Cost-Benefit Analysis

List of figures xi

List of tables xiv

List of examples xvi

List of Technical Notes xvii

Preface xviii

Acknowledgements xxii

Notes to the instructor xxiv

Chapter 1: Introduction to cost-benefit analysis 1

1.1 Introduction 1

1.2 The Referent Group 6

1.3 The structure of the cost-benefit model 8

1.4 The use of spreadsheets in cost-benefit analysis 11

1.5 The rationale for public projects 14

1.6 The role of the analyst 16

1.7 Further reading 17

Exercises 17

Chapter 2: Project appraisal: principles 19

2.1 Introduction 19

2.2 Project appraisal from an individual viewpoint 19

2.3 Investment opportunities in the economy as a whole 22

2.4 The algebra of NPV and IRR calculations 23

2.5 Annuities and perpetuities 30

2.6 The Rule of 72 34

2.7 Economic depreciation and the annual cost of capital 35

2.8 Treatment of inflation in project appraisal 36

2.9 Incorporating a risk factor in the discount rate 38

2.10 Further reading 39

Exercises 39

Chapter 3: Project appraisal: decision-rules 40

3.1 Introduction 40

3.2 Discounted cash flow analysis in practice 40

3.3 Discounting and the time value of money 41

3.4 Using Annuity Tables 44

3.5 Using investment decision-making criteria 45










The Net Present Value (NPV) criterion 45



The Benefit-Cost Ratio decision-rule 47



The Internal Rate of Return (IRR) criterion 48



Problems with the IRR decision criterion 51



Problems with the NPV decision criterion 53





3.6 Using spreadsheets 59

3.7 Further reading 64

Exercises 64

Chapter 4: Private cost-benefit analysis: financial appraisal 68

4.1 Introduction 68

4.2 Benefits and costs measured as cash flows 69










Identifying project inputs and outputs 69



Valuing inputs and outputs at market prices 70



Characteristics of cash flows 70





4.3 Inflation and relative prices 72

4.4 Incremental or relative cash flows 74

4.5 Capital costs and the treatment of depreciation 76

4.6 Interest charges, financing flows and cash flow on equity 78

4.7 Taxation and after-tax net cash flows 83

4.8 The discount rate 84

4.9 Summary of the relationship between the Market Analysis and the Private Analysis 85

4.10 Derivation of project private cash flows using spreadsheets 85

4.11 Further reading 91

Appendix to Chapter 4: Case Study of International Cloth Products 91

Exercises 97

Chapter 5: Cost-benefit analysis and economic efficiency 99

5.1 Introduction 99

5.2 The competitive market 100

5.3 Shadow-pricing project inputs and outputs 103

5.4 Shadow-pricing marketed inputs 104










Materials 105



Labour 109



Capital 117



Land 118



Rules for shadow-pricing marketed inputs 118





5.5 Shadow-pricing marketed outputs 119










Rules for shadow-pricing marketed outputs 124





5.6 The efficiency pricing rules: summary 124

5.7 Corrective taxation: the modified efficiency pricing rules 125

5.8 How to determine which pricing rule to follow 126

5.9 Shadow-pricing public funds 128

5.10 Shadow-pricing foreign exchange 133

5.11 The discount rate 133

5.12 Worked examples 136










Efficiency analysis of the National Fruit Growers (NFG) Project 136



Cost-benefit analysis of the 55 mph speed limit 140





5.13 Further reading 141

Appendix to Chapter 5: Economic Efficiency Analysis of the ICP Case Study 142

Exercises 146

Chapter 6: The distribution of project net benefits 149

6.1 Introduction 149

6.2 How to identify Referent Group net benefits in practice 150

6.3 Some examples of the classification of net benefits 154










Shadow-prices on project inputs 154



Shadow-prices on project outputs 160





6.4 Corrective taxation 161

6.5 Further examples 166

6.6 Lessons from the examples 168

6.7 Worked example: Referent Group Analysis of National Fruit Growers' (NFG) Project 168

6.8 Further reading 171

Appendix 1 to Chapter 6: Referent Group net benefits in the ICP Case Study 171

Appendix 2 to Chapter 6: Incorporating the public funds cost premium in the ICP Case Study 177

Exercises 180

Chapter 7: Consumer and producer surplus in cost-benefit analysis 182

7.1 Introduction 182

7.2 Real versus pecuniary effects 183

7.3 Consumer surplus 184










Aggregating consumer surplus measures 185



The significance of income distribution 186





7.4 Producer surplus 186

7.5 Accounting for output price changes 186










Benefits of urban transport projects 187



Benefits of worker training 193



Producer benefits from an irrigation project 196





7.6 Accounting for input price changes 201

7.7 Price changes in other markets 203

7.8 Classification of consumer and producer surplus changes 204

7.9 Further reading 205

Appendix 1 to Chapter 7: Allowing for an increase in the skilled wage in the ICP Case Study 206

