Chapter 4

97 Economic Analysis of Transportation Investments
Chapter 4
Economic Analysis
of Transportation
Improvements
Topics:
Interest Equations and Equivalencies, Methods of Economic Analysis, An Application of Economic Analysis
Methods: Optimal Timing of Investments,
4.1 Interest Equations and Equivalencies
4.1.1 Engineering Economics

4.1.2 Cash Flow Illustrations
4.1.3 The Concept of Interest
4.1.4 Types of Compounding and Interest Rates
4.1.5 Interest Equations
4.1.6 Special Cases of Interest Equations
4.1.7 Estimation of the Rate of Growth of Benefits or Costs
4.2 Methods of Economic Analysis
4.2.1 Introduction
4.2.2 Equivalent Uniform Annual Cost Method
4.2.3 Present Value of Costs
4.2.4 Equivalent Uniform Annual Return Method
4.2.5 Net Present Value Method
4.2.6 Internal Rate of Return
4.2.7 Benefit Cost Ratio Method
4.2.8 Evaluation Methods Using Incremental Attributes
4.3 An Application of Economic Analysis Methods: Optimal Timing of Investments
4.3.1 Introduction
4.3.2 Economic Effect of Postponement
4.3.3 Effect of Multi-Year Implementation of Investments
4.3.4 Multi-stage Implementation of Investments
4.3.5 Optimization of Stage Implementation of Investments
4.3.6 Application of Optimization of Stage Implementation: Optimal Time for Road Paving
4.1 Interest Equations and Equivalencies
4.1.1 Engineering Economics
The fundamental principle underlying all engineering economic analysis is that the value of money is
directly related to the time at which the value is considered. A given amount of money at the current time is not
equivalent to the same amount at a future year. Typically, the combined forces of inflation and opportunity cost
result in decreasing value of money over time. Inflation refers to the increase in the prices of goods and services
with time, and is reflected by a decrease in the purchasing power of a given sum of money with time. Opportunity
cost is the income that is forgone at a later time by not investing a given sum of money at a current period.
4.1.2 Cash Flow Illustrations
The time stream of amounts of money that occur within a given time period can be displayed either as a
cash flow table or a cash flow diagram. On a cash flow table, there are two columns: one for time and the other for
amount. On a cash flow diagram, time is represented on a horizontal axis, while vertical arrows depict the inflow or
outflow of money at various points in time. The sign of the amount and the direction of the arrows in cash flow
tables and figures respectively indicate the movement of the amount: A popular convention is to represent money
“coming in” (i.e., deposits or benefits) by positive signs and downward arrows pointing towards the horizontal time
line in the cash flow table and figure respectively. This convention also stipulates that money “going out” (i.e.,
disbursements or costs) is represented by negative signs and upward arrows in the cash flow table and diagram
respectively. The entire payment period (often referred to as the contract period, payment interval, planning horizon,
or planning period) is represented by the interval between the present period (denoted by time = 0), and the end of
that period (denoted by time = N). The planning period is typically divided into a number of equal periods called
compounding periods, or simply referred to as period, which is often taken as one year. In economic analysis, it is
conventional to assume that all transactions that occur within the compounding period occur at the end of that
period.
4.1.3 The Concept of Interest
The amount by which a given sum of money differs from its future value is typically represented as
interest. In this respect, a borrower of money from a financial institution at a current time, owes the initial amount
plus interest when the loan is due, to reflect for the fact that the value of the initial amount is not the same as the
value of the amount at the time of payback. Typically, lending institutions also add a small margin for profit.
The ratio of the interest paid at the end of the contract period (the originally agreed time between loan
acquisition and final payment) to the original amount invested at the beginning of the period, is termed the interest
rate. Therefore, a 10% interest rate, for example, indicates that for every dollar borrowed at the initial year, 10 cents
must be paid as interest at the end of each year. Central banks typically control of interest rates to remedy current or
expected economic problems. For instance, in a sluggish economy, the United States Federal Reserve Board
decreases interest rates to discourage saving and encourage individual spending and business investments, while
interest rates are increased when the economy is overheated. The interest rate typically undergoes several changes to
reflect the state of the economy. Therefore, the relationship between interest rate and the supply and demand for
money is a simultaneous one: interest rates are both a cause and effect of the market price of money.
In a stable economy such as those of developed countries, interest rates are typically lower than in
economies that have high inflation and are associated with uncertainty of investment returns. In developed countries,
the Minimum Attractive Rate of Return (MARR) typically ranges from 5-8%, while for most developing countries it
is estimated to be in the order of 10-15%.
The concept of interest rate is the underlying rationale for transforming amounts of or series of money from
one time period to another. This is addressed in Section 4.1.5 of this Chapter.
4.1.4 Types of Compounding and Interest Rates
Figure 4-1 illustrates the various categories of interest rates. Such rates could be simple or compound,
discrete, continuous, fixed or variable.
Interest
Compound Simple
(Interest is earned on (Interest calculation is based only
principal plus the interest on the original principal amount)
earned earlier)
Discrete Continuous
(Interest is calculated (Interest is calculated
and added to the existing and added to the existing
principal and interest at finite time principal and interest at infinitesimally
intervals) short time intervals)
Fixed Variable Fixed Variable

(Interest rate (Interest rate (Interest rate (Interest rate
is constant across changes after one or is constant changes
compounding more compounding over time) over time)
periods) periods)
Figure 4-1: Types of Interest Rates.
Interest may either be simple or compounded. In simple interest computations, the amount of interest at the
end of each period is the same as each of such amounts are a percentage of the initial amount, or principal. The
amount of compound interest in a given period is the interest charged on the total amount owed at the end of the
previous period, i.e., the sum of the principal and the previous period’s amount of interest. Therefore, amounts
borrowed on compound interest involve higher payments for amortization. Interests are typically computed using
compound interest rates.
Interests that are computed only at the end of each compounding period and with a constant interest rate are
typically referred to as fixed periodic rates, and the compounding period is 1 period for such cases, e.g., a fixed
annual rate, refers to the period of compounding as one year. Very often the compounding period is less than one
year, e.g., quarterly, monthly, or weekly. It is customary to quote interest rates on an annual basis, followed by the
compounding period if different from one year in length. For example, if the interest rate is 6% per interest period
and the interest period is six months, it is customary to speak of this rate as “12% compounded semiannually.” Here
the annual rate of interest is known as the nominal rate, 12% in this case. A nominal interest rate is represented by r.
But the actual annual rate on the principal is not 12% but something greater, because compounding occurs twice
during the year. The actual or exact rate of interest earned on the principal during one year is known as the effective
interest rate. The effective interest rate is computed by incorporating the effect of the multiplicity of compounding
periods. It should be noted that effective interest rates are always expressed on an annual basis unless specifically
stated otherwise. Table 4-1 shows how to compute effective annual interest rates for various scenarios of the
frequency of compounding within a year.
Table 4-1: Effective Annual Interest Rates for Various Compounding Frequency Scenarios
Frequency of Compounding Effective Annual Interest Rate Notation
Once a year =r
r = Nominal
Twice a year = (1 + r/2)2 – 1
Annual
Three times a year = (1 + r/3)3 – 1
Interest Rate
Every quarter = (1 + r/4)4 – 1
m = Number of
Six times a year = (1 + r/6)6 – 1
Compounding
Every month = (1 + r/12)12 – 1
Periods per year
m times a year = (1 + r/m)m – 1
4.1.5 Interest Equations
Interest equations, also referred to as equivalence equations, are relationships between amounts of money
that occur at different points in time, and are necessary to transform amounts or series of amounts of money from
one time period to another taking due cognizance of the time value of money. The vital links in such relationships
are the interest factors, which are functions of the interest rate and the payment period. Interest factors are expressed
as a formula (see Tables 4-2 to 4-4), or as values derived from such formula (see Appendix 1).
Interest equations typically involve the following five key variables as shown:
P- The initial amount
F- The amount at a specified future period
A- Periodic (typically yearly) amount
i- Effective Interest rate for compounding period
N- The number of compounding periods, or the analysis period
In a typical problem, three of these variables are given and it is required to find the fourth. The initial
amount, P, refers to the money borrowed or sunk into an investment at the initial period (represented by time 0 on a
cash flow diagram), while F refers to a payment or amount received at a future date. The periodic payment is the
amount paid at the end of every compounding period either to amortize a loan or to set up a sinking fund to achieve
a target amount after a number of years. Periodic payments could be a uniform series, or they can be increasing or
decreasing in a systematic manner (most commonly, arithmetic or geometric). i is the effective annual interest rate
for each period, while N is the number of compounding periods or the payment period.
Tables 4-2 to 4-4 present the formulae, cash flow diagram and notation for various cases of interest
equivalencies and relationships. This is done for discrete compounding and continuous compounding of the interest
rate.
Table 4-2: Interest Formulae for Discrete and Continuous Compounding

