the technique simply add up the value of the benefits of a course of action, and subtract the costs associated with it. Costs are either one-off, or may be ongoing. Benefits are most often received over time. We build this effect of time into our analysis by calculating a payback period. This is the time it takes for the benefits of a change to repay its costs. Many companies look for payback over a specified period of time e.g. three years. In its simple form, cost-benefit analysis is carried out using only financial costs and financial benefits. For example, a simple cost/benefit analysis of a road scheme would measure the cost of building the road, and subtract this from the economic benefit of improving transport links. It would not measure either the cost of environmental damage or the benefit of quicker and easier travel to work. The purpose of the financial benefit-cost analysis is to assess the financial viability of the proposed project, i.e., if the proposed project is financially attractive or not from the entitys viewpoint. This analysis is done for the chosen least cost alternative which is identified. In the financial benefit-cost analysis, the unit of analysis is the project and not the entire economy nor the entire water utility. Therefore, a focus on the additional financial benefits and costs to the water utility, attributable to the project, is maintained. In contrast, the economic benefit-cost analysis evaluates the project from the viewpoint of the entire economy whereas the financial analysis evaluates the entire water utility by providing projected balance, income, and sources and applications of fund statements. The financial benefit-cost analysis includes the following eight steps: (i) determine annual project revenues; (ii) determine project costs; (iii) calculate annual project net benefits; (iv) determine the appropriate discount rate (i.e., weighted average cost of capital serving as proxy for the financial opportunity cost of capital); (v) calculate the average incremental financial cost; (vi) calculate the financial net present value; (vii) calculate the financial internal rate of return; and (viii) risk and sensitivity analysis. Principles of CBA 1. There must be a common unit of Measurement 2. CBA Valuations Should Represent Consumers or Producers Valuations As Revealed by Their Actual Behavior 3. Benefits are usually measured by market choices 4. Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve 5. Some Measurements of Benefits Require the Valuation of Human Life 6. The Analysis of a Project Should Involve a With Versus Without Comparison 7. Cost Benefit Analysis Involves a Particular Study Area 8. Double Counting of Benefits or Costs Must be Avoided Project revenues, costs and net benefits are determined on a with-project and withoutproject basis. They are estimated in constant prices for a selected year, typically using the

official exchange rate at appraisal. The revenues of the project comprise of entirely user charges, that is, no government subsidies are included. Definition Internal Rate of Return The Internal Rate of Return method is the process of applying a discount rate that results in the present value of future net cash flows equal to zero. This is the base internal rate of return calculation formula and will be described later in this wiki. Internal rate of return assumes that cash inflows are reinvested at the internal rate. Investment projects with a return greater than the cost of capital or hurdle rate should be accepted. The greater the internal rate of return the more attractive the investment. Below is the IRR hurdle rate comparison. IRR > hurdle rate, accept the investment IRR < hurdle rate, reject the investment IRR = hurdle rate, the investment is marginal The internal rate of return meaning is described in more detail below. Internal Rate of Return Explaination Internal Rate of Return is a method to compare and evaluate different investments based on their cash flows. A proper internal rate of return calculation provides an interest rate equal to the total gains expected from a given investment. After discovering the internal rate of return for one project other IRRs can be compared in order to find the most valuable investment choice. Additionally, one compares an internal rate of return to the weighted average cost of capital of a project to decide whether the investment will create profit. IRR also accounts for the time value of monitary gains. It is generally used to evaluate a series of cash flows but can also be applied for other needs. Many equity investors, including angels and venture capitalists, have a required rate of return which must be met or exceeded by the IRR of a company seeking investment. This ensures the investment warrants the associated risk and will provide the cash flows necessary for profit. Internal Rate of Return Formula The internal rate of return formula can be found algebraically by using the Net Present Value formula below. In this: NPV = (CF 1 / (1 + r) ^1) + (CF 2 / (1 + r)^2) + (CF 3 / (1 + r) ^ 3) + ... Where: NPV = Net Present Value CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc. r = The Rate of Return

Net Present Value Method The net present value NPV method is an important criterion for project appraisal. Profitability of a project is evaluated by this method. It is also called as present value method. Net present value

is calculated by using an appropriate rate of interest which is the capital cost of a firm. This is the minimum rate of expected return likely to be earned by the firm on investment proposals. To find out the present value of cash flows expected in future periods, all the cash outflows and cash inflows are discounted at the above rate. Net present value is the difference between total present value of cash outflows and total present value of cash inflows occurring in periods over the entire life of project. When the net present value is positive, the investment proposal is profitable and worth selecting. But if it is negative, the investment proposal is non-profitable and rejectable. The method to compute the net present value index of different investment proposals is as under. NPV = Total Present Value of All Cash Flows Initial Investment

NPV method considers the time value of money. it compares time value of cash flows. NPV = Present Value of Gross Earnings Net Cash Investment NPV can be found out from the following: NPV = A1 (1+r)^1 + A2 (1+r)^2 + An (1+r)^n -C

Where A1, A2 are cash inflows at the end of first year and second year respectively, n is the expected life of investment proposals, r is Rate of discount which is equal to the cost of capital, C is present value of costs. Thus NPV = Sum of Discounted Gross Earnings - Sum of Discounted Value of Cost.

NPV vs IRR Methods

Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include: NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);

 However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recomendation. Recent variations of these methods include: The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields; it is designed for firms with active debt and a consistent market value leverage ratio; The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment; this method tends to favor smaller projects and is best used by firms with limited resources and high costs of capital; The Bailout Payback Method, which is a variation of the Payback Method, includes the salvage value of any equipment purchased in its calculations; The Real Options Approach allows for flexibility, encourages constant reassessment based on the riskiness of the project's cash flows and is based on the concept of creating a list of value-maximizing options to choose projects from; management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary; it is noteworthy that there is not a lot of support for this method among financial managers at this time.