This page intentionally left blank Benefit-Cost Analysis Financial and Economic Appraisal using Spreadsheets This text offers the perfect introduction to social benefit-cost analysis. The book closely inte- grates the theory and practice of benefit-cost analysis using a spreadsheet framework. The spreadsheet model is constructed in a truly original way which contributes to transparency, provides a check on the accuracy of the analysis, and facilitates sensitivity, risk and alternative scenario assessment. A case study incorporating the various issues is progressively developed on a spreadsheet with the links between each stage thoroughly explained.
The complete case study spreadsheet can serve as a template for the reader’s own appraisal of projects in the field. In addition to the worked examples in the text some exercises are appended at the end of each chapter. The book has several unique features: • the close integration of spreadsheet analysis with analytical principles; • the spreadsheet approach provides an invaluable cross-check on the accuracy of the appraisal; • the book is structured in a way that allows readers to choose the level of analysis which is relevant to their own purposes. The text is suitable for people with a basic understanding of elementary economics who wish to learn how to conduct a social benefit-cost analysis.
Harry Campbell and Richard Brown are both in the School of Economics at The University of Queensland. They have extensive experience in teaching and applied benefit-cost analysis and have between them held academic positions at universities in North America, Europe, Africa and Australia. For: Jenny, Jamie and Astrid Kathy, Ben, James, Oliver and Alex Benefit-Cost Analysis Financial and Economic Appraisal using Spreadsheets Harry F. Campbell and Richard P.
Brown The University of Queensland Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo Cambridge University Press The Edinburgh Building, Cambridge , United Kingdom Published in the United States of America by Cambridge University Press, New York www.org Information on this title: www. Campbell and Richard P. Brown 2003 This book is in copyright. Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press.
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Contents List of figures vi List of tables ix Preface xi 1 Benefit-Cost Analysis: Introduction and Overview 1 2 Investment Appraisal: Principles 18 3 Investment Appraisal: Decision-Rules 36 4 Private Benefit-Cost Analysis: Financial Analysis 62 5 Efficiency Benefit-Cost Analysis 92 6 Calculating the Net Benefits to the Referent Group 122 7 Consumer and Producer Surplus in Benefit-Cost Analysis 146 8 Valuing Traded and Non-traded Commodities in Benefit-Cost Analysis 177 9 Incorporating Risk in Benefit-Cost Analysis 194 10 The Social Discount Rate, Cost of Public Funds, and the Value of Information 221 11 Weighting Net Benefits to Account for Income Distribution 238 12 Valuation of Non-marketed Goods 261 13 Economic Impact Analysis 288 14 Writing the Benefit-Cost Analysis Report 304 Appendix 1: Case Study Assignment 332 Appendix 2: Discount and Annuity Tables 340 Index 342 Figures 1.1 The “With and Without” Approach to Benefit-Cost Analysis 3 1.2 Typical Time-Stream of Project Net Benefits 5 1.3 Relationship between the Project, Private, Efficiency and Referent Group Net Benefits 7 1.4 The Benefit-Cost Analysis Spreadsheet 12 1.5 Project Appraisal and Evaluation as a Continuous Process 15 2.1 Investment Appraisal – a Private Perspective 19 2.2 A Country’s Inter-temporal Production Possibilities Curve 22 2.3 The Inter-temporal Effects of International Trade 23 2.4 Net Benefit Stream of a Two-period Investment Project 25 2.5 Net Present Value in Relation to the Discount Rate 26 2.6 Calculating Internal Rates of Return – One Positive Value 27 2.7 Calculating Internal Rates of Return – Two Positive Values 28 2.8 Net Present Value in Relation to the Discount Rate – the Two Positive Internal Rates of Return