VI-Economic Evaluation of Facility Investments

1. VI-Economic Evaluation of Facility Investments 1. Project Life Cycle and Economic Feasibility 2.Basic Concepts of Economic Evaluation 3.Costs and Benefits of a Constructed Facility 4.Interest Rates and the Costs of Capital 5.Investment Profit Measures 6.Methods of Economic Evaluation 7.Depreciation and Tax Effects 8.Price Level Changes: Inflation and Deflation 9.Uncertainty and Risk 10.Effects of Financing on Project Selection 11.Combined Effects of Operating and Financing Cash Flows 12.Public versus Private Ownership of Facilities 13.Economic Evaluation of Different Forms of Ownership

2. 6.1 Project Life Cycle and Economic Feasibility • Facility investment decisions represent major commitments of corporate resources and have serious consequences on the profitability and financial stability of a corporation. In the public sector, such decisions also affect the viability of facility investment programs and the credibility of the agency in charge of the programs. It is important to evaluate facilities rationally with regard to both the economic feasibility of individual projects and the relative net benefits of alternative and mutually exclusive projects.

3. 6.1 Project Life Cycle and Economic Feasibility • Four major aspects of economic evaluation will be examined: • The basic concepts of facility investment evaluation, including time preference for consumption, opportunity cost, minimum attractive rate of return, cash flows over the planning horizon and profit measures. • Methods of economic evaluation, including the net present value method, the equivalent uniform annual value method, the benefit-cost ratio method, and the internal rate of return method. • Factors affecting cash flows, including depreciation and tax effects, price level changes, and treatment of risk and uncertainty. • Effects of different methods of financing on the selection of projects, including types of financing and risk, public policies on regulation and subsidies, the effects of project financial planning, and the interaction between operational and financial planning.

4. 6.2 Basic Concepts of Economic Evaluation • A systematic approach for economic evaluation of facilities consists of the following major steps: • Generate a set of projects or purchases for investment consideration. • Establish the planning horizon for economic analysis. • Estimate the cash flow profile for each project. • Specify the minimum attractive rate of return (MARR). • Establish the criterion for accepting or rejecting a proposal, or for selecting the best among a group of mutually exclusive proposals, on the basis of the objective of the investment. • Perform sensitivity or uncertainty analysis. • Accept or reject a proposal on the basis of the established criterion.

5. 6.3 Costs and Benefits of a Constructed Facility • The basic principle in assessing the economic costs and benefits of new facility investments is to find the aggregate of individual changes in the welfare of all parties affected by the proposed projects. The changes in welfare are generally measured in monetary terms, but there are exceptions, since some effects cannot be measured directly by cash receipts and disbursements.

6. 6.3 Costs and Benefits of a Constructed Facility • Examples include the value of human lives saved through safety improvements or the cost of environmental degradation. The difficulties in estimating future costs and benefits lie not only in uncertainties and reliability of measurement, but also on the social costs and benefits generated as side effects. Furthermore, proceeds and expenditures related to financial transactions, such as interest and subsidies, must also be considered by private firms and by public agencies.

7. 6.4 Interest Rates and the Costs of Capital • Constructed facilities are inherently long-term investments with a deferred pay-off. The cost of capital or MARR depends on the real interest rate (i.e., market interest rate less the inflation rate) over the period of investment. As the cost of capital rises, it becomes less and less attractive to invest in a large facility because of the opportunities foregone over a long period of time.

8. 6.5 Investment Profit Measures • A profit measure is defined as an indicator of the desirability of a project from the standpoint of a decision maker. A profit measure may or may not be used as the basis for project selection. Since various profit measures are used by decision makers for different purposes, the advantages and restrictions for using these profit measures should be fully understood.

9. 6.5 Investment Profit Measures • There are several profit measures that are commonly used by decision makers in both private corporations and public agencies. Each of these measures is intended to be an indicator of profit or net benefit for a project under consideration. Some of these measures indicate the size of the profit at a specific point in time; others give the rate of return per period when the capital is in use or when reinvestments of the early profits are also included • Net Future Value and Net Present Value • Equivalent Uniform Annual Net Value • Benefit Cost Ratio • Internal Rate of Return • Adjusted Internal Rate of Return • Return on Investment • Payback Period

10. 6.6 Methods of Economic Evaluation • Net Present Value Method • Net Future Value Method • Net Equivalent Uniform Annual Value Method • Benefit-Cost Ratio Method • Internal Rate of Return Method

11. 6.7 Depreciation and Tax Effects • For private corporations, the cash flow profile of a project is affected by the amount of taxation. In the context of tax liability, depreciation is the amount allowed as a deduction due to capital expenses in computing taxable income and, hence, income tax in any year. Thus, depreciation results in a reduction in tax liabilities.

12. 6.8 Price Level Changes: Inflation nad Deflation • In the economic evaluation of investment proposals, two approaches may be used to reflect the effects of future price level changes due to inflation or deflation. The differences between the two approaches are primarily philosophical and can be succinctly stated as follows: • The constant dollar approach. The investor wants a specified MARR excluding inflation. Consequently, the cash flows should be expressed in terms of base-year or constant dollars, and a discount rate excluding inflation should be used in computing the net present value. • The inflated dollar approach. The investor includes an inflation component in the specified MARR. Hence, the cash flows should be expressed in terms of then-current or inflated dollars, and a discount rate including inflation should be used in computing the net present value.

13. 6.9 Uncertaninty and Risk • Since future events are always uncertain, all estimates of costs and benefits used in economic evaluation involve a degree of uncertainty. Probabilistic methods are often used in decision analysis to determine expected costs and benefits as well as to assess the degree of risk in particular projects.

14. 6.10 Effects of Financing on Project selection • Selection of the best design and financing plans for capital projects is typically done separately and sequentially. Three approaches to facility investment planning most often adopted by an organization are: • Need or demand driven: Public capital investments are defined and debated in terms of an absolute "need" for particular facilities or services. With a pre-defined "need," design and financing analysis then proceed separately. Even when investments are made on the basis of a demand or revenue analysis of the market, the separation of design and financing analysis is still prevalent. • Design driven: Designs are generated, analyzed and approved prior to the investigation of financing alternatives, because projects are approved first and only then programmed for eventual funding. • Finance driven: The process of developing a facility within a particular budget target is finance-driven since the budget is formulated prior to the final design. It is a common procedure in private developments and increasingly used for public projects.

15. 6.11 Combined Effects of Operating and Financing Cash Flows • A general approach for obtaining the combined effects of operating and financing cash flows of a project is to make use of the additive property of net present values by calculating an adjusted net present value.

16. 6.12 Public versus Private Ownership of Facilities • In recent years, various organizational ownership schemes have been proposed to raise the level of investment in constructed facilities. For example, independent authorities are assuming responsibility for some water and sewer systems, while private entrepreneurs are taking over the ownership of public buildings such as stadiums and convention centers in joint ventures with local governments. Such ownership arrangements not only can generate the capital for new facilities, but also will influence the management of the construction and operation of these facilities. In this section, we shall review some of these implications.

17. 6.13 Economic Evaluation of Different Forms of Ownership • While it is difficult to conclude definitely that one or another organizational or financial arrangement is always superior, different organizations have systematic implications for the ways in which constructed facilities are financed, designed and constructed. Moreover, the selection of alternative investments for constructed facilities is likely to be affected by the type and scope of the decision-making organization.