Assignment Help !

prec0320

Chapter10-EvaluatingProjectswiththeBenefit-CostRatioMethod.pdf

Home >Business & Finance homework help >Accounting homework help >Assignment Help !

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Engineering Economy

Chapter 10: Evaluating Projects with

the Benefit-Cost Ratio Method

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The objective of Chapter 10 is to

demonstrate the use of the

benefit-cost ratio for the

evaluation of public projects.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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...

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

These elements make engineering

economy studies more challenging.

• 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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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).

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

B-C ratios for annual worth.

Conventional B-C ratio with AW

Modified B-C ratio with AW

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Pause and solve

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Annual benefits: $1,800,000

Annual O&M costs: $270,000

Capital Recovery: $5,700,000 (A/P, 8%,20) = $580,830

Solution

Since this value is 2.12, this is a good project for

Stillwater to consider.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Disbenefits (D) can be included in the B-C

ratio in either the numerator or denominator,

as shown with AW below.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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

maint. cost 1,800,000 1,200,000 2,100,000 2,000,000

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

Pause and solve

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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

maint. cost 1,800,000 1,200,000 2,100,000 2,000,000

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

Solution

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.