Cost-Benefit Analysis

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

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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
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Net Present Value
The difference between total discounted
benefits and total discounted costs
NPV = (PV
B
- PV
c
)
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

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Benefit/Cost Ratio
B/C = (PV
B
/ PV
C
)
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
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
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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)
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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
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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