ANNEX 1-3: GUIDELINES ON COST / BENEFIT ANALYSIS

The following paragraphs provide guidelines on how to perform a “simple” Cost/ Benefit Analysis by using the following case study of a virtual investment decision.

A Municipality owns a big parking space in the centre of the city with a capacity of 150 cars/day. The Municipality charges €3/day for each car that uses the parking and is almost full 365 days/year. The parking on the one hand is rather old and requires upgrade and on the other hand it cannot cover the increased parking needs of the citizens. For these reasons the Municipality considers to invest €1million in order to upgrade the existing parking facilities and increase the parking capacity to 250 cars/day by increasing also the charged fee to €4/day. After the investment the Municipality would have to pay every 5 years a once off amount of €30.000 to maintain the infrastructure.

It is noted that if the Municipality decides not to undertake the investment, it should at least perform (within the year) a basic renovation of the existing parking area (e.g. painting, signalisation, etc.) that will cost about €60.000 and an upgrade of the fire control system (in the next year) that will cost €80.000.

Examine the case and decide whether the Municipality should proceed with the investment or not.     

Case Study: Elaboration of Cost/ Benefit Analysis for an investment decision

Determining the lifetime of the investment/ project – Period of Analysis

To analyse the profitability of an investment we need to know the investment’s estimated lifetime which could range from a couple of weeks (e.g. the supply of printing consumables) until thirty years or more (e.g. the construction of water supply network). The period of analysis should extend to the useful life of the investment/ project. The useful life of an investment/ project will vary depending on what it is: for example buildings are likely to have a longer life than equipment. However, for some investments it is not possible to determine a finite asset life (e.g. waste treatment facilities, transport infrastructure). In such cases it is recommended to use an analysis period of 20 years, because impacts are usually insignificant beyond 20 years, if we take into account the time value of money (discounting).

What is very important and should be included in the analysis is the residual value of the project at the end of the analysis period. For example, the residual value of a car at the end of a 5years is the amount that the owner expects to be able to sell the car after 5 years. The recommended way to estimate residual value is to determine what similar, comparably aged property is currently selling for in commercial markets.

In our case we will use an analysis period of 10 years, which is a reasonable time period for such an investment decision. We could also use a 20years period, but for simplicity reasons (limiting the number of calculations) and demonstration purposes we chose a smaller period of analysis. 

The residual value of the investment will not be included in the analysis, since there is no liquidation at the end of the analysis period and consequently no real inflow of money. This means that regardless of the final decision, the Municipality will continue to exploit the parking area even after the 10 years and is not going to sell (liquidate) it.   

Identifying relevant Costs and Benefits

When attempting to identify all relevant costs and benefits, it is useful to constantly ask “Is the cost or benefit relevant and material to the analysis?”. If a proposed benefit or cost is outside the scope or its impact on the analysis is insignificant and is not capable to influence the final decision then it should be excluded.

Basic Categories of Relevant Costs

Basic Categories of Relevant Benefits

The basic assumption in the examined case is that opportunity costs, contingencies, externalities, as well as intangible costs and benefits will not be included in the analysis, since from the one hand it is very difficult to quantify them and on the other hand such an inclusion goes beyond the scope of this simplified approach for conducting CBA.

The costs and benefits associated with the decision of the Municipality not to upgrade and expand the parking area (Option 1) are the following:

Costs

Benefits

The costs and benefits associated with the decision of the Municipality to invest €1m in order to upgrade and expand the parking area (Option 2) are the following:

Costs

Benefits

Valuing/ estimating relevant Costs & Benefits

After the relevant costs and benefits have been identified, the next step is to assign monetary (€) values to them. The practical problem is that not all costs and benefits can be quantified and valued in Euro terms (as for example the environmental, social and health costs/benefits). When costs and benefits cannot be easily and reliably measured in monetary terms, they should be excluded from the quantitative analysis. However, these intangibles costs/ benefits may have an impact on the decision making process and the selection of the preferred option, so they should be analysed using qualitative and other techniques in order to be taken into account in the decision making process. 

In the specific case where it is not possible to assign monetary value to the major benefits of alternatives ways of producing the similar output/ benefit, it is suggested to use the Cost Effectiveness Analysis (CEA). The CEA is used to find the option that meets a predefined objective at a minimum cost.

Costs and benefits should be expressed in “constant prices” as opposed to “current prices” (i.e. prices at the time the goods or services are supplied). This means that inflation is excluded from the analysis because we are interested in costs and benefits in a common money value. What is generally recommended is to assume that the costs of a good or service will remain constant in real terms (i.e. before inflation) unless there is a reasonable expectance that its price will change relative to all other prices in the economy (e.g. high technology products for which prices are expected to fall in real terms, fuels for which supply is scarce or constrained, wages that are expected to increase faster than the inflation rate).

