Cost/Benefit Analysis Review Cost/Benefit can done using NPW or EAW, pick one! (choose whichever method is easiest for the problem statement) Criteria: Benefits – Disbenefits (to the public) Costs (to the sponsor) Benefits must outweigh costs, so if the B/C ratio is: > 1project is justified = 1barely justified – political < 1not justified Alternative viewpoints complicate the process! Terms: Primary Benefits – easy to measure, change to $$ Secondary Benefits – difficult to quantify (political) Disbenefits – paid by public users (tolls, etc.) Costs – 1 st costs & salvage, O & M paid – revenues collected by sponsor

Incremental Analysis with B/C Incremental Analysis MUST be used when comparing! (Cost/Benefit Ratio is a relative measure) Caution: Must compare only feasible projects! Steps: Order projects by increasing TOTAL costs AND eliminate any infeasible projects Use first feasible project – becomes current best Compare with Doing Nothing if that is an option Do same “apples to apples” comparison for all Pairwise Comparison on Incremental Cash Flow If incremental B/C > 1, then higher cost is better If incremental B/C ≤ 1, then lower cost is better Note: There is NO modified B/C analysis on exam!

Replacement Review Essentially, there are two aspects to replacement: What is the economic service life of the replacement alternatives (challengers)? What is the ownership life of the existing system (defender)? Criteria: Choose the lowest EAC method today Must take an outsider’s perspective when valuing the existing system Terms: Physical Life Ownership Life Economic Service Life Accounting Life Fair Market Value Market Value Trade-in Value Book Value

Economic Service Life Review Economic Service Life (ESL) is the length of time that minimizes the equivalent annual cost for the system Relationship: Total EAC Total = EAC ownership + EAC operation EAC ownership : 1 st Costs(A/P, i, N) – Salvage(A/F, i, N) Typically decrease with longer lifetime (N) EAC operation : Annualized Operating + Maintenance Costs Typically increase with longer lifetime (N) Steps: Find EAC Total for each year of remaining life (N = 1, 2, …) Find the lowest cost lifetime (ESL) among EAC total : Plan to use until end of ESL year Plan to replace at the start of the next year The system with the lowest cost ESL is the best replacement Challenger!

Outsider’s Perspective Review The outsider would have to purchase the existing system in order to use it – paying “Fair Market Value” Priority Order: (& information sources) 1. Market Value Independent Audit / Appraisal Want/For Sale Ads in paper/trade magazine Selling/Asking price at auction 2. Trade-In Value Must use if accepting lower challenger price from vendor Can shop around to different vendors “Blue Book” price Bank / Savings & Loan estimate 3. Book Value Prefer Book depreciation to MACRS value

Opportunity Cost Approach The fair market value of the defender will be treated as a cost to retain the defender (this is the opportunity cost that is foregone by retaining the defender) Fair Mkt. Value n = Lifetime Operating Cost DEFENDER DIAGRAM: Maintenance Cost Salvage Overhaul Cost

Ownership Life Review Ownership Life is the length of time to keep the existing system that minimizes the equivalent annual cost for the ongoing performance of the function Decision is based on expected costs as known today No sunk costs (original price doesn’t matter) Relevant costs only (common costs are just clutter) Steps: Use the Opportunity Cost approach (Fair Market Value appears as a cost on the Defender CFD) Find ESL of the best Challenger option Find each EAC total up through the physical lifetime for the Defender: Find the Ownership Life of the Defender Plan to replace with the Challenger at the start of the next year: when the EAC Defender > ESL Challenger