7 BENEFITCOST ANALYSIS Part 1 7 1 Why

7. BENEFIT-COST ANALYSIS: Part 1

7. 1. Why B-C analysis ? Projects compete for limited economic resources must be selected which one the most efficient in using resources As a tool for evaluating if efficiency use of economic resources in projects Some efficient criteria (NPV, B/C, net B/C, PP, IRR, etc)

7. 2. Efficient if Benefit > Cost Projects Benefit Cost Net Benefit (B-C) Benefit / Cost Ranks of Choice A 30 15 15 2. 00 1 B 145 103 42 1. 41 2 C 200 180 20 1. 11 3

7. 2. Consequence of Limited Government Resources (1) q. Resources available for financing projects is limited. Consequently, even if all proposed projects are efficient, the government cannot financed all these proposed projects.

7. 2. Consequence of Limited Government Resources (2) �The government has to select which one that it can finance. This will require to rank the efficiency of the projects. If the government can only finance one of the three proposed above, the government has to pick project A as its has the highest rank of efficiency.

7. 3. Notes (1) q. A project generally last more than one year. It could last for 10, 15, 20 or even 25 years q. There will be flow of benefit and cost over the project q. Often, investors are confronted with some potential projects and these projects normally differ in terms of flow and magnitude of benefit and cost.

7. 3. Notes (2) q. In comparing economic efficiency of the proposed projects, value of time has to be integrated in benefit-cost analysis. q. Value of time in investment an illustration Ø Which one you prefer to receive Rp 1 million today or to receive the same sum of many one year later ?

7. 4. Future Value of Money q. How much would you value your present money in the future (n year later)? q Pn = Po (1 + i)n Pn = nilai uang masa datang Po = nilai uang sekarang i = tingkat bunga n = tahun

7. 5. A Case q Two choices: Ø Having a motor vehicle of Rp 10 million today or having one of Rp 11 million next year, where interest rate 10 % per annum q To make your choice, you need to count present value of each choice

7. 6. PRESENT VALUE OF MONEY q How much present value of Rp U that you will receive in the future (e. g. next year)? P 0 = U / ((1+i)n) Po = present value U = some of money will be received in the future i = interest rate n = number of year

7. 7. Calculation of Present Value of Money: An Example q You will receive Rp 100 million two year to come. How its present value if interest rate 10 % per annum? q Answer :

7. 8. Some Formulas Used in Project Evaluation q Formulas v Net Present Value (NPV) v Net Benefit-Cost Ratio (Net B/C) v Internal Rate of Return (IRR) q Feasibility v NPV > 0 v Net B/C > 1 v IRR > i (Note, i = market interest rate)

7. 9. Net Present Value q Formula NPV = q Explanation: NPV = net present value i = interest rate (% per annum) B = Benefit C = cost

7. 10. Task: Calculate NPV of the Following Projects (assumed interest rate = 10 % per annum ) Year Cement Plant Palm Oil Plant 0 -1000 1 600 0 2 0 0 3 550 1200 Jumlah 150 200

7. 11. INTERVAL RATE OF RETURN (1) q Formulas IRR = q Explanation: Ø B = benefit Ø C = cost Ø n = number of year Ø i = market interest rate

7. 12. Net Benefit/Cost Ratio q Formula: Net B/C = q Explanation: Bt = Benefit at year t Ct = Cost at year t t = year i = interest rate

7. 13. Readings Mangkoesoebroto, Guritno. 1999. ”Ekonomi Publik”. Yogjakarta: BPFE. Chapter 7 Stiglitz, Joseph E. 2000. “Economics of the Public Sector”. New York: W. W. Norton and Company. Chapter 11