chapter 11 evaluating projects with the benefit / cost ratio method $$$ $
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CHAPTER 11CHAPTER 11
EVALUATING PROJECTS WITH THE BENEFIT / COST RATIO METHOD
EVALUATING PROJECTS WITH THE BENEFIT / COST RATIO METHOD
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PRIVATE VERSUS PUBLIC PROJECTSPRIVATE VERSUS PUBLIC PROJECTS• PURPOSE
Private Project -- Maximize profit, minimize costs
Public Project -- Offer social benefits (i.e., health, employment ) without profit
• CAPITAL SOURCES
Private Project -- Private investors and lenders
Public Project -- Taxation; Private Lenders• FINANCING
Private Project -- Individuals (for sole proprietorships and partnerships); stocks and corporate bonds (for corporations)
Public Projects -- Direct taxes, Low, no-interest or private loans, bonds, subsidies
• PURPOSE
Private Project -- Maximize profit, minimize costs
Public Project -- Offer social benefits (i.e., health, employment ) without profit
• CAPITAL SOURCES
Private Project -- Private investors and lenders
Public Project -- Taxation; Private Lenders• FINANCING
Private Project -- Individuals (for sole proprietorships and partnerships); stocks and corporate bonds (for corporations)
Public Projects -- Direct taxes, Low, no-interest or private loans, bonds, subsidies
PRIVATE VERSUS PUBLIC PROJECTSPRIVATE VERSUS PUBLIC PROJECTS• MULTIPLE PURPOSES
More frequently for public projects ( i.e., reservoir for: flood control, power source, irrigation, recreation)
• PROJECT LIFE
Private Project -- 5 to 20 years;
Public Project -- 20 to 60 years• CAPITAL PROVIDER RELATIONSHIP TO PROJECT
Private Project -- Direct
Public Project -- Indirect or none• NATURE OF BENEFITS
Private Project -- Monetary or near monetary
Public Project -- Non-monetary; difficult to equate to monetary terms
• MULTIPLE PURPOSES
More frequently for public projects ( i.e., reservoir for: flood control, power source, irrigation, recreation)
• PROJECT LIFE
Private Project -- 5 to 20 years;
Public Project -- 20 to 60 years• CAPITAL PROVIDER RELATIONSHIP TO PROJECT
Private Project -- Direct
Public Project -- Indirect or none• NATURE OF BENEFITS
Private Project -- Monetary or near monetary
Public Project -- Non-monetary; difficult to equate to monetary terms
PRIVATE VERSUS PUBLIC PROJECTSPRIVATE VERSUS PUBLIC PROJECTS• PROJECT BENEFICIARIES
Private Project -- Those undertaking project
Public Project -- General public• CONFLICT OF PURPOSES
More common for public projects (i.e., dam for flood control vs environmental preservation)
• CONFLICT OF INTERESTS
More common for public projects (i.e., intra-agency conflicts)• POLITICAL INFLUENCE
More common for public projects ( i.e., changing decision makers, pressure groups, financial and residential restrictions)
• EFFICIENCY MEASUREMENT
Private Project -- Rate of Return on capital
Public Project -- No direct comparison with private projects
• PROJECT BENEFICIARIES
Private Project -- Those undertaking project
Public Project -- General public• CONFLICT OF PURPOSES
More common for public projects (i.e., dam for flood control vs environmental preservation)
• CONFLICT OF INTERESTS
More common for public projects (i.e., intra-agency conflicts)• POLITICAL INFLUENCE
More common for public projects ( i.e., changing decision makers, pressure groups, financial and residential restrictions)
• EFFICIENCY MEASUREMENT
Private Project -- Rate of Return on capital
Public Project -- No direct comparison with private projects
BENEFITS, COSTS, AND BENEFITS, COSTS, AND DISBENEFITSDISBENEFITS
BENEFITS, COSTS, AND BENEFITS, COSTS, AND DISBENEFITSDISBENEFITS
• Benefits - The favorable consequences of the project to the project sponsors (i.e., the public for public projects)
• Costs -- Monetary disbursements required (i.e., of the government for public projects)
• Disbenefits -- The negative consequences of the project to the project sponsors
• Benefits - The favorable consequences of the project to the project sponsors (i.e., the public for public projects)
• Costs -- Monetary disbursements required (i.e., of the government for public projects)
• Disbenefits -- The negative consequences of the project to the project sponsors
SELF-LIQUIDATING PROJECT
SELF-LIQUIDATING PROJECT
Any public project that is expected to earn direct revenue sufficient to repay the project cost(s) in a specified period of time.
