Using Cost Benefit Analysis For Project Proposals Finance Essay

In a fast turning economic system, the authorities of India rolls out assorted programs related to substructure and development which has an impact on overall ecosystem. Thus these undertakings are made to go through through EIA, in the Southern Cross of which lies Cost-Benefit Analysis. These undertaking proposals have a structural impact on organisation, therefore at the origin stage hazard analysis comprising of methods such as scenario analysis and sensitiveness analysis are carried out. Same holds true for investing undertakings and choice and analysis of portfolios for which theoretical accounts such as CAPM and Beta Index is used.

Chapter 1: Introduction

A ) Mr. Oza is the proprietor of a small-cap ‘Resonance ‘ training institute which teaches secondary criterion pupils and has no subdivisions except the headquarter situated in Borivali. For last few months he ‘s being working out on assorted strategic transmutations he ‘s been believing of. There are three programs which can give him better gross. He ‘s besides concerned about the informal price reductions that have eaten into his gross. First, He plans to organize a strategic confederation with ‘Sundaram ‘ which provides a engineering bundle of learning pupils of category 5 to 10 on projector, with stuff to be given to pupils for surveies, trial documents provided by them. He besides intends to convey in better direction systems for accounting and agenda maintaining every bit good wishes to purchase a web-space. For each twelvemonth the stuff costs 8000 rupees for each criterion. Second, he plans to sell one portion of his lone installation and purchase another topographic point in Andheri and 3rd, he plans to incorporate both of the above and besides add a teaching staff of about 5 instructors per subdivision. For now he ‘s being paying his staff on hourly footing. He pays them 200 rupees per hr. Which program should he put in?

B ) Azim, caput of Wipro intends to put 2 billion dollars in philanthropic activities which are slated to supply primary instruction to kids in India. Wipro being a profit-oriented organisation, such a immense measure which is about non-profitable and largely a charity requires some consideration. Should he put such a immense sum behind a philanthropic activity?

C ) Delhi Metro which intends to fulfill the immense demand for public conveyance and service for improvement of the urban ecosystem comes at an unprecedented cost. The societal facet is besides to be considered that will apparently hold a batch of impact of such a plan. Are at that place plenty benefits to prolong such a immense cost?

Planing and budgeting are the built-in portion of any concern. Investing determinations require careful planning and consideration. A reappraisal or analysis of the current status or fiscal public presentation and the inadvertence of future with deduction of costs of the new undertakings leads to a determination to be taken and the budget to be prepared. A profit-oriented organisation by and large has gross as the end product but that ca n’t be true for all units within an organisation. For an illustration in some units the machine hours or the implicit in value of intangible assets can non be measured in footings of gross.

Cost-Benefit Analysis:

The Cost-Benefit Analysis is an attack that helps organisation in determination devising by comparing costs of a possible program with some step of benefits that may be achieved by ask foring such a cost. Such a method is used in copiousness in non-profit organisation. Such a method may every bit good be used in net income organisation to better its good will, to cut down pollution and every bit good to supply information to direction. In this attack, there is a high grade of uncertainness attached with some facets of benefits particularly in instance of a profit-making organisation and moreover when demand is n’t steady or about normal for the larger portion of strata.

Therefore the beginnings of hazards and uncertainness besides must be tapped before taking any determinations sing new undertakings. For this a carefully drawn Project Risk Analysis should be done.

An investing theoretical account with thorough consideration and some basic premises maps hazard with regard to expected returns is a CAPM ( Capital Asset Pricing Model ) which will be discussed exhaustively in the paper.

Statement of the Problem:

The seminar paper has an nonsubjective to reexamine the literature on Cost-Benefit Analysis ( CBA ) in item. It intends to show the subject in two different positions. 1. The impact of it on the managerial determinations ( Here we ‘ll discourse the three instances mentioned in the debut portion and from them Delhi Metro in great item. ) 2. The beginnings of hazards and uncertainity and widely used and recognized procedures to counter them 3. Cost-Benefit analysis from Risk-Return dimension ( Here we ‘ll discourse Risk Aversion, Diversification and CAPM ( Capital Asset Pricing Model ) )

Purpose of the Survey:

The survey explains the Cost-Benefit Analysis on a macro degree.

