Lecture 6-Benefit Cost Ratio Lecture 6-Benefit Cost Ratio Lecture 6-Benefit Cost Ratio

Lecture 6-Benefit Cost Ratio

1. Evaluating Projects with the Benefit Cost Ratio Method Prof. Dr. Sajjad Mubin

2. Objective of Presentation (1) To describe many of the unique characteristics of public projects. (2) To learn how to use the Benefit/Cost (B/C) ratio method as criterion for project selection. Consideration of both independent project and mutually exclusive project is presented.

3. PUBLIC SECTOR DEVELOPMENT PROJECTS The world “ development” is used in numerous contexts. In all these contexts, it denotes some kind of change . Therefore, most briefly stated, development is viewed as a process of “ societal change”. It may also express a state that has been attained through some noticeable change, for instance, improvement in literacy rate & health of general public, improvement in socio-economic conditions of the public, improvement in transportation system, improvement in IT skills of targeted beneficiaries, reduction in poverty etc. This change occurs due to certain “ intervention ” called development project . Development projects are initiated with intent of providing multipurpose services . Besides providing basic necessities related to health, education, transportation, water & sanitation and housing, provide services to general public, generate revenue and employment.

4. INDICATORS FOR MEASURES OF ECONOMIC DEVELOPMENT Real income per head – GDP per capita Levels of literacy and education standards Levels of health care e.g. number of doctors per 1000 population Quality and availability of housing Levels of environmental standards Better infrastructure Water and Food Security Better Public Services Delivery Reduction in Poverty Levels of infrastructure – e.g. transport and communication Levels of transparency, governance & corruption Educational standards and labor productivity Labor mobility

5. From 34 indicators on track on 11 off track on 23 5

6. MICS 2014

7. Negative Trend Indicators

8. Reduction in Mortality Rates Bureau of Statistics 8

9. Youth Literacy Rate (15-24 years) Bureau of Statistics 9

10. Use of Improved Drinking Water Sources Bureau of Statistics 10

11. INTRODUCTION TO B/C RATIO METHOD Different decision criteria are often used, which creates problems for the public (which pays the bill), for those who must make the decisions, and for those who must manage public works projects. The Benefit/Cost Ratio Method , which is normally used for the evaluation of public projects, has its roots in provincial and federal legislation. Specifically, the government project require that their benefits must be in excess of their costs. In general terms, benefit-cost analysis is a systematic method of assessing the desirability of government projects or policies when it is important to take a long view of future effects and a broad view of possible side effects. In meeting the requirements of this mandate, the B/C method evolved into the calculation of a ratio of project benefits to project costs. Rather than allowing the analyst to apply criteria more commonly used for evaluating private project ( IRR ), NPV , etc), most governmental agencies require the use of the B/C method.

12. PERSPECTIVE AND TERMINOLOGY FOR ANALYZING PUBLIC PROJECT Before applying the benefit/cost ratio method to evaluate a public project, the appropriate perspective must be established. In conducting an engineering economic analysis of any project, whether it is a public or private undertaking, the proper perspective is to maximize the net benefits to the owner of the enterprise considering the project. This process requires that the equation of who owns the project be addressed. Consider, for example, a project involving the expansion of a section of road from four to six lanes. Because the project is paid for primarily with federal funds channeled through the Department of Transportation, we might be inclined to say that the federal government is the “owner”. These funds, however, originated from tax dollars – thus the true owners of the project are the taxpayers. ……cont….

13. PERSPECTIVE AND TERMINOLOGY FOR ANALYZING PUBLIC PROJECT As mentioned previously, the benefit/cost method requires that a ratio of benefit to costs be calculated. Project benefits are defined as the favorable consequences of the project to the public, but project costs represent the monetary disbursement(s) required of the government. It is entirely possible, however, for a project to have unfavorable consequences to the public. Considering again the widening of 1-80, some of the owners of the project – farmers along the intersate – would lose a portion of their arable land, along with a portion of their annual revenues. Because this negative financial consequence is borne by (a segment of) the public, It cannot be classified as either a benefit or a cost. The term dis -benefits is generally used to represent the negative consequence of a project to the public. method.

14. SELF-LIQUIDATING PROJECTS The term self-liquidating project is applied to a public 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 sewerage disposal provided by a hydroelectric dam. Other examples of self-liquidating projects include toll bridges and highways. As a rule, self-liquidating projects are expected to earn direct revenues that offset their costs, but they are not expected to earn profits or pay income taxes . Although they also do not pay property taxes, in some cases in lieu payments are made to state, county, or municipal governments in place of the property and/or franchise taxes that would have been paid had the project been under private ownership. ……cont….

15. EXAMPLE OF SELF-LIQUIDATING PROJECTS T he U.S. government agreed to pay the states of Arizona and Nevada $300,000 each annually for 50 years in lieu of taxes that would have ensued if Hoover Dam had been privately constructed and operated. These in lieu payments are usually considerably less than the actual property and franchise taxes would have been. Furthermore, once such payments are agreed upon, usually at the origination of the project, they are virtually never changed thereafter. These unchanging payments are not the case with property taxes, which are based upon the appraised value of the property.

