Cost & Benefits Analysis

(Measuring Economic Impact)

What are economic impacts? (EDRP, 1997)

► Are effects on the level of economic activity in a

given area.
► Personal income, wealth, value added, business
outputs, employment generation, etc.
► Any of those measures are indicators of improvement of
the well-being of the community people.
How should economic impact be measured?

► Public information study

- aimed at representing the economic
impacts of an existing activity or planned
project.
- the number of additional jobs created is
the most popular benefit measure.
- aggregate peso measures of business
sales and wage income created as a result of
the project
Benefit/Cost Analysis

► Benefit/Cost (B/C) analysis

- aimed at aiding decision-making by
comparing the benefits to the costs of
implementing an existing or planned
project/program
- comparison of the net economic benefit
to the area with the net cost. Economic
benefit is usually expressed as either
personal income or value added.
-Property value changes can be another
measure of economic benefits
How should economic impact be
measured? Continued…

► Retrospective research study

- requires that the benefit measure be
based on available historical data; most
frequently employment, business sales and
or property values.
 How should the study area for economic impact
analysis be defined?
Based on the following factors:
► Area of jurisdiction for the sponsoring agency
- agency responsible for project funding, project
spending and/or project evaluation.
►Area of direct project influence
-includes the area in which people (participants or
non-participants) are affected
►Interest in distributional impacts on a sub-area
- some projects are motivated by a desire to
assist the economic development for a specific sub-
area, and that may be deemed to be socially
desirable goal even if the net-impact of the project is
merely a redistribution of income and wealth.
 How should the study area for economic impact
analysis be defined?

►Interest in external area consequences

- What might be economically efficient from the
viewpoint of “self interest” for a small jurisdiction may
have consequences (favorable or unfavorable) for a
broader area. There may be public interest in the
equity of impacts on external areas.
 How is benefit/cost analysis applied?
►Return on Investment (ROI) – to evaluate the
efficiency of the investment or to compare the
efficiency of a number of investments

Gain of investment - Cost of investment

ROI = ------------------------------------------------------
Cost of investment
Net profit
ROI = ----------------------- x 100%
Total investment
 How is benefit/cost analysis applied?
►B/C analysis is primarily relevant as an aid for
decision-making. Applicable tests for this decision
making are:
● Feasibility – a project is feasible if there is the
money and technical resources to do it. It is
applicable if there is a desire to do the project
regardless of resource costs – a rare circumstances
● Cost effectiveness – is the ratio of cost per unit
desired results (e.g. cost per ton of emissions
reduction, or cost per person served).
- applicable when the benefit measure cannot be
reliably translated into money terms.
- usefully applied when there is a clear goal for
the desired level of benefit results.
How is benefit/cost analysis applied? Continued…

● Net Present Value (NPV)

Reflects the value of the project at the time of
decision-making
 Evaluate project by taking into account a time
preference for money
 Used a criterion for deciding if a single project
should be funded or is economical acceptable/profitable
A criterion in choosing among mutually exclusive
project
Used as an intermediate calculation in
determining project’s internal rate of return
How is benefit/cost analysis applied? Continued…

● Net Present Value (NPV)

n Bt n Ct
NPV = Σ -------- - Σ ---------
t=1 (1 + i)t t=1 (1 + i)t

Where:
NPV = net present value
Bt = benefits at time t
Ct = costs at time t
i = discount rate
n = number of years in the rotation period
t = time, Year 1 to n
How is benefit/cost analysis applied? Continued…
● Net Present Value (NPV)
The decision criteria are:
How is benefit/cost analysis applied? Continued…

● Benefit/Cost Ratio
Amount of present value revenue per unit of
present value cost by dividing the sum of discounted
revenues by the sum of the discounted cost
 For agencies with constrained funding sources,
the B/C test is the preferred basis for decision-making
among alternatives.
 Desire threshold B/C for large new project is 1.5,
and 1.3 for incremental projects
How is benefit/cost analysis applied? Continued…
● Benefit Cost Ratio (BCR)
The formula is:
n Bt n Ct
BCR = Σ -------- / Σ ---------
t=1 (1 + i)t t=1 (1 + i)t

Where:
BCR= benefit cost ratio
Bt = benefits at time t
Ct = costs at time t
i = discount rate
n = number of years in the rotation period
t = time, Year 1 to n
How is benefit/cost analysis applied? Continued…
● B/C Ratio
The decision criteria are:

