Benefit Cost Analysis

Lecture slides to accompany
Basics of Engineering Economy

by
Leland Blank and Anthony Tarquin
Chapter 7
Benefit/Cost Analysis and Public
Sector Projects
Slide to accompany Blank and Tarquin

Basics of Engineering Economy, 2008
7-1
2008, McGraw-Hill
All rights reserved
Chapter 7 Benefit/Cost Analysis

TOPICS
PURPOSE
Learn about public
sector projects
compared to private
sector projects, and
perform a benefit/cost
analysis

7-2
Characteristics of public
and private sector
projects
B/C analysis of single
project
Incremental B/C method
for 2 or more projects
Service projects and CEA
Ethical considerations
2008, McGraw-Hill
All rights reserved
Sec 7.1 Public Sector Projects

Owned, used and financed by citizens of
government units. Some examples are:
Highways
Hospitals
Prisons
Emergency relief
Universities
Sports arenas
Public housing
Utilities
Public projects provide service to citizenry at

no profit
Partnerships of public entities and private
enterprise are more prevalent now as funding
for large public projects becomes
more
difficult
7-3
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Sec 7.1 Public Sector Project Characteristics

Size: Usually large compared to private projects with
initial investment distributed over several years
Life: Long-lived (often 30-50+ years); capitalized cost

method is useful with A = Pi estimating annual costs
Cash flows: No profits allowed; estimates are in form

of costs paid by government unit, benefits to the
citizenry (can include revenues or savings), and
disbenefits (descriptions on later slide)

7-4
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Sec 7.1 Public Sector Project Characteristics

Funding: Public projects use taxes, fees, bonds (and
gifts) for funding; taxes and fees are collected from

users of project services; funding examples are
federal/state taxes of various sorts, tolls, surcharge
fees
Interest rate: Called discount rate, it is considerably

lower than for private projects since no profit is
considered and governments are exempt from
taxes; typical rates in the 3 to 6% per year range
Alternative selection: Politics and special interest

groups make selection more complex for public
projects; B/C method developed to put more
objectivity into the analysis process

7-5
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Sec 7.1 Public Sector Project Estimates

Analysis requires estimates as accurate as possible for
costs, benefits, and disbenefits
Description
Example
Costs: expenditures to the

government to build,
maintain, & operate
project; salvage/sales
value possible
Bridge construction cost

Annual cost of drug
abusers treatment program
Benefits: advantages to
public; income and savings
New jobs and salary money

Reduced property taxes
Lower transportation costs
due to less gas used

7-6
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Sec 7.1 Public Sector Project Estimates

Disbenefits: expected undesirable, negative
consequences of project to owners the public;
usually these are economic disadvantages
estimable in monetary units
Disbenefits are not always included in the analysis;
subject to political and special interest argumentation
Examples
$55M school bond issue -- Increased property taxes
Tourist amusement park -- Higher local car insurance
premiums based on increased traffic accidents
New state prison Reduced property values for houses
in adjacent subdivisions
7-7
2008, McGraw-Hill
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Sec 7.1 Viewpoint for Public Sector Project

Analysis
Determine viewpoint (perspective) before
costs, benefits, and disbenefits are
estimated
Choose one and maintain it throughout
estimation and analysis. Sample viewpoints
Citizen
Tax base
Creation/retention of jobs
Economic development
Specific industry

7-8
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Sec 7.1 Types of Public Project Contracts

Traditional Construction Contract
Government funding via taxes, user fees and bonds
Constructed through fixed price or cost plus contract
with a profit margin specified for contractor
Owned and operated by government unit
CONTRACTOR SHARES NO RISK ON FINANCING OR OPERATION
Examples:
Design and construct a toll road
Install a networked IT system between 4 county offices
Design and build public housing for 400 families
7-9
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Public-Private Partnership
Often called BOT (Build-Operate-Transfer) contract
Contractor partially or completely responsible for
financial arrangements
Contractor operates and maintains system for
specified time period. Contract includes these funds
Ownership transferred to government in future. This
stage is often negotiated in different ways
Profit margin is specified for contractor during time of
involvement

