CBA Final Power Point

8/7/2019 CBA Final Power Point

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OverviewOverview

Cost-Benefit Analysis (CBA)

Origin

Definitions Purpose

Principles of CBA

Steps in Construction of CBA

Sample Case


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OriginOrigin

Conceived by the French engineer JulesDupuit in 1848

In 1936, through the Federal Navigation Act of1936, U.S. Corps of Engineers had createdsystematic methods for measuring benefitsand costs to carry out the improvement of the

waterway system. The engineers of the Corpsdid this without much assistance from theeconomics profession.


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OriginOrigin

In 1950s, economists tried to provide a rigorous,

consistent set of methods for measuring benefitsand costs and deciding whether a project is

worthwhile.


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CostCost--Benefit Analysis (CBA)Benefit Analysis (CBA)

"...a systematic quantitative methodof

assessing the desirability of governmentprojects or policies when it is important to

take a long view of future effects and a broad

view of possible side-effects."

(White House, 1994)


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Cost Benefit Analysis (CBA)Cost Benefit Analysis (CBA)

The implicit or explicit assessment of the

benefits and costs (i.e., pros and cons,advantages anddisadvantages) associated

with a particular choice


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Cost Benefit Analysis (CBA)Cost Benefit Analysis (CBA)

Commonly used in evaluating public projects

and programs such as:

Building dams, bridges, airports or highways Planning for safety (i.e. drunk driving laws, traffic

circles)

Spending f or education and research (i.e.

libraries, public schools) Health care systems

Other projects that government might fund


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Purpose ofCBAPurpose ofCBA

To ensure that the public sector allocates

scarce resources efficiently to competing

public sector projects.

To clarify which of the potential alternative

programs, policies or projects (including the

status quo) is the most efficient (closest to

efficient)


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To provide information to the decision-maker

the official who will appraise or evaluate

the project.

appraise in a prospective sense, referring to the

process of actually deciding whether resources

are to be allocated to the project or not

evaluate in a retrospective sense, referring to theprocess of reviewing the performance of a project

or program.

Purpose ofCBAPurpose ofCBA


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Principles ofCBAPrinciples ofCBA

Discounted PV of benefits > Disc PV

of costs

Time Value ofMoney

Involve a

With vs WithoutComparison

Common Unit of Measurement

Avoid DoubleCounting of

Benefits or Costs

Cost

Benefit

Analysis

MONEY ($ or )

Decision Criteria for

Projects


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1. There must be a common unit of measurement.

(The most convenient common unit is money. )

2. Time value of money needs to be considered.A dollar available five years from now is not as good as a dollar available now. This isbecause a dollar available now can be invested and earn interest for five years andwould be worth more than a dollar in five years.

If the interest rate is r then a dollar invested for t years will grow to be (1+r)t. Thereforethe amount of money that would have to be deposited now so that it would grow to beone dollar t years in the future is (1+r)-t.

This called the discounted value or present value of a dollar available t years in the

future.When the dollar value of benefits at some time in the future is multiplied by the discounted valueof one dollar at that time in the future the result is discounted present value of that benefit of theproject. The same thing applies to costs.

The net benefit of the projects is just the sum of the present value of the benefits less the presentvalue of the costs.

Principles ofCBAPrinciples ofCBA


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Principles of CBAPrinciples of CBA

3.The analysis of a project should involve a with versus withoutcomparison.

4.Double counting of benefits or costs must be avoided.

5. Involves a particular study area

6.Decision Criteria for Projects:If the discounted present value of the benefits exceeds the discounted presentvalue of the costs then the project is worthwhile. This is equivalent to thecondition that the net benefit must be positive. Another equivalent conditionis that the ratio of the present value of the benefits to the present value of thecosts must be greater than one.

If there are more than one mutually exclusive projects that have positive netpresent value then there has to be further analysis. From the set of mutuallyexclusive projects the one that should be selected is the one with the highestnet present value.


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WithWith--andand--Without ApproachWithout Approach

To build a dam

Scarce land, labor & capital

if combined can increase

production of food

(opportunity cost of building

the dam)

opportunity cost of

not building the

dam is the amount

of energy that can

be produced by the

dam

if the with path is chosen

additional electricity valued

by consumers at X

will be available

if the without path is

chosen extra food

valued at Y will be

available.


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Steps in Construction ofCBASteps in Construction ofCBA

A comprehensive cost-benefit analysis consists of:

Specification of objectives and constraints

I

dentification of all the factors (favorable andunfavorable) which can flow into community

because of that project

Financial valuation of costs and benefits

Decide on best alternative


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Specify ObjectivesSpecify Objectives

Objectives are often easy to state in general terms butare difficult to quantify

Ex. To improve mass transit services

Do we just want to move a given number of people in lesstime?

What kind of services should we offer? What aboutpassenger comfort?

Will the project impose environmental costs or reduce

them?

The constraint structure will help identify feasiblepreliminary planning objectives


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Costs - intended or unintended negative

effectsof a project

Direct

Indirect

Identify Factors which can flowIdentify Factors which can flow

into communityinto community


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Classification ofCostsClassification ofCosts

Direct Costs directly associated with the project or

activity

Research and planning outlays

Initial capital outlay

Maintenance and operation expenses over the projects

life

Implicit costs are difficult to estimate

Ex. Cost of using land use opportunity cost approach

-> ascertain its present value in its next best use


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Classification ofCostClassification ofCost

Indirect Costs external or 3rd party costs;

generally related to externalities

Externalities - welfare changes in societyattributable to the project, for which the

project does not pay or receive financial

compensation.

favorable (positive externalities)

detrimental (negative externalities)


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Project External Effect Classification

Immunization

program against

a transmittable

disease

individual not being able to spread the

disease to others

reduces absenteeism and creates a

better quality of life and higher living

standards

Positive

Positive

Construction of

subways

disruption of traffic and business activity

employment generation

Negative

Positive


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Benefits - intended or unintended positive

effects of a project.

