Cost Benefit Analysis (CBA) of a Project | Financial Management

In this article we will discuss about:- 1. Meaning of CBA 2. Investment Decisions under CBA 3. Procedure 4. Techniques.

Meaning of CBA:

CBA is defined as “an analytical tool in decision-making which enables a systematic comparison to be made between the estimated cost of undertaking of project and the estimated value and benefits which may arise from the operation of such a project”.

“It is the measurement of resources used in an activity and their comparison with the value of the benefit to be derived from the activity”. CBA is a more sophisticated technique recently introduced in long-term decision making in capital projects appraisal. CBA conducts a monetary assessment of the total costs and revenues or benefits of a project, paying particular attention to the social costs and benefits which do not normally feature in conventional costing exercises.

The underlying object of CBA is to identify and quantify as many tangible and intangible costs and benefits as possible. The aim is then to see a strategy which achieves the maximum benefit for the minimum cost. Only where benefits exceed costs, a project can be undertaken. CBA has been used in its more specialized sense to describe techniques for making investment decisions in a nonprofit making organizations.

Investment Decisions under CBA:

For public/non profit-making organizations seeking to make investment decisions, the concept of NPV may not be regarded as entirely appropriate. That is, the principle of discounting remains valid but, since the objective is no longer simply profit maximization, what are regarded as the cost and benefit of a project must be re-specified. This is the purpose of CBA, which is essentially discounted cash flow analysis for public sector institutions.

For a business assessing a project such as building a road bridge, the criterion for acceptance will be the profit potential of the project in comparison with the other investment opportunities currently available. As such, the only factors which will influence the decision will be those costs and benefits incurred and received privately by the firm.

In contrast, from society’s point of view, road building has effects in the community which confer both costs and benefits on society as a whole; e.g., increased traffic may add to the level of environmental pollution but at the same time may create jobs in the area around the road. The firm building the bridge does not have to pay society for the additional pollution created nor does it receive payment for the jobs created.

There exists, therefore, a difference between the private costs and benefits and the social costs and benefits of the project. It is this difference that CBA seeks to identify and take account of CBA may be used to ascertain whether or not a specific project should be undertaken, or perhaps more frequently it is used to ascertain which project or projects should be selected from a possible array of projects.

Basically, CBA is used to determine:

a. Whether or not a specific operation should be undertaken.

b. Which of the possible alternative projects should be selected.

c. Which time cycle would be most beneficial to the project.

It is important that not only should estimate costs and benefits be considered, but also that the timing of a project should be right both in terms Of cash flows and cost of capital.

CBA Procedure:

In seeking to help public organizations and nationalized industries in investment decisions, cost-benefit analysis serves as a means of establishing the factors which need to be taken into account when making the investment choices. The objective of private concern is one of profit maximization. In the public sector, the objective is the maximization of social welfare.

A suggested procedure for embarking on a CBA study is as follows:

1. Determine Problem to be Considered:

It is important to establish at the outset exactly what is being attempted and, if possible, to establish the objectives and possible advantages of pursuing such a scheme. In the case of large scale investments, the number of people and groups affected is likely to be large and it must be recognized that the effects may be direct or indirect, but for CBA both must be taken into account.

The costs and benefits which accrue to bodies other than the one sponsoring the project is termed as ‘externalities’. An essential difference between CBA and private sector project appraisal is that the former takes full account of such externalities in establishing a net present value for a project.

2. Ascertain Alternative Solutions to Problem:

It may be that there is only one solution to the problem, in such case there will be a simple go-ahead/not go-ahead decision. However, in most of the cases there will be alternative possibilities. At this stage it is essential to establish the existence of any constraints, because these will be the key factors in solutions.

Constraints are those factors which inhibit or even prohibit certain actions, for example legal constraints will restrict setting up of a certain project e.g. under ‘green belt’ regulations while financial constraints may inhibit projects involving expenditure above a certain limit.

3. Estimate and Analyze Costs and Benefits:

This is the stage of the analysis which involves most work. Having identified all the affected parties, the projects influence on their welfare must be expressed in monetary terms, as it would be valued by them. There are a few costs/benefits which cannot be valued in this way and they remain as separate issues for consideration when the final decisions on the project are made.

