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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 mayundertake 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 alsoinclude 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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What is Cost Benefit Analysis? CBA has been established primarily as a tool for use bygovernments 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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Other issues

Is the project worthwhile financially?

Is it the best option?

Should it be undertaken at all?


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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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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 associatedwith 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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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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CBA unlikely to be a useful

technique unless two main

conditions are met:

investment must be sufficiently large or important tomerit 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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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 includingcapital, 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 ofsocial benefits.

Cost calculated at rate of interest such that NPV=Zero

Ranking in order of [benefit-cost] or [benefit / cost]


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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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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 benefitsQuantify the costs and benefits

Summarise conclusion


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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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Let us first assume a calculation period for the CBA only covers sevenyears:

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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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


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Feasibility Study and Analysis

This section is a very brief introduction to the concept of feasibility studies. Theobjective 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 developmentschemes.

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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 compareit to the asking price, [or to determine a bid level at

auction].


Main Purposes

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Payback period

Residual

Discounted cashflow

Net Present Value

Internal Rate of Return


Main techniques

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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 forsale can be derive:

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

purchase land.

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Feasibility Study and AnalysisDiscounted

Cashflow Method Projects 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 AnalysisDiscount

Cashflow - 2 MethodsNet 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 DiscountCashflow - 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 AnalysisPaybackPeriod

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 AnalysisResidualMethod

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 DiscountedCashflow - NPV/IRR

Advantages: The cashflows model reality

recognises the time value of money

permits a precise assessment of costs and hencefinance 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.

Documents

BE343s4