Benefit Cost Ratio (BCR)
Contents |
Abstract
This article discusses the application of the Benefit Cost Ratio (BCR) method in the Cost Benefit Analysis. The Benefit Cost Ratio is a profitability indicator, and it is the ratio of the present value of the benefit of the project to the present value of the cost. It is usually used to summarize the results of the cost benefit analysis (CBA) during the financial appraisal of a proposed program, project or portfolio. [1] BCR indicates if the project is feasible or not, meaning the higher the BCR, the more attractive the risk-return profile of the project/asset. If the BCR value of a project is less than 1, the project's costs outweigh the benefits, and it should not be considered viable. Calculating the BCR of an asset or project is comparatively simple. In addition, the ratio considers the discount rate, hence the time value of the money.[2]. Despite the fact that BCR is a tool to show the attractiveness of a project or an asset, cannot simply be the only determinant of a project's feasibility.
Initially, this article discusses the origin of the Cost Benefit Analysis and BCR. Then, it focuses on the formula for the calculation of the Benefit Cost Ratio and how it considers the time value of the money. Next, there is a comparison between BCR and other CBA methods. After that, the article introduces other formulas and applications of the BCR. Finally, it discusses the advantages and the limitations of the Benefit Cost Ratio.
Cost Benefit Analysis
Cost-benefit analysis (CBA) is a method of economic assessment that seeks to quantify the positive and negative impacts of a proposed decision or project. The technique has been used for centuries, with the earliest known examples dating back to the 1700s. However, the use of CBA were mandatory only after regulations were established by the US government in the 1930s CBA is often used to determine whether or not a proposed decision or project is worth investing in. It is also used to compare different options or to determine which option will provide the greatest benefit to its stakeholders.
What is BCR?
The Benefit Cost Ratio is a profitability indicator, and it is the ratio of the present value of the benefit of the project to the present value of the cost. It is usually used to summarize the results of the cost benefit analysis (CBA) during the financial appraisal of a proposed program, project or portfolio.[1]
Time value of money
The time value of money is a basic financial concept used to calculate the present value of an amount of money today compared to its future value. This concept is based on the idea that money has a time value because it can earn interest over time. In other words, a dollar received today is worth more than a dollar received in the future due to the potential to earn additional. [2]
Discount Rate
The discount rate is the rate of interest used to calculate the present value of future cash flows in economic appraisals. It is used to discount the expected future cash flows to their present value. The discount rate used in economic appraisals is usually determined by the current level of interest rates.
How to Calculate BCR?
Where:
t: The calculation period in years
Bt: Benefits in year t
Ct: Costs in year t
i: The discount rate
Examples
Comparison Between BCR and NPV
BCR and NPV are two different methods of financial appraisal. BCR measures the ratio of benefits to costs, while NPV measures the present value of future cash flows. Both methods measure the profitability of an investment with different methods. BCR focuses on determining ROI, while NPV takes into account the present value of future cash flows.
Other formulas of BCR
1. Payback Period BCR = Initial Investment / Annual Cash Inflow
2. Return on Investment BCR = Annual Net Income / Initial Investment
3. Net Present Value BCR = Net Present Value / Initial Investment
4. Internal Rate of Return BCR = Internal Rate of Return / Discount Rate
5. Profitability Index BCR = Present Value of Future Cash Flows / Initial Investment
Advantages of BCR
The BCR translates the absolute amounts of benefits and costs into a ratio.
Limitations of BCR
The main limitation of the BCR is that it reduces a project to a simple number when the feasibility of an investment or a project relies on many factors and can be undermined by unforeseen events.
References
- ↑ 1.0 1.1 Shively G., An Overview of Benefit-Cost Analysis., (Gerald Shively, Purdue University, 2012),
- ↑ 2.0 2.1 CFI Team., Benefit-Cost Ratio (BCR), https://corporatefinanceinstitute.com/resources/accounting/benefit-cost-ratio-bcr
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