ECE 192 Spring 2023

Module 3: Comparison Methods – Part 4.

4/2/2023

Presented by: Ivan Calero

ECE Department
OUTLINE

▪ Private vs Public projects

▪ Benefit Cost Method:

▪ Benefit-Cost Ratios (BCR)

▪ Independent Project Criteria

▪ Mutually Exclusive Project Criteria

Module 3: Comparison Methods. PAGE 2

Private versus Public Sector Projects

▪ In private sector:
▪ The firm generally pays all costs and receives all benefits.

▪ Estimated benefits and costs are then compared, on a PW basis, using a pre-determined
discount rate (MARR).

▪ In public sector:
▪ Revenue is received through taxes and are supposed to be spent in public interest.

▪ Government pays costs, but receives very few benefits.

▪ These projects do not have “profits”.

Module 3: Comparison Methods. PAGE 3

Private versus Public Sector Projects

• Issues in public sector projects:

• How to quantify the benefits.

• Selection of an interest rate is often an issue:

• MARR for public investments is usually low to make the investments look attractive; i.e.,
interest rate on capital borrowed to fund the project.

• The Weighted Average Cost of Capital (WACC) can be used when multiple source of funds are
considered.

• What analysis should be used? PW, FW, etc.

• Projects can have undesirable consequences:

• Can be controversial in nature, draws media attention– debated on pros and cons.

Module 3: Comparison Methods. PAGE 4

Characteristics– Compared

Characteristic Public Sector Private Sector

Size of Investment Larger Some large; medium to small

Life Estimates Typically long: 30-50 years Shorter: 2-25 years

Annual Cash Flow Estimates Costs and benefits no profit Revenues, profit-cost estimates

Funding Taxes, fees, bonds, private Sale of new stocks, bonds,

funds, cost sharing loans, other earnings
arrangements exist
Interest Rate Tends to be lower (social Higher: At market cost
discount rates)
Risk Less perceived risks Higher risks

Module 3: Comparison Methods. PAGE 5

Costs and Benefits in Public Projects
• Costs (Sponsor’s Costs)

• Construction (Capital Costs), operation & maintenance, and salvage values.

• Initial costs are well known; while future O&M are less known and must be estimated.

• If project generates benefits, these should be subtracted from the sponsor’s costs; e.g., increased tax
revenue due to higher land values after a new road construction.

• Benefits (Social Benefits):

• Very difficult to estimate.

• Benefits = advantages to the public stated in $; e.g., reduction in traveling time, safety increased, jobs
created, etc.

▪ Disbenefits (Social Costs)

▪ Expected undesirable (negative) consequences to the project’s beneficiaries, assuming the project is
undertaken; e.g., increase in noise and air pollution, disruption to the local environment, etc.
▪ May be indirect economic disadvantages to the public.

▪ Very hard to estimate and convert to $ amounts.

Module 3: Comparison Methods. PAGE 6

Benefits and Costs Ratios (BCR)

▪ Using PW method:
𝑃𝑊 users′ benefits
𝐵𝐶𝑅 =
𝑃𝑊 sponsors′ costs

users ′ benefits = social benefits − social costs

▪ Using FW method:

𝐹𝑊 users′ benefits
𝐵𝐶𝑅 =
𝐹𝑊 sponsors′ costs

▪ Using AW method:

𝐴𝑊 users′ benefits
𝐵𝐶𝑅 =
𝐴𝑊 sponsors′ costs

Module 3: Comparison Methods. PAGE 7

Benefits and Costs Ratios (BCR)
▪ Conventional:

𝑃𝑊(social benefits − social costs) 𝐵 − 𝐷

𝐵𝐶𝑅 = =
𝑃𝑊(sponsors′ costs) 𝐶
▪ Modified:

𝑃𝑊(social benefits − social costs − sponsor ′ s O&M Costs) 𝐵 − 𝐷 − 𝑂𝑀

𝐵𝐶𝑅𝑀 = =
𝑃𝑊(sponsors ′ capital costs) 𝐾

▪ There is no difference between two approaches, although the B/C ratios will differ
in magnitude, but, the same absolute (accept/reject) decision will be taken.
▪ The modified benefit-cost ratio is used less, but it provides information about the
net gain per dollar invested by the project sponsor.

Module 3: Comparison Methods. PAGE 8

BCR Formulation

▪ Assignable life, N years.

▪ Estimate the sponsor’s costs ($), social benefits ($), social costs (disbenefits) ($).

