EVALUATION OF ALTERNATIVE TRANSPORTATION PLANS

COURSE FOR ROADS AND AERODROMES ENGINEERS

COMMONWEALTH DEPARTMENT OF WORKS
Keith Linard, B Eng, B Comm, BTRP, IEAust
Senior Engineer, Transport Operations & the Environment

Australian Department of Housing & Construction, Central Office.

August 1973

KEYWORDS:
Cost Benefit Analysis; CBA; Economic Evaluation; Transport Economics

ABSTRACT:
This lecture and the one immediately following are concerned with the evaluation of

alternative transportation plans. Although such examples as I give will be from the field
of transportation, primarily road transportation, the principles I enunciate are directly
applicable to any field of engineering planning.

This first lecture is fairly general in its approach. I intend to put to you what I consider
to be the framework of values and goals within which project evaluation should take

place; I will then discuss in general terms the various methodologies in current use for
project evaluation.

The second lecture will be confined to a discussion of the merits of economic

evaluation of engineering projects as a tool in decision making.

Table of Contents

KEYWORDS:..................................................................................................................................................................................... 1

ABSTRACT: ...................................................................................................................................................................................... 1
TABLE OF CONTENTS ................................................................................................................................................................... 3
FIGURES ............................................................................................................................................................................................ 4
TABLES .............................................................................................................................................................................................. 4

EVALUATION OF ALTERNATIVE TRANSPORTATION PLANS .......................................................................................... 5

Rationale for Evaluation......................................................................................................... 5

Indifference Curves and Utility Maximisation....................................................................... 5

Goal Structure of an Evaluation ............................................................................................. 8

Values ................................................................................................................................. 9
Goals ................................................................................................................................... 9

Objectives ........................................................................................................................... 9

Criteria ................................................................................................................................ 9
Standards .......................................................................................................................... 10

Interrelationship ................................................................................................................ 10

CURRENT APPROACHES TO TRANSPORTATION PLAN EVALUATION ...................................................................... 10

Two Frameworks for Plan Evaluation: Efficiency and Effectiveness ................................. 10

Plan Efficiency Criteria ........................................................................................................ 11

Investment Analysis - Financial ....................................................................................... 11

Investment Analysis - Economic ...................................................................................... 11

Plan Effectiveness Criteria ................................................................................................... 12

Checklist of Criteria.......................................................................................................... 12

Goal Achievement ............................................................................................................ 12

Planning Balance Sheet .................................................................................................... 13

ECONOMIC EVALUATION - A BRIEF RESUME OF PROCEDURES .................................................................................. 14

Derivation of Economic Evaluation Techniques ................................................................. 14

Deficiencies in Economic Evaluation Techniques ............................................................... 14

ECONOMIC EVALUATION METHODOLOGIES ..................................................................................................................... 15

Annual Cost:......................................................................................................................... 15

Benefit Cost Analysis (BCR) ............................................................................................... 16

Net Present Value Method ................................................................................................... 16

Internal Rate of Return Method: .......................................................................................... 16

CRITIQUE OF ECONOMIC METHODS .................................................................................................................................... 17

Benefit-Cost Ratio (BCR) .................................................................................................... 17

Net Present Value:................................................................................................................ 18

Internal Rate of Return: ........................................................................................................ 18

INFLATION AND ECONOMIC ANALYSIS ............................................................................................................................... 19

Discounting Future Costs and Benefits ................................................................................ 19

Sensitivity Analysis .............................................................................................................. 20

BIBLIOGRAPHY ........................................................................................................................................................................... 21

Figures

Figure 1: Contours of Equal Utility or Indifference Curves ..................................................... 6

Figure 2: Indifference Curves Relating to Non-Monetary Trade-Offs ...................................... 7
Figure 3: Budget Constraints and Optimal Resource Allocation............................................... 7
Figure 4: Conflicting Interest Groups with Differing Indifference Curves ............................... 8

TABLES

Table 1: Effect of treatment of non-capital costs on the BCR ................................................. 17

Table 2: Calculations of Net Present Value and Internal Rate or Return Method. .................. 19

EVALUATION OF ALTERNATIVE TRANSPORTATION PLANS

Rationale for Evaluation

Transportation is a sensitive and complicated process dependent on physical resources

and facilities, people and activities. If the transportation system is to achieve its goals in a
satisfactory manner it must be supplied with certain resources. It is with the allocation of
these human and material resources to processes such as transportation that we are concerned.
The need for the evaluation of alternative projects presupposes: that resources available for
use are limited. In particular evaluation presupposes that:
(1) available resources are insufficient to provide all the goods and services we would
like.
(2) there is competition between the transportation system and other activities for the use
of these scarce resources and,
(3) for any given transportation goal there are a number of mutually exclusive
alternatives, each with different demand for resources and each satisfying the various
transportation objectives to differing degrees.

