CTC 475 Review CTC 475 Review

Evaluating alternativesEvaluating alternatives Ranking Method (PW, AW, FW)Ranking Method (PW, AW, FW) Incremental Method (PW, AW, FW, IRR, Incremental Method (PW, AW, FW, IRR,

ERR, SIR)ERR, SIR) Put alternatives in order of initial investmentPut alternatives in order of initial investment Determine cash difference of first 2 Determine cash difference of first 2

alternativesalternatives Determine whether incremental benefits Determine whether incremental benefits

outweigh incremental costsoutweigh incremental costs Compare winner to next alternativeCompare winner to next alternative

CTC 475 CTC 475

Benefit-Cost AnalysesBenefit-Cost Analyses

ObjectivesObjectives

Know why B/C ratio is usedKnow why B/C ratio is used Know how public projects differ from Know how public projects differ from

private sector projects private sector projects Know the pitfalls of using B/C ratioKnow the pitfalls of using B/C ratio

Public ProjectsPublic Projects

1.1. Cultural development (education, Cultural development (education, historic, recreation)historic, recreation)

2.2. Economic Services (transportation, Economic Services (transportation, power generation)power generation)

3.3. Natural Resources (pollution control, Natural Resources (pollution control, flood control, wildlife management)flood control, wildlife management)

4.4. Protection (military services, police, Protection (military services, police, fire)fire)

Differences from private sector Differences from private sector projectsprojects

Big initial costs (millions)Big initial costs (millions) Long lives (50, 100 years)Long lives (50, 100 years) Multiple-uses (lake might be used for Multiple-uses (lake might be used for

recreation, flood control, irrigation, recreation, flood control, irrigation, power generation)power generation)

Difficult to define cash flow ($ value Difficult to define cash flow ($ value on aesthetics?)on aesthetics?)

Public projectsPublic projects

Standard method for evaluation is Standard method for evaluation is the B/C ratiothe B/C ratio

Flood Control Act of 1936 – Benefits Flood Control Act of 1936 – Benefits must exceed costsmust exceed costs

B/C ratioB/C ratio

Benefits-Public benefits associated Benefits-Public benefits associated with the project with the project

Costs-Government costs associated Costs-Government costs associated with the projectwith the project

Disbenefits-Unfavorable consequences Disbenefits-Unfavorable consequences to the public associated with the to the public associated with the projectproject

B/C Ratio ExampleB/C Ratio Example

Alt.Alt. Initial Initial CostCost

Total Total Govt. Govt. AnnualizeAnnualized Costs d Costs (initial and O&M)(initial and O&M)

Total Public Total Public Annualized Annualized Costs Costs (accidents, (accidents, time of travel, time of travel, operating costs) operating costs)

Route ARoute A $417,000$417,000 $677,000$677,000 $16,973,000$16,973,000

Route BRoute B $1,023,00$1,023,0000

$1,243,00$1,243,0000

$13,605,000$13,605,000

Route CRoute C $1,734,00$1,734,0000

$2,103,00$2,103,0000

$12,678,000$12,678,000

B/C ratio?B/C ratio?

There are no defined benefits, so you There are no defined benefits, so you can’t directly determine B/C ratiocan’t directly determine B/C ratio

However, spending extra money However, spending extra money does lower total public costs does lower total public costs

Need to use incremental methodNeed to use incremental method

Compare B and A (B-A)Compare B and A (B-A)

Incremental Benefits:Incremental Benefits:$16,973,000-$13,605,000=$3,368,000 per year$16,973,000-$13,605,000=$3,368,000 per year

Incremental Costs: Incremental Costs: $1,243,000-$677,000=$566,000 per year$1,243,000-$677,000=$566,000 per year

B/C B/C (B-A)(B-A) = 5.95 (>1) = 5.95 (>1)

Prefer Route B over Route APrefer Route B over Route A

Compare C and B (C-B)Compare C and B (C-B)

Incremental Benefits:Incremental Benefits:$13,605,000-$1,678,000=$927,000 per year$13,605,000-$1,678,000=$927,000 per year

Incremental Costs: Incremental Costs: $2,103,000-$1,243,000=$860,000 per year$2,103,000-$1,243,000=$860,000 per year

B/C B/C (C-B)(C-B) = 1.08 (>1) = 1.08 (>1)

Prefer Route C over Route BPrefer Route C over Route B

Annual Worth MethodAnnual Worth Method

Alt.Alt. Total Total Govt. Govt. AnnualizeAnnualized Costs d Costs (initial and O&M)(initial and O&M)

Total Public Total Public Annualized Annualized Costs Costs (accidents, time of (accidents, time of travel operating travel operating costs) costs)

Total Costs Total Costs

Route ARoute A $677,000$677,000 $16,973,00$16,973,0000

$17,650,00$17,650,0000

Route BRoute B $1,243,0$1,243,00000

$13,605,00$13,605,0000

$14,848,00$14,848,0000

Route CRoute C $2,103,0$2,103,00000

$12,678,00$12,678,0000

$14,781,00$14,781,0000

ConsiderationsConsiderations

1.1. Point of viewPoint of view2.2. Selecting MARRSelecting MARR3.3. Assessing benefit-cost factorsAssessing benefit-cost factors4.4. OvercountingOvercounting5.5. Unequal livesUnequal lives6.6. Tolls & feesTolls & fees7.7. Multiple-Use ProjectsMultiple-Use Projects8.8. Problems with B/C ratioProblems with B/C ratio

1. Point of View1. Point of View

IndividualIndividual Particular government agencyParticular government agency Local areaLocal area Regional areaRegional area Entire nationEntire nation

2. Choosing MARR2. Choosing MARR

Public projects are funded by taxes, Public projects are funded by taxes, bonds, tolls. Making a profit is not bonds, tolls. Making a profit is not government’s motive:government’s motive:

Use zero?Use zero? Use rate paid by government for Use rate paid by government for

borrowed money?borrowed money? Use rate that private investors use?Use rate that private investors use?

