Cost-Benefit Analysis

BY
A. SEYAMA
What is cost-benefit analysis ?
• When making Policies, decision making is involved.
• Cost Benefit Analysis (CBA) is the most commonly used economic
analysis for decision making due to its ‘simplicity’ in systematically
comparing all the costs and benefits that are accrued from a project.
• What is cost-benefit analysis?
• Cost–benefit analysis (CBA) is a method for assessing the economic
efficiency of proposed public policies through the systematic
prediction of social costs and social benefits. The concepts of
'willingness to pay' and 'opportunity cost' guide the valuation of
projected policy effects in terms of a money metric.
 Some important Questions that CBA
answers
• (1) Are the total benefits of this policy choice greater than the total costs?
• (2) Does this policy offer greater net benefits (total benefits – total costs) than another
alternative?
• (3) How large a budget is required for this policy?
• A detailed benefit-cost analysis of policy alternatives can help one to answer such questions.
The role of cost-benefit analysis
• In presence of limited resources, decision makers are left with the
difficult problem of evaluating and choosing investment projects and
assessing policies in a context of significant complexity and
uncertainty.
• For this purpose, decision makers have a need for a framework
which structures information in a way which makes feasible and
transparent this process of evaluation and selection.
The role of cost-benefit analysis
• Cost-benefit analysis provides a means of assessing and comparing the
impacts of projects and policies, even when benefits and costs occur over
long time horizons.
• It provides a systematic means to identify, quantify, and wherever possible
monetize all impacts of a project or policy (including their environmental
impacts), and present these impacts as social costs and social benefits.
• The role of cost-benefit analysis is to provide information to the
decision-maker about the costs and benefits of the project or the policy.
• The cost-benefit analysis informs decision-makers, does not replace them.
CONT’D
• Technically, the cost-benefit analysis…
• 1) Is a process (technique) to compare all the gains and losses resulting
from a project or from a policy into a common unit of measurement.
• 2) Summarizes all positive (benefits) and negative (costs) aspects of a
project or policy into one number.
• 3) The economic analysis of a project (or policy) serves as an organizing
framework for stakeholders to discuss the various aspects, both positive
and negative, of projects or policies.
• 4) Aims to provide information about the economic efficiency of a project
or policy.
• What are the 5 steps of cost-benefit analysis?
• The major steps in a cost-benefit analysis
• Step 1: Specify the set of options. ...
• Step 2: Decide whose costs and benefits count. ...
• Step 3: Identify the impacts and select measurement indicators. ...
• Step 4: Predict the impacts over the life of the proposed regulation. ...
• Step 5: Monetise (place dollar values on) impacts.
What is the Cost-Benefit Analysis Formula?

• The cost-benefit analysis involves comparing the costs to the benefits

of a project and then deciding whether to go ahead with the project.
• The costs and benefits of the project are quantified in monetary
terms after adjusting for the time value of money, which gives a real
picture of the costs and benefits.
• There are three popular models of carrying out cost-benefit analysis
calculations –
• 1. Net Present Value (NPV),
• 2. IRR and
• 3. Benefit-cost ratio.
Net Present Value (NPV)

• The Net Present Value (NPV) is defined as the sum of all discounted
values of cash-flows less the initial cost of investment
• The formula for NPV is given as follows:
Cont’d
Cont’d
Therefore using the decision rule, since the net present value is positive, one
should choose to invest in this project.
Advantages and Disadvantages of NPV
• Advantages
• The first advantage of the NPV is that the method considers the time value
of money.
• In addition, the NPV is intuitive because it concentrates all cash-flows into
an easy to understand index.

• Disadvantages
• The major shortfall with the NPV is that it assumes that inflows and
outflows can be forecasted over project’s life with a reasonable degree of
certainty. In addition, in real life the choice of discount rate is not as
straight forward, yet it can and does affect ranking of alternative projects.
2. Internal Rate of Return

• By definition, the Internal Rate of Return is the interest rate that

equates the Net Present Value to zero.
• That is, from the equation below solve for the rate of interest
Cont’d
Cont’d
• Decision Rule
• • For any one project, undertake project if and only if the IRR
exceeds the cost of borrowing.
• • Where there are a number of competing projects, invest in the
project with higher IRR.
Advantages and Disadvantages of IRR
• Advantages
• The main advantage of the IRR is that it is easy to understand and widely accepted.
• In addition, it allows for comparison of projects.

• Disadvantages

• The main drawback with IRR is that it is valid if financial conditions for different projects are the
same i.e. competing projects face similar cost of borrowing.
• Moreover, its dependency on investment base to calculate the interest rate distorts the scale of
actual benefits.
• For example using IRR one may choose a MK10million project with an IRR of 15% over
MK100million with IRR of 11%. Therefore it can lead to choice of projects with small impact but
large IRR.
3. Benefit/Cost Ratio Of Discounted Cash
Flows
• This is defined as the ratio of the sum of discounted benefits to sum
of discounted costs.
• The formula is given below:
Cont’d
Advantages and Disadvantages for Benefit/Cost
Ratio Of Discounted Cash Flows

• The advantages and disadvantages are the same as those for NPV.
• REVISE