Developed By:Dr. Don Smith, P.E.Department of Industrial EngineeringTexas A&M UniversityCollege Station, TexasExecutive Summary VersionChapter 9Benefit/Cost Analysis and Public Sector Economics

LEARNING OBJECTIVESPublic SectorB/C for single projectAlternative selectionMultiple alternatives

Sct 9.1 Public Sector Projects Public Sector:Ownership by citizens - the public Public Sector Projects:Provide needed services to the public at no profit Size of investment generally large Life estimates generally long (30 50 + Yrs) No profit; costs, benefits, and disbenefits are estimated Any revenues contribute to cover future costs

Terminology Costs estimated expenditures to the governmental entity for: Operations Maintenance Construction Benefits economic advantages to be experienced by the owners ( the public ) Disbenefits expected undesirable consequences to the owners (the public) Important:It is very difficult to estimate and agree upon the economic impact of benefits and disbenefits for many public sector projects

Interest (Discount) Rate Discount rate is term for interest rate for public sector projects Also called social discount rate Usually low in number, sinceGovernment projects pay no income taxesLow and very-low interest loans may be grantedGrants with selected no-repayment are available Discount rate often in range of 4% to 8% per year

The Viewpoint The viewpoint (perspective) must be determined before costs, benefits, and disbenefits are estimated There can be more than one viewpoint for a given public sector project. Select one:CitizenTax baseCreation/retention of jobsEconomic developmentSpecific industryStick with one view; using more than one can lead to problems in cost and revenue estimation

Sct 9.2 Benefit/Cost Analysis of a Single Project There are three B/C relationships, specifically;Sign convention:Costs are given a + signSalvage values are subtracted from costsDisbenefits are generally subtracted from benefits

Criteria and B/C Formulas If B/C 1.0 accept the alternative at the appropriate discount rate; If B/C < 1.0 the project is not economically acceptable but still could be funded for a variety of reasons.

Conventional B/C relation:

Modified B/C relation:

Sct 9.3 Alternative Selection Using Incremental B/C Analysis Given two or more mutually exclusive alternatives First, rank the alternatives from low to high based upon total costs in the denominator of the ratio

The 5-step PlanEstimate the total equivalent costs for the competing alternativesOrder the alternatives by total equivalent costSmaller one first then the larger cost alternativeCalculate the incremental cost (C) for the larger-cost alternative the denominator in the B/C ratio.

The 5-step Plan - continuedCalculate the total benefits and disbenefits for both alternativesCalculate the incremental benefits (B) for the larger cost alternativeThis is the (B-D) valueCalculate the B/C ratio

Accept the higher cost alternative if B/C 1, else the lower cost alternative is deemed undesirable

The Do-nothing OptionThe lower cost alternative should be compared to the Do-nothing (DN) option (maintain the status quo) If B/C for the lower cost alternative is < 1.00, then the DN option should be compared to B/C of the higher cost alternative If both alternative loose out to DN option, DN generally prevails unless there are compelling needs for one of the alternatives to be implemented

Sct 9.4 Incremental B/C Analysis of Multiple, Mutually Exclusive Alternatives Given three or more mutually exclusive alternatives; one must be selected Conduct the pair-wise B/C analysis The selection rule is:Choose the largest-cost alternative that is justified with an incremental B/C 1 when this alternative has been compared with another justified alternative See Example 9.5 - manual and spreadsheet

Independent Projects If multiple, independent projects are being evaluated and there is no budget limitation then:No need to conduct an incremental analysisCompare each alternative to the DN optionSelect and execute all projects with B/C ratios 1 If budget limitations exist, then some form of optimization routine must be performed See chapter 12 for the capital budgeting model

Chapter Summary B/C methods are used for the evaluation of public sector projects The analysis requires a discount rate (the social cost of capital or some variant of it) Apply either PW, AW, or FW analysis to the cash flows For two alternatives use the conventional B/C approach

Summary - continued For multiple (mutually exclusive) alternatives on must apply the incremental analysis approach similar to the ROR incremental approach For independent projects compare each alternative to the DN option

Chapter 9End of Set

At this point:1. Introduce yourself - your students are likely to want to know something about your qualifications and interests - overall, where you are coming from.2. Have students introduce themselves. Ask why they are taking this class. If you are fortunate enough to have a Polaroid camera, take pictures of each student for later posting on a class board so both they and you get to know each other.3. Discuss both choice of textbook and development of syllabus.4. If you are expecting students to work in teams, at east introduce the choice of team members. If at all possible, have students participate in a team building or team study exercise. It works wonders. Most student have been told to work in teams in prior classes, but have never examined exactly what a team is and how it works. One hour spent in a team building/examination exercise saves many hours and avoids many problems later on.