Cost Benefit Analysis

Decision making is about choices

• 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. They are also
expected to act within the political environment to satisfy the political agenda set
by the government of the day and finally, must also comply with environmental
considerations.
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 Cost Benefit Analysis
What is Cost Benefit Analysis?
• CBA has been established primarily as a tool for use by
governments in making their social and economic decisions.
• CBA measures costs and benefits to the community of adopting
a particular course of action e.g. Constructing a dam, by-pass
etc.
• CBA is a decision making device for evaluating activities that
are not priced by the market.
• CBA attempts to simulate a market result in areas where the
market does not operate to establish prices
• OR attempts to quantify and include in estimates of cost and
benefits to client but also to rest of community.
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 Cost Benefit Analysis

Other issues
• Is the project worthwhile financially?
• Is it the best option?
• Should it be undertaken at all?

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 Cost Benefit Analysis
Costs of a project can be divided into three areas (Seeley,
1996, p470)
• Social cost:
– being the sum total of costs involved as the result of an
economic action
• Private costs:
– Those that affect the decisions of the performers (ie production
costs including, labour, materials, lands and capital)
• External Costs:
– Resulting from damage to buildings or decline of property
values through smoke emanating from a factory, etc.
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Cost Benefit Analysis

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 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.

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 Cost Benefit Analysis
Time Problems
• Tackling future time problems by discounting future
costs and benefits.
• OR calculating the correct rate for future dollar value
as well as accounting for additional benefits and costs
associated.

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 Cost Benefit Analysis
CBA unlikely to be a useful
technique unless two main
conditions are met:

• investment must be sufficiently large or important to

merit time and cost of CBA.
• Social and other intangible costs and/or benefits must
be prospectively and sufficiently large for selection by
cost-in-use or investment appraisal to be invalid.

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 Cost Benefit Analysis
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]
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 Cost Benefit Analysis
Establishing a steel production plant in a port
community
Costs (-)
• construction.
• pollution.
• devaluing house prices etc.
Benefits (+)
• employment
• increase port trade
• steel for local industry
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 Cost Benefit Analysis
Establishing a brick production plant in a community
Identify the problem
Identify the sectors affected:
– local authorities
– developer
– existing occupiers
– proposed occupiers
– local community
Identify the costs and benefits
Quantify the costs and benefits
Summarise conclusion

Examples of CBA (See text pg T4/13)

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 Cost Benefit Analysis
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.
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 Cost Benefit Analysis
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

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 Cost Benefit Analysis
Example of Costs and Benefits of the dam
• Let us consider a ten year timespan:
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 ss4 14
 Feasibility Study and Analysis
This section is a very brief introduction to the concept of feasibility studies. The
objective is to introduce you to the terminology. Actual figures and costs are
dealt in Building Economics 344.
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.
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 Feasibility Study and Analysis
Main Purposes
• Most commonly used to assess the profitability of a
scheme where the land is already owned by the
developer.
• To calculate the value of a site up for sale and compare
it to the asking price, [or to determine a bid level at
auction].

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 Feasibility Study and Analysis
Main techniques
• Payback period
• Residual
• Discounted cashflow
– Net Present Value
– Internal Rate of Return

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 Feasibility Study and Analysis Payback
Period
• Time taken to recoup outlay.
• The shorter the PB, the more favourable is the project.
• The PB period for development projects will be either:
– Time to when project is sold; or
– Time to when rental income exceeds development costs.

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 Feasibility Study and Analysis Residual
Method
• Basic equation : Value - Cost = Profit
– The Value = Selling Price
– Costs = land cost, building cost, fees, finance etc.
• By rearranging the equation, the value of land up for
sale can be derive:

Value - [(All costs exc. Land) + (Profit)] = Money available to

purchase
land.

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 Feasibility Study and Analysis Discounted
Cashflow Method
• Project’s Costs / Revenues are broken up into periodic cashflows.
• Discounting is applied to the cashflows ie. Allowance make for the “Time
Value of Money”
• Discounting is bringing future costs back to an equivalent current cost
(present value).
• Example
– Assume we have $10 now, then with an inflation rate of 10% per annum this
should be worth $11 at the end of the year, or
– $11 at the end of the year should be worth $10 now if the inflation rate is 10%
per annum.

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 Feasibility Study and Analysis Discount
Cashflow - 2 Methods
Net Present Value [NPV]
• Cashflows discounted at a chosen discount rate.
• Basis for choosing a discount rate:
– Cost of Capital eg. Interest on loan;
– “Target Rate” demanded by developer;
– if own money, the returns available from alternative
investments ie. “Opportunity Cost”

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 Feasibility Study and Analysis Discount
Cashflow - 2 Methods
Internal Rate of Return [IRR]
• IRR = Discounted rate at which NPV is zero.
• Identifies the actual return from a project.

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 Feasibility Study and Analysis Payback
Period
Advantages:
• Simple and easy to understand
• quick to use
• emphasises solvency/liquidity
Disadvantages:
• ignores cashflows beyond PB period
• ignores timings of cashflows within PB period
• ignores the time value of money

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 Feasibility Study and Analysis Residual
Method
Advantages:
• Quick and relatively simple
Disadvantages:
• Does not permit sophisticated allowance for the timings
of costs and revenues.
• Does not permit an accurate assessment of finance costs.
• Does not identify the PB period, on peak cash outlay.
• Not easily applied to complex schemes [eg. Part sold
priod to completion]
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 Feasibility Study and Analysis Discounted
Cashflow - NPV/IRR
Advantages:
• The cashflows model reality
• recognises the time value of money
• permits a precise assessment of costs and hence finance
charges on these costs.
• Very adaptable for sensitivity analysis.
• Easily adapted to allow for tax and inflation.
• IRR - Not required to chose a discount rate.
• Alternative projects, the highest NPV/IRR is the most
profitable.
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