Public Sector Decision Making Part B: University of Toronto

Department of Chemical Engineering
and Applied Chemistry

University of Toronto
Course: CHE349
File: CHE349/PubSectorB19
Copyright: Joseph C. Paradi
1996-2004
Centre for Management of Technology and Entrepreneurship
Public Sector Decision
Making Part B
#
Course: CHE349 Centre for Management of Technology and Entrepreneurship
Highway Construction
Should a Right-of-Way at a dangerous intersection be built?
Construction cost $20,000,000
Annual Maintenance $350,000
Repaving every 8 years at a cost of $3,000,000
Value of lives saved annually $1,000,000
Annual time savings for commercial traffic $1,250,000
Value of time saved for commuters annually $1,000,000
Right-of-way land salvage value is $5,000,000
Discount rate 10%
Horizon 40 years
Benefits = $1M + $1.25M + $1M = $3.25M
Costs = 20M(A/P,10%,40) + 0.35M + 3M(A/F,10%,8) -5M(A/F,
10%, 40) - 3M(A/F,10%,40)
= 2.046M+0.35M+0.262M-0.0113M-0.0068M = $2.64M
B/C = 3.25M / 2.64M = 1.23 - so it is a go
#
Several Projects to Choose
From using Incremental B/C
There are two incorrect decisions in ranking projects:
selecting the largest B/C ratio
selecting the largest project whose B/C meets criteria
For mutually exclusive alternatives, we have to do an
incremental B/C analysis.

This process is exactly the same as we have seen before for
IRR.

In incremental analysis all "portions" of the investment must
perform to the IRR or MARR threshold we want. We start with
the smallest initial cost project that meets the requirement and
then look at the additional opportunities.
#
Incremental B/C Continued
PRESENT WORTH - all in Millions
Project B C B - C B/C Comment
A $3 $1 $2 3.0 Highest B/C
B 10 5 5 2.0
C 13 9 4 1.44
D 18 14 4 1.29
E 26 19 6 1.32 Best - max PW
F 30 27 3 1.11 Largest w B/C>1

