Engineering Economic Analysis Canadian Edition

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Engineering Economic AnalysisCanadian Edition

• Chapter 16 Economic Analysis in the Public Sector

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Chapter 16. . .

• distinguishes the unique objective and viewpoint
  of public decisions.
• explains methods for determining the interest
  rates for evaluating public projects.
• applies the benefit-cost ratio to projects.
• conventional
• modified

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• uses incremental benefit-cost for mutually
  exclusive projects.
• discusses the impact of financing, duration and
  politics in public project decisions.

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Introduction

• Several factors complicate the economic analysis
  by public organizations
• Purpose of the investment, Financing sources,
  Expected duration, Political effects, Project
  beneficiaries
• Public and private sectors have the same mission
• To make prudent investment decisions

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Investment Objective

• Private-sector companies seek to increase their
  wealth and economic stability
• Beneficiaries ? owners
• Public-sector organizations
• Overall concern is an increase in the general
  welfare, not the identification of winners and
  losers
• Purpose of investment decisions is sometimes
  ambiguous
• Difficult to identify investments that promote
  general welfare

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• Would the construction of a dam promote general
  welfare?
• Benefits water, electricity, flood control,
  recreational facilities
• Land losses farm land, woodlands for protected
  species
• Possible adverse effects on the water supply of
  downstream communities

Conflicting aspects are common to many public
sector projects
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Viewpoint for Analysis

• Public-sector viewpoint
• includes those who pay the costs and those who
  receive the benefits
• Town, city, region, province, national

• Industry viewpoint
• firms costs and benefits
• costs and benefits external to the firm have been
  generally ignored in the past
• broader perspective on costs and benefits today
• firms will internalize some externalities

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Selecting an Interest Rate

• Private-sector
• consistent with the goal of wealth maximization
• Public-sector
• less clear-cut than private sector because the
  goal is to promote general welfare (benefits
  outweigh costs)
• several interest rate alternatives

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Public Sector Interest Rate

• No time-value-of-money
• Set rate to 0 because there is no (short) lag
  between collecting and spending tax money
• Cost of capital
• Set rate equal to the cost of borrowed funds

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• Opportunity cost (Government and Taxpayer)
• Government set rate equal to that of the best
  project forgone (for which funding is not
  available)
• Taxpayer set rate equal to the return that would
  have been earned by the taxpayer in the absence
  of taxation

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Recommended Public Sector Interest Rate

• Select the largest of
• Cost of capital
• Government opportunity cost
• Taxpayer opportunity cost

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Sample Public Sector Interest Rates

• The Treasury Board of Canada recommends the use
  of a 10 interest rate for benefit-cost analyses
• 5 and 15 for sensitivity analyses
• Some Canadian provinces recommend 7.

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• In the United States
• Armed forces 4
• Federal agency for highway transportation safety
  3
• City school board 6.5
• State waterway commission 5

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B/C Ratios

• Any of the equivalent worth methods (present,
  future, and annual) can be used to calculate a
  B/C ratio
• Produce identical results
• Decision rule
• If B/C ratio is gt 1.0, invest in project
• If B/C ratio is lt 1.0, do not invest in project
• If B/C ratio 1.0, breakeven point (need more
  information and/or analysis to decide on course
  of action)

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Some B/C applications

• Replace ferry by bridge or tunnel?
• Nuclear, solar, or wind-tunnel power generation?
• Four- or five-day school week?
• Bridge two-lanes now versus three-lanes later?
• Portable versus regular school classrooms?
• Residential water metering

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B/C Ratios
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B/C Ratio PW, FW, and AW
Example 16 - 2
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(No Transcript)
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B/C Ratios Conventional
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B/C Ratios Modified
OM Operating and maintenance costs
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Examples of Benefits and Disbenefits for Public
Investment
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Incremental B/C Ratio

• For the IRR and the B/C ratio methods, it is
  inappropriate to select the best (mutually
  exclusive) project on the basis of individual
  project IRRs or B/C ratios
• an incremental approach must be used

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B/C Criteria
For the IRR and the B/C ratio methods, an
incremental approach must be used to select the
best mutually exclusive project.
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Which Alternative is Better?
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Which Alternative is Better?(Conventional B/C
Ratio)

• Conventional B/C Ratios
• Project A
• B/C ratio 110/200(A/P,10,5) 40 - 30(A/F,
  10,5)
• 1.3 gt 1 ? Project A is acceptable
• Project B
• B/C ratio 175/350(A/P,10,10) 60
• 1.5 gt 1 ? Project B is acceptable

If A and B are independent, select both (capital
rationing may be a consideration). If A and B are
mutually exclusive, use the incremental approach.
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Which alternative is better?(Conventional B/C
Ratio)

• (?B(B-A) /?C(B-A) ) (BB BA)/( CB CA)
• (?B/?C) (175 110)/(117 87.9)
• 65/29.1
• 2.2 gt 1
• Select the project B

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Elements of the Incremental B/C Ratio Approach

• Identify all alternatives
• Calculate the B/C ratio for each project.
  (Eliminate projects with B/C ratios lt 1.)
• Rank order the projects using the denominator of
  B/C ratio
• Identify the increment under consideration

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• Use the incremental B/C ratio to make a decision
  between the two projects
• Iterate to Step 4 until all increments (projects
  have been considered
• Select the best alternative from the set of
  mutually exclusive competing.

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Incremental B/C Ratios
Example 16 - 4
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Best Alternative

• If the four projects were independent
• projects I, II, and IV would be implemented in
  the absence of capital rationing
• B/C ratios gt 1
• If the four projects were mutually exclusive
• project II would be selected using the
  incremental B/C approach.

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Conventional B/C Ratios
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• If Projects A, B, C, D, and E are independent and
  capital rationing is not an issue, select all
  projects (B/C ratios gt 1).
• If A, B, C, D, and E are mutually exclusive,
  select project D.
• Compare A and B ?B/?C 1.5 select project B
• Compare B and C ?B/?C 1.2 select project C
• Compare C and D ?B/?C 1.3 select project D
• Compare D and E ?B/?C 0.9 select project D