Lectures in Engineering

Economy

Prof. Corrado lo Storto

DIEG, Dept. of Economics and Engineering
Management
School of Engineering, University of Naples Federico II
email: corrado.lostorto@unina.it
phone: 081-768.2932

Major issues
Framework of benefit-cost analysis
Valuation of benefits and costs
Benefit-cost ratios
Incremental B-C analysis

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Benefit-Cost analysis

The Benefit-cost analysis is commonly used to evaluate public

projects.

Benefits of a non-monetary nature need to be quantified in

dollar terms as much as possible and factored into the
analysis.

A broad range of project users distinct from the sponsor

should be consideredbenefits and dis-benefits to all these
users can (and should) be taken into account.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Framework of Benefit-Cost Analysis

Identifying all the users and sponsors of the project.
Identifying all the benefits and dis-benefits of the project.
Quantifying all benefits and dis-benefits in some unit of money
measure.
Selecting an appropriate interest rate at which to discount
benefits and costs to a present value.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Analyses for Government Agencies and Public

Utilities
The government (public sector) analyst has usually greater
difficulties when he/she tries to measure benefits than does
the private sector analyst because the government sector
analyst should include the social benefits and cost of the
project;
Economic studies for government agencies are made easier
because such agencies are not subject to income tax. While
funds for many such agencies are obtained through income
taxes none of the agencies pays income taxes to others.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Criteria for judging acceptability of government

projects
Analyses of capital expenditures for independent projects can
take many forms, such as:
1. Maximization of the ratio of benefits to costs on an annual or
present equivalent basis;
2. Minimization of combined annual cost to the public user and
the agency supplier of the facility when benefits are fixed;
3. Minimization of the present value sacrificed if the project
were cut.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Major difficulties
What is perceived to be in the best interest of the public may
vary sharply over time:
1. It depends on changes in such conditions as the state of the
economy, foreign relations, public health, environmental
degradation, and public services;
2. Intangibles or irreducibles are generally more important in
public works than they are in private enterprises.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Major difficulties
Analysts who perform economic studies for a government
agency sometimes fall into the trap of making the study based
on just the disbursements and receipts for that particular agency
or government body it represents.
For example, a state or local government might rationalize that a
particular project is justified if the federal government pays most
of the cost, even though the project may be unjustified based on
total costs and benefits.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example
Classification of benefits and costs related to the completion of a
new toll road through a rural area having as a major goal to
shorten the distance between two large communities:
Benefits to Public
- Reduced vehicle operating costs
- Reduced commercial and non commercial travel time
- Increased safety
- Increased accessibility between communities
- Ease of driving
- Appreciation of land values

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example
Disbenefits to Public
- Land removed from agrucultural production
- Damages resulting from changes of water flow
- Decreased movement of livestock across highway
- Increased air pollution and litter
Cost to State
- Construction costs
- Maintenance costs
- Administrative costs
Savings to State
- Toll revenues
- Increased taxes due to appreciated land and increased business
activity
Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example : Problem 1
A county is considering installing a water treatment system that
is expected to cause environmental and direct benefits of $
1,000,000 per year for its inhabitants. The system would require
an investment of $ 9,000,000 and have operating and
maintenance costs of $ 300,000 per year for an expected life of
20 years, after which it would have no value.
If money for this type of project costs the county 6%, is the
project justified on an economic basis? Suppose the state
government is willing to pay $ 4,000,000 of the investment. Now
is it justified?

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example: Solution to problem 1

Using the net present worth method based on total benefits and
costs, we get
Net PW = ($ 1,000,000 - $ 300,000)(P/A, 6%, 20) - $ 9,000,000 =
= - $ 971,000 < $ 0
Thus, it is not justified in total.
Based only on benefit and costs to the county:
Net PW = ($ 1,000,000 - $ 300,000)(P/A, 6%, 20)
- ($ 9,000,000 - $ 4,000,000) = $ 3,029,000 > $ 0
Thus, it is apparently justified to the county.
It would be common for county decision makers to consider only
the net PW = $ 3,029,000 on the county investment and
conclude that the project must be worthwhile, never seriously
considering that the net PW on the total investment is < $ 0.
Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example: Solution to problem 1

This is the equivalent of considering the states money as free,
which is sometimes rationalized on the basis that we ought
to get it, bacause if we dont some other agency or organization
will.
Nevertheless, one should consider in principle the total
benefits and costs to determine if the investment of state as well
as county fund is justified.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Benefit-Cost Ratio Criterion

Equivalent Users' Net Benefits

Benefit-Cost Ratio=
Equivalent Sponsor's Net Cost

If this BC ratio exceeds 1, the project can be justified

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Definition of Benefit-Cost Ratio

B
C

n
b
(1

i)
n

n 0
N

cn (1 i)n

n 0

bn=Benefit at the end of periodbnn, 0

c 0

cn=Expense at the end of period nn,

An= bn cn
N = Project life

i =Sponsors interest rate (discount rate)

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Breakdown of the Sponsors Cost

I cn (1 i) n
n 0

C' cn (1 i) n
n K 1

Equivalent capital investment

at n = 0
Equivalent O&M costs
at n = 0

B
B
BC(i)

, I C' 0
C I C'

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example of B-C Analysis

$30
K=1
N=5

$10

Benefits (bn)
$20

$20

$5
$10

$30

$5

$8

$8

Recurring costs (cn)

Investment (cn)

