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Cost-Benefit Analysis
Scientific criteria to evaluate projects
Determines the scale of the project on the basis of maximation of the
differences between benefit and cost
Cost-benefit analysis (CBA), or benefitcost analysis (BCA), is used to
assess benefits and costs of a project
Purpose of CBA is;
Determine if it is a sound investment/decision
Basis to compare projects.
Compares the total expected cost of each option against the total
expected benefits, to see whether the benefits outweigh the costs,
and by how much.
CBA focuses on economic efficiency
Calculates net benefits for each project
to describe and quantify the social advantages and disadvantages of the policy
in terms of a common monetary unit
3
Evaluation of Benefits:
Benefits ------ increase income of the people --------Increase production &
consumption.
Real and Nominal Benefits : Real benefits play a vital role.
Improvement in irrigation - increase in productivity of land per acre economic benefits - income rises
Ex: Irrigation Project flood control, irrigation, development of fisheries, power etc
Employment, new road way, livelihood etc are some of the indirect benefits
Evaluation of Costs:
Need of CBA
Recent government decisions give renewed focus to CBA
Agencies need to build their capacity to use CBA to improve the
quality of regulatory and financial analysis
Greater use of CBA expected by government for regulatory
proposals
community
Allows benefits and costs to be compared over time
Represents the costs and benefits accruing to different groups
within the community
6
Option 1
You have a proposal to build a 3 power generating station of
10 MW each costing 3 million. The expected life of the project
is 10 years, during which, there is adequate demand Site
available is perfectly suited
Expected life of project
Each 10 Mega Watt Plant costs
Accessories and Other costs
Initial Investment ( 3 power stations * each 10 MW cost +
accessories cost)
Over next 10 yrs expected revenue
Each year expected revenue
Incurring costs for 10 years
Incurring cost per year (O&M costs)
Total Cost (for DBFO) of the plant (Costs) (3*3+1+15)
Benefits for 10 years
Benefits> Costs
3 Power Plants
10 Years
3 million
1 million
10 million
35 million
3.5 million/annum
15 million
1.5 million/annum
25 million
35 million
Option 2
You have a proposal to build a 1 power generating station of 60
MW. The expected life of the project is 10 years, during which,
there is adequate demand Site available is perfectly suited
Expected life period
Each 60 Mega WattPlant costs
Accessories and Other O&M costs
Initial investment (1 * each 60 megawatt cost +accessories cost)
Over next 10 yrs expected revenue
each year expected revenue
Incurring costs for 10 years
Incurring cost per year
Total Cost for DBFO of the plant (Costs) - (1*13+2+20)
Benefits for 10 years
1
10
13
2
15
48
4.8
20
2
35
48
Power Plants
years
million
million
million
million
million/annum
million
million/annum
million
million
Year 1
Discounting
@10%
NPW
NPW Costs Benefits
50
0.91
45.45
0.00
50
0.83
41.32
0.00
40
0.75
0.00
30.05
60
0.68
0.00
40.98
75
0.62
0.00
46.57
100
175
86.78
117.60
Present value
The current worth of a future sum of money or
stream of cash flows given a specified rate of return
Future cash flows are discounted at the discount
rate, and the higher the discount rate, the lower the
present value of the future cash flows
Present value, also known as present discounted
value
Used to make comparisons between cash flows
13
Present Value
To calculate the present value of any future
amounts
Single amount
Varying amounts
Annuities
14
FV= 1,000
.....
1 year
0
1 year
1
1 year
2
1 year
3
19
20
15
Method 1:
PV = FV (1 + i)-n
16
Calculation 2
Calculate the present value of a single amount
of 1,00 at the end of 2 years assuming the
interest rate of 8% per year compounded
annually.
17
Calculation 3
What is the present value of receiving a single amount of 5,000
at the end of three years, if the time value of money is 8% per
year, compounded quarterly
PV= ??
FV= 5,000
.....
3 months
3 months
3 months
3 months
11
12
PV = 3,942.45
18
Future Value
Value of an asset or cash at a specified date in the
future that is equivalent in value to a specified
sum today
Two ways of calculating future value:
Simple interest
For an asset with simple annual interest = Original
Investment x (1+(interest rate*number of years))
Compound interest
For an asset with interest compounded annually=
Original Investment x ((1+interest rate)^number of
years)
19
20
= 1000*(1+0.10)5
= 1000*(1.10)5
= 1000*(1.610)
=1610.51
21
Annuities
Annuities - series of fixed payments required from
you or paid to you at a specified frequency over
time period.
Payment frequencies - Yearly, Semi-annually (twice
a year), Quarterly and Monthly.
There are two basic types of annuities:
Ordinary annuities : Payments are required at the end of each period.
Future Value
Present Value
Investing 1000 per year for the next 5 years, and investing that at
the 5%
Present value of an ordinary annuity returned a value of 4,329.48.
The present value of an ordinary annuity is less than that of an
annuity due because the further back we discount a future
payment, the lower its present value
23
Calculate the future value of each cash flow. Let's assume that you are
receiving 1,000 every year for the next five years, and you invested each
payment at 5%. (C*(1+r)^n (0-4))
Gives an accurate value
This means that if you could get a return on your invested funds of 5% per
year, receiving 5525.63.
24
NPV = 30.83???
27
IRR
It takes interest as a unknown factor
It calculates the maximum rate of
interest (represents in percentage terms
It gives predictions
How to Assess
the Internal Rate of Return ?
At what rate the project is profitable?
For this we use the Internal Rate of Return
It is that rate which makes the NPV=0 and the
B/C Ratio =1
IRR represents the average earning power of
money used in the project over the project
life.
Net
DF
NPV
DF
NPV
DF @
NPV
Year Costs Benefits Benefits @10% @10% @25% @25% 19.00% @19%
150
-150
0.91 -136.36
0.80 -120.00
0.84 -126.05
25
20
0.83
16.53
0.64
12.80
0.71
14.12
50
45
0.75
33.81
0.51
23.04
0.59
26.70
75
70
0.68
47.81
0.41
28.67
0.50
34.90
125
120
0.62
74.51
0.33
39.32
0.42
50.28
170
275
105
172.66
103.83
126.02
= 20.35%
Risk Analysis
Here we concentrate only on three issues:
Variations in Benefits How much can we
tolerate without dropping a project?
Variations in Costs - How much can we
tolerate without dropping a project?
How much delay the project can afford?
Risk Analysis
Present value of benefits PV of Costs
Variations in Benefits = -----------------------------------------------------Present Value of Benefits
Risk Analysis
9400 4206
Variations in Benefits = ------------------------- = 55%
9400
9400 - 4206
Variations in Costs = -------------------- = 123%
4206
4206
Variations in time = ----------------- = 0.45
9400
Using a 10% discount factor, this 0.45 is equivalent to 8 years.