Chapter 9 - Public Projects and Benefit-Cost

Ratio Method

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Public projects and benefit-cost ratio method

The project evaluation and selection methods we have learned

so far are directed towards private projects". The primary goal
of a private project is to make profit for the project owners and
investors. In these projects, a unified purpose is usually agreed
on and the projects evaluation is only based on monetary
values. On the other hand, public projects" do not aim to
generate profit, but instead have the (social) goal of providing
service and benefit to the general public. Difficulties:
- Quantifying service in monetary terms
- Multiple purposes and conflicting interests
Their evaluation requires different methods. One such method
is called Benefit-Cost (B-C) ratio method.

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B-C ratio method calculates the ratio of projects benefits to its

costs. The components are:
Benefits: Positive consequences to the public.
Costs: Monetary expenditures required for the project
(financed by government often through taxation).
Disbenefits: Negative consequences to a segment of the
public.
As in the private projects, time value of money is important for
the public projects, so an interest rate needs to be determined.
Several factors are considered in selecting an appropriate
interest rate, such as interest rate on borrowed capital and the
opportunity cost of capital both to the taxpayers and the
governmental agency.

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Notation:
B: benefits of the project
I: initial investment
O&M: operating and maintenance cost of the project
CR: capital recovery amount
D: disbenefits of the project
MV: market value of investment.
Conventional B-C ratio:
PW version: B C =
AW version: B C =

PW(B)
IPW(MV)+PW(O&M)
AW(B)
CR+AW(O&M) .

or

Modified B-C ratio:

PW version: B-C= PW(B)PW(O&M)
or
IPW(MV)
AW version: B-C= AW(B)AW(O&M)
.
CR
(Note that CR already includes MV.)
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A project is acceptable if B-C 1, otherwise not.

Conventional and modified B-C methods give identical
acceptability results (not necessarily the same numerical
results!).

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Example 9.1
The project is to extend the runways of an airport and it is
considered by the city municipality. The following costs have
been identified:
Land: $350,000
Construction: $600,000
Annual maintenance: $22,500
Terminal construction: $250,000
Annual operating and maintenance for the terminal: $75,000
Addition of air traffic controllers per year: $100,000
The project is estimated to bring the following benefits:
Rental receipts: $325,000
Tax to passengers: $65,000
Convenience: $50,000
Tourism: $50,000.
Apply the B-C ratio method with a study period of 20 years and
a MARR of 10% per year, and determine whether this is an
acceptable project or not.
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Solution:
Conventional B-C ratio:
PW version:
PW(B)
490,000(P/A,10%,20)
B-C= I+PW(O&M)
= 1,200,000+197,500(P/A,10%,20)
= 1.448 > 1.
AW version:
AW(B)
490,000
B-C= CR+AW(O&M)
= 1,200,000(A/P,10%,20)+197,500
= 1.448 > 1.
Modified B-C ratio:
PW version:
= 490,000(P/A,10%,20)197,500(P/A,10%,20)
=
B-C= PW(B)PW(O&M)
I
1,200,000
2.075 > 1.
AW version:
490,000197,500
B-C= AW(B)AW(O&M)
= 1,200,000(A/P,10%,20)
= 2.075 > 1.
CR
Extend runways.

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How to include disbenefits?

Two alternatives: reduce benefits or increase costs.
Conventional B-C ratio (with disbenefits):
AW(B)AW(D)
B-C= CR+AW(O&M)
AW(B)
.
B-C= CR+AW(O&M)+AW(D)

Continue with Example 11-2. Suppose the increased noise

level caused by the project will bring a disbenefit of $100,000
per year to the neighborhood. Still extend the runway?
AW(B)AW(D)
490,000100,000
B-C= CR+AW(O&M)
= 1,200,000(A/P,10%,20)+197,500
= 1.152 > 1.
AW(B)
490,000
B-C= CR+AW(O&M)+AW(D)
= 1,200,000(A/P,10%,20)+197,500+100,000
=
1.118 > 1. Extend runways.

