1. Chapter 5 PROJECT EVALUATION METHOD
ENGINEERING ECONOMIC
(BPK30902)
Chapter 5 PROJECT EVALUATION METHOD
HJ ZUIKARNAIN HJ DAUD

2. PROJECT EVALUATION METHOD
Introduction
Project Selection
The Benefit-Cost Ratio Method
Evaluating Independent Projects by B-C Ratios
Comparison of Mutually Exclusive Projects by B-C Ratios
Risk Analysis

3. OBJECTIVES
To learn about public sector projects compared to private sector projects, and perform a benefit/cost analysis
To demonstrate the use of the benefit- cost ratio for the evaluation of public projects

4. INTRODUCTION

5. Public Sector Projects
Owned, used and financed by citizens of government units. Some examples are:
Highways Universities
Hospitals Sports arenas
Prisons Public housing
Emergency relief Utilities
Public projects provide service to citizenry at no profit
Partnerships of public entities and private enterprise are more prevalent now as funding for large public projects becomes more difficult

6. Public Projects Are Unique
Frequently much larger than private ventures
They may have multiple, varied purposes that sometimes conflict
Often very long project lives
Capital source is ultimately tax payers
Decisions made are often politically influenced
Benefits are often nonmonetary and are difficult to measure

7. Types Of Public Project Contracts
Public-Private Partnership
Often called BOT (Build-Operate-Transfer) contract
Contractor partially or completely responsible for financial arrangements
Contractor operates and maintains system for specified time period. Contract includes these funds
Ownership transferred to government in future. This stage is often negotiated in different ways
Profit margin is specified for contractor during time of involvement

8. Types Of Public Project Contracts
Traditional Construction Contract
Government funding via taxes, user fees and bonds
Constructed through fixed price or cost plus contract with a profit margin specified for contractor
Owned and operated by government unit
Contractor shares no risk on financing or operation
Examples:
Design and construct a toll road
Install a networked IT system between 4 county offices
Design and build public housing for 400 families

9. Types Of Public Project Contracts
Public-Private Partnership
Contractor shares risk on financing and operation
Examples:
Design, finance construct operate nuclear power plant for 15 years
Recondition and operate state hospital for mental health patients
Organize and operate a municipal security (police) force for a 20-year period; contract renewable each 5 years

10. Public Sector Project Characteristics
Size: Usually large compared to private projects with initial investment distributed over several years
Life: Long-lived (often years); capitalized cost method is useful with A = Pi estimating annual costs
Cash flows: No profits allowed; estimates are in form of costs paid by government unit, benefits to the citizenry (can include revenues or ‘savings’), and disbenefits (descriptions on later slide)

11. Public Sector Project Characteristics
Funding: Public projects use taxes, fees, bonds (and gifts) for funding; taxes and fees are collected from ‘users’ of project services; funding examples are federal/state taxes of various sorts, tolls, surcharge fees
Interest rate: Called discount rate, it is considerably lower than for private projects since no profit is considered and governments are exempt from taxes; typical rates in the 3 to 6% per year range
Alternative selection: Politics and special interest groups make selection more complex for public projects; B/C method developed to put more objectivity into the analysis process

12. Viewpoint For Public Sector Project Analysis
Determine viewpoint (perspective) before costs, benefits, and disbenefits are estimated
Choose one and maintain it throughout estimation and analysis. Sample viewpoints
Citizen
Tax base
Creation/retention of jobs
Economic development
Specific industry

13. PROJECT SELECTION

14. 1. Net Benefits
For any project, the proper perspective is to consider the net benefits to the owners of the enterprise. For government projects, the owners are ultimately the taxpayers.
Benefits are favorable consequences of the project to the public (owners)
Costs represent monetary disbursements required of the government
Disbenefits represent negative consequences of a project to the public (owners)

15. 2. Self-liquidating
Self-liquidating projects are expected to repay their costs
These projects generally provide utility services (power, water, toll roads, etc.).
They earn direct revenue that offset their costs, but they are not expected to earn profits or pay taxes.
In some cases in-lieu payments are made to governments in place of taxes and fees that would have been paid had it been under private ownership.

16. 3. Cost Allocations
Cost allocations in multiple-purpose, public-sector projects tend to be arbitrary
Some projects naturally have multiple purposes—e.g., construction of a dam.
Some of the costs incurred cannot properly be assigned to only one purpose.
Purposes may be in conflict.
Often support for a public project, and its many purposes, is politically sensitive.