It analyzes the application of it on a immense undertaking such as Delhi Metro.

It views CBA from a different dimension by discoursing in item the Capital Asset Pricing Model and Beta Index.

It describes the beginnings of uncertainness and hazard and tools to supervise cardinal drivers over the life of investing.

It makes a unsmooth effort of hazard antipathy utilizing covariance method.

Significance of the Survey:

It signifies how the theoretical account is used in both net income and non-profit ventures. It besides views in deepness the deduction of CAPM.

Chapter 2: Reappraisal OF LITERTURE

Part 1: Cost-Benefit Analysis

Figure 1: Example of Cost-Benefit Analysis

The figure above is a typical illustration of Cost-Benefit Analysis. One can see in the diagram that there are three options considered for a new investing undertaking. The cost and the benefits sing each option are given in the tabular array. Therefore at the terminal the computation concludes which of the three is a net income earning option. Such an analysis is by and large done in Government undertakings and besides for non-profit organisations.

Now we look at the three instances mentioned in the debut portion.

In A, there are three options available to Mr. Jitendra Oza and he has to take one of them. Let us intensively look at each of the three options.

Option 1: Strategic Alliance with Sundaram and debut of direction system

Let us name down all the costs related to first option.

Cost

Sum

Installation Cost

1,40,000

Stationary and Material Cost

48,000

ERP Solution for Billing and Scheduling

1,00,000

Web Solution

2,00,000

Wages and wadges

1,50,000

Infrastructure Cost

80,000

Entire

7,18,000

Figure 2: Cost of option 1

Following option 1 i.e. increasing better direction patterns and technological substructure, he ‘ll incur a cost of Rs. 7,18,000. Amongst these, Installation, ERP solution, Web solution are erstwhile disbursals that will non be incurred once more. These constitute of Rs.4,40,000. Suppose if the net income of Resonance is 8,00,000, that means that out of these Mr.Oza used to use 2,78,000 yearly. After using such an option there will be merely 82,000 rupees net income in the twelvemonth when these procedures will be included.

The Benefits in this instance assumed by Mr.Oza are that of extra pupils who require quality of instruction and technology-aware and antiphonal pupils and parents. This option arises due to the research that Mr.Oza does around his country proposing that such procedures are required for new-age pupils. The debut of the new direction system which gave charge inside informations dismissed the undue disadvantages of late remunerators and price reductions.

Benefits

Sum

Net Income

8,00,000

Attention deficit disorders: Estimated additonal Income

1,00,000

Gross Income

9,00,000

Discount nest eggs

1,00,000

Entire

10,00,000

Figure 3: Benefits of option 1

Therefore, the first program earns a gross of rupees 2,82,000 for the twelvemonth in which the installing will be done. And Mr.Oza is anticipating this to increase bit by bit over the old ages.

This is how the Cost-Benefit analysis is done, the same can be carried out for all the other options to happen out the best possible option. This is a conjectural instance and the method besides is really superficial in existent universe much more amalgamate methods are used.

In B, Wipro ‘s caput Azim Premji invests a immense sum in philanthropic activity of supplying instruction to kids. This being a trust governed by Mr. Premji himself is a non-profit organisation. The activity is a non-profit venture and therefore can non be measured in footings of gross. It ‘s built on some set of rules and ends. Thus the benefits in this instance expected are the long term advantages and obliteration of one of the serious jobs of India that is supplying entree to primary instruction and authorising the hapless.

We ‘ll now discourse in great item the Cost-Benefit Analysis of Delhi Metro.

Delhi Metro: Cost-Benefit Analysis:

Delhi being one of the most crowded metropoliss in India with its current transit system has an inauspicious impact on the ecosystem. Therefore, assorted different manners of transit are encouraged. With an belowground tube undertaking, this demand can be met sufficiently. Here, we try to throw visible radiation on the survey done by Planing Commission, Government of India and done at the Institute of Economic Growth. We besides discuss cost and benefits associated with first two stages of the undertaking. The committee estimates a 17 % fiscal internal ROI and 24 % economic rate of return. The benefit in this instance assumed of decrease in pollution increases the economic rate of return by 1.4 % .

