Lectures in Engineering Economy Prof. Corrado lo Storto DIEG, Dept. of Economics and Engineering Management School of Engineering, University of Naples Federico II phone:

Major issues Engineering Economy/public activities/ 2005 /prof. corrado lo storto Framework of benefit-cost analysis Valuation of benefits and costs Benefit-cost ratios Incremental B-C analysis

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 considered—benefits 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: Engineering Economy/public activities/ 2005 /prof. corrado lo storto 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

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

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 Thus, it is not justified in total. Based only on benefit and costs to the county: 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 state’s money as free, which is sometimes rationalized on the basis that “… we ought to get it, bacause if we don’t 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 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 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) Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Breakdown of the Sponsor’s Cost Equivalent capital investment at n = 0 Equivalent O&M costs at n = 0 Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example of B-C Analysis $10 $5 $8 $20 $30 K = 1 N = 5 Benefits (b n ) Recurring costs (c n ) Investment (c n ) Engineering Economy/public activities/ 2005 /prof. corrado lo storto

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

Relationship between B/C Ratio and NPW 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) Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Example 2: Incremental Benefit-Cost Ratios A1A2A3 I$5,000$20,000$14,000 B12,00035,00021,000 C’C’4,0008,0001,000 PW(i)$3,000$7,000$6,000 Engineering Economy/public activities/ 2005 /prof. corrado lo storto

Solution A1A2A3 BC(i) Ranking Base A1A3A2 I +C’$9,000$15,000$28,000 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 AB First cost$ 10,000$ 15,000 Life5 yr10 yr Salvage value$ 2,000$ 0 Annual receipts$ 5,000$ 7,000 Annual disbursements$ 2,200$ 4,300 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. 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. For lathe 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, 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 benefit-cost 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 ABCDEF Investment$ 1,000$ 1,500$ 2,500$ 4,000$ 5,000$ 7,000 Annual savings in cash disbursements $ 150$ 375$ 500$ 925$ 1,125$ 1,425 Salvage value$ 1,000$ 1,500$ 2,500$ 4,000$ 5,000$ 7,000 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: The decision rule is if BC(i) > 1, the project is acceptable. The net B/C ratio is defined as 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