Benefit Cost Analysis

The analysis of the benefits vis-a-vis costs is a very important component of any project appraisal and implementation process. It is therefore imperative that before the implementation of the project is under way, some formative evaluative process is undertaken to ascertain the project’s viability. Private Cost Benefits Analysis The cost benefit analysis of a proposed project plays a central role in the likelihood of its viability and sustainability. The development and appraisal of any project will take into considerations the cash flows of the proposed project.

The lifespan of a project guides the projects planning horizons and has to be specified from the formative stages. This will guide the development of the cash flows that will guide the implementation process of the project. Ideally, the vitality of any project will vary substantially from one to another. In infrastructural development, for example, a substantive amount of money will go towards initial investment and a relatively small amount will go towards maintenance costs. Inherently the benefits of any investment will mainly include the value of the output of the project.

However, not all projects will lead to cash outlays or cash receipts. Rather, the benefit may simply be public good. Similarly, it need be appreciated that while inflation would affect some cost of the project it is assumed that it will equally affect the benefits and therefore leaves the effects counterbalanced between the benefits and the costs. To evaluate the project, the performance of the project is normally looked at in retrospect. The analysis is undertaken through the consideration of the internal rate of return (IRR).

The prices of the various components of the project would be subjected to deflator constructed from the consumer price index or the gross domestic product. This analysis offers a more all inclusive approach as it inculcates numerous components of the economy in the analysis of the benefits and the costs. As an investment project accrues benefits, it need be observed that there are components of the project that will be declining in value. The value of land, machinery, plant and building will tend to depreciate resulting from tear and wear.

This expenditure items will appear as negatives in the cash flows and therefore should be treated as expenditures. In additions some investment such as mining and nuclear plants would be very expensive to close down; inherently they will take the form of negatives in the cash flows. Similarly, it ought to be appreciated that the investment costs would only be put in the cash flow during the year for which they were incurred. This would assist in the process of the preparing of the profit and loss account of the project.

Depreciation will always be treated as a purely bookkeeping device though it ideally implies setting aside some money that is meant to be invested in the project at a later date. The depreciation would be calculated based on the straight line method or the reducing balance method. In the process of project implementation, the implementing agency need to maintain some amount of money that will keep the project running through its lifespan. This amount will be treated as an investment cost or a negative function in the cash flow.

If the projected working capital at the beginning of the year is more than what is realized at the end of the year then the discrepancy will always be treated as an inflow. This is in most cases witnessed during the final year. The project would also have just borrowed some money from external sources; interest charged on this loan would not however, be treated as a cash flow cost. Though, in calculating the profitability of the project, the interest on the loan would be treated as a project cost. Presumably, this is a central idea of private appraisal.

In any project they are the cash flows that are largely used in the analysis of the benefit cost analysis. However, it is of essence appreciating the fact that the calculation of the benefit costs should be considered regardless of the financing terms. Ideally, this avoids the situation where the conditions of the financing tend to dictate the nature of the project. In retrospect, the method of valuation of profitability, whether IRR or NPV are only meant to indicate the opportunity cost of the project relative to alternatives.

Inherently, any analysis of the project would be purely based on the project’s overall project cash flow without considerations to the financing arrangement. However, this is not indicative of the fact that the projects ignore the debt financing. The project would have two central financing sources that would definitely be captured in the cash inflows and out flows. The financing inflows would include the loans or the owners’ funds taking the form of shares and equity. The total inflows and outflows should always correspond with the inflows and the outflow of the benefits and cost of the project over its entire life.

In deriving the net cash flow, it implies that the taxes on profits need to be taken into consideration. Besides, it need be appreciated that the tax laws may differ from one country to the next. Subsequently, once the appropriate tax rate is deduced, it can be applied to the tax due cash flow. Losses will always be treated with some compensation aspect. Principally the losses incurred in one financial year would be covered in the next financial year. To assess the attractiveness of the project, the private analysis will be undertaken from a private point.

The private IRR will be compared with the expected rate of returns on the investment or it could still be done by the use of the net present value of the project. The rate of discount ought to be broad enough to include such estimates as are appropriate. Where there is the least need for inflating the benefits or the costs, then the real rate of interest would be adopted for calculations. The reason for the use of a range of discount would range from, the lack of knowledge on the rate of return on equity, to some feasible reason for why a shadow price would be adopted.

In addition, this would be precipitated by the need to assess the sensitivity of the NPV to choice of a discounting rate. The application of private benefit cost analysis therefore becomes a core function of the project evaluation process. Once proper calculations have been undertaken it is possible to rate the performance of a project. Reference Campbell H F. , Brown R P S. , (2003) Benefit-cost analysis: financial and economic appraisal using spreadsheets, Cambridge University Press, Cambridge, p 60-90