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Cost Benefit Analysis (CBA)

Cost Benefit Analysis (CBA). D1. Presentation Outline. What is Cost Benefit analysis Net Present Value Payback period. What is CBA?.

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Cost Benefit Analysis (CBA)

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  1. Cost Benefit Analysis(CBA) D1

  2. Presentation Outline • What is Cost Benefit analysis • Net Present Value • Payback period

  3. What is CBA? • Process of quantifying costs and benefits of a decision, program, or project (over a certain period), and those of its alternatives (within the same period), in order to have a single scale of comparison for unbiased evaluation. • CBA is an analytical framework used to assess the benefits and costs of system proposals

  4. What is CBA? • Based on CBA results a specific project(system) proposal will be rejected or accepted • CBA is not limited to monetary considerations only. It often includes those environmental and social costs and benefit (intangible costs and benefits) that can be reasonably quantified.

  5. Payback Period • The length of time required to recover the cost of an investment. • All other things being equal, the better investment is the one with the shorter payback period.

  6. 1st Method • It is calculated as: Payback period= Cost of Project / Annual Cash Inflows. For example, if a project cost BD. 100,000 and was expected to return Bd. 20,000 annually. How much the payback period will be?

  7. 1st Method • The payback period would be calculated as: 100,000 / 20,000 = 5 years

  8. 2nd Method • If the initial investment is Bd. 100,000 and the expected returns are: Year1: BD. 40,000 Year2: BD. 35,000 Year3: BD. 25,000 Year4: BD. 20,000 Year5: BD. 15,000

  9. 2nd Method • The investment of BD. 100,000 is recovered in 3 years as 40,000+35,000+25,000 • So the payback period is 3 years.

  10. Problems with the Payback Period • It ignores any benefits that occur after the payback period, and so doesn’t measure profitability. • It ignores the time value of money.

  11. Net Present Value • It is a method used to estimate the attractiveness of an investment opportunity. • It is calculated by estimating cash flows into the future and discounting them back at an appropriate interest rate.

  12. Net Present Value • NPV compares the value of a Bahraini Dinar today versus the value of that same Bahraini Dinar in the future, after taking inflation and return into account.

  13. NPV

  14. Present Value: • Define • R=amount to be received in future • r=rate of return on investment • T=years of investment • The present value (PV) of the investment is:

  15. NPV Example 1: • A corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. • This project will have an immediate (year=0) cash outflow of $100,000 (which might include machinery, and employee training costs). • Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 per year for years 1-6. • Therate of returnis 10%. Calculate the present value (PV) for each year and Net Present Value.

  16. Solution

  17. Follow… • The sum of all these present values is the net present value, which equals $8,881.52. • Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no alternative with a higher NPV.

  18. Example 2:

  19. Task 1 • ABC corporation must decide whether to introduce a new information system in its Sales department. The new system will have startup costs, operational costs, and incoming cash flows over five years. • This project will have an immediate (year=0) cash outflow of $100,000 • Other cash outflows and inflows for years 1-5 are expected to be as shown below Year Inflow cash Outflow cash 1 70000 10000 2 60000 30000 3 50000 25000 4 30000 20000 5 30000 20000 • Therate of returnis 14%. Should this project be carried out. What do you suggest?

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