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

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

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

INTRODUCTION

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

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

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

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

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

Public Sector Project Characteristics Size: Usually large compared to private projects with initial investment distributed over several years Life: Long-lived (often 30-50+ 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)

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

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

PROJECT SELECTION

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)

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.

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.

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.

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.

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.

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.

THE BENEFIT-COST RATIO METHOD

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

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

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

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

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.

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

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

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

B/C Analysis – Single Project Guideline for economic justification If B/C ≥ 1.0 accept project If B/C < 1.0 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

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

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.

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

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

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)

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

EVALUATING INDEPENDENT PROJECTS BY B-C RATIOS

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

COMPARISON OF MUTUALLY EXCLUSIVE PROJECTS BY B-C RATIOS

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

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.

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.

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

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

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

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 →

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 →

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 →

Spreadsheet Example

EXAMPLES

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 →

B/C Analysis – Example 1 Step 4. ∆B/C = 800,000/685,500 = 1.17 Step 5. 1.17 > 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 5. 0.72 < 1, eliminate 2; 1 is survivor Step 6. Select design 1

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 →

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 + 10,000 = $60,000 ∆C = 93,614 – 66,867 = $26,747 Step 4. ∆B/C = 60,000/26,747 = 2.24 Step 5. 2.24 > 1.0; eliminate 1; 2 survives cont →

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 →

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

RISK ANALYSIS

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

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.

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