7 - 10
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Public-Private Partnership
CONTRACTOR SHARES RISK ON FINANCING AND OPERATION
Examples:
Design, finance construct operate nuclear power plant
for 15 years
Recondition and operate state hospital for mental health
patients
Organize and operate a municipal security (police) force
for a 20-year period; contract renewable each 5 years
7 - 11
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Sec 7.2 B/C Analysis Single Project

Convert all estimates to
PW, AW or FW value at
discount rate i%. If PW used
If disbenefits are estimated,

subtract from benefits
Use PW, AW or FW for B/C
PW of benefits
PW of costs
Same formula for AW or FW
If D is added to costs in
denominator, the B/C
value changes, but
economic decision is the
same
All + signs, costs included

Salvage has sign;
subtracted from costs
7 - 12
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Guideline for economic justification
If B/C 1.0
accept project
If B/C < 1.0
project not acceptable
Example: P = $15 M
A = $500 K per year

B = $1,500 K per year
D = $200 K per year
i = 6%
n = 10 years
AW equivalent of P = $15M(A/P,6%,10) = $2,038 K
B/C =
= 0.51
7 - 13
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TWO ALTERNATE BENEFIT-COST MEASURES
Determine PW, AW or FW equivalent; place any salvage
in denominator with only initial investment cost
Same selection guideline: accept if B/C 1.0

If difference relation is desired, subtract net C from
net B, once equivalents are determined
Difference B-C = B C
Selection guideline: accept if B - C 0
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7 - 20
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Direct Formula Connection b/w the B/C of A

Public & Private Sector
Revenue alternative both revenues & costs are estimated
PW of project = PW of revenues PW of costs

Private sector revenues public sector benefits disbenefits (B D)
Denominator only first cost

Numerator only cash flows that result from the project from years 1
through its life.
Private sector disbenefits are omitted

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7 - 22
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7 - 23
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Sec 7.3 B/C Analysis for 2 Alternatives

Technique similar to incremental ROR
evaluation using i* for ME alternatives
ME are the mutually exclusive alternatives
Find equivalent PW, AW or FW; calculate B/C
Selection guideline
If B/C 1.0 select larger-cost alternative
Otherwise select lower-cost alternative
Decision is based on incrementally justified total
project cost, not incremental initial investment
7 - 24
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Sec 7.3-B/C Analysis for 2 ME Alternatives

PROCEDURE FOR B/C OF MUTUALLY EXCLUSIVE ALTERNATIVES
1.
Determine equivalent values for costs, benefits (and

disbenefits, if estimated)
2.
Order alternatives by increasing total equivalent cost

(for direct benefit alternatives, add DN first)
3.
For each pair 2 and 1, determine incremental C and B

over LCM. For usage cost alternative, use
B = usage cost2 usage cost1
4.
Determine B/C or (B-D)/C
5.
If B/C 1.0, eliminate A; B is survivor

Otherwise, A is survivor
Compare survivor with next alternative; continue steps
(3) (5) until only 1 alternative survives
6.

7 - 25
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Sec 7.3 B/C Analysis Example 1

Equal 30-year life; i = 5%; direct benefit alternatives
Step 1. No disbenefits; use equivalent AW of costs

AW1 = 10 M(A/P,5%,30) + 35,000 = $685,500
AW2 = 15 M(A/P,5%,30) + 55,000 = $1,030,750
Step 2. Add DN option with C = $0 and B = $0; comparison
order is DN, 1, 2
Step 3. Compare 1-to-DN over 30 years
7 - 26
cont
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Step 4.
B/C = 800,000/685,500 = 1.17
Step 5.
1.17 > 1, eliminate DN; 1 is survivor
Step 6.
Compare 2-to-1 (back to step 3)
Step 3. B = 1,050,000 800,000 = $250,000