Costs and benefits should also be based upon “market prices”, unless market prices are not directly observable or easy to estimate as they are for example the social and environmental costs/ benefits. In such cases a preference testing approach should be followed in order to estimate the consumer’s willingness to pay for good or service or willingness to accept compensation to tolerate a negative economic outcome.

Cost and benefit estimation can be a very difficult task, depending on the case under consideration, and you are advised to seek the input from accountants, economists and other specialists depending on the case.

The basic assumption in the examined case is that all the identified costs will remain constant during the analysis period, so the impact of inflation is not taken into account.

Note: The values of costs and benefits are not real market prices but they are used for demonstration purposes only.   

The estimations for costs and benefits associated with Option 1 are the following:

Costs

Benefits

The estimations for costs and benefits associated with Option 2 are the following:

Costs

Benefits

Preparing the cashflows for the analysis period

Once the costs and benefits have been identified and estimated, you should be in a position to prepare the cashflows for the defined time period over which the proposed investment is being evaluated. The term cashflow is used to describe the amount of cash that flows in to (benefit) and out of (cost) the business during a specific period.

Usually, for evaluation periods over than four years it is better to use yearly flows, while for shorter time periods you could also use monthly flows. Qualitative costs or benefits, which can be estimated in monetary terms, they should be included in the analysis as any other cash flow.

In order to calculate the net cashflow for each period of the project (usually for each year) you first need to add all the cash inflows and outflows for this particular period in order to calculate the total cash inflow and total cash outflow respectively and then you should apply the following formula:

Net cashflows can be positive or negative numbers. A positive net cashflow indicates a profit for that given period (i.e. revenues/ benefits are higher than costs); while a negative cashflow indicates a loss (i.e. costs are higher than revenues/ benefits).

The forecasted cashflows of the two options for the analysis period of 10 years, as well as the calculated net cashflows for each option are presented in the next two tables.

Table 1: Net Cashflows of Option 1 (not to invest €1m)

Table 2: Net Cashflows of Option 2 (invest €1m)

Discounting of Cashflows to Present Values

Since cashflows usually occur at different points in time it is not appropriate to treat them as all having the same weight. For this reason the future cashflows should be discounted (given less weight) in order to be comparable with cashflows which occur sooner. The discounting technique is based on the concept that most people would prefer receiving a Euro today instead of receiving a Euro in a year’s time. This is known as time preference or the time value of money.

The discounting of cashflows to present values can be easily done using a relative function in an Excel spreadsheet. However, the discounting of a future value can also be performed manually by applying the following formula:

The discount rate is the rate at which future values are discounted to the present. It is considered roughly equal to the opportunity cost of capital. For example, €1 invested at an annual discount rate of 5% will be 1+ 5%= €1,05 after one year; (1,05) x (1,05)= €1,1025 after two years; (1,05) x (1,05) x (1,05)= €1,157625 after three years, etc. On the opposite, the discounted economic value of a Euro that will be spent or earned in two years is 1/1,1025= €0,907029; in three years 1/1,57625= €0,863838.

There is no single discount rate for every project. However, a reasonable discount rate to use in CBA for public investment projects is between 5% and 10%, depending on the type of the project under consideration and on any official guidelines (national or EU). Regardless of what discount rate is chosen, attention should be paid to remove the effect of inflation if cashflows are expressed in current prices.

In the demonstrated case, a discount rate of 6% is chosen (according to EU guidelines for financial analysis of public investment projects). Based on this rate, the discount factor for each year was calculated and then it was multiplied by the corresponding net cashflow to calculate the net discounted cashflow. The results of these calculations are presented in the following tables.

Table 3: Net Discounted Cashflows of Option 1 (not to invest €1m)

Table 4: Net Discounted Cashflows of Option 2 (invest €1m)

Calculation of Net Present Value (NPV) – Alternative evaluation methods for the selection of the preferred option

One of the traditional and preferred methods for the assessment of costs and benefits of an investment or a project is the calculation of the Net Present Value (NPV). The NPV is the sum of the discounted net cashflows over the analysis period. A positive NPV means that the investment or the project generates net benefit and it is generally viable and desirable.

When comparing several projects or alternative solutions, the one having the highest NPV is the one that typically should be chosen. However, in cases where many costs and benefits are intangible and difficult to quantify, the NPV should not be the only decision-making criterion. For example, a negative NPV does not necessarily imply that an investment or project proposal should be rejected, since there may be other important qualitative benefits (e.g. social or environmental benefits) which may outweigh the quantitative negative impacts. In order for the NPVs to be strictly comparable, the assessed proposals should have equal lives or appraisal periods and also same intangible costs and benefits. 

