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Cost-Benefit Analysis (CBA)

- Jule Dupuit
- A simple way of weighing up project costs and benefits
- A decision making device for evaluating activities that are not priced by the

CBA Tools

1. Payback Period (PP)

IC= Investment Cost
NACI = Net Annual Cash Inflow

*Even Cash Inflow

*Uneven Cash Inflow

PP=Last Negative Year+(-(Last Negative Return)/Cash Inflow)

2. Future Value (FV)

- The value of a current asset at a specified date in the future based on an
assumed rate of growth over time

Simple Interest Method

FV = I x (1+ (RxT))
I = Initial Investment
R = Interest Rate
T = Time

Compounded Interest Method

FV = I x ((1+R)T)
Excel Formula: fx=A1*((1+B1)^C1)

3. Present Value (PV)

PV = FV / ((1+R)T)
R = discount rate per period of time
Excel Formula: fx=A1/((1+B1)^C1)

4. Net Present Value (NPV)

SP = Sum of Present Value
IRR Internal rate of return (IRR)

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.

Internal rate of return (IRR) is a metric used in capital

budgeting measuring the profitability of potential investments.
Internal rate of return is a discount rate that makes the net
present value (NPV) of all cash flows from a
particular project equal to zero. IRR calculations rely on the same
formula as NPV does.

The following is the formula for calculating NPV:


Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

To calculate IRR using the formula, one would set NPV equal to
zero and solve for the discount rate r, which is here the IRR.
Because of the nature of the formula, however, IRR cannot be
calculated analytically, and must instead be calculated either
through trial-and-error or using software programmed to calculate
Generally speaking, the higher a project's internal rate of return,
the more desirable it is to undertake the project. IRR is uniform for
investments of varying types and, as such, IRR can be used to
rank multiple prospective projects a firm is considering on a
relatively even basis. Assuming the costs of investment are equal
among the various projects, the project with the highest IRR
would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR).

FIRR Financial Internal rate of return (FIRR)

EIRR Economic Internal rate of return (EIRR)

Payback Period

The payback period formula is used to determine the length of time it will take to
recoup the initial amount invested on a project or investment. The payback period
formula is used for quick calculations and is generally not considered an end-all
for evaluating whether to invest in a particular situation.

The result of the payback period formula will match how often the cash flows are
received. An example would be an initial outflow of $5,000 with $1,000 cash
inflows per month. This would result in a 5 month payback period. If the cash
inflows were paid annually, then the result would be 5 years.

At times, the cash flows will not be equal to one another. If $10,000 is the initial
investment and the cash flows are $1,000 at year one, $6,000 at year two, $3,000
at year three, and $5,000 at year four, the payback period would be three years as
the first three years are equal to the initial outflow.

Use of Payback Period Formula

There are a few drawbacks to the payback period formula that may warrant one to
consider using another method of determining whether to invest.
One issue is that the payback period formula does not look at the value of all
returns. Suppose a situation where there are two choices to choose from where
investment X has a payback period of 1 year and investment Y has a payback
period of 2 years. However, investment X will only return the initial investment
whereas investment Y will eventually pay double the initial investment. Given the
additional information not provided by the payback period formula, one may
consider investment Y to be preferable. The formula for the net present value
method may be used to close this information gap in order to properly evaluate the
best choice.
However, it is worth mentioning that although the net present value method may
be preferable to determine long term profitability, the payback period formula
helps with cash flow analysis for short term budgeting. Suppose a situation where
investment X has a net present value of 10% more than its initial investment and
investment Y has a net present value of triple its initial investment. At first glance,
investment Y may seem the reasonable choice, but suppose that the payback
period for investment X is 1 year and investment Y is 10 years. Investment Y
could cause problems if the investment is needed sooner. An analogy of this
would be like banks where maintaining cash flows of their investments(loans) is
vital to their business.
Another issue with the formula for period payback is that it does not factor in the
time value of money. The time value of money concept, as it applies to the
payback period formula, proposes that each future cash flow is worth less when
compared to today's value. The discounted payback period formula may be used
instead to consider the time value of money, however the discounted payback
period formula takes away the benefit of making quick calculations.

Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.

The formula to calculate payback period of a project depends on whether the cash flow per period
from the project is even or uneven. In case they are even, the formula to calculate payback period is:

Initial Investment
Payback Period =
Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and
then use the following formula for payback period:

Payback Period = A +

In the above formula,

A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A

Both of the above situations are applied in the following examples.

Decision Rule
Accept the project only if its payback period is LESS than the target payback period.

Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105 million. The project
is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.
Payback Period = Initial Investment Annual Cash Flow = $105M $25M = 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million and is
expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in
Year 4 and $22 million in Year 5. Calculate the payback value of the project.
(cash flows in millions) Cumulative
Cash Flow
Year Cash Flow
0 (50) (50)

1 10 (40)

2 13 (27)

3 16 (11)

4 19 8

5 22 30
Payback Period
= 3 + (|-$11M| $19M)
= 3 + ($11M $19M)
3 + 0.58
3.58 years

Advantages and Disadvantages

Advantages of payback period are:
1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life
are considered more uncertain, payback period provides an indication of how certain the project
cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that would return
money early.
Disadvantages of payback period are:
1. Payback period does not take into account the time value of money which is a serious drawback
since it can lead to wrong decisions. A variation of payback method that attempts to remove this
drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.
Future Value

Future Value (FV) is a formula used in finance to calculate the value of a cash flow
at a later date than originally received. This idea that an amount today is worth a
different amount than at a future time is based on the time value of money.
The time value of money is the concept that an amount received earlier is worth
more than if the same amount is received at a later time. For example, if one was
offered $100 today or $100 five years from now, the idea is that it is better to
receive this amount today. The opportunity cost for not having this amount in an
investment or savings is quantified using the future value formula. If one wanted to
determine what amount they would like to receive one year from now in lieu of
receiving $100 today, the individual would use the future value formula. See
example at the bottom of the page.
The future value formula also looks at the effect of compounding. Earning .5% per
month is not the same as earning 6% per year, assuming that the monthly
earnings are reinvested. As the months continue along, the next month's earnings
will make additional monies on the earnings from the prior months. For example, if
one earns interest of $40 in month one, the next month will earn interest on the
original balance plus the $40 from the previous month. This is known as
compound interest.
Use of Future Value
The future value formula is used in essentially all areas of finance. In many
circumstances, the future value formula is incorporated into other formulas. As
one example, an annuity in the form of regular deposits in an interest account
would be the sum of the future value of each deposit. Banking, investments,
corporate finance all may use the future value formula is some fashion.

Example of Future Value Formula

An individual would like to determine their ending balance after one year on an
account that earns .5% per month and is compounded monthly. The original
balance on the account is $1000. For this example, the original balance, which
can also be referred to as initial cash flow or present value, would be
$1000, r would be .005(.5%), and n would be 12 (months).
Putting this into the formula, we would have:

After solving, the ending balance after 12 months would be $1061.68.

As a side note, notice that 6% of $1000 is $60. The additional $1.68 earned in this
example is due to compounding.
Alternative Formula
The Future Value formula may also be shown as
Compound Interest

The compound interest formula calculates the amount of interest earned on an

account or investment where the amount earned is reinvested. By reinvesting the
amount earned, an investment will earn money based on the effect of
Compounding is the concept that any amount earned on an investment can be
reinvested to create additional earnings that would not be realized based on the
original principal, or original balance, alone. The interest on the original balance
alone would be called simple interest. The additional earnings plus simple interest
would equal the total amount earned from compound interest.
Rate and Period in Compound Interest Formula
The rate per period (r) and number of periods (n) in the compound interest
formula must match how often the account is compounded. For example, if an
account is compounded monthly, then one month would be one period. Likewise,
if the account is compounded daily, then one day would be one period and the
rate and number of periods would accommodate this.
Example of Compound Interest Formula
Suppose an account with an original balance of $1000 is earning 12% per year
and is compounded monthly. Due to being compounded monthly, the number of
periods for one year would be 12 and the rate would be 1% (per month). Putting
these variables into the compound interest formula would show

