Chapter 7:

Framework of Analysis
I. Benefit - Cost Analysis
1. DEFINITION OF BENEFIT COST ANALYSIS
(BCA)

— BCA aims to identify and compare the benefits and costs of the
programs, policies, and projects (named projects) that increase or
decrease social welfare.

— Benefit-cost analysis (BCA) is a tool for helping to make public

decisions – what policies and programs to introduce – done from the
standpoint of society in general rather than from that of a single
profit - making firm.

— It incorporates the social valuation of all project-related inputs and

outputs, whether or not they are transacted in private markets.
 2. Goal

— Goal: Maximize total net benefits (=total benefits –

total costs)
— Some costs and benefits can be observed directly
from market data. Others will need to be inferred
from the data.
=> Major challenge for BCA: How to value non-
market costs and benefits
 3. When BCA is used?

— It is particularly useful when a choice has to be made

between several projects (selection) and when the
project involves a stream of benefits and costs over
more than one year.
— A BCA can be made before the project starts (ex-ante
BCA) or after completion of the project (ex-post
BCA); BCA that is carried out during a project (In
medias res BCA), Combination between ex-ante BCA
and ex-post BCA (Comparative BCA)
— A project's economic feasibility statement is usually
required; therefore, most CBAs are ex - ante.
 Projects – example

• Building a new airport,

• Building a bridge,
• Building a tunnel,
• A new motorway,
• A new highway,
• Hosting the SEA Games, Olympic, or
World Cup.
Example
• Consider a small village with a lake and a small local
community.
• There are scarce local labor opportunities, and the regulator
wants to support industries that create job opportunities,
maintaining the local life of its citizens.
Consider a case where the local cornerstone company is a
mining industry. The industry needs permission to dump
mineral waste into the lake to expand and create job
opportunities. à This cheap and easy solution benefits the
area's economic activity.
However, this would have future
consequences for the fishing industry and the
local ecosystem in the area
 What should the regulator do?

— Let an independent and neutral party, the analyst,

perform a cost-benefit analysis, comparing the
ü The economic benefits of establishing a local
industry
ü The future environmental damage to the ecosystem
and biodiversity
— The decision and consideration is a political task
4. Basic questions in BCA

¡What would happen if the project

were not implemented?

¡Ifthe project is implemented,

could this be done in different
ways?
 Example

— A proposed project involves the rehabilitation of a

road linking a regional town to the main capital.
— At present 1000 cars use this road daily.
— Three consultants were asked to estimate the
benefits of road improvement.
— After completing the project, they all agreed that
1400 cars would use the road daily. The
consultants give the following justifications for
their estimates:
 Example (cont)
— Consultant 1: the benefit is 400 because of the
increase in daily traffic.
— Consultant 2: the benefit is 100 because even if the
road is not rehabilitated, traffic will increase to 1300
because of autonomous economic growth in the
region, and drivers will still use the road, even when
it is in bad condition.
— Consultant 3: the benefit is 800 because, without the
project, traffic would decline to 600 cars daily
because few drivers are willing to use the road when it
continues to deteriorate further
 5. Benefit-Cost Analysis (BCA) vs.
Financial Analysis(FA)
— FA is concerned with how to fund a project over its
lifespan and measures the adequacy of current and
future funds and revenues to cover the cost of building,
operating, and maintaining the project.
— BCA attempts to capture all benefits and costs
accruing to society from a project or course of action,
regardless of which party realizes them or how they are
realized. Thus, BCA maximizes the net benefits to the
public by locating resources.
 Financial Analysis (FA)vs.
Benefit-Cost Analysis (BCA)
FA BCA

— Focuses mainly on — Focuses on the net benefit of

strict economic society.
returns. — Environmental valuation gives
— The implicit value put environmental impacts a
on nature is zero. monetary value
— If the financial benefits — A project is only judged efficient
of an action outweigh if the sum of its financial,
its costs, then FA economic, and environmental
considers it efficient. benefits outweighs its costs in
these areas.
 6. Types of projects

(+) Beneficial for the (+) Beneficial for the

investors investors
(+) Beneficial for the (-) Un-beneficial for the
society society
1 2
(-) Un-beneficial for the (-) Un-beneficial for the
investors investors
(+) Beneficial for the (-) Un-beneficial for the
society society
3 4
 Type 3

— CBA is especially important in

environmental projects because it focuses on
the value of the environment to society.
— The financial analysis is often unprofitable,
but the economic analysis is profitable.
 Example