Description Cash Flow Computational Factor
Diagram Formula Computation
Finding the future P F? F = P * SPCAF
compounded amount
(F) at the end of a The Single Payment
specified period, Compound Amount Factor,
SPCAF = (1 + i ) N
given the initial SPCAF (i%, N) may be
amount (P) and read off from Appendix 1, SPCAF = e N *i
interest rate. 0 1 … … N or may be computed as
shown.
Finding the initial P? F P = F * SPPWF 1
amount (P) that SPPWF =
would yield a given The Single Payment (1 + i ) N
future amount (F) at Present Worth Factor,
the end of a specified SPPWF (i%, N) may be
period, given the read off from Appendix 1, 1
SPPWF =
interest rate. 0 1 … … N or may be computed as e N *i
shown.
Finding the uniform A? A? A? A? A = F * USSFDF
yearly amount (A) i
that would yield a The Uniform Series USSFDF =
given future amount Sinking Fund Deposit (1 + i ) N − 1
(F) at the end of a Factor, USSFDF (i%, N)
specified period, may be read off from ei − 1
given the interest rate. 0 1 2 … N Appendix 1, or may be USSFDF =
computed as shown.
e N *i − 1
F
Finding the future A A A A F = A * USCAF
compounded amount
(1 + i) N − 1
(F) at the end of a The Uniform Series USCAF =
specified period due Compounded Amount i
to annual payments Factor, USCAF (i%, N)
(A), given the interest may be read off from e −1
N *i
rate. 0 1 2 … N Appendix 1, or may be

USCAF = i
computed as shown.
e −1
F
Finding the initial P? A A A A P = A * USPWF
amount (P) that is
(1 + i ) N − 1
equivalent to a series The Uniform Series Present USPWF =
of uniform annual Worth Factor, USPWF (i%, i * (1 + i ) N
payments (A), given N) may be read off from
the interest rate. Appendix 1, or may be 1 − e − N *i
0 1 2 … N computed as shown. USPWF =
ei − 1
Finding the amount P A? A? A? A? A = P * USCRF
of uniform yearly
i * (1 + i ) N
payments (A) that The Uniform Series capital USCRF =
would completely Recovery Factor, USCRF (1 + i ) N − 1
recover an initial (i%, N) may be read off
amount (P) at the end from Appendix 1, or may
of a specified period, 0 1 2 … N be computed as shown. ei − 1
given the interest rate. USCRF =
1 − e − N *i
Note: 1) In column 4, upper and lower formulae are for discrete and continuous compounding, respectively.
2) For fixed discrete compounding yearly, i = nominal interest rate and N represents years.
3) When there is more than one compounding period per year, the formulae and tables can be used as long as there is a
cash flow at the end of each interest period. i represents the interest rate per period and N is the number of periods.
4) When the compounding is more frequent than a year, but the cash flows are annual, the formulae can be used with N
as number of years and i as the effective annual interest rate.
Table 4-3: Interest Formulae for Arithmetic Gradient series with discrete compounding
Description Cash Flow Computational Factor
Diagram Formula Computation
Finding the future
compounded amount (N-1)G F = G * GSCAF
(1 + i ) N − 1
(F) at the end of a GSCAF =
specified period due The Gradient Series i2
to linearly increasing 2G Compounded Amount
annual payments (G), 1G Factor, GSCAF (i%, N)
N
given the interest rate. 0G may be computed as −
shown. i
0 1 2 … N
F?
Finding the amount
of linearly increasing (N-1)G? G = F * GSSFDF
annual payments (G) GSSFDF
that would yield a The Gradient Series
future compounded 2G? Sinking Fund Deposit
amount (F) at the end 1G? Factor, GSSFDF (i%, N) i2
of a specified period, 0G? may be computed as =
given the interest rate. shown.
(1 + i ) N − 1 − N * i
0 1 2 … N
F
Finding the initial
amount, (P) that (N-1)G P = G * GSPWF GSPWF
would be equivalent
to specified linearly P? The Gradient Series Present
increasing annual 2G Worth Factor, GSPWF (i%,
payments (G), given 1G N) may be read off from (1 + i ) N − 1 N
the interest rate. 0G Appendix 1, or may be =[ 2
− ] / [1 + i ] N
computed as shown.
i i
0 1 2 … N
Finding the amount

of linearly increasing P (N-1)G? G = P * GSCRF GSCRF
annual payments (G)
that would The Gradient Series Capital
completely recover an 2G? Recovery Factor, GSCRF
initial amount, (P) at 1G? (i%, N) may be computed (1 + i ) N * i 2
the end of a specified 0G? as shown. =
period, given the
(1 + i) N − 1 − N * i
interest rate.
0 1 2 … N
Note: 1) In column 4, upper and lower formulae are for discrete and continuous compounding, respectively.
2) For fixed discrete compounding yearly, i = nominal interest rate and N represents years.
3) When there is more than one compounding period per year, the formulae and tables can be used as long as there is a
cash flow at the end of each interest period. i represents the interest rate per period and N is the number of periods.
4) When the compounding is more frequent than a year, but the cash flows are annual, the formulae can be used with N
as number of years and i as the effective annual interest rate.
Table 4-4: Conversion Factors between Uniform Annual Series and Selected Non-Uniform Series
Type of Direction of Computational Formula

Compounding Conversion
1 N 
A = G* −  = G * GSUAF
a
Linear Gradient
i (1 + i ) − 1
N
Series (G) to
Equivalent Uniform
Series (A)
Discrete
Compounding
Geometric Series1
(M) to Equivalent
1 + t  N 
  − 1
Uniform Series (A)
  1+ i    i (1 + i ) N 
A=M* *
 t −i   (1 + i ) N − 1
 
 
Linear Gradient
 1 N 
Series (G) to A = G* i − N *i
Equivalent Uniform  e − 1 e − 1
Series (A)
Continuous
Compounding Geometric Series
(M) to Equivalent  (1 + t ) N − e Ni   e i − 1 
Uniform Series (A) A = M *  *  Ni 
 1 + t − e   e − 1
i
a
GSUAF, Gradient Series Uniform Amount Factor, can also be read off from Appendix 1.
1
The cash flow patterns are changing at a constant rate of t% per period. The initial cash flow in this series, M, occurs at the end
of period 1. The cash flow at the end of period 2 is M(1+t) and at the end of period N is M(1+t)N-1.
4.1.6 Special Cases of Interest Equations
4.1.6.1 Present Worth of Periodic Payments in Perpetuity
In some cases of investment economic evaluation, it may be more appropriate to consider the analysis
period as not finite, but perpetual in time. This is particularly the case where an investment is expected to recur
forever, such as most civil engineering structures (construction of bridges, highways, etc.) that will probably be
needed as long as there is a need for land transportation by humans. Consider the general case of an infrastructure
system that has periodic payments, R, made after every period, N (Figure 4-2). The period N is described as the life-
cycle or service life of that part of the infrastructure system that needs to be provided every Nth year. Such a
provision may involve removal of the existing component and its replacement, or the addition of a new component
on the existing component. The period N is assumed to be constant for this analysis, but it should be noted that N
could be increasing or decreasing as time goes on, depending on the level of usage and technological advances.
Increasing levels of usage, all else being constant would translate to decreasing values of N as time goes on,
and vice versa. Also, increasing quality of materials and other inputs would lead to increasing values of N, all else
being the same. In Figure 4-2, it is assumed that the initial investment, P is not the same as the periodic investments,
as recurring investments typically cover a lesser scope than the initial one. A case in point is highway construction,
where the initial investment includes right-of-way acquisition, embankment construction, relocation of utilities,
wetlands restoration and other costs aspects that are typically not found in recurring investments such as pavement
resurfacing or reconstruction.
P R R R R
Time
N N N N
∞
R = Compounded amount of all cash flows within a life-cycle

N = Life-cycle of the project that recurs every N years.
Figure 4-2: Present Worth of Periodic Payments (R) in Perpetuity.
Present Worth all R payments made every N years in perpetuity is given by:
R R R
PWR ,∞ = + + + ...
(1 + i ) N
(1 + i ) 2N
(1 + i ) 3 N
 1 1 1 
= R + + + ...
 (1 + i ) (1 + i ) 2 N (1 + i ) 3 N
N

 
 1  R
= R − 1 =
1 − 1  (1 + i ) N − 1
 (1 + i ) N 
4.1.6.2 Effect of Infinite Number of Compounding Periods in a Year
In some cases of economic evaluation, not only are there several times the interest rate is compounded
within a year, but it is possible for the frequency of compounding of such rates (and consequently, their periods) to
be so many that the number of compounding periods can be considered infinite. Consider the general case of an
investment where r is the nominal interest rate per year and m is the number of interest periods in a year. This means
that the interest rate per compounding period is given by r/m. The continuously compounded value of a single
amount P, after n years is given by:
m
 r *r *n
F = P(1 + r / m) m*n
= P(1 + r / m)  
But
m
 r r
lim 1 +  = e
m →∞
 m
Therefore,
F = Pe r*n
er*n is defined as the continuously compounded amount factor for the case of infinitely multiple compounding
periods. Similarly, the continuously discounted value of a single future amount F, after n years is given by:
F
P=
e r *n
1/er*n is defined as the continuously discounted factor for the case of infinitely multiple compounding periods.
For the case of an infinite number of compounding periods in a year, the effective annual interest rate is given by:
F − P P (e r ) − P
= = er −1
P P
4.1.6.3 Present Worth of Continuously Compounded Payments with Continuously Compounded Interest
In yet another instance of economic evaluation, the cash stream may involve continuous compounding of
payments with continuously compounded interest within a year. Consider a general case where Rj payments are
made each year j. i is the interest rate per year, and r is the rate of growth of payments (expressed as a percentage)
per year (Figure 4-3).
R0 R1 R2 R3 Rn-1 Rn
1st year 2nd year 3rd year nth year
Rj = Cash flow at the end of year j
Figure 4-3: Present Worth of Continuously Compounded Payments with Continuously Compounded Interest.
Bringing all future streams to the present gives:

R0: Present worth of R0 = R0 = R
R1: Present worth of R1 = (R × er)/ei
R2: Present worth of R2 = (R × e2r)/e2i
Rn: Present worth of Rn = (R × enr)/eni
Summing up the values of all present worths yields:
 e r e 2r e nr   e ( n+1)( r −i ) − 1
PWCCP ,CCI = R × 1 + i + 2i + ... + ni  = R ×  r −i 
 e e e   e −1 
PWCCP, CCI = present worth of continuously compounded payments with continuously compounded interest.
4.1.7 Estimation of the Rate of Growth of Benefits or Costs

Assuming continuous compounding,
F = P × ern
Ö => ern = F/P = α, say
Ö r × n = loge α
Ö r = (loge α)/n
The slope measured from a log-normal plot of payments vs. time (Figure 4-4), is r.
log F − log P log( F / P) log α

r= = =
n n n
Where α is the ratio of future annual value estimate to first year value estimate, F/P,
And n is the number of years (period of estimate).
log ($Value)
log F
r
log P
Time
n years
Figure 4-4: Estimation of the Rate of Growth of Benefits or Costs.
4.2 Methods of Economic Analysis
4.2.1 Introduction
The evaluation of engineering projects is typically carried out using a broad range of criteria that may be
monetary or non-monetary or both. While non-monetary criteria involve effectiveness, the monetary criteria are
based on dollar values, and are therefore associated with project efficiency. In this regard, the fundamental principle
underlying all engineering economic analysis is that the value of money is directly related to the time at which the
value is considered. Therefore, the interest equations studied in Section 4.1.5 are a key aspect of economic analysis.
For economic analysis of engineering projects, benefits and costs are translated to their common dollar
values. For public projects such as non-toll road construction, there are not direct benefits, and therefore reduction in
road user costs is considered a benefit. There are six computational methods for economic analysis as identified and
discussed below. The first two methods are applicable only when all alternatives are associated with the same level
of benefits, and therefore cost minimization is the sole criterion.
1 Equivalent Uniform Annual Cost (EUAC)
2 Present Value of Costs
3 Equivalent Uniform Annual Return
4 Net Present Value
5 Internal Rate of Return
6 Benefit-Cost Ratio
4.2.2 Equivalent Uniform Annual Cost Method

This method combines all initial costs, subsequent maintenance and operation costs and terminal salvage
costs, if any, of an infrastructure system into a single annual cost over the analysis period of n years. Consider the
general case of a system that is associated with an initial investment P, maintenance costs Mj for each year j,
operation costs Rj for each year j, and salvage value S at the end of its service life. The equivalent annual cost EUAC
is given by the following expression:
[ ]
n
EUAC = P * USCRF (i, n) + ∑ ( M j + R j ) * SPPWF (i, j ) * USCRF (i, n) − S * USSFDF (i, n)
j =1
4.2.3 Present Value of Costs

This method converts all initial investments, subsequent maintenance and operation costs and terminal
salvage costs, if any, of an infrastructure system into an equivalent single cost incurred at the beginning of the
analysis period (time zero). The equivalent present value of costs, or Present Value of Costs, PVC, is given by the
following expression:
[ ] [ ]
n n
PVC = P + ∑ M j * SPPWF (i, j ) + ∑ R j * SPPWF (i, j ) − S * SPPWF (i, n)
j =1 j =1
The use of EUAC and PVC for economic evaluation is associated with the assumption that benefits across
alternatives are similar or their monetary values are difficult to determine. However, using costs alone for economic
analysis is inadequate if there are measurable and significant differences in values of benefits from one alternative to
another.
4.2.4 Equivalent Uniform Annual Return Method

The EUAR method combines all initial costs, subsequent maintenance and operation costs and terminal
salvage costs, if any, and annual, periodic, and terminal benefits of an infrastructure system into a single annual
value of return (benefits less costs) over the analysis period. Consider the general case of a system that is associated
with an initial investment P, maintenance costs Mj for each year j, operation costs Rj for each year j, annual benefits
Bj for each year j, and salvage value S at the end of its service life. The equivalent uniform annual return, EUAR, is
given by the following expression:
[ ]
n
EUAR = − P * USCRF (i, n) + ∑ ( B j − M j − R j ) * SPPWF (i, j ) * USCRF (i, n)
j =1
+ S * USSFDF (i, n)
4.2.5 Net Present Value Method

The NPV of an investment is the difference between the present value of benefits and the present value of
costs. The NPV method combines all initial costs, subsequent maintenance and operation costs and terminal salvage
costs, if any, and annual, periodic, and terminal benefits of an infrastructure system into an equivalent single value
of return (benefits less costs) at the beginning of the analysis period. Consider the general case of a system that is
associated with an initial investment P, maintenance costs Mj for each year j, operation costs Rj for each year j,
annual benefits Bj for each year j, and salvage value S at the end of its service life. The equivalent net present value,
NPV, is given by the following expression:
NPV = Present worth of Benefits – Present Worth of Costs

[ ] [ ] [ ]
n n n
NPV = ∑ B j * SPPWF (i, j ) − P − ∑ M j * SPPWF (i, j ) − ∑ R j * SPPWF (i, j ) + S * SPPWF (i, n)
j =1 j =1 j =1
Investments associated with the highest NPV are considered the best investments.
4.2.6 Internal Rate of Return

An economic rate of return is defined as the vestcharge, that is, interest rate at which the net present worth
or equivalent uniform annual return is equal to zero. The Internal Rate of Return (IRR) method determines the
interest rate that is associated with a zero NPV and is consequently associated with an equilibration of present value
of benefits and present value of costs. Then the IRR is compared to the Minimum Attractive Rate of Return
(MARR). If IRR exceeds MARR, then the investment is considered worthwhile.
Consider the general case of a system that is associated with an initial investment P, maintenance costs Mj
for each year j, operation costs Rj for each year j, annual benefits bj for each year j, and salvage value S at the end of
its service life. The IRR value is found as follows:
Present worth of Benefits = Present Worth of Costs
∑ [B ] [ ] [ ]
n n n
j * SPPWF (i, j ) + S * SPPWF (i, n) = P + ∑ M j * SPPWF (i, j ) + ∑ R j * SPPWF (i , j )

j =1 j =1 j =1
Alternatively, IRR value can be found as follows:

Equivalent Uniform Annual Benefits = Equivalent Uniform Annual Costs
∑ [B ]
n
j * SPPWF (i, j ) * USCRF (i, n) + S * USSFDF (i, n)

j =1
[ ]
n
= P * USCRF (i, n) + ∑ ( M j + R j ) * SPPWF (i, j ) * USCRF (i, n)
j =1
The value of the interest rate that satisfies the above equations can be found using trial and error, or a
computer spreadsheet. If several alternative investments are being evaluated, the best investment is one that has the
highest IRR.
4.2.7 Benefit Cost Ratio Method

The benefit cost ratio (BCR) is a ratio of the equivalent uniform annual value (or net present value) of all
benefits to that of all costs incurred over the analysis period. An alternative investment with a BCR exceeding 1 is
considered to be economically feasible, and the alternative with the highest BCR value is considered the best
alternative. The BCR of an investment is calculated as follows:
EUAB NPB
BCR = =
EUAC NBC
Where EUAB = Equivalent Uniform Annual Benefits

EUAC = Equivalent Uniform Annual Costs
NPB = Net Present Benefits
NPC = Net Present Costs
The U.S. Flood Control Act of 1936, in making a reference to the use of BCR for evaluating economic
feasibility, was probably the first organization to use this method of evaluation.
4.2.8 Evaluation Methods Using Incremental Attributes

The foregoing discussion has been on determining the values of an evaluation attribute (benefit, cost, IRR,
benefit/cost ratio, etc.) associated with each individual investment. The best investment is considered as that with the
“most desired” value of the attribute. However, to obviate certain problems associated with such individualized
approached, evaluation of investments are increasingly been carried out using an incremental approach. In the
incremental approach, a particular investment is taken as the base case or base alternative. The attributes of all other
investment alternatives are compared to that of the base alternative (the difference between such is termed the
incremental value of the attribute). An example is found in highway pavement maintenance: For a given family of
pavements, there are several maintenance and rehabilitation scenarios over pavement life. Each scenario is
associated with costs (contract sums, or force expenditure on labor, equipment, material, etc.) and benefits (decrease
in vehicle operating costs arising from decreased surface roughness). The base case could be the scenario where the
pavement does not receive any maintenance. For each alternative scenario, the incremental benefits and costs would
be the benefits and costs of that scenario with respect to those of the zero maintenance alternative.
Table 4-5: Economic Evaluation Methods and Criteria for Choice of Best Investment
Criteria for Choice of Best Investment
Method of Economic Evaluation
Individual Approach Incremental Approach
Equivalent Uniform Annual Cost (EUAC) Lowest EUAC Lowest (EUAC - EUACBase Case)
Net Present Cost (NPC) Lowest NPC Lowest (NPC - NPCBase Case)
Equivalent Uniform Annual Return (EUAR) Highest EUAR Highest (EUAR - EUARBase Case)
Net Present Value (NPV) Highest NPV Highest (NPV - NPVBase Case)
Internal Rate of Return (IRR) Highest IRR that exceeds MARR Highest (IRR - IRRBase Case)
Benefit Cost Ratio (BCR) Highest BCR that exceeds 1 Highest (BCR - BCRBase Case)
In infrastructure management, a frequently proposed alternative is to improve an existing facility. The