B/C Ratio Value Efficiency

Less than 1 Project cost exceeds the
revenue; not economically
acceptable/efficient
More than 1 Project revenue exceeds
cost; economically
acceptable/efficient
Equals 1 Break-even result of project
investments
How is benefit/cost analysis applied? Continued…
● Internal Rate of Return
Measured by the rate the project actually earns
on money invested
 Like NPV, IRR is computed from the present
worth of gross incremental benefits and costs.
 Unlike NPV, IRR does not indicate the present
worth of the net incremental benefit
Rather, IRR is an efficiency measure, reflecting
the pay-off of the project in terms of the present return
on outlays
IRR is compared to opportunity costs to
determine if the amount of return on investment is
sufficiently high to justify the project
How is benefit/cost analysis applied? Continued…

● Internal Rate of Return

The efficiency rule is: a project with IRR higher
than the prevailing discount rate or interest rate is ought
to be financially/economically efficient
In comparing project alternative, the higher is the
IRR, the higher is that project alternative
How is benefit/cost analysis applied? Continued…
● Steps to Calculate IRR

1. Compute for NPV using a discount rate. If NPV is

(+) proceed to Step 2. If it is ( - ), choose a lower
discount rate and compute for the NPV again, repeating
this process until NPV becomes ( + ). Then proceed to
Step 2.
2. Compute for NPV using higher discount rate. If
NPV is ( - ), proceed to Step 3. If NPV is ( + ) use a
higher discount rate until NPV becomes ( - ).

So you have to say i1 with ( + ) NPV and i2 with (

- ) NPV. The IRR then lies between the two interest
rate.
How is benefit/cost analysis applied? Continued…
● Steps to Calculate IRR (continued)

3. Determine IRR through interpolation using any of

the formula below:

IRR = i+ - NPV+ i - - i+
NPV- - NPV+
Or

IRR = Lower + Difference NPV of lower rate

rate bet. two rates Sum of the NPVs of the
two rates, signs ignored
Sample problem

Calculate the NPV, B/C and IRR of the following

reforestation activities. Use the interest rate of 3% & 6%

Year Activity Cost (Php) Revenue (Php)

0 Plantation establishment 20,000
1 Herbicide & fertilizer 5,000
2 Pre commercial thinning 15,000
3 Commercial thinning & 25,000 60,000
fertilizer
5 Final Harvesting 50,000 180,000
Annual Administrative 500
Formula in Solving Annual Administrative Present
Value

t
AR (1 + I) -1
Vt = --------------------
t
i (1+i)

Vt = Present value of the annual payment

AR = Annuity rate
i = Discount rate
t = Time , total number of years
Answer
Year Present Value of Present Value of Benefits
Cost (P) (P)
i = 3% i = 6% i = 3% i = 6%
0 20,000 20,000
1 3,720.47 2,791.97
2 8,305.14 4,677.07
3 10,299.67 4,352.75 24,719.21 10,446.61
5 11,405.35 2,714.42 41,059.27 9,771.91
Annual Admin 12,864.88 7,880.93
(500)
TOTAL 66,595.51 42,417.14 65,778.48 20,218.52
i =3% i =6%
NPV -817.03 -22,198.62
B/C Ratio 0.99 0.48
IRR Cannot be computed because corresponding NPV
are both negative
Using i = 2%
Year Present Value of Present Value of
Cost (P) Benefits (P)
i = 3% i = 2% i = 3% i = 2%
0 20,000 20,000
10 3,720.47 4,101.74
20 8,305.14 10,094.57
30 10,299.67 13,801.77 24,719.21 33,124.25
50 11,405.35 18,576.39 41,059.27 66,875.02
Annual Admin 12,864.88 15,711.80
(500)
TOTAL 66,595.51 82,286.27 65,778.48 99,999.27
i =3% i =2%
NPV -817.03 17,713.00
B/C Ratio 0.99 1.22
IRR 0.029 = 3%
 Comparative income with vs. without project or
before vs. after the project
● Time series data
● Ask for the units, volume and weight of the products both
inputs and outputs, man-days for labor, etc., instead of the
amount or in money terms, before and after ; or with and
without the project
● Ask for the present local market prices of those commodities
and services. These will be used as multiplier to determine the
total costs and benefits of the two periods (before and after)
or with and without projects
●Solve for the net income (Costs – Benefits).
● Compare the net income of the two periods and solve for the %
increase or decrease
● You can also compare the significant difference of the income of
the two periods using statistical tool such as t-test.
Thank you…
Group Activity

Calculate the NPV, B/C and IRR of the following

reforestation activities. Use the interest rate of 2% & 3%

Year Activity Cost (Php) Revenue (Php)

0 Plantation establishment 20,000
10 Fertilizer Inputs 5,000
30 Commercial thinning & 25,000 80,000
fertilizer
50 Final Harvesting 50,000 200,000
Annual Administrative 600