16. MULTIPLE-PURPOSE PROJECTS An important characteristic of public sector projects is that such projects have a 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: assist in flood control, provide water for irrigation generate electric power provide recreational facilities, and provide drinking water. Developing such a project to meet more than one objective ensures that greater overall economy can be achieved. Because the construction of dam involves very large sums of capital and the use of a valuable natural resource – a river – it is likely that the project could not be justified unless it served multiple purposes. This type of situation is generally desirable, but, at the same time, it creates economic and managerial problems due to the overlapping utilization of facilities and possibility of a conflict of interest between the several purpose and the agencies involved.

17. DIFFICULTIES IN EVALUATING PUBLIC SECTOR PROJECTS There is no profit standard to be used as a measure of financial effectiveness, most public projects are intended to be non-profit. The monetary impact of many of the benefits of public projects is difficult to quantify. There may be little of no connection b/w the project and public (the owner) There is a strong political influence in public projects. The usual profit motive as stimulus to promote effective operation is absent. The direct profit stimuli present in private sector projects. Public projects are usually much more subject to legal restrictions than private projects The ability of Govt. bodies to obtain capital is much more restricted than private enterprise. The appropriate interest rate for discounting the benefits and costs of public projects is often controversially and political sensitive.

18. THE BENEFIT/COST RATIO METHOD Any method for formally evaluating projects in the public sector must consider the worthiness of allocating resources to achieve social goals. For over 60 years, the B/C ratio method has been the accepted procedure for making go/no-go decisions on independent projects. It will lead to identical recommendations, assuming all these procedures are properly applied. Accordingly, the purpose of this section is to describe and illustrate the mechanics of the B/C ratio method for evaluating projects. 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 or AW is used. An interest rate for public projects, as discussed in the previous section, is used in the equivalent worth calculations. The benefit/cost ratio is also known as the Savings-Investment Ratio (SIR) by some governmental agencies. Several different formulations of the B/C ratio have been developed. Two of the more commonly used formulations are presented here, illustrating the use present worth.

19. Conventional B/C ratio with PW: B/C = = PW(.)= present worth of (.) B= Benefit of the proposed project I= initial investment in the proposed project O&M= operating and maintenance costs of the proposed project.  Modified B/C ratio with PW:   B/C= The numerator of the modified benefit / cost ratio expresses the equivalent worth of the benefits minus the equivalent worth of the O&M costs, and the denominator includes only the initial investment costs. A project is acceptable when the B/C ratio, as defined in either mentioned above is greater than or equal to 1.0. THE BENEFIT/COST RATIO METHOD

20. THE BENEFIT/COST RATIO METHOD Conventional B/C ratio with PW, Salvage Value included :   B/C = = Where; PW(.)= present worth of (.) B= Benefit of the proposed project I= initial investment in the proposed project S= salvage value of investment O&M= operating and maintenance costs of the proposed project.   Modified B/C ratio with PW Salvage Value included :   B/C=

21. EXAMPLE-1 The city of Bugtussle is considering extending the runw ) ays of its Municipal Airport so that commercial jets can use the facility. The land necessary for the runway extension is currently farmland, which 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: $ 325,000 Rental receipts from airlines leasing a space at the facility $65,000 Airport tax charged to passengers $50,000 Convenience benefit for residents of Bugtussle $50,000 Additional tourism dollars for Bugtussle Apply the B/C ratio method with a study period of 20 years and a nominal interest rate of 10% per year to determine whether the runways at Bugtussle Municipal Airport should be extended.

22. The Benefit/Cost Ratio Method

23. Example -2 A new road project is proposed in a sub urban area. The capital investment on this project is Rs . 20,000,000/- . This road will bring development in the area and local people will get employment, smooth and easy access to the city and other economic benefits after construction of this road. The equivalent social and economic benefits of the road are amounting to Rs . 2,000,000/- per year. Annually Rs . 1,500,000 /- will be collected as toll tax (as revenue) from the vehicles using this road, which will be an added benefit of this road. Annually Govt. has to spend Rs . 1,000,000 /- on repair and maintenance of the road. The designed project life is 12 years. Considering 10% per year interest rate, find conventional and modified benefit/cost ratio of the project. Also recommend whether project is suitable/economically justified by using B/C ratio method.

24. EXAMPLE - 3 A toll bridge across the Mississippi River is being considered as a replacement for the current 1-40 bridge linking Tennessee to Arkansan. Because this bridge, if approved, will become a part of the U.S. Interstate Highway system, the B/C ratio method must be applied in the evaluation. Investment costs of the structure are estimated to be $17,500,000 and $325,000 per year in operation and maintenance cost are anticipated. In addition, the bridge must be resurfaced every fifth year of its 30-year projected life, at a cost of $1,250,000 per occurrence (no resurfacing cost in year 30). Equivalent revenues generated from the toll are anticipated to be $2,500,000 per year. Assuming zero market (salvage) value for the bridge at the end of 30 years and an MARR of 10% per year, should the toll bridge be constructed?