procedure discussed above involves the comparison of evaluation attributes with the base case, which is also
referred to as the “null” or “do nothing” alternative, strategy, or scenario. This formulation is particularly useful in
instances where it is sought to determine the viability of improvements to an existing facility, for instance “Is it
worthwhile to keep a freeway section operating at a certain level of congestion? Are the suggested improvements to
a transit system economically viable, or should the system be left as in its current form?”
Each economic analysis method has its unique logic, merits and demerits. The equivalent uniform annual
cost and present value of costs methods are applicable only when all competing alternatives are associated with the
same level of service, and therefore the monetary value of benefits do not change from one alternative to another.
The equivalent uniform annual return and net present value methods, are a step above the cost-only methods, as they
consider the benefits, and are therefore appropriate where competing alternatives have significant and very different
levels of service. NPV, which is expressed as a lump sum, and not a rate, ratio, or index, provides a readily
comprehensible magnitude of the net benefit of an investment. For this reason, NPV is the method recommended by
AASHTO (1997). Like the NPV and EUAR, the IRR method considers both benefits and costs. Also, no assumption
need be made about the interest rate, although the minimum attractive rate of return must be known. The main
disadvantage of the IRR method is the mathematical problems associated with the computation of IRR: a unique
solution is not always guaranteed. Many multilateral agencies, including the World Bank, use the IRR method for
project appraisal. The benefit cost ratio duly considers both benefits and costs, but the use of this method is
susceptible to any ratio-based index: different values of BCR may be obtained depending on the definition, units,
and dimensions of benefits and costs. Most importantly, BCR does not provide any indication of the total extent of
benefit. The use of benefit cost ratio has been common, but is no longer recommended as a desirable approach.
Other evaluation criteria were identified by Winfrey (1970) who stated that the degree of economic
desirability could also be determined using any of the following approaches:
• Determination of the willingness of users in the community to pay for the facility,
• Comparison of the costs associated with the absence of the facility (for example, if bridge
replacement is being considered, evaluation of this activity could be carried out on the basis of the
extra costs incurred by road users on lengthy detours if the bridge were put out of action for any
reason,
• Determination of the social welfare function served by the facility.
4.3 An Application of Economic Analysis Methods: Optimal Timing of Investments
4.3.1 Introduction
In the previous chapter, the economic evaluation of an alternative was made assuming a given project was
implemented immediately or in year 0. However, varying the time of implementing a project can result in very
different economic returns. Suppose a state government plans to build a four-lane highway through a region. Some
pertinent questions that may be posed include: “Should the highway be built now or some years in the future? If it is
to be delayed, what is the desirable year to start construction?” In the case where the location is such that the
highway will have little traffic if it is built now, the user benefit will not be sufficient compared to the construction
cost. In such cases, the government may prefer to postpone the construction by a certain number of years until such
a time that the new road will have enough traffic to produce sufficient user benefit. This type of decision is
particularly common in many developing countries. Finding a point in time when traffic grows high enough to
justify the project is considered as the optimal timing for the improvement project. The underlying assumption for
such analysis is that there is a growing demand for road services with time, reflected by increasing traffic levels.
This section discusses the procedures for determining optimal timing for transportation investments.
4.3.2 The Economic Effect of Postponement

Consider a project that seeks to improve an existing road. Figures 4-5A and 4-5B illustrate the cash flows
associated with each timing scenario: implementing the project immediately, and postponing the project by one year,
respectively. A comparison of the two cash flow diagrams shows that the difference between them includes the loss
of the first year’s benefit by postponing the project by one year and the gain by not paying interest by one year on
the capital investment. In addition to that, the salvage value of the facility constructed a year later (Case B) may be
slightly higher than that constructed at the current year (Case A), even though the gain due to higher salvage will be
relatively small. Salvage differences can therefore be ignored in such cases where there is relatively little timing
difference in the initial investments.
b1 b2 b3 b4 b5 b6 bn-1 bn
0
1 2 3 4 5 6 n-1 n Year
C
A: Implementing the Project immediately
b2 b3 b4 b5 b6 bn-1 bn
0 1
2 3 4 5 6 n-1 n Year
C
B: Postponing Project Implementation by One Year
Figure 4-5: Cash Flow Illustration of the Effect of Investment Postponement.

In Figure 4-5 the initial investment cost is denoted by C, while the benefit in each year is denoted by bt. Let
NPVt be the Net Present Value in the general case where the initial investment occurs in year t. Assuming that the
benefits associated with the occurrence of an initial investment start accruing in the following year, the Net Present
Value for Case A (ignoring the salvage value) is:
NPV0 = -C + b1*SPPWF (i, 1) +b2 * SPPWF (i, 2) + … + bn*SPPWF (i, n)
Where i is the interest rate.
In Case B (postponement by one year), the net present value is:
NPV1 = -C*SPPWF (i, 1) +b2 * SPPWF (i, 2) + … + bn*SPPWF (i, n)
The algebraic difference between the above two equations for NPV0 and NPV1 yields the saving obtained
due to the delay of the postponement by one year, is given as follows:
S(1) = NPV1 – NPV0 = (-C-b1)*SPPWF (i, 1) + C
i * C − b1
=
(1 + i )
The numerator in the above equation is the interest on initial construction cost minus the first year’s benefit
and the denominator is simply SPCAF. If S(1) is discounted to Year 1, the NPV0 equation 1 ends up with interest ion
initial capital minus the first year’s benefit. For the postponement by one year to be justifiable, it is obvious that first
year’s benefit should be less than i*C and it should be tested if additional postponement is also worthwhile.
Additional postponement by another year is worthwhile if NPV2 is greater then NPV1. In other words, S(2) must be
positive in order to justify postponement of the implementation by an additional year. Generally,
NPV2 = -C* SPPWF (i, 2) + b3*SPPWF (i, 3) + …
S(2) = NPV2 - NPV1 = (-C – b2)* SPPWF (i, 2) + C*SPPWF (i,1)
i * C − b2
=
(1 + i ) 2
S(2) must generally be positive to make the postponement of the implementation by one additional year
justifiable. Generally,
i * C − bt
S (t ) =
(1 + i ) t
The timing of the initial investment can be delayed as long as the NPV at year t is equal to or greater than
that of the previous year (i.e., as long as S(t) ≥ 0). The year at which NPV is just less than NPV at the previous year
(i.e., when S(t) becomes < 0) is the optimal year for implementing the project by carrying out the initial investment.
In other words, the optimal timing of the investment is the year at which bt is greater than i*C. Therefore the
decision criterion for deferring (or implementing) a project can be stated as follows:
1. If S(t) ≥ 0, defer the project

2. If S(t) < 0, implement the project so that the benefit for the first year after the initial investment is
greater than the annual interest on the capital.
This criterion is called the First Year Benefit (FYB) criterion. Whenever S(t) is less than 0, the interest on
the initial capital investment, C, is less than the first year benefit, bt. Therefore the FYB criterion can be restated as
follows:
1. If the ratio of the first year benefit to the initial cost, bt /C) is smaller than or equal to the interest rate,
defer the project,
2. If the ratio of the first year benefit to the initial cost, bt /C) is greater than the interest rate, then
implement the project.
The ratio bt /C is the first year rate of return. So the second criterion above is referred to as the First Year
Rate of Return criterion. As soon as the project implementation is justified by the criterion, it is imperative that the
implementation begins early enough to open the facility in year t, so that there is full benefit bt obtained by the end
of the first year. If the project implementation period is expected to last for a long time, the project must be started
well in advance, so that the implementation is completed by the start of the year t.
Figure 4-6 shows the gains from delaying a project by one year, S(t), and NPV of the project over a period
of time. NPV keeps increasing and reaches the point at which NPV becomes positive for the first time. This point of
time is called the breakeven year, nBE. From this point of time, the starting of the project is justifiable. From this
breakeven point, postponement of the project by one year will produce a net gain because the benefit increases and
NPV will grow until it reaches the maximum value. The point at which NPV is a maximum is the optimal time, nOPT
for implementing the project. As shown in Figure 4-6, NPV will be a maximum when S(t) is zero. After nOPT, the
gain by postponement by another year becomes negative and NPV starts to decrease.
S(t)
Time of
Implementation
NPV(t)
Time of
Implementation
nOPT
nBE
Figure 4-6: Net Present Value and Gain due to Postponement of Implementation.
Example 4.3-1
A county highway agency intends to build a bridge. The data below shows the cash flow of the project for a
period of 10 years. There will be a major improvement after 10 years. Find the optimal timing for the bridge project.
Assume MARR is 10%.
Year 0 1 2 3 4 5 6 7 8 9 10
3
Construction Cost ($10 ) -1000
3
Benefits ($10 ) -- 83 101 124 138 155 170 188 200 210 215
Year 11 12 13 14 15 16 17 18 19 20
3
Construction Cost ($10 )
Benefits ($103) 225 232 241 255 270 284 300 311 325 329
Solution
Five investment scenarios are considered: Construction in each year from year 0 to year 4. For each
scenario, the cash flows and present (at Year 0) worth of all such payments are calculated, and the net present value
is found (Table 4-6). The table shows that opening the facility in Year 1 produces an NPV of 300 when discounted
to Year 0. Since NPV is greater than 0, the project is feasible. The table also presents the NPV values if the project
were deferred. It can be seen that NPV values keep increasing with postponement of up to 2 years. After 2 years,
further postponement does not yield an increase in NPV. Therefore, the optimal time of implementing the project is
Year 3. Applying the First Year Benefit or the FYRR criterion would yield the same result as shown.
From the FYB criterion,