▪ Assign an interest rate, i (%/year).

▪ Convert all amounts to either:

▪ Present Worth, PW(i%).

▪ Annual Worth, AW(i%).

▪ Future Worth, FW(i%).

▪ Then calculate a BCR in one of three ways using the conventional or modified
BCRM.

Module 3: Comparison Methods. PAGE 9

Decision Rule for Independent Projects

▪ If BCR > 1
▪ Accept the alternative.

▪ If BCR < 1
▪ Reject the alternative.

▪ If BCR close to 1, then intangible factors may sway the decision to accept or reject.

Module 3: Comparison Methods. PAGE 10

Incremental BCR for Mutually Exclusive Projects

▪ Select from two mutually exclusive alternatives X and Y:

▪ The Do Nothing (DN) alternative always exists and should be evaluated as an alternative.

▪ Requires a proper ordering of alternatives:

▪ Ascending order of PW of total cost 𝐶; e.g., assume 𝐶𝑋 ≥ 𝐶𝑌 , where 𝑋 and 𝑌 are the two project
alternatives.

▪ Calculate the Incremental BCR:

𝐵𝑋 − 𝐵𝑌
∆𝐵𝐶𝑅 = 𝐵𝐶𝑅(𝑋 − 𝑌) =
𝐶𝑋 − 𝐶𝑌

▪ If (BCR) > 1, select the higher cost alternative 𝑋; otherwise select lower-cost alternative 𝑌.

▪ If 𝐶𝑋 = 𝐶𝑌 , then choose the project with greater PW of benefits.

▪ If 𝐵𝑋 = 𝐵𝑌 , then choose the project with the lowest PW of cost.

Module 3: Comparison Methods. PAGE 11

Incremental BCR for Mutually Exclusive Projects

▪ For comparing multiple mutually exclusive projects:

▪ For each alternative, determine equivalent PW, AW or FW for costs 𝐶, and benefits 𝐵, or 𝐵 − 𝐷
if disbenefits are considered.

▪ Order alternatives by increasing total equivalent costs:

▪ Add Do-nothing as the first alternative, if that option has intrinsic costs or benefits.

▪ Determine the incremental cost (C) and benefits (B) between first two alternatives.

BCR = (B - D)/C

▪ If (BCR) ≥ 1, eliminate 1; 2 is survivor; otherwise alternative 1 is survivor.

▪ Continue comparing alternatives until one alternative remains as survivor.

Module 3: Comparison Methods. PAGE 12

Example

▪ A current process in a factory has a yearly cost of $50,000. Two alternative

systems are to be implemented to improve the efficiency of this process, thus
reducing the annual costs:

System 1 System 2

Investment cost ($) 10,000 15,000

Annual cost ($/year) 45,000 42,000

▪ Are these alternatives worth to implement? Consider an 𝑖 = 10% and 𝑁 = 5

years.

Module 3: Comparison Methods. PAGE 13

Example

▪ Solution:
▪ Order the alternatives from lowest to largest present worth of their costs:
Alternative Costs Benefits
Do nothing 0 0
System 1 10,000@t=0 50,000-45,000=5,000 $/year
System 2 15,000@t=0 50,000-42,000=$8,000 $/year

▪ Calculate the incremental benefit cost of the first two:

BCR = (B - D)/C
Alternative PW Costs ($) PW (B-D) ($)

10,000 – 0 = BCR = 18,953.9/10,000

Sys. 1 – Do-nothing 5,000 (P/A,10%,5)-0 = 18,953.9
10,000 BCR = 1.89>1

15,000-10,000 = (8,000-5,000)(P/A,i,N) = BCR = 11,372.4/5,000

Sys.2 – Sys. 1
5,000 3,000 (P/A,10%,5) = 11,372.4 BCR = 2.2744>1

▪ Best alternative 2.

Module 3: Comparison Methods PAGE 14

Summary

▪ BCR is primarily a public-sector analysis technique.

▪ Uses PW, AW, or FW with a social cost of capital interest rate (specified before
analysis is conducted).
▪ BCR > 1 indicates economic desirability.

▪ Results may depend upon viewpoints that define costs and benefits.

Module 3: Comparison Methods. PAGE 15

REFERENCES

▪ K. Bhattacharya, ECE 390 “Engineering Economics, Analysis, and Impact on

Society, slides, Fall 2017.

Module 2: Time Value of Money. PAGE 16