17. 4. Difficulties Inherent
Difficulties inherent (inbuilt/natural) in engineering economy studies in the public sector
Profit standard not used to measure effectiveness
Monetary effect of many benefits is difficult to quantify
May be little or no connection between the project and the public (owners).
Often strong political influence whenever public funds are used, with little consideration to long- term consequences.

18. 4. Difficulties Inherent (cont’d)
Public projects are more subject to legal restrictions than private projects
The ability of governmental bodies to obtain capital is more restricted than that of private enterprise
The appropriate interest rate for discounting benefits and costs is often controversially and politically sensitive.

19. 5. Interest Rate
Selecting the interest rate to use in public projects is challenging
Main considerations are
the rate on borrowed capital,
the opportunity cost of capital to the governmental agency, and
the opportunity cost of capital to the taxpayers.
If money is borrowed specifically for a project, the interest rate on the borrowed capital is appropriate to use as the rate.

20. 6. Others Consideration More interest rate considerations
The 1997 Office of Management and Budget directive states that a 7% rate should be used, as an approximation of the return tax payers could earn from private investments.
Another idea is to use a market-determined risk-free rate, about 3-4% per year.
Bottom line: there is no simple formula, and it is an important policy decision at the discretion of the governmental agency.

21. THE BENEFIT-COST RATIO METHOD

22. Public Sector Project Estimates
Analysis requires estimates as accurate as possible for costs, benefits, and disbenefits

23. Public Sector Project Estimates
Costs:
Expenditures to the government to build, maintain, & operate project; salvage/sales value possible
Example:
Bridge construction cost
Annual cost of drug abusers’ treatment program

24. Public Sector Project Estimates
Benefits:
Advantages to public; income and savings
Example:
New jobs and salary money
Reduced property taxes
Lower transportation costs due to less gas used

25. Public Sector Project Estimates
Disbenefits:
Expected undesirable, negative consequences of project to owners – the public; usually these are economic disadvantages estimable in monetary units
Disbenefits are not always included in the analysis; subject to political and special interest argumentation
Example:
$55M school bond issue -- Increased property taxes
Tourist amusement park -- Higher local car insurance premiums based on increased traffic accidents
New state prison – Reduced property values for houses in adjacent subdivisions

26. Some Criticisms Of B-C Analysis.
B-C is often used as an “after-the-fact” justification tool.
Distributional inequities (one group benefits, another pays the cost) may not be accounted for.
Qualitative information is often ignored.
Bottom line: these are largely reflective of the inherent difficulties in evaluating public projects rather than the B-C method itself.

27. Applying The Benefit-cost Ratio Method
The consideration of the time value of money means this is really a ratio of discounted benefits to discounted costs.
Recommendations using the B-C ratio method will result in identical recommendations to those methods previously presented.
B-C ratio is the ratio of the equivalent worth of benefits to the equivalent worth of costs

28. B-C Ratios For Annual Worth
Conventional B-C ratio with AW
Modified B-C ratio with AW

29. B/C Analysis – Single Project
If disbenefits are estimated, subtract from benefits Use PW, AW or FW for B/C If D is added to costs in denominator, the B/C value changes, but economic decision is the same
Convert all estimates to
PW, AW or FW value at
discount rate i%. If PW used
PW of benefits
PW of costs
Same formula for AW or FW
All + signs, costs included
Salvage has – sign;
subtracted from costs

30. B/C Analysis – Single Project
Guideline for economic justification
If B/C ≥ 1.0 accept project
If B/C < project not acceptable
Example: P = $15 M A = $500 K per year
B = $1,500 K per year D = $200 K per year
i = 6% n = 10 years
AW equivalent of P = $15M(A/P,6%,10) = $2,038 K
B/C = = 0.51
Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008
© 2008, McGraw-Hill
All rights reserved

31. B/C Analysis – Single Project
TWO ALTERNATE BENEFIT-COST MEASURES
Determine PW, AW or FW equivalent; place any salvage
in denominator with only initial investment cost
Same selection guideline: accept if B/C ≥ 1.0
If difference relation is desired, subtract net C from
net B, once equivalents are determined
Difference B-C = B – C
Selection guideline: accept if B - C ≥ 0

32. Two B-C ratios Conventional B-C ratio with PW
Modified B-C ratio with PW
A project is acceptable when the B-C ratio is greater than or equal to one.