In a capital budgeting decision costs and benefits will be specific to the company concerned. It is not particularly interested in costs and benefits which may accrue to anyone outside the company. However, in CBA we are interested in all the costs and benefits, in other words we are considering a wider spectrum.

4. Appraise Estimated Costs and Benefits:

This stage is probably the most difficult, but most crucial one. The problems inherent in forecasting are considerable and particularly in projects which have a long time cycle the problem of forecasting costs and revenues is of some magnitude.

However, there is the added problem in CBA of calculating to social costs and benefits. An attempt must be made to quantify these items, although in many cases this may prove to be virtually impossible. Any evaluation of social costs must be subjective or relative, but atleast it is a guide to the decision-maker.

5. Decide on Optimal Solution:

The estimated costs and benefits for each alternative solution have been computed and presented to management for decision-making.

Techniques of CBA:

The decision-maker will evaluate the project in any of the following manner:

Discounted Cash Flow Techniques:

For a private sector project, the rate of discount is the marginal or weighted average cost of capital for the business. In the public sector, the selected rate of discount must reflect the cost of investment funds to society as a whole, so it is generally referred to as ‘social rate of discount’.

This is complex because, in selecting a discount rate, one is effectively placing a value on consumption in the future relative to consumption today. If the government spends Rs.2 crores on constructing new hospitals, that Rs.2 crores will provide better medical care facilities at the sum invested, which could, for example have been used to reduce the rate of income-tax.

As a simple way out of the problem, the discount rate could be set at the market rate of interest on long-term risk free investments such as gilt-edged securities. In practice, the market interest rate does not necessarily reflect the value to society of investment.

A market interest rate, therefore, forms the starting point for determining a social rate of discount and this will then be adjusted to a level which ensures an optimal consumption; investment ratio; this optimum is government determined.

1. Net Present Value (NPV):

This is a discounted cash flow technique and thus it attempts to consider the time value of money, i.e. Rs.1 today is of more value than Rs.1 tomorrow. It discounts future earnings to make them comparable with present investment.

This is done using standard DCF procedures on the familiar equation:

Where, B = Sum of the benefits of the project

r = Social rate of discount

C = Sum of the costs of the project

n = Expected project life

NPV is a widely used technique in decision – making and is particularly useful when considering cash flows over a relatively long time cycle.

2. Internal Rate of Return (IRR):

This is also discounted cash flow technique and is sometimes referred to as the ‘trial and error’ technique. Unlike NPV technique, it does not have an accepted discount or cutoff rate, but it calculates a discounted rate at which the cash outflows are equated with the cash inflows.

Thus if Rs.100 is to be earned in one year from the investment in a machine which will cost Rs.1,000 now, then:

IRR is not as popular as NPV because of inherent mathematical complications which may arise when solving the rate. The project is acceptable under NPV method if there is a positive return by a project after discounting benefits and costs at given rate. The project is acceptable under IRR if the rate of return after discounting benefits and costs is greater than the cost of capital.

Benefit/Cost Comparison:

The estimated benefits and the estimated costs which may arise from undertaking a project are compared and the project is undertaken if benefits are considered to be greater than costs. The method is clearly unsatisfactory because it does not allow for time value of money, i.e. it does not consider that Rs.1 received today is better than Rs.1 to be received next year.

Another problem with this method is that it does not give much guidance to the decision-makers because the figures are not relative, e.g. it may show that projects A and B are expected to produce a return of Rs.5,000 and Rs.1,000 respectively, which makes project A look satisfactory until it is revealed that investment in A is Rs.1,00,000 while that in B is only Rs.5,000.

Benefit/Cost Ratio:

This is a ratio which assesses estimated benefits as a ratio to estimated costs. If the resulting figure is greater than 1 it is positive and if less than 1 it is negative. It suffers from the same fault as to the lack of consideration of the time value of money, but it does produce relative figures enabling comparisons between projects to be made. However, it can also be used after discounting cash flows, which makes it much more useful because the benefit/cost used in the calculation will have been based on discount rates.