Cost Benefit Analysis Script
Cost Benefit Analysis Script
Labor costs, equipment rent and all costs of running a mining operation
Since you started with a million, and you made an extra Php 850,000, then you should do it right?
Well, NOT NECESSARILY - Just because you made money does not mean that it’s the best idea.
Slide 4
We need to compare this decision to others. The point of this analysis is to decide whether this project is a
good idea or not or what are other options/alternatives we can go with. Or at least compare it to doing
nothing. So let’s say you invest it in a bank at a 5% interest for 5 years. So after 5 years, it could be this
much money. It starts to look like the mining operation is a good idea.
You would just be looking at the money coming in and out of your firm. Now let’s look at a different
situation.
Let’s say you for the local government unit, and there is a deposit of copper in your area you can make
some money on. You have a million pesos to get started, what do you do? Just like earlier, you look
whether the mining project will be able to make money. However, you work for the government, you are
not concerned only for the government but with the welfare of everyone. So what else do we need to
consider? Which people are paying the costs, and who are getting the benefits? Will the project reduce
unemployment? Will it lose access to forest products? Will noise affect the municipality and the wildlife?
We also need to look into the future. Does the forest grow back? And how about the toxic products – will
this affect the existing water supply? How about the endemic species if any in the area? Are there any
other alternatives? – how about maintaining a conservation park instead? And how big is the analysis
going to be? Or how many people are we going to include? Is there another nearby municipality we need
to include in the analysis? Different projects may affect the entire world, especially when we start
including global warming.
Slide 6
Now let’s look at the players involved in a project, what are their incentives and how do they measure
costs and benefit?
PRIVATE FIRMS – range from Retailer, Restaurants, Forest Industry, Fishermen, Hotels, Power
Generators. They are most looking out for their own benefit and wanna see how much money they can
make. So their COSTS are… and they measure BENEFITS as…
BANK – deal in money. They pay interest to people to borrow their money and people pay interest to the
bank when people borrow their money. Just like the private firms, they are interested to lending their
money to individuals or firms that would give them the best returns.
Slide 7
GOVERNMENT – basically maintains order in a society, we pay them money to police us and maintain
justice and uphold the laws. Since private firms are concerned with themselves, if a factory pollutes the air
which hurts people or their property – this constitutes and EXTERNALITY. Pollution is an example of a
negative externality. An example of a positive externality is the conduct of Research and Development by
the company. SO here is where the government steps in. if an activity provides a negative externality the
government would tax or prevent the activity (implicitly say that the firm pays everyone for this activity)
if an activity provides a positive externality, the government would want to subsidize something
(implicitly say that everyone would pay for this activity).
Slide 8
With the private firm or a government, it is easy to see how they are gaining or losing, it is just a matter of
knowing whether a particular project make more or less money. But if we include all of society, we need a
different mindset. What happens in a society that can increase or decrease its wealth? What it comes
down to is does a project use more or less resources than it creates?
Slide 9
Slide 10
From a Societal Point-of-View, subsidies, taxes, levies, and financing do not increase or decrease resources
to society. Basically, transfer of money from government or when money is just changing hands, no actual
resource is being used up.
Slide 11
How about transfer of resources, when foresters sell lumber – the price of the product represents how
much people value the service and the product. The value of the sale represents the benefit to society,
meanwhile the cost is represented by the resources used in forestry operation (labor, machinery,
transport of trees). Moreover, if the forest is abundant with endemic wildlife prior to the forestry
operations, this will constitute a loss of benefits.
Further, we also need to take into account resources which may not be paid for or do not have a price, but
is valuable to the society. These are non-market goods. For example, a wetland may provide water
purification and flood control services but it’s loss is a loss of benefit to the society. These must be
considered in the economic analysis. So we will measure the wetland’s benefit to the society and compare
it against the new project’s benefit to the society to find the opportunity cost of taking down the wetland.
So we add all the economic costs and benefits and examine society as one unit to determine whether the
project increases/ decreases the total economic well-being of the society.
Slide 12
There are market distortions so that the price does not actually reflect the value of the good to society.
For example if a person owns all the diamonds in the world and he held back the supply to increase the
price, this now does not accurately represent the cost and benefits of the diamond to society. These
distortions does not actually reflect the value of the good to society. Economic analysis does not use the
market price (actual price) of goods, instead it uses Shadow Prices – it approximates the underlying cost
of producing the goods and how much consumers value them. When doing Cost Benefit Analysis, people
use a conversion factor for goods to change financial prices to shadow prices.
Slide 14
In 2000, a full tank of gas would cost you Php 1500.00, now Php 1500.00 could only go for half tank or
even less. A hundred years back, we traded products which we think was of equal value – a chicken for
3 heads of cabbage, or a sack of rice for a sack of corn. Today we use money in paying for the
equivalent value of a product. So a chicken in exchange for 500.00 and so on. The thing about money is
that it can be reproduced easily. And so for example when there is an increase in the supply of money,
they will buy more chicken, consumers will eventually compete for a limited supply of chicken,
resulting to an increase in the value or cost of the chicken. This will happen for all commodities, if
everyone has more money – this is INFLATION. The price of chicken will depend on how much people
want it, how hard its to produce, and how scarce it is. If the price changes because of this, we can say
that it is a change in the real value of the good.