33. B/C Analysis for ≥ 2 Alternatives
Technique similar to incremental ROR evaluation using ∆i* for ME alternatives
ME are the mutually exclusive alternatives
Find equivalent PW, AW or FW; calculate ∆B/C
Selection guideline
If ∆B/C ≥ 1.0 → select larger-cost alternative
Otherwise → select lower-cost alternative
Decision is based on incrementally justified total project cost, not incremental initial investment

34. B/C Analysis for ≥ 2 Alternatives
To perform the ∆B/C analysis correctly
Order alternatives by increasing equivalent total costs.
Note: If this is not done, a larger-cost alternatives that is actually justifiable may be rejected because ∆B/C < 1 results
Equal service requirement is necessary. If lives are short, use LCM method
Note: Public projects usually have long lives (> 25 or 30 years), so lives are equal, or long enough to use capitalized cost

35. B/C Analysis for ≥ 2 Alternatives
Two types of benefits that require different treatment during ∆B/C analysis
USAGE COST ESTIMATES
DEFINITION
Implied benefits based on difference in cost estimates of alternatives
TREATMENT
Comparison of alternatives is against each other only
DIRECT BENEFIT ESTIMATES
DEFINITION
Benefits estimated for each alternative
TREATMENT
Comparison of alternatives is
against DN first, then each other
(Like revenue alternatives in ROR analysis)

36. Analysis for ≥ 2 ME Alternatives
PROCEDURE FOR ∆B/C OF MUTUALLY EXCLUSIVE ALTERNATIVES
Determine equivalent values for costs, benefits (and disbenefits, if estimated)
Order alternatives by increasing total equivalent cost (for direct benefit alternatives, add DN first)
For each pair 2 and 1, determine incremental C and B over LCM. For usage cost alternative, use
∆B = usage cost2 – usage cost1
4. Determine ∆B/C or ∆(B-D)/C
5. If ∆B/C ≥ 1.0, eliminate A; B is survivor
Otherwise, A is survivor
6. Compare survivor with next alternative; continue steps (3) – (5) until only 1 alternative survives

37. EVALUATING INDEPENDENT PROJECTS BY B-C RATIOS

38. Categorized As Grouping
The choice to select any particular project in the group is independent of choices regarding any and all other projects within the group
Project is better than other is unimportant
Criterion for selecting each of those projects is whether their respective B-C ratios are equal to or greater than 1.0
Example of federal project – a flood control & power project

39. COMPARISON OF MUTUALLY EXCLUSIVE PROJECTS BY B-C RATIOS

40. Group Of Projects
MEP defines as a group of projects from which, at most, one project may be selected
B-C methods provide ratio of benefits to costs rather than direct measure of potential profit
Comparing ME Alternatives with B-C ratio method are the first ranked in order of increasing total equivalent worth of cost
Rank ordering will be identical based on PW, AW, or FW

41. Incremental B-C Analysis For Mutually Exclusive Projects
Incremental analysis must be used in the case of B-C and mutually exclusive projects.
Rank alternatives in order of increasing total equivalent worth of costs.
With “do nothing” as a baseline, begin with the lowest equivalent cost alternative and determine the incremental B-C ratio (B/C), selecting the alternative with the higher equivalent cost if the ratio is greater than one.

42. Which, if any, of the MEA projects below should be selected using B-C analysis? Assume a 20 year study period and MARR=10%. A B C
Investment
$125,000
$160,000
$180,000
Annual O&M
10,000
9,500
MV (20 yrs.)
40,000
50,000
Benefit/yr.
35,000
42,000
44,000
PW(10%)-costs
204,190
237,703
253,447
PW(10%)-benefits
297,975
357,570
374,597
B-C ratio
1.46
1.50
1.47
Each alternative is attractive.