Any public project that is expected to earn direct revenue sufficient to repay the project cost(s) in a specified period of time.
PROBLEMS ASSOCIATED WITH MULTIPURPOSE PROJECTS
PROBLEMS ASSOCIATED WITH MULTIPURPOSE PROJECTS
• Difficult to evaluate and compare all benefits and all disbenefits associated with the project.
• Difficult to allocate costs appropriately to each of the various purposes.
• Difficult to prioritize importance of purposes where conflict of interest occurs between purposes.
• Difficult to deal with the various political sensitivities of Multipurpose public projects.
• Difficult to evaluate and compare all benefits and all disbenefits associated with the project.
• Difficult to allocate costs appropriately to each of the various purposes.
• Difficult to prioritize importance of purposes where conflict of interest occurs between purposes.
• Difficult to deal with the various political sensitivities of Multipurpose public projects.
DIFFICULTIES IN EVALUATING PUBLIC SECTOR PROJECTS
DIFFICULTIES IN EVALUATING PUBLIC SECTOR PROJECTS
1. No profit standard as a measure of effectiveness
2. Difficult to quantify monetary impact of benefits
3. Little or no connection between project and public
4. Short-term rather than long-term benefits are emphasized for political reasons
5. Profit motive as a stimulus for effectiveness is absent
6. More legal restrictions with public projects
7. Greater difficulty in obtaining capital for public projects
8. Selection of interest rates controversial and politically sensitive
1. No profit standard as a measure of effectiveness
2. Difficult to quantify monetary impact of benefits
3. Little or no connection between project and public
4. Short-term rather than long-term benefits are emphasized for political reasons
5. Profit motive as a stimulus for effectiveness is absent
6. More legal restrictions with public projects
7. Greater difficulty in obtaining capital for public projects
8. Selection of interest rates controversial and politically sensitive
CHOOSING AN INTEREST RATE FOR A PUBLIC PROJECT
CHOOSING AN INTEREST RATE FOR A PUBLIC PROJECT
The choice of an interest rate in the public sector is intended to determine how available funds should best be allocated among competing projects to achieve social goals --
maximization of social benefits.
The choice of an interest rate in the public sector is intended to determine how available funds should best be allocated among competing projects to achieve social goals --
maximization of social benefits.
INTEREST RATE CONSIDERATIONSINTEREST RATE CONSIDERATIONS1. Interest rate on borrowed capital
Generally, this is the interest selected for any project targeted for these borrowed funds
2. Opportunity cost of capital to governmental agency
If projects are selected based on estimated return (in terms of benefits) -- return on all accepted projects is higher than on any rejected project -- the interest rate used is that of the best opportunity foregone.
3. Opportunity cost of capital to taxpayers
The interest on the best taxpayer opportunity foregone -- usually the highest of the three, and the most recommended
1. Interest rate on borrowed capital
Generally, this is the interest selected for any project targeted for these borrowed funds
2. Opportunity cost of capital to governmental agency
If projects are selected based on estimated return (in terms of benefits) -- return on all accepted projects is higher than on any rejected project -- the interest rate used is that of the best opportunity foregone.
