EVALUATION OF ALTERNATIVE TRANSPORTATION PLANS COURSE FOR ROADS AND AERODROMES ENGINEERS COMMONWEALTH DEPARTMENT OF WORKS Keith Linard, B Eng, B Comm, BTRP, IEAust Senior Engineer, Transport Operations & the Environment Australian Department of Housing & Construction, Central Office. August 1973

KEYWORDS: Cost Benefit Analysis; CBA; Economic Evaluation; Transport Economics

ABSTRACT:

This lecture and the one immediately following are concerned with the evaluation of alternative transportation plans. Although such examples as I give will be from the field of transportation, primarily road transportation, the principles I enunciate are directly applicable to any field of engineering planning. This first lecture is fairly general in its approach. I intend to put to you what I consider to be the framework of values and goals within which project evaluation should take place; I will then discuss in general terms the various methodologies in current use for project evaluation. The second lecture will be confined to a discussion of the merits of economic evaluation of engineering projects as a tool in decision making.

Table of Contents KEYWORDS: ..................................................................................................................................................................................... 1 ABSTRACT: ...................................................................................................................................................................................... 1 TABLE OF CONTENTS ................................................................................................................................................................... 3 FIGURES ............................................................................................................................................................................................ 4 TABLES .............................................................................................................................................................................................. 4 EVALUATION OF ALTERNATIVE TRANSPORTATION PLANS .......................................................................................... 5

Rationale for Evaluation......................................................................................................... 5 Indifference Curves and Utility Maximisation....................................................................... 5 Goal Structure of an Evaluation ............................................................................................. 8

Values ................................................................................................................................. 9 Goals ................................................................................................................................... 9 Objectives ........................................................................................................................... 9 Criteria ................................................................................................................................ 9 Standards .......................................................................................................................... 10 Interrelationship ................................................................................................................ 10

CURRENT APPROACHES TO TRANSPORTATION PLAN EVALUATION ...................................................................... 10 Two Frameworks for Plan Evaluation: Efficiency and Effectiveness ................................. 10 Plan Efficiency Criteria ........................................................................................................ 11

Investment Analysis - Financial ....................................................................................... 11 Investment Analysis - Economic ...................................................................................... 11

Plan Effectiveness Criteria ................................................................................................... 12 Checklist of Criteria.......................................................................................................... 12 Goal Achievement ............................................................................................................ 12 Planning Balance Sheet .................................................................................................... 13

ECONOMIC EVALUATION - A BRIEF RESUME OF PROCEDURES .................................................................................. 14 Derivation of Economic Evaluation Techniques ................................................................. 14 Deficiencies in Economic Evaluation Techniques ............................................................... 14

ECONOMIC EVALUATION METHODOLOGIES ..................................................................................................................... 15 Annual Cost: ......................................................................................................................... 15 Benefit Cost Analysis (BCR) ............................................................................................... 16 Net Present Value Method ................................................................................................... 16 Internal Rate of Return Method: .......................................................................................... 16

CRITIQUE OF ECONOMIC METHODS .................................................................................................................................... 17 Benefit-Cost Ratio (BCR) .................................................................................................... 17 Net Present Value: ................................................................................................................ 18 Internal Rate of Return: ........................................................................................................ 18

INFLATION AND ECONOMIC ANALYSIS ............................................................................................................................... 19 Discounting Future Costs and Benefits ................................................................................ 19 Sensitivity Analysis .............................................................................................................. 20

BIBLIOGRAPHY ........................................................................................................................................................................... 21

Figures Figure 1: Contours of Equal Utility or Indifference Curves ..................................................... 6 Figure 2: Indifference Curves Relating to Non-Monetary Trade-Offs ...................................... 7 Figure 3: Budget Constraints and Optimal Resource Allocation............................................... 7 Figure 4: Conflicting Interest Groups with Differing Indifference Curves ............................... 8

TABLES Table 1: Effect of treatment of non-capital costs on the BCR ................................................. 17 Table 2: Calculations of Net Present Value and Internal Rate or Return Method. .................. 19

EVALUATION OF ALTERNATIVE TRANSPORTATION PLANS

Rationale for Evaluation Transportation is a sensitive and complicated process dependent on physical resources

and facilities, people and activities. If the transportation system is to achieve its goals in a satisfactory manner it must be supplied with certain resources. It is with the allocation of these human and material resources to processes such as transportation that we are concerned. The need for the evaluation of alternative projects presupposes: that resources available for use are limited. In particular evaluation presupposes that:

(1) available resources are insufficient to provide all the goods and services we would like.

