Lecture: Cost Benefit Analysis

1. Benefit - Cost Analysis is a systematic quantitative method of assessing the

desirability of government projects or policies when it is important to take a long view of
future effects and a broad view of possible side-effects.
2. Benefit - Cost Analysis is the main analytical tool used to evaluate water resource and
environmental decision.
3. Benefit - Cost Analysis ensure that projects use capital efficiently, provide a framework
for comparing alternative projects and estimate the impacts of regulatory changes.
4. The basic principle of Benefit - Cost Analysis is that project benefits must exceed
costs.
5. Cost and benefits are expressed in similar units.
6. Opportunity Cost is what you’re NOT going to get if you spend your money to build the
project
7. Opportunity Cost = Return of Most Lucrative Option - Return of Chosen Option
8. Direct costs of alternative include Capital costs & Operation, maintenance, and
replacement costs.
9. Indirect costs of alternative include costs imposed on society or the environment.
10. A financial analysis addresses the implications to the enterprise; while an economic
analysis addresses the implications to the society.
11. Economic values exceed financial values as a result of output taxes, input subsidies,
foreign exchange premia, consumer surplus, and positive externalities.
12. Financial values exceed economic values as a result of output subsidies, input
taxes, foreign exchange discounts, producer surplus, and negative externalities.
13. Financial values are accounting measures (direct account cash flows) are usually
expressed in nominal (i.e. constant price) terms
14. Economic values reflect actual resource use (including opportunity costs of time,
money and labour)
15. Economic values exclude transfers (e.g. taxes and subsidies) which are simply a
reallocation of resources among groups in society, rather than an actual resource use
16 Economic values include externalities (unintended environmental and social impacts
of a particular activity).
17. Economic values use real (present day) values to account for past/future cost-benefit
streams.
18. Economic equivalence is established, in general, when we are indifferent between a
future payment, or series of future payments, and a present sum of money
19. $1 today is worth more than $1-dollar next year.
20. The Present Value of receiving cash C t in a future year t is obtained by discounting
the net benefits at an appropriate discount rate.
21. If PV > 0: This project is better than making an investment at i% per year for the life
of the project. Also this project is worth further consideration.
22. PV < 0: This project does not provide enough financial benefits to justify
investment, since alternative investments are available that will earn i% (that is the meaning
of "opportunity cost"). Also the project will need additional, possibly non-cash benefits
to be justified.
23. Equivalence Factors
a [F/P,i,N] = future value F after N periods given present value P and discount
rate i
b. [P/F,i,N] = present value given future value F, i, & N
c. [F/A,i,N] = "uniform series compound amount factor" How large will my IRA
be after contributing $A at i% for N years?
d. [A/F,i,N] = "sinking fund payment“ Annual savings to have a down payment of
a house in N years
e. [A/P,i,N] = "capital recovery factor“ What will the mortgage payments be?
f. [P/A,i,N] = "uniform series present worth factor “My business makes $A/year -
should I sell for $X?
24. The MARR is the lowest return that you would be willing to accept given: the risks
associated with this project & the other opportunities for investment.
25. Debt: Borrow money from a bank or issue bonds (pay a defined payment of principal
plus interest rate per period, but retain complete ownership of the company)
26. Sell stock (raise money without committing to interest payments, but also give up
ownership of the company)
27. The discount rate (i.e. the interest rate that you use in finding equivalent values) should
be greater than or equal to your average cost of capital (not necessarily your cost of
capital for a particular project)
28. The discount rate should be at least as high as your other investment opportunities
(adjusted for risk)
29. The discount rate therefore will equal your "minimum acceptable rate of return".
30. The discount rate reflects the opportunity cost for the person or organization that will
receive the cash flows (e.g. the federal government specifies a rate to be used).
31. Real rates are used in constant-dollar analyses.
32. Nominal rates reflect expected inflation (market interest rates are therefore "nominal"
interest rates).
33. The discount rate is not the same as the interest rate obtained to finance the
project.
34. Higher risks will require a higher discount rate.
35. Discount Rate: US federal practise: Average rate of interest on government bonds with
terms of 15 years or more”.
36. Static efficiency is defined as maximization of net benefits for a single time period.
37. Many economic decisions with environmental implications are dynamic.