3. Opportunity cost of capital to taxpayers
The interest on the best taxpayer opportunity foregone -- usually the highest of the three, and the most recommended
SOCIAL DISCOUNT RATESOCIAL DISCOUNT RATE
An additional theory on establishing interest rates for federal projects advocates which suggests the interest rate be the market-determined risk-free rate for private investments -- 3 to 4%
An additional theory on establishing interest rates for federal projects advocates which suggests the interest rate be the market-determined risk-free rate for private investments -- 3 to 4%
BENEFIT / COST RATIO METHODBENEFIT / COST RATIO METHOD
• The time-value of money must be considered to account for the timing of cash flows (benefits) occurring after inception of project
• A ratio of discounted benefits to discounted costs
• The ratio of equivalent worth (i.e., AW, PW or FW) of benefits to the equivalent worth of costs
• Also known as savings-investment ratio by some governmental agencies
• The time-value of money must be considered to account for the timing of cash flows (benefits) occurring after inception of project
• A ratio of discounted benefits to discounted costs
• The ratio of equivalent worth (i.e., AW, PW or FW) of benefits to the equivalent worth of costs
• Also known as savings-investment ratio by some governmental agencies
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
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CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
PW (benefits of the proposed project)
B/C = ---------------------------------------- PW(total costs of the proposed project)
PW (benefits of the proposed project)
B/C = ---------------------------------------- PW(total costs of the proposed project)
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CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
PW (benefits of the proposed project) PW(B)
B/C = ---------------------------------------- = ------------- PW(total costs of the proposed project) I +PW(O&M)
PW (benefits of the proposed project) PW(B)
B/C = ---------------------------------------- = ------------- PW(total costs of the proposed project) I +PW(O&M)
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CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
PW (benefits of the proposed project) PW(B)
B/C = ---------------------------------------- = ------------- PW(total costs of the proposed project) I +PW(O&M)
where: PW(•) = present worth of (•)
B = benefits of the proposed project
I = initial investment of the proposed project
O&M = operating and maintenance costs of the proposed project
PW (benefits of the proposed project) PW(B)
B/C = ---------------------------------------- = ------------- PW(total costs of the proposed project) I +PW(O&M)
where: PW(•) = present worth of (•)
B = benefits of the proposed project
I = initial investment of the proposed project
O&M = operating and maintenance costs of the proposed project$$$$$$$$$$ $$$$$$$$$$
MODIFIED BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
MODIFIED BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
PW(B) - PW(O&M)
B/C = --------------------------
I
PW(B) - PW(O&M)
B/C = --------------------------
I
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH ANNUAL WORTH (AW)
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH ANNUAL WORTH (AW)
AW (benefits of the proposed project) AW(B)
B/C = ---------------------------------------- = ------------- AW(total costs of the proposed project) CR +AW(O&M)
where: AW(•) = annual worth of (•)
B = benefits of the proposed project
CR = capital recovery amount (i.e., the equivalent annual cost of the initial investment, I, including an allowance
for salvage value, if any)
O&M = operating and maintenance costs of the proposed project
AW (benefits of the proposed project) AW(B)
B/C = ---------------------------------------- = ------------- AW(total costs of the proposed project) CR +AW(O&M)
where: AW(•) = annual worth of (•)
B = benefits of the proposed project
CR = capital recovery amount (i.e., the equivalent annual cost of the initial investment, I, including an allowance
for salvage value, if any)
O&M = operating and maintenance costs of the proposed project
MODIFIED BENEFIT / COST (B/C) RATIO WITH ANNUAL WORTH (AW)
MODIFIED BENEFIT / COST (B/C) RATIO WITH ANNUAL WORTH (AW)
AW(B) - AW(O&M)
B/C = --------------------------
CR
AW(B) - AW(O&M)
B/C = --------------------------
CR
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
SALVAGE VALUE INCLUDED
CONVENTIONAL BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW)
SALVAGE VALUE INCLUDED
PW (benefits of the proposed project) PW(B)
B/C = ----------------------------------- = ----------------- PW(total costs of the proposed project) I - PW(S)
+PW(O&M)
where: PW(•) = present worth of (•)
B = benefits of the proposed project
I = initial investment of the proposed project
S= salvage value of investment O&M = operating and maintenance costs of the
proposed project
PW (benefits of the proposed project) PW(B)
B/C = ----------------------------------- = ----------------- PW(total costs of the proposed project) I - PW(S)
+PW(O&M)
where: PW(•) = present worth of (•)
B = benefits of the proposed project
I = initial investment of the proposed project
