CTC 475 Review Evaluating alternatives Evaluating alternatives Ranking Method (PW, AW, FW) Ranking Method (PW, AW, FW) Incremental Method (PW, AW, FW, IRR, ERR, SIR) Incremental Method (PW, AW, FW, IRR, ERR, SIR) Put alternatives in order of initial investment Put alternatives in order of initial investment Determine cash difference of first 2 alternatives Determine cash difference of first 2 alternatives Determine whether incremental benefits outweigh incremental costs Determine whether incremental benefits outweigh incremental costs Compare winner to next alternative Compare winner to next alternative

CTC 475 Benefit-Cost Analyses

Objectives Know why B/C ratio is used Know why B/C ratio is used Know how public projects differ from private sector projects Know how public projects differ from private sector projects Know the pitfalls of using B/C ratio Know the pitfalls of using B/C ratio

Public Projects 1. Cultural development (education, historic, recreation) 2. Economic Services (transportation, power generation) 3. Natural Resources (pollution control, flood control, wildlife management) 4. Protection (military services, police, fire)

Differences from private sector projects Big initial costs (millions) Big initial costs (millions) Long lives (50, 100 years) Long lives (50, 100 years) Multiple-uses (lake might be used for recreation, flood control, irrigation, power generation) Multiple-uses (lake might be used for recreation, flood control, irrigation, power generation) Difficult to define cash flow ($ value on aesthetics?) Difficult to define cash flow ($ value on aesthetics?)

Public projects Standard method for evaluation is the B/C ratio Standard method for evaluation is the B/C ratio Flood Control Act of 1936 – Benefits must exceed costs

B/C ratio Benefits-Public benefits associated with the project Benefits-Public benefits associated with the project Costs-Government costs associated with the project Costs-Government costs associated with the project Disbenefits-Unfavorable consequences to the public associated with the project Disbenefits-Unfavorable consequences to the public associated with the project

B/C Ratio Example Alt. Initial Cost Total Govt. Annualized Costs (initial and O&M) Total Public Annualized Costs (accidents, time of travel, operating costs) Route A $417,000$677,000$16,973,000 Route B $1,023,000$1,243,000$13,605,000 Route C $1,734,000$2,103,000$12,678,000

B/C ratio? There are no defined benefits, so you can’t directly determine B/C ratio There are no defined benefits, so you can’t directly determine B/C ratio However, spending extra money does lower total public costs However, spending extra money does lower total public costs Need to use incremental method Need to use incremental method

Compare B and A (B-A) Incremental Benefits: Incremental Benefits: $16,973,000-$13,605,000=$3,368,000 per year Incremental Costs: Incremental Costs: $1,243,000-$677,000=$566,000 per year B/C (B-A) = 5.95 (>1) B/C (B-A) = 5.95 (>1) Prefer Route B over Route A Prefer Route B over Route A

Compare C and B (C-B) Incremental Benefits: Incremental Benefits: $13,605,000-$1,678,000=$927,000 per year Incremental Costs: Incremental Costs: $2,103,000-$1,243,000=$860,000 per year B/C (C-B) = 1.08 (>1) B/C (C-B) = 1.08 (>1) Prefer Route C over Route B Prefer Route C over Route B

Annual Worth Method Alt. Total Govt. Annualized Costs (initial and O&M) Total Public Annualized Costs (accidents, time of travel operating costs) Total Costs Route A $677,000$16,973,000$17,650,000 Route B $1,243,000$13,605,000$14,848,000 Route C $2,103,000$12,678,000$14,781,000

Considerations 1. Point of view 2. Selecting MARR 3. Assessing benefit-cost factors 4. Overcounting 5. Unequal lives 6. Tolls & fees 7. Multiple-Use Projects 8. Problems with B/C ratio

1. Point of View Individual Individual Particular government agency Particular government agency Local area Local area Regional area Regional area Entire nation Entire nation

2. Choosing MARR Public projects are funded by taxes, bonds, tolls. Making a profit is not government’s motive: Use zero? Use zero? Use rate paid by government for borrowed money? Use rate paid by government for borrowed money? Use rate that private investors use? Use rate that private investors use?

3. Determining Benefit-Cost Factors How far do you go in determining benefit- costs? Short-term benefits to local economy? Short-term benefits to local economy? Secondary benefits? Secondary benefits? How do you put a price tag on aesthetics, wildlife, views, etc.? How do you put a price tag on aesthetics, wildlife, views, etc.?

4. Overcounting Must be careful and not count twice Wages lost through disability Wages lost through disability Company’s cost of disability insurance Company’s cost of disability insurance

5. Unequal Lives How do you calculate salvage values for public works projects?

6. Tolls, Fees and User Charges Tolls and user fees effect B/C ratio, but not necessarily B-C Example: EUAC=$20,000 for public facility EUAC=$20,000 for public facility 10,000 people per year attend facility 10,000 people per year attend facility Person receives $3 of benefits per event Person receives $3 of benefits per event

Without User Fee B/C=($3*10,000)/$20,000=1.5 B/C=($3*10,000)/$20,000=1.5 B-C=$30,000-$20,000=$10,000 per year B-C=$30,000-$20,000=$10,000 per year

With User Fee Fee of $1.50 is charged Fee of $1.50 is charged Net benefits are only $1.50 Net benefits are only $1.50 Govt. Cost is reduced by $15,000 Govt. Cost is reduced by $15,000 Govt. Cost is $5,000 per year Govt. Cost is $5,000 per year B/C=($1.5*10,000)/$5,000=3 B/C=($1.5*10,000)/$5,000=3 B-C=$15,000-$5,000=$10,000 per year B-C=$15,000-$5,000=$10,000 per year

7. Multiple-Use Project For incremental costs you can sometimes expand a public project to provide multiple benefits

Example Project PW Costs (millions) PW Benefits (millions) B/C ratio Dam& Res. For Irrigation $14.5$ Dam & Res. For Flood Control $9$60.67 Dam & Reservoir for Irrigation & Flood Control $18.5$311.68

Use incremental analysis to Evaluate Dam for Irrigation Only versus Dam for Irrigation & Flood Control Incremental benefits 31-25=6 Incremental benefits 31-25=6 Incremental costs = =4 Incremental costs = =4 Incremental B/C ratio = 1.5 Incremental B/C ratio = 1.5 >1 means that it’s worth spending the extra money to derive both benefits >1 means that it’s worth spending the extra money to derive both benefits

Problems with B/C Don’t make the mistake of ranking B/C ratios Don’t make the mistake of ranking B/C ratios In previous example, ranking would have given us the wrong answer (see next slide) In previous example, ranking would have given us the wrong answer (see next slide)

Example Project PW Costs PW Ben. B/C ratio B-C Dam& Res. For Irrigation $14.5$251.72$10.5 Dam & Res. For Flood Control $9$60.67-$3 Dam & Reservoir for Irrigation & Flood Control $18.5$311.68$12.5

Other Problems with B/C Ratio Benefits/Costs must be determined objectively Benefits/Costs must be determined objectively Don’t play games to get the result you want Don’t play games to get the result you want

Other types of Analysis Sometimes you can’t measure a project in terms of $ alone Sometimes you can’t measure a project in terms of $ alone Reliability, performance, availability, maintainability may be important Reliability, performance, availability, maintainability may be important Defense and space systems may use other methods than consideration of costs alone Defense and space systems may use other methods than consideration of costs alone

Next lecture Taxes affect cash flows Taxes affect cash flows Depreciation affects taxes Depreciation affects taxes Interest affect taxes Interest affect taxes