Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-1 Developed By: Dr. Don Smith, P.E. Department of Industrial Engineering Texas A&M University College Station, Texas Executive Summary Version Chapter 9 Benefit/Cost Analysis and Public Sector Economics

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-2 LEARNING OBJECTIVES 1.Public Sector 2.B/C for single project 3.Alternative selection 4.Multiple alternatives

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-3 Sct 9.1 Public Sector Projects  Public Sector:  Ownership – by citizens - the public  Public Sector Projects:  Provide needed services to the public at ‘no profit’  Size of investment – generally large  Life estimates – generally long (30 – 50 + Yrs)  No profit; costs, benefits, and disbenefits are estimated  Any revenues contribute to cover future costs

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-4 Terminology  Costs – estimated expenditures to the governmental entity for:  Operations  Maintenance  Construction  Benefits – economic advantages to be experienced by the owners ( the public )  Disbenefits – expected undesirable consequences to the owners (the public)  Important:  It is very difficult to estimate and agree upon the economic impact of benefits and disbenefits for many public sector projects

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-5 Interest (Discount) Rate  Discount rate is term for interest rate for public sector projects  Also called social discount rate  Usually low in number, since…  Government projects pay no income taxes  Low and very-low interest loans may be granted  Grants with selected no-repayment are available  Discount rate often in range of 4% to 8% per year

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-6 The Viewpoint  The viewpoint (perspective) must be determined before costs, benefits, and disbenefits are estimated  There can be more than one viewpoint for a given public sector project. Select one:  Citizen  Tax base  Creation/retention of jobs  Economic development  Specific industry  Stick with one view; using more than one can lead to problems in cost and revenue estimation

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-7 Sct 9.2 Benefit/Cost Analysis of a Single Project  There are three B/C relationships, specifically; Sign convention:  Costs are given a + sign  Salvage values are subtracted from costs  Disbenefits are generally subtracted from benefits

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-8 Criteria and B/C Formulas  If B/C ≥ 1.0 – accept the alternative at the appropriate discount rate;  If B/C < 1.0 – the project is not economically acceptable but still could be funded for a variety of reasons.  Conventional B/C relation:  Modified B/C relation:

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-9 Sct 9.3 Alternative Selection Using Incremental B/C Analysis  Given two or more mutually exclusive alternatives  First, rank the alternatives from low to high based upon total costs in the denominator of the ratio

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-10 The 5-step Plan 1.Estimate the total equivalent costs for the competing alternatives 2.Order the alternatives by total equivalent cost  Smaller one first then the larger cost alternative  Calculate the incremental cost (∆C) for the larger- cost alternative →the denominator in the B/C ratio.

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-11 The 5-step Plan - continued 3.Calculate the total benefits and disbenefits for both alternatives  Calculate the incremental benefits (∆B) for the larger cost alternative  This is the ∆(B-D) value 4.Calculate the ∆B/C ratio 5.Accept the higher cost alternative if B/C ≥ 1, else the lower cost alternative is deemed undesirable

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-12 The Do-nothing Option  The lower cost alternative should be compared to the Do-nothing (DN) option (maintain the status quo)  If B/C for the lower cost alternative is < 1.00, then the DN option should be compared to ∆B/C of the higher cost alternative  If both alternative loose out to DN option, DN generally prevails – unless there are compelling needs for one of the alternatives to be implemented

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-13 Sct 9.4 Incremental B/C Analysis of Multiple, Mutually Exclusive Alternatives  Given three or more mutually exclusive alternatives; one must be selected  Conduct the pair-wise ∆B/C analysis  The selection rule is:  Choose the largest-cost alternative that is justified with an incremental B/C ≥ 1 when this alternative has been compared with another justified alternative  See Example manual and spreadsheet

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-14 Independent Projects  If multiple, independent projects are being evaluated and there is no budget limitation then:  No need to conduct an incremental analysis  Compare each alternative to the DN option  Select and execute all projects with B/C ratios ≥ 1  If budget limitations exist, then some form of optimization routine must be performed  See chapter 12 for the capital budgeting model

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-15 Chapter Summary  B/C methods are used for the evaluation of public sector projects  The analysis requires a discount rate (the social cost of capital or some variant of it)  Apply either PW, AW, or FW analysis to the cash flows  For two alternatives use the conventional B/C approach

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-16 Summary - continued  For multiple (mutually exclusive) alternatives on must apply the incremental analysis approach similar to the ROR incremental approach  For independent projects compare each alternative to the DN option

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 9-17 Chapter 9 End of Set