Course : CIVL6027 – Highway Engineering

Effective Period : September 2021

Principles of Economic Evaluation of

Road Based Projects
 Acknowledgement
These slides have been adapted from:

NZ Transport Agency, Economic Evaluation Manual,

First edition, Amendment 0

ISBN 978-0-478-35257-3 (print)

ISBN 978-0-478-35256-6 (online)
 Table of Contents

• Methods of Undertaking Financial Analysis…………………………………………………………………………….(3)

– Introduction
– Cost Benefit Analysis
– Externalities.
– Intangibles
– Double Counting
– Time value of Money
– Time Zero
– First Year Rate of Return (FYRR) Method
– Discounted cash flow method
– Net Present Value Method (NPV)
– Internal Rate of Return (IRR)
– Benefit/Cost Ratio BCR Method
– Incremental Benefit/Cost Ratios
• Economic Evaluation of Roading Projects ……………………………………………………………………..……….(31)
– Introduction
– Roading Improvement Benefits
– Costs
Methods of Undertaking Financial
Analysis
 Introduction

• Proposals to improve or extend existing transportation systems can range

from limited improvements, for example, the widening of a section of road
or the improvement of an intersection, to comprehensive proposals,
which involve the construction of significant sections of urban motorway
such as is required in the Auckland Region in the next 20+ years
• The decision on whether to adopt one specific proposal over another
makes the analysts job very complex because of the different social,
economic and environmental factors that must be considered
• To reduce the complexity of the task, economic techniques can be used as
an aid to decision making. This is done by placing a common measure of
value, usually money, on the parameters being considered. The analyst
then tries to list the costs and benefits associated with the factors that
need to be taken into account in making decisions about the project
 Cost Benefit Analysis

• Social cost benefit analysis usually called cost benefit analysis, is similar to
a conventional financial analysis undertaken for a business or private
individual except that the analysis takes account of the national viewpoint
and generally applies to publicly funded projects. In many cases returns and
to a lesser degree the costs are not as readily identified as in the private
sector and normally comprise costs and benefits to the wider community.
• In roading proposals, the savings in vehicle operating costs and in travel time
of their occupants and any predicted crash savings are the primary benefits
which result from investment.
• In summary, this analysis involves determining the various costs and
benefits associated with each project option over a certain evaluation
period, selecting the most economically advantageous option and then
comparing the result obtained with analyses of other projects as a means
of project selection.
 Externalities.

• Costs and benefits which are relevant to the project under consideration
but are not within the domain of the funding authority are termed
“externalities”. As cost benefit analysis is taken from a national viewpoint,
externalities should be identified and included in the analysis.

• E.g., Social cost of crashes

 Intangibles

• Costs and benefits which cannot readily be expressed in monetary terms are
known as “intangibles”. Examples are environmental factors such as visual
amenity, noise, atmospheric pollution and waterway and ecology pollution.
• Although it may be difficult to set a value on these intangibles as input to a
cost benefit appraisal, the study may provide an estimate of the social cost
of retention of environmental amenities, i.e..

• Water quality treatment to control sediment borne pollutants such as heavy

metals (lead, zing, copper, chrome, etc.).
• Noise barriers.
• Landscaping procedures
 Double Counting

• Care must be taken to avoid “double counting” of the benefits. For example,
improved road access to an area will result in road user savings which will
probably cause an increase in land values. Inclusion of the land value
increases as well as road-user savings in the assessment of benefits
arising from the investment would incorrectly inflate the value of the
benefits.
 Time value of Money

• Because of the earning potential of money, society places a higher value on

sums which are immediately available than those of equal amount playable
or receivable in the future. Thus, cash flows which occur at different times
cannot be directly compared and allowance is normally made by discounting
future sums to their present value.
• The concept of the time value of money arises from the application of
interest rates and is quite separate from price inflation. The latter is usually
handled by the use of “constant dollars”, i.e., making all cash flow estimates
in terms of today’s “purchasing power”.
 Time Zero

• It is usual that in any financial analysis all monetary costs and benefits be
expressed in terms of present-day values. In the Land Transport NZ PEM,
it is usual for this to be 1 July, 200x (where ‘x’ is related to the relevant
financial year) often called Time Zero.
 First Year Rate of Return (FYRR) Method

• The First Year Rate of Return (FYRR) only considers the benefits which accrue
in the first year following the construction of the project, and as such, no
allowance is made for the time value of money or costs incurred after the first
investment.