Case 29 2.9 Net Present Value in Relation to the Discount Rate – the No Internal Rate of Return Case 30 3.2 Spreadsheet Presentation of DCF Calculation 54 3.3 Using Built-In Spreadsheet Formulae 56 3.4 Referencing within the Spreadsheet 58 3.5 Selecting and Pasting a Built-in Formula 59 4.1 NFG Case Study: Key Variables Table 80 4.2 NFG Case Study: Project Cash Flow Table 81 4.3 NFG Case Study: Private Net Benefits Table 83 A4.1 ICP Project Solution: Key Input Variables 89 A4.2 ICP Project Solution: The Project Cash Flow 89 A4.3 ICP Project Solution: The Private Cash Flow 90 5.1 The Efficiency Benefit-Cost Analysis Pricing Rule 93 5.2 Competitive Market Equilibrium 94 5.3 The Effect of a Minimum Wage 97 5.4 An Individual’s Leisure Supply and Demand 99 5.5 The Market for Rental Units with Rent Control 100 5.6 The Market for an Imported Good Subject to a Tariff 101 5.7 The Market for Diesel Fuel Subject to a Subsidy 102 5.8 Demand and Costs in the Electricity Industry 103 5.9 Demand for Labour by a Monopoly 105 5.10 Supply for Labour to a Monopsony 106 5.11 Monopoly Output with and without a Subsidy 107 5.12 A Consumer Good Subject to an Indirect Tax 109 5.13 NFG Case Study: Key Variables Table with Efficiency Prices 115 Figures vii 5.14 NFG Case Study: Efficiency Cash Flow Table 116 A5.1 ICP Project Solution: The Efficiency Cash Flow 118 6.1 The Relationship between Referent Group and Non-referent Group Net Benefits at Market Prices and Efficiency Prices 123 6.2 NFG Case Study: Referent Group Analysis Table 136 6.3 Distribution of Efficiency Net Benefits ($ thousands, @ 10% discount rate) 137 A6.1 ICP Project Solution: The Referent Group Cash Flow 139 A6.2 ICP Project Solution: Consolidated Tables 142 7.2(a) Consumer Surplus with Inelastic Demand 150 7.2(b) Consumer Surplus with Elastic Demand 151 7.3 Benefits of a Bridge 153 7.4 Effect of a Bridge Toll 155 7.5 Subsidizing Bus Fares 156 7.6 Effects of Worker Training 159 7.7 Benefits of an Irrigation Project 161 7.8 Change in the Rental Value of Land 163 7.9 Irrigation Water Sold at Less than Market Value 165 7.10 Effect of an Increase in Demand for Labour 166 7.11 Effects of Building a Bridge on the Benefits from a Ferry 168 7.12 ICP Project Solution: Higher Skilled Wages 170 A7.1 Compensating and Equivalent Variation 173 8.1 Consumption Opportunities with and without an Import-Replacing Project 180 8.2 The UNIDO and LM Approaches to Project Appraisal 186 8.3 The Foreign Exchange Market with a Fixed Exchange Rate 188 8.4 Supply and Demand for Foreign Exchange with Tariffs and Subsidies 189 8.5 ICP Project Solution with a Shadow Exchange Rate 192 9.1 Triangular Probability Distribution 202 9.2 Cumulative Probability Distribution 203 9.3 Projects with Different Degrees of Risk 204 9.4 The Relationship between Utility and Wealth for a Risk Averse Individual 205 9.5 A Risk Averse Individual’s Indifference Map between Mean and Variance of Wealth 207 9.6(a) Entering the Data 209 9.6(b) Entering the Simulation Settings 210 9.6(c) Running the Simulation 211 9.6(d) Reading the Results of the Simulation 211 9.6(e) Graphing the Probability Distribution 212 9.6(f) Generating a Cumulative Probability Distribution 212 9.6(g) Saving the Risk Analysis Results to a Spreadsheet 213 9.6(h) Selecting a Range of Values as Risk Analysis Outputs 213 9.6(i) Producing Summary Graphs for a Range of Outputs 214 9.7 ICP Project Risk Analysis: Programming a “Random Walk” 217 viii Figures 9.8 ICP Project Risk Analysis: Summary Statistics for Referent Group Net Benefits 218 9.9 ICP Project Risk Analysis: Summary Graph for a Range of Discount Rates 218 10.1 Taxation and Labour Supply 228 10.2 The Benefit and Cost of Delaying an Investment 231 10.3 ICP Project Solution with a Premium on Public Funds 235 11.1 The Lorenz Curve 240 11.2 Total Utility Curve 245 11.3 Marginal Utility Curve 246 11.4 Weighting Factors for Extra Income 249 12.1 Total Economic Value of Coral Reef Ecosystems 267 12.2 Measures of Value using the