1 Chapter 12 Benefit-Cost Analysis Framework of Benefit- Cost Analysis Evaluation of Benefits and Costs Benefit-Cost Ratios

2 Benefit-Cost Analysis Benefit-cost (BC) analysis is a decision making tool commonly used to systematically develop useful information about the desirable and undesirable effects of public projects. In the Benefits-cost analysis determining social benefits of a public activity is more important than costs. Examples of BC analyses: Public transportation systems, Environmental regulations on noise and pollution, Public safety programs, Education and training programs, Public health programs, Water resource development projects, and national defense programs.

3 Framework of Benefit-Cost Analysis 1) Identifying all the users’ benefits (favorable outcome) and disbenefits (unfavorable outcomes) expected to arise from the project. 2) Quantifying all benefits and disbenefits in dollars to allow comparisons. 3) Identify sponsor’s cost and quantify them. 4) Determine the equivalent benefits and costs at the base period and use an appropriate interest rate for the project. 5) Accept the project if the equivalent users’ benefits exceed the equivalent sponsors’ costs.

4 Benefit-Cost Ratios Alternative way to express the value of a public project is to compare the users’ benefits (B) to sponsors’ cost (C) by taking the ratio B/C. Define the benefit-cost (B/C) ratio, and explain the relationship between the conventional NPW criterion and the B/C ratio. If this BC ratio exceeds 1, the project can be justified

5 b n =Benefit at the end of period n, c n =Expense at the end of period n, A n = b n – c n N = Project life i =Sponsor’s interest rate (discount rate) Definition of Benefit-Cost Ratio

6 Equivalent capital investment at n = 0 Equivalent O&M costs at n = 0 Breakdown of the Sponsor’s Cost The sponsor’s cost ( C ) consist of the capital expenditure ( I ) and the equivalent annual operating and maintenance costs ( C’ ) accumulated in each successive period. Let’s assume series of initial investment required during the first K periods, while annual operating and maintenance costs accumulate in each period.

7 Relationship between B/C Ratio & NPW B > (I + C’) B – (I+ C’) > 0 PW(i) = B – C > 0

8 Example 12.1 BC Analysis $10 $5 $8 $20 $30 K = 1 N = 5 Benefits (b n ) Recurring costs (c n ) Investment (c n )

9 Solution: