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Engineering Economy: Evaluating Projects With The Benefit-Cost Ratio Method - Chapter 10

The document provides an overview of using the benefit-cost ratio method to evaluate public projects. It discusses that public projects have unique challenges including larger scale, multiple purposes that may conflict, long time horizons, political influences, and difficulties measuring non-monetary benefits. It also covers challenges like selecting an appropriate discount rate for public projects and using incremental analysis for mutually exclusive alternatives. The benefit-cost ratio compares the present value of benefits to present value of costs, and a ratio over 1 indicates a project should be selected.

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53 views36 pages

Engineering Economy: Evaluating Projects With The Benefit-Cost Ratio Method - Chapter 10

The document provides an overview of using the benefit-cost ratio method to evaluate public projects. It discusses that public projects have unique challenges including larger scale, multiple purposes that may conflict, long time horizons, political influences, and difficulties measuring non-monetary benefits. It also covers challenges like selecting an appropriate discount rate for public projects and using incremental analysis for mutually exclusive alternatives. The benefit-cost ratio compares the present value of benefits to present value of costs, and a ratio over 1 indicates a project should be selected.

Uploaded by

ismail
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© © All Rights Reserved
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Engineering Economy

Lecture 8
Evaluating Projects with the Benefit-Cost Ratio Method - Chapter 10

Engineering Economy
Lecture Objective
The objective of this lecture is to demonstrate
the use of the benefit-cost ratio for the
evaluation of public projects.

Engineering Economy
Public projects are unique in many ways.
Frequently much larger than private ventures
They may have multiple, varied purposes that
sometimes conflict
Often very long project lives
Capital source is ultimately tax payers
Decisions made are often politically influenced
Benefits are often nonmonetary and are difficult to
measure
more...

Engineering Economy
Private vs. Public Projects

Engineering Economy
These elements make engineering economy studies more challenging

In the USA:
The Flood Control Act of 1936 requires that
benefits must exceed costs to justify federally
funded projects, this is a criterion now used in most
public projects.
There can be difficulty defining benefits, and
even in establishing costs.

Engineering Economy
Perspective
For any project, the proper perspective
is to consider the net benefits to the
owners of the enterprise.
For government projects, the owners are ultimately the taxpayers.
Benefits are favorable consequences of the project to the public
(owners).
Costs represent monetary disbursements required of the
government.
Disbenefits represent negative consequences of a project to the
public (owners).

Engineering Economy
Self-liquidating projects

Self-liquidating projects are expected to


repay their costs.
These projects generally provide utility services
(power, water, toll roads, etc.).
They earn direct revenue that offset their costs, but
they are not expected to earn profits or pay taxes.
In some cases in-lieu payments are made to
governments in place of taxes and fees that would
have been paid had it been under private
ownership.

Engineering Economy
Cost allocations

Cost allocations in multiple-purpose,


public-sector projects tend to be arbitrary.
Some projects naturally have multiple purposes—
e.g., construction of a dam.
Some of the costs incurred cannot properly be
assigned to only one purpose.
Purposes may be in conflict.
Often support for a public project, and its many
purposes, is politically sensitive.

Engineering Economy
Difficulties

Difficulties inherent in engineering


economy studies in the public sector.
Profit standard not used to measure effectiveness
Monetary effect of many benefits is difficult to
quantify
May be little or no connection between the project and
the public (owners).
Often strong political influence whenever public funds
are used, with little consideration to long-term
consequences.
Engineering Economy
Difficulties

Difficulties inherent in engineering


economy studies in the public sector.

Public projects are more subject to legal restrictions


than private projects
The ability of governmental bodies to obtain capital is
more restricted than that of private enterprise
The appropriate interest rate for discounting benefits
and costs is often controversially and politically
sensitive.

Engineering Economy
Interest rate
Selecting the interest rate to use in public
projects is challenging.
Main considerations are
the rate on borrowed capital,
the opportunity cost of capital to the governmental
agency, and
the opportunity cost of capital to the taxpayers.
If money is borrowed specifically for a project,
the interest rate on the borrowed capital is
appropriate to use as the rate.
Engineering Economy
Interest rate

More interest rate considerations…


The 1997 Office of Management and Budget
directive states that a 7% rate should be used, as
an approximation of the return tax payers could
earn from private investments.
Another idea is to use a market-determined risk-
free rate, about 3-4% per year.
Bottom line: there is no simple formula, and it is
an important policy decision at the discretion of
the governmental agency.