The second portion of the formula would be 1.12683 minus 1. By multiplying the
original principal by the second portion of the formula, the interest earned is
Simple Interest vs. Compound Interest
Using the prior example, the simple interest would be calculated as principal times
rate times time. Given this, the interest earned would be $1000 times 1 year times
12%. After using this formula, the simple interest earned would be $120. Using
compound interest, the amount earned would be $126.83. The additional $6.83
earned would be due to the effect of compounding. If the account was
compounded daily, the amount earned would be higher.
Compound Interest Formula in Relation to APY
The compound interest formula contains the annual percentage yield formula of

This is due to the annual percentage yield calculating the effective rate on an
account, based on the effect of compounding. Using the prior example, the
effective rate would be 12.683%. The compound interest earned could be
determined by multiplying the principal balance by the effective rate.
Alternative Compound Interest Formula
The ending balance of an account with compound interest can be calculated
based on the following formula:

As with the other formula, the rate per period and number of periods must match
how often the account is compounded.
Using the prior example, this formula would return an ending balance of $1126.83.
Simple Interest

The simple interest formula is used to calculate the interest accrued on a loan or
savings account that has simple interest. The simple interest formula is fairly
simple to compute and to remember as principal times rate times time. An
example of a simple interest calculation would be a 3 year saving account at a
10% rate with an original balance of $1000. By inputting these variables into the
formula, $1000 times 10% times 3 years would be $300.
Simple interest is money earned or paid that does not have compounding.
Compounding is the effect of earning interest on the interest that was previously
earned. As shown in the previous example, no amount was earned on the interest
that was earned in prior years.
As with any financial formula, it is important that rate and time are appropriately
measured in relation to one another. If the time is in months, then the rate would
need to be the monthly rate and not the annual rate.
Ending Balance with Simple Interest Formula
The ending balance, or future value, of an account with simple interest can be
calculated using the following formula:

Using the prior example of a $1000 account with a 10% rate, after 3 years the
balance would be $1300. This can be determined by multiplying the $1000 original
balance times [1+(10%)(3)], or times 1.30.
Instead of using this alternative formula, the amount earned could be simply
added to the original balance to find the ending balance. Still using the prior
example, the calculation of the formula that is on the top of the page showed $300
of interest. By adding $300 to the original amount of $1000, the result would be
Present Value

Present Value (PV) is a formula used in Finance that calculates the

present day value of an amount that is received at a future date. The
premise of the equation is that there is "time value of money".
Time value of money is the concept that receiving something today is
worth more than receiving the same item at a future date. The
presumption is that it is preferable to receive $100 today than it is to
receive the same amount one year from today, but what if the choice is
between $100 present day or $106 a year from today? A formula is
needed to provide a quantifiable comparison between an amount today
and an amount at a future time, in terms of its present day value.
Use of Present Value Formula
The Present Value formula has a broad range of uses and may be
applied to various areas of finance including corporate finance, banking
finance, and investment finance. Apart from the various areas of finance
that present value analysis is used, the formula is also used as a
component of other financial formulas.
Example of Present Value Formula
An individual wishes to determine how much money she would need to
put into her money market account to have $100 one year today if she is
earning 5% interest on her account, simple interest.
The $100 she would like one year from present day denotes
the C1 portion of the formula, 5% would be r, and the number of periods
would simply be 1.
Putting this into the formula, we would have

When we solve for PV, she would need $95.24 today in order to reach
$100 one year from now at a rate of 5% simple interest.
Alternative Formula
The Present Value formula may sometimes be shown as
Net Present Value

Net Present Value(NPV) is a formula used to determine the present

value of an investment by the discounted sum of all cash flows received
from the project. The formula for the discounted sum of all cash flows
can be rewritten as

When a company or investor takes on a project or investment, it is

important to calculate an estimate of how profitable the project or
investment will be. In the formula, the -C0 is the initial investment, which
is a negative cash flow showing that money is going out as opposed to
coming in. Considering that the money going out is subtracted from the
discounted sum of cash flows coming in, the net present value would
need to be positive in order to be considered a valuable investment.