(2) there is competition between the transportation system and other activities for the use of these scarce resources and,

(3) for any given transportation goal there are a number of mutually exclusive alternatives, each with different demand for resources and each satisfying the various transportation objectives to differing degrees.

This concept implies some kind of ordering of priorities. It is therefore necessary that evaluation procedures be devised to enable the decision makers to make rational choices in regard to allocating available resources such that the community wants are satisfied to the greatest possible degree for a given outlay of public resources. To illustrate the resource allocation problem in simple terms it is useful to consider briefly the basic economic concepts of indifference curves and utility maximization. Indifference Curves and Utility Maximisation

In brief these concepts imply, that given any two "goods", there will exist a number of different combinations of these goods which will yield the same benefit or utility to any particular individual, and between these combinations the individual will be indifferent to which combination he chooses. In Figure 1, contour line U1 represents, for a given budget, possible combinations of expenditure (in this case, expenditure on schools versus expenditure on transport), which yield the same composite satisfaction or utility. The shape of the curve will differ between individuals and, indeed, over time for the same individual.

Figure 1: Contours of Equal Utility or Indifference Curves Obviously, with different budgets there will, be other combinations which yield higher or lower utility. Figure 1 illustrates a possible set of "utility contours" or indifference curves. Contour line U1 indicates all combinations of expenditure which yield utility U1. Other contour lines, U2 and U3, indicate contours of higher utility based on higher available budgets. These actual shape of such indifference curves depend on the societal or cultural values; in this case, for example, the value individuals and society place on equality of opportunity, on economic growth, on cultural development would determine the relative trade-offs between expenditure on education and transport. This sort of "trade off" or substitution applies equally in decisions between different impacts of alternative transportation projects. Consider, for example, the problem of deciding between different transport routes which, in varying degrees, destroy sections of a unique environment. The "trade-off" in this case, illustrated in Figure 2, might be between the preservation of the environment and travel time, construction cost or operating cost. The Indifference Curves U1, U2 and U3 represent different levels of aggregate resources applied to the particular project.

Figure 2: Indifference Curves Relating to Non-Monetary Trade-Offs Before any decision could be made on the "optimum trade-off" between these two public goods, transport services and environmental services, it is also necessary to consider the range of technical possibilities or the resource restraints. Consider, for example, the situation where a transport authority has only $100 million to spend on a specific road project, to be allocated (in this very simplistic example) between road construction and environmental preservation. This is illustrated in Figure 3. The authority is faced with the problem of apportioning this finance between the two options to achieve the optimum distribution. Which raises the question – “optimum from whose viewpoint?” In the example depicted in Figure 3, the optimum distribution from the local residents' viewpoint would be given by point of tangency between the budget line and an indifference curve, indicated by point A. In this case this represents about $40 million for transport system construction and $60 million for mitigation of social impacts,

Figure 3: Budget Constraints and Optimal Resource Allocation

Other individuals, or groups, would not be likely to have identical or even similar indifference curves. The local residents' opinions are unlikely to coincide with the preferences of drivers from other areas who want freeways through the area or even with the preferences of residents living on the other side of the city. This changes the decision making problems of the authority because there is no longer only one "optimum" distribution of resources. This situation is illustrated in Figure 4 where the indifference curves UL1 – UL3 represent those of hypothetical local resident affected by a proposed freeway. Their optimal trade-off point is represented by A1, which is heavily skewed in favour of expenditure to mitigate impacts. Indifference curves UC1 – UC3 represent those of hypothetical freeway users and their optimal trade-off point is at A2.

