Cost Benefit Analysis

1. 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

2. 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 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. ss4

3. Cost Benefit Analysis Other issues • Is the project worthwhile financially? • Is it the best option? • Should it be undertaken at all? ss4

4. 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 capital) • External Costs: • Resulting from damage to buildings or decline of property values through smoke emanating from a factory, etc. ss4

5. Cost Benefit Analysis ss4

6. 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

7. 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 associated. ss4

8. 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

9. Cost Benefit Analysis 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 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 • Ranking in order of [benefit-cost] or [benefit / cost] ss4

10. Cost Benefit Analysis 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 ss4

11. 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 Examples of CBA (See text pg T4/13) ss4

12. Cost Benefit Analysis 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. ss4

13. Cost Benefit Analysis Example of Costs and Benefits of the dam • Let us first assume a calculation period for the CBA only covers seven years: 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 ss4

14. Cost Benefit Analysis Example of Costs and Benefits of the dam • 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 Conclude that Project is acceptable ss4

15. 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 schemes. ss4

16. Feasibility Study and Analysis Main Purposes • 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 compare it to the asking price, [or to determine a bid level at auction]. ss4

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

18. 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. ss4

19. 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 for sale can be derive: Value - [(All costs exc. Land) + (Profit)] = Money available to purchase land. ss4

20. Feasibility Study and AnalysisDiscounted 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

21. Feasibility Study and AnalysisDiscount 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

22. 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

23. Feasibility Study and AnalysisPayback Period 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 ss4

24. Feasibility Study and AnalysisResidual Method 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] ss4

25. Feasibility Study and Analysis Discounted Cashflow - NPV/IRR Advantages: • 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