Private Benefit-Cost Analysis: Financial Analysis
As noted in Chapter 1, social benefit-cost analysis takes a wide, [social] perspective in the context of investment appraisal – it measures and compares the costs and benefits experienced by all members of [society]. In contrast, when a project is being evaluated by a private or public enterprise from a purely commercial or [private] perspective, account is taken only of the benefits and costs of the project that accrue to the enterprise itself and that affect its profitability. The project may have wider implications – environmental and employment effects, for example – but if these do not affect the enterprise's commercial profitability, they are omitted from the private analysis.
It is to be expected that the private enterprise would already have undertaken a private investment analysis of the project and will be basing its investment decision on the results of that analysis. However these results may not be available to the public sector decision-maker, and the social benefit-cost analysis, using discounted cash flow techniques very similar to those used in private benefit-cost analysis, and incorporating a private analysis, may be important in helping the public decision-maker decide what incentives are required in the form of tax concessions, for example, to induce the firm to undertake the project. For this reason the appraisal of a proposed project from a purely private viewpoint is often an integral part of a social benefit-cost analysis undertaken by the project analyst. This Chapter focuses on the methodology of private benefit-cost analysis, using discounted cash flow (DCF) analysis.
It can be noted that, in the case of a public project, similar considerations of revenue and cost flows to those addressed in the private analysis may be relevant in determining whether the government department decides to undertake the project or not. However, issues relating to government expenditure and tax flows are dealt with in the referent group analysis discussed in Chapter 6, and in the part of Chapter 10 dealing with the opportunity cost of public funds. The present Chapter considers only private sector projects.
Cash flows play a central role in the development and appraisal of almost any investment project: they are a summary presentation of the various costs and benefits expected to accrue over the project's life. As we saw in the previous Chapter, it is these cash flows that provide the main basis for deciding whether a project is [worthwhile] (are benefits greater than costs?), and/or which of a number of project variants or alternatives is the [best] (shows the greatest net benefits).