• Example -> next slide

 First Year Rate of Return (FYRR) Method

• As an example, if the capital cost for upgrading a 4 km section of road is

$50,000 and the net maintenance saving in the first year is $1,200 per
kilometer of road then:

FYRR = 0%
= 0%

= 9.6%

• This rate of return would be compared with a minimum value adopted for
roading work and a decision made as to whether to go ahead. If a reseal is
required in a few year’s time, then this is clearly not taken into account.
 Discounted cash flow method

• The Discounted cash flow method allows for all costs associated with a
project and the concept of present value of an operation carried out in the
future is used. The cost of an investment is subtracted from the incomes
and if the net present value is equal to, or greater than, zero, the proposed
improvement is accepted; if not, it is rejected.

• The method uses the theory of compound interest, that if a capital sum S is
invested and earns interest at a rate of I per annum, then after one year
the sum will have risen to:

S + Si, i.e., S(1 + i).

 Discounted cash flow method

• If the investment is retained then, after a second year the sum will have
risen to:
S(1 + i) (1 + i) or S(1 + i)2

• Therefore, after n years the sum will be

S(1 + i)n

• Thus if $10,000 is invested at 15% interest/annum then after 10 years the

sum will have risen to: 10000(1 + 0.15)10 = $40,450

• If 20 years, 10000(1 + 0.15)20 = $163,200

 Discounted cash flow method

• Conversely a roading project costing $40,450 which is due to be carried

out in 10 years time can be covered financially by investing $10,000 at 15%
interest today. Thus $10,000 is the present value of the roading project.
Therefore, in general a project costing $P in n years has a Net Present
Value (NPV) of:

NPV = …………………………...……(1)

• Extending this formula to a series for maintenance costing $P annually for

n years, the Net Present Value, i.e., the sum required to be invested now
to cover all the work is given by:
NPV = ……………………(2)
 Discounted cash flow method

• As an example, if $1,000/km is spent on maintenance annually, and the

interest rate i, is 15%, then the sum required for investment today, to
cover the maintenance cost over 20 years is given by:
NPV =
=

= 6.718 $1,000

= $6,718

If the rate is 12%, 10%, and 8%, the NPV is $7,909, $8,932, $10,206
respectively.

As the rate i decreases, more money (NPV) is needed

 Net Present Value Method (NPV)

• The costs are calculated for two (or more) alternative schemes C A, CB for each
year of the analysis period up to year N, using the discount rate selected and
expressions (1) and (2) above, which are typically the “do-nothing” scheme A
and an alternative scheme involving reconstruction B. The scheme involving the
greatest benefit is chosen. That is, solving the equation below for NPV; if the
equation is positive, road B is more economic than road A.

NPV = where:

NPV = Net Present Value of all costs associated with the project
to replace, say, road A by road B;
CA , C B = All costs incurred on Roads A and B in year n respectively;
N = The analysis period in years;
i = Discount rate.
 Internal Rate of Return (IRR)

• The costs are calculated for the full analysis period for alternative schemes
A and B as before, but NPV is made to zero to allow the equation to be
solved for i. The value i is the internal rate of return on the marginal
investment, that is, the additional investment required to replace road A
by road B.

• Here, if the internal rate of return is greater than some adopted preset
minimum rate of return (usually the test discount rate), then road B is
more economic than road A.
Benefit/Cost Ratio (BCR) Method
 Introduction

• In this method, which is most commonly used by Land Transport NZ, its
predecessors and Territorial Local Authorities, the costs C A, CB are
calculated up to year N for each year, but the construction capital costs
are calculated separately from al other costs. Any maintenance costs should
be allocated as non-capital cost. The NPV for capital and non-capital costs
are calculated using the selected discount rate, and the NPV of the non-
capital costs is divided by the NPV of the capital costs to give the
benefit/cost ratio. If the ratio is greater than 1.0, road B is more economic
than road A*, or it is assumed that scheme B will cost more than scheme
A.

*doesn’t mean you’ll get the funding, but it will be considered, to get funding
BCR ≥ 4
 Introduction

• Scheme A is often called the ‘do minimum’ option because it may consist only
of ongoing maintenance costs, defined as the lowest annual cost which allows
the road to continue to perform its function to a minimum acceptable
standard. It should be recognized that the ‘do nothing’ option is seldom a
practical course of action as if this option was considered it would accelerate
deterioration of the asset past minimum performance standards. The benefits
will include savings in highway user costs for s as travelling time and vehicle
operation which may either be expressed in graphical form or itemized; the
cost of accidents eliminated are also taken into account as a benefit by making
the improvement.

Benefit/cost ratio =
=
=
 National Benefit Cost Ratio

• The BCR of an activity is the PV of net benefits divided by the PV of net costs. An activity is regarded as economic
or worthy of execution if the PV of its benefits is greater than the PV of its costs, ie an activity is economic if the
BCR is greater than 1.0.
• The NZTA uses the national benefit cost ratio (BCRN) as a measure of economic efficiency from a national
perspective. In its basic form, the BCRN is defined as:

BCRN =

Where:
National economic benefits = net direct and indirect benefits and disbenefits to all affected transport users
plus all other monetised impacts
National economic costs = net costs to the NZTA and approved organisations (where there is no service
provider or non-government contribution)

net service provider costs plus net costs to the NZTA and approved
organisations (where there is a service provider)

• Where an external service provider is involved, the net costs to government include the ‘funding gap’ that is paid
by local and central government to the service provider so that the service is financially viable to the service
provider.
• The BCRN applies equally to TDM activities, transport services and road infrastructure activities. It indicates
whether it is in the national interest to do the activity from an economic efficiency perspective.
 Government Benefit Cost Ratio

• The NZTA also uses a government benefit cost ratio (BCRG), which indicates the monetized benefits
obtained for the government expenditure (value for money from a central and local government
perspective).
• In its basic form, the BCRG is defined as:

BCRG =

Where:
National economic benefits = net direct and indirect benefits and disbenefits to all affected
transport users plus all other monetised impacts
Government costs = net costs to the NZTA and approved organizations.

• Where an external service provider is involved, the net costs to government include the ‘funding gap’
that is paid by local and central government to the service provider so that the service is financially
viable to the service provider.
• The BCRG is equal to the BCRN where there is no service provider or non-government contribution
• The BCR shall be rounded to one decimal place if the ratio is below 10 and to whole numbers if the
ratio is above 10.
Incremental Benefit/Cost Ratios
 Introduction

• Where activity alternatives and options are mutually exclusive (section 2.13),
incremental cost benefit analysis of the alternatives and options shall be used to
identify the optimal economic solution.
• The incremental BCR indicates whether the incremental cost of higher-cost activity
alternatives and options is justified by the incremental benefits gained (all other
factors being equal). Conversely, incremental analysis will identify whether a lower
cost alternative or option that realizes proportionally more benefits is a more
optimal solution.
• Incremental BCR is defined as the incremental benefits per dollar of incremental
cost.