Example of Net Present Value

To provide an example of Net Present Value, consider company Shoes
For You's who is determining whether they should invest in a new
project. Shoes for You's will expect to invest $500,000 for the
development of their new product. The company estimates that the first
year cash flow will be $200,000, the second year cash flow will be
$300,000, and the third year cash flow to be $200,000. The expected
return of 10% is used as the discount rate.
The following table provides each year's cash flow and the present value
of each cash flow.
Year Cash Flow Present Value
0 -$500,000 -$500,000
1 $200,000 $181,818.18
2 $300,000 $247,933.88
3 $200,000 $150,262.96
Net Present Value = $80,015.02
The net present value of this example can be shown in the formula

When solving for the NPV of the formula, this new project would be
estimated to be a valuable venture.
Net Present Value, Benefit Cost
Ratio, and Present Value Ratio for
project assessment
Net Present Value (NPV)
As explained in the first lesson, Net Present Value (NPV) is the cumulative present worth of
positive and negative investment cash flow using a specified rate to handle the time value of money.
NPV = Present Worth Revenue or Saving @i* - Present Worth Costs @i*
NPV = Net Present Worth Positive and Negative Cash Flow @i*
NPV = Present Worth of All Cash Flows @i*
If the calculated NPV for a project is positive, then the project is satisfactory, and if NPV is
negative then the project is not satisfactory.
The following video, NPV function in Excel , explains how NPV can be calculated using
Microsoft Excel (8:04).

Click for the transcript of "NPV function in Excel " video.

In the video NPV and IRR in Excel 2010(link is external)(8:59) you can find another useful
video for calculating NPV using Excel NPV function. In this video cash flow is formatted in
the vertical direction (there is absolutely no difference between vertical and horizontal
formatting, using spreadsheet).
In the following video, IRR function in Excel, I'm explaining how to calculate the Rate of
Return for a given cash flow using Microsoft Excel IRR function (4:19).

Click for the transcript of "IRR function in Excel" video.

Example 3-6:
Please calculate the NPV for the following cash flow, considering minimum discount rate of
10% and 15%.

C=60,000 C=50,000 I=24,000 I=24,000 ... I=24,000

0 1 2 3 ... 10

C: Cost, I:Income
i* = 10%: NPV = -60,000 50,000*(P/F10%,1) + 24,000*(P/F10%,1)*(P/A10%,9) = 20,196.88 dollars
i* = 15%: NPV = -60,000 50,000*(P/F15%,1) + 24,000*(P/F15%,1)*(P/A15%,9) = - 3,897.38 dollars
If using spreadsheet, following method can be more convenient:
i* = 10%: NPV = -60,000 50,000*(P/F10%,1)+ 24,000*(P/F10%,2)+ 24,000*(P/F10%,3) + ...
+24,000*(P/F10%,10)= 20,196.88 dollars
i* = 15%: NPV = -60,000 50,000*(P/F15%,1)+ 24,000*(P/F15%,2) ++ 24,000*(P/F15%,3) + ...
+24,000*(P/F15%,10)= - 3,897.38 dollars
Figure 3-5 illustrates the calculation of the NPV function in Microsoft Excel. Please note that
in order to use the NPV function in Microsoft Excel, all costs have to be entered with
negative signs.

