Select Evaluation Method
When all financial data have been identified
and broken down into cost categories, the
analyst must select a method of evaluation.
The most common methods are:
Net Benefit Analysis
Present Value Analysis
Net Present Value
Pay Back Analysis
Break-even Analysis
Cash-flow Analysis
Net Benefit Analysis
This method involves subtracting total
costs from total benefits.
Advantage: It is easy to calculate, easy to
interpret and easy to present.
Drawback:It does not account for time
value of money and does not discount for
future cash flow. Money has a time
value.The time lag accounts for time value
of the money. The time value of money is
extremely important in evaluation process.
Net Benefit Analysis-an example
Cost/Benefit Year 0 Year 1 Year2 Total
Costs -1000 -2000 -2000 -5000
Benefits 0 650 4900 5550
Net Benefits -1000 -1350 -2900 550
Present Value Analysis
In developing long-term projects, it is
difficult to compare today’s cost with the
full value of tomorrow’s benefits. The time
value for money allows for interest rates,
inflation and other factors.
Present value analysis controls these
problems by calculating the cost and
benefits of the system in terms of today’s
value of investment. The investment has to
be made today, whereas the benefits are in
the future.
The amount we are willing to invest
today is determined by the value of
benefits at the end of given period.
The amount is called present value of
the benefit. Present value formula is:
P=F/(1+I)n where
P=Present value
F=Future value
I= Interest rate
n=No. of years
Present Value Analysis-an example
Suppose Rs. 3000 is to be invested in a
system and the average annual benefit is
Rs. 1500 for the 4 year life of the system.
So the present value of Rs. 1500 at 10%
interest at the end of 4th year is:
P=1500/(1+0.10)4 = 1500/1.61
=Rs. 1027.39
If we invest Rs. 1027.39 today at 10%
interest, we can expect to have Rs. 1500 in
four years.
Present value Analysis using 10% interest
rate
Estimated Discount Present Cumulative
Year Future value rate Value Present value
of benefits
1 Rs. 1500 x 0.908 = Rs. 1363 Rs. 1363
2 1500 x 0.826 = 1239 2602
3 1500 x 0.751 = 1127 3729
4 1500 x 0.683 = 1027 4756
Discount Rate= 1/(1+I)n
Net Present Value
The net present value is equal to
discounted benefits minus discounted
costs. The net present value is expressed
as a percentage of investment. The formula
is:
Net present value(in %)=
net present gain/investment
In our example,
Net present value=1756/3000=0.55%
Pay Back Analysis
It determines the time it takes for the
accumulated benefits to be equal to the
initial investment.
The shorter the pay-back period, the
sooner a profit is realized and more
attractive is the investment. The payback
period can be calculated by the following
formula:
Payback period=
Overall cost/Annual cash returns
The payback method is easy to calculate and
allows two or more activities to be ranked.
Break-even Analysis
Break-even is the point where the cost of
the candidate system is equal to the cost
of current system. When a candidate
system is developed, initial costs usually
exceed those of the current system. This
is an investment period. When both costs
are equal, it is break-even. Beyond that
point, the candidate system provide better
benefits. This is called return period.
Break-even analysis is used to compare
costs of using present and candidate
system.
Cash Flow Analysis
Cash flow analysis keep track of the
accumulated costs and revenue on a
regular basis.Here
Cash Flow=Revenues-expenses
Advantage: It combines the benefits
of payback and break-even analysis.
Cash Flow Analysis-An example
Jan Feb Mar Apr May June Jul Aug
Revenues 2200 2200 2600 2700 4000 5500 6300 10500
Expenses 5500 4200 3500 3300 3100 3200 2900 3000
Cash flow –3500 -2000 -900 -600 900 2300 3400 7300
Accumulated -3500 -5500 -6400 -7000 -6100 -3800 –400 6900
Cash Flow
Here, break-even occurs in May month. The cash flow was
Rs. 900,although the accumulated cash flow was –6100.
Accumulated Cash flow begins to become +ve in Aug, this
is the beginning of the pay back period.
Summary
CBA is a tool for evaluating projects rather
than a replacement of the decision maker.
In real-life business situations, whenever a
choice among alternatives is considered,
CBA is an important tool. However, it has
some problems:
Valuation problem:Intangible costs and
benefits are difficult to quantify and
tangible costs are more pronounced than
tangible benefits.
Distortion Problem:There are 2 ways of
distorting the results of CBA.
Intentional favoritism of an alternative for
political reasons.
When data are incomplete or missing from
the analysis.
Completeness Problem: Occasionally, an
alternative is overlooked that compromises
the quality of the final choice. The cost
may be on higher side or not enough costs
may be considered to do a complete
analysis. In either case, the reliability of
final choice is in doubt.