Engineering Economy
Applying the benefit-cost ratio method

The consideration of the time value of money


means this is really a ratio of discounted
benefits to discounted costs.
Recommendations using the B-C ratio method
will result in identical recommendations to
those methods previously presented.
B-C ratio is the ratio of the equivalent worth of
benefits to the equivalent worth of costs.

Engineering Economy
Two B-C ratios
Conventional B-C ratio with PW

Modified B-C ratio with PW

A project is acceptable when the B-C ratio is greater


than or equal to one.
B-C ratios for annual worth.
Conventional B-C ratio with AW

Modified B-C ratio with AW


Example
Stillwater has initiated discussions on attracting rail service. A depot
would need to be constructed, which would require $500,000 in land and
$5.2 million in construction costs. Annual operating and maintenance
costs for the facility would be $150,000, and personnel costs would be
an additional $120,000. Other assorted costs would be born by the
railroad and federal authorities. Annual benefits of the rail service are
estimated as listed below.

$1,300,000 Railroad annual payments


$200,000 Rail tax charged to passengers
$180,000 Convenience benefits to local residents
$120,000 Additional tourism dollars for Stillwater

Apply the B-C ratio method, with a MARR of 8% per year and 20 year study
period, to determine if the rail service should be established.

Engineering Economy
Disbenefits (D) can be included in the B-C
ratio in either the numerator or denominator,
as shown with AW below.

or
Added benefits vs. reduced cost

As with the different types of ratios, the


question arises if classifying certain cash
flows as either added benefits or reduced
costs.
As before, while the numerical value of the
ratio may change, there is no impact on
project acceptability regardless of how the
cash flows are handled.

Engineering Economy
Selecting projects

If projects are independent, all projects that


have a B-C great than or equal to one may
be selected.
For projects that are mutually exclusive, a
B-C greater than one is required, but
selecting the project that maximizes the B-C
ratio does not guarantee that the best project
is selected.

Engineering Economy
Incremental B-C analysis for mutually exclusive projects.

Incremental analysis must be used in the case of B-


C and mutually exclusive projects.
Rank alternatives in order of increasing total
equivalent worth of costs.
With “do nothing” as a baseline, begin with the
lowest equivalent cost alternative and determine the
incremental B-C ratio (B/C), selecting the
alternative with the higher equivalent cost if the
ratio is greater than one.

Engineering Economy
The Incremental B–C Ratio Procedure

Engineering Economy
Which, if any, of the MEA projects below should
be selected using B-C analysis? Assume a 20
year study period and MARR=10%.
A B C
Investment $125,000 $160,000 $180,000
Annual O&M 10,000 10,000 9,500
MV (20 yrs.) 40,000 50,000 50,000
Benefit/yr. 35,000 42,000 44,000
PW(10%)-costs 204,190 237,703 253,447
PW(10%)-benefits 297,975 357,570 374,597
B-C ratio 1.46 1.50 1.47

Each alternative is attractive.


Incremental analysis
(B-A) (C-B)
Investment $35,000 $20,000
Annual O&M 0 -500
MV (20 yrs.) 10,000 0
Benefits/yr. 7,000 2,000
PW(10%)-costs 33,514 15,743
PW(10%)-benefits 59,595 17,027
B-C ratio 1.78 1.08
Conclusion B is better C is better

Choose alternative C.
Example

Tempe is considering four mutually exclusive public-works


projects. Their costs and benefits are presented in the table
below. Each project has a useful life of 50 years and the
MARR is 12% per year. Which of the projects, if any,
should be selected?
A B C D
Capital investment $23,000,000 $18,000,000 $31,000,000 $26,000,000
Annual op. and
1,800,000 1,200,000 2,100,000 2,000,000
maint. cost
Market value 2,400,000 2,200,000 4,000,000 3,100,000
Annual benefit 5,000,000 4,500,000 6,500,000 5,800,000

Engineering Economy
Some criticisms of B-C analysis.

B-C is often used as an “after-the-fact”


justification tool.
Distributional inequities (one group
benefits, another pays the cost) may not be
accounted for.
Qualitative information is often ignored.
Bottom line: these are largely reflective of
the inherent difficulties in evaluating public
projects rather than the B-C method itself.
Engineering Economy

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