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  2. Cost-Benefit Analysis (CBA) CBA is one of the techniques used in project selection by analyzing the project costs and benefits with a view of determining whether or not the project is economically or socially or environmentally feasible or viable. Cost- benefit analysis is a technique that attempts to identify, quantify and compare the costs and benefits of a proposed project over a given time period in order to determine its acceptability or rejection.
  3. Cont’ In principal, a proposed project or investment activity is said to be economically feasible or viable or acceptable when the benefits out weigh the costs. The following are the steps, which are used in cost-benefit analysis (CBA) to determine whether a project or policy is worthwhile or feasible.
  4. Cont’ 1. Set the project targets or objectives in relation to the problem identified 2. Identify or propose a suitable project to address the problem or to achieve a set of objectives 3. Identify and define the problem and its root causes to be addressed 4. List some anticipated impacts or effects from the proposed project on the environment, different groups or segments of the society, on the economy and other stakeholders
  5. Cont’ 5. Collect information or data related to the proposed project using consultation, research, etc 6. Classify each effect/impact of the project as a benefit or a cost to the society, economy, regulated agents, environment and implementer of the project 7. Quantify the expected costs and benefits over the intended period of the project
  6. Cont’ 8. Identify the future costs and benefits and estimate their monetary values 9. Determine the life cycle of the project 10. Estimate when (time or year) the future benefits or costs will occur and identify which discounting rate or interest rate should be used in discounting the benefits or costs
  7. Cont’ 11. Discount (D) the quantified costs and benefits as a process of converting the future values (F) of the costs and benefits into their present values (P). This can be done using a discounting factor.  D=  t r  1 1 P=          t r F 1 1
  8. Cont’ Where P=Present value of benefits or costs F=Future value of benefits or costs r=Discount rate t= Number of years or time period within which a benefit or a cost occurs
  9. Cont’ 12. When there are many projects being compared, make relevant comparisons among all the projects by putting each on a cost-benefit matrix or scale in order to select one, which greatly outweigh the costs when using the various decision criteria or methods.
  10. Benefit-Cost Ratio (BCR or B/C)  BCR criterion/method gives the ration of the present value of benefits to the present value of costs. It is calculated by getting present value of benefits (PVB) divided by the initial investment (I). I.e BCR= I PVB
  11. Decision criterion based on BCR (B/C) 1. If B/C >1, the project is accepted since the value of benefits outweigh the value of costs 2. If B/C <1, the project should be rejected since the benefits are less than the costs 3. If the B/C =1, the situation is a marginal case or break- even point situation. This implies that B = C or NPV=0 (B-C=0).In this case the decision maker is indifferent or indecisive such that he may or not accept the implementation of the project.
  12. Cont’  NB: If there are more alternative projects whose BCRs are greater than 1, then, one with a higher benefit-cost value should be selected for implementation, ceteris paribus.
  13. Example Given initial investment of $100,000 Cost of capital (r), 12% Stream of benefits are given below Year cash inflow 1 25,000 2 40,000 3 40,000 4 50,000 Required: Calculate the BCR
  14. Solution Solution Year Cash flows Discount factor (  t r  1 1 (12%) Present value (PV) 0 100,000 1 (100,000) 1 25,000 0.8928571 22321.43 2 40,000 0.7971939 31887.76 3 40,000 0.7117802 28471.21 4 50,000 0.6355181 31775.90 PVB= 114456.3
  15. Cont’ BCR= I PVB = 100000 3 . 114456 =1.14.
  16. Cont’  Since BCR is greater than 1, the project is feasible or acceptable. NB. You can also compute the Net Benefit Cost Ratio (NBCR), which is the present value of benefits to the initial investment, minus one (1). I.e.
  17. Continue NBCR = 1  I PVB Using the above example, NBCR=1.45-1=0.145 Since the NBCR is greater than 0,the project is acceptable as being worthy. NB: If NBCR is 0 (Zero), decision maker is indifferent. If NBCR is less than zero, the project should be rejected.
  18. Limitations of Benefit-Cost Analysis 1. It ignores the income distribution effects because it does not consider the issue of actual distribution of gains and losses of the project under consideration 2. It helps decision makers to choose between different methods of achieving particular objectives but not to choose between the different objectives
  19. Cont’ 3. Cost-benefit analysis ignores the problem of opportunity cost that should be part of total cost of the project 4. The assumed discount rate (arbitrary discount rate) for discounting the future costs and benefits to their present values is difficult to determine, as it may be too large or small. 5. It is calculated based on data and sometimes data may not be available
  20. BENEFIT-COST ANALYSIS FOR SOCIAL DEVELOPMENT PROJECTS Allocation of Resources in the public sector In the market, resources are allocated through the interaction of demand and supply. Prices are the signals which coordinate the wishes of consumers with the cost of supplying goods.
  21. Cont’  But market signals may be either non-existent or defective. This applies particularly to many of the goods supplied by the government, such as roads, bridges, airports, parks, education, health services, new urban areas and housing. Such goods are provided free or at less than cost.