Direct benefits obtained by the users of the

project or activity

Indirect benefits similar to indirect costs, related

to externalities



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A valuation of benefits of non-market nature

and in-tangible benefits should be based on

one from three possible methods: direct valuation,

indirect market value

social values

Financial valuation of costsFinancial valuation of costs

and benefitsand benefits


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Discounting

If costs and benefits occur over time, it will benecessary to discount the value of such stream usingsocial rate of discount(lowerthan thatused byprivate sector)

Results can be sensitive to the discount rate chosen

Conduct a sensitivity analysis to see how sensitivethe results are to changes in assumptions about thediscount rate, costs, and benefits




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Net Present Value or Internal Rate of Return

most commonly used decision criteria of CBA.

Less used is the Benefit-Cost Ratio (BCR). They are used equally for financial and economic

CBA.




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Net Present Value (NPV)

The sum of all discounted costs and benefits.

This sum reflects how much the project willearn.

If the NPV is negative, clearly the costsoutweigh the benefits and the project is not

economically feasible. Project are selected if NPV>=0


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Internal Rate of Return (IRR)

rate with which the discounted costs equal

the discounted benefits, that is it would bejust break-even at that particular rate

if the IRR is higher, the project would be

profitable


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Benefit-cost ratio (BCR)

while NPV is the difference between all costs and

benefits, the BCR is the ratioof (discounted) costs

and benefits

For a project to be selected, the BCR should

exceed 1


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The choice is between the status quo and theproject. A project with positive net benefit is animprovement on the status quo.

Example The government is considering building a dam along a

major river in Luzon. There are 6 possible dam plans,including the option of not building.

The one with the maximum net benefit should beselected. If all dam plans imply negative net benefits, notbuilding the dam delivers the highest net benefit: zero.




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A program should be undertaken if, and only if,

N

SB = TSB TSC > 0where:

NSB = Netsocial benefits

TSB = Totalsocial benefits

TSC = Totalsocial costs

Decision CriteriaDecision Criteria


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Sample CaseSample Case

Ferry (status quo)

5 million trips annually at

$2 per trip

Average cost per trip is $1,

profit per trip is $1

Proposed Bridge

Construction Cost $85M

Annual operating and

maintenance cost $5M

Toll-free

10M estimated commuting

trips per year

Assumed discount rate = 4%

Project: Construction of a harbor bridge to connect to an

island


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CBA of Building a BridgeCBA of Building a Bridge

0

1

2

3

4

5 10

Trip Demand P = 4-.4Q

Millions of trips

Price per trip

Average cost

per trip

$


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Alternative Affected Groups Annual Flow Net Present

Value*

Ferry

(status quo)

Ferry Operators

Ferry Commuters

$5.0

$5.0 (consumer surplus)

$125 M

$125 M

TotalNet Benefit $10.0 $250 M

Bridge Ferry Operator

Bridge Commuters

Taxpayers

$0(profit)

$20 (consumer surplus)

-$5.0 (maintenance cost)

(capital cost)

$0

$500 M

-$125 M

-$85 M

TotalNet Benefit $ 290 M


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0

1

2

3

4

5 10


Millions of trips

Price per trip

Average cost

per trip

Consumersurplus-ferry

Ferrys profit

$ 5M

$


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Explanation on FerryExplanation on Ferry

Ferrys annual profit: (P 2.0-AC 1.0)(5M trips)=$ 5M

Commuters benefit=consumer surplus

Consumer surplus is the difference between whatconsumers are willing to pay and the actual price charged

Triangular Area between the demand curve and price line

(1/2) (5M trips) (4.0-2.0)=$ 5M

present value = $5M/4% = $ 125M


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0

1

2

3

4

5 10


Millions of trips

Price per trip

Average cost

per trip

Consumer

surplus-bridge

$20M

$


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Explanation on BridgeExplanation on Bridge

Last two are burden to taxpayers; they must foot the

bill for construction and maintenance costs

Because it is toll-free, the bridge generates no

revenue

Consumer surplus = (1/2)(10M trips)($4)=$ 20M


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Alternative Affected Groups Annual Flow Net Present

Value

Ferry

(status quo)

Ferry Operator

Ferry Commuters

$5.0

$5.0 (consumer surplus)

$125 M

$125 M

TotalNet Benefit $10.0 $250 M

Bridge Ferry Operator

Bridge Commuters

Taxpayers

$0(profit)

$20 (consumer surplus)

-$5.0 (maintenance cost)

(capital cost)

$0

$500 M

-$125 M

-$85 M

TotalNet Benefit $ 290 M

The bridge should be built because its projected net benefit

exceeds that of the current ferry operation


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Decision CriteriaDecision Criteria


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Sample Case 2Sample Case 2

Should this project be approved? Someone unfamiliar with discounting would say yes,

because after an initial investment of $ 500 the project earns a total of $ 650. Ifdiscounting is omitted, however, the principle of incremental analysis is ignored,

particularly the time value of money.


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To obtain the net present value (NPV), all future cash flows are discounted to year 0. Using

discount tables (or using calculators) with a 10% interest rate, the discounted or present

values are obtained.


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