Cost Benefit Analysis: The Logic and Process behind ERRs

ERR is the discount rate at which the net present value (NPV) of an income stream is equal to zero. This rate reflects the time preference for cash flows, with money today being considered more valuable than money in the future. The discount rate is a critical component of CBA, as it takes into account the interest rate and the value of money over time. NPV compares the present value of cash inflows with the present value of cash outflows, netting the difference and considering the discount rate. When NPV equals zero, the project is considered to be no better or worse off than investing in a bank. If NPV is greater than zero, the project is considered to be a good investment, while a negative NPV indicates that the project is not worth investing in. In contrast, CBA solves for the discount rate at which NPV equals zero, providing the ERR. If the ERR is higher than the interest rate, the project is considered to be a good investment. However, studies have shown that estimated ERRs are consistently biased upward, highlighting the need for checks and balances and an expanding evidence base. One of the key advantages of CBA is that it requires a clear development hypothesis, allowing for the inclusion of non-monetary costs, such as the opportunity cost of time. CBA also helps identify issues for evaluation and study, provides targets against which to measure success, and highlights critical assumptions that can be tested for sensitivity. Additionally, CBA is widely used by development agencies, making it a standard approach in the field. However, CBA also has some limitations. A higher ERR does not necessarily mean a higher absolute return, as the value of the return can be influenced by various factors. Furthermore, project investments can be lumpy, making it difficult to move resources from one project to another quickly, even if one project has a much higher ERR. Despite these limitations, CBA remains a widely used and effective tool for evaluating the investment-worthiness of projects.