Lectures in Engineering EconomyProf. Corrado lo StortoDIEG, Dept. of Economics and Engineering ManagementSchool of Engineering, Uniersity of !aples "ederico IIemail# corrado.lostorto$unina.itphone# %&'()*&.+,-+Ma.or issues Engineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoFramework of beneft-cost analysisValuation of benefts and costsBeneft-cost ratiosIncremental B-C analysis2ene3t(Cost analysisThe Beneft-cost analysis is commonly used to evaluate public projectsBenefts of a non-monetary nature need to be !uantifed in dollar terms as much as possible and factored into the analysis" broad ran#e of project users distinct from the sponsor should be considered$benefts and dis-benefts to all these users can %and should& be taken into accountEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo storto"rame4or5 of 2ene3t(Cost 6nalysisIdentifyin# all the users and sponsors of the projectIdentifyin# all the benefts and dis-benefts of the project'uantifyin# all benefts and dis-benefts in some unit of money measure(electin# an appropriate interest rate at whichto discount benefts and costs to a present valueEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo storto6nalyses for Goernment 6gencies and Pu0lic UtilitiesThe #overnment %public sector& analyst has usually #reater di)culties when he*she tries to measure benefts than does the private sector analyst because the #overnment sector analyst should include the social benefts and cost of the project+,conomic studies for #overnment a#encies are made easier because such a#encies are not subject to income ta- .hile funds for many such a#encies are obtained throu#h income ta-es none of the a#encies pays income ta-es to othersEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoCriteria for .udging accepta0ility of goernment pro.ects"nalyses of capital e-penditures for independent projects can take many forms/ such as01 2a-imi3ation of the ratio of benefts to costs on an annual or present e!uivalent basis+4 2inimi3ation of combined annual cost to the public user and the a#ency supplier of the facility when benefts are f-ed+5 2inimi3ation of the present value sacrifced if the project were cutEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoMa.or di7culties.hat is perceived to be in the best interest of the public may vary sharply over time01 It depends on chan#es in such conditions as the state of the economy/ forei#n relations/ public health/ environmental de#radation/ and public services+4 Intan#ibles or irreducibles are #enerally more important in public works than they are in private enterprisesEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoMa.or di7culties"nalysts who perform economic studies for a #overnment a#ency sometimes fall into the trap of makin# the study based on just the disbursements and receipts for that particular a#ency or #overnment body it representsFor e-ample/ a state or local #overnment mi#ht rationali3e that a particular project is justifed if the federal #overnment pays most of the cost/ even thou#h the project may be unjustifed based on total costs and beneftsEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoE8ample Classifcation of benefts and costs related to the completion of a new toll road throu#h a rural area havin# as a major #oal to shorten the distance between two lar#e communities0Engineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo storto2ene3ts to Pu0lic- 6educed vehicle operatin# costs- 6educed commercial and non commercial travel time- Increased safety- Increased accessibility between communities- ,ase of drivin#- "ppreciation of land valuesE8ample Engineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoDis0ene3ts to Pu0lic- 7and removed from a#rucultural production- 8ama#es resultin# from chan#es of water 9ow- 8ecreased movement of livestock across hi#hway- Increased air pollution and litterCost to State- Construction costs- 2aintenance costs- "dministrative costsSaings to State- Toll revenues- Increased ta-es due to appreciated land and increased business activityE8ample # Pro0lem '" county is considerin# installin# a water treatment system that is e-pected to cause environmental and direct benefts of : 1/;;;/;;; per year for its inhabitants The system would re!uire an investment of : / is the project justifed on an economic basis? (uppose the state #overnment is willin# to pay : @/;;;/;;; of the investment Aow is it justifed?Engineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoE8ample# Solution to pro0lem 'Bsin# the net present worth method based on total benefts and costs/ we #etAet C. D %: 1/;;;/;;; - : 5;;/;;;&%C*"/ =>/ 4;& - : +B G %I S CHH&B L %IS CHH& G ;C.%i& D B L C G ;Engineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoIncremental 6nalysis 2ased on BC5 1:41/;;; :14/ ;;;BC%i&%:1@/;;; :Q/ ;;;& %:1/ ;;; :@/ ;;;&1Q 1/select "4= + = >Engineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoInterest rate for goernment pro.ectsThree main choices for the interest rate to use in #overnment economic studies are as follows01 borrowin# rate4 the opportunity cost to the #overnmental a#ency5 the opportunity cost to the ta-payerEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo storto>he 0orro4ing rateIn #eneral/ it is appropriate to use the borrowin# rate only for cases in which money is borrowed specifcally for the project under analysis and where use of that money will not cause other worthy projects to be fore#oneEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo storto>he opportunity costIt is the interest rate on the best investment opportunity fore#oneIf projects are chosen so that the return rate on alla accepted projects is hi#her than the return on any of the rejected projects/ then the interest rate for use in the economic analysis is e!ual to the opportunity costIf this is done for all projects and investment capital available within a #overnment a#ency/ then the result is a #overnment opportunity cost If/ on the other hand/ one considers the best opportunity available to the ta-payers if the money were not obtained throu#h ta-es for use by the #overnment a#ency/ the result is a ta-payersH opportunity costEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoComparing alternaties using 0ene3t(cost analysis 4hen receipts and dis0ursements are 5no4n# an e8ample7athe"B First cost : 1;/;;; : 1Q/;;;7ifeQ yr 1; yr(alva#e value: 4/;;; : ;"nnual receipts: Q/;;; : E/;;;"nnual disbursements: 4/4;; : @/5;;2inimum attractive rate of returnDR>(tudy periodD1; yrTwo alternatives lathes are considered in the analysis "nnual receipts are treated as annual benefts/ while annual disbursements are treated as annual operatin# and maintenance costsEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoComparing alternaties using 0ene3t(cost analysis 4hen receipts and dis0ursements are 5no4n# solution to the e8ampleIt is assumed that after Q years lathe " will be replaced with another lathe havin# an identical cash 9ow profle Uence/ annual worths for individual life cycles can be used in computin# the beneft-cost ratioThe frst increment of investment %the : 1;/;;; for lathe "& has a B*C of 14/ 1;& D : 4/45QEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoComparing alternaties using 0ene3t(cost analysis 4hen receipts and dis0ursements are 5no4n# solution to the e8ampleFor the second increment of investment/( ) ( ): E/;;; - : @/5;; : Q/;;;-: 4/4;;B*C D : 4/45Q - : 4/1=5: 4/E;; - : 4/R;; : 4/45Q - : 4/1=5=- : 1;;DD -15< F 1: E4(ince the modifed B*C ratio for the increment of investment from lathe " to lathe B has a value less than 1/ the increment cannot be justifed and thus lathe " is recommendedEngineering Economy/pu0lic actiities/ +%%1 /prof. corrado lo stortoComparing numerous alternaties using 0ene3t(cost analysis 4hen receipts and dis0ursements are 5no4n# e8ampleThe followin# e-ample shows = investment alternatives ,ach alternative has a salva#e value e!ual to the investment and there is no depretiation cost/ and the incremental capital recovery cost e!uals the product of the 2"66 and the incremental investment0"lternatives" B C 8 , FInvestment : 1/;;; : 1/Q;; : 4/Q;; : @/;;; : Q/;;; : E/;;;"nnual savin#s in cash disbursements: 1Q; : 5EQ : Q;; :