S= salvage value of investment O&M = operating and maintenance costs of the
proposed project
MODIFIED BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW), WITH SALVAGE
VALUE INCLUDED
MODIFIED BENEFIT / COST (B/C) RATIO WITH PRESENT WORTH (PW), WITH SALVAGE
VALUE INCLUDED
PW(B) - PW(O&M)
B/C = --------------------------
I - PW(S)
PW(B) - PW(O&M)
B/C = --------------------------
I - PW(S)
BENEFIT / COST ANALYSIS IN DETERMINING ACCEPTABILITY OF A PROJECT
BENEFIT / COST ANALYSIS IN DETERMINING ACCEPTABILITY OF A PROJECT
All of the preceding formulations for benefit / cost analysis result in consistent acceptance or rejection:
• B / C > 1.0 --- Project accepted• B / C = 1.0 --- Project accepted• B / C < 1.0 --- Project Rejected
Conventional B / C ratios for PW and AW formulations result in the same numerical values
Modified B / C ratios for PW and AW formulations result in the same numerical values (but not the same as the conventional B / C ratios)
All of the preceding formulations for benefit / cost analysis result in consistent acceptance or rejection:
• B / C > 1.0 --- Project accepted• B / C = 1.0 --- Project accepted• B / C < 1.0 --- Project Rejected
Conventional B / C ratios for PW and AW formulations result in the same numerical values
Modified B / C ratios for PW and AW formulations result in the same numerical values (but not the same as the conventional B / C ratios)
DISBENEFITS IN THE BENEFITS / COST (B / C) RATIO
DISBENEFITS IN THE BENEFITS / COST (B / C) RATIO
• The traditional approach to incorporating disbenefits into a benefit / cost analysis to reduce the benefits by the amount of disbenefits (i.e., to subtract disbenefits from benefits in the numerator of the B/C ratio).
• Alternatively, the disbenefits could be treated as costs (i.e., add disbenefits to costs in the denominator).
• The traditional approach to incorporating disbenefits into a benefit / cost analysis to reduce the benefits by the amount of disbenefits (i.e., to subtract disbenefits from benefits in the numerator of the B/C ratio).
• Alternatively, the disbenefits could be treated as costs (i.e., add disbenefits to costs in the denominator).
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, BENEFITS REDUCED
BY AMOUNT OF DISBENEFITS
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, BENEFITS REDUCED
BY AMOUNT OF DISBENEFITS AW(benefits) - AW(disbenefits)
B / C = -----------------------------------------
AW(costs)
AW(benefits) - AW(disbenefits)
B / C = -----------------------------------------
AW(costs)
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, BENEFITS REDUCED
BY AMOUNT OF DISBENEFITS
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, BENEFITS REDUCED
BY AMOUNT OF DISBENEFITS AW(benefits) - AW(disbenefits) AW(B) -
AW(D)
B / C = ----------------------------------------- = --------------------
AW(costs) CR + AW(O&M)
AW(benefits) - AW(disbenefits) AW(B) - AW(D)
B / C = ----------------------------------------- = --------------------
AW(costs) CR + AW(O&M)
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, BENEFITS REDUCED
BY AMOUNT OF DISBENEFITS
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, BENEFITS REDUCED
BY AMOUNT OF DISBENEFITS AW(benefits) - AW(disbenefits) AW(B) -
AW(D)
B / C = ----------------------------------------- = --------------------
AW(costs) CR + AW(O&M)
where AW(•) =annual worth of (•)
B =benefits of proposed project
D =disbenefits of proposed project
CR =capital recovery amount (i.e., the equivalent annual cost of the initial investment, I, including an allowance for salvage value, if any)
O&M =operating and maintenance costs of the proposed project
AW(benefits) - AW(disbenefits) AW(B) - AW(D)
B / C = ----------------------------------------- = --------------------
AW(costs) CR + AW(O&M)
where AW(•) =annual worth of (•)
B =benefits of proposed project
D =disbenefits of proposed project
CR =capital recovery amount (i.e., the equivalent annual cost of the initial investment, I, including an allowance for salvage value, if any)
O&M =operating and maintenance costs of the proposed project
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, COSTS INCREASED
BY AMOUNT OF DISBENEFITS
CONVENTIONAL BENEFIT / COST RATIO WITH ANNUAL WORTH, COSTS INCREASED
BY AMOUNT OF DISBENEFITS AW(benefits) AW(B)
B / C = ------------------------------ = ---------------------------
AW(costs) + AW(disbenefits) CR + AW(O&M) + AW(D)
where AW(•) =annual worth of (•)
B =benefits of proposed project
D =disbenefits of proposed project
CR =capital recovery amount (i.e., the equivalent annual cost of the initial investment, I, including an allowance for salvage value, if any)
O&M =operating and maintenance costs of the proposed project
AW(benefits) AW(B)
B / C = ------------------------------ = ---------------------------
AW(costs) + AW(disbenefits) CR + AW(O&M) + AW(D)
where AW(•) =annual worth of (•)
B =benefits of proposed project
D =disbenefits of proposed project
CR =capital recovery amount (i.e., the equivalent annual cost of the initial investment, I, including an allowance for salvage value, if any)
O&M =operating and maintenance costs of the proposed project
IS ANALYSIS AFFECTED BY IDENTIFYING A POSITIVE CHANGE IN BENEFIT AS AN INCREASED BENEFIT OR
REDUCED COST ?
