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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
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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
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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
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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
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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
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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
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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
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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:
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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
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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.
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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
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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
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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 9.5 - manual and spreadsheet
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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
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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
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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
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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
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