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FINANCIAL MANAGEMENT

STEPS IN CAPITAL BUDGETING, INVESTMENT CRITERIA

(BENEFIT COST RATIO )

SUBMITTED TO SUBMITTED BY
MS.GARIMA WADHWA
DHAWAN NAME: SAHIL

FINANCIAL MANAGEMENT

ENROLLMENT NO.: A3221512060 BBA.LLB (HONS) 4 TH SEMESTER

BENEFIT COST ANALYSIS

What is benefit-cost analysis?


Benefit-cost analysis (BCA) is a technique for evaluating a project or investment by comparing the economic benefits with the economic costs of the activity. Benefit-cost analysis has several objectives. First BCA can be use! to evaluate the economic merit of a project. "econ! the results from a series of benefit-cost analyses can be use! to compare competing projects. BCA can be use! to assess business !ecisions to e#amine the worth of public investments or to assess the wis!om of using natural resources or altering environmental con!itions. $ltimately BCA aims to e#amine potential actions with the objective of increasing social welfare. %egar!less of the aim all benefit-cost analyses have several properties in common. A BCA begins with a problem to be solve!. For e#ample a community may have the goal of alleviating congestion on roa!s in an area. &arious projects that might solve the particular problem are then i!entifie!. As an e#ample alternative projects to alleviate roa! congestion in an area might inclu!e a new highway a public bus system or a light rail system. 'he costs an! benefits of these projects woul! be i!entifie! calculate! an! compare!. (ecisions are typically not ma!e solely on the basis of BCA but BCA is useful an! sometimes require! by law. )ithout a !oubt results from a BCA can be use! to raise the level of public !ebate surroun!ing a project.*

BCA exam les


+#plicitly or implicitly nearly every public an! private !ecision involves some comparison of benefits an! costs. Although a formal BCA is not use! for all !ecision ma,ing the principles are applie! in many settings. -ere are a few brief e#amples. +#ample *. "ociety must !eci!e whether to open-up an ol!-growth forest for logging. /ogging woul! provi!e a variety of benefits but will also entail costs. 'he pro!ucts an! employment generate! by logging are benefits. "ome of the costs of cutting the ol!growth forest inclu!e the cost of cutting the loss of wil!life habitat !amages to local streams !ue to runoff an! the loss of an opportunity to cut the forest sometime in the future. +#ample 0. An agency must !eci!e whether to impose regulations to conserve a biologically important wetlan!. Conserving the wetlan! has environmental benefits. 'he wetlan! provi!es habitat for a variety of animals inclu!ing waterfowl. 'he wetlan!
*

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ultimately provi!es benefits to hunters an! bir!-watchers. 'he wetlan! also provi!es benefits because it helps to maintain water quality an! re!uces floo!ing in neighboring areas. -owever lan! that woul! be conserve! coul! be use! in a !ifferent way say for agriculture or a shopping mall. 'his loss in use is an opportunity cost. /an!owners may also incur some !irect costs in protecting wetlan!s on their property or some opportunity costs associate! with not using these areas in another way. BCA can be use! to compare the benefits an! costs of imposing the regulation.

BCA in a timeless #o'l(


)e now consi!er an e#ample of BCA in greater !epth. "uppose society is consi!ering the construction of a large !am. 'he !am an! resulting reservoir will provi!e numerous benefits an! entail many types of costs. -ere we simplify the story for the sa,e of our e#ample. First consi!er the cost of buil!ing the !am. )e assume the cost of construction is 01cr for materials an! 23cr for labor. 4ow consi!er the benefits. 5nce the !am has been built people will be able to go swimming boating an! fishing in the reservoir. 'he total value of these recreational benefits is 03cr. 'he !am is also e#pecte! to provi!e floo! control benefits for !ownstream resi!ents. 'he saving !ue to this floo! control is estimate! as *1cr in re!uce! !amages to homeowners or farmers. 'he !am also pro!uces electricity value! at 01cr. "ince the total benefits are 63cr an! the total costs are 11cr the benefits e#cee! the costs an! !am construction appears to be a goo! investment. Benefitcost analysis has been use! to compare the benefits an! costs of the project. -owever to ,now whether society shoul! actually buil! the !am other information is nee!e!. For e#ample it will be necessary to compare the !am project with other possible uses of the fun!s. 7t might be the case that a 11cr investment in e!ucation coul! lea! to more than 63cr in benefits. 7f so the !am might be a goo! use of society8s resources but perhaps not the best use of those resources.0