— Conserving a forest without logging can be

unprofitable for the owner; the forest must be
maintained but does not generate direct revenues.
However, the benefits the forest enjoys – water
provision, tourism, wildlife, biodiversity, scenic
beauty, etc. - may outweigh the costs to society as a
whole.
— Similarly, maintaining soil fertility may not be
profitable for an individual or group of farms, but it
can benefit the whole community or area.
 7. Steps to benefit-cost analysis

— Specify clearly the project or program,

including its scale and the perspective of
the study
— Determine quantitatively the inputs and
outputs of the program.
— Estimate the social costs and benefits of
these inputs and outputs.
— Compare these costs and benefits.
 7.1 Specify the project or program, including its
scale and the perspective of the study

— The first step in any CBA is to define and

delineate the purpose of analysis or to
define the “project.”
— A project is an activity in which resources
are combined to achieve one or more goals.
— Resources can include labor, capital, know-
how, natural resources, etc.
 Scale and Perspective of a CBA Project or
Program

Physical project or Regulatory program

ü Physical project: involved direct public production such

as a dam, water treatment plant, land purchased for

preservation

ü Regulatory programs aim to enforce environmental laws

and regulations, such as pollution-control standards,

technological choices, and waste disposal practices.
 7.2 Determine quantitatively the inputs and
outputs of the program

— Describe all project inputs & outputs.

— It is important to distinguish between transfers of

resources due to substitution and the creation of new

resources.

— For example, jobs created by a project should normally

not be included as a benefit.

¢ Jobs created are a transfer of resources. The workers could have
been used elsewhere if the project had not been completed.
7.3 Estimate the social costs and benefits
of these inputs and outputs.
— Put values on input and output flows

— Measure cost and benefit in monetary terms.

— In many cases, benefits and costs are not directly

registered on markets.
 Planting a protection forest
§ Benefit:
ØReducing storm damage
ØGathering wood
Ø…
§ Cost
ØBuying seeds
ØImproving land
ØWage
 7.4 Compare these costs and benefits.

— Compute the net benefit (NB) of the project or

program.

— Sometimes, another criterion uses benefit-cost ratio

 8. Discounting and Choosing Projects

Need to concern two questions:

— What rule do we use if there is more than one way

to achieve a goal?
— Cost and benefit occur over more than one year, so
how can we calculate the cost and benefit?
 Discounting

— The value of US$ 100 now is not the same as US$

100 in one year ’s time=> This is called “time
preference”
— The rate of time preference, or discount rate, is often
equated to the interest rate.
— All costs and benefits are “brought back” to the
starting time using a discount rate.
 Discounting
Formula for discounting:
PV =𝒎/ (𝟏+𝒓) t
PV: Present value
m: the value in any time period
r: discount rate
t: the number of year involved
Ex: What is the present value of $1,000 in 10 years
from now if the discount rate is 5%
Present value = $1,000/(1 + 0.05)10 = $613.91
 What is the present value if
the discount rate is higher?

For example, r = 10%

PV = 1000/(1+0.1)10 = 385.55

àIf the discount rate is higher, the present value

would be lower.
à The higher the discount rate, the lower the present
value of any future value
 Future value

Formula for compounding

𝑭𝑽=𝒎( 𝟏+𝒓) 𝒕
FV: Future value
m: the value at present time
r: discount rate
t: the number of year involved
Ex: If we deposit $600 in bank today, what is exactly
value in next 10 years? If the discount rate is 5 %
— Future value = $600 (1 + 0.05)10 = $977.33
 9. Major Indicators

— Net Present Value (NPV)

— Benefit-Cost Ratio (BCR)
— Internal Rate of Return (IRR)
 NPV

— Net present Value (NPV) : is the difference between

the present value of cash inflows and the present
value of cash outflows over a period of time.

NPV > 0 : effective project

NPV≤ 0: ineffective project
 Using NPV to select the projects

- One project/one option: NPV >0

-- More than two projects/options: NPV
max
--- Projects with budget: Select NPV max
and satisfy the budget
 Advantages & Disadvantage
of NPV

Advantages Disadvantages

— Indicate how large of — Depend on r , which

NPV depends on the analyst
— Accurate number for — In the case of mutually
making decision exclusive projects with
different duration,
NPV can not be used.
 BCR

— The benefit-cost ratio BCR is similar to the NPV. The

NPV is the difference between all costs and benefits,
but the BCR is the ratio of (discounted) costs and
benefits.
— For a project to be selected, the BCR should exceed 1.

BCR > 1 : effective project

BCR ≤ 1: ineffective project
 Advantages & Disadvantage
of BCR

Advantages Disadvantages

— Accurate result of — Using BCR may choose

project’s effectiveness the project with low
— Can be used in case of
NPV
mutually exclusive — Depending on analyst
projects that are
expected in different
time periods
 Example

PV of PV of Net NPV of BCR

Capital Cash Project
Costs Flows

Project X 1,000 1,300 300 1.3

Project Y 8,000 9,400 1,400 1.175

Project Z 1,500 2,100 600 1.4

 IRR

— The Internal Rate of Return (IRR) is the rate at which the

discounted costs equal the discounted benefits; that is, it
would be just break-even at that particular rate.

