What is the Benefit-Cost Ratio (BCR)?
The benefit-cost ratio (BCR) is a profitability indicator used in cost-benefit analysis to determine the viability of cash flows generated from an asset or project. The BCR compares the present value of all benefits generated from a project/asset to the present value of all costs. A BCR exceeding one indicates that the asset/project is expected to generate incremental value.
Formula for the Benefit-Cost Ratio
The formula for the benefit-cost ratio is outlined below:
- CF = Cash flow
- i = Discount rate
- n = Number of periods
- t = Period that the cash flow occurs
Although the formula above may appear complicated, the calculation is simply the discounted cash inflows divided by the discounted cash outflows. The discount rate used refers to the cost of capital, which can be the company’s required rate of return, the hurdle rate, or the weighted average cost of capital.
- The benefit-cost ratio is used to determine the viability of cash flows from an asset or project.
- The higher the ratio, the more attractive the project’s risk-return profile.
- Poor cash flow forecasting or an incorrect discount rate would lead to a flawed benefit-cost ratio.
Example of the Benefit-Cost Ratio
Cash flow projections for a project are provided below. The relevant discount rate is 10%.
Question: What is the benefit-cost ratio of the project?
The benefit-cost ratio would be calculated as $97,670.72 / $33,625.09 = 2.90.
Interpreting the Benefit-Cost Ratio
The higher the BCR, the more attractive the risk-return profile of the project/asset. The value generated by the BCR indicates the dollar value generated per dollar cost.
For example, the BCR of 2.90 in the preceding example can be interpreted as “For each $1 of cost in the project, the expected dollar benefits generated is $2.90.” The following shows the value range of the BCR and its general interpretation:
Advantages of the Benefit-Cost Ratio
Key advantages of the benefit-cost ratio include:
- It is a useful starting point in determining a project’s feasibility and whether it can generate incremental value.
- If the inputs are known (cash flows, discount rate), the ratio is relatively easy to calculate.
- The ratio considers the time value of money through the discount rate.
- The ratio indicates the value generated per dollar of costs.
Limitations of the Benefit-Cost Ratio
Key limitations of the benefit-cost ratio include:
- The reliability of the BCR depends heavily on assumptions. Poor cash flow forecasting or an incorrect discount rate would lead to a flawed ratio.
- The ratio itself does not indicate the project’s size or provide a specific value on what the asset/project will generate. For example, both projects below show a BCR of 2, but present value cash flows are significantly different:
Although the benefit-cost ratio is a simple tool to gauge the attractiveness of a project or asset, it should not be the sole determinant of a project’s feasibility. Other ratios and further analysis are recommended.
The BCR is extremely sensitive to the cash flow forecasts and discount rates. If you think the underlying assumptions are incorrect or biased, the benefit-cost ratio should not be relied on.
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