This concept implies some kind of ordering of priorities. It is therefore necessary that
evaluation procedures be devised to enable the decision makers to make rational choices in
regard to allocating available resources such that the community wants are satisfied to the
greatest possible degree for a given outlay of public resources.
To illustrate the resource allocation problem in simple terms it is useful to consider briefly
the basic economic concepts of indifference curves and utility maximization.
Indifference Curves and Utility Maximisation

In brief these concepts imply, that given any two "goods", there will exist a number of
different combinations of these goods which will yield the same benefit or utility to any
particular individual, and between these combinations the individual will be indifferent to
which combination he chooses. In Figure 1, contour line U1 represents, for a given budget,
possible combinations of expenditure (in this case, expenditure on schools versus expenditure
on transport), which yield the same composite satisfaction or utility. The shape of the curve
will differ between individuals and, indeed, over time for the same individual.

Figure 1: Contours of Equal Utility or Indifference Curves

Obviously, with different budgets there will, be other combinations which yield higher or
lower utility. Figure 1 illustrates a possible set of "utility contours" or indifference curves.
Contour line U1 indicates all combinations of expenditure which yield utility U1. Other
contour lines, U2 and U3, indicate contours of higher utility based on higher available
budgets.

These actual shape of such indifference curves depend on the societal or cultural values; in
this case, for example, the value individuals and society place on equality of opportunity, on
economic growth, on cultural development would determine the relative trade-offs between
expenditure on education and transport.

This sort of "trade off" or substitution applies equally in decisions between different impacts
of alternative transportation projects. Consider, for example, the problem of deciding between
different transport routes which, in varying degrees, destroy sections of a unique
environment. The "trade-off" in this case, illustrated in Figure 2, might be between the
preservation of the environment and travel time, construction cost or operating cost. The
Indifference Curves U1, U2 and U3 represent different levels of aggregate resources applied
to the particular project.

Figure 2: Indifference Curves Relating to Non-Monetary Trade-Offs

Before any decision could be made on the "optimum trade-off" between these two public
goods, transport services and environmental services, it is also necessary to consider the
range of technical possibilities or the resource restraints. Consider, for example, the situation
where a transport authority has only $100 million to spend on a specific road project, to be
allocated (in this very simplistic example) between road construction and environmental
preservation. This is illustrated in Figure 3.

The authority is faced with the problem of apportioning this finance between the two options
to achieve the optimum distribution. Which raises the question optimum from whose
viewpoint? In the example depicted in Figure 3, the optimum distribution from the local
residents' viewpoint would be given by point of tangency between the budget line and an
indifference curve, indicated by point A. In this case this represents about $40 million for
transport system construction and $60 million for mitigation of social impacts,

Figure 3: Budget Constraints and Optimal Resource Allocation

Other individuals, or groups, would not be likely to have identical or even similar
indifference curves. The local residents' opinions are unlikely to coincide with the
preferences of drivers from other areas who want freeways through the area or even with the
preferences of residents living on the other side of the city. This changes the decision making
problems of the authority because there is no longer only one "optimum" distribution of
resources.
This situation is illustrated in Figure 4 where the indifference curves UL1 UL3 represent
those of hypothetical local resident affected by a proposed freeway. Their optimal trade-off
point is represented by A1, which is heavily skewed in favour of expenditure to mitigate
impacts. Indifference curves UC1 UC3 represent those of hypothetical freeway users and
their optimal trade-off point is at A2.

