When it comes to making an informed investment decision, one way is to use the benefit-cost ratio (BCR).
Benefit-Cost Ratio Defined
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.
How the Benefit-Cost Ratio is Calculated
= ((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:
| 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
Analyzing the Results
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.
Conclusion
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.