With addition in population, immense dependance on route transit, route lengths non run intoing the rush in the figure of vehicle, coachs ( the chief manner of transit ) , addition in congestion on roads such a mass manner conveyance ( Delhi Metro ) which does n’t increase the congestion, does n’t impact the ecological system is a welcome undertaking.

Construction of the first stage took ten old ages from 1996 to 2005, this consist of three corridors ( belowground, alleviated, rate rail ) . Capital costs for Phase 1 are about 63,260 million where as that of stage two is 80,060 million.

Such an ambitious undertaking helps people reach to their finish faster, decreases the pollution and besides decreases the legion accidents happening on route. The investing outflows include cost of goods, cost of buying land and expenses to skilled and unskilled labour. At stage one the costs of Delhi metro include both foreign exchange ( FE ) and domestic costs.

Following table gives the cost of Delhi Metro at Phase 1.

Particulars

Iron

Domestic

Entire Cost

Civil plants

31237

31237

Electrical plants

6790

6790

Telecommunication

2575

1940

4515

Rippling stock

4600

6400

11000

Land

3340

3340

Consultancy charges

325

4780

5105

Eventualities

225

1595

1820

Figure 4: Cost estimations of DM

Reports from RITES suggest that the benefit related to this esteemed undertaking is the income generated from ads and belongings development. The other most of import coevals of income comes from the menu that will be collected for such a service. This are estimated to be more than the local conveyance installations. It may besides be considered that addition in menu will for certain create a batch in people taking this manner of conveyance. Thus the optimum solution in this state of affairs is Rs. 5 per rider trip.

Another benefit assumed is the lessening in the figure of coachs and figure of people utilizing that manner of transit and lessening in the sum of money invested by the authorities on route development etc. With addition in the regional economic system, the Delhi Metro may every bit good go a blessing for India ‘s quickly turning economic system.

An appraisal of benefits over the period of old ages is constructed whereby it can be seen that the gross expected in 2041 is165437 million. The RITES sanctioned commission uses several statistical methods to gauge these Numberss.

Some of the benefit estimates harmonizing to RITES studies are as follows:

Decrease in Vehicles on route:

Year

Four Wheelers

Two-wheelers

Buss

2004-05

50587

284455

3400

2009-10

80730

479285

4777

2014-15

236725

1396492

12385

2019-20

371005

2421990

17375

Figure 5: Benefit Estimate 1

Savingss in fuel ingestion:

Following table provides information about the one-year tally, ingestion of fuel norms and estimated nest eggs in the twelvemonth 2005.

Manner

Fuel Consumption Norm

Daily Run

Fuel Savingss ( in million )

Four-wheeler

13

31

5255

Two-wheeler

35

26

9765

Buss

18

210

715

Figure 6: Benefit Estimate 2

The other benefits include: Decrease in Air pollution every bit good as Decrease in rider clip.

For the above estimations and the 1s stated in the line above, statistical methods such as arrested development analysis is used sing all these factors to be dependent variables.

Other cost-benefit analysis indexs such as NPEB ( Net Present Economic Benefits ) and ERR ( Economic Return Ratio ) . These indexs take into history different scenarios such as market monetary value, shadow monetary values of unskilled labour, foreign exchange and investing etc.

Therefore after comprehensively explicating the three instances, we can state that all the three undertakings required some appraisal to be worked out. Be it a little organisation undertaking or a authorities undertaking.

The theory of Cost-Benefit Analysis:

In such an analysis, the entire cost and benefits are adjusted for the clip value of money so that over the period of clip they are expressed on a common land.

Assorted organisation across the universe usage some of the undermentioned CBA indexs:

Net Present Value ( NPV )

Present Value of Benefits ( PVB )

Present Value of Costs ( PVC )

Benefit-Cost Ratio ( BCR=PVB/PVC )

Net Benefit=PVB-PVC

Models such as this are besides widely used in EIA ( Environment Impact Assessment ) . Harmonizing to the Torahs, the Indian authorities has mandated that every major undertaking before its origin must be presented for environmental clearance. Then an EIA papers is prepared and assorted options of the same undertaking with their cost deduction are suggested to the people puting down the undertaking taking into consideration environment safety.