Figure 4: Conflicting Interest Groups with Differing Indifference Curves

The culminating step in any real evaluation process involves the decision maker in making
judgements about the worth of the consequences of alternative plans. Explicitly, when all
factors are consciously considered, or implicitly when there are hidden or obscure issues, this
judgement takes place within a framework that can be referred to as the goal structure of the
evaluation process. This goal structure provides the ideal, or set of ideals, against which the
"trade-offs" we have been looking at can be compared and weighted.
Goal Structure of an Evaluation

If transportation planning is undertaken within the framework provided by a

previously established value and goal hierarchy there will be greater likelihood that the
proposals will gain general community acceptance. Selecting transportation plans outside
such a framework, however, is likely to result in the implicit evaluation and choice of
objectives within the planning process. This may adversely affect the achievement of other
program goals and may lead to changes in regional environmental characteristics in directions
which do not, in fact, reflect the needs and desires of society.
With its predilection for design 'codes', planning and design 'standards' and with the ready
availability of computers for stretching trend projections and simulation studies to limits far
beyond the validity of the data available and the underlying assumptions of the computer

models, the engineering profession has a proclivity for overlooking the planning objectives to
which design standards and evaluation criteria should relate, and for ignoring the broader
community goals to which the planning objectives should relate.
It is essential, therefore, for planners to recognize the interrelationship between standards,
criteria, objectives, goals and values.
Values
Societal or cultural values could be defined as those 'irreducibles' which form the basic
desires and drives governing our behaviour. An enumeration of such 'invariants' which
constitute the value framework of our society might include, for example, the desire to
survive, the need to belong, the need for order and security. Urban form and function
contribute to our satisfaction and dissatisfaction insofar as they provide or limit opportunities
to develop behaviour patterns in support of our values. Clearly values are high level
abstractions, and it is therefore not possible to talk directly about a highway project in terms
of its consistency or conflict with our values.
Goals
Subservient to values there are certain idealized end states of the environment toward which
planners strive in their work. The idealized end states or 'planning goals', although less
abstract than values, are not close enough to a set of physical referents that their attainment
can be measured. Goals are generalized statements which broadly relate the physical or social
environment to values. Thus the goal of maximizing the mutual accessibility of points in
physical space may be viewed as being derived from the values of belonging and security.
Goals represent the first step toward 'operationalizing' values, but the mapping between
values and goals is not a unique one. Hence persons maintaining the same value set may have
different goals. As a consequence the derivation of goals from values is a complex task.
Objectives

An 'objective' is a specific statement which is the outgrowth of a goal and which is

truly attainable because of its reference to the real world and because it is stated in such a
way as to permit some form of measurement of the degree to which it has been attained.
Referring to the goal of maximizing mutual accessibility, one objective derived from this may
be that all residences within a city should be within a 500 metres of a public transport stop.
Again it is obvious that a number of complementary or conflicting objectives may be derived
from any given goal. Given a clear set of goals, the development of planning objectives is
still a complex task.
Criteria

'Criteria' are the specific measures or tests which reflect the degree of attainment of
particular objectives. Criteria result directly from the fact that the level of attainment of the
objectives of urban planning is directly measurable. They include quantitative tests which are
applied to alternative physical system plans in order to compare alternative systems and to

determine the degree to which they meet the specified objectives. The benefit-cost ratio is a
simple example of a commonly used criterion.
Standards

The minimum acceptable level of the criterion level, or the limiting grade of the
criterion test is known as a 'standard'. The standard represents that fixed level of attainment of
an objective which is the lowest level of attainment adoptable for a number of purposes.
Standards are useful in that they enable us to routinize decision making, but they may also
make the decision making process inflexible, particularly when they are not subjected to
periodic analysis and re-evaluation. In addition it is difficult to employ standards where
criteria deal with phenomena which are difficult to represent in quantitative terms, or which,
because of their particular nature, must be subjective.
Interrelationship

In terms of the preceding chain of interrelated definitions it is clear that the existence
of meaningful standards and criteria in the urban transportation planning process implies the
existence of specific objectives. Such objectives are valid only if they are derived from stated
goals, which in turn depend on social values.

Unless there is a clear, explicit and valid statement of planning objectives, then evaluation of
the relative effectiveness of alternative transport projects can become a meaningless exercise.
Without such a statement the construction of subjective rating or weighting formulae is of
little value. Without such a statement the validity of the planning process is liable to be called
into question by those affected by the proposals.
Current Approaches to Transportation Plan Evaluation

