When it comes to making an informed investment decision, one way is to use the benefit-cost ratio (BCR).
The BCR calculates how profitable a project’s (or an asset’s) cash flows are via a present value cash flow analysis. It takes the value of all incoming cash flows and weighs it against the same project’s or asset’s outgoing cash flows. If the calculation results in a BCR higher than 1, then more than likely that asset and/or project will provide a positive outcome.
=Â ((Moneys received / 1 + discount rate) ^ Cash flow time frames)) / ((Moneys expended / 1 + discount rate) ^ Cash flow time frames))
Money received can also be referred to as the cash flows’ benefits. Money expended is also referred to as cash flow. This formula essentially divides the discounted cash flows by the discounted cash outflows. It’s important to mention that the discount rate can also be referred to as the business’s or investor’s required return.
The following is an example of the different levels of cash flows:
| Â | Start | 1 Year Later | 2 Years Later | 3 Years Later |
|---|---|---|---|---|
| Outflows | -$8,000 | -$16,000 | -$20,000 | -$27,500 |
| In-Flows | — | — | $80,000 | $120,000 |
| Net Cash Flow | -$8,000 | -$16,000 | $60,000 | $92,500 |
Based on the calculations, the following illustrates the results for both Discounted Costs and Discounted Benefits:
| Time Frame | Discounted Costs | Discounted Benefits |
|---|---|---|
| Start | $8,000 | 0 |
| After 1 Year | -$16,000 / (1 + 10 percent)1 = $14,545.45 | 0 |
| After 2 Years | -$20,000 / (1 + 10 percent)2 = $16,528.93 | $80,000 / (1 + 10 percent)2 = $66,115.70 |
| After 3 Years | -$27,500 / (1 + 10 percent)3 = $20,661.16 | $92,500 / (1 + 10 percent)3 = $69,496.62 |
The final calculation sums up the Discounted Benefits and the Discounted Costs and then divides them, resulting in:
$135,612.32 / $59,735.54 = 2.27
The resulting figure means that $2.27 is expected to be generated per $1 invested. It can be used by both internal stakeholders and potential external investors to gauge if the asset or project is worth the risk.
If the BCR came back at less than 1, it would indicate an Internal Rate of Return (IRR) that is lower than the discount rate. This reading would also show that the net present value of the project or asset is projected to be negative.
If the BCR is 1, this essentially means the net pre-set value is zero. The IRR would be equal to the discount rate.
If, however, the BCR is more than 1 – as in the example above – it means the IRR is higher than the discount rate, and the net present value is more than zero.
It’s important to consider that these are only assumptions. If, for example, the cash flow forecasting is incorrect or the discount rate is off, the ratio can provide wide variances.
Whether it’s an internal stakeholder or a potential investor, this ratio can and should be used as part of a holistic financial analysis program.
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The BCR calculates how profitable a project’s (or an asset’s) cash flows are via a present value cash flow analysis. It takes the value of all incoming cash flows and weighs it against the same project’s or asset’s outgoing cash flows. If the calculation results in a BCR higher than 1, then more than likely that asset and/or project will provide a positive outcome.
=Â ((Moneys received / 1 + discount rate) ^ Cash flow time frames)) / ((Moneys expended / 1 + discount rate) ^ Cash flow time frames))
Money received can also be referred to as the cash flows’ benefits. Money expended is also referred to as cash flow. This formula essentially divides the discounted cash flows by the discounted cash outflows. It’s important to mention that the discount rate can also be referred to as the business’s or investor’s required return.
The following is an example of the different levels of cash flows:
| Â | Start | 1 Year Later | 2 Years Later | 3 Years Later |
|---|---|---|---|---|
| Outflows | -$8,000 | -$16,000 | -$20,000 | -$27,500 |
| In-Flows | — | — | $80,000 | $120,000 |
| Net Cash Flow | -$8,000 | -$16,000 | $60,000 | $92,500 |
Based on the calculations, the following illustrates the results for both Discounted Costs and Discounted Benefits:
| Time Frame | Discounted Costs | Discounted Benefits |
|---|---|---|
| Start | $8,000 | 0 |
| After 1 Year | -$16,000 / (1 + 10 percent)1 = $14,545.45 | 0 |
| After 2 Years | -$20,000 / (1 + 10 percent)2 = $16,528.93 | $80,000 / (1 + 10 percent)2 = $66,115.70 |
| After 3 Years | -$27,500 / (1 + 10 percent)3 = $20,661.16 | $92,500 / (1 + 10 percent)3 = $69,496.62 |
The final calculation sums up the Discounted Benefits and the Discounted Costs and then divides them, resulting in:
$135,612.32 / $59,735.54 = 2.27
The resulting figure means that $2.27 is expected to be generated per $1 invested. It can be used by both internal stakeholders and potential external investors to gauge if the asset or project is worth the risk.
If the BCR came back at less than 1, it would indicate an Internal Rate of Return (IRR) that is lower than the discount rate. This reading would also show that the net present value of the project or asset is projected to be negative.
If the BCR is 1, this essentially means the net pre-set value is zero. The IRR would be equal to the discount rate.
If, however, the BCR is more than 1 – as in the example above – it means the IRR is higher than the discount rate, and the net present value is more than zero.
It’s important to consider that these are only assumptions. If, for example, the cash flow forecasting is incorrect or the discount rate is off, the ratio can provide wide variances.
Whether it’s an internal stakeholder or a potential investor, this ratio can and should be used as part of a holistic financial analysis program.
DisclaimerÂ
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact a professional regarding the topics in these articles. The images linked to these articles are protected by copyright and should not be copied for any reason.
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