Now, allow ‘s travel our treatment to a instead more amalgamate position on it. In the preceding subdivision we discuss Project hazard analysis, the risk-return theoretical account CAPM and Beta.

Part 2: Undertaking Hazard Analysis:

There ‘s a more concrete method by which fiscal analysts evaluate undertaking proposals. That method is described as follows:

First, the analyst uses steps such as NPV, IRR to imagine the possible benefits or consequences of an investing.

Second, he tries to happen out the underlying cause of hazard i.e. the footing.

Harmonizing to an article published in ‘The direction comptroller ‘ , Sensitivity analysis and scenario analysis are considered to be the most preferred method to mensurate hazard and uncertainness.

Sensitivity Analysis:

The analyst in the first phase of the above procedure estimates the end products as against the outlooks. The Sensitivity Analysis addresses inquiries such as how confident can one be that the undertaking will blossom as expected? What are the cardinal drivers that should be monitored?

Scenario Analysis:

To measure the sensitiveness of any investing ‘s value under different scenarios, the analyst uses a method viz. Scenario Analysis. These are the scenarios that may happen in future. In this we may besides measure the undertaking against optimistic estimations every bit good as pessimistic estimations. The defect of this method is that there is no formal manner to depict the scenarios.

Break-Even Sensitivity Analysis:

While in the 2nd stage of hazard analysis procedure one of the widely used procedure is the brak-even sensitiveness analysis. This method finds out the drivers of hazard or the beginnings of hazard. We use an illustration of CSM, Inc ‘s Eartilizer Project to explicate this method.

Variable-Forecast or Assumption

Expected Value

Critical Value

% Change

Gross saless growing rate

10 %

5.66 %

-43.40 %

Gross Profit Margin= Gross Profit/Sales

32.60 %

31.12 %

-4.54 %

Operating disbursals ( before depreciation )

10 %

11.48 %

14.80 %

Tax Rate

30 %

40.14 %

33.80 %

Net working capital/Sales

25 %

33.40 %

33.60 %

Basal twelvemonth gross revenues for 2008 ( 2009 )

$ 1,000,000

$ 923,171

-7.68 %

Figure 7: Break even sensitivity analysis

The tabular array lists six factors that are of influence. Second table lists the expected value for each of the value drivers. Third table contains the break-even value of each value drivers.

The analysis helps us detect the three of the most influential value drivers to the investing of the earthilizer undertaking. Furthermore, if the house intends to set about the investing so big sum of informations can be gathered for these three drivers and they can be besides monitored closely.

Simulation Analysis:

Not widely used. Monte Carlo simulation is a powerful tool that helps analyst evaluate that can go on to the investing ‘s future hard currency flows and summarizes the possibilities in a chance distribution.

Part 3: Fiscal Model CAPM and Beta

Capital Markets and in that specifically secondary markets, there ‘s a high grade of volatility and hazard. Every investing in securities is therefore plagued by a tradeoff between hazard and return of securities. By this we mean that higher the hazard of a security, the higher the expected return to the investor. Therefore, a diversified investing cut downing the hazard associated with it and increasing the chance of higher returns is required. Before we proceed any farther, a formal definition of hazard, return and assorted facets of them should be discussed.

Tax return: Suppose that a individual invests some sum of money into a security. After keeping this investing for some period of clip he gets a hard currency dividend due to ownership plus the alteration in the market monetary value of the security divided by the beginning monetary value.

Hazard: The activity of buying common stocks in any company and keeping it over a period does n’t ever give the awaited return and there ‘s besides a possibility that after a twelvemonth the market monetary value of that stock may fall. Thus it ‘s the variableness associated with existent returns as against expected. Treasure measures and authorities bonds are dependable and riskless manners of securities but they do n’t offer a fringy ROI, therefore though hazardous there ‘s a tonss of activity and investing done in the secondary market.