There is insufficient time available to look at the means for determination of

appropriate goals for transportation projects. Suffice it therefore to reiterate that the decision
maker must endeavour to establish clearly the goals of the planning process and to enumerate
explicitly the particular objectives of particular projects.
Assuming that this has been done, we are faced with the problem of developing or selecting
an appropriate evaluation methodology which considers satisfactorily the criteria which flow
from the objectives and goals.
Two Frameworks for Plan Evaluation: Efficiency and Effectiveness
There are two interrelated frames of reference within which alternative plans may be
evaluated. Firstly each plan should be considered in terms of the degree to which it is
expected to accomplish the tasks for which it is intended. These frameworks considers only
the effectiveness of the plan in meeting its objectives, and so plan effectiveness criteria are
concerned only with those costs and benefits directly related to the program goals and project
costs.
The second frame of reference is necessary because plans should also be evaluated in terms
of the relative value of the return resulting from their implementation. This is the basic issue

of "getting one's money's worth", and is termed the plan efficiency criterion. Plan efficiency
criteria relate to the relationship between some aggregate of all the benefits and the sum of all
the costs accruing from the project.
Such a separation is useful for two reasons; firstly it reflects the two basic categories of
evaluation procedures used today in transportation system planning, and secondly the
dichotomy simplifies the discussion of the evaluation process.
Plan Efficiency Criteria
Encompassed within this group are two basic methodologies:(1) Investment analysis - financial
(2) Investment analysis - economic

Investment Analysis - Financial

The feature of this method is that only the financial (i.e., monetary) costs and returns
directly of affecting the balance sheet of the investing or decision making body are relevant,
and the inevitable external costs or benefits are ignored.

Whilst this approach is generally more applicable to the private sector than the public sector,
this approach is used in some areas of Government investment, particularly in respect of
Government business operations.

This method is clearly extremely narrow as only a portion of the costs and benefits accruing
to the community as a whole are considered. Non quantifiable (in monetary terms) effects are
completely ignored.
Investment Analysis - Economic

This method would include cost-benefit analysis, rate of return analysis, comparison
of capitalized value etc. Basically these amount to listing all the benefits and costs from each
alternative plan, whether these are monetary benefits or costs or for example environmental
or social benefits or costs, and then comparing results. As far as possible the consequences of
each plan are detailed in monetary terms, and the assumption in this should be recognized.
Intangibles are treated in one of three ways.
First, they may be given a subjective weighting and appended to the monetary analysis.
Second, when this is not possible, verbal descriptions of intangible impacts may be provided.
Finally they can be ignored.
It is suggested that subjective weightings or verbal descriptions of intangible impacts will
make for less impact on the decision maker than "objective" metricized outputs. This
methodology therefore biases the selection process towards consequences which can be
measured in money terms.

Unfortunately the overall procedures appear to be so analytically objective that one tends to
think that all aspects of a plan can be and have been similarly characterized. They have an
image of sophistication that does not, in fact, exist at present. Most important of all, such

evaluation procedures refer only to the goal of economic efficiency, and other community
goals may get "short shift" because of the manner in which problems are considered.
Nevertheless such methods do play valuable part in providing informational support for
decisions.
Plan Effectiveness Criteria

Encompassed within this group are basic methodologies

(1) Checklist of Criteria

(2) Goal Achievement
(3) Planning Balance Sheet
Checklist of Criteria

This method is clearly illustrated by reference to a study by Kitching in relation to the

four sites selected by the Roskill Commission for the 3rd London Airport. He first
enumerates seven characteristics which one would ideally seek in siting a major international
airport: communication, noise impacts, population and industrial growth potential labour
costs, amenity and agriculture and services.
He then examines each of the four sites in relation to these criteria using such data as are
available and forms a judgement as to the order of choice in relation to each. From these he
ranks the sites from 1 to 4. From this table of crude, that is unweighted, rankling he draws
conclusions.

This is a crude, but in some circumstances useful, method for reducing the number of
alternatives. In other words it is most useful as a relatively quick sieve. Its prime drawbacks
include the fact that the incidence of advantages and costs is not brought out and that it is not
an optimizing method since it is not really applicable to searching for new alternatives.
Goal Achievement

There are a number of different approaches which can broadly be lumped under this
group. They have in common a simple approach: to what extent will the plans as designed
meet objectives which have been set in advance.

Perhaps the most comprehensive of these approaches is that developed by Hill with the Goal
Achievement Matrix. The characteristic of this method is that costs and benefits are always
defined in terms of goal achievement. Thus benefits represent progress toward the desired
objectives whilst costs represent retrogression from these objectives. These objectives must
be specified with respect to different locations and/or groups within the community. For each
objective and for each alternative course of action, costs and benefits are compared,
aggregated where possible, and reported separately. The approach presents the decision
maker with a matrix indicating the costs and the benefits associated with each objective. The
decision maker can then make decision with respect to trade-offs.

Alternatively, weighted indices of goal achievement can be predetermined, leading to a single

unequivocal result. The validity of this, however, is dependent on the validity of the
weighting and of the measurement scales employed.

