Cost/Benefit Analysis Review

1. Cost/Benefit Analysis Review • Cost/Benefit can done using NPW or EAW, pick one! (choose whichever method is easiest for the problem statement) • Criteria: Benefits – Disbenefits(to the public) • Costs(to the sponsor) • Benefits must outweigh costs, so if the B/C ratio is: • > 1 project is justified • = 1 barely justified – political • < 1 not justified • Alternative viewpoints complicate the process! • Terms: • Primary Benefits – easy to measure, change to $$ • Secondary Benefits – difficult to quantify (political) • Disbenefits – paid by public users (tolls, etc.) • Costs – 1st costs & salvage, O & M paid – revenues collected by sponsor

2. Incremental Analysis with B/C • Incremental Analysis MUST be used when comparing! (Cost/Benefit Ratio is a relative measure) • Caution: Must compare only feasible projects! • Steps: • Order projects by increasing TOTAL costs ANDeliminate any infeasible projects • Use first feasible project – becomes current best • Compare with Doing Nothing if that is an option • Do same “apples to apples” comparison for all • Pairwise Comparison on Incremental Cash Flow • If incremental B/C > 1, then higher cost is better • If incremental B/C ≤ 1, then lower cost is better • Note: There is NO modified B/C analysis on exam!

3. Replacement Review • Essentially, there are two aspects to replacement: • What is the economic service life of the replacement alternatives (challengers)? • What is the ownership life of the existing system (defender)? • Criteria: Choose the lowest EAC method today • Must take an outsider’s perspective when valuing the existing system • Terms: • Physical Life • Ownership Life • Economic Service Life • Accounting Life • Fair Market Value • Market Value • Trade-in Value • Book Value

4. Economic Service Life Review • Economic Service Life(ESL) is the length of time that minimizes the equivalent annual cost for the system • Relationship: Total EACTotal = EACownership + EACoperation • EACownership: • 1st Costs(A/P, i, N) – Salvage(A/F, i, N) • Typically decrease with longer lifetime (N) • EACoperation: • Annualized Operating + Maintenance Costs • Typically increase with longer lifetime (N) • Steps: • Find EACTotal for each year of remaining life (N = 1, 2, …) • Find the lowest cost lifetime (ESL) among EACtotal: • Plan to use until end of ESL year • Plan to replace at the start of the next year • The system with the lowest cost ESL is the best replacement Challenger!

5. Outsider’s Perspective Review • The outsider would have to purchase the existing system in order to use it – paying “Fair Market Value” • Priority Order: (& information sources) • Market Value • Independent Audit / Appraisal • Want/For Sale Ads in paper/trade magazine • Selling/Asking price at auction • Trade-In Value • Must use if accepting lower challenger price from vendor • Can shop around to different vendors • “Blue Book” price • Bank / Savings & Loan estimate • Book Value • Prefer Book depreciation to MACRS value

6. DEFENDER DIAGRAM: Salvage 1 2 3 n = Lifetime 0 Overhaul Cost Operating Cost Fair Mkt. Value Overhaul Cost Maintenance Cost Opportunity Cost Approach The fair market value of the defender will be treated as a cost to retain the defender (this is the opportunity cost that is foregone by retaining the defender)

7. Ownership Life Review • Ownership Life is the length of time to keep the existing system that minimizes the equivalent annual cost for the ongoing performance of the function • Decision is based on expected costsas known today • No sunk costs (original price doesn’t matter) • Relevant costs only (common costs are just clutter) • Steps: • Use the Opportunity Cost approach • (Fair Market Value appears as a cost on the Defender CFD) • Find ESL of the best Challenger option • Find each EACtotal up through the physical lifetime for the Defender: • Find the Ownership Life of the Defender • Plan to replace with the Challenger at the start of the next year: when the EACDefender > ESLChallenger