bt = 101
Ci = 1000* 0.1= 100
The first time bt exceeds 100 is the second year.
From the FYRR criterion,

b t /C = 0.101
MARR = 0.1
The first time bt/C exceeds MARR is the second year.
Table 4-6: Cash Flows and Present Worths for Different Project Timing for Example 4.3-1
Construction Starts Construction Starts Construction Starts Construction Starts Construction Starts
in Year 0 in Year 1 in Year 2 in Year 3 in Year 4
Year Cash PW year Cash PW year Cash PW year Cash PW year Cash PW year
Flow 0 Flow 1 Flow 2 Flow 3 Flow 4
0 -1000 -1000
1 83 74 -1000 -893
2 101 81 101 81 -1000 -797
3 124 88 124 88 124 88 -1000 -712 -1000 -636
4 138 88 138 88 138 88 138 88 138 88
5 155 88 155 88 155 88 155 88 155 88
6 170 86 170 86 170 86 170 86 170 86
7 188 85 188 85 188 85 188 85 188 85
8 200 81 200 81 200 81 200 81 200 81
9 210 76 210 76 210 76 210 76 210 76
10 215 69 215 69 215 69 215 69 215 69
11 225 65 225 65 225 65 225 65 225 65
12 232 60 232 60 232 60 232 60 232 60
13 241 55 241 55 241 55 241 55 241 55
14 255 52 255 52 255 52 255 52 255 52
15 270 49 270 49 270 49 270 49 270 49
16 284 46 284 46 284 46 284 46 284 46
17 300 44 300 44 300 44 300 44 300 44
18 311 40 311 40 311 40 311 40 311 40
19 325 38 325 38 325 38 325 38 325 38
20 339 35 339 35 339 35 339 35 339 35
NPV +300 +333 +348 +338 +250
4.3.3 Effect of Multi-year Implementation of Investments

So far, it has been assumed that the construction cost was accrued in one year. Such as assumption may be
unduly restrictive in many actual cases. If the implementation period (time taken for construction) exceeds 1 year,
then implementation costs spread over more then one year, and consequently a separate set of computations may be
necessary to determine the optimal timing for construction. This can be illustrated through the use of an example
below:
Example 4.3-2
Consider a project that would take 4 years to complete. Figure 4-7A show the cash flow diagram if the
project is started immediately, and Figure 4-7-B shows the cash flows if the beginning of the construction is
postponed by one year. C1, C2, C3 and C4 are the costs for the first, second, third and fourth years of completion
respectively. The benefit streams start at the completion of the project, and they are counted at the end of each year.
The net present worth values for the two cases can be computed as follows:
C2 C3 C4 b4 b5
NPV0 = −C1 − − − + + …
1 + i (1 + i ) 2
(1 + i ) 3
(1 + i ) 4
(1 + i ) 5
C1 C2 C3 C4 b5
NPV1 = − − − − + …
1 + i (1 + i ) 2
(1 + i ) 3
(1 + i ) 4
(1 + i ) 5
The saving from deferring the project by one year, S(1), is obtained by subtracting NPV0 from NPV1, as
shown below:
i (C1 (1 + i ) 3 + C 2 (1 + i ) 2 + C 3 (1 + i ) + C 4 ) − b4 iC * −b4
S (1) = =
(1 + i ) 4 (1 + i ) 4
Where,
C* = C1 (1 + i ) 3 + C 2 (1 + i ) 2 + C 3 (1 + i ) + C 4
C* represents the sum of the discounted values of all the construction costs in the year preceding the
opening of the project. To justify one year delay of the project, S(t) should be greater then 0, or i*C* should be
greater than b4. The First Year Benefit criterion applied to this case in the same way as in the case of one-year
construction except that the construction costs should be compounded in the year preceding the first benefit year.
b4 b5 b6 bN-1 bN
0 1 2 3
4 5 6 N-1 N
C1 C2 C3 C4
A: Case A- Implementing the Project “Immediately”
b5 b6 bN-i bN
0 1 2 3 4
5 6 N-1 N
C1 C2 C3 C4
B: Case B- Postponing Project Implementation by One Year
Figure 4-7: Cash Flows for Investments with Multiyear Implementation Periods.
Example 4.3-3
Assume a 3-year construction period for a project; benefits begin accruing in the fourth year. The
construction costs spread over three years, and $50,000, $250,000 and $200,000 are spent in the first, second and
third year, respectively. Yearly benefits for four years are tabulated in Table 4-7. The interest rate is assumed to be
6%.
Table 4-7: Yearly Benefits for Example 4.3-3
Year Benefits (in $103)
1998 31
1999 34
2000 37
2001 40
Solution
Table 4-8 shows costs discounted to the year preceding the first benefit year. Using FYB criterion, the first
year S(t) becomes negative is 1999, (b3 = 34, which is more than 521*6%). Since the construction takes 3 years, the
construction should start in 1996.
Table 4-8: Yearly Construction Costs for Example 4.3-3

Year Costs (in $103) Cost Compounded in Year 3
1 50 56
2 250 265
3 200 200
Total 521
4.3.4 Multi-stage Implementation of Investments

When considering a construction of transportation facility, the following question is often raised, “Should
we build the facility now at the full service level to serve the future demand, or construct in stages as the demand
develops?” This problem can be illustrated by considering the following example.
Example 4.3-4
Consider the following situation where a four-lane roadway is to be constructed to full capacity now or in
two stages (two lane road way is built now and additional two lanes are built n years from now). Construction costs
for the two cases are the following:
Single Stage Construction
Construct four-lane roadway now $1,866,000
Two Stage Construction
Construct two-lanes now $1,200,000
Construct additional two-lanes n years from now $1,866,000
For the purpose of simplifying the example, annual benefits for both cases are assumed to be the same and zero
salvage value at end of the service life. Assuming the service life is infinite, find which option is economically more
viable? Interest rate is 7%.
Solution
Since the annual benefits for both cases are the same, the Net Present Cost method can be used. Present
worth of cost for the single stage construction is:
PW1 = $1,866,000
PW of cost for the two-stage construction case is:
PW2 = $1,200,000 + $1,500,000*SPPWF(7%, n)
Sample calculations of PW2 for several values of n are
n=5 $1,200,000 + $1,500,000*SPPWF(7%, 5) = $2,269,500
n = 10 $1,200,000 + $1,500,000*SPPWF(7%, 10) = $1,962,450
n = 12 $1,200,000 + $1,500,000*SPPWF(7%, 12) = $1,896,000
n = 20 $1,200,000 + $1,500,000*SPPWF(7%, 20) = $1,587,600
n = 30 $1,200,000 + $1,500,000*SPPWF(7%, 30) = $1,397,100
A plot of PW of costs for the two cases is shown in Figure 4-8. The x-axis variable is the time the second
stage construction is conducted. PW of the single stage construction remains constant regardless of the second
construction time of the two-stage construction alternative. The present worth of the two stage construction
alternative decreases as the second construction is done 12 years from now. Until year 12, PW of cost for the two-
stage construction alternative is greater than that of single stage construction alternative. If the second stage is
needed before year 12, PW of cost for the single stage is smaller then PW of the two stage alternative. This implies
that if, in the two-stage construction, the second stage should be constructed before year 12, the single stage
construction is preferred. On the other hand, if the second stage construction is not needed until year 12, it would be
better to wait and build the facility in two stages.
4.3.5 Optimization of Stage Implementation of Investments
Stage construction, an example of stage implementation of investments, is the process of making

progressive improvements to a facility over an extended period of time, rather than constructing or improving it
initially to some high standard (World Bank, 1990). Stage construction can be economically desirable even though
the total of several stage construction costs may be higher than the single stage construction cost because of the time
value of money. If stage construction is preferred, the optimal timing of each construction stage should be
determined. Methods of determining the optimal timing of successive stage are introduced in the section.
Consider an existing roadway that currently provides a low level of service. Improvements are being
considered for the road. Instead of improving the road to achieve the full standard level of service, a two-stage
construction is proposed. Annual costs including user costs and maintenance costs are assumed to increase linearly
with time. In other words, the recurring functions are of the form: a + b*t. After each improvement, it is expected
that these annual costs will be significantly reduced and the form of the cost functions will change even though the
linear increase over time is assumed. Figure 4-9 shows the pattern of costs with the two-stage construction. The
period from now to the first upgrading time is defined as Stage 0. For upgrading the roadway from Stage 0 to Stage
1, the construction cost is C1 incurred in year t1. After the first upgrading of the road, there is a sharp drop in annual
cost line. Following the drop, cost start to grow linearly again until the next upgrading. This so-called saw-tooth
pattern continues every time a stage upgrading is conducted.
Present
Worth
of Costs
($*106)
3.0
2.0
Single Stage
1.0
2-Stage
Construction
5 10 15 20 25 30
Year
Figure 4-8: Present Worth of Costs for Single Stage and Two-Stage Construction.
Total Costs
C1 C2
a0+b0*t a1+b1*t a2+b2*t
Year
Stage 0 Stage 1 Stage 2
(Existing)
t1 t2
Figure 4-9: Pattern of Costs with Two-Stage Construction.