Hill's method assumes that benefits and costs have meaning only in relation to a well-defined
objective, and hence a criterion of maximizing net benefits in the abstract would be
meaningless. Whereas benefits can be computed referring to different planning objectives,
these benefits and costs are not necessarily additive or comparable. It is meaningful to add or
compare costs and benefits only if they refer to a common objective. Furthermore, since
benefits and costs can legitimately be compared only in terms of an objective, if the objective
is of little or no value either for an entire community or for any sections within it, then the
benefits and costs referring to such an objective are irrelevant. For example, if the community
as a whole and all interests within it place no value on the retention of historic buildings, it is
not legitimate to place any value on their retention.
This basic problem with this approach lies in the identification of and selection of goals.
Goals may be conflicting; there may not be unanimous agreement on what the goals are; and
certainly the relative significance of different goals will vary.
Planning Balance Sheet

This approach, developed by Lichfield in the early 1960's for evaluating alternative
urban development plans, in effect is a modification of the cost/benefit approach. The
traditional cost benefit approach in effect considers only the goal of economic efficiency; this
technique attempts to consider all benefits and costs with respect to all community goals in
one enumeration. This balance sheet of costs and benefits is intended to enable the choice of
a course of action which in some way will maximize the achievement of community goals.
In Lichfield's words this method enables the decision-maker to balance the monetary costs
and benefits with the intangible costs and benefits. By indicating the incidence of costs and
benefits, the analyst identifies the sections of the community that will bear the costs and the
sections which reap the benefits. The balance sheet will also enable the decision makers to
appraise those elements in design which are high in cost or low in benefits.

This differs from Hill's approach in that the planning balance sheet rejects Hill's contention
that benefits and costs have only instrumental value in respect of predefined objectives. The
Planning Balance Sheet seeks to enumerate all costs and all benefits and to classify these
according to the beneficiaries.

ECONOMIC EVALUATION - A BRIEF RESUME OF PROCEDURES

In this lecture I will comment briefly on the strengths and weaknesses of methods of
economic evaluation and then look at some of the specific draw backs of each of the main
methods.
The objective of this lecture is to communicate that, although these methods are valuable
tools for the decision-maker, their assumptions and limitations must be recognized.
Derivation of Economic Evaluation Techniques

Benefit Cost and similar methodologies find their status to legitimacy in theoretical
welfare economics, from which they are derived. Theoretical welfare economics may be
defined as that branch of economics which endeavours to formulate propositions by which
we may rank, on the scale of better or worse, alternative economic situations open to society.
The goal of traditional economic evaluation processes could be defined as the maximisation
of the net project contribution to the national income.
These methodologies are conceptually derived from the theory of the firm and the endeavour
of the firm to maximize profits. According to welfare economic theory, such private profit
maximization by individual firms in an economy of pure competition leads to optimal
community welfare.

Economic evaluation, then, in relation to the public sector is conceptually designed to choose
not only the course of action which maximize "economic efficiency", but assumes in the
process that economic welfare is maximized. However, this is so only if the following
conditions are met:(1) Opportunity costs are borne by the beneficiaries in such a way as to retain the initial
income distribution.
(2) The initial income distribution is in some way the 'best'
(3) If the marginal social rates of transformation between any two commodities are
everywhere equal to their corresponding rates of substitution, except for the areas in
question, then welfare can be improved by intervention in the area in question.

The first condition is only partly feasible in most cases; the second is, at best, questionable;
and the third is improbable.
Thus, whereas cost-benefit analysis identifies the most efficient course in strict economic
terms, it is questionable whether this course of action maximizes economic welfare.

Economic evaluation therefore does not necessarily provide accurate guidance in allocating
investment among unlike projects, although in ranking or comparing courses of action
designed to attain roughly the same ends it is generally useful.
Deficiencies in Economic Evaluation Techniques

The main deficiencies in economic evaluation methods are as follows:-

(1) The evaluations do not consider the incidence of the costs or benefits.