It should be noted that the NPV analysis is not the same as Cost/ Benefit Analysis. CBA is the wider process of proposals’ assessment and selection, whereas NPV analysis is just one tool which may be applied in CBA. 

Other alternative methods/ measures for evaluating investments/ projects, which can be used also in combination with NPV analysis, are the following:

However, there are cases in which the IRR method does not work. For example, there may be no discount rate that gives an NPV of zero or there may be more than one IRR or the investments/ projects may have different sizes. In the last case a project that has an NPV of €1.000.000 and an IRR of 16% should be considered preferable to a project with an NPV of €10.000 and an IRR of 20% even though it has a lower IRR, since the smaller project cannot be replicated many times in order to cover the gap with the large NPV.

However, the payback period is not the most important criterion when evaluating public invstments/ projects and should be used only as supplementary to other more trustworthy methods. Moreover, it has several drawbacks: a) Simple payback period (i.e. without using the discounted cashflows) does not take into account the time value of money, b) it ignores cash flows received after the end of the payback period and c) it is a measure of time and not a measure of value, i.e. it does not take into account the overall profitability of the project.

It should be noted that in order to overcome the drawback of simple payback period, which does not take into account the time value of money, you can use the Discounted Payback Period, which determines the number of years after which the cumulative net discounted cashflows exceed zero.

If the BC ratio is greater than one, which implies that NPV is greater than zero, then the project is cost effective. The higher the ratio is, the greater the benefits relative to the costs are. Note that simple benefit-cost ratio is insensitive to the magnitude of net benefits and therefore may favor projects with small costs and benefits over those with higher net benefits.

Using the expected cashflows from the tables 1-1, 1-2, 1-3 & 1-4, the NPV, IRR, Payback Period and BC ratio were calculated for each option and the results are presented below:

Option 1 (not to invest €1m)

Option 2 (invest €1m)

According to the criteria of NPV and BC ratio, the Municipality should select the second option, which is to invest €1million for upgrading the parking area and increasing its capacity, even if the first option has a higher IRR and a lower payback period. The reason that the Municipality cannot base its decision on the IRR or the payback period is deriving from the weaknesses of these two methods, which are described in the main text.  

After performing all the above tasks you are advised to perform a risk analysis in order to study the probability of a project to achieve a satisfying performance (in terms of IRR or NPV), as well as the variability of the result compared to the best estimate previously made. One of the most commonly used methods for doing this is the Sensitivity Analysis. The purpose of the sensitivity analysis is to select the “critical” variables and parameters of the CBA model, that is those whose variations, positive or negative, compared to the value used as the best estimate, cause the most significant changes on the IRR or the NPV. The criteria to be adopted for the choice of the critical variables vary according to the specific project and must be accurately evaluated case by case. As a general criterion it is recommended to consider those parameters for which a variation (positive or negative) of 1% gives rise to a corresponding variation of 1% in IRR or 5% in the base value of the NPV.

Sensitivity analysis can help draw attention to those factors that require especially careful assessment or management. This analysis can address two key questions:

The simplest form of sensitivity analysis is Scenario Analysis. The scenario analysis is about asking “what if” questions and recalculating the expected NPV or IRR for several scenarios. For example, what if one or more “critical” variables were changed by ±10% or ±50% or whatever is a realistic and possible variation. If, after running the various scenarios, the NPVs or IRRs do not alter significantly enough to affect the final decision, then it is possible to feel more comfortable about the robustness of the analysis and the net benefits of the proposal/ option.

In the demonstrated case, the critical variables of the CBA model are the operating costs and the revenues from the parking fees, since a slight variation on them affects significantly the values of NPV and IRR. Therefore, it is worth examining the model’s sensitivity against these parameters by running a few alternative scenarios. The results of the scenario analysis for both options are presented in the following table (Table 5).

The results showed that the first option is very sensitive to any variation of the critical parameters. More specifically, if the forecasted operating costs increase 5% or the expected revenues decrease 5%, the option of not to invest €1m appears to be financially unviable (negative NPV and IRR smaller than the discount rate). In addition, the analysis showed that even if we had made an optimistic estimation about the revenues (i.e. 2% increase), the first option would have given a lower NPV compared with the option to invest €1m and thus wouldn’t have been preferable neither at that case. On the contrary, the second option generates net benefit even if we run more conservative or pessimistic scenarios (i.e. increase of operating costs or decrease of revenues).

Therefore, the results of the performed analysis enable us to feel more confident about the use of the specific CBA model and thus about our initial decision to proceed with the second option (to invest €1m).      

Table 5: Scenario Analysis Results