Benefit-Cost RatioDefined along with Formula & How to Calculate
The Benefit-Cost Ratio (BCR) measures the rate of profitability of the planned project and is used to summarize its benefits and relative costs in a cost-benefit analysis.
When the BCR is more than 1.0, it is expected that a positive net present value can be expected from the project to the firm and its investors.
The BCR is commonly expressed in qualitative terms or values.
How Benefit-Cost Ratio Works?
The Benefit-Cost Ratio is widely used in Capital Budgeting that helps the business to identify, evaluate and select the right capital investment for taking on a new project based on the firm’s current situation.
The new project may be for a replacement or an expansion of the firm’s existing Property, Plant, or Equipment (PPE), the improvement of a product, or technological innovations.
For particularly large projects, assumptions and uncertainties are not easy to quantify and this causes the cost-benefit analysis harder to get right.
To determine whether taking on a new project is viable, the BCR is used.
It is also used to measure how much of the Internal Rate of Return (IRR) of the project exceeds the discount rate which is computed by deducting the opportunity cost of capital from the Weighted Average Cost of Capital (WACC).
Benefit-Cost Ratio Formula = Present Value of Cash Inflows (Benefit) / Present Value of Cash Outflow (Cost)
In the computation of the BCR, the total cash benefits and total cash costs are computed.
Before these two are divided, their present values need to be computed first while also considering the terminal values including salvage or remediation costs.
What Does the BCR Tell You?
If the BCR has a value that is greater than 1, it can mean the following: the Net Present Value (NPV) is a positive value, and the Internal Rate of Return (IRR) is above the discount rate used in DCF calculation.
Simply stated, it means that the NPV of the cash flows of the project outweighs the NPV of the costs and the firm should consider going ahead with the project.
If the BCR is equal to 1, this means that the cost equals the profits while a BCR of less than 1 is an outcome that should not be considered for the cost outweighs the profits.
Example of How to Use the BCR
ABC Company plans to replace its coffee roasting machine across all its 25 branches.
The company intended to buy a new roasting machine worth $5,000 each or a total of $125,000.
Each machine is expected to have an annual cash inflow of $1,800 for the next 5 years.
The company wants to achieve a rate of return of 20% on the invested capital.
The present value of annual cash inflows of $45,000 for 5 years is:
$134,577 or (($45,000 / (1 + .20)1)) + (($45,000 / (1 + .20)2)) + (($45,000 / (1 + .20)3)) + (($45,000 / (1 + .20)4)) + (($45,000 / (1 + .20)5)).
The Benefit-Cost Ratio is therefore:
$1.08 ($134,577 / $125,000)
This indicates that the new project is almost breakeven with only $1.08 in benefits for every $1 cost.
Limitations of the BCR
Using the BCR alone may not be sufficient for firms to decide whether to go ahead with a project or not and must be used along with other forms of financial analysis so that firms can make better financial decisions.
There are many factors that affect the success or failure of projects and it cannot be based on a number of more than 1 for it to be deemed successful and less than 1 for it to be considered not viable.
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University of Pennsylvania "A Primer for Understanding Benefit-Cost Analysis" White paper. April 21, 2022
Penn State "Net Present Value, Benefit Cost Ratio, and Present Value Ratio for project assessment" Page 1 . April 21, 2022