Evaluating Public Projects

with Benefit-Cost Ratio

Method
KNS 4343 ENGINEERING ECONOMICS
INTRODUCTION

• A fundamental analysis method for public sector projects.

• Developed to introduce more objectivity into public sector economics
• ALL COSTS must be converted to a common monetary unit (PW,
AW, or FW) at discount rate (interest rate).
COST – Estimated expenditure to government entity for construction
BENEFITS – Advantages experiences by the owners, the public.
Benefits can include revenue & savings
DISBENEFITS – Expected undesirable consequences that are indirect
economic disadvantages to the owners if the alternative implemented
 Perspective and Terminology for Analyzing
Public Projects
Benefits and Costs of a Convention Center and Sports Complex

A new convention center and sports complex has been proposed to the Kuching City
Council. This public-sector project, if approved, will be financed through the issue of
municipal bonds. The facility will be located in the City Park near downtown Kuching
City, in a wooded area, which includes a bike path, a nature trail, and a pond. Because
the city already owns the park, no purchase of land is necessary. List separately the
project’s benefits, costs, and any disbenefits.
 Perspective and Terminology for Analyzing
Public Projects
Benefits and Costs of a Convention Center and
Sports Complex
COSTS
Architectural design of the facility
Solution
Construction of the facility
BENEFITS
Design and construction of parking garage adjacent to
Improvement of the image of the downtown area of the facility
Kuching City
Operating and maintenance costs of the facility
Potential to attract conferences and conventions to
Kuching City Insurance costs of the facility
Potential to attract professional sports franchises to
Kuching City DISBENEFITS
Revenues from rental of the facility Loss of use of a portion of the City Park to Kuching City
Increased revenues for downtown merchants of residents, including the bike path, the nature trail, and
Kuching City the pond
Use of facility for civic events Loss of wildlife habitat in urban area
 Self-Liquidating Projects

• The term self-liquidating project is applied to a governmental project that is

expected to earn direct revenue sufficient to repay its cost in a specified
period of time.
• Most of these projects provide utility services—for example, the fresh water,
electric power, irrigation water, and sewage disposal provided by a
hydroelectric dam.
• Other examples of self-liquidating projects include toll bridges and
highways
 Multiple-Purpose Projects
• An important characteristic of public-sector projects is that many such
projects have multiple purposes or objectives.
• One example of this would be the construction of a dam to create a
reservoir on a river. This project would have multiple purposes: (1) assist in
flood control, (2) provide water for irrigation,
Difficulties in Evaluating Public-Sector Projects
There are a number of difficulties inherent in public projects that must be considered in
conducting engineering economy studies and making economic decisions regarding those
projects. Some of these are as follows:
1. There is no profit standard to be used as a measure of financial effectiveness. Most
public projects are intended to be nonprofit.
2. The monetary impact of many of the benefits of public projects is difficult to quantify.
3. There may be little or no connection between the project and the public, which is the
owner of the project.
4. There is often strong political influence whenever public funds are used. When
decisions regarding public projects are made by elected officials who will soon be
seeking reelection, the immediate benefits and costs are stressed, often with little or
no consideration for the more important long-term consequences.
Difficulties in Evaluating Public-Sector Projects
1. Public projects are usually much more subject to legal restrictions than are
private projects. For example, the area of operations for a municipally owned
power company may be restricted such that power can be sold only within the
city limits, regardless of whether a market for any excess capacity exists
outside the city.
2. The ability of governmental bodies to obtain capital is much more restricted
than that of private enterprises.
3. The appropriate interest rate for discounting the benefits and costs of public
projects is often controversially and politically sensitive. Clearly, lower interest
rates favor long-term projects having major social or monetary benefits in the
future. Higher interest rates promote a short-term outlook whereby decisions
are based mostly on initial investments and immediate benefits.
 What Interest Rate Should Be Used
for Public Projects?