Time an( (isco&ntin%


'he e#ample use! above ignores the issue of time. 7n comparing the benefits an! costs of the !am we !i!n9t really consi!er when those benefits an! costs occurre!. But in many cases the timing of benefits an! costs is an important aspect of the project un!er consi!eration. For this reason !ealing a!equately with the timing of benefits an! costs becomes a crucial part of the BCA. For e#ample what if the cost of constructing the !am is incurre! this year but the benefits of using the !am are not felt until ne#t year after the !am is complete!. 7n this case will ne#t year8s benefits outweigh this year8s costs: 'o !eal with this ,in! of question benefit-cost analysis uses a concept ,nown as !iscounting.

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Benefit-Cost 1eas&'es

Benefit-cost 'atio 2BC+3


A ratio attempting to i!entify the relationship between the cost an! benefits of a propose! project. Benefit cost ratios are most often use! in corporate finance to !etail the relationship between possible benefits an! costs both quantitative an! qualitative of un!erta,ing new projects or replacing ol! ones. As mentione! the ratio is use! to measure both quantitative an! qualitative factors since sometimes benefits an! costs cannot be measure! e#clusively in financial terms. 7n cases where at all possible however qualitative factors shoul! be translate! to quantitative terms in or!er for the results to be easily un!erstan!able an! tangible.4

Calculating the Simple Benefit-Cost Ratio

*. n;* < the number of years over which benefits an! costs are analy=e! Bi < the benefits of the project in year i i<3 to n Ci < the costs of the project in year i ! < the !iscount rate First !iscount the costs an! benefits in future years. 'he !iscounte! benefits of the project in year i are equal to Bi>(*;!)i 'he !iscounte! costs of the project in year i are equal to Ci>(*;!)i 'hen sum both the !iscounte! benefits an! the !iscounte! costs over all years (3 though n) an! !ivi!e the sum of the !iscounte! benefits by the sum of the !iscounte! costs. 52Bi"267(3i3"5 2Ci"267(3i38 s&mme( o)e' i 9 . to n$0. Another way to calculate BC% is to first calculate 4?& i.e. 4+' ?%+"+4' &A/$+.

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Net 'esent )al&e 2N:;3 - 'he net present value (4?&) is the current value of all project net benefits. 4et benefits are simply the sum of benefits minus costs. 'he sum is !iscounte! at the !iscount rate. $sing this metho! if the project has a 4?& greater than =ero then it appears to be a goo! can!i!ate for implementation. 'he formula use! to calculate the 4?& is <.

O+
N:;9 => 2to t963 ?Ct " 267'3t @

4ow that we have got 4?& using this we can calculate BC% by using this formula.- /

BC+9 N:;" initial )al&e

A *. 'he e#pecte! cash YEA+ . 6 B 4 < CALC*LATE N:; C 6BD E BC+ CASA FLOW 68 ..8... B.8 ... 4.8 ... -.8 ... <.8 ... 4.8 ...

SLO*TION!
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N:;9 B.8..." 2676B36 7 4.8..." 2676B3B 7 -.8..."2676B34 7 <.8..."2676B3- 7 4.8..."2676B3< 9 B.8..." 6$6B. 7 4.8..."6$B<- 7 -.8..."6$-.< 7 <.8..."6$<F- 7 4.8..."6$F/B 9 6F8G<F$6- 7 B48HB4$-- 7 BG8-/H$F< 7 468F//$B. 7 6F8.B/$6 I 68..8... 9 684H8.-4 I 68..8... 9 4H8.-4

BC+ 9 N:;" INITIAL IN;EST1ENT 9 4H8.-4" 68..8... 9 .$4H.-4 "ince BC% calculate! is greater than =ero i.e. the value of BC% is positive therefore it will be accepte!.

J B$ F
I$ Estimate( cost of 'o0ect
148391 Cost of link canal, canal structures including Command area development

II$

Ann&al benefits

a3 :ost- 'o0ect
i) Bross value of pro!uce ii) Cost of e#pen!iture iii) 4et value of pro!uce
<F6F. 6GFGB 4G4GG

b3 :'e- 'o0ect
i3 ,'oss )al&e of 'o(&ce ii3 Cost of ex en(it&'e iii3 Net )al&e of 'o(&ce Loss in agricultural production in land going out of Cultivation due to distributaries system @10 of
C

BG.G/ 6B/6F 2-3 6<-/H

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gross value of produce before irrigation !based on t"e figures adopted by t"e #$%$ &tate in t"e %olavaram pro'ect report(

2-3 BG.H

)et *alue
III. Annual cost
a( +nterest @ 10 of pro'ect cost of capital cost

B.66.