But on a normal day, we don’t deal on the real price of a good, we deal with the nominal price of the
good – a price which includes inflation. Real price needs to be calculated.
Slide 15
Would you want Php 1,000.00 today or Php 1,000.00 in 2030? Of course, you would want it today,
because you can anything with it today, put it in a bank and gain interest for it or buy a guitar and gain
a profession out of it or gain enjoyment from it – an enjoyment which we would wait for 10 years if we
don’t get it today. Everyday into the future is another day we are uncertain we will be alive so we
prefer to have things today. There is an opportunity to do things with money goods and services
today, as well as an uncertainty and risk that we may not enjoy them in the future. There is greater
value in having things in the present than having them in the future. For our purposes, we are using
the real value of the money. Meaning a thousand pesos today buys the same things in the future. It’s
just that having money today let’s you do things which may increase its value in the future. Therefore
when comparing costs and benefits across time periods, we Discount the future. What is 1,000.00
gained in 10 years worth today? But before that let’s calculate how much 1,000.00 today is in 10
years?
So if I ask would you want to receive 1,000.00 today or 1,628.89 in the future, you should have no
preference because they’re basically the same. It’s not that the costs and benefits are less in the future,
but discounting the future is a decision making tool. We can use it to compare the costs and benefits of
different projects to find out which gives the greater payoffs when considering the time preference of
money and how money is valued in different times. Choosing the discount rate is then important in
this process.
Slide 17
So if you have money coming in from different sources with different interest rates for the same
project. If you have 70% coming from investors at a 16% interest rate and 30% from the bank at 5%.
So 12.7% is the discount rate to be used for the project.
When doing an Economic Analysis, we will look into the Economic Opportunity Cost of Capital – what
is the next best alternative use of these public funds.
The Economic Discount Rate is typically lower from the Financial Discount Rate. This is because the
government has more patience than individuals. The planning horizon accounts for more than a single
individual’s viewpoint. So the preference of consuming something in the present and the risk of not
being able to experience something in the future isn’t an important factor from a societal POV. More
weight can be put into the future and a lower discount rate may be used.
So when an individual sets up a conservation park with a fee, would expect higher returns and will
discount the future more because he expects to enjoy the benefits as soon as he can. Whereas the
government is more patient and discounts based on everyone’s ability to enjoy. Also the government
borrows money at lower interest rates than private citizens. And there is less pressure to gain
immediate benefits. In other words, the opportunity cost to public projects is lower so public projects
use lower discount rates. Also in areas where the situation is very unstable or there is political unrest,
a higher discount rate is used since we would want to enjoy immediate benefits. A risky investment
requires a higher discount rate.
Slide 18
Now let’s look at how to treat costs and benefits that happen in the past, projects with different useful
lives and problems in discounting.
Let’s say that there is a solar power plant already operating with the following cost benefit payoffs,
then we want to know if switching to a coal power plant is a better alternative. When conducting our
analysis we will not count anything that happened before YR 0, we are only concerned in changes that
happens in the future. Costs before now are SUNK COSTS – because we cant take them back. It is
because we are deciding on whether or not to switch to coal. We are only concerned on decisions we
make starting now, not with the past costs and benefits.
Now let’s compare project alternatives with different useful lives. For example we look at road
regravelling and concreting of road. When do the costs start and when to the benefits start? For a
paved road – there is the initial construction cost, there will be little or no maintenance in the
following year then costs for maintenance will accrue in the succeeding years. Benefits will start as
soon the roads will open. Now let’s compare these two alternatives, what we can do is just to repeat
the project two times over ten years.
Slide 19
Now let’s see how to apply discounting to determine a project’s feasibility. Let’s look at the Net
Present Value. If these are the total cash flows for your project.
Slide 20
We value gains and losses in the future less than we value gains and losses today.
Gains we got later in the project aren’t as important when we consider the opportunity cost of capital.
The initial cost isn’t discounted as they happen in the present. Whereas the benefits that accrue over
the life of the project are discounted more and more because they happen alter in the future. So in
general, as discount rate increases, the Net Present Value, decreases. The Discount rate is meant to
represent the opportunity cost of capital.
Slide 21
The most basic decision rule is to reject projects with Negative NPV and consider projects with NPV.
From these projects, which would you choose? Project B has the highest NPV. However, remember
that NPV only tells us of the net value and we will probably be working on a budget. We need to look
at the investment costs of these projects.
Slide 25
Another feasibility measure we will look at is the Payback Period. Let’s say we have a graph which
contains the cumulative net present value, not just a graph which contains the quantity of benefits or
costs each year. But a cumulative amount of money that went in and out of the project.