Benefit Cost Ratio Analysis

A variant of SNPV analysis that is often used in complex capital budgeting situations is called benefit-cost (B/C) ratio analysis. The benefit-cost ratio is calculated as follows:

PV of MSB{ PV of MSCi

The B/C ratio shows the relative attractiveness of any social program or public-sector investment project, or the present value of marginal social benefits per dollar of marginal social cost.

In Table 16.1, SNPV > 0 implies a desirable investment program and B/C ratio > 1. For example, the benefit-cost ratio for program B is

PV of MSB PV of MSC

social internal rate of return

Interest or discount rate that equates the present value of the future benefits to the initial cost or outlay

This means that program B returns $1.42 in marginal social benefits for each dollar of marginal social costs, when both figures are expressed in present-value terms. On the other hand, program A returns only in marginal social benefits for each dollar of marginal social costs, whereas program C returns $1.27 in marginal social benefits for each dollar of marginal social cost.

In B/C ratio analysis, any social program with B/C ratio > 1 should be accepted; any program with B/C ratio < 1 should be rejected. Programs will be accepted provided that they return more than a dollar of discounted benefits for each dollar of cost. The B/C ratio and SNPV methods always indicate the same accept/reject decisions for independent programs, because B/C ratio > 1 implies SNPV > 0 and B/C ratio < 1 implies SNPV < 0. However, for alternative programs of unequal size, B/C ratio and SNPV criteria can give different program rankings.

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