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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?) Measurement issues:
Direct & indirect (i.e. externalities) effects Tangible & intangible effects Pecuniary effects
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
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
$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%
$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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Givens (i.e. some authority imposes one) Bank interest rates Rates of return on certain investments (e.g. government bonds) Social discount rates
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
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Benefit/Cost Ratio
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
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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 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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They are clearly similar, but not identical With multiple projects, some may do better under NPV analysis, others under B/C
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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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