  22. The nature of CBA  CBA is the technique which seeks to bring greater objectivity into decision-making. It does this by identifying all the relevant benefits and costs of a particular scheme and quantifying them in money terms. This allows all the benefits and costs to be aggregated, as it were, in the form of a balance sheet upon which the ultimate
  23. Cont’ decision can be made. E.g. the benefits of a new motorway would obviously include the time saved in travel, fuel economies, reduced congestion in towns through which motor traffic formerly passed, fewer road accidents and the pleasure derived by the extra motorists who could now make day trips. Against this, however, would have
  24. Cont’ to set the cost of constructing the motorway, the additional noise suffered by nearby residents, the congestion on the feeder roads, the toll of animal life, etc. There are some methods used to quantify some of the non- marketed items although these methods are still not accurate. These include:
  25. Cont’ 1. Revealed preference method. The valuation of benefits and costs should reflect preferences revealed by choices which have been made. For example, improvements in transportation frequently involve saving time. The question is how to measure the money value of that time saved? The value should not be merely what transportation planners think time should be worth or even what people say their time is worth. The value of time should be that which the public reveals their time is worth through choices involving tradeoffs between time and money.
  26. Cont’  If people have a choice of parking close to their destination for a fee of 500 shillings or parking farther away and spending 10 minutes more walking and they always choose to spend the money and save the time and effort then they have revealed that their time is more valuable to them than 50 shillings per minute. If they were indifferent between the two choices they would have revealed that the value of their time to them was exactly 50 shillings per minute.
  27. Cont’ If all the listed benefits and costs are quantified through this method, then benefit-cost ratio can be computed to determine the worthiness of the project. 2. Contingent valuation method (CVM). It is basically used to estimate economic values for all kinds of ecosystem and environmental services. CVM involves directly asking people in a survey, how much they would be willing to pay for specific social or environmental services.
  28. Cont’ It is called “contingent” valuation because people are asked to state their willingness to pay, contingent on a specific hypothetical scenario. The CVM is preferred to as a “stated preference” method because it asks people to directly state their values, rather than inferring values from the actual choices as the “revealed preference” methods do.
  29. Cont’ The fact that CVM is based on what people say they would do, as opposed to what people are observed to do, is the source of its greatest strengths and its weaknesses. However, applying the CVM is generally a complicated, lengthy, and expensive process. In order to collect useful data and provide useful results, the CV survey must be properly
  30. Cont’ designed, pre-tested, and implemented. CV survey questions must focus on specific social or environmental services and specific context that is clearly defined and understood by survey respondents. The result of CV surveys are often highly sensitive to what people believe they are being asked to value, as well as the context that is described in the survey.
  31. Cont’ Thus, it is essential for CV researchers to clearly define the services and the context, and demonstrate that respondents are actually stating their values for these services when they answer the valuation questions. Limitations of CVM  There is considerable controversy over whether it adequately measures peoples willingness to pay for social services or environmental quality.
  32. Cont’  Information bias may arise whenever respondents are forced to value attributes with which they have little or no experience.  Many people including jurist policy-makers, economists and others, do not believe in the results of CVM.
  33. Cont’ Therefore, in giving both theoretical and practical valuation of social developmental projects a lot of difficulties are always met.  There is likely to be some form of income redistribution. For the construction of the road for example those who suffer from
  34. Cont’ the noise of the traffic on the by-pass, lose; the motorists and lorry drivers who save traveling time gain. Only if the losers can be fully compensated by the gainers can be satisfied that there has been no loss of satisfaction. But can we identify all those who are adversely affected by noise, and the extent of the noise on them? This difficulty of identification occurs frequently.
  35. Cont’  Since there is no charge for the use of the road,it is not possible to value the benefits to be received. Much as the number of motorists to use the road are likely to be estimated,it is not possible to value the journey each makes, since some are traveling on business and others on leisure. Similarly with the reduction in accidents; we can estimate the saving to the hospital service, in police time, etc, but it is hard to value the physical sufferings that are avoided. The road may result in fewer deaths,
  36. Cont’ but is not possible to put a price on saving of human life. Similarly problems arise in valuing such intangibles as noise, traffic congestion and the toll of animal life.It may be possible to obtain a price by analogy, e.g. the fall in the value of houses resulting from the noise, and the life- span earning-power of people dying in accidents, but no such calculation can be completely satisfactory.
  37. Cont’  Therefore while social factors can be identified, it is almost difficult to to apply CBA and therefore computing benefit cost ratio becomes difficult. Revision questions 1. Government has a plan of providing either a school or a health center in one of the remote areas of Uganda and yet these projects are mutually exclusive, meaning that by implementing one another one is foregone due scarcity of resources.
  38. Cont’ Using the cost benefit analysis, highlight the procedure that should be taken to choose the project that worthy undertaking. 2. Salama publishing co. wishes to invest in newer models of printing machines. They are unsure whether to make the U$ 15,000 investment on model A or B. Given that the cost of capital is 12% p.a. Using benefit cost ratio, determine which of the two models is worthwhile?
  39. Cont’ Year 1 2 3 4 Model A 8000 6800 4000 3500 Model B 6000 6000 6000 6000