Figure 4: Conflicting Interest Groups with Differing Indifference Curves The culminating step in any real evaluation process involves the decision maker in making judgements about the worth of the consequences of alternative plans. Explicitly, when all factors are consciously considered, or implicitly when there are hidden or obscure issues, this judgement takes place within a framework that can be referred to as the goal structure of the evaluation process. This goal structure provides the ideal, or set of ideals, against which the "trade-offs" we have been looking at can be compared and weighted. Goal Structure of an Evaluation

If transportation planning is undertaken within the framework provided by a previously established value and goal hierarchy there will be greater likelihood that the proposals will gain general community acceptance. Selecting transportation plans outside such a framework, however, is likely to result in the implicit evaluation and choice of objectives within the planning process. This may adversely affect the achievement of other program goals and may lead to changes in regional environmental characteristics in directions which do not, in fact, reflect the needs and desires of society. With its predilection for design 'codes', planning and design 'standards' and with the ready availability of computers for stretching trend projections and simulation studies to limits far beyond the validity of the data available and the underlying assumptions of the computer

models, the engineering profession has a proclivity for overlooking the planning objectives to which design standards and evaluation criteria should relate, and for ignoring the broader community goals to which the planning objectives should relate. It is essential, therefore, for planners to recognize the interrelationship between standards, criteria, objectives, goals and values. Values Societal or cultural values could be defined as those 'irreducibles' which form the basic desires and drives governing our behaviour. An enumeration of such 'invariants' which constitute the value framework of our society might include, for example, the desire to survive, the need to belong, the need for order and security. Urban form and function contribute to our satisfaction and dissatisfaction insofar as they provide or limit opportunities to develop behaviour patterns in support of our values. Clearly values are high level abstractions, and it is therefore not possible to talk directly about a highway project in terms of its consistency or conflict with our values. Goals Subservient to values there are certain idealized end states of the environment toward which planners strive in their work. The idealized end states or 'planning goals', although less abstract than values, are not close enough to a set of physical referents that their attainment can be measured. Goals are generalized statements which broadly relate the physical or social environment to values. Thus the goal of maximizing the mutual accessibility of points in physical space may be viewed as being derived from the values of belonging and security. Goals represent the first step toward 'operationalizing' values, but the mapping between values and goals is not a unique one. Hence persons maintaining the same value set may have different goals. As a consequence the derivation of goals from values is a complex task. Objectives

An 'objective' is a specific statement which is the outgrowth of a goal and which is truly attainable because of its reference to the real world and because it is stated in such a way as to permit some form of measurement of the degree to which it has been attained. Referring to the goal of maximizing mutual accessibility, one objective derived from this may be that all residences within a city should be within a 500 metres of a public transport stop. Again it is obvious that a number of complementary or conflicting objectives may be derived from any given goal. Given a clear set of goals, the development of planning objectives is still a complex task. Criteria

'Criteria' are the specific measures or tests which reflect the degree of attainment of particular objectives. Criteria result directly from the fact that the level of attainment of the objectives of urban planning is directly measurable. They include quantitative tests which are applied to alternative physical system plans in order to compare alternative systems and to

determine the degree to which they meet the specified objectives. The benefit-cost ratio is a simple example of a commonly used criterion. Standards

The minimum acceptable level of the criterion level, or the limiting grade of the criterion test is known as a 'standard'. The standard represents that fixed level of attainment of an objective which is the lowest level of attainment adoptable for a number of purposes. Standards are useful in that they enable us to routinize decision making, but they may also make the decision making process inflexible, particularly when they are not subjected to periodic analysis and re-evaluation. In addition it is difficult to employ standards where criteria deal with phenomena which are difficult to represent in quantitative terms, or which, because of their particular nature, must be subjective. Interrelationship

In terms of the preceding chain of interrelated definitions it is clear that the existence of meaningful standards and criteria in the urban transportation planning process implies the existence of specific objectives. Such objectives are valid only if they are derived from stated goals, which in turn depend on social values. Unless there is a clear, explicit and valid statement of planning objectives, then evaluation of the relative effectiveness of alternative transport projects can become a meaningless exercise. Without such a statement the construction of subjective rating or weighting formulae is of little value. Without such a statement the validity of the planning process is liable to be called into question by those affected by the proposals. Current Approaches to Transportation Plan Evaluation

There is insufficient time available to look at the means for determination of appropriate goals for transportation projects. Suffice it therefore to reiterate that the decision maker must endeavour to establish clearly the goals of the planning process and to enumerate explicitly the particular objectives of particular projects. Assuming that this has been done, we are faced with the problem of developing or selecting an appropriate evaluation methodology which considers satisfactorily the criteria which flow from the objectives and goals. Two Frameworks for Plan Evaluation: Efficiency and Effectiveness There are two interrelated frames of reference within which alternative plans may be evaluated. Firstly each plan should be considered in terms of the degree to which it is expected to accomplish the tasks for which it is intended. These frameworks considers only the effectiveness of the plan in meeting its objectives, and so plan effectiveness criteria are concerned only with those costs and benefits directly related to the program goals and project costs. The second frame of reference is necessary because plans should also be evaluated in terms of the relative value of the return resulting from their implementation. This is the basic issue

of "getting one's money's worth", and is termed the plan efficiency criterion. Plan efficiency criteria relate to the relationship between some aggregate of all the benefits and the sum of all the costs accruing from the project. Such a separation is useful for two reasons; firstly it reflects the two basic categories of evaluation procedures used today in transportation system planning, and secondly the dichotomy simplifies the discussion of the evaluation process. Plan Efficiency Criteria Encompassed within this group are two basic methodologies:-

(1) Investment analysis - financial (2) Investment analysis - economic

Investment Analysis - Financial The feature of this method is that only the financial (i.e., monetary) costs and returns

directly of affecting the balance sheet of the investing or decision making body are relevant, and the inevitable external costs or benefits are ignored. Whilst this approach is generally more applicable to the private sector than the public sector, this approach is used in some areas of Government investment, particularly in respect of Government business operations. This method is clearly extremely narrow as only a portion of the costs and benefits accruing to the community as a whole are considered. Non quantifiable (in monetary terms) effects are completely ignored. Investment Analysis - Economic

This method would include cost-benefit analysis, rate of return analysis, comparison of capitalized value etc. Basically these amount to listing all the benefits and costs from each alternative plan, whether these are monetary benefits or costs or for example environmental or social benefits or costs, and then comparing results. As far as possible the consequences of each plan are detailed in monetary terms, and the assumption in this should be recognized. Intangibles are treated in one of three ways. First, they may be given a subjective weighting and appended to the monetary analysis. Second, when this is not possible, verbal descriptions of intangible impacts may be provided. Finally they can be ignored. It is suggested that subjective weightings or verbal descriptions of intangible impacts will make for less impact on the decision maker than "objective" metricized outputs. This methodology therefore biases the selection process towards consequences which can be measured in money terms. Unfortunately the overall procedures appear to be so analytically objective that one tends to think that all aspects of a plan can be and have been similarly characterized. They have an image of sophistication that does not, in fact, exist at present. Most important of all, such

evaluation procedures refer only to the goal of economic efficiency, and other community goals may get "short shift" because of the manner in which problems are considered. Nevertheless such methods do play valuable part in providing informational support for decisions. Plan Effectiveness Criteria

Encompassed within this group are basic methodologies (1) Checklist of Criteria (2) Goal Achievement (3) Planning Balance Sheet

Checklist of Criteria This method is clearly illustrated by reference to a study by Kitching in relation to the

four sites selected by the Roskill Commission for the 3rd London Airport. He first enumerates seven characteristics which one would ideally seek in siting a major international airport: communication, noise impacts, population and industrial growth potential labour costs, amenity and agriculture and services. He then examines each of the four sites in relation to these criteria using such data as are available and forms a judgement as to the order of choice in relation to each. From these he ranks the sites from 1 to 4. From this table of crude, that is unweighted, rankling he draws conclusions. This is a crude, but in some circumstances useful, method for reducing the number of alternatives. In other words it is most useful as a relatively quick sieve. Its prime drawbacks include the fact that the incidence of advantages and costs is not brought out and that it is not an optimizing method since it is not really applicable to searching for new alternatives. Goal Achievement

There are a number of different approaches which can broadly be lumped under this group. They have in common a simple approach: to what extent will the plans as designed meet objectives which have been set in advance. Perhaps the most comprehensive of these approaches is that developed by Hill with the Goal Achievement Matrix. The characteristic of this method is that costs and benefits are always defined in terms of goal achievement. Thus benefits represent progress toward the desired objectives whilst costs represent retrogression from these objectives. These objectives must be specified with respect to different locations and/or groups within the community. For each objective and for each alternative course of action, costs and benefits are compared, aggregated where possible, and reported separately. The approach presents the decision maker with a matrix indicating the costs and the benefits associated with each objective. The decision maker can then make decision with respect to trade-offs. Alternatively, weighted indices of goal achievement can be predetermined, leading to a single unequivocal result. The validity of this, however, is dependent on the validity of the weighting and of the measurement scales employed.