Figure 3-5:Calculating NPV in Microsoft Excel

Benefit Cost Ratio
Benefit Cost Ratio (B/C ratio) or Cost Benefit Ratio is another criteria for project investment
and is defined as present value of net positive cash flow divided by net negative cash flow
at i*.
Benefit Cost Ratio = PV of Net Positive Cash Flow/PV of Net Negative Cash Flow
Equation 3-1
For the project assessment:
If B/C >1 then project(s) is economically satisfactory
If B/C =1 then project(s) the economic breakeven of the project is similar to other projects
(with same discount rate or rate of return)
If B/C <1 then project(s) is not economically satisfactory
Present Value Ratio
Present Value Ratio (PVR) can also be used for economic assessment of project(s) and it
can be determined as net present value divided by net negative cash flow at i*.
Present Value Ratio (PVR) = NPV/PV of Net Negative Cash Flow
Equation 3-2
If PVR>0 then project(s) is economically satisfactory
If PVR=0 then project(s) is in an economic breakeven with other projects (with same
discount rate or rate of return)
If PVR<0 then project(s) is not economically satisfactory
Example 3-7
Calculate the B/C ratio and PVR for the cash flow in example 3-6.
i* = 10%:
B/C Ratio = 24,000*(P/F10%,1)*(P/A10%,9)/ [60,000 + 50,000*(P/F10%,1)] =1.19 project
iseconomicallysatisfactory at i* = 10%
PVR = NPV/[60,000 + 50,000*(P/F10%,1)] =0.19 project iseconomically satisfactoryat i* = 10%
i* = 15%:
B/C Ratio = 24,000*(P/F15%,1)*(P/A15%,9)/ [60,000 + 50,000*(P/F15%,1)] =0.96 project is not
economicallysatisfactory at i* = 15%
PVR = NPV/[60,000 + 50,000*(P/F15%,1)] = -0.04 project is not economicallysatisfactory ati* =
Cost-Benefit Analysis
Deciding, Quantitatively, Whether to Go Ahead
(Also known as CBA and Benefit-Cost Analysis)
Do the benefits justify the cost?
Imagine that you've recently taken on a new
project, and your people are struggling to keep up
with the increased workload.
You are therefore considering whether to hire a new team member.
Clearly, the benefits of hiring a new person need to significantly outweigh
the associated costs.
This is where Cost-Benefit Analysis is useful.
CBA is a quick and simple technique that you can use for non-critical
financial decisions. Where decisions are mission-critical, or large sums of
money are involved, other approaches such as use of Net Present
Values and Internal Rates of Return are often more appropriate.
About the Tool
Jules Dupuit, a French engineer and economist, introduced the concepts
behind CBA in the 1840s. It became popular in the 1950s as a simple way
of weighing up project costs and benefits, to determine whether to go
ahead with a project.
As its name suggests, Cost-Benefit Analysis involves adding up the
benefits of a course of action, and then comparing these with the costs
associated with it.
The results of the analysis are often expressed as a payback period this is
the time it takes for benefits to repay costs. Many people who use it look
for payback in less than a specific period for example, three years.
You can use the technique in a wide variety of situations. For example,
when you are:
Deciding whether to hire new team members.
Evaluating a new project or change initiative.
Determining the feasibility of a capital purchase.
However, bear in mind that it is best for making quick and simple financial
decisions. More robust approaches are commonly used for more complex,
business-critical or high cost decisions.
How to Use the Tool
Follow these steps to do a Cost-Benefit Analysis.
Step One: Brainstorm Costs and Benefits
First, take time to brainstorm all of the costs associated with the project, and
make a list of these. Then, do the same for all of the benefits of the project.
Can you think of any unexpected costs? And are there benefits that you may
not initially have anticipated?
When you come up with the costs and benefits, think about the lifetime of the
project. What are the costs and benefits likely to be over time?
Step Two: Assign a Monetary Value to the Costs
Costs include the costs of physical resources needed, as well as the cost of
the human effort involved in all phases of a project. Costs are often relatively
easy to estimate (compared with revenues).
It's important that you think about as many related costs as you can. For
example, what will any training cost? Will there be a decrease in productivity
while people are learning a new system or technology, and how much will this
Remember to think about costs that will continue to be incurred once the
project is finished. For example, consider whether you will need additional
staff, if your team will need ongoing training, or if you'll have increased
Step Three: Assign a Monetary Value to the Benefits
This step is less straightforward than step two! Firstly, it's often very difficult to
predict revenues accurately, especially for new products. Secondly, along with
the financial benefits that you anticipate, there are often intangible, or soft,
benefits that are important outcomes of the project.
For instance, what is the impact on the environment, employee satisfaction, or
health and safety? What is the monetary value of that impact?
As an example, is preserving an ancient monument worth $500,000, or is it
worth $5,000,000 because of its historical importance? Or, what is the value
of stress-free travel to work in the morning? Here, it's important to consult with
other stakeholders and decide how you'll value these intangible items.
Step Four: Compare Costs and Benefits
Finally, compare the value of your costs to the value of your benefits, and use
this analysis to decide your course of action.
To do this, calculate your total costs and your total benefits, and compare the
two values to determine whether your benefits outweigh your costs. At this
stage it's important to consider the payback time, to find out how long it will
take for you to reach the break even point the point in time at which the
benefits have just repaid the costs.
For simple examples, where the same benefits are received each period, you
can calculate the payback period by dividing the projected total cost of the
project by the projected total revenues:
Total cost / total revenue (or benefits) = length of time (payback period).
Custom Graphic Works has been operating for just over a year, and sales are
exceeding targets. Currently, two designers are working full-time, and the
owner is considering increasing capacity to meet demand. (This would involve
leasing more space and hiring two new designers.)
He decides to complete a Cost-Benefit Analysis to explore his choices.
Currently, the owner of the company has more work than he can cope with, and he
is outsourcing to other design firms at a cost of $50 an hour. The company
outsources an average of 100 hours of work each month.
He estimates that revenue will increase by 50 percent with increased capacity.
Per-person production will increase by 10 percent with more working space.
The analysis horizon is one year: that is, he expects benefits to accrue within the
Cost in First
Category Details