The existent rate of return follows a chance distribution map which considers the undermentioned factors.

The expected return

The standard divergence

The expected return Re is, Re = a?‘ ( Ri ) ( Pi )

Ri – Tax return for ith chance

Pi- Probability of return

The above mentioned is the expression for standard divergence. A hgher value of standard divergence signifies a higher grade of hazard related to the investing.

If hazards are calculated utilizing such a method there ‘s a job though. See two proposals for investing. The expected returns for A and B severally are 0.08 and 0.24. Standard divergence for A and B severally are 0.06 and 0.08 and the coefficient of discrepancy being 0.75 and 0.33 for A and B severally. Thus, merely because B ‘s standard divergence is higher than that of A, one ca n’t state that investing B has higher hazard. Relative to the size of the expected return A has greater fluctuation.

Concept of Risk Aversion:

Analyze the undermentioned exercising carefully. Suppose if I say to you that there are two doors and behind one of them is $ 10000. Now, you choose one of the doors to claim but at that clip I offer you to take compensation and leave that door. Now how much would you desire to have back sing that you had a 50/50 opportunity of winning? It might be something lesser than 5000.

Here we explained the rule of Cash Equivalent ( CE ) : As the opportunities of you winning or losing 10000 were 50/50, the sum you think that equals the sum with the hazard was something less than 5000 Lashkar-e-Taiba ‘s state 3,500.

Now If CE & lt ; Expected value of return, Risk antipathy is present.

Portfolio Return:

Investors to minimise or to distribute the hazard by and large create a portfolio which is a group of investings. Returns, in this instance is the leaden norm of expected returns and their returns. Here by weights we mean, the per centum portion of money invested in a peculiar security. Portfolio Return Rp is,

Wj- Total financess invested in a security

Rj- Expected return of security

Importance of Covariance:

It measures the grade to which two variables move together. If the covariance is zero that means both of the variables do n’t hold an impact on each other. If it is extremely positive and nearing 1, it shows that they both move together and if it ‘s extremely negative, it shows that both move in opposite way. Therefore, if a portfolio is chosen in such a manner that there is a negative covariance, we minimize the hazard as when one stock goes up the other will travel down.

Capital Asset Pricing Method ( CAPM ) :

Investings carry with them a hazard which comprises of systematic and unsystematic type. Systematic hazard is the return on stocks or portfolios associated with alterations in return on the market and unsystematic hazard is an evitable hazard through variegation. The CAPM is based on Risk-Averse investors. It was founded by William Sharpe which argues that there exists equilibrium between hazard and expected return. It is the most researched theoretical account for Portfolio analysis and choice. Harmonizing to CAPM, the expected return is the riskless rate plus the premium based on the systematic rate of security.

Risk-free Security: A type of security whose return over a period of clip is certain

Market Portfolio: It ‘s a portfolio comprising of all the available common stocks and is weighted harmonizing to their market monetary value. S & A ; P indexes are used as Market Portfolios are instead complex. The theoretical account discusses two portfolios i.e. Efficient and other

Efficient Portfolio:

It says every investor is the same i.e. what implies to one besides implies to all other. These are the investors that together represent the market.

Figure 8: Efficient PortfolioPoint B is the tangent to the consecutive line C. It is the point where the risk-averse investor neither borrows nor invests at the hazard free rate. We ‘ll name this the market portfolio. Other points on the line Rf-B-C represent hazard free investings and MP. Point Rf denotes that the full fund is invested into hazard free assets.

South dakota at Rf is zero. Rf-B-C is known as the capital market line.

Inefficient portfolios lie below the capital market line.

The equation of capital market line is as follows:

Re- Expected return on an efficient portfolio

Rf- Risk-free Tax return

Rm-Return on market portfolio

I?m – South dakota on Market portfolio

I?e- SD on efficient portfolio

Other Portfolio:

Market hazard ca n’t be eliminated through variegation. For this we use a step of market hazard Beta.

Beta:

It measures sensitiveness of a stock w.r.t market. It ‘s applicable for any security and uses a simple statistical method-regression. Dependent variable is the value of security and value of a related market index is an independent variable. In an equation therefore of type, , the value of ‘b ‘ signifies Beta.

