CHAPTER 9

Benefit Cost Analysis and Public Sector

Economics
 Section 9. 1
Public Sector Projects

•Public Sector:
•Ownership – by citizens- the public
•Public Sector Projects:
•Provide needed services to the public an “no profit”
9.1 Types of Projects

•Hospitals
•Parks and recreation facilities
•Highways, Dams, Bridges
•Courts, schools, prisons
•Public Housing
•Many other types
 9.1 Characteristics - compared
Characteristic Public Sector Private Sector
Size of Investment Larger Some Large; medium to
small
Life Estimates Quite Long 30 – 50 years Shorter:
2-25 years
Annual Cash Flow No Profit: costs and benefits Revenues – profit cost
estimates estimates
Funding Taxes, fees, bonds, Pvt. funds Sale of new stock, bonds,
loans, Ret. earnings
Interest Rate Tends to be lower Higher: At market cost

Selection Criteria Multiple or many Rate of Return or Present

Value
Environment of the Political Arena Primarily economic
evaluation (debated, pressure groups)
9. 1 Attributes

• Public Sector Projects do not have “profits” per se

•Projects can have certain undesirable consequences associated
•Thus, can be controversial in nature
•Draw media attention – debated on pros and cons
 Private Sector

Disneyland Park is a theme park located

in Anaheim, California, owned and
operated by the Walt Disney Parks and
Resorts division of the Walt Disney
Company.
Known as Disneyland when it opened on
July 18, 1955, and still almost universally
referred to by that name, it is the only
theme park to be designed and built
under the direct supervision of Walt
Disney.
In 1998, the theme park was re-branded
"Disneyland Park" to distinguish it from
the larger Disneyland Resort complex.

Authored by Don Smith, Texas A&M

11/30/2019 University 2004 6
9. 1 Estimating for Public Projects COSTS
•Basic elements for public projects:
•Costs
•Construction, operations, maintenance less est. salvage values
•Initial costs fairly well know
•Future O&M are less know and must be estimated
•BENEFITS to the public (users) must be estimated in terms of
periodic dollar values
•Very difficult to do
•Benefits = the advantage's to the public stated in $$
•Owners – generally the public
•Disbenefits
•Expected undesirable (negative) consequences to the (public)
•Assuming the project is undertaken
•May be indirect economic disadvantages to the public
•Very hard to estimate and convert to $ amounts
Example of Benefits, Dis-Benefits & Cost

Expenditure of $ 11,000 for new interstate

highway ( Cost )
$ 50,000 annual income to local residents
from tourists because of new reservoir and
recreation area (benefit)
$ 150,000 per year upkeep cost for irrigation
canals (Cost)
$ 25,000 per year loss by farmers because of
highway right-of-way (Disbenefit)
9. 1 General Principle

•For public projects we find:

It is very difficult to estimate and reach agreement on the

economic impacts of benefits and disbenefits for public sector
projects
9. 1 Funding Public Projects
• Generally low interest charges
• Public entities do not pay taxes
• Project investments basically backed by public agencies
• Cost sharing arrangements often exist
• Less perceived risk with public projects

9. 1 Determination of an Interest Rate

• Determined differently than in the private sector
• Called the social discount rate
• For Federal Projects a current working rate (2001) is 10% per year
9.1 Selection Process
• Not as “clean” as in the private sector
• Involves interest and pressure groups
• Often draw media attention
• Involve many different viewpoints

9. 1 Evaluation Process
•The viewpoint finally adopted will:
•Determine the estimates of..
•Costs
•Benefits
•Disbenefits
•Thus, the viewpoint must be established before the economic evaluation
 Section 9. 2
B/C Analysis – Single Project

• Historical Point
• B/C analysis philosophy was instituted and promoted by the Flood Control
Act of 1936
• Introduced to promote a sense of objectivity in an analysis
9.2 B/C Formulations

•Assignable life, N - years

•Estimate costs ($)
•Estimate benefits in ($)
•Estimate disbenefits in ($)
•Assign an interest rate – i (%/year)

Then convert all amounts to either a

•Present Worth - PW(i%)
•Annual Worth – AW(i%)
Then calculate a B/C ratio in one of three ways…..
9. 2 B/C Ratios: 3 formats

•Three acceptable formats are:

PW (benefits )
B/C 
PW (cos ts )
AW (benefits )

AW (cos ts )
FW ( benefits )

FW (cos ts )
9. 2 Notes regarding signs

•By convention:
•Revenues are assigned (+) signs
•Costs are assigned (+) signs
•Salvage values are subtracted from costs
•Disbenefits are treated more than one way
9. 2 Handling Disbenefits

1. Disbenefit values are subtracted from benefits

2. Disbenefit values are added to costs
3. Either approach will result in a consistent analysis – but be consistent
through out an analysis

9. 2 Decision Rule

•IF B/C ratio (=>) 1.00, conditionally accept the alternative

•IF B/C ratio (<) 1.00, conditionally reject the alternative
•IF B/C ratio “close” to 1.00 then intangible factors may sway the decision to
accept or reject
Benefits, Disbenefits, Cost Calculations of a Single Project
Any method – present worth, future worth, annual worth
Conventional B/C: (B – D) / C
B/C ratio could change if disbenefit considered as cost
 B/C = (10-8)/8 = 0.25
 B/C = 10/(8+8) = 0.625
Modified B/C Ratio : (B – D – O&M costs) / Initial Inv
 B/C >= 1 economically advantageous
Difference Benefit – Cost : B – C
 B – C > = 0 project is acceptable
 This method has advantages of eliminating discrepancies when
disbenefits are regarded as costs
 Substracting Disbenefit : B – C = [(10-8)-8] = -6
 Adding disbenefit to cost : B – C = [(10-(8+8)]=-6
9. 2 Convention vs. Modified?