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Selection of alternatives by B-C ratio

Independent projects: Select any project that has a B-C

ratio of greater than or equal to one. (if no budget
restriction!)
Mutually exclusive projects: We must perform incremental
B-C analysis. (Selecting the project with the highest B-C
ratio is not correct!)

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Selection of alternatives by B-C ratio

Incremental analysis for mutually exclusive projects:
1
For each alternative, determine its C and B [or (B - D) if
disbenefits are considered] in the B-C ratio.
Conventional B-C ratio:
PW version: C = I PW(MV) + PW(O&M); B = PW(B).
AW version: C = CR + AW(O&M); B = AW(B).
Modified B-C ratio:
PW version: C = I PW(MV); B = PW(B) PW(O&M).
AW version: C = CR; B = AW(B) AW(O&M).
2
3

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Rank the projects in order of increasing C.

If there is DN, select DN as the baseline alternative.
Otherwise, select the first alternative in the ordered list of
Step 2 as the baseline alternative.
Calculate the incremental B-C ratio B/C (Next project current baseline project). Select next project as the new
baseline project if the incremental ratio 1; otherwise
maintain the (last) baseline project. Iterate until all projects
are considered.
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Example 9.2

The city of Garden Ridge, Florida has received two design

proposals for a new wing to the municipality hospital.

Construction cost $
Building maintenance cost $/year
Patient benefits, $/year

Design 1
10M
35K
0.8M

Design 2
15M
55K
1.05M

The MARR is 5% per year, and the life of the addition is

estimated at 30 years. Suppose there is DN alternative.
a) Use AW verison of conventional B-C ratio method to make
the selection.

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b) Once the two designs were publicized, the privately owned

hospital in the adjacent city of Forest Glen lodged a complaint
that Design 1 will reduce its own municipal hospitals income by
an estimated $0.6M per year because some of the day-surgery
features of Design 1 duplicate its services. Subsequently, the
Garden Ridge merchants association argued that Design 2
could reduce its annual revenue by an estimated $0.4M
because it will eliminate an entire parking lot used for
short-term parking. What is the decision now?

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Solution:
a) AW1 (C) = $10,000,000(A/P,5%,30) + $35,000=$685,500
AW2 (C) = $15,000,000(A/P,5%,30) + $55,000=$1,030,750
Rank order: DN-Design 1-Design 2.
B/C(1 DN) = 800, 000/685, 500 = 1.17. Design 1 is the
base alternative.
B(2 1)=1,050,000-800,000=$250,000
C(2 1)=1,030,750-685,500=$345,250.
B/C(2 1) = 250, 000/345, 250 = 0.72. Design 1 is selected.
b) The revenue loss estimates are considered disbenefits.
Since the disbenefits of Design 2 are $200,000 less than those
of 1, this positive difference is added to the $250,000 benefits
of 2 to give it a total benefit of $450,000.
B/C(2 1) = $450, 000/$345, 250 = 1.30.
Design 2 is now favored. The inclusion of disbenefits reversed
the decision.
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Incremental B-C analysis with unequal project lives

If some of the projects in a set of mutually exclusive

public-works projects have different lives, we need to use the
techniques introduced in Chapter 6 to make them to have equal
lives before we conduct the incremental B-C analysis.

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Example 9.3
Two mutually exclusive alternative public-works projects are
under consideration.

Capital investment $
Annual operating and maintenance $/year
Annual benefit $/year
Useful life (years)

Project I
750K
120K
245K
35

Project II
625K
110K
230K
25

The MARR is 9% per year. Assume the assumption of

repeatability is valid. Suppose there is DN alternative. Use the
AW version of conventional B-C ratio method to make your
selection.

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Solution:
AWI (Costs) = $750,000 (A/P, 9%, 35) + $120,000 = $190,977,
AWII (Costs) = $625,000 (A/P, 9%, 25) + $110,000 = $173,629,
Rank order: DN - Project II - Project I.
B/C(II DN) = 230, 000/173, 629 = 1.3247 > 1.0.
Therefore, Project II is the base alternative.
B/C(I II) = (245, 000 230, 000)/(190, 977 173, 629) =
0.8647 < 1.0.
Therefore, increment required for Project I is not acceptable.
Decision: Project II should be selected.

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