ANSWER

Cost-Benefit Analysis (CBA) is a critical activity in the work of a business analyst.  While many business analysts may be brought onto a project well after this activity has occurred, nearly all projects which require a large amount of resources (time, people, or money) are assessed based on the CBA of the project.  The activity is typically performed by a business analyst, often one specializing in the area of financial analysis, though any business analyst can learn this straightforward activity.

The most prominent and well known aspect of CBA is Discounted Cash Flow (DCF) analysis which discounts future cash flows (both negative and positive) using a Discount Rate to arrive at a Net Present Value (NPV).   This is represented by the following equation.

NPV = (FVpos – FVneg) / [(1 + i)^t]

where,

• NPV = Net Present Value
• FVpos = Future Value of a Positive Cash Flow at “t” years
• FVneg = Future Value of a Negative Cash Flow at “t” years
• i = Discount Rate
• t = time (years from present)

Future cash flows are discounted using a Discount Rate (i) that is chosen to accurately reflect several factors:

1. Time Preference – The theory that a person or institution would rather have money in hand now to spend on immediate wants or needs rather than waiting for future cash flows.
2. Interest – Accounts for the fact that a person or institution that doesn’t receive money for several years also loses the opportunity to gain interest on the money for that period of time.
3. Risk Premium – Reflects the additional return that a person or institution requires on later cash flows to account for the risk of future payments not materializing.

While the Discount Rate used for DCF calculations will vary, it becomes clear that the discount rate should be larger than any single factor above.  If the interest that can be attained on the money that is being tied up is %5 per year, the discount rate should certainly be higher than 5% to account for Time Preference and the Risk Premium.