• The IRR is the most popular profitability indicator

because it is a relative measure that allows a direct
comparison between investments and market interest rates
(yield).
 Decision rules

To determine whether a project is profitable:

— The net present value (NPV) should be positive;

— The benefit-cost ratio (BCR) should exceed 1

— The internal rate of return (IRR) should exceed

the interest rate.
 Assumptions

— Is it a reasonable project lifetime?

— Is the “correct” discount rate being applied?

The relationship among NPV, BCR and IRR

NPV BCR IRR

If >0 then >1 and >r
If<0 then <1 and<r
If=0 then =1 and=r
 Selection/Ranking rule
Selection/Ran NPV BCR IRR
king Rules
Independent Project

Unlimited Select all the Select all projects Select all project that
Investment projects that that have BCR >1 have IRR>r
Costs have NPV > 0 (Ranking
(Ranking unnecessary)
unnecessary)
Limited Not suitable for Ranking projects by Ranking projects by
Investment ranking projects using BCR always using IRR may lead
Cost gives the right to incorrect ranking
result
Substitute Projects
Unlimited Select a project Choosing the project Choosing the project
Investment that have by using the highest with a large IRR can
Cost highest NPV BCR may lead to lead to incorrect
incorrect result results
Discounting Critical Critical No relation
 Notes of CBA

vThe benefits and cost of the project are identified

and valued from the social perspectives
vAll costs and benefit are monetary
vBenefits and costs are discounted by a social
discount rate
vThe chosen projects are selected under the
principles of social net benefit maximization
 Problems with BCA

— 1. Identifying all costs and benefits

— 2. Valuing externalities (noise)

— 3. Valuing future costs/benefits today when

future interest rates are unknown
— 4. Innovation changes future costs/benefits
 Example 1
Cash flows of a 2-year project (Discount factor r=10%)

Year 0 1 2

Benefits 0 9 16

Operation Costs 13 2 1

Externality Costs 2 1 0.6

Should this project be approved?

 Example 2
r=12%

Cost/Benefit 0 1 2 3 4 5
Constructio 170 500 600 700 800 900
n cost 0
Externality 200 100 100 100 100 100
cost
Benefit 0 1100 1200 1300 1400 1500

1. NPV formula?
2. Does the investor want to proceed this project?
3. Do the policy makers want to implement this
project?
 Example 2
r=12%
— 1)

— 2) Investor doesn’t take externality cost into account

= 462.86 > 0

3) Policy makers take externality cost into account

500 500 500 500 500
!"# = −1900 + + + + +
1.12 1.12! 1.12! 1.12! 1.12!

= -97.61 <0
 II. Environmental Impact Analysis
1. General understanding

— The Environmental Impact Analysis (EIA) is

made to ensure that environmental aspects are
addressed and potential problems are foreseen
at the appropriate stage of project design.
— EIA should be envisaged as an integral part of
the planning process and initiated at the project
level from the start.
 Concept of Environmental Impact
Assessment (EIA)

o EIA of a socio-economic development activities (policies,

programs, projects,..) is to
-identify,
- analyze,
- and predict
the impacts in short-term and long-term that may have
during the implementation of such activities on natural
resources, environmental quality, human life
→ To propose measures to prevent, avoid or overcome the
negative impacts
 Main functions of EIA

— To Predict problems
— To find ways to avoid them
— To enhance positive effects
2. Major steps of EIA
Preliminary activities

Impact identification

Baseline study

Impact evaluation

Assessment

Documentation

Decision-making

Post audits
 Preliminary activities

— Selection of a coordinator for the EIA

— Collection of background information

— Undertaken as soon as a project has been identified

 Impact identification

— Broad analysis of the impacts of project activities

— Identifying those which are worthy of a detailed
study.
 Baseline study

— Collection of detailed information and data on the

condition of the project area prior to the project's
implementation.
 Impact evaluation

— Include the working-out of potential mitigation

measures.
— After define alternative project, complete this step to
get permit decision
 Assessment

— Combining environmental losses and gains with

economic costs and benefits
— Cost-benefit analysis should include environmental
impacts
 Documentation

— Stated and argued recommendations for immediate

action.
— Make a list of project alternative with comments on
the environmental and economic impacts of each.
 Decision-making

— Decision maker request further study if accept one of

the project alternatives.
 Post audits

— To be made to determine how close to reality the EIA

predictions were.