Project PW(B) PW(C) Incremental B/C
A vs. Null 3 1 3/1 = 3.0
A vs. B 7 4 7/4 = 1.75
B vs. C 3 4 3/4 = 0.75
B vs. D 8 9 8/9 = 0.89
B vs. E 15 14 15/14 = 1.07
E vs. F 5 8 5/8 = 0.63
#
Selection with Constraints
Governments just like corporations have budgetary limits, so a
selection of a subset of desirable projects must be made - once
again using the IRR process.
Selecting on the basis of B/C ratio is incorrect - see example
(i=15% for B/C, life in yrs.)
Proj 1st-Cost AnnBen Grad Life IRR B/C
A(3) 400 -100 70 10 22.7 1.72
B 300 100 -5 25 27.3 (2) 1.52
C 250 80 -5 15 23.9 (4) 1.34
D(1) 500 70 10 40 22.8 1.80
E 350 0 30 10 21.9 1.46
F 200 50 0 20 24.7 (3) 1.56
G(2) 125 - 90 20 30 17.1 1.79
H 250 100 -7 50 31.0 (1) 1.43
#
Selection with Constraints
Continued
This Government agency has a budget for the current year of
$1,000,000 and asked us to recommend which projects from
the list they should choose.
To try to decide which of these projects should be funded we
will use two different methodologies:
When ranked on the B/C ratio basis, we get:
D,G,A,F,B,E,H and C; the first 3 have a combined FC of $1,025,000
Then, on the IRR basis:
H,B,F,C,D,A,E and C; the first 4 has a combined FC of $1,000,000
But when the capital budget is at $1M the MARR is 23%. If the
B/C was calculated at 24% the B/C ranking could have been
used. But this is only after the IRR ranking shows the real
MARR for the case.
#
Value of Life
How much is a life worth?
Many projects have to consider the lives saved as a benefit
and put a price on it.
in wrongful death cases, the PV of the persons future earnings is
usable.
sometimes the break even value of a life can be calculated (cost per
fatality)
Young engineer dies - she is married and has a child
salary is $45,000 / year, salary grows $1,000/year constant value
dollars, age 35, retirement at 65, i = 6%
P = 45,000(P/A, 6%, 30) + 1,000(P/G, 6%, 30)
= 45,000 * 13.765 + 1,000 * 142.36
= $761,800
But this is not taking emotional values into account!
#
Cost of Life in Government
Projects
The following is a highway improvement project:
present rate is 8 deaths/100M vehicle miles
adding another lane reduces this to 5 deaths/100M along with
proportional reduction in other accidents; for each fatality have:
40 non-fatal injuries @ $15,000 present cost each.
300 property damage accidents @ $2,000 each.
Interest is at 8%
Road costs $1.5M per mile and 3% /yr maintenance
life cycle is 40 years, there are 10,000 vehicles/day
EAC
mile
= 1.5M(A/P, 8%, 40) + 45K = $170,800
$170,800 = (3/8) * 0.292(Life + 40 * 15K + 300 * 2K)
Thus, here a life is worth = $359,800
What we want is the lowest cost per life because that is the
best way to spend taxpayers' money - more can be
saved/dollar
#
Another Highway Project
The Government of Ontario plans to rebuild a particularly dangerous curve in
a local highway to avoid the many accidents the current road configuration
seems to cause. The cost information available is:
the right-of-way for a new highway will cost $1.5 Million
Road construction will be $2.5 Million
Paving is $1.2 Million
Road must be repaved every 25 years
Road maintenance is $250,000 per year
Project horizon is 25 years
Discount rate is 8%
Benefits of this new road are expected to be
Travellers time savings to be $300,000 per year
The accidental deaths will be reduced by 0.5 per year
12 less personal injury accidents at $12,000 per injury
90 less property damage accidents at $1,500 per accident.
Now calculate how much a human life is worth.
EAC = 5.2M(A/P, 0.08, 25) + 250,000 -300,00 = 437,240
437,240 = 0.5Life + 12*12,000 + 90*1,500
437,240 - 279,000 = 0.5Life 316,480 = Life
#
Cost Estimate for a Highway
Improvement
The Province of Ontario's Department of Transportation and
Communications is considering a proposal for an additional turning lane at a
busy intersection:
The added maintenance costs will be $3,000 annually
10 year horizon.
The time saving for motorists is valued at $4,000 per year.
The improved traffic flow is estimated to save 0.8 lives per year and a life is
worth $359,000.
Use a 12% interest rate.
How much should the Government pay for this improvement?
So here we set the Benefit Cost Ratio B/C =1.0
Value of savings in human life = 0.8*359,000 = 287,200
EAB = Total savings per year = 287,200 + 4,000 = $291,200
B/C = 1 = 291,200 / [FC(A/P, 12% , 10) + 3,000]
291,200 - 3000 = FC * 0.1770
288,200 /0.177 = $1,628,000
#
Budget Constraints in Selection
The Province of Ontario is willing to invest $16,500,000 to highway safety
projects. Their Engineers and Economists are asked to determine how to
best spend this money with saving lives as the top objective. Here are the
details of these projects:
Project Total Cost Life Years Saved/yr* Life Cost
Rank
A 450,000 14 32,143
3
B 750,000 20 37,500
4
C 1,200,000 14 85,714
8
D 700,000 10 70,000
7
E 1,100,000 18 61,111
6
F 3,000,000 96 31,250
2
G 6,000,000 206 29,126
1
H 6,000,000 156 38,462
5

* Note: A "life year" is one person's life for a year, so a 30 year old person
has 30 life years. This is another way to say that we are saving a "life" but
represents only one year of a person's life.
#
Budget Constraints in Selection -
Continued
Now we choose on the basis of the cheapest lives first, then to use up as
much of the cash as possible:

Project Cost Running total Life Years Total life Years
G 6,000,000 6,000,000 206 206
F 3,000,000 9,000,000 96 302
A 450,000 9,450,000 14 316
B 750,000 10,200,000 20 336
H 6,000,000 16,200,000 156 492
#
Multiple Angles to Highway
improvements
The Province of Alberta is considering widening lanes on major
highways from 6 meters to 7.5 meters to reduce accidents.
The following data is available for this project:

Accidents per 100,000,000 vehicle km in 6 m lanes 150
Accidents per 100,000,000 vehicle km in 7.5 m lanes 90
Serious personal injuries per accident 10%
Average non-human cost per accident $2,500
Annual road use (vehicles) 7,500,000
First costs per kilometre $175,000
Operating and Maintenance per km/year $7,500
Project life 25 years
MARR 10%
#
Multiple Angles to Highway
improvements
a. Compute the PW of costs of the lane widening.
b. Find the PW of savings of non-human accident costs.
c. What is the minimum value for a serious personal injury that
would justify the project?
Note all calculations on a per kilometre basis
(a) PW = - 175,000 - 7,500(P/A, 10%, 25)
=-175,000-7,500(9.077)=-75,000-68,077= -243,077
(b) 7,500,000/100,000,000*(150-90)=4.5 serious injuries
PW=4.5*2,500(P/A,10%,25)=11,250(9.077) = $102,116
(c) Now, we have -243,077 + 102,116 = $140,961
but we have 10% serious accidents, this is 0.45, therefore
EAW=140,961(A/P,10%,25)=140,961(0.11017) = $15,530
Then, human cost is 15,530/0.45 = $34,510
#
Multiple Design Choices
An old wooden bridge over a bay is in danger of collapse. The highway
department is currently considering two alternatives to alleviate the situation
and provide for expected increases in future traffic. One plan is a
conventional steel bridge, and the other is a tunnel under the bay. The
department is familiar with bridge construction and maintenance, but has no
experience with maintenance costs for tunnels.
The following data has been developed for the bridge:
First cost $17,000,000
Painting every 6 years $1,000,000
Deck resurfacing every 10 years $3,000,000
Structural overhaul at the end of 15 years $4,000,000
Annual maintenance $300,000
The tunnel is expected to cost $23,000,000 and will require repaving every
10 years at a cost of $2,000,000. Both designs are expected to last 30 years
with negligible salvage value.
#
Continued 1
(a)Determine the maximum value of the equivalent annual costs of other
maintenance for the tunnel (except repaving) so that the tunnel would be
chosen instead of the bridge. Let i=7 %.
Solution:
EAC
BR
= 9000*(A/P,7%,30)+1000*(A/P,7%,6) +3000*(A/P,7%,10)
+4000*(A/P,7%,15)+300=2,101.6
EAC
TU
= 21000*(A/P,7%,30)+2000*(A/P,7%,10)=1977.4
So the other yearly maintenance costs can be up to 2,101.6 - 1977.4 =
$124,200, and the tunnel will still be preferred.
Very important to note the method of braking the Main FC into its
components (remember we are using EAC here):
$9M is not repeated so use it as a 30 year component
$1M is redone every 6 years
$3M deck resurfacing every 10 years
$4M structural overhaul every 15 years
One of each of the repeated component is included in the FC
#
Continued 2
(b) Assume instead that we have some information about the yearly tunnel
maintenance costs, which is that it is expected to be as low as $80,000 with
a probability of 20%, medium cost $100,000 with a probability of 50% or
high at $150,000 with a probability of 30%. Which solution will now be
preferred?
Solution: E(A)=0.2*80+0.5*100+0.3*150=111
which is < 124.2 so this means that the tunnel will be preferred.
(c) Politicians worry more about re-election next year than the future costs
resulting from their decision, they want the lowest FC solution. Also, they
realise, that they can save $2,000,000 on the FC by omitting a certain safety
feature. This results in one fatal accident every 10 years. How much can
they pay out in compensation to the relatives of the dead at the end of year
10, 20 and 30 respectively (equal amounts, so this resembles an annuity),
and still be cheaper than the safety feature? Interest rate i=7.2 % (and
transform this into the 10-year interest rate). Ignore any inflation
considerations.
Solution: i=7.2%, i
10
=1.072
10
-1=100%
2,000,000=A*(P/A,100%,3), A=2,000,000/0.875= $2,285,714
#
Multiple Choices, Payers and
Politics
North Bay wants to attract the Winter Olympics, so they need to build speed
skating facilities - have two choices as follows:
Expenditure Ice Palace Temporary inflatable rink
Facility cost $20,000,000 $5,000,000
Salvage Value 0 $1,000,000
Extra practice rink 0 (included) $4,000,000
Annual O&M $1,000,000 $50,000
N = 40 years, 1 Olympics and 39 City use, i=10%
Temporary inflatable rink (and cinder track after the Olympics):
PW
OLY
= -5M +4M + 1M(P/F,10%,1) = -$8.04M
PW
NB
= -50K(P/A, 10%,39)(P/F,10%,1) = -440K
Ice Palace - two cases, Olympics Pays all or just the $8.04M
PW
OLY
= -20M and PW
NB
= 1M(P/A,10%,39)*(P/F,10%,1) = -8.87M
PW
OLY
= -8.04
PW
NB
= -20M + 8.04M -8.87M = -20.83M
So the choice is easy - except if the Ice Palace is not built, the Olympics
may not be warded to North Bay.

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