Hill's method assumes that benefits and costs have meaning only in relation to a well-defined objective, and hence a criterion of maximizing net benefits in the abstract would be meaningless. Whereas benefits can be computed referring to different planning objectives, these benefits and costs are not necessarily additive or comparable. It is meaningful to add or compare costs and benefits only if they refer to a common objective. Furthermore, since benefits and costs can legitimately be compared only in terms of an objective, if the objective is of little or no value either for an entire community or for any sections within it, then the benefits and costs referring to such an objective are irrelevant. For example, if the community as a whole and all interests within it place no value on the retention of historic buildings, it is not legitimate to place any value on their retention. This basic problem with this approach lies in the identification of and selection of goals. Goals may be conflicting; there may not be unanimous agreement on what the goals are; and certainly the relative significance of different goals will vary. Planning Balance Sheet

This approach, developed by Lichfield in the early 1960's for evaluating alternative urban development plans, in effect is a modification of the cost/benefit approach. The traditional cost benefit approach in effect considers only the goal of economic efficiency; this technique attempts to consider all benefits and costs with respect to all community goals in one enumeration. This balance sheet of costs and benefits is intended to enable the choice of a course of action which in some way will maximize the achievement of community goals. In Lichfield's words this method “enables the decision-maker to balance the monetary costs and benefits with the intangible costs and benefits. By indicating the incidence of costs and benefits, the analyst identifies the sections of the community that will bear the costs and the sections which reap the benefits. The balance sheet will also enable the decision makers to appraise those elements in design which are high in cost or low in benefits.” This differs from Hill's approach in that the planning balance sheet rejects Hill's contention that benefits and costs have only instrumental value in respect of predefined objectives. The Planning Balance Sheet seeks to enumerate all costs and all benefits and to classify these according to the beneficiaries.

ECONOMIC EVALUATION - A BRIEF RESUME OF PROCEDURES In this lecture I will comment briefly on the strengths and weaknesses of methods of

economic evaluation and then look at some of the specific draw backs of each of the main methods. The objective of this lecture is to communicate that, although these methods are valuable tools for the decision-maker, their assumptions and limitations must be recognized. Derivation of Economic Evaluation Techniques

Benefit Cost and similar methodologies find their status to legitimacy in theoretical welfare economics, from which they are derived. Theoretical welfare economics may be defined as that branch of economics which endeavours to formulate propositions by which we may rank, on the scale of better or worse, alternative economic situations open to society. The goal of traditional economic evaluation processes could be defined as the maximisation of the net project contribution to the national income. These methodologies are conceptually derived from the theory of the firm and the endeavour of the firm to maximize profits. According to welfare economic theory, such private profit maximization by individual firms in an economy of pure competition leads to optimal community welfare. Economic evaluation, then, in relation to the public sector is conceptually designed to choose not only the course of action which maximize "economic efficiency", but assumes in the process that economic welfare is maximized. However, this is so only if the following conditions are met:-

(1) Opportunity costs are borne by the beneficiaries in such a way as to retain the initial income distribution.

(2) The initial income distribution is in some way the 'best' (3) If the marginal social rates of transformation between any two commodities are

everywhere equal to their corresponding rates of substitution, except for the areas in question, then welfare can be improved by intervention in the area in question.

The first condition is only partly feasible in most cases; the second is, at best, questionable; and the third is improbable. Thus, whereas cost-benefit analysis identifies the most efficient course in strict economic terms, it is questionable whether this course of action maximizes economic welfare. Economic evaluation therefore does not necessarily provide accurate guidance in allocating investment among unlike projects, although in ranking or comparing courses of action designed to attain roughly the same ends it is generally useful. Deficiencies in Economic Evaluation Techniques

The main deficiencies in economic evaluation methods are as follows:- (1) The evaluations do not consider the incidence of the costs or benefits.

(2) They assume that the marginal utility of a change in income is constant for all groups in the community. That is, they assume that a $100 benefit to a millionaire has the same social impact as a $100 benefit to an unemployed person.

(3) They are concerned only with the single narrow goal of maximization of national product.

