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Engineering Economic Analysis Canadian Edition

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Title: Engineering Economic Analysis Canadian Edition


1
Engineering Economic AnalysisCanadian Edition
  • Chapter 16 Economic Analysis in the Public Sector

2
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

3
  • uses incremental benefit-cost for mutually
    exclusive projects.
  • discusses the impact of financing, duration and
    politics in public project decisions.

4
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

5
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

6
  • 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
7
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

8
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

9
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

10
  • 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

11
Recommended Public Sector Interest Rate
  • Select the largest of
  • Cost of capital
  • Government opportunity cost
  • Taxpayer opportunity cost

12
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.

13
  • In the United States
  • Armed forces 4
  • Federal agency for highway transportation safety
    3
  • City school board 6.5
  • State waterway commission 5

14
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)

15
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

16
B/C Ratios
17
B/C Ratio PW, FW, and AW
Example 16 - 2
18
(No Transcript)
19
B/C Ratios Conventional
20
B/C Ratios Modified
OM Operating and maintenance costs
21
Examples of Benefits and Disbenefits for Public
Investment
22
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

23
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.
24
Which Alternative is Better?
25
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.
26
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

27
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

28
  • 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.

29
Incremental B/C Ratios
Example 16 - 4
30
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.

31
Conventional B/C Ratios
32
  • 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
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