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Understanding Cost-Benefit Analysis for Rational Investment Decisions

Cost-Benefit Analysis (CBA) is a tool to evaluate investment projects by quantifying costs and benefits in monetary terms. Learn how to predict cash flows, calculate NPV, PP, and IRR, and consider non-monetary factors. The article also highlights the importance of using the Water LINK CBA Tool in Excel to simplify the process.

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Understanding Cost-Benefit Analysis for Rational Investment Decisions

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  1. Cost-Benefit Analysis What is it? What use is it? How do you do it? Richard Harrison-Murray Research consultant richard@rhmscience.co.uk

  2. What exactly is CBA? (Cost Benefit Analysis) • An aid to making rational investment decisions • Framework for evaluating investment ‘projects’ e.g. investment in new irrigation equipment • Based on predictions of future cash flows • Takes account of time value of money • Requires all costs and benefits to be given a monetary value

  3. How do you go about it? • Quantify relevant costs and benefits, i.e. those that depend on the decision to invest • Take account of tax (excl. VAT, incl. tax relief) • Predict cash flows over your planning horizon • Decide on the appropriate discount factor taking account of • cost of borrowing • inflation • risk • return on alternative investment (e.g. stock market)

  4. Calculate indicators of investment quality • Net Present Value (NPV) = benefits – costs, all in “today’s money” • Payback Period (PP) = years till benefits exceed costs • Internal Rate of Return (IRR) = annual % return on investment • Use these indicators to decide whether the proposal is financially attractive. • Consider any non-monetary factors e.g. legislative pressure, effect on staff morale, etc. • Decision time !

  5. Key points about CBA • Examines the effect of a change; it needs much less data than a complete economic analysis • Running a large number of scenarios may lead to useful generalisations but it is better for individual nurseries to run a CBA for their own situation and their own proposal • It depends on predicting the future so it is sensible to test the effect of errors in those predictions on expected returns • A software tool to do the donkey-work is very useful

  6. The water LINK CBA Tool • MS Excel Spreadsheet • Helps assemble the data and do the calculations • Simple to use but flexible • Help from extensive pop-up comments • Formulae protected from accidental changes • Advanced users can customise • Colour indicates where input is required etc. • “What if” exploration is easy and results can be transferred to user-defined graph

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