INDE/EGRM 6617-02

Engineering Economy and Cost Estimating

Chapter 10: Evaluating Projects with the

Benefit-Cost Ratio Method

Dr. Alireza Namdari

anamdari@newhaven.edu
➢ Objective
The objective of this chapter is to demonstrate the use of the
benefit-cost ratio for the evaluation of public projects.

Public Projects
• Public projects are those authorized, financed, and
operated by federal, state, and local governmental
agencies.
• Public works are frequently much larger than private
ventures.
• Since they require the expenditure of capital, such
projects are subject to the principles of engineering
economy.
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 Examples of Public Projects
• Public buildings (municipal buildings, schools,
hospitals)
• Infrastructure (roads, railroads, bridges, pipelines,
canals, ports, airports)
• Public spaces (public squares, parks, beaches)
• Public services (water supply, sewage, electrical
grid, dams)

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 Some Basic Differences between Privately
Owned and Publicly Owned Projects
Private Public
Purpose Provide goods or services at a Protect health; protect lives and
profit; maximize profit or property; provide services (at no
minimize cost profit); provide jobs
Sources of capital Private investors and lenders Taxation; private lenders
Method of Individual ownership; Direct payment of taxes, loans
financing partnerships; corporations without interest; loans at low interest;
self-liquidating bonds; indirect
subsidies, guarantee of private loans
Project life Usually relatively short (5 to 10 Usually relatively long (20 to 60 years)
years)
Nature of benefits Monetary or relatively easy to Often nonmonetary, difficult to
equate to monetary terms quantify, difficult to equate to
monetary terms
Measurement of Rate of return on capital Very difficult; no direct comparison
efficiency with private projects
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 Public Projects & B-C Analysis
• As a consequence of these differences, it is
often difficult to make engineering economy
studies and investment decisions for public-
works projects in exactly the same manner as
for privately owned projects.
• Rather than allowing the analyst to apply criteria
more commonly used for evaluating private
projects (IRR, PW, and so on), most governmental
agencies require the use of the B-C method.

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The next step is to identify three items regarding a
public project:

➢ Benefits (Benefits are favorable consequences of the

project to the public)

➢ Costs (Costs represent monetary disbursements

required of the government)

➢ Disbenefits (Disbenefits represent negative

consequences of a project to the public)

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 Public Project of Bikeways
The City of Saint Paul, Minnesota 2013 is developing a public project - building
bikeways in Marshall Avenue between Snelling Avenue and John Ireland
Boulevard.
Benefits:
• Reducing a city's carbon footprint, good for environment
• Improving the safety of pedestrians and cyclists
• Reducing traffic accidents
• Potential to attract people move here and increase the economy (i.e. more
taxes)
• More sales of bicycles as well as taxes
Costs:
• Bikeway design
• Construction
• Operation and maintenance costs of the bikeway
DisBenefits:
• Traffic jam might happen
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 What Interest Rate Should Be Used for
Public Projects?
• When public-sector projects are evaluated, interest rates play
the same role of accounting for the time value of money as in
the evaluation of projects in the private sector.

The rationale for the use of interest rates, however, is somewhat

different:
✓ The choice of an interest rate in the private sector is intended
to lead directly a selection of projects to maximize profits or
minimize cost.
✓ In the public sector, the goal is the maximization of social
benefits.

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 Three main considerations:
– The interest rate on borrowed capital
If money is borrowed specifically for a project, the interest rate on the
borrowed capital is appropriate to use as the rate.

– The opportunity cost of capital to the governmental agency

If projects are selected such that the estimated return on all accepted
projects is higher than that on any of the rejected projects, then the
interest rate used in economic analyses is that associated with the best
opportunity forgone.

– The opportunity cost of capital to the taxpayers

It is based on the philosophy that all government spending takes potential
investment capital away from the taxpayers.

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 More interest rate considerations…
• The 1997 Office of Management and Budget
directive states that a 7% rate should be used, as an
approximation of the return tax payers could earn
from private investments.
• Another idea is to use a market-determined risk-free
rate, about 3-4% per year.
➢ Bottom line: there is no simple formula, and it is an
important policy decision at the discretion of the
governmental agency.

