Can anyone tell me how to undertake cost benefit analysis (calculations of NPV, and IRR) for one year project in the agricultural sector? Most studies on cost benefit analysis are of a longer duration, between 5-30 years. For my case however, I want to do a CBA for just one year. Can this be possible in terms of determining cash flow?
If it is a one year study, then you wouldn't need to discount cash flows.
I would just sum cash flows in and out the projet ajusting for inflation. This Will give the NPV that is the net worth of the project today. Best regards
I am not sure what one year project is - if both costs and benefits are happening in (only) one year period; or if, for instance, the costs are one-time spent (irrigation equipment is built within several moths), but benefits are observable for longer period of time (several years)
Set the cash flow up on a monthly basis. Treat the first month as period 'zero' if using beginning-of-period accrual assumption or as period 'one' if using end-of-period accrual assumption (choice won't affect IRR but will affect NPV slightly). For NPV calculation, divide the annual discount rate (interest rate) by 12 (i.e., the APR method -- i.e., 12% annually becomes one percent monthly), and do everything as you would if the months had been years. If you calculate the IRR, the result will be the rate of return per month rather than per year. Because agricultural project cash flows often repay within one year, this approach is common in agricultural project appraisals -- especially in the financial analysis as opposed to economic analysis, since the loan terms often are set up to accommodate poor farm families who cannot finance a year of consumption out of their own savings -- thus, you would get 'infinite' IRR if you run the analysis on annualized basis! To 'annualize' the RESULTS for explanation purposes, once you have completed the calculations, you may simply reverse the APR process and multiply the IRR by 12. No need to multiply the NPV by 12, of course. Note that the APR method is not the only way to deal with the less-than-year conversion, but it is widely used, widely understood, and is incorporated into the commercial laws of many countries. [Note that you can do weekly and daily conversions with the same kinds of mathematics. This kind of time=period conversion also is commonly needed in energy efficiency applications -- for example, CBA of light bulb comparisons.]
Thanks a lot William Ward,.
I terms of decission criteria, which one is the best? NPV or IRR or both?
Capital budgeting textbooks typically tell you to use NPV, but that presumes you know with some degree of accuracy the cost of capital or the time preference rate with which to discount the cash flow. One problem is that most estimates of discount rate using cost of capital approach differ significantly from discount rate using time preference rates. Another problem is that estimates of each can vary significantly when different people make the calculation. And still another problem in developing countries -- particularly the least-developed countries -- is that national economic data sets are incomplete and not very good for estimating "national parameters" for cost-benefit analysis (such as shadow exchange rate and discount rate), partly due to prominence of informal sector/trade/employment in those countries. Thus, World Bank and the other multilateral development banks typically use the IRR, which allows them to then compare the project's IRR with notional costs of capital or time preference rates. By establishing a fairly high cutoff rate for the IRR, they are able to assure that the project meets both the IRR and the NPV criterion. Typical cutoff rates used by bi-lateral and multilateral development organizations are 10% and 12% (per annum) when cash flows are set up in constant prices -- which they always are for economic cost-benefit analysis.
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