ENGR 3360U Winter 2014

Unit 16
Engineering Economic Analysis
in the Public Sector
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-07

Unit 16 EEA in the Public Sectors

Change Record
2014-I-07 Initial Creation

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2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
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Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
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10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Unit 16 Road Map

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16.1 Public decision factors

16.2 Interest rates in the public projects
16.3 BenefitCost Ratio
16.4 Conventional and Modified B/C
16.5 Incremental B/C
16.6 Financing, duration, and politics of
investments

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

16.1 Public Projects

Investment Objective

Purpose of investment in public projects can

sometimes be ambiguous.
General welfare of society
There are different perspectives to consider.

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Positive and negative effects

How do you measure benefits or

consequences?
The government answers to everyone.

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Viewpoint
Industry viewpoint consists largely of the
counting costs and benefits.

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External consequences are typically not considered

unless there is government regulation in that regard.

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Viewpoint
Government generally takes the viewpoint
of its constituents.

Municipality, province, and country

A viewpoint in the any problem is to take

the viewpoint at least as broad as those
who pay the costs and those who receive
the benefits.

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Costs can spread across different areas and

benefit local regions (bridges etc.).

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

15.2 Public Project Interest Rate

Setting an interest rate in the public sector is not as
clear-cut as doing so in industry.
Time-value of money

Some would argue that there is little or no time between

collecting money from tax payers and spending those tax
dollars.
As such there is a 0% interest rate

Cost of Capital

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Most levels of government borrow money in addition to

collecting taxes and as such the interest rate should be the
cost of borrowing money.

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Public Project Interest Rate, contd.

Opportunity Cost

Two types with government:

Government Opportunity Cost: Opportunity cost on best

opportunity foregone to government.
Taxpayer Opportunity Cost: Suggests that a taxpayer could have
invested that money instead of paying the taxes.

General rule of thumb:

Select the largest of the:

Cost of Capital
Government opportunity cost
Taxpayer opportunity cost

The government may also set guidelines.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

16.3 BenefitCost Ratio

Method used almost exclusively in public
investment analysis:
B/C Ratio = Equivalent worth of net benefits/Equivalent worth of costs

= PW benefits/PW costs
= FW benefits/FW costs
= AW benefits/AW costs

B/C ratio decisions:

B/C ratio is > 1.0 decision should be to invest
B/C ratio is < 1.0 decision should be not to invest
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

BenefitCost Ratio (EW=EQUIVALENT WORTH)

The conventional B/C ratio:
= EW of net benefits/(EW of initial costs + EW of operating and maintenance
costs)

Modified B/C ratio:

= (EW of net benefits EW of operating and maintenance costs)/EW
of initial costs

Both ratios will produce the same recommendation, but

the B/C ratios wont be the same.
Net benefits to users are:
Expected Benefits Disbenefits

Disbenefits are negatives effects on individuals or

groups.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Example 16-2
Show that the B/C ratio is the same for PW,
FW and AW for this highway project.
First cost
1.5M
Annual Maintenance
65K
Annual Benefits to drivers 225K
SV
300K
Life
30 years
IR
8%
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

PW
PWbenefits = 225(P/A, 8%, 30) + 300(P/F, 8%,
30) = 2.563M
PWcosts = 1500K + 65(P/A, 8%, 30) =
2.232M
B/C = 2.563/2.232 = 1.15

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

FW
FWbenefits = 225(F/A, 8%, 30) + 300 =
25.790M
FWcosts = 1500(F/P, 8%, 30) + 65(F/A, 8%,
30) = 22.460M
B/C = 25.790/22.460 = 1.15

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

AW
AWbenefits = 225 + 300(F/A, 8%, 30) = 227.6
AWcosts = 1500(A/P, 8%, 30) + 65= 198.2
B/C = 227.6/198.2 = 1.1

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

16.4 Modified B/C Ratio

B/Cmratio = [225(P/A, 8%, 30)+300(P/F, 8%,
30) -65(P/A, 8%, 30)]/1500 = 1.22

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

16.5 Incremental B/C Analysis

For multiple alternatives, it is not proper to
simply calculate the B/C ratios in the each
alternative.
Incremental BenefitCost Ratio Method:

Identify all relevant alternatives (optional).

Calculate the B/C ratio of each alternative.

Rank the order of projects:

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Ratios < 1.0 can be eliminated from further

consideration
Smallest to largest size of denominator

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Incremental B/C Analysis

Incremental BenefitCost Ratio Method
contd.

Identify increment under consideration.

Calculate B/C in the increment.

Incremental costs and incremental benefits

Use the incremental B/C to determine which is

the better alternative.
Iterate until all projects have been considered.
Select Best Alternative

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Lowest cost to next highest cost

Last justified alternative left

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

16.6 Other Public Project Effects

Project financing:

Smaller projects are fully funded through

taxation.
Larger projects may require borrowing through
bonds.

P3: PublicPrivate Partnership

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Needs identified by the government, who then

enters into an agreement with private industry.

2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Other Public Project Effects, contd.

Project Duration

Government projects often have long lives.

20 to 50 years or longer (museums, highways, etc.)

Large projects with large initial investment

Long lives reduce the effect of the large

investment.

Lower interest rates reduce the capital

recovery cost.
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2014-I-07

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Quantifying Effects
Many projects have difficulty quantifying
benefits.

Example: building a school

$ of benefit per person? Educational outcomes?

As a consequence of the difficulty in

verifying benefits and disbenefits, different
groups may quantify differently to support
their positions.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Project Politics
Political influences have an impact on

public projects.
Competing views and political support

Example: Economic development versus

environmental concerns?

Controversy
Long term projects versus short term

politicians
The role of politics is far-reaching in public
projects, as opposed to in industry projects.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Summary
Governments projects try to maximize benefits to
the public, while minimizing the disbenefits to the
public.
Legislative restrictions
Tend to be larger and affect more people and
groups
Interest rates in the public projects are more
complicated to determine or are legislated.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 16 EEA in the Public Sectors

Summary, contd.
Benefitscost ratio is a widely used method to
evaluate and justify government-funded projects.
For considering mutually exclusive alternatives,
incremental B/C analysis is used.
Two types of B/C ratios:
Conventional B/C ratio: operating and
maintenance cost in the denominator
Modified B/C ratio: operating and maintenance
cost in the numerator
Both provide identical recommendations.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco