ES 312b – Engineering Economy 1st Sem S.Y.

2020-2021

PERSPECTIVE AND TERMINOLOGIES OF PUBLIC PROJECTS

Introduction

Public projects are those authorized, financed, and operated by federal, state, or
local governmental agencies. Such public works are numerous, and although they may be
of any size, they are frequently much larger than private ventures. Since they require the
expenditure of capital, such projects are subject to the principles of engineering economy
with respect to their design, acquisition, and operation. Because they are public projects,
however, a number of important special factors exist that are not ordinarily found in
privately financed and operated businesses. The differences between public and private
projects are listed as follows.

Table 1. Some Basic Differences Between Privately Owned and Publicly Owned Projects
Purpose
Sources of capital
Method of financing
Multiple purposes
Project life
Relationship of
suppliers of capital
to project
Private Public
Provide goods or services at a Protect health; protect lives
profit; maximize profit or
minimize cost
Private investors and lenders
Individual ownership;
partnerships; corporations
Moderate
Usually relatively short (5 to
10 years)
Direct
and property;
provide services (at no profit);
provide jobs
Taxation; private lenders
Direct payment of taxes;
loans without interest; loans
at low interest; self-
liquidating bonds; indirect
subsidies; guarantee of
private loans
Common (e.g., reservoir
project for flood control,
electrical power generation,
irrigation, recreation,
education)
Usually relatively long (20 to
60 years)
Indirect, or none

Nature of benefits Monetary or relatively easy to Often nonmonetary, difficult

equate to monetary terms to quantify, difficult to equate
to monetary terms
Beneficiaries of Primarily, entity undertaking General public
Project project

Conflict of purposes Moderate Quite common (dam for flood

Conflict of interests
Effect of politics
Measurement of
efficiency
Moderate
Little to moderate
Rate of return on capital
control versus environmental
preservation)
Very common (between
agencies)
Frequent factors; short-term
tenure for decision makers;
pressure groups; financial
and residential restrictions;
etc.
Very difficult; no direct
comparison with private
projects

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

As a consequence of these differences, it is often difficult to make engineering

economy studies and investment decisions for public-works projects in exactly the same
manner as for privately owned projects. Different decision criteria are often used, which
creates problems for the public (who pays the bill), for those who must make the decisions,
and for those who must manage public-works projects.

Perspective and Terminology for Analyzing

Public Projects
In conducting an engineering economic analysis of any project, whether it is a
public or a private undertaking, the proper perspective is to consider the net benefits to
the owners of the enterprise considering the project. This process requires that the question
of who owns the project be addressed.

Project benefits are defined as the favorable consequences of the project to the
public, but project costs represent the monetary disbursement(s) required of the
government. It is entirely possible, however, for a project to have unfavorable
consequences to the public. The term disbenefits is generally used to represent the
negative consequences of a project to the public.

Self-Liquidating Projects
The term self-liquidating project is applied to a governmental project that is expected
to earn direct revenue sufficient to repay its cost in a specified period of time. Most of
these projects provide utility services—for example, the fresh water, electric power,
irrigation water, and sewage disposal provided by a hydroelectric dam. Other examples
of self-liquidating projects include toll bridges and highways.

Multiple-Purpose Projects
An important characteristic of public-sector projects is that many such projects
have multiple purposes or objectives. One example of this would be the construction of a
dam to create a reservoir on a river. This project would have multiple purposes: (1) assist
in flood control, (2) provide water for irrigation, (3) generate electric power, (4) provide
recreational facilities, and (5) provide drinking water.

Developing such a project to meet more than one objective ensures that greater overall
economy can be achieved. Because the construction of a dam involves very large sums of
capital and the use of a valuable natural resource—a river—it is likely that the project
could not be justified unless it served multiple purposes. This type of situation is generally
desirable, but, at the same time, it creates economic and managerial problems due to the

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

overlapping utilization of facilities and the possibility of a conflict of interest between the
several purposes and the agencies involved.

Difficulties in Evaluating Public-Sector Projects

There are a number of difficulties inherent in public projects that must be considered in
conducting engineering economy studies and making economic decisions regarding those
projects. Some of these are as follows:
1. There is no profit standard to be used as a measure of financial effectiveness. Most
public projects are intended to be nonprofit.
2. The monetary impact of many of the benefits of public projects is difficult to quantify.
3. There may be little or no connection between the project and the public, which is the
owner of the project.
4. There is often strong political influence whenever public funds are used. When
decisions regarding public projects are made by elected officials who will soon be
seeking reelection, the immediate benefits and costs are stressed, often with little or no
consideration for the more important long-term consequences.
5. Public projects are usually much more subject to legal restrictions than are private
projects. For example, the area of operations for a municipally owned power company
may be restricted such that power can be sold only within the city limits, regardless of
whether a market for any excess capacity exists outside the city.
6. The ability of governmental bodies to obtain capital is much more restricted than that
of private enterprises.
7. The appropriate interest rate for discounting the benefits and costs of public projects is
often controversially and politically sensitive. Clearly, lower interest rates favor long-
term projects having major social or monetary benefits in the future. Higher interest
rates promote a short-term outlook whereby decisions are based mostly on initial
investments and immediate benefits.

What Interest Rate Should Be Used for Public Projects?

When public-sector projects are evaluated, interest rates∗ play the same role of
accounting for the time value of money as in the evaluation of projects in the private
sector. The rationale for the use of interest rates, however, is somewhat different. The
choice of an interest rate in the private sector is intended to lead directly to a selection of
projects to maximize profit or minimize cost. In the public sector, on the other hand,
projects are not usually intended as profit-making ventures. Instead, the goal is the
maximization of social benefits, assuming that these have been appropriately measured. The
choice of an interest rate in the public sector is intended to determine how available funds
should best be allocated among competing projects to achieve social goals.

Three main considerations bear on what interest rate to use in engineering

economy studies of public sector projects.
1. The interest rate on borrowed capital
2. The opportunity cost of capital to the governmental agency
3. The opportunity cost of capital to the taxpayers

As a general rule, it is appropriate to use the interest rate on borrowed capital as

the interest rate for cases in which money is borrowed specifically for the project(s) under

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ES 312b – Engineering Economy 1st Sem S.Y. 2020-2021

consideration. For example, if municipal bonds are issued specifically for the financing of
a new school, the effective interest rate on those bonds should be the interest rate.

Figure 1. Relative Differences in Interest Rates for Governmental Agencies, Regulated Monopolies, and
Private Enterprises

For public-sector projects, the opportunity cost of capital to a governmental agency

encompasses the annual rate of benefit to either the constituency served by that agency or
the composite of taxpayers who will eventually pay for the project. If projects are selected
such that the estimated return (in terms of benefits) on all accepted projects is higher than
that on any of the rejected projects, then the interest rate used in economic analyses is that
associated with the best opportunity forgone.
If this process is done for all projects and investment capital available within a
governmental agency, the result is an opportunity cost of capital for that governmental agency.
A strong argument against this philosophy, however, is that the different funding levels
of the various agencies and the different nature of projects under the direction of each
agency would result in different interest rates for each of the agencies, even though they
all share a common primary source of funds—taxation of the public.
The third consideration—the opportunity cost of capital to the taxpayers—is based on the
philosophy that all government spending takes potential investment capital away from
the taxpayers. The taxpayers’ opportunity cost is generally greater than either the cost of
borrowed capital or the opportunity cost to governmental agencies, and there is a
compelling argument for applying the largest of these three rates as the interest rate for
evaluating public projects; it is not economically sound to take money away from a
taxpayer to invest in a government project yielding benefits at a rate less than what could
have been earned by that taxpayer.

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