750 square feet available next door at

Lease $18 per square foot $13,500

Leasehold Knock out walls and reconfigure office

improvements space $15,000
Cost in First
Category Details

Salary, including benefits $75,000

Hire two more Recruitment costs $11,250
designers Orientation and training $3,000

Two additional Furniture and hardware $6,000

workstations Software licenses $1,000

Construction Two weeks at approximately $7,500

downtime revenue per week $15,000

Total $139,750

Benefit Within
12 Months

50 percent revenue increase $195,000

Paying in-house designers $15 an hour, versus $50 an hour

outsourcing (100 hours per month, on average: savings equals
$3,500 a month) $42,000

10 percent improved productivity per designer ($7,500 +

$3,750 = $11,250 revenue per week with a 10 percent increase
= $1,125/week) $58,500

Improved customer service and retention as a result of 100

percent in-house design $10,000

Total $305,500
He calculates the payback time as shown below:
$139,750 / $305,500 = 0.46 of a year, or approximately 5.5 months.

Inevitably, the estimates of the benefit are subjective, and there is a degree of
uncertainty associated with the anticipated revenue increase. Despite this, the
owner of Custom Graphic Works decides to go ahead with the expansion and
hiring, given the extent to which the benefits outweigh the costs within the first
Flaws of Cost-Benefit Analysis
Cost-Benefit Analysis struggles as an approach where a project has cash
flows that come in over a number of periods of time, particularly where returns
vary from period to period. In these cases, use Net Present Value (NPV)
and Internal Rate of Return (IRR) calculations together to evaluate the
project, rather than using Cost-Benefit Analysis. (These also have the
advantage of bringing "time value of money" into the calculation.)
Also, the revenue that will be generated by a project can be very hard to
predict, and the value that people place on intangible benefits can be very
subjective. This can often make the assessment of possible revenues
unreliable (this is a flaw in many approaches to financial evaluation). So, how
realistic and objective are the benefit values used?
Key Points
Cost-benefit analysis is a relatively straightforward tool for deciding
whether to pursue a project.
To use the tool, first list all the anticipated costs associated with the
project, and then estimate the benefits that you'll receive from it.
Where benefits are received over time, work out the time it will take for
the benefits to repay the costs.
You can carry out an analysis using only financial costs and benefits.
However, you may decide to include intangible items within the analysis.
As you must estimate a value for these items, this inevitably brings more
subjectivity into the process.