Chapter 9 - Public Projects and Benefit-Cost
Ratio Method
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Public projects and benefit-cost ratio method
The project evaluation and selection methods we have learned
so far are directed towards “private projects". The primary goal
of a private project is to make profit for the project owners and
investors. In these projects, a unified purpose is usually agreed
on and the projects’ evaluation is only based on monetary
values. On the other hand, “public projects" do not aim to
generate profit, but instead have the (social) goal of providing
service and benefit to the general public. Difficulties:
- Quantifying service in monetary terms
- Multiple purposes and conflicting interests
Their evaluation requires different methods. One such method
is called Benefit-Cost (B-C) ratio method.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
B-C ratio method calculates the ratio of project’s benefits to its
costs. The components are:
Benefits: Positive consequences to the public.
Costs: Monetary expenditures required for the project
(financed by government often through taxation).
Disbenefits: Negative consequences to a segment of the
public.
As in the private projects, time value of money is important for
the public projects, so an interest rate needs to be determined.
Several factors are considered in selecting an appropriate
interest rate, such as interest rate on borrowed capital and the
opportunity cost of capital both to the taxpayers and the
governmental agency.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Notation:
B: benefits of the project
I: initial investment
O&M: operating and maintenance cost of the project
CR: capital recovery amount
D: disbenefits of the project
MV: market value of investment.
Conventional B-C ratio:
PW(B)
PW version: B − C = I−PW(MV)+PW(O&M) or
AW(B)
AW version: B − C = CR+AW(O&M) .
Modified B-C ratio:
PW version: B-C= PW(B)−PW(O&M)
I−PW(MV) or
AW version: B-C= AW(B)−AW(O&M)
CR .
(Note that CR already includes MV.)
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
A project is acceptable if B-C ≥ 1, otherwise not.
Conventional and modified B-C methods give identical
acceptability results (not necessarily the same numerical
results!).
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Example 11-1: The project is to extend the runways of an
airport and it is considered by the city municipality. The
following costs have been identified:
Land: $350,000
Construction: $600,000
Annual maintenance: $22,500
Terminal construction: $250,000
Annual operating and maintenance for the terminal: $75,000
Addition of air traffic controllers per year: $100,000
The project is estimated to bring the following benefits:
Rental receipts: $325,000
Tax to passengers: $65,000
Convenience: $50,000
Tourism: $50,000.
Apply the B-C ratio method with a study period of 20 years and
a MARR of 10% per year, and determine whether this is an
acceptable project or not.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Solution:
Conventional B-C ratio:
PW version:
PW(B) 490,000(P/A,10%,20)
B-C= I+PW(O&M) = 1,200,000+197,500(P/A,10%,20) = 1.448 > 1.
AW version:
AW(B) 490,000
B-C= CR+AW(O&M) = 1,200,000(A/P,10%,20)+197,500 = 1.448 > 1.
Modified B-C ratio:
PW version:
B-C= PW(B)−PW(O&M)
I = 490,000(P/A,10%,20)−197,500(P/A,10%,20)
1,200,000 =
2.075 > 1.
AW version:
B-C= AW(B)−AW(O&M)
CR
490,000−197,500
= 1,200,000(A/P,10%,20) = 2.075 > 1.
Extend runways.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
How to include disbenefits?
Two alternatives: reduce benefits or increase costs.
Conventional B-C ratio (with disbenefits):
AW(B)−AW(D)
B-C= CR+AW(O&M)
AW(B)
B-C= CR+AW(O&M)+AW(D) .
Continue with Example 11-2. Suppose the increased noise
level caused by the project will bring a disbenefit of $100,000
per year to the neighborhood. Still extend the runway?
AW(B)−AW(D) 490,000−100,000
B-C= CR+AW(O&M) = 1,200,000(A/P,10%,20)+197,500 = 1.152 > 1.
AW(B) 490,000
B-C= CR+AW(O&M)+AW(D) = 1,200,000(A/P,10%,20)+197,500+100,000 =
1.118 > 1. Extend runways.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Selection of alternatives by B-C ratio
Independent projects: Select any project that has a B-C
ratio of greater than or equal to one. (if no budget
restriction!)
Mutually exclusive projects: We must perform incremental
B-C analysis. (Selecting the project with the highest B-C
ratio is not correct!) Incremental analysis:
1 Rank the projects in order of increasing EW(Costs). Add
the do-nothing alternative as the first project, and select it
as the baseline alternative.
2 Calculate the incremental B-C ratio ∆B/∆C (Next project -
current baseline project). Select next project as the new
baseline project if the incremental ratio ≥ 1; otherwise
maintain the (last) baseline project. Iterate until all projects
are considered.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Example 11-2: The city of Garden Ridge, Florida has received
two design proposals for a new wing to the municipality
hospital.
Design 1 Design 2
Construction cost $ 10M 15M
Building maintenance cost $/year 35K 55K
Patient benefits, $/year 1M 1.3M
The interest rate is 5% per year, and the life of the addition is
estimated at 30 years.
a) Use conventional B-C ratio analysis to select design 1 or 2.
b) Garden Ridge merchants’ association argues that design 2
could reduce its annual revenue by an estimated $200K
because it will eliminate an entire parking lot used for
short-term parking. Design 1 duplicates some of the same-day
surgery features offered by the municipal hospital of an
adjacent city. Analysts argue that design 1 will lead to an
annual income reduction by $300K for the neighbor city
hospital. What is the decision now?
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
Solution:
a) AW1 (C) = -$10,000,000(A/P,5%,30)-$35,000=-$685,500
AW2 (C) = -$15,000,000(A/P,5%,30)-$55,000=-$1,030,750
Rank order: DN-Design 1-Design 2.
∆B/∆C(1 − DN) = 1, 000, 000/685, 500 = 1.46. Design 1 is the
base alternative.
∆B(2 − 1)=1,300,000-1,000,000=$300,000
∆C(2 − 1)=1,030,750-685,000=$345,250.
∆B/∆C(2 − 1) = 300, 000/345, 250 = 0.87. Design 1 is selected.
b) ∆B/∆C(2 − 1) = 400, 000/345, 250 = 1.16. Design 2 is
selected.
SEEM2440A/B Chapter 9 - Public Projects and Benefit-Cost Ratio Method