•It makes no difference which approach is used

•However, the ratio values will differ (magnitude)
•But, the same absolute (accept/reject) decision will be the same

9. 2 Benefit-Cost Difference

•B-C Cost difference is not a ratio

•B-C cost difference is: (Benefits – Costs) (as a PW or AW)
•The “B” represents the Net Benefit
•Benefits - Disbenefits
9. 2 See Example 9-2

•Applies all three approaches to the same problem situation

•B/C = 0.51 (reject)
•Mod B/C = 0.39 (reject)
•(B-C) = $-1.24 million (< 0…reject)
•Result: Same decision with varying magnitudes of the ratio
9.2 Example 9.3

•Given two alternatives

•Bypass construction
•Upgrade construction
•Note: Unequal lives ..use AW
•i is set to 8%
•Answer :
•Conventional B/C – Bypass = 1.17
•Conventional B/C – Upgrade = 1.13
•Both B/C ratios are > 0
•Both proposal are economically justified at 8%
•Which one would you select?
 Section 9. 3
Alternative Selection using Incremental Analysis:
2 Alternatives

• This approach is similar to the material in chapter 8

• Requires a proper ordering of the alternatives
• Order alternatives on the basis of Total Costs
9. 3 Rank on Total Costs - Rules

1. Determine total equivalent costs for both alternatives;

2. Order by total costs: Smaller first then larger
3. Calculate the incremental cost for the larger alternative = (C) – be the
denominator in the B/C ratio
4. For both alternatives determine:

• Total equivalent benefits and disbenefits.

• Calculate the (B) for the larger cost alternative or (B-D) if
disbenefits are involved

4. Calculate the { (B-D)/C } ratio

`If (B/C) (=>) 1.00 go with the higher cost alternative else, Go with lower
cost alternative!
9. 3 Important Point

• If one is using a PW to determine equivalency, then you must have an equal

life model or lowest common multiple of lives.
•Or, apply the annual worth on a typical cycle for the alternatives and the
repeatability assumption applies.
 Section 9. 4
Incremental B/C for Multiple Projects

•Select from three or more mutually exclusive alternatives

•Same approach as that in Chapter 8, Section 8.6
•Remember, the Do Nothing alternative always exists and should be
evaluated as an alternative.
9. 4 Steps for Multiple Incremental Analysis

1. Using either PW or AW determine the total equivalent cost for all options.
If unequal lives, apply AW
2. Create the rankings based upon lowest to highest total cost of the
alternatives
3. Determine the total equivalent net benefits for each alternative

4. The lowest cost option is the first Defender and the next higher cost
alternative is the first challenger
Compute the B/C ratio on the increment
If B/C < 0, eliminate the Challenger else eliminate the Defender.
Current winner becomes new Defender
5. Compare the new defender to the next higher cost challenger and repeat
the analysis.
6. Continue through the alternative until there are no more challengers.
7. The last “champion” is the winner
 Non Profit Organization

The Wartol foundation, a nonprofit educational research organization, is

contemplating an investment of $ 1.5 million in grants to develop new ways
to teach people the rudiments of a profession.
The grants would extend over 10 year period and would create an estimated
savings of $ 500,000 per year in professor salaries, student tuition and other
expenses. The foundation uses a rate of return of 6% per year on all grant
investments .
In this case the program would be an addition to ongoing and planned
activities . An estimated $ 200,000 a year would thus have to be released
from other programs to support the educational research. To make this
program successful, a $ 50,000 per year operating expense will be incurred
by the foundation from its regular O&M budget.
Use the following analysis methods to determine if the program is justified
over a 10 year period: Conventional B/C, modified B/C , B-C analysis
Solutions

EUAW :
 Benefit : $ 500,000 per year
 Investment : 1,500,000 (A/P, 6%,10) = $ 203,805
 O&M cost : $ 50,000 per year
 Disbenefit : $ 200,000 per year
A. Conventional B/C Analysis :
 B/C = (500,000-200,000)/(203,805+50,000)

B. Modified B/C = (500,000-200,000-50,000)/203,805=1.23

C. B-C = (500,000-200,000)-(203,805-50,000) =$46,195

 B-C > 0 the investment is again justified
Two routes are under consideration for a new interstate highway. The
northerly route N would be located about 5 miles from the central business
district and would require longer travel distance by local commuter traffic.
The southerly route S would pass directly through the downtown area and,
although its construction cost would be higher, it would reduce the travel time
and distance for local commuters. Assume that the costs for the two routes
are as follows :
 Route N Route S
Initial Cost $ 10,000,000 $ 15,000,000
Annual Maintenance 35,000 55,000
Road user cost/yr 450,000 200,000
North or South ?

If the roads are assumed to last 30 years with no salvage value, which route
should accepted on the basis of a benefit/cost analysis using an interest rate
of 5% per year?
Solutions

Cost
EUAW (N) = 10,000,000 (A/P,5%,30) + 35,000 = 685,500
EUAW (S) = 15,000,000 ( A/P,5%,30) + 55,000 = 1,030,750
C = EUAW(S) – EUAW(N) = 345,250 per year

Benefit
• B = $ 450,000-$ 200,000

B/C Ratio
 250,000/345,250 = 0.724
Select N
 Mutually Exclusive
Alternatives , 30 years, i%

C A B D
Building Cost 190,000 200,000 275,000 350,000
Cash Flow 19,500 22,000 35,000 42,000
PW of CF 183,826 207,394 329,945 395,934
Overall B/C 0.97 1.03 1.2 1.13
Project Compared B to A D to B
Increment Benefit 122,551 65,989
Increment Cost 75,000 75,000
Increment B/C 1,64 0.88
Project Selected B B