(2) They assume that the marginal utility of a change in income is constant for all groups
in the community. That is, they assume that a $100 benefit to a millionaire has the
same social impact as a $100 benefit to an unemployed person.
(3) They are concerned only with the single narrow goal of maximization of national
product.
(4) Evaluations have not generally considered a full range of valid alternatives.
(5) Evaluations have been based on an uncritical acceptance of the view that current
conditions and trends will continue.
(6) Inadequate effort has been made to take intangibles into account in a systematic way.
(7) The listing of non-quantifiable factors with the supposedly "objective" economic data
inevitable results in inordinate weighting to the "objective" data.
(8) The assumptions relating to the costing" of intangibles (such as travel time, traffic
accidents, etc.) are hidden.
(9) There is often inconsistency in the evaluation of costs and benefits - for example
changes in vehicular travel time on a road may be measured, but changes in travel
time forced on pedestrians by the road improvement are ignored.
(10) Cost estimates, travel forecasts, accident forecasts, etc., which are the key inputs to
the evaluation process, are not generally as accurate or reliable as the "objective"
result would seem to indicate.
(11) Analysts have gone beyond their proper role (which is to present differences between
alternatives in explicit ways), and in cases where value judgements were critical the
analysts have wrongly assumed the role of decision-makers.

Perhaps the most dramatic case of formal evaluation providing misleading guidance
to decision-making is associated with the widespread rejection of urban freeway projects in
the United States. Their evaluations involved all of the errors listed above. Most critically the
assumption was made that if a freeway had more benefits than costs it should be built. Little
consideration was given to alternatives (such as those relating to public transport,
employment distribution, transport pricing, etc.). Higher returns could quite conceivably
result from selective investment in such areas.
It should be stressed that many of these criticisms can apply to any evaluation method, and
that many of them can largely be eliminated through modifications to the traditional
economic evaluation methodologies. Indeed this is what Lichfield's Planning Balance Sheet,
for example, attempts to do.
ECONOMIC EVALUATION METHODOLOGIES

We turn now to the specific economic evaluation methodologies. The four principal
techniques for analysing investments are:(1)
(2)
(3)
(4)

Annual Cost.
Benefit Cost Analysis
Net Present Value, and
Internal Rate of Return

Annual Cost:

In the method the capital and operating costs of a project are considered on an
equivalent annual cost basis. It is the annual cost of owning an asset computed over its entire

life. Once all alternative projects, including the do-nothing possibility, have been analysed,
the project with the lowest annual cost is selected as the most desirable.
The equivalent annual cost can be calculated as:

Asset Price x Discount Rate / 1-(1+Discount rate)-Number of Periods

It should be noted that benefits are not considered - it is therefore implicitly assumed that
benefits from all alternative investment projects are the same. Since the conditions under
which this occurs are pretty remote this method is ruled out as a general tool for economic
analysis.
Benefit Cost Analysis (BCR)

In this method the discounted present value of Benefits is divided by the discounted
present value of costs.
BCR = (Discounted Net Benefits) / (Discounted Costs)

If the B/C ratio is greater than 1.0, the benefits exceed the costs and the project is, ipso facto,
in some sense warranted. Conversely, if B/C ratio is less than 1.0 the benefits are less than the
costs and the project is not warranted.
In ranking an annual works program, projects with higher BCR desirably should have higher
priority over those with lower BCR
The BCR provides a useful means of ranking a schedule of projects. It is somewhat
problematic in evaluating mutually exclusive options.
Net Present Value Method

In this method, present and future costs and benefits are discounted to their present
and summed; the difference between the sums is computed. No project having a net present
value less than zero is acceptable and the project with the highest net present value is the
most desirable among mutually exclusive alternatives.
The Net present Value (NPV) =

{Net Period Cash Flow/(1+ Discount rate) Number of Periods } - Initial Investment

The discount rate used is the appropriate opportunity cost of capital or the minimum
attractive rate of return.

The Net Present Value method always gives the correct answer and should be preferred over
all other methods.
Internal Rate of Return Method:

In broad terms the rate of return method involves finding the discount rate at which
two alternatives to a problem have equal present worth. The first step is to find the rate of

return on each proposed investment, as compared with the solution requiring the least capital
outlay, which is often the status quo. Secondly, if the rate of return on the investment
requiring the smallest capital outlay exceeds an acceptable interest rate (e.g., opportunity cost
of capital) then tentatively accept that proposal. Next compute the rate of return on the
incremental outlay needed for the investment requiring the second lowest outlay. If the rate
exceeds the adoptable interest rate, accept the investment requiring the greater outlay in
preference to that requiring the lesser. Proceed by such paired comparisons based on rates of
return on incremental outlay to eliminate all but one investment.
The internal rate of return on a project is the "annualized effective compounded return rate"
or rate of return that makes the net present value of all cash flows (both positive and
negative) from a particular investment equal to zero. It can also be defined as the discount
rate at which the present value of all future cash flow is equal to the initial investment or in
other words the rate at which an investment breaks even.
The Internal Rate of Return is valid only in very specific and limited circumstances and
should always be avoided in project analysis.
Critique of Economic Methods

We have already rejected the Annual Cost Method since it fails to apply when
benefits of alternative projects are not equal.
Benefit-Cost Ratio (BCR)

The BCR, by itself, has little significance, and its relative value therefore is difficult
to understand or interpret. The significance of the difference between two projects having
BCR, for example of 1.05 compared with 1.10, is not as clear as the differences shown using
the Net Present Value method. This problem is compounded when projects with different
outlays are considered.