(4) Evaluations have not generally considered a full range of valid alternatives. (5) Evaluations have been based on an uncritical acceptance of the view that current

conditions and trends will continue. (6) Inadequate effort has been made to take intangibles into account in a systematic way. (7) The listing of non-quantifiable factors with the supposedly "objective" economic data

inevitable results in inordinate weighting to the "objective" data. (8) The assumptions relating to the “costing" of intangibles (such as travel time, traffic

accidents, etc.) are hidden. (9) There is often inconsistency in the evaluation of costs and benefits - for example

changes in vehicular travel time on a road may be measured, but changes in travel time forced on pedestrians by the road improvement are ignored.

(10) Cost estimates, travel forecasts, accident forecasts, etc., which are the key inputs to the evaluation process, are not generally as accurate or reliable as the "objective" result would seem to indicate.

(11) Analysts have gone beyond their proper role (which is to present differences between alternatives in explicit ways), and in cases where value judgements were critical the analysts have wrongly assumed the role of decision-makers. Perhaps the most dramatic case of formal evaluation providing misleading guidance

to decision-making is associated with the widespread rejection of urban freeway projects in the United States. Their evaluations involved all of the errors listed above. Most critically the assumption was made that if a freeway had more benefits than costs it should be built. Little consideration was given to alternatives (such as those relating to public transport, employment distribution, transport pricing, etc.). Higher returns could quite conceivably result from selective investment in such areas. It should be stressed that many of these criticisms can apply to any evaluation method, and that many of them can largely be eliminated through modifications to the traditional economic evaluation methodologies. Indeed this is what Lichfield's Planning Balance Sheet, for example, attempts to do. ECONOMIC EVALUATION METHODOLOGIES

We turn now to the specific economic evaluation methodologies. The four principal techniques for analysing investments are:-

(1) Annual Cost. (2) Benefit Cost Analysis (3) Net Present Value, and (4) Internal Rate of Return

Annual Cost: In the method the capital and operating costs of a project are considered on an

equivalent annual cost basis. It is the annual cost of owning an asset computed over its entire

life. Once all alternative projects, including the do-nothing possibility, have been analysed, the project with the lowest annual cost is selected as the most desirable.

The equivalent annual cost can be calculated as: Asset Price x Discount Rate / 1-(1+Discount rate)-Number of Periods

It should be noted that benefits are not considered - it is therefore implicitly assumed that benefits from all alternative investment projects are the same. Since the conditions under which this occurs are pretty remote this method is ruled out as a general tool for economic analysis. Benefit Cost Analysis (BCR)

In this method the discounted present value of Benefits is divided by the discounted present value of costs.

BCR = (Discounted Net Benefits) / (Discounted Costs)

If the B/C ratio is greater than 1.0, the benefits exceed the costs and the project is, ipso facto, in some sense warranted. Conversely, if B/C ratio is less than 1.0 the benefits are less than the costs and the project is not warranted. In ranking an annual works program, projects with higher BCR desirably should have higher priority over those with lower BCR The BCR provides a useful means of ranking a schedule of projects. It is somewhat problematic in evaluating mutually exclusive options. Net Present Value Method

In this method, present and future costs and benefits are discounted to their present and summed; the difference between the sums is computed. No project having a net present value less than zero is acceptable and the project with the highest net present value is the most desirable among mutually exclusive alternatives.

The Net present Value (NPV) = ∑ {Net Period Cash Flow/(1+ Discount rate) Number of Periods } - Initial Investment

The discount rate used is the appropriate opportunity cost of capital or the minimum attractive rate of return. The Net Present Value method always gives the correct answer and should be preferred over all other methods. Internal Rate of Return Method:

In broad terms the rate of return method involves finding the discount rate at which two alternatives to a problem have equal present worth. The first step is to find the rate of

return on each proposed investment, as compared with the solution requiring the least capital outlay, which is often the status quo. Secondly, if the rate of return on the investment requiring the smallest capital outlay exceeds an acceptable interest rate (e.g., opportunity cost of capital) then tentatively accept that proposal. Next compute the rate of return on the incremental outlay needed for the investment requiring the second lowest outlay. If the rate exceeds the adoptable interest rate, accept the investment requiring the greater outlay in preference to that requiring the lesser. Proceed by such paired comparisons based on rates of return on incremental outlay to eliminate all but one investment. The internal rate of return on a project is the "annualized effective compounded return rate" or rate of return that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero. It can also be defined as the discount rate at which the present value of all future cash flow is equal to the initial investment or in other words the rate at which an investment breaks even. The Internal Rate of Return is valid only in very specific and limited circumstances and should always be avoided in project analysis. Critique of Economic Methods