6-G4H 6-G64H$F-

b( ,epreciation @ 1

c( #nnual -./ c"arges@ 0s$100 per "a for 64HF-. ha

TOTAL

6/-/B$F-

Benefit-cost ratio B.66."6/-/B$F- 9 6$BBL

Calculating the Incremental Benefit-Cost Ratio

'his metho! is applicable if there are two or more alternative projects to compare to the base case. 7t is also ,nown as the DChallenger-(efen!er Eetho!.D B, < the total !iscounte! benefits of an alternative , calculate! as above C, < the total !iscounte! costs of an alternative , calculate! as above First !iscount all future costs an! benefits to obtain C, an! B, for each alternative an! for the base case. 'hen start by i!entifying the base case as the !efen!er represente! by the subscript Df.D ?ic, the alternative with the least value of total !iscounte! costs as the challenger Dc.D Calculate the incremental benefit-cost ratio to compare the challenger an! !efen!er. (BfB!)>(Cf-C!) 7f the incremental B>C ratio is greater than * the challenger becomes the !efen!er. 5therwise the !efen!er remains. 7n either case the ne#t alternative in or!er or increasing value of C, is pic,e! as the new challenger.

Continue to compare challenger to !efen!er following the above logic until all alternatives have been consi!ere!. 'he surviving !efen!er is the economically preferre! alternative. 'his proce!ure is mathematically equivalent to 4et ?resent &alue an! it always gives the same result but use of this proce!ure may provi!e greater insights into the relationships between costs an! benefits of the !ifferent projects.

A()anta%es an( (isa()anta%es of &sin% benefit-cost analysis

BCA is a valuable tool for !ecision ma,ing. 7t is most useful because it provi!es a starting point from which to begin evaluation of a project. BCA forces project a!vocates an! opponents to provi!e quantitative !ata to bac, up qualitative arguments. )ith BCA actual !ata must be use! to support the analysis. 'ypically some subjective reasoning or value ju!gments come into play when !eci!ing on projects or investments. )hile BCA may not be able to inclu!e all the criteria which is !eeme! important in evaluation it !oes allow intereste! parties to clearly !efine the issues involve!. BCA is also useful because it allows comparisons to be ma!e between investments or projects. 'his comparison is ma!e easier because all investments are evaluate! using the same metho!. 7t then becomes easier to e#clu!e obviously ba! projects from consi!eration. )hile BCA can be useful there are some !ifficulties with its application. First it requires that the analyst assign monetary values to all benefits an! costs. As we ,now however there are numerous benefits an! costs which are intangible an! therefore !ifficult to value. For projects with an environmental impact for e#ample it can be !ifficult to place a !ollar value on the benefits an! costs. )hile the value of timber may be easy to calculate the value of a spotte! owl may not. Another !rawbac, with BCA is the fact that results can be very sensitive to the choice of the !iscount rate. 'he entire result from a comple# BCA may hinge on the choice of a single number for the !iscount rate. For this reason BCA can be very controversial. 'he rate that is chosen can ra!ically change the outcome of analysis (to convince yourself of this try re-wor,ing the e#amples above using !ifferent !iscount rates). Finally an important !rawbac, with BCA is that while most benefits an! costs that arise in the present are ,nown many that arise in the future are un,nown. A BCA must be con!ucte! using information that is available. 'his information will be limite! by our current ,nowle!ge of benefits an! costs. "ome future benefits an! costs cannot conceive! much less measure!. -owever the role of uncertainty plagues not only BCA but also most other !ecision-ma,ing metho!s.

*NSOL;EM J*ESTIONS

Exam le 6$G "uppose a tunnel is propose! to be built to save travel time an! roa! construction cost aroun! a mountain. 7n or!er to save on first cost a twin tunnel system is propose! with *>0 capacity in each shaft. Construction < F2 333 333 --- "haft * -- 4ow F@ 333 333 --- "haft 0 --Built in 03 years (4 < 03) Eaintenance ("haft lining) < F*63 333>-alf -- every *3 years Benefits < F063 333>yr 4 < *-03 F233 333>yr 4 < 0*-13 7f 7 < 1G an! 4<13yrs is the project justifie!:

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