Lecture 5: Cost-Benefit Analysis
The last of the five strategies for comparison of investment strategies is
. This method is
commonly used for public planning, by national or local governments, rather than by individual companies.
Although there are significant differences between planning in the public and private sectors, the benefit/cost
ratio is neutral with respect to these differences, giving the same result as would the
Formally, the benefit/cost ratio is defined as the fraction
Present worth of benefits/Present worth of costs
If this ratio is greater than unity, the project should go ahead, otherwise not.
One apparent pitfall in this method is some ambiguity in what should be considered a cost and what a benefit.
For example, a project with startup costs
which generates annual revenue
and which must meet annual
could be described as having equivalent costs
C + K(P/A,i,N)
and equivalent benefits
So the B/C ratio would be
On the other hand, the same project could be considered as yielding an annual profit of
P = R-K
. This annual
profit is certainly a benefit, so we could argue that the benefit/cost ratio should be
But these two ratios are different, so how can we decide which to use?
Fortunately, we don't need to decide. The only thing we care about is whether the ratio is greater than 1, and
it can be shown that when one of these fractions meets that criterion, so does the other.
This means that the benefit/cost ratio