COST-BENEFIT

ANALYSIS (CBA)
CHAPTER 2
Learning Objectives
• Cost-Benefit Analysis
• Present Value definition and formula
• Net Present Value definition and formula
• Benefit-Cost Ratio definition and formula
• PV Computation
• BRC Computation
• NPV Computation
COST-BENEFIT ANALYSIS
■ What Is a Cost-Benefit Analysis? A cost-benefit analysis is a systematic
process that businesses use to analyze which decisions to make and which
to forgo. The cost-benefit analysis sums the potential rewards expected
from a situation or action and then subtracts the total costs associated with
taking that action.
Present Value
■ Is the current value of a future sum of money or stream of cash flow given a specified rate of return.
■ PV takes the FV and CF and applies discount rate that could be earned if invested.
■ FORMULA
 FUTURE VALUE (PV of Benefit)

FV
PV=
(1+i)

PV= Present Value

FV= Future Value
i= Discount Rate
 CASH FLOW (PV of Costs)

CF
PV=
(1+i)

PV= Present Value

CF= Cah Flow
i= Discount Rate
Benefit – Cost Ratio
■ Is a ratio used in a CBA to analyze the overall relationship between the relative costs
and benefits of a proposed project.
■ If projects BCR is equal to 1.0 the ratio indicated that NPV of expected profit equals the
costs. (can deliver positive NPV to investors)
■ If projects BCR is less than 1.0 the project costs outweigh the benefits and it shouldn’t
consider.
■ FORMULA
PV of all the Expected Benefits
Benefit – Cost Ratio =
PV of all the Associated Costs
Net Present Value
■ Is a capital budgeting method used as a part of CBA to determine the profitability of an investment.
■ FORMULA

Net Present Value = PV of all the Expected Benefits – PV of all Associated Costs
CBA FORMULA EXAMPLE # 1
■ Let us take the example of financial technology start-up which is contemplating on
hiring two new programmers. The promoter expects the programmers to increase the
revenue by 25% while incurring an additional cost of $35,000 in the next one year. The
help promoter decides whether to go ahead with the recruitment based on cost-benefit
analysis if the revenue of the company in the current year is $220,000 and the relevant
discount rate is 5%.

PARTICULARS VALUES
CURRENT REVENUE $220,000
DISCOUNT RATE 5%
BENEFIT $55,000 (25%)
COSTS $35,000
■ PV of Benefit is Calculated as

FV
PV=
(1+i)

$55,000
PV=
(1+5%)

PV=
$52, 380.95
■ PV of Costs is Calculated as

CF
PV=
(1+i)

$35,000
PV=
(1+5%)

PV=
$33,333.33
■ Benefit - Cost Ratio is Calculated as

PV of all the Expected Benefits

BCR=
PV off all the Associated Costs

$52,380.95
BCR=
$33,333.33

1.57BCR=
■ Net Present Value is Calculated as

NPV= PV of all the Expected Benefits - PV off all the Associated Costs

NPV= - $33,333.33
$52,380.95

NPV= $19, 047.62

• Therefore, both the method of CBA suggests that the promoter should go ahead
with recruitment.
CBA FORMULA EXAMPLE #2
■ Example of 2 projects to illustrate the use of CBA
■ The sum of the Present Value of all the Expected Benefit from project 1 is $50 million
with Present Value of all the Associated Costs of $30 million. On the other hand, the
Present Valur of all the Expected Benefit from project 2 is $10 million wwith Present
Value of all the Associated Costs of $5 million. Discussed which project is better based
on CBA.

PARTICULARS PROJECT 1 PROJECT 2

Sum of all the Expected Benefits $50 million $10 million
Sum of all the Associated Costs $30 million $ 5 million
■ Benefit - Cost Ratio is Calculated as (project 1)

PV of all the Expected Benefits

BCR=
PV off all the Associated Costs

$50,000,000
BCR=
$30,000,000

1.67
BCR=
■ Benefit - Cost Ratio is Calculated as (project 2)

PV of all the Expected Benefits

BCR=
PV off all the Associated Costs

$10,000,000
BCR=
$5,000,000

2.00
BCR=
■ Net Present Value is Calculated as (project 1)

NPV= PV of all the Expected Benefits - PV off all the Associated Costs

NPV= - $30,000,000
$50,000,000

NPV= $20,000,000
■ Net Present Value is Calculated as (project 2)

NPV= PV of all the Expected Benefits - PV off all the Associated Costs

NPV= - $5,000,000
$10,000,000

NPV= $5,000,0000

• Therefore, as per the BCR, project 2 is better while the NPV suggest project 1 is
better. Although this stalemate (tie) mind of situation, the inherently NPV gets the
preference. Therefore, project 1 will be considered better.