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Applying the benefit-cost ratio method
• let us denote
B: benefits of the project;
I: initial capital investment;
CR: capital recovery;
O&M: operating and maintenance costs.

• B-C ratio is the ratio of the equivalent worth of

benefits to the equivalent worth of costs.
• A project is acceptable when the B-C ratio is
greater than or equal to one.
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 B-C Ratios for Present Worth (PW)

Conventional B-C ratio with PW

Modified B-C ratio with PW

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B-C Ratios for Annual Worth (AW)
Conventional B-C ratio with AW

Modified B-C ratio with AW

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 Example 10-2
The city of Columbia is considering extending the runways of its municipal airport so
that commercial jets can use the facility. The land necessary for the runway extension is
currently a farmland that can be purchased for $350,000. Construction costs for the
runway extension are projected to be $600,000, and the additional annual maintenance
costs for the extension are estimated to be $22,500. If the runways are extended a small
terminal will be constructed at a cost of $250,000. The annual operating and maintenance
costs for the terminal are estimated at $75,000. Finally, the projected increase in flights
will require an addition of two air traffic controllers at an annual cost of $100,000.
Annual benefits of runways extension have been estimated as follows:

$325,000 Rental receipts from airline leasing space at the facility

$65,000 Airport tax charged to passengers
$50,000 Convenience benefit for the residents of Columbia
$50,000 Additional truism dollars for Columbia

Apply the B-C ratio method with a study period of 20 years and a MARR of 10% to
determine whether the runways at Columbia Municipal Airport should be extended.
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 Solutions
𝑪𝒐𝒏𝒗𝒆𝒏𝒕𝒊𝒐𝒏𝒂𝒍 𝑩 − 𝑪 = 𝑃𝑊(𝐵)/[𝐼 − 𝑃𝑊 𝑀𝑉 + 𝑃𝑊(𝑂&𝑀)]
𝐵 − 𝐶 = $490,000(𝑃/𝐴, 10%, 20)/[$1,200,000 + $197,500(𝑃/𝐴, 10%, 20)]
𝑩 − 𝑪 = 𝟏. 𝟒𝟒𝟖 > 𝟏; 𝒆𝒙𝒕𝒆𝒏𝒅𝒆𝒅 𝒓𝒖𝒏𝒘𝒂𝒚𝒔.

𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑩 − 𝑪 = [𝑃𝑊 𝐵 − 𝑃𝑊(𝑂&𝑀)]/[𝐼 − 𝑃𝑊 𝑀𝑉 ]

𝐵 − 𝐶 = [$490,000(𝑃/𝐴, 10%, 20) − $197,5000(𝑃/𝐴, 10%, 20)]/$1,200,000
𝑩 − 𝑪 = 𝟐. 𝟎𝟕𝟓 > 𝟏; 𝒆𝒙𝒕𝒆𝒏𝒅𝒆𝒅 𝒓𝒖𝒏𝒘𝒂𝒚𝒔.

𝑪𝒐𝒏𝒗𝒆𝒏𝒕𝒊𝒐𝒏𝒂𝒍 𝑩 − 𝑪 = 𝐴𝑊(𝐵)/[𝐶𝑅 + 𝐴𝑊(𝑂&𝑀)]

𝐵 − 𝐶 = $490,000/[$1,200,000(𝐴/𝑃, 10%, 20)] + $197,5000]
𝑩 − 𝑪 = 𝟏. 𝟒𝟒𝟖 > 𝟏; 𝒆𝒙𝒕𝒆𝒏𝒅𝒆𝒅 𝒓𝒖𝒏𝒘𝒂𝒚𝒔.

𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝑩 − 𝑪 = [𝐴𝑊 𝐵 − 𝐴𝑊(𝑂&𝑀)]/𝐶𝑅

𝐵 − 𝐶 = [$490,000 − $197,5000]/[$1,200,000(𝐴/𝑃, 10%, 20)]
𝑩 − 𝑪 = 𝟐. 𝟎𝟕𝟓 > 𝟏; 𝒆𝒙𝒕𝒆𝒏𝒅𝒆𝒅 𝒓𝒖𝒏𝒘𝒂𝒚𝒔. 15
 Example
A toll bridge across the Mississippi River is being considered as a
replacement for the current I-40 bridge linking Tennessee to
Arkansas. Because this bridge, if approved, will become a part of the
U.S. Interstate Highway system, the B-C ratio method must be applied
in the evaluation. Investment costs of the structure are estimated to be
$17,500,000, and $325,000 per year in operating and maintenance
costs are anticipated. In addition, the bridge must be resurfaced every
fifth year of its 30-year projected life at a cost of $1,250,000 per
occurrence (no resurfacing cost in year 30). Revenues generated from
the toll are anticipated to be $2,500,000 in its first year of operation,
with a projected annual rate of increase of 2% per year due to the
anticipated annual increase in traffic across the bridge. Assuming zero
market (salvage) value for the bridge at the end of 30 years and MARR
of 10% per year, should the toll bridge be constructed?
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 Solutions
Geometric Sequences of Cash Flows, 𝑓 ≠ 𝑖
𝑨𝟏 [𝟏 − 𝑷/𝑭, 𝒊%, 𝑵 𝑭/𝑷, 𝒇%, 𝑵 ]
𝑷=
𝒊−𝒇

$2,500,000 ∗ [1 − (𝑃/𝐹, 10%, 30)(𝐹/𝑃, 2%, 30)]

𝑃𝑊 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 =
0.10 − 0.02
= $2,500,000 ∗ 11.2026 = $28,006,462

𝑃𝑊 𝑐𝑜𝑠𝑡𝑠
= $17,500,000 + $325,000 ∗ 𝑃/𝐴, 10%, 30 + $1,250,000 ∗ 𝐴/𝐹, 10%, 5
∗ 𝑃/𝐴, 10%, 25 = $22,422,258

$28,006,462
𝐵/𝐶 = = 1.25 > 1
$22,422,258

➢ Therefore, the toll bridge should be constructed. 17

 Example
A retrofitted-space heating system is being considered for a small
office building. The system can be purchased and installed for
$120,000, and it will save an estimated 300,000 Kilowatt-hours (kWh)
of electric power each year over a six-year period. A Kilowatt-hour of
electricity costs $0.10, and the company uses a MARR of 15% per
year in its economic evaluations of refurbished systems. The market
value of the system will be $8,000 at the end of six years, and
additional annual operating and maintenance expenses are negligible.
1) Use the benefit-cost method to make a recommendation.
2) What is the benefit-cost ratio of the project if the general inflation
rate is 4% per year and the market value is negligible? The market
interest rate (im ) is 18% per year, and the annual savings are
expressed in year-zero dollars.
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 Solutions
Part a)
300,000 ∗ $0.10 ∗ 𝑃/𝐴, 15%, 6 $113,535
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 = = <1
$120,000 − $8,000 ∗ 𝑃/𝐹, 15%, 6 $116,542
The project is not acceptable.

Part b)
The present worth of benefits is:
A1 [1 − (𝑃/𝐹, 𝑖%, 𝑁)(𝐹/𝑃, 𝑓%, 𝑁)]
, 𝑓≠𝑖
𝑃𝑊(𝑖%) = ቐ i−f
A1 𝑁 𝑃/𝐹, 𝑖%, 1 , 𝑓=𝑖
300,000 ∗ $0.10 ∗ 1.04 ∗ [1 − (𝑃/𝐹, 18%, 6)(𝐹/𝑃, 4%, 6)]
𝑃𝑊 18% =
0.18 − 0.04
$118,410
𝐵/𝐶 = <1
$120,000
The project is still unacceptable.
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But we have not considered the disbenefits in the
calculation so far.
Let D denote the amount of disbenefits.
There are basically two ways to count D:

or

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 Example 10-4
In addition to the benefits and costs, suppose that there are
disbenefits associated with the runway extension project.
Specifically, the increased noise level from commercial jet traffic
will be serious nuisance to homeowners living along the
approach path to the Columbia Municipal Airport. The annual
disbenefit to citizens of Columbia caused by this noise pollution
is estimated to be $100,000. Given this additional information,
reapply the conventional B-C ratio, with equivalent annual
worth, to determine whether this disbenefit affects your
recommendation on the desirability of this project.