Significance of different values of Beta:

If it ‘s equal to 1, there is a high grade of correlativity between the stock monetary value and the market monetary value and would travel together exactly.

If it ‘s less than 1, the stock is conservative and moves lesser than the market.

Beta more than 1 signifies or fund that is more aggressive than the market.

It has a immense application in the common fund strategies and most of the common fund companies rely on the value of Beta to mensurate market hazard.

Figure 9: Beta Index

Therefore in the other portfolio we can plot, Return v/s Beta as follows

Figure 10: Other Portfolio

Suppose if we make a portfolio of A and B, with equal investings the leaden norm of Beta of a portfolio would be ( 0.5*1 ) + ( 0.5*2 ) i.e. 1.5. The leaden norm of returns for the same will be 9 % , which is the Point C. The Line A-C-B is called the Security Market Line. Points below the line mean lower returns for the same degree of Beta.

The point in the graph where SML touches the Y-axis is the point where Beta peers Zero i.e. an investing without systematic hazard. Thus it will give a riskless return.

Return on any security can be given by the expression, Rs = a+bI? i.e. Rs = Rf+ ( Rm-Rf ) *I?

Therefore the returns from any security are a combination of riskless and a systematic hazard portion.

CAPM Premises:

Efficient capital markets, Informed Investors

Low dealing cost, negligible limitations on investing

Investors can borrow and impart limitless sum of money at riskless rate and can besides sell the risk-prone assets.

Personal income-tax is ignored.

Investor ‘s behaviour is driven by expected returns and Standard divergences.

CAPM Challenges:

Anomalies: Evidence of certain divergences has been found.

Small-firm consequence: The statement is such that the companies with low market-cap provide higher returns than the high-cap companies.

January Consequence: Keeping a common stock from December to January frequently produces higher returns.

Fama and Gallic Study: The survey found that the size and market-to-book-value are the best indexs of mean stock returns.

Chapter 3: Methodology

The paper is constructed utilizing wholesome sum of Secondary Data. The study has taken into consideration the thesis written over the topic in assorted Books. It has besides gathered some utile information from articles written in Journals. It has besides used some of the web sites to acquire an overview of the subject.

Chapter 4: Summary AND CONCLUSION

Summary:

The article presents an overview on how carefully investings should be done and is done. It views how scenario based determination doing with cost-benefit analysis helps in measuring which is the best possible scenario and provides direction with a batch of directing information and inadvertence.

It discussed in item, Delhi Metro and its assorted Costss and Benefits spread over the first two stages.

The paper besides discusses the widely used processs for Project Risk analysis which provides as with a position that how the undertaking proposal is officially treated in an organisation.

The paper describes the hazards and returns relative to securities and describes a theoretical account which is immensely used in Mutual Fund houses to find the market hazard and expected return.

Decision:

It can be concluded from the paper that, Cost-Benefit Analysis, Risk Analysis ( Scenario analysis and sensitiveness analysis ) and CAPM-Beta Model are widely accepted and are significantly successful. Despite some of the challenges these provide sufficient dependability

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Sheridan Titman, John D. Martin, V. Ravi Anshuman, 2009, Valuation- Analyzing planetary investing chances, India, Pearson instruction

Thomas S.Y.Ho, Sang Bin Lee, 2005, Securities Valuation, Newyork, Oxford University Press

Robert N Anthony, David F Hawkins, Keneth A Merchant, 2010, Accounting 12th edition, New Delhi, Tata Mcgraw Hill Education Pvt. Ltd.

James C. Van Horne, John M. Wachowicz, Jr. , 2009, Fundamentalss of Financial Management, New Delhi, PHI Learning Pvt. Ltd.

M N Murty, Kishore Kumar Dhavala, Meenakshi Ghosh and Rashmi Singh, 2006, Social Cost-Benefit Analysis of Delhi Metro, Institute of Economic Growth, India

Cost-Benefit Analysis. Accessed on December 2,2010 from hypertext transfer protocol: //www.wikipedia.org