CEIE 301 Engineering and Economic Models in Civil Engineering

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CEIE 301Engineering and Economic Models in Civil
Engineering

• Lecture 3
• Eng Econ Choice Between Alternatives

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Basic Methods of Choosing Alternatives

• Present Worth
• Annual Cash Flow
• Incremental Benefit-Cost
• Incremental Rate of Return

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Basic Concepts

• Objective
• Maximize net benefits
• Other objectives?
• What gets counted
• Sunk costs
• External costs and benefits
• Non-commensurate costs and benefits

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Scale of Project v Present Value of Benefits and
Costs
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Present Value of Benefits Minus Costs
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Assumptions

• All benefits and costs moved to the same time
  (e.g. the present or time zero)
• All benefits and costs measured (no
  externalities)
• All benefits and costs are measured in dollars
• All benefits and costs are measured accurately
• All options have the same lifetime
• An appropriate interest rate is used for
  discounting

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Externalities

• Effects that are not measured/accounted for by
  the competitive markets
• Air quality
• Aesthetics
• Water quality
• Human life
• Safety

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What to do about Externalities

• Attempt to value them in and then put them in
  the analysis with other impacts
• Account for them without conversion to --
  muliti-objective analysis
• Bribes to mimic market efficiency
• Taxes to mimic market efficiency

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Sunk Costs

• Money or effort already expended and
  unrecoverable
• Common inclination count them
• Correct decision forget them and move on

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Opportunity Cost

• The best value of a resource if used in something
  other than your project
• In a perfect market, an opportunity cost equals
  the price of a resource
• Dont assume that a resource has no value if you
  dont use it
• Count the loss of this opportunity cost if you
  divert a resource to your use

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Mutually Exclusive Projects
Project PV of Revenue PV of Cost PV of Rev - Cost
A 100 50 50
B 360 300 60
C 150 49 101
D 170 128 42
E 210 257 -47
F 320 410 -90
G 203 96 107
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Mutually Exclusive Projects
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Mutually Exclusive Projects
Project PV of Revenue PV of Cost PV of Rev - Cost

C 150 49 101
A 100 70 30
G 224 96 128
D 170 128 42
E 210 257 -47
B 360 300 60
F 320 410 -90
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Mutually Exclusive Projects
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Present Worth Analysis

• PWB present value of all benefits
• PWC present value of all costs
• PWNB present value of net benefits PWB
  PWC
• Objective maximize PWNB of the set of projects
  selected

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Present Worth Analysis

• Constraints
• Afford costs
• Interest rate appropriate
• All projects have same lifetime
• Select only non-mutually-exclusive projects

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Present Worth Analysis Example
Project PV of Revenue PV of Cost PV of Rev - Cost
C 150 49 101
A 100 70 30
G 224 96 128
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Alternatives
Alternatives PV of Revenue PV of Cost PV of Rev - Cost
A 100 70 30
C 150 49 101
G 224 96 128
A and C 250 119 131
A and G 324 166 158
C and G 374 145 229
A and C and G 474 215 259
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Selection of Alternatives
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Annual Cash Flow Analysis

• Convert the PV of Net Benefits of each
  alternative into an annual, uniform equivalent
  amount (A)
• Compare the values of A for all alternative
  combinations

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Interest Rate 0.07, n 10 years
Alternatives PV of Revenue PV of Cost PV of Rev - Cost Annual Equivalent
A 100 70 30 4.27
C 150 49 101 14.38
G 224 96 128 18.22
A and C 250 119 131 18.65
A and G 324 166 158 22.50
C and G 374 145 229 32.60
A and C and G 474 215 259 36.88
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Incremental Benefit Cost Ratio

• Trickier
• Gives same result when done properly
• Analyze alternatives in increasing order of cost
• Skip alternative if the B/C ratio for additional
  investment is not positive
• Stop when budget is reached

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Incremental Rate of Return

• Same result as other methods when done right
• Trickier
• Internal Rate of Return (IRR) is the interest
  rate for an alternative that makes the present
  value of benefits equal to the present value of
  costs
• Consider alternatives in increasing value of cost
• If IRR is less than your mininum acceptable rate
  of return (MARR) dont invest
• Skip alternative if IRR of additional investment
  is not above MARR
• Stop when you reach your budget