EVALUATING PROJECTS WITH THE BENEFIT / COST RATIO METHOD CHAPTER 11 EVALUATING PROJECTS WITH THE BENEFIT / COST RATIO METHOD

Objective of This Chapter Objectives To describe characteristics of public projects To learn how to use the B/C ratio method as a criterion for project selection Public Projects Public projects are those authorized, financed, and operated by federal, state, or local governmental agencies

Differences Between Private And Public Projects Purpose Private Project -- Maximize profit, minimize costs Public Project -- Offer social benefits (i.e., health, employment) without profit Capital Sources Private Project -- Private investors and lenders Public Project -- Taxation; Private Lenders, bonds Multiple Purposes Private Project -- Moderate Public Project -- More frequently common (i.e., reservoir projects for: flood control, power source, irrigation, recreation)

Private And Public Projects-Cont. Project Life Private Project – Short -- 5 to 20 years; Public Project – Long -- 20 to 60 years Nature Of Benefits Private Project-Monetary or near monetary Public Project-Non-monetary; difficult to equate to monetary terms Conflict Of Interests Public Project -- More common for public projects (i.e., intra-agency conflicts) Private Project--Moderate Efficiency Measurement Private Project -- Rate of Return on capital Public Project – Very difficult, no direct comparison with private projects

Benefits, Costs, And Disbenefits Benefits - The favorable consequences of the project to the project sponsors (i.e., the public for public projects) Costs -- Monetary disbursements required (i.e., of the government for public projects) Disbenefits -- The negative consequences of the project to the project sponsors The Roots Of The Benefit/cost Ratio The benefit/cost ratio method, which is normally used for the evaluation of public projects, has its roots in federal legislation Specifically, the Flood Control Act of 1936 requires that for a federally financed project to be justified, its benefits must be in excess of its costs.

Difficulties In Evaluating Public Sector Projects No profit standard as a measure of effectiveness Difficult to quantify monetary impact of benefits Profit motive as a stimulus for effectiveness is absent More legal restrictions with public projects Greater difficulty in obtaining capital for public projects Selection of interest rates controversial and politically sensitive

B/C Formulations Conventional Modified B/C

Decision Rule , or B/C IF B/C ratio (=>) 1.00 Conditionally accept the alternative IF B/C ratio (<) 1.00, conditionally reject the alternative IF B/C ratio “close” to 1.00 then intangible factors may sway the decision to accept or reject

Notes Regarding Signs By convention: Revenues are assigned (+) signs Costs are assigned (+) signs Salvage values are subtracted from costs Disbenefits are treated more than one way Disbenefit values are subtracted from benefits Disbenefit values are added to costs Either approach will result in a consistent analysis – but be consistent through out an analysis

Example 11-2, page 471 The city of Bugtussle is considering extending the runways of its Municipal Airport so that commercial jets can use the facility. The land necessary for the runway extension is currently farmland, which can be purchased for $350,000. Construction costs for the runway extension are projected to be $600,000, and the additional annual maintenance costs for the extension are estimated to be $22,500. If the runways extended, a small terminal will be constructed at a cost of $250,000. The annual operating and maintenance costs for the terminal are estimated at $75,000. Finally, the projected increase in flights will require the addition of two air traffic controllers, at an annual cost of $100,000. Annual benefits of the runway extension have been estimated as follows: $325,000 rental receipts from airlines leasing space $65,000 airport tax charged to passengers $50,000 convenience benefits for residents of Bugtussle $50,000 additional tourism dollars for Bugtussle Apply B/C ratio method with a study period of 20 years and I = 10%.

Solution Conventional B/C using PW: Modified B/C using PW: B/C = PW(B)/[I + PW (O&M)] B/C= 490000(P/A,10%,20)/[1200000-197500(P/A,10%,20)]= 1.44 Modified B/C using PW: B/C = [PW (B) – PW (O&M]/I B/C=[490,000(P/A,10%,20)-197500(P/A,10%,20)]/1200000 =2.07 Conventional B/C using AW: B/C = AW(B)/[CR + AW (O&M)] B/C = $490,000/[$1,200,000 (A/P, 10%, 20) + $197,500]= 1.448 Modified B/C using AW: B/C = [AW (B) – AW (O&M]/CR B/C = [$490,000 + $197,500]/$1,200,000 (A/P, 10%, 20)=2.075

Comparison Of Mutually-exclusive Projects By B / C Ratios When using equivalent worth methods to select among mutually-exclusive alternatives (MEAs), the best alternative selected by maximizing PW, AW, or FW. When using B / C method, no direct measure of each project’s profit potential is provided. Use incremental cash flow analysis