Ch9 BenefitCostAnalysis Student

Chapter 9
Benefit/Cost
Analysis
Lecture slides to accompany
Engineering Economy
7th edition
Leland Blank
Anthony Tarquin
2012 by McGraw-Hill All Rights Reserved

9-1
LEARNING OUTCOMES
1. Explain difference in public vs. private sector projects

2. Calculate B/C ratio for single project
3. Select better of two alternatives using B/C method
4. Select best of multiple alternatives using B/C method

9-2
Differences: Public vs. Private Projects
Characteristic Public Private
Size of Investment Large Small, medium, large
Life Longer (30 50+ years) Shorter (2 25 years)
Annual CF No profit Profit-driven
Funding Taxes, fees, bonds, etc. Stocks, bonds, loans, etc.
Interest rate Lower Higher
Selection criteria Multiple criteria Primarily ROR
Environment of evaluation Politically inclined Economic

9-3
Types of Contracts
Contractors does not share project risk
Fixed price - lump-sum payment
Cost reimbursable - Cost plus, as negotiated
Contractor shares in project risk
Public-private partnerships (PPP), such as:
Design-build projects - Contractor responsible from
design stage to operations stage
Design-build-operate-maintain-finance (DBOMF)
projects - Turnkey project with contractor managing
financing (manage cash flow); government obtains
funding for project

9-4
Cash Flow Classifications and B/C Relations
Must identify each cash flow as either benefit, disbenefit, or cost
Benefit (B) -- Advantages to the public

Disbenefit (D) -- Disadvantages to the public
Cost (C) -- Expenditures by the government
Note: Savings to government are subtracted from costs
Conventional B/C ratio = (BD) / C

Modified B/C ratio = [(BD) C] / Initial Investment
Profitability Index = NCF / Initial Investment
Note 1: All terms must be expressed in same units, i.e., PW, AW, or FW
Note 2: Do not use minus sign ahead of costs
9-5
Decision Guidelines for B/C and PI
Benefit/cost analysis
If B/C 1.0, project is economically justified at
discount rate applied
If B/C < 1.0, project is not economically acceptable
Profitability index analysis of
revenue projects
If PI 1.0, project is economically justified at
discount rate applied
If PI < 1.0, project is not economically acceptable
9-6
B/C Analysis Single Project
B-D
Conventional B/C ratio = If B/C 1.0,
C
accept project;
Modified B/C ratio = B D M&O otherwise, reject
C
Denominator is
PW of NCFt
PI = initial investment
PW of initial investment
If PI 1.0,
accept project;
otherwise, reject 2012 by McGraw-Hill All Rights Reserved
9-7
Example: B/C Analysis Single Project
A flood control project will have a first cost of $1.4 million with an annual
maintenance cost of $40,000 and a 10 year life. Reduced flood damage is
expected to amount to $175,000 per year. Lost income to farmers is estimated
to be $25,000 per year. At an interest rate of 6% per year, should the
project be undertaken?
Solution: Express all values in AW terms and find B/C ratio

B = $175,000
D = $25,000
C = 1,400,000(A/P,6%,10) + $40,000 = $230,218
B/C = (175,000 25,000)/230,218
= 0.65 < 1.0
Do not build project
9-8
Defender, Challenger and Do Nothing Alternatives
When selecting from two or more ME alternatives, there is a:

Defender in-place system or currently selected alternative
Challenger Alternative challenging the defender
Do-nothing option Status quo system
General approach for incremental B/C analysis of two ME alternatives:

Lower total cost alternative is first compared to Do-nothing (DN)
If B/C for the lower cost alternative is < 1.0, the DN option is compared to
B/C of the higher-cost alternative
If both alternatives lose out to DN option, DN prevails, unless overriding
needs requires selection of one of the alternatives

9-9
Alternative Selection Using Incremental B/C
Analysis Two or More ME Alternatives
Procedure similar to ROR analysis for multiple alternatives
(1) Determine equivalent total cost for each alternative

