AGRICULTURAL ECONOMICS & FARM MANAGEMENT

CHAPTER V
 COST-BENEFIT ANNALYSIS

The benefit-cost analysis method is mainly used for economic evaluation of public
projects which are mostly funded by government organizations. In addition this method
can also used for economic evaluation of alternatives for private projects.
The main objective of this method is used to find out desirability of public projects as
far as the expected benefits on the capital investment are concerned.
As the name indicates, this method involves the calculation of ratio of benefits to the
costs involved in a project.
 COST BENEFIT ANALYSIS OVERVIEW

General Description-why do we need to do this project, justification etc.?

Alternative scenarios- what are the alternative ways to do the project?
Identify cost and benefits- major step to identify cost and benefits.
Principal cost- cost of investment, machinery etc.
Personnel Cost- hiring people, workforce.
Direct and Indirect cost- electricity, power etc.
Depreciation- reducing value of machinery, slowing down of efficiency.
Annual Cost- maintenance cost.
Benefit-
production increase,
Staff reduction
Organizational Efficiency
Employer and customer satisfaction
Time period
Calculate present value of money
Compare alternatives.
Sensitivity analysis
 Tractor 24HP Tractor B 32 HP Tractor C 45 HP
Cost
Tractor cost 400000 500000 600000
Fuel 20000 25000 30000
Maitenance 12000 15000 17000
Total 432000 540000 647000
Benefits
Tractor Use benefit 100000 140000 170000
Star rating xxxx xxxx xxxxx
C/B Ratio 0.23 0.26 0.26

The lower is the C/B ratio the best alternative it is.

 Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present
value of an investment becomes zero. In other words, IRR is the discount
rate which equates the present value of the future cash flows of an
investment with the initial investment. It is one of the several measures
used for investment appraisal.

Internal rate of return (IRR) is the interest rate at which the net present
value of all the cash flows (both positive and negative) from a project or
investment equal zero.
Internal rate of return is used to evaluate the attractiveness of a project
or investment. If the IRR of a new project exceeds a company’s required rate
of return, that project is desirable. If IRR falls below the required rate of
return, the project should be rejected.
 How do we calculate IRR?
• NPV = Net Present Value of the project
• Initial Investment
• Ct=Cash flow at time t
• IRR = Internal Rate of Return
 Calculating IRR…
• Set the NPV = 0
• Plug in your Cash Flows & Initial Investment
• Solve for IRR!
• This is the same equation used for NPV, except
you know your interest rate, i.
 So now what?
• Once you’ve calculated IRR
 If IRR is greater than the cost of capital, then you’ve got a
GOOD project on your hands (go for it!).
 If IRR is less than the cost of capital, then you’ve got a BAD
project on your hands (don’t undertake the project…).
 If the IRR and cost of capital are equal, then you should
use another method to evaluate the project!
 Basically, the higher the IRR, the better the project
 PAYBACK PERIOD

The payback period is the time required for the amount invested in an asset to be
repaid by the net cash flow generated by the asset. It is a simple way to evaluate the
risk associated with a proposed project. An investment with a shorter payback period
is considered to be better, since the investor's initial outlay is at risk for a shorter
period of time.

The calculation used to derive the payback period is called the payback method. The
payback period is expressed in years and fractions of years. For example, if a company
invests $300,000 in a new production line, and the production line then produces
positive cash flow of $100,000 per year, then the payback period is 3.0 years ($300,000
initial investment ÷ $100,000 annual payback).
The formula for the payback method is simplistic: Divide the cash outlay (which is
assumed to occur entirely at the beginning of the project) by the amount of net cash
inflow generated by the project per year (which is assumed to be the same in every
year).