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Cost Benefit Analysis

Costbenefit analysis (CBA), is a systematic process for calculating and comparing benefits and costs of a project, decision or government policy. CBA has been established primarily as a tool for use by governments in making their social and economic decisions. CBA is a decision making device for evaluating activities that are not priced by the market. To determine if it is a sound investment/decision (justification/feasibility), To provide a basis for comparing projects. It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much.

Cost Benefit Analysis

For an individual They might rely on intuition, a gut feel for the right choice. They decide to do an analysis of the choices or it may be a combination of both of these. For a company Being concerned with the profit earning capacity and income flow, they may undertake a cashflow analysis or a full financial appraisal of the project. For the Government Decision making for governments is much harder. Not only are they expected to consider the profitability (or at least neutrality) of the costing but must also include consideration of the social cost and benefits of their choices.

Cost Benefit Analysis


Issues Is the project worthwhile financially? Is it the best option? Should it be undertaken at all?

Cost Benefit Analysis


Costs of a project can be divided into three areas : Social cost:

being the sum total of costs involved as the result of an economic action Those that affect the decisions of the performers (ie production costs including, labour, materials, lands and capital) Resulting from damage to buildings or decline of property values through smoke emanating from a factory, etc.

Private costs:

External Costs:

Cost Benefit Analysis

Cost Benefit Analysis


Measurement Problems Difficulties encounter in measuring intangible costs such as foul atmosphere or intangible benefits such as a peaceful neighbourhood. Assuming several other costs & benefits associated with the activities; and estimating the costs and benefits involves. Affects by Market condition, state of economy etc. Uneven distribution of benefit to community. Time Problems Tackling future time problems by discounting future costs and benefits. OR calculating the correct rate for future value as well as accounting for additional benefits and costs associated.

Method Identify all possible alternatives. Prepare table showing life of the project i.e. year to year basis. Establish Cost of project during the year including capital, operating and maintenance costs, social and other tangible costs Establish total benefits to be obtained from project by way of sales of goods and services including value of social benefits. Cost calculated at rate of interest such that NPV=Zero Ranking in order of [benefit-cost] or [benefit / cost]

Example of Costs and Benefits of the dam Costs

The dam is completed in five years at a cost of $200,000,000. Inflation in the interim period is estimated to be 5%.

Discounted to present value

= 0.7352 x $0.2 billion = $156,704,000

Benefit

The dam will not start to provide benefits until the water is used for irrigation and crop yields improve. Let us assume this will be in seven years time and the value of this benefit is $100,000,000 per year in future values. We will keep the same inflation rate for ease of comparision.

Example of Costs and Benefits of the dam


Let us first assume a calculation period for the CBA only covers seven years: Discounted to present value = 0.71068 x $0.1 billion = $71,068,000

Conclusion: Based on a seven year timespan Costs = $157 million Benefits = $71 million Conclude that Project is not acceptable

Example of Costs and Benefits of the dam Let us consider a ten year time span: Benefit: Discount $100,000,000 in year 7 = $100,000,000 x 0.71068 in year 8 = $100,000,000 x 0.67683 in year 9 = $100,000,000 x 0.64460 in year 10 = $100,000,000 x 0.61391 Total present value = 265,000,000

Conclusion: Based on a seven year timespan Costs = $157 million Benefits = $265 million Conclude that Project is acceptable

Feasibility Study and Analysis


What is Feasibility Study? A feasibility study is a report designed to highlight, evaluate and structure the advantages and disadvantages over time of alternative solutions to given problems. The appraisal of the viability of property development schemes.

Feasibility Study and Analysis


Main techniques

Payback period Residual Discounted cashflow


Net Present Value Internal Rate of Return