38. BCA is an economic technique used to evaluate a project or investment over time
and compare the merits of a set of projects
39. BCA is conducted by comparing economic benefits of an activity with economic
costs of an activity.
40. As a tool for economic analysis, BCA seeks to examine potential actions with the
objective of increasing wellbeing.
41. Decisions are typically not made on the basis of BCA alone but BCA can be useful for
providing information on economic features of projects or activities, and can therefore
be useful for informing the debate.
42. Often the benefits and costs of a project accrue at different times. The technique
used to deal with this issue is discounting.
43. Discounting is a technique used to convert all benefits and costs to a common point in
time, usually the present.
44. The value of a project, expressed in terms of the present, is called the Present Value.
45. Discounting is based on the premise that a dollar of benefit received today is worth
more than a dollar of benefit received in the future.
46. Discounting is the opposite of compounding.
47. The rate at which a current value is compounded is called the interest rate.
48. The rate at which a future value is discounted is called the discount rate.
49. There is no simple rule for choosing a discount rate. Often a “well known” interest
rate is used.
50. Whenever benefits and costs accrue at different points in time, amounts should be
converted to present values for comparison.
51. BCA is a decision-support tool, not a decision-making tool.
52. Discounting can be used regardless of the length of time under consideration, but
discounting has implications for equity.
53. NPV is the current value of all net benefits associated with a project.
54. Net benefit is simply the sum of benefits minus the sum of costs.
55. The net present value of benefits is the present value of those net benefits.
56. The net benefits are converted to present value by discounting.
57. If the project has a NPV > 0, then it is worth considering on its economic merits.
58. If the project has a NPV < 0, then it fails to return benefits greater than the value of
the resources used.
59. Net present value (NPV) is also called net discounted present value (NDPV).
60. According to ADB (1997), 'the NPV is the difference between the present value of the
benefit stream and the present value of the cost stream for a project.
61. The net present value calculated at the Banks discount rate should be greater than
zero for a project to be acceptable'.
62. A positive NPV will also give a positive IRR, and a negative NPV will give a negative
IRR.
63. The IRR will favour small investments with immediate returns, while the NPV will
favour larger investments with more distant returns.
64. For public investments, the NPV is regarded as a more valid indication of the feasibility.
65. BCR is computed as the PV of Benefits divided by the present value of Costs.
66. If the project has a BCR > 1, then it is worth considering on its economic merits.
67. If the project has a BCR < 1, then it fails to return benefits larger than its costs.
68. The Payback Period is simply the number of years required for the cash income
from a project to return the initial cash investment in the project.
69. The investment decision criteria for this technique suggests that if the calculated
payback is less than some maximum value acceptable to the company, the
proposal is accepted.
70. The IRR is the maximum interest rate that could be paid for the project resources that
would leave enough money to cover investment costs and still allow society to break
even.
71. The IRR is the discount rate at which the PV of benefits equals the present value of
costs.
72. The IRR must exceed the chosen discount rate for the project to be accepted.
73. The internal rate of return (IRR) is the estimated rate of return from an investment.

74. The investment is regarded as 'acceptable' if the IRR is higher than the market rate of
interest.
75. Perhaps the primary advantage offered by using IRR as an evaluation criterion is that it
provides a single figure which can be used as a measure of project value.
76. IRR is expressed as a percentage value. Most managers and engineers prefer to think
of economic decisions in terms of percentages as compared with absolute values
provided by present, future, and annual value calculations.
77. IRR is determined internally for each project and is a function of the magnitude and
timing of the cash flows.
78. IRR eliminates the need to have an external interest rate supplied for calculation
purposes
79. A positive IRR will also give a positive NPV, and a negative IRR will give a negative
NPV.
80. The IRR will favour small investments with immediate returns, while the NPV will
favour larger investments with more distant returns.
81. For public investments, the NPV is regarded as a more valid indication of the feasibility.
82. BCA is quantitative.
83. BCA is based on facts.
84. BCA requires valuation.
85. BCA is silent on equity.
86. BCA is anthropocentric.