25. EXAMPLE - 4 Project Annual Benefits Annual Costs A $1,800,000 $2,000,000 B 5,600,000 4,200,000 C 8,400,000 6,800,000 D 2,600,000 2,800,000 E 6,600,000 5,400,000 Five independent projects are available for funding by a certain public agency. The following tabulation shows the equivalent annual benefits and costs for each. Assume that the projects are of the type for which the benefits can be determined with considerable certainly and that the agency is willing to invest money as long as the B/C ratio is at least 1. Which alternates should be selected for funding? What is the rank ordering of projects from best to worst? If the projects involved intangible benefits that required considerable judgment in assigning their values, would your recommendation be affected?

26. Dis-benefits are defined as negative consequence to public resulting from implementation of public-sector project. The conventional approach for incorporating dis-benefits into B/C ratio analysis is to reduce benefits by amount of dis-benefits (i.e. to subtract dis-benefits from benefits in the numerator). Alternatively, the dis-benefits could be treated as cost (i.e. add dis-benefits to cost in the denominator). OR         THE DIS-BENEFITS IN BENEFIT/COST RATIO

27. Example - 5 Considering example 1, in addition to 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 Bugtussle Municipal Airport. The annual disbenefits to citizens of Bugtussle caused by this “noise pollution” is estimated to be $100,000. Given this additional information, reapply the conventional B/C ratio, with annual worth, to determine whether or not the desbenfits effects your recommendation on the desirability of this project.

28. Example - 4 (Solution) B/C = [AW (B) – AW (D)]/[CR + AW (O&M)] B/C = [490,000 – 100,000]/[1,200,000 (A/P, 10%, 20) + 197,500] B/C = 1.152

29. SELF-LIQUIDATING PROJECTS The term self-liquidating project is applied to a public 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 sewerage disposal provided by a hydroelectric dam. Other examples of self-liquidating projects include toll bridges and highways. As a rule, self-liquidating projects are expected to earn direct revenues that offset their costs, but they are not expected to earn profits or pay income taxes . Although they also do not pay property taxes, in some cases in lieu payments are made to state, county, or municipal governments in place of the property and/or franchise taxes that would have been paid had the project been under private ownership. ……cont….

30. EXAMPLE OF SELF-LIQUIDATING PROJECTS T he U.S. government agreed to pay the states of Arizona and Nevada $300,000 each annually for 50 years in lieu of taxes that would have ensued if Hoover Dam had been privately constructed and operated. These in lieu payments are usually considerably less than the actual property and franchise taxes would have been. Furthermore, once such payments are agreed upon, usually at the origination of the project, they are virtually never changed thereafter. These unchanging payments are not the case with property taxes, which are based upon the appraised value of the property.

31. COMPARISON OF MUTUALLY EXCLUSIVE PROJECTS BY B/C RATIOS Mutually Exclusive Projects (MEA) are group of projects from which at most, one project may be selected. When using equivalent worth method to select from among a set of Mutually Exclusive Alternatives the best alternative may be selected by maximizing the PW (or AW or FW). Because the benefits/cost method provides a ratio of benefits to costs rather than a direct measure of each project’s profit potential selecting the project that maximizes the B/C ratio doesn’t guarantee that the best project is selected. In addition to the fact that maximizing the B/C ration for mutually exclusive alternatives is incorrect and will produce inconsistent ranking of projects by the conventional B/C ratio versus the modified B/C ration as conventional B/C ratio might favor a different project that would the modified B/C ratio. Therefore, for evaluating mutually exclusive alternatives by B/C ratio method incremental benefit/cost analysis be conducted .

32. Is this the last MEA? No Stop Baseline is the preferred Alternative Yes Stop Baseline is the preferred Alternative Yes No Yes No

33. COMPARISON OF MUTUALLY EXCLUSIVE PROJECTS BY B/C RATIOS While comparing MEA with B/C ratio method, they are first ranked in order of increasing total equivalent worth of costs. The do nothing alternative is selected as baseline alternative. The B/C ratio is then calculated for alternative having lowest equivalent cost. If B/C ratio for this alternative is equal or greater than 1.0, then that alternative becomes the new baseline otherwise do nothing remains as baseline. The next least cost alternative is then selected and the difference in respective benefits and costs is calculated to find incremental B/C ration ( ∆B/∆C ). If the ratio is greater than or equal to 1.0, then higher equivalent cost becomes baseline. Otherwise last baseline is maintained. Incremental B/C ratios are determined for each successfully higher equivalent cost alternative until the last alternative has been compared. The flow chart of process is shown in previous slide.

34. EAXAMPLE 6 : Evaluation of MEAs Three Mutually Exclusive Alternative public works projects are currently under consideration. Their respective costs and benefits are included in the table below. Each of the projects has a useful life of 50 years and the nominal interest rate is 10% per year. Which if any, of these project should be selected. Use Incremental B/C method for analysis. Description Project A Project B Project C Capital Investment $8,500,000 $10,000,000 $12,000,000 Annual O&M $750,000 $725,000 $700,000 Salvage Value $1,250,000 $1,750,000 $2,000,000 Annual Benefits $2,150,000 $2,265,000 $2,500,000

35. THANK YOU