The variables in Figure 4-9 are defined as:

tj = optimal timing of upgrading from Stage j to j+1,
aj, bj = coefficients of annual costs as a linear function of time during Stage j.
The optimal timing of the two improvements in the example should be determined so that the total costs are
minimized. Assuming each stage construction is completed in one year, the present worth (PW) of all costs with
interest rate is:
t1 t2 ∞
PW = ∫ (a0 + b0 * t )e − i*t
dt + C1 * e −i*t1
+ ∫ (a1 + b1 * t )e −i*t
dt + C 2 * e −i*t 2
+ ∫ (a 2 + b2 * t )e −i*t dt
0 t1 t2
It can be noticed that continuous discounting is used for the above equation.
To obtain a set of timings, t1, and t2 that minimizes the present worth value, the PW expression is
differentiated with respect to t1 and t2, and the resulting partial derivatives are set to zero. After simplifying, optimal
values of t1 and t2 can be obtained as shown below:
C1 * i − (a0 − a1 )
t1 =
b0 − b1
C2 * i − (a1 − a2 )
t2 =
b1 − b2
The generalized form of optimal stage construction timing can be stated as:
C j * i − (a j −1 − a j )
tj =
b j −1 − b j
Where tj = optimal timing for any sequential upgrading from stage j to j+1
Cj = upgrading cost
aj, bj = coefficients of linear yearly cost functions
Total Costs
C1 C2
a0+b0*ekt a1+b1*ekt a2+b2*ekt …
Year
Stage 0 Stage 1 Stage 2
(Existing)
t1 t2
Figure 4-10: Pattern of Costs with Two-Stage Construction.
Example 4.3-5
A developing country is planning to upgrade an existing 14.3 mile gravel road first by stabilizing it in a few
years from now and then providing an asphalt surface several years after the first improvement. The project will thus
have three stages and the base year is 1995. A strategy is needed for implementation of the project. The data on the
type of construction and unit cost for each upgrading are as follows:
1. From gravel surface to stabilized surface: $320,000/mile
2. From stabilized surface to asphaltic concrete surface: $400,000/mile
From previous similar type of projects in this particular region, the continuously increasing recurring cost
functions (user and maintenance) are estimated as follows:
Stage 0 (from 1995 to year of stabilizing): 2.93 + 3.41t
Stage 1 (from year of stabilizing to year of asphaltic concrete surfacing): 2.59 + 3.41t
Stage 2 (after asphaltic concrete surfacing): 2.17 + 2.88t
Where t is the number of years from the base year.
What would be the optimal year for successive regarding? Assume that traffic growth is linear and the MARR is
5.5%.
Solution:
Construction cost for each upgrade is as follows:
C1 = $320,000 * 1.43 = $4,576,000
C2 = $400,000 * 1.43 = $5,720,000
Cost functions are defined as aj + bj *t,

Where aj’s and bj’s are as follows:
Stage j aj bj
0 2.93 3.41
1 2.59 3.14
2 2.17 2.88
Applying the general equation for optimal stage construction timing yields:
C1 * i − (a0 − a1 ) 4,576,000 * 0.055 − (2.93 − 2.59) * 10 5

t1 = = = 8.06
b0 − b1 (3.41 − 3.14) * 105
C 2 * i − (a1 − a 2 ) 5,270,000 * 0.055 − (2.59 − 2.17) *10 5

t2 = = = 10.48
b1 − b2 (3.14 − 2.88) *10 5
So, the stabilizing should be done in 8 years from 1995 and then in another two years the road should be
upgraded to an asphalt surface.
The above example assumes linear increasing function of recurring costs. However, in practice, annual
recurring costs can be rather exponentially increasing (Figure 4-10) because the traffic increase is exponential and
expressed in percent per year. In this case the recurring costs can be expressed as ai + bi*ekt, where k is the annual
traffic growth rate. The optimal timing (tj) for stage construction with exponentially increasing cost function can be
derived in a similar manner, and is given by:
C j * i − (a j −1 − a j )
log e
b j −1 − b j
tj =
k
Example 4.3-6
A two-lane 12.5-mile highway section has a current Average Daily Traffic of 6,500 vehicles. The highway
is in a poor condition causing excessive user and maintenance costs each year. Due to the high demand of this
highway, the county has decided to do a major improvement. It will include the reconstruction of the existing
pavement in addition to building two new lanes. However, because of high cost and funding problems, the county is
planning to do the reconstruction in stages. The county will undertake the setting up of a sinking fund to finance the
project where an annual deposit will be made until the completion of the project. The fund is expected to earn 10%
per year. The recurring annual cost functions (in $105) are exponential and of the form: a + b*ekt where k is traffic
growth rate and t is time.
The plan is to implement the project in the following stages and it is expected that the construction in each
stage can be completed in one year.
Table 4-9: Costs for Stage Construction for Example 4.3-6

Construction Coefficients of Recurring
Work to be Traffic Growth
Stage Cost Cost Function
Accomplished Rate
(in $105) a b
0 Current
- 0.62 0.20 -
Reconstruction of the old
1 pavement 4.72 0.413 0.14 5.1
2 New one-lane widening

2.5 0.317 0.07 5.7
New one-lane widening
3 overlaying all 3 lanes 4.12 0.167 0.005 7.0
From the given data, we will determine the optimal timing to start each stage. Knowing that the depositing
in the fund will start at the beginning of the project, how much should be deposited annually for each stage? Assume
MARR = 6.5 %.
Applying the equation for tj,

t1 = 3
t2 = 5
t3 = 7
4.3.6 Application of Optimization of Stage Implementation: Optimal Timing for Paving Low-Volume Gravel
Roads (Bhandari and Sinha, 1985)
Gravel surface roads are generally adequate for most situations of low volume traffic. However, as traffic
increases, the maintenance and vehicle operating costs also increase. Therefore, it is eventually necessary to
consider paving the gravel surface. In order for the paving the road to be economically viable, savings in
maintenance cost and user cost should be substantial enough to justify the construction cost. If maintenance cost is
assumed to be constant over time, traffic volume, which benefits by the improvement, should be large enough to
produce much savings in comparison to improvement cost. In most cases of gravel low-volume road, the base year
volume is low so that investing the capital is hardly returned if construction is conducted in base year (n0). In that
case, it is preferred postponing the construction until it is, at least, economically feasible to pave the road. When the
base year volume is low but increasing with time, it is possible to invest the capital somewhere else in the economy
to obtain returns that are in excess of the benefits foregone during the years that construction is deferred. If the
concept of break-even analysis is applied to determine the cut-off volume (and the corresponding year) above which
it is economically feasible, this volume represents the minimum volume, above which the net present value of
paving is in excess of zero. But, it is more advantageous to postpone construction beyond the break-even volume
until such time when the net present value is maximized. The net present value by paving the road in the year in
which first year benefits are equal to the interest rate by First Year Benefit criterion described in the previous
section. The volume of traffic in this year is referred to as the optimal volume. If the road is paved a year before the
optimal volume, it would mean foregoing excess benefits that could be obtained from an alternative investment in
the economy, while paving the road a year after, would mean losing excess benefits that could have accrued had the
road been paved a year earlier. This typical situation is illustrated in Figure 4-11. The top portion of the figure shows
the stream of annual net benefits arising from paving the road in the year, say n1.
Compared to the benefit patterns in Figure 4-11, annual net benefits is increasing somewhat exponentially
rather than linearly increasing. The net benefits of paving the road in any other year should be the same as shown,
except for the years before paving when the net benefits are zero. For example, the net benefits corresponding to
construction in the break-even year (nbe) and the optimal year (nopt) would be correspond to the lines 0nbepq and
0noptq, respectively. The lower portion of the figure shows the net present value of the entire project, given the year
of construction. The points nbe and nopt correspond to zero and maximum net present values, respectively.
Figure 4-11: Net Present Value as a Function of the Year of Construction [Bhandari and Sinha, 1985]
In order to appropriately analyze the project, it is necessary to properly define important factors such as
service life, costs and benefits. For most road project it is true that a newly constructed facility will have a fixed
physical life varying from 15 to 49 years. However, generally, or often the case, major rehabilitation will be done at
the end of this period and in subsequent periods to perpetuate the useful life of that facility. For road projects, this is
often done in the form of major reconstruction and overlay, whenever the serviceability of the pavement has fallen
below an acceptable level. Under this assumption, benefits may be assumed to accrue indefinitely, for all practical
purposes. Thus, service life is assumed be infinite. The frequency of major rehabilitation is assumed to be planned in
advance, even though the physical life of a pavement is a function of the design standard and the traffic volume that
it is subjected to. Gain in salvage values being zero by deferring construction a few years can be also explained
using the concept of this indefinite service life. The primary costs associated with road projects consist of the
construction, routine maintenance, planned rehabilitation and vehicle operating costs. Construction costs are
assumed to occur only in the first year of construction while routine maintenance costs are assumed to remain
constant over time. Major rehabilitation costs are planned to occur every N years, where N is presumably close to the
physical life of the pavement.
The benefits from paving a gravel road comprise largely of the reduction in the total vehicle operating and
routine maintenance costs. Net benefits are then obtained after allowing for the construction and rehabilitation costs.
Let the variables relevant to a gravel road being considered for paving be defined as follows.
Q0: volume of traffic in the base year, in vehicles per day