3. Determining Benefit-Cost 3. Determining Benefit-Cost FactorsFactors

How far do you go in determining How far do you go in determining benefit-costs?benefit-costs?

Short-term benefits to local Short-term benefits to local economy?economy?

Secondary benefits?Secondary benefits? How do you put a price tag on How do you put a price tag on

aesthetics, wildlife, views, etc.?aesthetics, wildlife, views, etc.?

4. Overcounting4. Overcounting

Must be careful and not count twiceMust be careful and not count twice

Wages lost through disability Wages lost through disability Company’s cost of disability Company’s cost of disability

insuranceinsurance

5. Unequal Lives5. Unequal Lives

How do you calculate salvage values How do you calculate salvage values for public works projects?for public works projects?

6. Tolls, Fees and User Charges6. Tolls, Fees and User Charges

Tolls and user fees effect B/C ratio, Tolls and user fees effect B/C ratio, but not necessarily B-C but not necessarily B-C

Example:Example:

EUAC=$20,000 for public facilityEUAC=$20,000 for public facility 10,000 people per year attend facility10,000 people per year attend facility Person receives $3 of benefits per Person receives $3 of benefits per

eventevent

Without User FeeWithout User Fee

B/C=($3*10,000)/$20,000=1.5B/C=($3*10,000)/$20,000=1.5 B-C=$30,000-$20,000=$10,000 per B-C=$30,000-$20,000=$10,000 per

yearyear

With User FeeWith User Fee

Fee of $1.50 is chargedFee of $1.50 is charged Net benefits are only $1.50Net benefits are only $1.50 Govt. Cost is reduced by $15,000 Govt. Cost is reduced by $15,000 Govt. Cost is $5,000 per yearGovt. Cost is $5,000 per year

B/C=($1.5*10,000)/$5,000=3B/C=($1.5*10,000)/$5,000=3 B-C=$15,000-$5,000=$10,000 per B-C=$15,000-$5,000=$10,000 per

yearyear

7. Multiple-Use Project7. Multiple-Use Project

For incremental costs you can For incremental costs you can sometimes expand a public project to sometimes expand a public project to provide multiple benefits provide multiple benefits

ExampleExample

ProjectProject PW Costs PW Costs (millions)(millions)

PW PW Benefits Benefits (millions)(millions)

B/C ratioB/C ratio

Dam& Res. For Dam& Res. For IrrigationIrrigation

$14.5$14.5 $25$25 1.721.72

Dam & Res. Dam & Res. For Flood For Flood ControlControl

$9$9 $6$6 0.670.67

Dam & Dam & Reservoir for Reservoir for Irrigation & Irrigation & Flood ControlFlood Control

$18.5$18.5 $31$31 1.681.68

Use incremental analysis to Evaluate Use incremental analysis to Evaluate Dam for Irrigation Only versus Dam for Dam for Irrigation Only versus Dam for

Irrigation & Flood ControlIrrigation & Flood Control

Incremental benefits 31-25=6Incremental benefits 31-25=6 Incremental costs = 18.5-14.5=4Incremental costs = 18.5-14.5=4 Incremental B/C ratio = 1.5Incremental B/C ratio = 1.5

>1 means that it’s worth spending >1 means that it’s worth spending the extra money to derive both the extra money to derive both benefitsbenefits

Problems with B/CProblems with B/C

Don’t make the mistake of ranking Don’t make the mistake of ranking B/C ratiosB/C ratios

In previous example, ranking would In previous example, ranking would have given us the wrong answer (see have given us the wrong answer (see next slide)next slide)

ExampleExample

ProjectProject PW PW CostsCosts

PW PW Ben. Ben.

B/C B/C ratioratio

B-CB-C

Dam& Res. For Dam& Res. For IrrigationIrrigation

$14.5$14.5 $25$25 1.721.72 $10.5$10.5

Dam & Res. Dam & Res. For Flood For Flood ControlControl

$9$9 $6$6 0.670.67 -$3-$3

Dam & Dam & Reservoir for Reservoir for Irrigation & Irrigation & Flood ControlFlood Control

$18.5$18.5 $31$31 1.681.68 $12.5$12.5

Other Problems with B/C Ratio Other Problems with B/C Ratio

Benefits/Costs must be determined Benefits/Costs must be determined objectivelyobjectively

Don’t play games to get the result Don’t play games to get the result you wantyou want

Other types of AnalysisOther types of Analysis

Sometimes you can’t measure a Sometimes you can’t measure a project in terms of $ aloneproject in terms of $ alone

Reliability, performance, availability, Reliability, performance, availability, maintainability may be importantmaintainability may be important

Defense and space systems may use Defense and space systems may use other methods than consideration of other methods than consideration of costs alonecosts alone

Next lectureNext lecture

Taxes affect cash flowsTaxes affect cash flows

Depreciation affects Depreciation affects taxestaxes

Interest affect taxesInterest affect taxes