(2) Order alternatives by increasing total cost
(3) Identify B and D for each alternative, if given, or go to step 5
(4) Calculate B/C for each alternative and eliminate all with B/C < 1.0
(5) Determine incremental costs and benefits for first two alternatives
(6) Calculate B/C; if >1.0, higher cost alternative becomes defender
(7) Repeat steps 5 and 6 until only one alternative remains

9-10
Example: Incremental B/C Analysis
Compare two alternatives using i = 10% and B/C ratio
Alternative X Y
First cost, $ 320,000 540,000
M&O costs, $/year 45,000 35,000
Benefits, $/year 110,000 150,000
Disbenefits, $/year 20,000 45,000
Life, years 10 20
Solution: First, calculate equivalent total cost

AW of costsX = 320,000(A/P,10%,10) + 45,000 = $97,080
AW of costsY = 540,000(A/P,10%,20) + 35,000 = $98,428
Order of analysis is X, then Y
X vs. DN: (B-D)/C = (110,000 20,000) / 97,080 = 0.93 Eliminate X
Y vs. DN: (150,000 45,000) / 98,428 = 1.07 Eliminate DN
9-11 2012 by McGraw-Hill All Rights Reserved

Example: B/C Analysis; Selection Required
Must select one of two alternatives using i = 10% and B/C ratio
Alternative X Y
First cost, $ 320,000 540,000
M&O costs, $/year 45,000 35,000
Benefits, $/year 110,000 150,000
Disbenefits, $/year 20,000 45,000
Life, years 10 20
Solution: Must select X or Y; DN not an option, compare Y to X
AW of costsX = $97,080 AW of costsY = $98,428
Incremental values: B = 150,000 110,000 = $40,000
D = 45,000 20,000 = $25,000
C = 98,428 97,080 = $1,348
Y vs. X: (B - D) / C = (40,000 25,000) / 1,348 = 11.1 Eliminate X

B/C Analysis of Independent Projects
Independent projects comparison does not require

incremental analysis
Compare each alternatives overall B/C with DN option
+ No budget limit: Accept all alternatives with B/C 1.0

+ Budget limit specified: capital budgeting problem; selection
follows different procedure (discussed in chapter 12)

Summary of Important Points
B/C method used in public sector project evaluation
Can use PW, AW, or FW for incremental B/C analysis, but must
be consistent with units for B,C, and D estimates
For multiple mutually exclusive alternatives, compare two at a time
and eliminate alternatives until only one remains
For independent alternatives with no budget limit, compare each against

DN and select all alternatives that have B/C 1.0

9-14

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Chapter 9

2012 by McGraw-Hill All Rights Reserved

1. Explain difference in public vs. private sector projects

2012 by McGraw-Hill All Rights Reserved

Life Longer (30 50+ years) Shorter (2 25 years)

Annual CF No profit Profit-driven

Funding Taxes, fees, bonds, etc. Stocks, bonds, loans, etc.

Interest rate Lower Higher

Selection criteria Multiple criteria Primarily ROR

Environment of evaluation Politically inclined Economic

2012 by McGraw-Hill All Rights Reserved

2012 by McGraw-Hill All Rights Reserved

Benefit (B) -- Advantages to the public

Conventional B/C ratio = (BD) / C

Solution: Express all values in AW terms and find B/C ratio

When selecting from two or more ME alternatives, there is a:

General approach for incremental B/C analysis of two ME alternatives:

2012 by McGraw-Hill All Rights Reserved

Procedure similar to ROR analysis for multiple alternatives

(1) Determine equivalent total cost for each alternative

2012 by McGraw-Hill All Rights Reserved

Solution: First, calculate equivalent total cost

9-11 2012 by McGraw-Hill All Rights Reserved

9-12 2012 by McGraw-Hill All Rights Reserved

Independent projects comparison does not require

+ No budget limit: Accept all alternatives with B/C 1.0

9-13 2012 by McGraw-Hill All Rights Reserved

For independent alternatives with no budget limit, compare each against

2012 by McGraw-Hill All Rights Reserved

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