We have already rejected the Annual Cost Method since it fails to apply when benefits of alternative projects are not equal. Benefit-Cost Ratio (BCR)

The BCR, by itself, has little significance, and its relative value therefore is difficult to understand or interpret. The significance of the difference between two projects having BCR, for example of 1.05 compared with 1.10, is not as clear as the differences shown using the Net Present Value method. This problem is compounded when projects with different outlays are considered. There is considerable ignorance regarding the definition of the numerator and denominator in this equation. It can be shown that only those averted costs that are currently available to the planning/construction agency properly belong in the calculation of net budgetary cost (i.e., the denominator) all other costs (e.g., environmental or social costs) must be considered as negative benefits and included in the numerator. For example consider Table 1, four mutually exclusive projects each with identical net benefits. In the first definition of BCR, all costs (capital, operating and maintenance) are included in the denominator. In the second definition of BCR, only capital costs are included in the denominator, whilst changes in maintenance and operating costs are includes with direct benefits in the numerator. Definition 1 sees Option 3 as the most desirable and Option 4 as the worst option. Definition 2 sees option 4 as the best option. Table 1: Effect of treatment of non-capital costs on the BCR Project

Option 1 $m

Project Option 2

$m Project

Option 3 $m

Project Option 4

$m Capital Cost -7 -20 -4 -2 Direct Benefits +11 +12 +6 +23

Changes in Operating Costs -2 +4 +2 -10 Changes in Maintenance Costs -1 +5 -3 -10 NET BENEFIT $1m $1m $1m $1m BCR Definition 1: Costs = Capital + Operating + Maintenance Benefits = Direct Benefits only Benefit Cost Ratio (BCR)

-10 +11 1.1

-11 +12 1.09

-5 +6 1.2

-22 +23 1.04

BCR Definition 2: Costs = Capital Benefits = Direct Benefits + Operating Cost Savings + Maintenance Cost Savings Benefit Cost Ratio (BCR)

-7 +8

1.14

-20 +21

1.05

-4 +5

1.25

-2 +3

1.5

It can be shown that the correct specification of BCR requires that only those costs directly attributable to the project proponent (e.g., the State Road Authority or Municipal Council) should be included in the denominator. This, however, is not intuitive and many evaluations are in error in this regard. Provided the costs are correctly treated, the BCR is very useful in ranking projects in a works program. In comparing mutually exclusive project options, the Net present Value method is to be preferred. Net Present Value:

This method, if undertaken properly, will always give correct economic decision-making answers in a clear unambiguous manner. It should be noted that the net present value method assumes that funds or returns obtained from the project prior to the end of the evaluation period are re-invested at the rate equal to the discount rate. Internal Rate of Return: Problems arising from this method are:-

(1) Difficulty for many to understand the concept of internal rate of return, etc. (2) Inherent problems in analysis.

In relation to the first point, when dealing with purely financial transactions the concept of internal rate of return is straight forward. The ‘dollars’ are earned on an investment each year can be reinvested. In relation to a transport project, however, where many of the returns are ‘social dollars’, for example reduced air pollution or travel time savings, such benefits cannot be ‘reinvested’. This second point arises because re-investment aspects are generally handled implicitly and assume that returns from the investment during the life of the project are re-invested for the remainder of the project life at a rate equal to the rate of return. Thus, in the example in Table 2 the internal rates of return for Options 1 and 2 are 20% and 25% respectively. Assuming all

benefits from the options are actual dollars, the IRR methodology implicitly assumes that these dollar benefits at the end of years 1 and 2 can be reinvested at 20% and 25% respectively. There is rarely ever any justification for such an assumption. The NPV methodology, on the other hand, assumes all project benefits are reinvested at the social time preference rate of 5%. TABLE 2: CALCULATIONS OF NET PRESENT VALUE AND INTERNAL RATE OR RETURN METHOD. Project Option

1 Project

Option 2 Initial Capital Outlay - year 0 -$100,000 -$100,000 Annual Earnings or Benefits Accruing at end of year 1 Accruing at end of year 2

$20,000 $120,000

$100,000 $31,250

Discounted Internal Rate of Return for Two year period 20% 25% Net Present Value for Two Year Period $27,890 $23,580 Cost of Capital 5% 5% Implied Re-investment Rate NPV. method IRR method