There is considerable ignorance regarding the definition of the numerator and denominator in
this equation. It can be shown that only those averted costs that are currently available to the
planning/construction agency properly belong in the calculation of net budgetary cost (i.e.,
the denominator) all other costs (e.g., environmental or social costs) must be considered as
negative benefits and included in the numerator.
For example consider Table 1, four mutually exclusive projects each with identical net
benefits. In the first definition of BCR, all costs (capital, operating and maintenance) are
included in the denominator. In the second definition of BCR, only capital costs are included
in the denominator, whilst changes in maintenance and operating costs are includes with
direct benefits in the numerator. Definition 1 sees Option 3 as the most desirable and Option
4 as the worst option. Definition 2 sees option 4 as the best option.
Table 1: Effect of treatment of non-capital costs on the BCR
Project
Project
Project
Project
Option 1 Option 2 Option 3 Option 4
$m
$m
$m
$m
-7
-20
-4
-2
Capital Cost
Direct Benefits

+11

+12

+6

+23

Changes in Operating Costs

Changes in Maintenance Costs

NET BENEFIT

BCR Definition 1:

Costs = Capital + Operating + Maintenance

Benefits = Direct Benefits only

Benefit Cost Ratio (BCR)

BCR Definition 2:

Costs = Capital
Benefits = Direct Benefits + Operating Cost
Savings + Maintenance Cost Savings

Benefit Cost Ratio (BCR)

-2

+4

+2

$1m

$1m

$1m

$1m

-10
+11
1.1

-11
+12
1.09

-5
+6
1.2

-22
+23
1.04

-7
+8

-20
+21

-4
+5

-2
+3

1.14

1.05

1.25

1.5

-1

+5

-3

-10

-10

It can be shown that the correct specification of BCR requires that only those costs directly
attributable to the project proponent (e.g., the State Road Authority or Municipal Council)
should be included in the denominator. This, however, is not intuitive and many evaluations
are in error in this regard.

Provided the costs are correctly treated, the BCR is very useful in ranking projects in a works
program. In comparing mutually exclusive project options, the Net present Value method is
to be preferred.
Net Present Value:

This method, if undertaken properly, will always give correct economic decisionmaking answers in a clear unambiguous manner.

It should be noted that the net present value method assumes that funds or returns obtained
from the project prior to the end of the evaluation period are re-invested at the rate equal to
the discount rate.
Internal Rate of Return:

Problems arising from this method are:(1) Difficulty for many to understand the concept of internal rate of return, etc.
(2) Inherent problems in analysis.
In relation to the first point, when dealing with purely financial transactions the concept of
internal rate of return is straight forward. The dollars are earned on an investment each year
can be reinvested. In relation to a transport project, however, where many of the returns are
social dollars, for example reduced air pollution or travel time savings, such benefits cannot
be reinvested.
This second point arises because re-investment aspects are generally handled implicitly and
assume that returns from the investment during the life of the project are re-invested for the
remainder of the project life at a rate equal to the rate of return. Thus, in the example in Table
2 the internal rates of return for Options 1 and 2 are 20% and 25% respectively. Assuming all

benefits from the options are actual dollars, the IRR methodology implicitly assumes that
these dollar benefits at the end of years 1 and 2 can be reinvested at 20% and 25%
respectively. There is rarely ever any justification for such an assumption. The NPV
methodology, on the other hand, assumes all project benefits are reinvested at the social time
preference rate of 5%.
TABLE 2: CALCULATIONS OF NET PRESENT VALUE AND INTERNAL RATE OR RETURN METHOD.