C = 1,030,750 685,500 = $345,250
Step 4.
B/C = 250,000/345,250 = 0.72
Step 5.
0.72 < 1, eliminate 2; 1 is survivor
Step 6.
Select design 1

7 - 27
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8-year study period; i = 7%; usage cost alternatives
Step 1. Total cost is sum of two incentives. Determine AW

over 8 years. For proposal 1
AW1 = 250,000(A/P,7%,8) + 25,000 = $66,867
7 - 28
cont
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Step 2. Order alternatives by increasing AW of total costs
Step 3. Compare 2-to-1 over 8 years; use usage costs for B

B = entrance fee decrease + sales tax receipt increase
= 50,000 + 10,000 = $60,000
C = 93,614 66,867 = $26,747
Step 4. B/C = 60,000/26,747 = 2.24
Step 5. 2.24 > 1.0; eliminate 1; 2 survives
7 - 29
cont
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Step 6.
Compare 3-to-2 (back to step 3)

Table below completes the analysis

7 - 30
cont
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Results of comparisons
Compare 3-to-2: B/C = 25,000/40,120 = 0.62
Proposal 2 survives
Compare 4-to-2: B/C = 220,000/120,360 = 1.83
Proposal 2 eliminated; 4 survives
Conclusion: Select Proposal 4

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Service Sector Projects

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7 - 34
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Ethical Considerations in the Public Sector

7 - 35
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Benefit Cost Analysis

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Lecture slides to accompany

Basics of Engineering Economy

Slide to accompany Blank and Tarquin

Chapter 7 Benefit/Cost Analysis

Slide to accompany Blank and Tarquin

Sec 7.1 Public Sector Projects

Public projects provide service to citizenry at

Sec 7.1 Public Sector Project Characteristics

Life: Long-lived (often 30-50+ years); capitalized cost

Cash flows: No profits allowed; estimates are in form

Slide to accompany Blank and Tarquin

Sec 7.1 Public Sector Project Characteristics

gifts) for funding; taxes and fees are collected from

Interest rate: Called discount rate, it is considerably

Alternative selection: Politics and special interest

Slide to accompany Blank and Tarquin

Sec 7.1 Public Sector Project Estimates

Costs: expenditures to the

Bridge construction cost

New jobs and salary money

Slide to accompany Blank and Tarquin

Sec 7.1 Public Sector Project Estimates

Sec 7.1 Viewpoint for Public Sector Project

Slide to accompany Blank and Tarquin

Sec 7.1 Types of Public Project Contracts

Sec 7.1 Types of Public Project Contracts

Slide to accompany Blank and Tarquin

Sec 7.1 Types of Public Project Contracts

Sec 7.2 B/C Analysis Single Project

If disbenefits are estimated,

All + signs, costs included

Sec 7.2 B/C Analysis Single Project

If B/C < 1.0

project not acceptable

A = $500 K per year

Sec 7.2 B/C Analysis Single Project

Same selection guideline: accept if B/C 1.0

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Direct Formula Connection b/w the B/C of A

Revenue alternative both revenues & costs are estimated

PW of project = PW of revenues PW of costs

Denominator only first cost

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Slide to accompany Blank and Tarquin

Sec 7.3 B/C Analysis for 2 Alternatives

Sec 7.3-B/C Analysis for 2 ME Alternatives

Determine equivalent values for costs, benefits (and

Order alternatives by increasing total equivalent cost

For each pair 2 and 1, determine incremental C and B

Determine B/C or (B-D)/C

If B/C 1.0, eliminate A; B is survivor

Slide to accompany Blank and Tarquin

Sec 7.3 B/C Analysis Example 1

Step 1. No disbenefits; use equivalent AW of costs

Sec 7.3 B/C Analysis Example 1

B/C = 800,000/685,500 = 1.17

1.17 > 1, eliminate DN; 1 is survivor