BE343s4ppt - Cost Benefit Analysis

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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 may
    undertake 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 also
    include 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.         ss4                                        1
               Cost Benefit Analysis
What is Cost Benefit Analysis?
• CBA has been established primarily as a tool for use by
  governments 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
• 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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              Cost Benefit Analysis

Other issues
• Is the project worthwhile financially?
• Is it the best option?
• Should it be undertaken at all?

                            ss4            3
                Cost Benefit Analysis
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
• External Costs:
   – Resulting from damage to buildings or decline of property
                              ss4                                4
     values through smoke emanating from a factory, etc.
Cost Benefit Analysis

          ss4           5
              Cost Benefit Analysis
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 associated
  with the activities; and estimating the costs and
  benefits involves.
• Affects by Market condition, state of economy etc.
• Uneven distribution of benefit to community.

                           ss4                             6
              Cost Benefit Analysis
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

                            ss4                             7
              Cost Benefit Analysis
CBA unlikely to be a useful
technique unless two main
conditions are met:

• investment must be sufficiently large or important to
  merit 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.

                            ss4                              8
              Cost Benefit Analysis
• Identify all possible alternatives.
• Prepare table showing life of the project i.e. year to
  year basis.
• Establish Cost of project during the year including
  capital, 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 of
  social benefits.
• Cost calculated at rate of interest such that NPV=Zero
                              ss4                         9
• Ranking in order of [benefit-cost] or [benefit / cost]
             Cost Benefit Analysis
    Establishing a steel production plant in a port
Costs (-)
• construction.
• pollution.
• devaluing house prices etc.
Benefits (+)
• employment
• increase port trade
• steel for local industry
                          ss4                         10
                Cost Benefit Analysis
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 benefits
Quantify the costs and benefits
Summarise conclusion
                             ss4                   11
                  Cost Benefit Analysis
Example of Costs and Benefits of the dam
• 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
• 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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                   Cost Benefit Analysis
Example of Costs and Benefits of the dam
• Let us first assume a calculation period for the CBA only covers seven
Discounted to
present value    = 0.71068 x $0.1 billion
                 = $71,068,000

Based on a seven year timespan
Costs = $157 million
Benefits = $71 million
Conclude that Project is not acceptable

                                          ss4                              13
                   Cost Benefit Analysis
Example of Costs and Benefits of the dam
• Let us consider a ten year timespan:
  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

Based on a seven year timespan
Costs = $157 million
                                     ss4       14
Benefits = $265 million
          Feasibility Study and Analysis
This section is a very brief introduction to the concept of feasibility studies. The
   objective 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 development
                                        ss4                                       15
        Feasibility Study and Analysis
                Main Purposes
• Most commonly used to assess the profitability of a
  scheme where the land is already owned by the
• To calculate the value of a site up for sale and compare
  it to the asking price, [or to determine a bid level at

                            ss4                          16
        Feasibility Study and Analysis
               Main techniques
• Payback period
• Residual
• Discounted cashflow
  – Net Present Value
  – Internal Rate of Return

                              ss4        17
  Feasibility Study and Analysis             Payback
• 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.

                              ss4                            18
  Feasibility Study and Analysis                  Residual
• 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 for
  sale can be derive:

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

                                 ss4                             19
   Feasibility Study and Analysis Discounted
                           Cashflow Method
• Project’s 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.

                                          ss4                                           20
   Feasibility Study and Analysis Discount
                  Cashflow - 2 Methods
Net 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”

                               ss4                          21
   Feasibility Study and Analysis Discount
               Cashflow - 2 Methods
Internal Rate of Return [IRR]
• IRR = Discounted rate at which NPV is zero.
• Identifies the actual return from a project.

                           ss4                   22
   Feasibility Study and Analysis Payback
• Simple and easy to understand
• quick to use
• emphasises solvency/liquidity
• ignores cashflows beyond PB period
• ignores timings of cashflows within PB period
• ignores the time value of money

                          ss4                     23
  Feasibility Study and Analysis Residual
• Quick and relatively simple
• Does not permit sophisticated allowance for the
  timings of costs and revenues.
• Does not permit an accurate assessment of finance
• Does not identify the PB period, on peak cash outlay.
• Not easily applied to complex schemes [eg. Part sold
  priod to completion]
                           ss4                            24
  Feasibility Study and Analysis Discounted
                Cashflow - NPV/IRR
• The cashflows model reality
• recognises the time value of money
• permits a precise assessment of costs and hence
  finance 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.                ss4                        25

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