Appendix 2 to Chapter 7: Compensating and equivalent variation 209

Exercises 215

Chapter 8: Non-market valuation 217

8.1 Introduction 217

8.2 Causes of market failure 217

8.3 Valuing environmental costs and benefits 219

8.4 Incorporating non-market values in cost-benefit analysis 223

8.5 Methods of non-market valuation 224










The production approach 225



The utility approach 230





8.6 Revealed and stated preference methods of applying the utility approach 233










Revealed preference methods 234



Stated preference methods 240





8.7 Benefit Transfer and Threshold Analysis 243

8.8 Alternative approaches to environmental valuation 244

8.9 Non-market valuation: the value of life 245

8.10 The Pandemic

8.11 Climate Change

8.12 Further reading

Appendix to Chapter 8: The annual benefits of the Virginia Creeper Trail as measured by the Travel Cost Method 248

Exercises 251

Chapter 9: Uncertainty, information and risk 253

9.1 Introduction 253

9.2 The value of information 255

9.3 An abbreviated cost-benefit analysis 257

9.4 The option of delay 257

9.5 Calculating the value of information 260

9.6 The cost of risk 262










The theory of risk aversion 262



Dealing with project risk 265





9.7 Risk modelling 267










Use of discrete probability distributions 268



Joint probability distributions 269



Continuous probability distributions 270





9.8 Using risk analysis in decision-making 273

9.9 Modelling risk in spreadsheet applications using ExcelSim (c) 274










Modelling a "random walk" 279





9.10 Further reading

Appendix 1 to Chapter 9: Incorporating risk analysis in the ICP Case Study 282

Appendix 2 to Chapter 9: Using the @Risk (c) (Palisade) Risk Modelling Program 285

Exercises 290

Chapter 10: Valuing traded and non-traded goods in cost-benefit analysis 292

10.1 Introduction 292

10.2 Traded and non-traded goods 292

10.3 Valuing traded and non-traded goods and services 293

10.4 Worked example: domestic and international price structures 294










Evaluation of an import-replacing project in real terms 294



Evaluation of an import-replacing project in money terms 295





10.5 Summary of the two approaches to valuation: border versus domestic prices 298

10.6 Equivalence of the two approaches 298

10.7 Determinants of the shadow exchange rate 302

10.8 Further reading 308

Appendix to Chapter 10: Shadow-pricing foreign exchange in the ICP case study 305

Exercises 308

Chapter 11: Appraisal of the distribution of project benefits and costs 310

11.1 Introduction 310

11.2 Measuring the degree of inequality 311

11.3 Alternative measures of income distribution 313

11.4 Policies to change the income distribution 314

11.5 The use of income distribution weights in project appraisal: some illustrative examples 314

11.6 The derivation of distribution weights 316

11.7 Distributional weighting in practice 322

11.8 Worked example: Incorporating income distribution effects in the NFG Project 326

11.9 Inter-temporal distribution considerations 327

11.10 Further reading 331

Exercises 331

Chapter 12: Economic impact analysis 334

12.1 Introduction 334

12.2 Multiplier analysis 334










The closed economy 334



The open economy 339



Crowding out 340



Cost-benefit analysis of fiscal stimulus 341



The employment multiplier 342





12.3 Inter-industry analysis 342










Inter-industry analysis and the national income multiplier 345



Inter-industry analysis and employment 346





12.4 General equilibrium analysis 348

12.5 Case study: The impact of the ICP Project on the economy 349

12.6 Further reading 352

Appendix to Chapter 12: The annual economic impact of the Virginia Creeper Trail 350

Exercises 352

Chapter 3: Writing the cost-benefit analysis report 354

13.1 Introduction 354

13.2 Contents of the report 355










The Executive Summary 355



The Introduction 355



The Methodology 355



The Analysis 356



The Conclusion 356





13.3 Other issues 357

Appendix to Chapter 13: Report on International Cloth Products Ltd.: Spinning Mill Proposal 357

Appendix 1: Case study assignments 371

A1.1 South Australian Olive Oil Project 372 A1.2 Walnuts Tasmania Project 376

A1.3 A tuna cannery in Papua New Guinea 380

A1.4 Urban water supply in South-East Queensland 383

A1.5 The Scottish Highlands and Islands remote dental care program 388 A1.6 The Defarian Early Childhood Intervention Program (DECIP) 392 A1.7 A pulp mill for Tasmania? 399

A1.8 Qingcheng Water Project 403 A1.9 Highway Project 2012 409

A1.10 International Mining Corporation (IMC) Copper Mining Project 416

A1.11 Comparative Levelized Cost of Electricity: Renewables vs Coal

A1.12 Cost-Benefit Analysis of the Proposed Repeal of Water Saving Regulations

A1.13 Cost-Benefit Analysis of the Proposed Extension to the Mount Beno Walking Trail

A1.14 Cost-Benefit Analysis of a Proposed Drug Court Program in the State of Euphoria, Federal Republic of Oz

Appendix 2 Discount and Annuity Factors 424

Glossary 427

Index