3 Analysing the Options
3.1 Cashflows
Chapter 2 provided guidance about the types of costs and benefits that should be included in a cost-benefit analysis. Chapter 2 also indicated that costs and benefits over the economic life of the proposal should be included. And real costs and benefits (i.e. all prices in today’s dollars) should be used unless significant relative price changes are expected.
In simple terms, once the advice in chapter 2 is followed, a forecast of the relevant net cashflows should be available for each period of the project, over the known length of time over which the proposal is being evaluated. There would be one net cashflow for each year, for example, or one for each month for shorter proposals. For proposals of less than four years, it is a good idea to use monthly flows. Remember that costs and benefits do not necessarily have to correspond to physical flows of cash (although they usually do). If non-monetary/qualitative costs or benefits can be estimated in monetary terms, they can be included in the analysis as per any other cash flow (e.g. costs of death or injury).
These cashflows will be referred to as cashflows for “net present value” purposes. The term “net present value”, abbreviated to NPV, will be explained in the course of this chapter.
Some net cashflows may be positive and some may be negative.
Example 3.1: Net Cashflows
The Ministry of Information Technology is considering an interim upgrade to its existing fines-collection software.
The interim upgrade will initially require a significant investment of $100 million. From the first year the upgrade is fully operational, running costs (IT staff, training of operators) will be $20 million a year higher than with the existing system. However, the upgrade is expected to reduce the on-the-ground costs of collecting fines considerably, because collection agencies will be provided with correct and timely information, and the system will be able to identify those people most likely to pay if followed up. These cost savings are expected to amount to $65 million per year. All amounts are expressed in today’s prices (i.e. in real terms).
The upgraded system would run for a three-year period after which a completely new replacement system is expected to be available.
The table below shows the expected cash inflows, outflows and net cashflows for NPV purposes. All cashflows are marginal (or incremental), i.e. over and above the cashflows in the case of no upgrade (i.e. the status quo or do nothing option).
| Year | 0 | 1 | 2 | 3 |
|---|---|---|---|---|
| Forecast cash inflow | 0 | 65 | 65 | 65 |
| less forecast cash outflow | 100 | 20 | 20 | 20 |
| Forecast net cashflow | -100 | 45 | 45 | 45 |
