Benefit-Cost Analysis as a Tool - Essay Example

Projects are accepted or rejected after weighing the different cost and benefits associated with the project. It the benefits outweigh the cost the project is accepted and if the cost is more than the estimated benefits then the project is rejected. This thereby requires estimating the future earnings and cost correctly and is brought back to the present year after discounting the same. Benefit-cost analysis is one such tool which helps to take better and informed decisions as it looks to analyze the future cost, benefits, payback period and discount rate along with inflation so that informed decisions are taken. This essay looks to evaluate the different reasons why the future benefits and cost are converted into present value and the manner in which benefit-cost analysis helps in informed decision making. It also looks at explaining the different reasons for discounting the future value and the social rate of discount which is used. The process will thereby enable to take better and informed decisions thereby helping to reduce the overall risk for the business. Benefit-Cost Analysis looks at estimating the total equivalent money value of the benefits and cost which a project has so that a decision regarding the establishment of the project can be determined or not (Drever, 2006). Estimating the cost and benefits of the future projects and discounting the future value to the present value helps to analyze whether acquiring the project will be beneficial or not. It is thereby a technique which looks at evaluating the project by comparing the economic benefits with the economic cost of the project or activity. It thereby helps to achieve different objectives which are as It helps to evaluate the economic merit that the project so that acceptance or rejection of the project becomes possible It provides a base for comparing the results with other projects so that the long term prospect and future returns can be estimated It helps to examine different potential actions so that the overall social welfare of the project can be increased Despite the different alternatives which projects have, all benefit-cost analysis have some properties which are common to each other. It looks at analyzing the problems by providing different solutions. For example congestion on the road will look at evaluating different alternatives like construction of a fly over, development of a public bus system or light rail system (Drever, 2006). Evaluating the different cost and benefits and analyzing the same will have to provide useful information regarding which project needs to be picked as it will look at discounting the future value of the expected returns to its present value. This brings to an important notion that all decisions whether in the private or public arena are taken based on comparing the different cost and benefits through the usage of benefit-cost analysis. A formal process of the use of benefit-cost analysis might not be developed but the different principles are used in different settings so that better and responsive decisions are taken. The benefit-cost analysis thereby looks to translate the effects of investment into monetary terms as the benefits which the project will provide is generally accrued to a longer period of time but the capital investment which is made is made in the initial years. This thereby looks at brining the estimated future earnings to the present value by using an appropriate discount rate and time period so that the correct value of the present investment can be decided and based on it appropriate decisions can be taken. The benefit-cost analysis looks at comparing a base case with different alternatives which are present. The cash flow for each alternative over a different period of time is identified by using a discounting method. The cash flow is converted into a present value using a discounting rate which is identified as appropriate. The cash flow which has been calculated is compared with the base case and alternative solutions. If the present value of the alternative is better than the present value of the base alternative then the alternative is selected as it is advantageous to use that alternative. If the present value of the alternative and the base case is similar than both the projects are indifferent. In case the present value of the alternative is lower than the present value of the base alternative then the alternative is selected as it is disadvantageous to use that alternative (Pike, Cheng & Chadwick, 2008). This thereby helps to take useful decisions and provides a framework based in which different alternatives and decisions are taken. The discount rate which is identified for the project needs to be determined based on different aspect and facets and should look to include inflation in it so that the changes in the purchasing power of money is properly encountered. To gauge the return from the different alternatives it is imperative that the cash flows are identified for the entire life cycle of the project. In case of projects associated with technology, the life cycle for the project is short which makes it imperative that the cash flows are estimated accurately. This has to be matched by using an appropriate discounting rate which is determined using different bases which is considered appropriate. Some projects uses growth rate, interest rates and similar other rates to find out the appropriate cash flows which the business will look to generate in the future. The discount rate which is used depends on a large degree on cost of equity and funding the different cost. The analysis should look to include the rate of inflation which has been identified and the analysis should reflect the same. In case the analysis is carried out on real terms then the discount rate which is to be used is the real discount rate. Similarly, in case of overseas components the discount rate which has to be charged is the exchange rate or other rates which seems appropriate. Thus the selection of the correct discounting rate to bring the future value of the project to the present value is important as it will help to analyze and understand whether the project or idea is feasible or not. This will help in improved decision making and will provide the required dimensions through which better efficiency will be achieved and better decisions will be taken. The farther the project looks into the future estimating the net present value correctly becomes important which thereby maximizes the importance of selecting the correct discounting rate and time period. It increases the degree of risk as estimating the returns correctly for the future especially