Project Option
1
-$100,000

Project
Option 2
-$100,000

Accruing at end of year 1

Accruing at end of year 2

$20,000
$120,000

$100,000
$31,250

Net Present Value for Two Year Period

$27,890

$23,580

5%
20%

5%
25%

Initial Capital Outlay - year 0

Annual Earnings or Benefits

Discounted Internal Rate of Return for Two year period

Cost of Capital

Implied Re-investment Rate

NPV. method
IRR method

Optimum Project
NPV Method
IRR Method

20%
5%

25%
5%

Option 1
Option 2

Inflation and Economic Analysis

It must be stated at the outset that inflation is irrelevant to economic analysis since all
costs, whether they occur now or fifty years hence, are measured in terms of todays resource
costs. That is to say that building costs for a project evaluated in the year 2000 but scheduled
to be constructed in 2030, for example, are measured in terms of 2000 dollars.
Allowance for price or cost changes with time is only made if there are likely changes in
relative resource costs. For example, if due to technological advances, the cost of computers
relative to the cost of other goods is predicted to fall or the cost of oil relative to other
resources is predicted to rise, then an appropriate allowance should be made. It is stressed
again that general inflation in price levels is implicitly taken into account by costing all
capital costs, social and environmental costs and all benefits in terms of today's resource
costs.
Discounting Future Costs and Benefits

It is generally held that people, both individually and collectively, prefer present
goods in preference to future goods, although a number of eminent economists have
challenged this assumption. Others have argued that while individuals might place less value
on future expenditures, if only because of the possibility of death, Government is "the trustee
of unborn generations as well as for its present citizens" and should therefore endeavour to
provide for the future welfare of both current and future generation in a more rational way
than would individuals.

Notwithstanding the above it is almost universal practice in economic analysis of projects to

value future costs or benefits (as measured in today's resource costs) at a lower figure than
identical costs or benefits incurred today. In other words future costs or benefits are
discounted at an appropriate rate to an equivalent present value. Thus if $F is a future cost
incurred n years hence and d is the appropriate discount rate, then the present value, PV, is:
PV =

F / (1 + d)n

The problem of what discount rate to use is one which has generated a vast amount of
literature. Even the theoretical basis on which the discount rate should be based is subject to
considerable dispute. Two fundamentally different approaches have been advocated: social
time preference (STP) and Social Opportunity Cost (SOC).

A social time preference function indicates a rate which expresses the consensus of the
electorate concerning the rate of discount applicable to particular areas of concern which they
wish to be applied to future costs and benefits emanating from Government projects. The
social opportunity cost on the other hand is a measure of the value to society of the next best
alternative use to which funds employed in a public project could otherwise be put. In both
cases there is considerable theoretical and practical difficulty in determining the discount
rate, and in the case of STP there is no valid reason to suggest that the discount rate should be
constant over time.
In the case of environmental benefits, the benefits are not-investable: some of the factors
being considered may be irreplaceable and if lost now are also lost for all future generations;
some health hazards may also be irreversible.
In circumstances like these there seems to be very little reason for proposing a high rate
of interest which by implication says that nothing that happens more than twenty years
from now needs to be taken into consideration when deciding on today's program.

Possibly a low rate should often be used for environmental factors and in some cases
even a negative rate might be appropriate." (OECD1973)

Sensitivity Analysis

The foregoing discussion has had the intention of illustrating some of the more
significant assumptions underlying the outwardly scientific appraisal of projects. Time costs,
accident costs, discount rates and many other basic parameters cannot be accurately
determined or predicted in the way that, for example, construction costs can be.
It is essential therefore that these limitations be recognized and stated. Perhaps of more
importance, where parameters are open to question, a range of rates (high, medium and low)
should be used in order to determine how sensitive the outcome of an analysis is to the value
of the parameter.

Bibliography

de Neufville, R and Stafford, J, 1974, Systems Analysis for Engineers and Managers,
McGraw Hill.

Flowerdew, ADJ, 1972, Choosing a Site for the Third London Airport: The Roskill
Commission Approach In Cost Benefit Analysis, R. Layard (ed), Penguin.

Hill, M, 1973, Planning for Multiple Objectives: An Approach to the Evaluation of

Transportation Plans. Technion.

Lichfield, N, 1971, `Cost Benefit Analysis in Planning: A Critique of the Roskill

Commission, Regional Studies, Volume 5, pp 157183.

Kitching, LC, 1969, Regional planning considerations, in Evidence Submitted at Stage III to
the Commission on the Third London Airport, Cambridgeshire et al., Ch. 2.

Nijkamp, P, 1975 A Multicriteria Analysis for Project Evaluation: EconomicEcological

Evaluation of a Land Reclamation Project Papers of the Regional Science
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Organization for Economic Co-Operation and Development, 1973, Effects of Traffic and
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