1. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 1 Benefit-Cost Analysis

2. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 2 of 52 Chapter 12 Benefit-Cost Analysis Framework of Benefit- Cost Analysis Valuation of Benefits and Costs Benefit-Cost Ratios Incremental B-C Analysis

3. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 3 of 52 Benefit-Cost Analysis The Benefit-cost analysis is commonly used to evaluate public projects. Benefits of a nonmonetary 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 disbenefits to all these users can (and should) be taken into account.

4. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 4 of 52 Framework of Benefit-Cost Analysis 1) Identifying all the users and sponsors of the project. 2) Identifying all the benefits and disbenefits of the project. 3) Quantifying all benefits and disbenefits in dollars or some other unit of measure. 4) Selecting an appropriate interest rate at which to discount benefits and costs to a present value.

5. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 5 of 52 Benefit-Cost Ratio Criterion If this BC ratio exceeds 1, the project can be justified

6. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 6 of 52 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

7. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 7 of 52 Equivalent capital investment at n = 0 Equivalent O&M costs at n = 0 Breakdown of the Sponsor’s Cost

8. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 8 of 52 Example 12.1 BC Analysis $10 $5 $20 $30 K = 1 N = 5 Benefits (b n ) Recurring costs (c n ) Investment (c n )

9. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 9 of 52 Solution:

10. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 10 of 52 Relationship between B/C Ratio and NPW B > (I + C’) B – (I+ C’) > 0 PW(i) = B – C > 0

11. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 11 of 52 Incremental Analysis Based on BC(i)

12. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 12 of 52 Example 12.2 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

13. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 13 of 52 Solution A1A2A3 BC(i)1.331.251.40 Ranking Base A1A3A2 I +C’$9,000$15,000$28,000

14. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 14 of 52 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 dollars or some other unit of measure. 4)Selecting an appropriate interest rate at which to discount benefits and costs to a present value.

15. www.izmirekonomi.edu.tr Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 15 of 52 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.