1. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 1 Lecture slides to accompany Basics of Engineering Economy by Leland Blank and Anthony Tarquin Chapter 7 Benefit/Cost Analysis and Public Sector Projects

2. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 2 Chapter 7 – Benefit/Cost Analysis PURPOSE Learn about public sector projects compared to private sector projects, and perform a benefit/cost analysis TOPICS  Characteristics of public and private sector projects  B/C analysis of single project  Incremental B/C method for 2 or more projects  Spreadsheet usage for B/C analysis

3. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 3 Sec 7.1 – Public Sector Projects Owned, used and financed by citizens of government units. Some examples are: HighwaysUniversities HospitalsSports arenas PrisonsPublic housing Emergency reliefUtilities 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

4. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 4 Sec 7.1 – 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)

5. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 5 Sec 7.1 – 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

6. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 6 Sec 7.1 – Public Sector Project Estimates Analysis requires estimates as accurate as possible for costs, benefits, and disbenefits Description Costs: expenditures to the government to build, maintain, & operate project; salvage/sales value possible Benefits: advantages to public; income and savings Example Bridge construction cost Annual cost of drug abusers’ treatment program New jobs and salary money Reduced property taxes Lower transportation costs due to less gas used

7. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 7 Sec 7.1 – 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 Examples  $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

8. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 8 Sec 7.1 – 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 Read Example 7.1 for some specific samples

9. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 9 Sec 7.1 – 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

10. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 10 Sec 7.1 – 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

11. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 11 Sec 7.1 – 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

12. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 12 Sec 7.2 – B/C Analysis – Single Project 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 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

13. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 13 Sec 7.2 – B/C Analysis – Single Project Guideline for economic justification If B/C ≥ 1.0accept project If B/C < 1.0project not acceptable Example: P = $15 MA = $500 K per year B = $1,500 K per yearD = $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

14. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 14 Sec 7.2 – 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

15. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 15 Sec 7.3 – 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

16. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 16 Sec 7.3 – 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

17. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 17 Sec 7.3 – 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)

18. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 18 Sec 7.3-B/C Analysis for ≥ 2 ME Alternatives PROCEDURE FOR ∆B/C OF MUTUALLY EXCLUSIVE ALTERNATIVES 1.Determine equivalent values for costs, benefits (and disbenefits, if estimated) 2.Order alternatives by increasing total equivalent cost (for direct benefit alternatives, add DN first) 3.For each pair 2 and 1, determine incremental C and B over LCM. For usage cost alternative, use ∆B = usage cost 2 – usage cost 1 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

19. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 19 Sec 7.3 – Book Correction to ∆B/C Procedure Please note these corrections on pages 168 and 169 of textbook Page 168, bottom: should read “If ∆B/C ≥ 1.0, …” Page 169, step 5: should read “If ∆B/C ≥ 1.0, …”

20. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 20 Sec 7.3 – B/C Analysis – Example 1 Equal 30-year life; i = 5%; direct benefit alternatives Step 1. No disbenefits; use equivalent AW of costs AW 1 = 10 M(A/P,5%,30) + 35,000 = $685,500 AW 2 = 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 →

21. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 21 Sec 7.3 – 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

22. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 22 Sec 7.3 – B/C Analysis – Example 2 8-year study period; i = 7%; usage cost alternatives cont → Step 1. Total cost is sum of two incentives. Determine AW over 8 years. For proposal 1 AW 1 = 250,000(A/P,7%,8) + 25,000 = $66,867

23. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 23 Sec 7.3 – B/C Analysis – Example 2 Step 2. Order alternatives by increasing AW of total costs cont → 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

24. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 24 Sec 7.3 – B/C Analysis – Example 2 Step 6.Compare 3-to-2 (back to step 3) Table below completes the analysis cont →

25. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 25 Sec 7.3 – 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

26. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 26 Sec 7.3 - 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  Example 7.5 illustrates both of these situations

27. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 27 Sec 7.4 – 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 pairwise ∆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

28. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 28 Sec 7.4 – Spreadsheet Example 15-year equal lives; usage-cost alternatives; i = 5% cont → Step 1. PV function determines PW over 15 years : Total costs (initial and maintenance costs) Benefits (utility bill differences) Disbenefits (back-up system cost)

29. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 29 Sec 7.4 – Spreadsheet Example Step 2. Evaluation order is G, H, C. Note that G has lower PW costs, though H has a lower initial cost cont → Note minus sign on PV functions

30. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 30 Sec 7.4 – 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) Complete analysis on spreadsheet Conclusion: Select C (Crumbley) with ∆(B-D)/C = 1.22 cont →

31. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 7 - 31 Sec 7.4 – Spreadsheet Example