Benefit-Cost Ratio (BCR) Definition - Investopedia

Key Takeaways · A benefit-cost ratio (BCR) is an indicator showing the relationship between the relative costs and benefits of a proposed project, expressed in ... CorporateFinance&Accounting FinancialRatios FinancialRatios GuidetoFinancialRatios WhatIsaBenefit-CostRatio(BRC)? Abenefit-costratio(BCR)isaratiousedinacost-benefitanalysistosummarizetheoverallrelationshipbetweentherelativecostsandbenefitsofaproposedproject.BCRcanbeexpressedinmonetaryorqualitativeterms.IfaprojecthasaBCRgreaterthan1.0,theprojectisexpectedtodeliverapositivenetpresentvaluetoafirmanditsinvestors. KeyTakeaways Abenefit-costratio(BCR)isanindicatorshowingtherelationshipbetweentherelativecostsandbenefitsofaproposedproject,expressedinmonetaryorqualitativeterms.IfaprojecthasaBCRgreaterthan1.0,theprojectisexpectedtodeliverapositivenetpresentvaluetoafirmanditsinvestors.Ifaproject'sBCRislessthan1.0,theproject'scostsoutweighthebenefits,anditshouldnotbeconsidered. HowBenefit-CostRatioWorks Benefit-costratios(BCRs)aremostoftenusedincapitalbudgetingtoanalyzetheoverallvalueformoneyofundertakinganewproject.However,thecost-benefitanalysesforlargeprojectscanbehardtogetright,becausetherearesomanyassumptionsanduncertaintiesthatarehardtoquantify.ThisiswhythereisusuallyawiderangeofpotentialBCRoutcomes. TheBCRalsodoesnotprovideanysenseofhowmucheconomicvaluewillbecreated,andsotheBCRisusuallyusedtogetaroughideaabouttheviabilityofaprojectandhowmuchtheinternalrateofreturn(IRR)exceedsthediscountrate,whichisthecompany’sweighted-averagecostofcapital(WACC)–theopportunitycostofthatcapital. TheBCRiscalculatedbydividingtheproposedtotalcashbenefitofaprojectbytheproposedtotalcashcostoftheproject.Priortodividingthenumbers,thenetpresentvalueoftherespectivecashflowsovertheproposedlifetimeoftheproject–takingintoaccounttheterminalvalues,includingsalvage/remediationcosts–arecalculated. WhatDoestheBCRTellYou? IfaprojecthasaBCRthatisgreaterthan1.0,theprojectisexpectedtodeliverapositivenetpresentvalue(NPV)andwillhaveaninternalrateofreturn(IRR)abovethediscountrateusedintheDCFcalculations.ThissuggeststhattheNPVoftheproject’scashflowsoutweighstheNPVofthecosts,andtheprojectshouldbeconsidered. IftheBCRisequalto1.0,theratioindicatesthattheNPVofexpectedprofitsequalsthecosts.Ifaproject'sBCRislessthan1.0,theproject'scostsoutweighthebenefits,anditshouldnotbeconsidered. ExampleofHowtoUseBCR Asanexample,assumecompanyABCwishestoassesstheprofitabilityofaprojectthatinvolvesrenovatinganapartmentbuildingoverthenextyear.Thecompanydecidestoleasetheequipmentneededfortheprojectfor$50,000ratherthanpurchasingit.Theinflationrateis2%,andtherenovationsareexpectedtoincreasethecompany'sannualprofitby$100,000forthenextthreeyears. TheNPVofthetotalcostoftheleasedoesnotneedtobediscounted,becausetheinitialcostof$50,000ispaidupfront.TheNPVoftheprojectedbenefitsis$288,388,or($100,000/(1+0.02)^1)+($100,000/(1+0.02)^2)+($100,00/(1+0.02)^3).Consequently,theBCRis5.77,or$288,388dividedby$50,000. Inthisexample,ourcompanyhasaBCRof5.77,whichindicatesthattheproject'sestimatedbenefitssignificantlyoutweighitscosts.Moreover,companyABCcouldexpect$5.77inbenefitsforeach$1ofcosts. LimitationsofBCR TheprimarylimitationoftheBCRisthatitreducesaprojecttoasimplenumberwhenthesuccessorfailureofaninvestmentorexpansionreliesonmanyfactorsandcanbeunderminedbyunforeseenevents.Simplyfollowingarulethatabove1.0meanssuccessandbelow1.0spellsfailureismisleadingandcanprovideafalsesenseofcomfortwithaproject.TheBCRmustbeusedasatoolinconjunctionwithothertypesofanalysistomakeawell-informeddecision. 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Provider Name Description RelatedTerms InternalRateofReturn(IRR) Theinternalrateofreturn(IRR)isametricusedincapitalbudgetingtoestimatethereturnofpotentialinvestments. more NetPresentValue(NPV) NetPresentValue(NPV)isthedifferencebetweenthepresentvalueofcashinflowsandthepresentvalueofcashoutflowsoveraperiodoftime. more HowtoUsetheProfitabilityIndex(PI)Rule Theprofitabilityindex(PI)ruleisacalculationofaventure'sprofitpotential,usedtodecidewhetherornottoproceed. more ProfitabilityIndex Theprofitabilityindex(PI)isatechniqueusedtomeasureaproposedproject'scostsandbenefitsbydividingtheprojectedcapitalinflowbytheinvestment. more DiscountedAfter-TaxCashFlowDefinition Thediscountedafter-taxcashflowmethodvaluesaninvestment,startingwiththeamountofmoneygenerated. more WhatIsthePaybackPeriod? Thepaybackperiodreferstotheamountoftimeittakestorecoverthecostofaninvestmentorhowlongittakesforaninvestortohitbreakeven. more PartnerLinks RelatedArticles FinancialRatios HowDoICalculateaDiscountRateOverTimeUsingExcel? CorporateFinance AnIntroductiontoCapitalBudgeting FinancialRatios HowDoYouCalculateIRRinExcel? FinancialRatios WhatIstheFormulaforCalculatingNetPresentValue(NPV)? FinancialRatios WhatIstheDifferenceBetweenWACCandIRR? FinancialAnalysis HowtoCalculateReturnonInvestment(ROI)