m,m': uniform equivalent annual routine maintenance costs per km, before and after paving, respectively
c,c': average operating costs per veh-km on gravel and paved surfaces, respectively
C: fixed construction costs per km of paving
N: frequency of major rehabilitation, in years
R: cost of rehabilitation, in dollars per km
i: opportunity cost of capital (interest rate)
k: traffic growth rate per annum (generally less than i)
n: the year in which the gravel road is paved
The present value (PV) of various cost elements per km of roadway are obtained as follows:
PV of construction costs
1
= *C
(1 + i ) n
P.V. of rehabilitation costs
1 R
= *
(1 + i ) (1 + i ) N − 1
n
It should be noted that the road is kept in service indefinitely through periodic rehabilitation.
PV of savings in routine maintenance costs
1 ( m − m' )
= *
(1 + i ) n
i
PV pf savings in vehicle operating costs
1 1+ k 
= * Qn * 365 * (c − c' ) 
(1 + i ) n
i−k 
for k < i,
Where
Qn = Q0*(1+k)n, and
(1+k)/(i-k) = the discount factor for present value of a geometric series with growth rate k and
discount rate i, over an indefinite period (for k < i).
The net present value of paving is then obtained as follows:
1   1 + k   m − m'  R 
NPV = * Qn * 365 * ( c − c ' )  +   − C − 
(1 + i ) n  i−k   i  (1 + i ) N − 1
If the breakeven year is now denoted by n, then the break-even volume, Qbe, may be obtained by setting the
NPV equal to zero in the above equation.
R ( m − m' )
C+ −
(1 + i ) − 1
N
i
Qbe =
1+ k 
365 * (c − c' ) *  
i−k 
Provided the base year volume, Q0, is less than the volume in the break-even year (Qbe), the break-even
year, nbe, may then be obtained as follows:
Qbe = Q0 (1 + k ) nbe
log e (Qbe / Q0 )
nbe =
log e (1 + k )
for Q0 < Qbe, otherwise zero.
The optimal year for paving the gravel road is obtained by maximizing the NPV equation with respect to n.
However, as seen in Figure 4-12, with the discount rate equal to the opportunity cost of capital, the net present value
is maximum when the undiscounted net benefits in the year of paving are equal to zero. For such maximum to exist,
it is necessary that the benefits increase monotonically with time. This is ensured as long as the savings in the
vehicle operating costs and traffic growth rate both non-negative. The net benefits in the first year after paving are
given as follows:
Ri
NPV = Qn * (1 + k ) * 365 * (c − c' ) + (m − m') − Ci −
(1 + i ) N − 1
To obtain the optimal volume Qopt, Qn is substituted by Qopt in the above expression and set it equal to zero.
R *i
Ci + − ( m − m' )
(1 + i ) N − 1
Qopt =
365 * (c − c' ) * (1 + k )
Again, if Q0 is less than Qopt, the optimal year of paving, nopt, is obtained as follows:
log e (Qopt / Q0 )
nopt =
log e (1 + k )
for Q0 < Qopt, otherwise zero.
The break-even and optimal years obtained from the nbe and nopt equations are rounded to the nearest whole
numbers, in line with the usual assumption of year-end cost outlays.
Net
Present
Value
(NPV)
Year of
0 Implementation
nbe nopt (Construction)
Figure 4-12: Net Present Value as a Function of the Year of Construction.
Example 4.3-7
A 40-km gravel surface road on a reasonably good alignment is now carrying an annual average daily
traffic of 100 (10% truck). The traffic is expected to grow at an annual rate of 5% compounded (for each road type
and all vehicles). The minimum attractive rate of return is 10% per annum. It is proposed to pave the road with
minor reconstruction and the rest of the project details are shown below:
Item Value
1. Road Paving or Reconstruction Cost $50,000 per km
2. Road Maintenance
$600 per km/year
a) Existing Road
$450 per km/year
b) Paved Road
3. Vehicle Operating Costs on a Gravel Cars- 10 cents per day
Surfaced-Road Trucks- 12 cents per day
4. Vehicle Operating Costs on a Cars- 7 cents per day
Bituminous Surfaced-Road Trucks- 9 cents per day
$25,000 per km every 10
5. Rehabilitation/Resealing Cost
years
Determine:
1. The optimal year of paving and the break-even year of paving
2. The traffic volumes at the optimal year of paving and the break-even year of paving
3. The first year benefits and costs after the year of paving
4. The sensitivity of break even and optimal traffic volumes (and their corresponding years) with respect
to the interest rate.
Solution
1. Average operating cost per veh-km on gravel surface is:
c = 0.9 × 0.1 + 0.1 × 0.12 = $0.102/veh-km
2. Average operating cost per veh-km on bituminous surface is:
c’ = 0.9 × 0.07 + 0.1 × 0.09 = $0.072/veh-km
Using the equations for break-even traffic volume and year, and the optimal volume and year are obtained,
as shown below:
25000 600 − 450

50000 + −
Qbe = 1 . 110
− 1 0 .1 = 279vehs / day
1.05
365(0.102 − 0.072) *
0.1 − 0.05
log e (279 / 100)

nbe = = 21years
log e 1.05
25000 * 0.10
50000 * 0.10 + − (600 − 450)
Qopt = 1.110 − 1 = 558vehs / day
365(0.102 − 0.072)(1 + 0.05)
log e (558 / 100)

nopt = = 35.2 years
log e 1.05
After break-even year:

1st year benefits = Qbe × (k+1) × 365 × (c – c’) + (m-m’)
= 279 × 1.05 × 365 × (0.102 – 0.072) + 150
= $3357.8
st
1 year costs
Ri
= C *i +
(1 + i ) N − 1
25000 * 0.10
= 50000 * 0.10 + = $6568.63
(1 + 0.10)10 − 1
After the optimal year:

1st year benefits = Qopt × (1+k) × 365 × (c – c’) + (m-m’)
= 586 × 1.05 × 365 × (0.102 – 0.072) + 150
= $6565.61
1st year costs
Ri
= C *i +
(1 + i ) N − 1
25000 * 0.10
= 50000 * 0.10 + = $6568.63
(1 + 0.10)10 − 1
3. The sensitivity of the break-even volumes and their corresponding years is presented as follows:
Interest Rate Qbe nbe Qopt nopt

5% 0 0 369 28.2
8% 182 12.3 509 33.4
10% 279 21.0 558 35.2
12% 369 26.8 664 38.8
15% 498 32.9 784 42.2
1000
800
600
Traffic Volume
Qbe
Qopt
400
200
0
0 5 10 15 20
Interest Rate (%)
Figure 4-13: Sensitivity of Breakeven Volume to Interest Rate.

50
40
30
Years
nbe
nopt
20
10
0
0 5 10 15 20
Interest Rate (%)
Figure 4-14: Sensitivity of Breakeven Years to Interest Rate.
EXERCISES
1) What is the difference between fixed annual rate and effective annual interest rate?
2) Under what assumption can ‘Equivalent Uniform Annual Cost’ or ‘Present value of cost’ method be used
for evaluation of engineering projects?
3) What is the First Year Benefit criterion? What is the First Year Rate of Return criterion? What are they
used for?
4) What is breakeven year? How is it related to NPV? What is the optimal year?
5) What fixed annual interest rate compounded monthly yields an effective annual interest rate of 19.56%?
6) Derive an expression for calculating the present worth of a geometric gradient series with an interest rate of
i% compounded continuously over a period of n years. The series starts with an amount of M at the end of
first year and grows at the rate of r% per year.
7) Derive a generalized expression to compute the present worth of a geometric gradient series with an
interest rate of i% per year over a period of N years (compounded annually). Assume that the cash flow at
the end of year one is M which grows at f% per year.
8) The rate of growth of traffic on a newly constructed bridge is 3% per year. By the end of first year 500,000
vehicles would have used it. Determine the number of vehicles using the bridge in the tenth year of service.
Assuming that a toll of $0.75 is collected per vehicle, calculate the present worth of the total toll collections
during the ten-year period using the equation derived in problem-6. Assume an interest rate of 10% with
continuous compounding. For simplicity cash flows can be considered discrete, occurring at the end of each
year.
9) Calculate the present worth of the cash flow diagram shown below. Assume interest is compounded
monthly.
P=? $1000 $5000 $1000 $10,000
0 1 2 3 4 5 (Years)
5% 7% 10% (Nominal Interest

Rate per year)
10) 20 equal annual payments, of $2000 each, are made starting one year from today. What is the future
equivalent value of this series at the end of 20 years? Assume 10% interest per year.
11) Consider the following two alternatives for a transportation project:
Alternative A Alternative B
Initial investment $ 50,000 $ 100,000
Annual maintenance cost $ 15,000 $ 10,000
Annual User Benefits $ 20,000 $ 25,000
Useful life (years) 10 10
Salvage Value $ 20,000 $ 25,000
Which alternative would you recommend based on:

(i) Equivalent Uniform Annual Return method?
(ii) Net Present Value method?
(iii) Internal Rate of Return method?
(iv) Benefit-Cost Ratio method?
Assume 10% interest per year and MARR of 8%.
12) Three alternative designs are being considered for a potential improvement project related to the operation
of an engineering department. The prospective net cash flows for these alternatives are shown below.
MARR is 15% per year.
End of year A B C
0 -$200,000 -$230,000 -$212,500
1 $90,000 $108,000 -$15,000
2 $90,000 $108,000 $122,500
3 $90,000 $108,000 $122,500
4 $90,000 $108,000 $122,500
5 $90,000 $108,000 $122,500
6 $90,000 $108,000 $122,500
Apply the IRR method and the NPV method using incremental analysis procedure to select an
alternative. (Source: Engineering Economy, Degarmo, E. P. et al.)
13) The alternatives for an engineering project are reduced to three designs. The estimated capital investment
amounts and annual savings are shown in the table below. Assume that the MARR is 12% per year, the
study period is six years, and the market value is zero for all three designs. Apply the NPV method to
determine the preferred alternative. (Source: Engineering Economy, Degarmo, E. P. et al.)
Hint: Use the expression derived in Problem-7 for Design-1.
End of year Design-1 Design-2 Design-3

0 -$100,000 -$80,000 -$100,000
1 $25,000 $30,000 $20,000
2 After year one, the annual After year one, the annual Uniform sequence of
3 savings are estimated to savings are estimated to annual savings.
4 increase at the rate of 6% increase $150 per year.
5 per year.
6
7
8
9
10
14) You loaned out an amount of $12,500 at an interest rate of 13% per year for a period of six years. How
much total interest would you owe at the beginning of the 4th year? Assume that you make no payments
until the end of loan period and interest is compounded annually.
15) Draw a cash flow diagram for a $15,000 loan which needs to be repaid over a 5 year period in equal
uniform annual amounts. What is the amount of annual repayment if the interest rate is 12%?
16) Answer the following questions with reference to the cash flow diagram shown below:
(i) What future sum can be accumulated in 5 years with equal annual payments of $1,000 if the interest
rate is 10%?
(ii) What is the amount of uniform annual payment required to provide a future sum of $10,000 in 5 years
from now if the interest rate is 10%?
(iii) You want to accumulate a future sum of $15,000, but you can afford to pay only $1000 per year. If the
interest rate is 12%, what is the minimum number of years you will take to accumulate that money?
(iv) You make uniform annual payments of $1,000 each for 10 years. If you accumulate an amount of
$20,000 at the end of 10 years, what is the interest rate?
A A A A
0 1 2 … N
F
17) The initial investment for constructing a road is $500,000. The maintenance is expected to cost $15,000 per
year for the first 5 years of service, followed by $30,000 per year for the next 5 years. A rehabilitation
program is scheduled at the end of 10th year costing $150,000 after which the maintenance costs are
expected to reduce to $20,000 per year. What is the equivalent uniform annual cost over a 20 year period of
service if money is worth 8% per year? What is the equivalent present worth of all the road expenses?
18) A rehabilitation program is scheduled 4 years from now. If the expenditure is expected to be $50,000 then,
what amount should be set aside now to provide for that expenditure? Assume that funds earn 8% interest
per year.
19) A bridge project is considered for which two alternatives are being studied. Under the first alternative, a 4-
lane bridge will be constructed now for $5,000,000. The maintenance cost would be $30,000 for the first
year which is expected to increase by $2500 per year. Economic salvage value at the end of 20 years is
$1,000,000. The second alternative is to construct a 2-lane bridge now costing $3,000,000. Maintenance
would be $30,000 per year for 10 years. At the 10th year 2 more lanes would be added to accommodate for
the expected growth in traffic. This would cost $4,000,000 after which the maintenance cost for the new
facility would be $60,000 per year. Economic salvage value at the end of year 20 is $1,500,000. If the
interest rate is 10%, should the deferment of 2-lanes be preferred?
20) The cash flow table below shows expenditures and benefits for the construction of a parking facility
assuming that the construction takes place now. Find the optimal timing for the project. MARR is 9%.
Year 0 1 2 3 4 5
Construction Cost $100,000
Benefits -- $5000 $8000 $10,000 $13,000 $15,000
21) A transportation facility has a linear cost function given by: $(30,000 + 15,000*t ) where t is in years. A
rehabilitation program is planned in two stages. The maintenance cost function after stage-1 is expected to
be linear given by: $(25,000 + 10,000*t)
And the cost function after stage-2 is given by: $(20,000 + 8000*t)
The costs of implementing stages 1 and 2 are $300,000 and $200,000 respectively. Find the optimal timing
for each stage. MARR is 8%.
22) Find the present worth of the following cash flow diagram if i=18%. (Hint: The given series can be looked
at as a cumulative sum of various uniform and gradient series, positive and negative).
100 100
150 150
200 200
250 250
300 300
350
23) You deposit funds which represent an arithmetic gradient series. The first deposit is at the end of month 2
of amount G. The amount increases by G every month. You deposit till the end of 2 years. What is the
value of G if you want to accumulate $100,000 at the end of 2 years? The interest rate is 12% per year
compounded monthly?
24) The capital investment for a project is $100,000 now. This is to be repaid by a uniform annual series in 5
years. What is the annual repayment amount if the interest rate is 12% per year compounded monthly?
25) What is the effective annual interest rate for a nominal annual interest rate of 13% compounded
continuously?
26) A highway improvement is scheduled every 5 years in perpetuity. Each improvement costs $50,000. What
is the present worth of all the costs of the improvement project if the interest rate is 8% per year?
27) If the current year (beginning of year 1) user benefit from a road improvement is $5 million and the total
project cost is $80 million, what must be the minimum rate of growth of benefit in % per year, for the
project to be economically viable? Assume that the project life is 25 years and the benefit grows
continuously. The interest rate is 8% per year compounded continuously.
REFERENCES
1. AASHTO (1997)
2. Winfrey (1970)
3. World Bank, 1990
4. Bhandari and Sinha, 1985
5. Engineering Economy, Degarmo, E. P. et al
(Full detail of incomplete references will be provided to the students in due course.)

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97 Economic Analysis of Transportation Investments

4.1 Interest Equations and Equivalencies

4.1.1 Engineering Economics

4.2 Methods of Economic Analysis

4.3 An Application of Economic Analysis Methods: Optimal Timing of Investments

4.1 Interest Equations and Equivalencies

4.1.1 Engineering Economics

4.1.2 Cash Flow Illustrations

4.1.3 The Concept of Interest

4.1.4 Types of Compounding and Interest Rates

Fixed Variable Fixed Variable

Figure 4-1: Types of Interest Rates.

4.1.5 Interest Equations

Table 4-2: Interest Formulae for Discrete and Continuous Compounding

rate. 0 1 2 … N Appendix 1, or may be

Finding the amount

Type of Direction of Computational Formula

4.1.6 Special Cases of Interest Equations

4.1.6.1 Present Worth of Periodic Payments in Perpetuity

R = Compounded amount of all cash flows within a life-cycle

Figure 4-2: Present Worth of Periodic Payments (R) in Perpetuity.

4.1.6.2 Effect of Infinite Number of Compounding Periods in a Year

1st year 2nd year 3rd year nth year

Rj = Cash flow at the end of year j

Bringing all future streams to the present gives:

Summing up the values of all present worths yields:

4.1.7 Estimation of the Rate of Growth of Benefits or Costs

log F − log P log( F / P) log α

Figure 4-4: Estimation of the Rate of Growth of Benefits or Costs.

4.2 Methods of Economic Analysis

4.2.2 Equivalent Uniform Annual Cost Method

4.2.3 Present Value of Costs

4.2.4 Equivalent Uniform Annual Return Method

4.2.5 Net Present Value Method

NPV = Present worth of Benefits – Present Worth of Costs

4.2.6 Internal Rate of Return

Present worth of Benefits = Present Worth of Costs

j * SPPWF (i, j ) + S * SPPWF (i, n) = P + ∑ M j * SPPWF (i, j ) + ∑ R j * SPPWF (i , j )

Alternatively, IRR value can be found as follows:

j * SPPWF (i, j ) * USCRF (i, n) + S * USSFDF (i, n)

4.2.7 Benefit Cost Ratio Method

Where EUAB = Equivalent Uniform Annual Benefits

4.2.8 Evaluation Methods Using Incremental Attributes

In infrastructure management, a frequently proposed alternative is to improve an existing facility. The

4.3 An Application of Economic Analysis Methods: Optimal Timing of Investments

4.3.2 The Economic Effect of Postponement

B: Postponing Project Implementation by One Year

Figure 4-5: Cash Flow Illustration of the Effect of Investment Postponement.

NPV0 = -C + b1*SPPWF (i, 1) +b2 * SPPWF (i, 2) + … + bn*SPPWF (i, n)

Where i is the interest rate.

In Case B (postponement by one year), the net present value is:

NPV1 = -C*SPPWF (i, 1) +b2 * SPPWF (i, 2) + … + bn*SPPWF (i, n)

S(1) = NPV1 – NPV0 = (-C-b1)*SPPWF (i, 1) + C

NPV2 = -C* SPPWF (i, 2) + b3*SPPWF (i, 3) + …

S(2) = NPV2 - NPV1 = (-C – b2)* SPPWF (i, 2) + C*SPPWF (i,1)

1. If S(t) ≥ 0, defer the project

From the FYB criterion,

From the FYRR criterion,

NPV0 = -C + b1SPPWF (i, 1) +b2 SPPWF (i, 2) + … + bn*SPPWF (i, n)

NPV1 = -CSPPWF (i, 1) +b2 SPPWF (i, 2) + … + bn*SPPWF (i, n)

a0+b0t a1+b1t a2+b2*t

a0+b0ekt a1+b1ekt a2+b2*ekt …