43. Incremental Analysis D(B-A) D(C-B) Investment $35,000 $20,000
Annual O&M
-500
MV (20 yrs.)
10,000
Benefits/yr.
7,000
2,000
PW(10%)-costs
33,514
15,743
PW(10%)-benefits
59,595
17,027
B-C ratio
1.78
1.08
Conclusion
B is better
C is better
Choose alternative C

44. B/C Analysis-Additional Comments
Long lives (consider infinite for analysis purposes)
Use capitalized cost to determine PW or AW. Incremental analysis is performed after using the equivalency relations
A = P(i) or P = A/i
Independent Projects (with no budget limitation)
No incremental analysis needed
Compare each project to DN option
Select all projects with B/C ratio ≥ 1.0

45. Spreadsheet Usage for B/C Analysis for ME Alternatives
Spreadsheet format is same as that for incremental ROR evaluation
Common approach is to use PV and NPV functions to find PW equivalents, then order alternatives by increasing total equivalent cost
Use 6-step procedure to calculate pair wise ∆B/C; select one best alternative with ∆B/C ≥ 1.0
Remember minus sign convention on PV function to retain correct sign sense for responses

46. 15-year equal lives; usage-cost alternatives; i = 5%
Spreadsheet Example
15-year equal lives; usage-cost alternatives; i = 5%
Step 1. PV function determines PW over 15 years:
Total costs (initial and maintenance costs)
Benefits (utility bill differences)
Disbenefits (back-up system cost)
cont →

47. Note minus sign on PV functions
Spreadsheet Example
Note minus sign on PV functions
Step 2. Evaluation order is G, H, C. Note that G has lower PW costs, though H has a lower initial cost
cont →

48. Spreadsheet Example Steps 3-4. H-to-G comparison
Requires ∆B calculation as difference in PW of usage costs (utility bills)
∆B = H bill – G bill = 10,379,658 – 9,964,472
Value of ∆B = $- 415,186 for ∆(B-D)/C equation, since H has higher utility bill
∆(B-D)/C will be < 0. It is actually -0.51
Step 5. Eliminate H; G survives;
Step 6. Compare C-to-G (back to step 3)
Conclusion: Select C (Crumbley) with ∆(B-D)/C = 1.22
cont →

49. Spreadsheet Example

50. EXAMPLES

51. Equal 30-year life; i = 5%; direct benefit alternatives
B/C Analysis – Example 1
Equal 30-year life; i = 5%; direct benefit alternatives
Step 1. No disbenefits; use equivalent AW of costs
AW1 = 10 M(A/P,5%,30) + 35,000 = $685,500
AW2 = 15 M(A/P,5%,30) + 55,000 = $1,030,750
Step 2. Add DN option with C = $0 and B = $0; comparison order is DN, 1, 2
Step 3. Compare 1-to-DN over 30 years
cont →

52. B/C Analysis – Example 1 Step 4. ∆B/C = 800,000/685,500 = 1.17
Step > 1, eliminate DN; 1 is survivor
Step 6. Compare 2-to-1 (back to step 3)
Step 3. ∆B = 1,050,000 – 800,000 = $250,000
∆C = 1,030,750 – 685,500 = $345,250
Step 4. ∆B/C = 250,000/345,250 = 0.72
Step < 1, eliminate 2; 1 is survivor
Step 6. Select design 1

53. 8-year study period; i = 7%; usage cost alternatives
B/C Analysis – Example 2
8-year study period; i = 7%; usage cost alternatives
Step 1. Total cost is sum of two incentives. Determine AW over 8 years. For proposal 1
AW1 = 250,000(A/P,7%,8) + 25,000 = $66,867
cont →

54. B/C Analysis – Example 2
Step 2. Order alternatives by increasing AW of total costs
Step 3. Compare 2-to-1 over 8 years; use ∆usage costs for ∆B
∆B = entrance fee decrease + sales tax receipt increase
= 50, ,000 = $60,000
∆C = 93,614 – 66,867 = $26,747
Step 4. ∆B/C = 60,000/26,747 = 2.24
Step > 1.0; eliminate 1; 2 survives
cont →

55. Table below completes the analysis
B/C Analysis – Example 2
Step 6. Compare 3-to-2 (back to step 3)
Table below completes the analysis
cont →

56. B/C Analysis – Example 2 Results of comparisons
Compare 3-to-2: ∆B/C = 25,000/40,120 = 0.62
Proposal 2 survives
Compare 4-to-2: ∆B/C = 220,000/120,360 = 1.83
Proposal 2 eliminated; 4 survives
Conclusion: Select Proposal 4

57. RISK ANALYSIS

58. Disbenefits (D) can be included in the B-C ratio in either the numerator or denominator, as shown with AW below. or

59. Selecting Projects
If projects are independent, all projects that have a B-C great than or equal to one may be selected.
For projects that are mutually exclusive, a B-C greater than one is required, but selecting the project that maximizes the B-C ratio does not guarantee that the best project is selected.

60. Thank You