Benefit-Cost Ratio Lecture No. 66 Chapter 16 Contemporary Engineering Economics Copyright © 2006 Contemporary Engineering Economics, 4th edition, © 2007 Benefit-Cost Analysis The Benefit-cost analysis is commonly used to evaluate public projects. Benefits of a nonmonetary nature need to be quantified in dollar terms as much as possible and factored into the analysis. A broad range of project users distinct from the sponsor can and should be considered—benefits and disbenefits to all these users can and should be taken into account. Contemporary Engineering Economics, 4th edition, © 2007 Framework of Benefit-Cost Analysis 1) 2) 3) 4) Identifying all the users and sponsors of the project. Identifying all the benefits and disbenefits of the project. Quantifying all benefits and disbenefits in dollars or some other unit of measure. Selecting an appropriate interest rate at which to discount benefits and costs in future to a present value. Contemporary Engineering Economics, 4th edition, © 2007 Benefit-Cost Ratio Criterion Benefit - C ost R atio = Equivalent U sers' N et Benefits Equivalent Sponsor' s N et C ost If this BC ratio exceeds 1, the project can be justified. Contemporary Engineering Economics, 4th edition, © 2007 Definition of Benefit-Cost Ratio N B b n (1 i ) n c n (1 i ) n n0 N C n0 bn=Benefit at the end of period n, bn 0 cn=Expense at the end of period n, c n 0 An= bn – cn N = Project life i =Sponsor’s interest rate (discount rate) Contemporary Engineering Economics, 4th edition, © 2007 Breakdown of the Sponsor’s Cost K I c n (1 i ) n Equivalent capital investment at n = 0 n0 N C' c n (1 i ) n n K 1 B C (i) B C B I C' Equivalent O&M costs at n = 0 , I C' 0 Contemporary Engineering Economics, 4th edition, © 2007 Example 16.1 Benefit-Cost ratio K=1 N=5 Contemporary Engineering Economics, 4th edition, © 2007 Solution: B = $20( P / F , 10% , 2 ) + $30( P / F , 1% , 3 ) +$30( P / F , 10% , 4 ) + $20( P / F , 10% , 5 ) = $71.98 C = $10 + $10( P / F , 10% , 1) + $5( P / F , 10% , 2 ) + $5( P / F , 10% , 3 ) + $8( P / F , 10% , 4 ) + $8( P / F , 10% , 5 ) = $37.41 I = $10 + $10( P / F , 10% , 1) = $19.09 C’ = C – I = $18.3 B C (10% ) 71.98 $19. 09 $18.32 1.92 1, A ccept the project. Contemporary Engineering Economics, 4th edition, © 2007 Relationship between B/C Ratio and NPW B I C' 1 B > (I + C’) B – (I+ C’) > 0 PW(i) = B – C > 0 Contemporary Engineering Economics, 4th edition, © 2007 Incremental Analysis Based on BC(i) If BC(i)k-j > 1, select alternative j. If ΔI + ΔC’ = 0, we cannot use the benefit-cost ratio. When this happens, just select the project with the largest B value. In situations where public projects with unequal service lives are to be compared , compute all component values (B, I, and C’) on an annual basis. B Bk B j I Ik I J C' C' k C' BC ( i ) k j Contemporary Engineering Economics, 4th edition, © 2007 j B I C ' Example 16.2 Incremental Benefit-Cost Ratios – Three Alternatives A1 A2 A3 I $5,000 $20,000 $14,000 B 12,000 35,000 21,000 C’ 4,000 8,000 1,000 PW(i) $3,000 $7,000 $6,000 Contemporary Engineering Economics, 4th edition, © 2007 Solution A1 A2 A3 BC(i) 1.33 1.25 1.40 Ranking Base A1 A3 A2 I +C’ $9,000 $15,000 $28,000 B C ( i ) 2 1 $ 2 1, 0 0 0 $ 1 2, 0 0 0 ($ 1 4, 0 0 0 $ 5, 0 0 0 ) ($ 1, 0 0 0 $ 4, 0 0 0 ) 1.5 1, select A 2 . B C (i) 2 3 $ 3 5, 0 0 0 $ 2 1, 0 0 0 ($20, 0 0 0 $ 1 4, 0 0 0 ) ($8, 0 0 0 $ 1, 0 0 0 ) 1. 0 8 1, select A 2 . Contemporary Engineering Economics, 4th edition, © 2007 Summary 1) 2) 3) 4) A benefit-cost analysis is commonly used to evaluate public projects: Difficulties involved in public project analysis include the following: Identifying all the users who can benefit from the project. Identifying all the benefits and disbenefits of the project. Quantifying all benefits and disbenefits in dollars or some other unit of measure. Selecting an appropriate interest rate at which to discount benefits and costs to a present value. Contemporary Engineering Economics, 4th edition, © 2007 The B/C ratio is defined as: B C (i ) B C B I C' , I C' 0 The decision rule is if BC(i) > 1, the project is acceptable. The net B/C ratio is defined as B / C (i ) B C' I B' ,I 0 I' The net B/C ratio expresses the net benefit expected per dollar invested. The same decision rule applies as for the B/C ratio. Contemporary Engineering Economics, 4th edition, © 2007