Replacement Cost Method 272 12.3 Willingness-to-pay and Consumer Surplus 274 12.4 Change in Consumer Surplus from Demand Curve Shift 275 12.5 Change in Consumer Surplus Resulting from a Price Change 275 12.6 Approximate Individual Demand Curve for Park Visits 277 13.1 The Circular Flow of Income 289 Tables 3.1 Discount Factors for 10% and 15% Discount Rates 39 3.2 Discounted Net Cash Flow for a Hypothetical Project ($ millions) 39 3.3 Ranking of Projects by NPV and Profitability Ratio ($ thousands) 50 3.4 Ranking Lumpy Projects ($ thousands) 51 3.5 Two Investments with Different Lives 52 3.6 Establishing Equal Project Lives 52 4. Real Cash Flows 65 4.2 Incremental Cash Flows 68 4.3 Calculating Depreciation Using the Straight-Line Method 70 4.4 Investment in Working Capital 71 4.5 Deriving the Private Cash Flow on Farmer’s Equity 73 4.6 Project Cash Flows Equal Debt Plus Equity (Private) Cash Flows 74 4.7 NFG’s Annual Operating Costs 79 A4.1 Investment Costs: Yarn-Spinning Project: ICP 86 A4.2 Employment: Yarn-Spinning Project: ICP 87 A4.3 Additional Cost of Locating in Southern Thailand 88 5.1 Indirect Taxes or Subsidies on NFG Project Inputs 114 6.1 Classification of Net Benefits 123 6.2 Using Shadow-prices to Identify Referent Group Benefits and Costs 126 9.1 Sensitivity Analysis Results: NPVs for Hypothetical Road Project ($ thousands at 10% discount rate) 197 9.2 A Discrete Probability Distribution of Road Construction Costs ($ thousands) 198 9.3 Calculating the Expected Value from a Discrete Probability Distribution ($ thousands) 199 9.4 Joint Probability Distribution: Correlated Variables ($ thousands) 200 9.5 Joint Probability Distribution: Uncorrelated Variables ($ thousands) 200 11.1 Distribution of Households by Annual Income 239 11.2 Income Distribution by Deciles 239 11.3 Distribution of Income by Sector 240 11.4 Income Distribution by Percentile 241 11.5 Comparing Projects with Different Atemporal Distributions 243 11.6 Comparing Projects with Different Aggregate Benefits and Distributions 244 11.7 Applying Distributional Weights to Project Net Benefits 244 11.8 Responsiveness of Distributional Weights to Changes in n 249 11.9 Threshold Distributional Weights 253 11.10 Distributional Weighting in the NFG Project 254 11.11 Threshold Combinations of Distributional Weights 255 11.12 Composite Distributional Weights 258 12.1 Hypothetical Water Quality Improvement Project Options 270 12.2 Hypothetical Travel Cost Example 277 12.3 Impact of Road Noise Changes on Property Values 280 x Tables 12.4 Estimating Net Benefits of Improved Water Quality using CVM 281 12.5 Example of a Hypothetical Choice Set 282 13.1 Inter-Industry Structure of a Small Closed Economy 297 A14.4 Referent Group Analysis 314 A14.6 Option 1: Bangkok – No Concessions – Key Variables 317 A14.7 Option 1: Bangkok – No Concessions 318 A14.8 Option 2: Bangkok – No Duties 320 A14.9 Option 3: Bangkok – No Profits Tax 322 A14.10 Option 4: Southern Thailand – No Concessions 324 A14.11 Option 5: Southern Thailand – No Duties 326 A14.12 Option 6: Southern Thailand – No Profits Tax 328 A14.13 Option 7: Southern Thailand – No Duties, No Profits Tax 330 Preface This book is intended for people with a basic understanding of elementary economics who wish to learn how to conduct a social cost-benefit analysis. We use the term social benefit-cost analysis to refer to the appraisal of a private or public project from a public interest viewpoint.
We follow professional practice in using the terms benefit-cost analysis and cost-benefit analysis (with or without the social prefix) interchangeably. A social cost-benefit analysis of a publicly funded project may be commissioned by a municipal, state or federal government, or by an international agency such as the World Bank, IMF, UN or OECD. Proponents of private projects which have significant social impacts may also commission an economic analysis of this type in order to support an application for approval to proceed with the project.