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Solution
B = $20(P/F, 10%, 2) + $30(P/F, 1%, 3)
+$30(P/F, 10%, 4) + $20(P/F, 10%, 5)
= $71.98
C = $10 + $10(P/F, 10%, 1) + $5(P/F, 10%, 2) + $5(P/F, 10%, 3)
+ $8(P/F, 10%, 4)+ $8(P/F, 10%, 5)
=$37.41
I = $10 + $10(P/F, 10%, 1)
= $19.09
C = C I
= $18.3
BC(10%)

71.98
1.92 1, Accept the project.
$19.09 $18.32

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Relationship between B/C Ratio and NPW

B
1
I C'
B > (I + C)

B (I+ C) >
0
PW(i) = B C > 0

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Incremental Analysis Based on BC(i)

B Bk Bj
I I k I J
C' C'k C'j

BC(i)k j

I C'

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example 2: Incremental Benefit-Cost Ratios

A1

A2

A3

$5,000

$20,000

$14,000

12,000

35,000

21,000

4,000

8,000

1,000

$3,000

$7,000

$6,000

PW(i)

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Solution
A1

A2

A3

BC(i)

1.33

1.25

1.40

Ranking
Base

A1

A3

A2

I +C

$9,000

$15,000

$28,000

BC(i)31

$21,000 $12,000
($14,000 $5,000) ($1,000 $4,000)

1.5 1, select A2.

$35,000 $21,000
($20,000 $14,000) ($8,000 $1,000)
1.08 1, select A2.

BC(i)23

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Interest rate for government projects

Three main choices for the interest rate to use in government
economic studies are as follows:
1. borrowing rate
2. the opportunity cost to the governmental agency
3. the opportunity cost to the taxpayer

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

The borrowing rate

In general, it is appropriate to use the borrowing rate only for
cases in which money is borrowed specifically for the project
under analysis and where use of that money will not cause other
worthy projects to be foregone.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

The opportunity cost

It is the interest rate on the best investment opportunity
foregone.
If projects are chosen so that the return rate on alla accepted
projects is higher than the return on any of the rejected projects,
then the interest rate for use in the economic analysis is equal to
the opportunity cost.
If this is done for all projects and investment capital available
within a government agency, then the result is a government
opportunity cost. If, on the other hand, one considers the best
opportunity available to the taxpayers if the money were not
obtained through taxes for use by the government agency, the
result is a taxpayers opportunity cost.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Comparing alternatives using benefit-cost analysis

when receipts and disbursements are known: an
example
Lathe
A

$ 10,000

$ 15,000

5 yr

10 yr

Salvage value

$ 2,000

$0

Annual receipts

$ 5,000

$ 7,000

Annual disbursements

$ 2,200

$ 4,300

First cost
Life

Minimum attractive rate of

return=8%
Study period=10 yr

Two alternatives lathes are considered in the analysis. Annual receipts

are treated as annual benefits, while annual disbursements are treated
as annual operating and maintenance costs.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Comparing alternatives using benefit-cost analysis

when receipts and disbursements are known:
solution to the example
It is assumed that after 5 years lathe A will be replaced with
another lathe having an identical cash flow profile. Hence,
annual worths for individual life cycles can be used in computing
the benefit-cost ratio.
The first increment of investment (the $ 10,000 for lathe A) has
a B/C of 1.294 > 1.
Hence, the increment of investment in lathe A is justified.
The next step is to determine if the second increment of
investment is justified. The simplest approach is to divide the
difference in the annual worths of net annual benefits by the
differences in capital recovery costs.
CR=lathe
$ 15,000(A/P,
8%, 10) = $ 2,235
For
B,

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Comparing alternatives using benefit-cost analysis

when receipts and disbursements are known:
solution to the example

For the second increment of investment,

B/C =

$ 7,000 - $ 4,300 $ 5,000-$ 2,200

$ 2,235 - $ 2,163

$ 2,700 - $ 2,800
$ 2,235 - $ 2,163

- $ 100
= -1.39 < 1
$ 72

Since the modified B/C ratio for the increment of investment from lathe
A to lathe B has a value less than 1, the increment cannot be justified
and thus lathe A is recommended.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Comparing numerous alternatives using benefitcost analysis when receipts and disbursements are
known: example
The following example shows 6 investment alternatives. Each
alternative has a salvage value equal to the investment and there is no
depretiation cost, and the incremental capital recovery cost equals the
product of the MARR and the incremental investment:
Alternatives
A

Investment

$ 1,000 $ 1,500 $ 2,500 $ 4,000 $ 5,000 $ 7,000

Annual savings in cash

disbursements

$ 150

Salvage value

$ 1,000 $ 1,500 $ 2,500 $ 4,000 $ 5,000 $ 7,000

$ 375

$ 500

$ 925

$ 1,125 $ 1,425

MARR = 18%
Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Summary
A benefit-cost analysis is commonly used to evaluate
public projects;
Difficulties involved in public project analysis include the
following:
1) Identifying all the users who can benefit from the
project;
2) Identifying all the benefits and disbenefits of the
project;
3) Quantifying all benefits and disbenefits in some
money unit of measure;
4) Selecting an appropriate interest rate at which to
discount benefits and costs to a present value;
Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Summary
The B/C ratio is defined as:

BC(i)

B
B

,I C' 0
C I C'

The decision rule is if BC(i) > 1, the project is acceptable.

The net B/C ratio is defined as

B C' B'
B / C(i)
,I 0
I
I'
The net B/C ratio expresses the net benefit expected per
dollar invested. The same decision rule applies as for
the B/C ratio.

Engineering Economy/public activities/ 2005 /prof. corrado lo storto