over longer period of time becomes difficult. The calculation of the net present value is thereby based on the following premise Inflation: Changes in the purchasing power of money needs to be included while calculating the net present value. Since, the purchasing power of money changes as either it becomes costly or cheap and needs to be encountered while looking to calculate the future value of the project (Carey & Flynn, 2005). This is an imperative constituent and will determine the future option of selecting or rejecting the project Return on Investment: The rate of return which the project is estimated to provide in the next year and other years need to estimated accurately and based on it the decisions regarding the net present value should be taken (Carey & Flynn, 2005). This should also look at ensuring that the inflation which results in the change in the purchasing power of currency is estimated along with it. This will help to determine the future potential of the project and will help to take future decisions regarding the project Thus while looking to calculate the net present value the following have to be estimated correctly Allowable Payback Period: Estimating correctly the period of time when the different benefits and cost which the business indulges in will be involved (Hodorogel, 2009). This has to be done precisely in a correct manner as it will determines the long term success or failure of the project and will help to analyze whether the business will be able garner returns from their investment or not. Discount Rate: Estimating the discount rate correctly is very important as it will help to bring about a change in the future value earnings to the net present value. The discount rate which has been chosen should also look at encountering the changes in inflation and should estimate the returns after removing inflation (Hodorogel, 2009). Further, the base which has been chosen for discount rate should be estimated accurately as it would otherwise make some good projects to be rejected or some poor projects to be accepted. The process of estimating the present value of the future earning through the benefit-cost analysis needs to look at different aspect and areas so that the present value is estimated with accuracy. This has to be matched by ensuring that the social rate of discount which has been used is estimated based on different dimensions and areas so that correct calculations are done in the different respective areas (Binks, Ennew & Reed, 2002). Discounting rate and time period are one of the most important component as it helps to take useful decisions are helps to formulate strategies based on which the future direction of the project will be determined. Having different discount rates which are based for different situations will further help to look at the project from different business situations like growth rate, decline rate and similar other rates so that better and informed decisions are made. Using the benefit-cost analysis helps to provide different advantages which are as Firstly, it helps in useful and valuable decision making by looking at different facets which would otherwise have been ignored. The most important part is that it provides a starting point from where the evaluation of the project process starts. Secondly, it helps to provide quantitative data which supports both the quantitative and qualitative aspect thereby helping in better and informed decision making. Thirdly, it facilitates comparison between different investment or projects and thereby helps to look at different aspect so that selection or rejection of the project is taken on better and sounder grounds. Despite the different advantages which benefit-cost analysis provides there are several disadvantages associated with it which is as Firstly, benefit-cost analysis requires assigning monetary values to all the cost and benefits and there are certain aspect where assigning values doesn’t becomes possible due to the intangible value which they carry (Wickham, 2006). This thereby makes it difficult to estimate the present value of the project correctly Secondly, the result which the benefit-cost analysis can be very controversial as choosing different discount rates will impact the project (Wickham, 2006). Since, the discount rate which is selected can be controversial and might have been chosen for different reasons so it raises doubts regarding the results and creates controversies in the entire process Thirdly, the different benefits and cost which the project might face in the future is uncertain and the estimate is done based on the present situation and condition (Wickham, 2006). This might be completely different when the project is undertaken and thereby creates doubts whether using the benefit-cost analysis will help to provide correct judgment and will provide correct estimate of the future cost and benefits which the business might earn. Thus, the benefit-cost analysis is an important tool if used correctly and will ensure that better and informed decisions are taken. This will require estimating the discount rate correctly and taking care of inflation. The different base which is chosen for calculating the discount rate should be based on sound grounds and should justify the reasons for selecting it. Converting future earnings and cost into present value becomes imperative as it helps to take important decision whether a business project will be accepted or rejected. This requires looking at smaller aspect like discount rate, time period and future estimated income and cost correctly so that the decision regarding the project can be done with accuracy. This helps to reduce the risk and helps to take decisions which are better informed and is taken after analyzing different aspect which will help in better decision making. References Binks, M., Ennew, C., & Reed, G. 2002. Information Asymmetries and the Provision of Finance to Small firms. International Small Business Journal, 11, 35-36 Carey, D., & Flynn, A. 2005. Is bank finance the Achilles’ heel of Irish SMEs? Journal of European Industrial Training, 29(9), 712-729 Drever, M. F. 2006. Determinants of Liquidity for Australian Small and Medium-Sized Enterprises (SMEs). University of New England, Armidale Hodorogel, R. G. 2009. The Economic Crisis and its Effects on SMEs. Theoretical & Applied Economics, 79-88 Pike, R., Cheng, N., & Chadwick, L. 2008. Managing Trade Credit for Competitive Advantage: A study of Large UK Companies. The Chartered Institute of Management Accountants. London Wickham, P. 2006. Strategic Entrepreneurship. New York, Harlow: Financial Times Prentice Hall. 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