IS ANALYSIS AFFECTED BY IDENTIFYING A POSITIVE CHANGE IN BENEFIT AS AN INCREASED BENEFIT OR
REDUCED COST ? • Arbitrarily classifying a cost or benefit has no
impact on project acceptability:Let B = equivalent annual worth of project benefits
C = equivalent annual worth of project costs
X = equivalent annual worth of cash flow (added benefit or reduced cost) not included in B or C
If you classify X as added benefit: B / C = (B+X) / C
If you classify X as reduced cost: B / C = B / (C - X)
Given project is acceptable:
[ (B+X) / C ] > 1 : ( B + X ) must be greater than C
[ B / (C - X) ] > 1 : B must be greater than C -X (or transposing X, ( B + X ) must be greater than C)
• Arbitrarily classifying a cost or benefit has no impact on project acceptability:
Let B = equivalent annual worth of project benefits
C = equivalent annual worth of project costs
X = equivalent annual worth of cash flow (added benefit or reduced cost) not included in B or C
If you classify X as added benefit: B / C = (B+X) / C
If you classify X as reduced cost: B / C = B / (C - X)
Given project is acceptable:
[ (B+X) / C ] > 1 : ( B + X ) must be greater than C
[ B / (C - X) ] > 1 : B must be greater than C -X (or transposing X, ( B + X ) must be greater than C)
COMPARISON OF MUTUALLY-EXCLUSIVE PROJECTS BY B / C RATIOS
COMPARISON OF MUTUALLY-EXCLUSIVE PROJECTS BY B / C RATIOS
• When using equivalent worth methods to select among mutually-exclusive alternatives (MEAs), the best alternative selected by maximizing PW, AW, or FW.
• When using B / C method, no direct measure of each project’s profit potential is provided.– Only a ratio of benefits to costs is provided for each project– Selecting the project that maximizes the B / C ratio does not
guarantee the best project is selected.• Ranking of projects changes when using conventional
versus modified B / C ratio.• Approach of classifying cash flow items as added
benefits rather than reduced costs could also change preference for one MEA over another.
• When using equivalent worth methods to select among mutually-exclusive alternatives (MEAs), the best alternative selected by maximizing PW, AW, or FW.
• When using B / C method, no direct measure of each project’s profit potential is provided.– Only a ratio of benefits to costs is provided for each project– Selecting the project that maximizes the B / C ratio does not
guarantee the best project is selected.• Ranking of projects changes when using conventional
versus modified B / C ratio.• Approach of classifying cash flow items as added
benefits rather than reduced costs could also change preference for one MEA over another.
CRITICISMS AND SHORTCOMINGS OF THE BENEFIT / COST RATIO METHODCRITICISMS AND SHORTCOMINGS OF THE BENEFIT / COST RATIO METHOD
1. It is often used for after-the-fact justifications
2. Distributional inequities (i.e., one group benefits while another group incurs costs) are typically not accounted for by the B / C analysis
3. Qualitative information is often ignored in a B / C analysis
1. It is often used for after-the-fact justifications
2. Distributional inequities (i.e., one group benefits while another group incurs costs) are typically not accounted for by the B / C analysis
3. Qualitative information is often ignored in a B / C analysis