Chapter 11 Evaluating Projects with the BenefitCost Ratio Method

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Chapter 11Evaluating Projects with the
Benefit-Cost Ratio Method
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Characteristics of Economic Analysis in the
Public Sector

• More complicated due to the following factors
• Overall purpose of investment
• Viewpoint for analysis
• Selection of interest rate
• Financing sources of project
• Expected project duration
• Qualifying and valuing benefits and dis-benefits
• Effects of politics
• Beneficiaries of investment
• Multipurpose nature of investments

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Investment Objectivesof Public Projects

• To promote the general welfare (Preamble of
  Constitution)
• Conflict of interests
• Conflict in opinions
• To ensure the potential benefits exceed overall
  costs (Flood Control Act of 1936)

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Viewpoint for Analysis in Public Projects

• To take a viewpoint at least as broad as those
  who pay the costs and those who receive the
  benefits
• Be consistent

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Selecting an Interest Rate for Public Projects

• No time-value-of-money concept
• Cost of capital concept
• Municipal bonds are exempt from federal taxes
• General obligation municipal bonds
• Revenue bonds
• Opportunity cost concept
• Government opportunity cost
• 7 set by Office of Management and Budget (OMB)
  A94 directive

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Benefit-Cost Ratio Analysis
If B/C ratio gt 1.0, then the decision is to
invest If B/C ratio lt 1.0, then the decision is
not to invest
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Example 11A B/C Ratio Calculation
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Variations on Benefit-Cost Ratio

• Conventional B/C ratio

• Modified B/C ratio

• All B/C ratios use same criterion B/C 1
• Various B/C ratios may differ in value, but they
  provide consistent recommendations

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Example 11B B/C Ratio Calculation
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Incremental Benefit-Cost Analysis

• Identify all relevant alternatives.
• Calculate the B/C ratio of each alternative
  (Optional).
• Rank order the projects according to the size of
  denominators.
• Identify the increment under consideration.
• Calculate the B/C ratio for the incremental cash
  flows.
• Use the incremental B/C ratio to decide which
  alternative is better.
• Repeat steps 4-6 until all increments have been
  considered.
• Select the best alternative.

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Example 11C Incremental Conventional B/C Ratio
Analysis
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Example 11C Incremental Conventional B/C Ratio
Analysis
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Example 11D Incremental Modified B/C Ratio
Analysis
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Example 11D Incremental Modified B/C Ratio
Analysis
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Other Effects of Public ProjectsProject
Financing

• Taxation
• Revenue from operations
• Public borrowing with the following restrictions
• Local government is limited to a specific
  percentage of the assessed property value in the
  district
• Local voters approval required for new
  construction
• Repayment plan must be made

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Other Effects of Public ProjectsProject Duration

• Typical public projects have longer lives (2050
  years) than projects in private sectors (515
  Years)
• Public projects usually require substantial
  funding in early years
• To reduce the annual costs in B/C analysis
• Lower interest rates
• Longer project lives

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Other Effects of Public ProjectsQuantifying and
Valuing Benefits

• General Approach for evaluating project benefits
• Identify and count the number of people affected
• Estimate the dollar value for each person
• Benefits and disbenefits are difficult to
  quantify and value. The estimated values have
  more uncertainty.

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Other Effects of Public ProjectsProject Politics

• Political influences exist in both public and
  private projects
• For public projects, politics are felt at all
  levels because
• Larger scale and multi-purpose nature
• Use of citizens common pool of money
• Different views and values from industries and
  government