VI-Economic Evaluation of Facility
Investments
1. Project Life Cycle and Economic Feasibility
2.Basic Concepts of Economic Evaluation
3.Costs and Benefits of a Constructed Facility
4.Interest Rates and the Costs of Capital
5.Investment Profit Measures
6.Methods of Economic Evaluation
7.Depreciation and Tax Effects
8.Price Level Changes: Inflation and Deflation
9.Uncertainty and Risk
10.Effects of Financing on Project Selection
11.Combined Effects of Operating and Financing Cash Flows
12.Public versus Private Ownership of Facilities
13.Economic Evaluation of Different Forms of Ownership
6.1 Project Life Cycle and
Economic Feasibility
• Facility investment decisions represent major
commitments of corporate resources and have
serious consequences on the profitability and
financial stability of a corporation. In the public
sector, such decisions also affect the viability of
facility investment programs and the credibility of
the agency in charge of the programs. It is
important to evaluate facilities rationally with
regard to both the economic feasibility of
individual projects and the relative net benefits of
alternative and mutually exclusive projects.
6.1 Project Life Cycle and
Economic Feasibility
• Four major aspects of economic evaluation will be
examined:
– The basic concepts of facility investment evaluation, including
time preference for consumption, opportunity cost, minimum
attractive rate of return, cash flows over the planning horizon
and profit measures.
– Methods of economic evaluation, including the net present value
method, the equivalent uniform annual value method, the
benefit-cost ratio method, and the internal rate of return
method.
– Factors affecting cash flows, including depreciation and tax
effects, price level changes, and treatment of risk and
uncertainty.
– Effects of different methods of financing on the selection of
projects, including types of financing and risk, public policies on
regulation and subsidies, the effects of project financial
planning, and the interaction between operational and financial
6.2 Basic Concepts of Economic
Evaluation
• A systematic approach for economic evaluation of
facilities consists of the following major steps:
– Generate a set of projects or purchases for investment
consideration.
– Establish the planning horizon for economic analysis.
– Estimate the cash flow profile for each project.
– Specify the minimum attractive rate of return (MARR).
– Establish the criterion for accepting or rejecting a proposal,
or for selecting the best among a group of mutually
exclusive proposals, on the basis of the objective of the
investment.
– Perform sensitivity or uncertainty analysis.
– Accept or reject a proposal on the basis of the established
6.3 Costs and Benefits of a
Constructed Facility
• The basic principle in assessing the economic costs
and benefits of new facility investments is to find the
aggregate of individual changes in the welfare of all
parties affected by the proposed projects. The
changes in welfare are generally measured in
monetary terms, but there are exceptions, since
some effects cannot be measured directly by cash
receipts and disbursements.
6.3 Costs and Benefits of a
Constructed Facility
• Examples include the value of human lives saved
through safety improvements or the cost of
environmental degradation. The difficulties in
estimating future costs and benefits lie not only in
uncertainties and reliability of measurement, but also
on the social costs and benefits generated as side
effects. Furthermore, proceeds and expenditures
related to financial transactions, such as interest and
subsidies, must also be considered by private firms
and by public agencies.
6.4 Interest Rates and the
Costs of Capital
• Constructed facilities are inherently long-term
investments with a deferred pay-off. The cost of
capital or MARR depends on the real interest rate
(i.e., market interest rate less the inflation rate) over
the period of investment. As the cost of capital rises,
it becomes less and less attractive to invest in a large
facility because of the opportunities foregone over a
long period of time.
6.5 Investment Profit
Measures
• A profit measure is defined as an indicator of the
desirability of a project from the standpoint of a
decision maker. A profit measure may or may not be
used as the basis for project selection. Since various
profit measures are used by decision makers for
different purposes, the advantages and restrictions
for using these profit measures should be fully
understood.
6.5 Investment Profit
Measures
• There are several profit measures that are commonly used by
decision makers in both private corporations and public
agencies. Each of these measures is intended to be an indicator
of profit or net benefit for a project under consideration. Some
of these measures indicate the size of the profit at a specific
point in time; others give the rate of return per period when the
capital is in use or when reinvestments of the early profits are
also included
– Net Future Value and Net Present Value
– Equivalent Uniform Annual Net Value
– Benefit Cost Ratio
– Internal Rate of Return
– Adjusted Internal Rate of Return
– Return on Investment
– Payback Period
6.6 Methods of Economic
Evaluation
• Net Present Value Method
• Net Future Value Method
• Net Equivalent Uniform Annual Value Method
• Benefit-Cost Ratio Method
• Internal Rate of Return Method
6.7 Depreciation and Tax
Effects
• For private corporations, the cash flow profile of a
project is affected by the amount of taxation. In the
context of tax liability, depreciation is the amount
allowed as a deduction due to capital expenses in
computing taxable income and, hence, income tax in
any year. Thus, depreciation results in a reduction in
tax liabilities.
6.8 Price Level Changes:
Inflation nad Deflation
• In the economic evaluation of investment proposals, two
approaches may be used to reflect the effects of future price
level changes due to inflation or deflation. The differences
between the two approaches are primarily philosophical and can
be succinctly stated as follows:
– The constant dollar approach. The investor wants a specified MARR
excluding inflation. Consequently, the cash flows should be
expressed in terms of base-year or constant dollars, and a discount
rate excluding inflation should be used in computing the net
present value.
– The inflated dollar approach. The investor includes an inflation
component in the specified MARR. Hence, the cash flows should be
expressed in terms of then-current or inflated dollars, and a
discount rate including inflation should be used in computing the
net present value.
6.9 Uncertaninty and Risk
• Since future events are always uncertain, all
estimates of costs and benefits used in economic
evaluation involve a degree of uncertainty.
Probabilistic methods are often used in decision
analysis to determine expected costs and benefits as
well as to assess the degree of risk in particular
projects.
6.10 Effects of Financing on
Project selection
• Selection of the best design and financing plans for capital
projects is typically done separately and sequentially. Three
approaches to facility investment planning most often adopted
by an organization are:
– Need or demand driven: Public capital investments are defined and
debated in terms of an absolute "need" for particular facilities or
services. With a pre-defined "need," design and financing analysis
then proceed separately. Even when investments are made on the
basis of a demand or revenue analysis of the market, the
separation of design and financing analysis is still prevalent.
– Design driven: Designs are generated, analyzed and approved prior
to the investigation of financing alternatives, because projects are
approved first and only then programmed for eventual funding.
– Finance driven: The process of developing a facility within a
particular budget target is finance-driven since the budget is
formulated prior to the final design. It is a common procedure in
private developments and increasingly used for public projects.
6.11 Combined Effects of Operating
and Financing Cash Flows
• A general approach for obtaining the combined
effects of operating and financing cash flows of a
project is to make use of the additive property of net
present values by calculating an adjusted net present
value.
6.12 Public versus Private Ownership
of Facilities
• In recent years, various organizational ownership
schemes have been proposed to raise the level of
investment in constructed facilities. For example,
independent authorities are assuming responsibility
for some water and sewer systems, while private
entrepreneurs are taking over the ownership of public
buildings such as stadiums and convention centers in
joint ventures with local governments. Such
ownership arrangements not only can generate the
capital for new facilities, but also will influence the
management of the construction and operation of
these facilities. In this section, we shall review some
of these implications.
6.13 Economic Evaluation of Different
Forms of Ownership
• While it is difficult to conclude definitely that one or
another organizational or financial arrangement is
always superior, different organizations have
systematic implications for the ways in which
constructed facilities are financed, designed and
constructed. Moreover, the selection of alternative
investments for constructed facilities is likely to be
affected by the type and scope of the decisionmaking organization.