3 - Payback Method and B-C Method

Payback (Payout)
Period Method
437 365
108 512
108
The payback method, which is often called the
simple payout method, mainly indicates a
project’s liquidity rather than its profitability.
The payback method calculates the number of
years required for cash inflows to just equal
cash outflows.
The simple payback period is the smallest value
of θ(θ ≤ N) for which this relationship is satisfied
under our normal EOY cash-flow convention.
A project where all capital investment occurs at
time 0, we have
Example 1
A public school is being renovated for $13.5
million. The building has geothermal
heating and cooling, high-efficiency
windows, and a solar array that permits
the school to sell electricity back to the
local electric utility. The annual value of
these benefits is estimated to be $2.7
million. In addition, the residual value of
the school at the end of its 40-year life is
negligible. What is the simple payback
period and internal rate of return for the
renovated school?
Solution to Example 1:
The simple payback period is
$13.5 million
= 5 years
$2.7 million/year
This is fairly good for a publicly sponsored
project.
.
The IRR can be computed using the equation
.
0 = −$13.5 million + $2.7 million (P/A, i′%, 40),

.
yielding i’% (the IRR) = 20% per year. The IRR

indicates the project is profitable for a MARR
of 20% per year or less.
Example 2
The management of Health Supplement
Inc. wants to reduce its labor cost by
installing a new machine. Two types of
machines are available in the market –
machine X and machine Y. Machine X
would cost $18,000 where as machine Y
would cost $15,000. Both the machines can
reduce annual labor cost by $3,000.
Which is the best machine to purchase
according to payback method?
Solution to Example 2
Payback period of machine X:

$18,000/$3,000 = 6 years
Payback period of machine Y:
$15,000/$3,000 = 5 years
According to payback method, machine Y is

more desirable than machine X because it
has a shorter payback period than machine
X.
The Benefit-Cost Ratio Method
Two heavily travelled interstate
highways currently intersect in the
middle of a major metropolitan
area. A 25-mile, four-lane bypass
is being considered to connect the
busy interstate highways at a point
outside of the metropolitan area.
The projected construction cost of
the bypass is $20 million. Annual and expanded opportunities for commercial
maintenance of the roadway is businesses are anticipated to be around $2
expected to be $500,000. Major million per year. This bypass would be state
monetary benefits of reduced owned and maintained and is therefore
time delays due to traffic considered a public project. In this chapter,
congestion, improved traveller you will learn how public projects such as
safety (fewer traffic accidents), this are evaluated using a benefit–cost ratio.
Before applying the B–C ratio
method to evaluate a public
project, the appropriate
perspective must be
established. In conducting an
engineering economic
analysis of any project,
whether it is a public or a
private undertaking, the
proper perspective is to
consider the net benefits to
the owners of the enterprise
considering the project
This process requires that the
question of who owns the project
be addressed. Consider, for
example, a project involving the
expansion of a section of road from
four to six lanes. Because the
project is paid for primarily with
funds channelled through the
DPWH, we might be inclined to say
that the federal government is the
owner. These funds, however,
originated from tax dollars—thus,
the true owners of the project are
the taxpayers.
Project benefits are defined as the favourable
consequences of the project to the public, but project
costs represent the monetary disbursement(s) required
of the government. It is entirely possible, however, for a
project to have unfavourable consequences to the public.
Considering again the widening of land, some of the
owners of the project—farmers along the interstate—
would lose a portion of their arable land, along with a
portion of their annual revenues. Because this negative
financial consequence is borne by (a segment of) the
public, it cannot be classified as either a benefit or a cost.
The term disbenefits is generally used to represent the
negative consequences of a project to the public.
Example 3
A new convention center and sports complex has been

proposed to the Gotham City Council. This public-sector
project, if approved, will be financed through the issue of
municipal bonds. The facility will be located in the City Park
near downtown Gotham City, in a wooded area, which
includes a bike path, a nature trail, and a pond. Because the
city already owns the park, no purchase of land is necessary.
List separately the project’s benefits, costs, and any
disbenefits.
Solution to Example 3.
BENEFITS
• Improvement of the image of the downtown area of the city
• Potential to attract conferences and conventions to the city
• Potential to attract professional sports franchises to the city
• Revenues from rental of the facility
• Increased revenues for downtown merchants of Gotham City
• Use of facility for civic events
COSTS
• Architectural design of the facility
• Construction of the facility
• Design and construction of parking garage adjacent to the facility
• Operating and maintenance costs of the facility
• Insurance costs of the facility
Solution to Example 3 .
DISBENEFITS
• Loss of use of a portion of the City Park to Gotham City
residents, including the bike path, the nature trail, and the pond
• Loss of wildlife habitat in urban area
The B–C ratio method involves the calculation of a
ratio of benefits to costs. Whether evaluating a
project in the private sector or in the public sector,
the time value of money must be considered to
account for the timing of cash flows (or benefits)
occurring after the inception of the project. Thus, the
B–C ratio is actually a ratio of discounted benefits to
discounted costs.
Conventional B–C ratio with PW:
.
𝑃𝑊(𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑜𝑠𝑒𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡)
𝐵−𝐶 =
𝑃𝑊(𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑜𝑠𝑒𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡)
𝑃𝑊(𝐵)
=
𝐼 − 𝑃𝑊(𝑀𝑉) + 𝑃𝑊(𝑂&𝑀)
.
where PW(·) = present worth of (·);

B = benefits of the proposed project;
I = initial investment in the proposed project;
MV = market value at the end of useful life;
O&M = operating and maintenance costs of the
proposed project.
Modified B–C ratio with PW:
𝑃𝑊(𝐵) − 𝑃𝑊(𝑂&𝑀)
𝐵−𝐶 =
𝐼 − 𝑃𝑊(𝑀𝑉)
Conventional B–C ratio with AW:
.
𝐴𝑊(𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑜𝑠𝑒𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡)
𝐵−𝐶 =
𝐴𝑊(𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑜𝑠𝑒𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡)
𝐴𝑊(𝐵)
=
𝐶𝑅 + 𝐴𝑊(𝑂&𝑀)
.
where AW(·) = present worth of (·);

B = benefits of the proposed project;
CR = capital-recovery amount (i.e., the equivalent
annual cost of the initial investment, I, including an
allowance for market, or salvage value, if any);
O&M = operating and maintenance costs of the
proposed project.
Modified B–C ratio with AW:
𝐴𝑊(𝐵) − 𝐴𝑊(𝑂&𝑀)
𝐵−𝐶 =
𝐶𝑅
Example 4
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
the addition of two air traffic controllers at an annual cost of
$100,000.
Annual benefits of the runway extension have been estimated as
follows:
Apply the B–C ratio method with a study period of 20 years and a
MARR of 10% per year to determine whether the runways at
Columbia Municipal Airport should be extended.
As can be seen in the preceding example, the difference between
conventional and modified B–C ratios is essentially due to subtracting the
equivalent-worth measure of operating and maintenance costs from both
the numerator and the denominator of the B–C ratio. In order for the B–C
ratio to be greater than 1.0, the numerator must be greater than the
denominator. Similarly, the numerator must be less than the denominator
for the B–C ratio to be less than 1.0. Subtracting a constant (the equivalent
worth of operating and maintenance costs) from both numerator and
denominator does not alter the relative magnitudes of the numerator and
denominator. Thus, project acceptability is not affected by the choice of
conventional versus modified B–C ratio. This information is stated
mathematically as follows for the case of B–C > 1.0:
Example 5
We will evaluate the bypass described in the beginning of the
chapter. The construction cost of the bypass is $20 million, and
$500,000 would be required each year for annual maintenance.
The annual benefits to the public have been estimated to be $2
million. If the study period is 50 years and the state’s interest rate
is 8% per year, should the bypass be constructed? What impact
does a social interest rate of 4% per year have on the B–C ratio of
the project?
At an interest rate of 8% per year, the conventional B–C ratio of

the proposed bypass is:
$2,000,000
𝐵−𝐶 = = 0.94
𝐴
$20,000,000 , 8%, 50 + $500,000
𝑃
Because this ratio is less than one, the bypass is not economically
acceptable at 8% interest. If a social interest rate of 4% per year
was used, the B–C ratio would be 1.40 and the bypass would be
acceptable.
REFERENCES:
Sullivan, w., et. al. (2015). Engineering Economy 16th Edition.

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Payback (Payout)

0 = −$13.5 million + $2.7 million (P/A, i′%, 40),

yielding i’% (the IRR) = 20% per year. The IRR

Payback period of machine X:

According to payback method, machine Y is

A new convention center and sports complex has been

where PW(·) = present worth of (·);

where AW(·) = present worth of (·);

At an interest rate of 8% per year, the conventional B–C ratio of

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