5% 20%

5% 25%

Optimum Project NPV Method IRR Method

Option 1 Option 2

Inflation and Economic Analysis It must be stated at the outset that inflation is irrelevant to economic analysis since all

costs, whether they occur now or fifty years hence, are measured in terms of today’s resource costs. That is to say that building costs for a project evaluated in the year 2000 but scheduled to be constructed in 2030, for example, are measured in terms of 2000 dollars. Allowance for price or cost changes with time is only made if there are likely changes in relative resource costs. For example, if due to technological advances, the cost of computers relative to the cost of other goods is predicted to fall or the cost of oil relative to other resources is predicted to rise, then an appropriate allowance should be made. It is stressed again that general inflation in price levels is implicitly taken into account by costing all capital costs, social and environmental costs and all benefits in terms of today's resource costs. Discounting Future Costs and Benefits

It is generally held that people, both individually and collectively, prefer present goods in preference to future goods, although a number of eminent economists have challenged this assumption. Others have argued that while individuals might place less value on future expenditures, if only because of the possibility of death, Government is "the trustee of unborn generations as well as for its present citizens" and should therefore endeavour to provide for the future welfare of both current and future generation in a more rational way than would individuals.

Notwithstanding the above it is almost universal practice in economic analysis of projects to value future costs or benefits (as measured in today's resource costs) at a lower figure than identical costs or benefits incurred today. In other words future costs or benefits are discounted at an appropriate rate to an equivalent present value. Thus if $F is a future cost incurred n years hence and d is the appropriate discount rate, then the present value, PV, is:

PV = F / (1 + d)n

The problem of what discount rate to use is one which has generated a vast amount of literature. Even the theoretical basis on which the discount rate should be based is subject to considerable dispute. Two fundamentally different approaches have been advocated: social time preference (STP) and Social Opportunity Cost (SOC). A social time preference function indicates a rate which expresses the consensus of the electorate concerning the rate of discount applicable to particular areas of concern which they wish to be applied to future costs and benefits emanating from Government projects. The social opportunity cost on the other hand is a measure of the value to society of the next best alternative use to which funds employed in a public project could otherwise be put. In both cases there is considerable theoretical and practical difficulty in determining the discount rate, and in the case of STP there is no valid reason to suggest that the discount rate should be constant over time. In the case of environmental benefits, the benefits are not-investable: some of the factors being considered may be irreplaceable and if lost now are also lost for all future generations; some health hazards may also be irreversible.

In circumstances like these there seems to be very little reason for proposing a high rate of interest which by implication says that nothing that happens more than twenty years from now needs to be taken into consideration when deciding on today's program. Possibly a low rate should often be used for environmental factors and in some cases even a negative rate might be appropriate." (OECD1973)

Sensitivity Analysis The foregoing discussion has had the intention of illustrating some of the more

significant assumptions underlying the outwardly scientific appraisal of projects. Time costs, accident costs, discount rates and many other basic parameters cannot be accurately determined or predicted in the way that, for example, construction costs can be. It is essential therefore that these limitations be recognized and stated. Perhaps of more importance, where parameters are open to question, a range of rates (high, medium and low) should be used in order to determine how sensitive the outcome of an analysis is to the value of the parameter.

Bibliography de Neufville, R and Stafford, J, 1974, Systems Analysis for Engineers and Managers,

McGraw Hill. Flowerdew, ADJ, 1972, ‘Choosing a Site for the Third London Airport: The Roskill

Commission Approach’ In Cost Benefit Analysis, R. Layard (ed), Penguin. Hill, M, 1973, Planning for Multiple Objectives: An Approach to the Evaluation of

Transportation Plans. Technion. Lichfield, N, 1971, `Cost Benefit Analysis in Planning: A Critique of the Roskill

Commission’, Regional Studies, Volume 5, pp 157–183. Kitching, LC, 1969, ‘Regional planning considerations’, in Evidence Submitted at Stage III to

the Commission on the Third London Airport, Cambridgeshire et al., Ch. 2. Nijkamp, P, 1975 ‘A Multicriteria Analysis for Project Evaluation: Economic–Ecological

Evaluation of a Land Reclamation Project’ Papers of the Regional Science Association, Volume 35, pp 87–111.

Organization for Economic Co-Operation and Development, 1973, Effects of Traffic and Roads on the Environment in Urban Areas. OECD.