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 Solutions
𝑫𝒊𝒔𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔 𝒓𝒆𝒅𝒖𝒄𝒆 𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔 𝐵 − 𝐶
= [𝐴𝑊 𝐵 − 𝐴𝑊(𝐷)]/[𝐶𝑅 + 𝐴𝑊(𝑂&𝑀)]
𝐵 − 𝐶 = [$490,000 − $100,000]/[$1,200,000(𝐴/𝑃, 10%, 20) + $197,5000]
𝑩 − 𝑪 = 𝟏. 𝟏𝟓𝟐 > 𝟏; 𝒆𝒙𝒕𝒆𝒏𝒅𝒆𝒅 𝒓𝒖𝒏𝒘𝒂𝒚𝒔.

𝑫𝒊𝒔𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔 𝒕𝒓𝒆𝒂𝒕𝒆𝒅 𝒂𝒔 𝒂𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 𝐵 − 𝐶

= 𝐴𝑊 𝐵 /[𝐶𝑅 + 𝐴𝑊(𝑂&𝑀) + 𝐴𝑊(𝐷))]
𝐵 − 𝐶 = $490,000/[$1,200,000(𝐴/𝑃, 10%, 20) + $197,5000 + $100,000]
𝑩 − 𝑪 = 𝟏. 𝟏𝟏𝟖 > 𝟏; 𝒆𝒙𝒕𝒆𝒏𝒅𝒆𝒅 𝒓𝒖𝒏𝒘𝒂𝒚𝒔.

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 Selecting projects
• If projects are independent, all projects that
have a B-C greater than or equal to one may
be selected.
• For projects that are mutually exclusive, a B-C
greater than one is required, but selecting the
project that maximizes the B-C ratio does not
guarantee that the best project is selected.

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 Incremental B-C analysis for mutually
exclusive projects.
• Incremental analysis must be used in the case of B-
C and mutually exclusive projects.
• Rank alternatives in order of increasing total
equivalent worth of costs.
• With “do nothing” as a baseline, begin with the
lowest equivalent cost alternative and determine the
incremental B-C ratio (B/C), selecting the
alternative with the higher equivalent cost if the
ratio is greater than one.

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 Example 10-7
Three mutually exclusive alternative public-works projects are
currently under consideration. Their respective costs and benefits
are included in the table that follows. Each of the projects has a
useful life of 50 years, and MARR is 10% per year. Which, if
any, of these projects should be selected.

A B C
Capital investment $8,500,000 $10,000,000 $12,000,000
Annual operating and maintenance costs $750,000 $725,000 $700,000
Market value $1,250,000 $1,750,000 $2,000,000
Annual benefit $2,150,000 $2,265,000 $2,500,000

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B-C Analysis with Unequal Project Lives
• Recall from chapter 6 that the AW criterion can be
used to select from among alternatives with different
lives as long as the assumption of repeatability is
valid.
• Similarly, if a mutually exclusive set of public-works
projects includes projects with varying useful lives, it
may be possible to conduct an incremental B-C
analysis by using the AW of benefits and costs of the
various projects.

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 Example 10-8
Two mutually exclusive alternatives public-works projects
are under consideration. Their respective costs and benefits
are included in the table that follows. Project X has an
anticipated life of 35 years and the useful life of project Y
has been estimated to be 25 years. If the MARR is 9% per
year, which, if either, of these projects should be selected?
Project X Project Y
Capital investment $750,000 $625,000
Annual operating and maintenance $120,000 $110,000
Annual benefit $245,000 $230,000
Useful life of project (years) 35 25

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 Solutions
𝐴𝑊(𝐶𝑜𝑠𝑡𝑠, 𝑋) = $750,000 𝐴/𝑃, 9%, 35 + $120,000
= $190,977
𝐴𝑊(𝐶𝑜𝑠𝑡𝑠, 𝑌) = $625,000 𝐴/𝑃, 9%, 25 + $110,000
= $173,629
B/C 𝑜𝑓 𝑋 − 𝑌
= ($245,000 − $230,000)/($190,977 − $173,629)
= 0.8647 < 1.0

Therefore, increment required for Project X is not

acceptable.
Decision: Project Y should be selected.
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