2. 2
Benefit-Cost Analysis
The objective of private investment is to increase
the net worth of the company.
In the public sector, government spend a lot of
money in projects such as education, road
construction, hydro-power plants etc. to increase
net public benefits.
Benefit-Cost Analysis is a decision-making tool
for systematically developing useful information
about the desirable or undesirable effects of a
public project.
Benefit-Cost Analysis tries to determine whether
the social benefits are greater than social costs.
Lecture 11 - Dr. Shree Raj Shakya
3. 3
There are three types of benefit-Cost
Analysis problems
1. to maximize benefits over any costs
2. to maximize net benefits when
benefits and costs vary
3. to minimize costs to get a certain
level of benefits
Lecture 11 - Dr. Shree Raj Shakya
4. 4
Benefit-Cost Ratio Analysis
1. Identify users' benefits from the project
2. Quantify, as much as possible, in Rupee term
3. Identify sponsors' costs
4. Quantify, as much as possible, in Rupee term
5. Determine the equivalent benefits and costs at the
base period using the social interest rate
Lecture 11 - Dr. Shree Raj Shakya
5. 5
Social benefits and Social costs
Social Benefits
1. Benefits due to reduction of deaths
2. Benefits due to reduction of damage to property
3. Primary users' disbenefits
Social Costs
1. Primary Sponsors' costs
2. Primary Sponsors' savings
B -C should be positive
DBBBB 121
SCC 11
Lecture 11 - Dr. Shree Raj Shakya
6. 6
Benefit-Cost Ratio Analysis
6. If BC (i) >1 we should accept a public project
sponsor's costs (C) consist of the equivalent capital expenditure ( I )
and the equivalent annual operating costs (C') accrued in each
successive period
Lecture 11 - Dr. Shree Raj Shakya
7. 7
Net B/C Ratio
• considers only the initial capital expenditure as a
cash outlay, and uses annual net benefits.
some analysts prefer this measure because, it indicates
the net benefit (B') expected per dollar invested
If we are to accept a project, the B'C(i) must be greater
than 1
Lecture 11 - Dr. Shree Raj Shakya
8. 8
Example
A public project being considered by a local government
has the following estimated benefit-cost profile
Assume that i = 10%, N = 5.
Compute B, C, I, C', BC(10%) and B'C(10%).
Lecture 11 - Dr. Shree Raj Shakya
12. 12
Incremental Analysis based on BC(i)
Consider three investment projects, A1, A2, and A3. Each
project has the same service life, and the present worth of
each component value (B, I, and C') is computed at 10% as
follows.
(a) If all three projects are independent, which projects would
be selected based on BC(i) and B'C(i) criteria, respectively?
(b) If the three projects are mutually exclusive, which project
would be the best alternative? Show the sequence of calculations
required to produce the correct results, using (1) the aggregate BIC
ratio, and (2) the netted BIC ratio.
13. 13
Solution
(a) Since PW(i)1, PW(i)2, and PW(i)3 are positive,
all projects would be acceptable if they were
independent.
Also, BC(i) and B'C(i) values for each project are greater
than 1, so the use of either ratio will lead to the same
accept-reject conclusion under the NPW criterion.
Lecture 11 - Dr. Shree Raj Shakya
14. 14
(b) If these projects are mutually exclusive, we must
use the principle of incremental analysis.
1. Remove any alternatives with a BIC ratio less than 1
2. Arrange the remaining alternatives in the increasing
order of the denominator (I + C').
Thus, the alternative with the smallest denominator should
be first (j), the alternative with the next smallest second (k),
and so forth.
Lecture 11 - Dr. Shree Raj Shakya
15. 15
3. Compute the incremental differences for each term (B,
I, and C') for the paired alternatives j, k) in the list.
Select A1 and A3 as they have least denominator (cost)
4. Compute the BC(i) on incremental investment by evaluating
Since the ratio is greater than 1, we prefer A3 over A1. Therefore,
A3 becomes the "current best" alternative.
16. 16
Therefore, we need to compare A2 and A3 as follows:
The incremental B/C ratio again exceeds 1, and therefore we prefer
A2 over A3.
With no further projects to consider, A2 becomes the ultimate choice.
5. Compare the selected alternative with the next one on the list by
computing the incremental benefit-cost ratio. Continue the process
until you reach the bottom of the list. The alternative selected during
the last pairing is the best.
Lecture 11 - Dr. Shree Raj Shakya
17. 17
Using the net B/C (B'C(i)) ratios:
If we had to use the net BIC ratio on this incremental investment
decision, we would obtain the same conclusion.
Since all B'C(i) ratios exceed 1, there will be no do-nothing alternative.
By comparing the first pair of projects on this list, we obtain
Project A3 becomes the current best."
Next, comparing A2 and A3 yields
Therefore, A2 becomes the best choice by the net BIC criterion.
Lecture 11 - Dr. Shree Raj Shakya
18. 18
Solve 1
A city government is considering town-dump sanitary system.
The project requires an initial outlay of $400,000, with
annual operating and maintenance costs of $50,000 for
the next 15 years. Fee collections from the residents
would be $85,000 per year. The interest rate is 8%, and
there is no salvage value associated with either system.
Determine economics feasibility of the project using the
benefit-cost ratio and net benefit-cost ratio.
Lecture 11 - Dr. Shree Raj Shakya
19. 19
Solve 2
A city which operates automobile parking facilities is evaluating a proposal
that it erect and operate a structure for parking in a city's downtown area.
Three designs for a facility to be built on available sites have been identified.
(All dollar figures are in thousands.)
At the end of the estimated service life, whichever facility had been
constructed would be torn down and the land would be sold. It is estimated
that the proceeds from the resale of the land will be equal to the cost of
clearing the site. If the city's interest rate is known to be 10%, which
design alternative would be selected based on the benefit-cost criterion?