• Three main considerations bear on what interest rate to use in engineering

economy studies of public-sector projects:
1. The interest rate on borrowed capital
2. The opportunity cost of capital to the governmental agency
3. The opportunity cost of capital to the taxpayers
 The Benefit−Cost Ratio Method

The B–C ratio method involves the calculation of a ratio of benefits to costs. Whether
evaluating a project in the private sector or in the public sector, the time value of
money must be considered to account for the timing of cash flows (or benefits)
occurring after the inception of the project.
• The B–C ratio is defined as the ratio of the equivalent worth of benefits to the
equivalent worth of costs. The equivalent-worth measure applied can be present
worth, annual worth, or future worth, but customarily, either PW orAW is used.
• An interest rate for public projects, as discussed in the previous section, is used in
the equivalent-worth calculations.
• The B–C ratio is also known as the savings-investment ratio (SIR) by some
governmental agencies
EQUATION NO. 1

• The sign convention for B/C Analysis is +ve sign

The decision guideline is simple:
• If B/C ≥ 1.0, accept the project as economically acceptable
for the estimates and discount rate applied.
• If B/C < 1.0, the project is not economically acceptable.
EQUATION NO. 2 – conventional B/C
ratio method (commonly used)
EQUATION NO. 2 – conventional B/C
ratio method (commonly used)
EQUATION NO. 3 – modified B/C ratio
EXAMPLE NO. 1
The Petronas Foundation expects to award RM15 million in grants to
public high schools to develop new ways to teach the fundamentals of
engineering that prepare students for university-level material. The
grants will extend over a 10-year period and will create an estimated
savings of RM1.5 million per year in faculty salaries and student-
related expenses. The Foundation uses a rate of return of 6% per year
on all grant awards.

This grants program will share Foundation funding with ongoing

activities, so an estimated RM200,000 per year will be removed from
other program funding. To make this program successful, a RM 500,000
per year operating cost will be incurred from the regular M&O budget.
Use the B/C method to determine if the grants program is economically
justified.
 SOLUTION
Use annual worth as the common monetary equivalent. All three B/C models are used
to evaluate the program.

AW of investment cost. RM 15,000,000(A/P,6%,10) RM 2,038,050 per year

AW of benefit. RM 1,500,000 per year
AW of disbenefit. RM 200,000 per year
AW of M&O cost. RM 500,000 per year

Use Equation [Eq.2] for conventional B/C analysis, where M&O is placed in the
denominator as an annual cost.

The project is not ACCEPTABLE, since B/C < 1.0.

SOLUTION(CONT’D)
By Equation [3] the modified B/C ratio treats the M&O cost as a reduction
to benefits.

The project is also not justified by the modified B/C method, as

expected.
For the (B - C) model, B is the net benefit, and the annual M&O cost is
included with costs.
B - C = (1,500,000 - 200,000) - (2,038,050 + 500,000) = RM -1.24
million
Since (B - C) < 0, the program is not justified.
 Equivalence of the B−C Ratio Formulations

The city of Columbia 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 a farmland that 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 are
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:
Apply the B–C ratio method with a study period of 20 years and a MARR of
10% per year to determine whether the runways at Columbia Municipal
Airport should be extended.
 Disbenefits in the B−C Ratio
Disbenefits were defined as negative consequences to the public resulting from the
implementation of a public-sector project. The traditional approach for incorporating
disbenefits into a B–C analysis is to reduce benefits by the amount of disbenefits (i.e.,
to subtract disbenefits from benefits in the numerator of the B–C ratio).
 Including Disbenefits in a B−C Analysis

Refer back to previous example. In addition to the benefits and costs, suppose that
there are disbenefits associated with the runway extension project.
Specifically, the increased noise level from commercial jet traffic will be a serious
nuisance to homeowners living along the approach path to the Columbia Municipal
Airport. The annual disbenefit to citizens of Columbia caused by this noise pollution is
estimated to be $100,000. Given this additional information, reapply the conventional
B–C ratio, with equivalent annual worth, to determine whether this disbenefit affects
your recommendation on the desirability of this project.
Bring home QUIZ (submit by 3 May 2019)
The project is to extend the runways of an airport and it is considered by the city
municipality. The following costs have been identified:
Land : RM 350,000
Construction : RM 600,000
Annual maintenance : RM 22,500
Terminal construction : RM 250,000
Annual operating and maintenance for the terminal : RM 75,000
Addition of air traffic controllers per year : RM 100,000

The project is estimated to bring the following benefits:

Rental receipts : RM 325,000
Tax to passengers : RM 65,000
Convenience : RM 50,000
Tourism : RM 50,000.
Apply the both conventional and modified cases using PW and AW methods with a
study period of 20 years and a rate of return 10% per year, and determine whether this
is an acceptable project or not.
Pause and solve (in class exercise 11)

Department of Transportation has planned a bypass loop that is expected to

cost RM9,000,000 and save motorists RM820,000 per year in gasoline and
other automobile related expenses.
However local business will suffer sales losses estimated at RM135,000 each
year.
(a) Calculate the conventional B/C ratio using a discount rate of 6% per year
and a 20 year study period.
(b) Is the project economically justified if disbenefits are considered.