Incremental BCR =
 Introduction
• An analysis of incremental B/C ratios is required when two or more MUTUALLY
EXCLUSIVE project options exist, and one must be chosen. In the case of our notes
and the simplified procedures, all the options will be mutually exclusive.
• For mutually exclusive project options, it may not be correct to accept a small-scale
high B/C ratio option if this precludes a large-scale option with a lower but acceptable
B/C ratio(see diagram below).
 Example
• The concept of incremental cost benefit analysis is illustrated in the figure below, which
considers two options – A and B.
• The BCR for option B is 4.0 (4000/1000). Such a value would usually result in the activity
receiving a ‘high’ rating for the economic efficiency criteria considered under the NZTA’s
funding assessment. The less-costly option A, with a BCR of 7.5 (3000/400), would receive the
same ‘high’ rating. However, incremental cost benefit analysis demonstrates that the
incremental benefits gained by supporting option B ahead of option.
• Option A represent only a small return on the additional cost, as the incremental BCR is 1.7
((4000–3000)/(1000–400)).
 Incremental Analysis Method

1. Array the alternatives in ascending order of cost.

2. Starting at the lowest cost alternative, consider next higher cost alternative and
calculate ratio of the present value of incremental benefits to the present value of
incremental costs (i.e., the excess of the benefits and costs of lower costs alternative).
3. If incremental B/C ratio > incremental cut-off B/C ratio, discard lower cost alternative
and compare against next higher cost alternative.
4. If incremental B/C ratio > incremental cut-off B/C ratio, discard higher cost alternative
and use lower cost alternative as the basis for the next increment.
5. Repeat procedure until all alternatives have been analyzed.
6. Select the alternative with the highest capital cost which has an incremental B/C ratio
equal to or greater than the incremental cut-off value

*An incremental ratio greater than the incremental cut-off B/C ratio implies that the
incremental benefits are achieved at a sufficiently high rate per dollar spent to compete with
other independent projects.
 Base date for costs and Benefits

• The base date and therefore $Costs and $Benefits are set in the EEM
manual for all variables (e.g., TTS, VOCS, comfort benefits, driver
frustration, etc.) is
– July 2002 costs except for
– Accident cost savings which is July 2006 and
– Travel behavior change benefits July 2004
• All costs since this date and for all projects in future need to be updated by
the Construction Cost Indices (CCI) refer to Appendix A12 of the EEM
 Target incremental benefit cost ratio

• The target incremental benefit cost ratio (BCR) used when undertaking
incremental analysis of activity options shall be chosen and reported.
Where the selected target incremental ratio differs to the guidance below,
a detailed explanation supporting the chosen value must be provided. The
following guidance is provided:

1. The minimum incremental BCR shall be 1.0, in order to ensure that a

higher cost activity option is more efficient than a lower cost option.
2. Where the BCR of the preferred option is greater than 2.0 but less than
4.0, the target incremental BCR shall be 2.0.
3. Where the BCR of the preferred option is greater than or equal to 4.0,
the target incremental BCR shall be 4.0.
 Sensitivity testing of incremental analysis

• The results of the incremental BCR analysis should be sensitivity tested

using a target incremental BCR that is 1.0 higher than the chosen target
incremental BCR. If this affects the choice of preferred activity alternative
or option, the results of this sensitivity test must be described and
included in the activity report. For example, if the target incremental ratio
is 3.0, the choice of activity alternative or option should also be tested by
using a target incremental ratio of 4.0 and report how this affects the
choice of option.
 Incremental cost benefit analysis

• To analyze five mutually exclusive activity options against a target

incremental BCR of 3.0, first rank the options in order of increasing cost as
follows:

Options Benefits Costs BCR

A 110 15 7.3
B 140 30 4.7
C 260 45 5.8
D 345 65 5.3
E 420 100 4.2
 Incremental cost benefit analysis
• Next, calculate the incremental BCR of each higher cost option, discarding those below the target
incremental BCR as follows:

Above/ Discount rate

Base option below the (r) = 8%
Next higher Incremental
for Calculation target
cost option BCR
comparison incremental (Higher than
BCR other countries)

A B 2.0 Below
Australia/US =
A C 5.0 Above 3-5%

C D 4.3 Above

D E 2.1 Below
• Finally select the option that has the highest cost and an incremental BCR greater than the target
incremental BCR, which in this example is option D.
Economic Evaluation of Roading
Projects
 Introduction

• Sometimes, it may be cheaper to reconstruct the road rather than keep

maintaining the road.
• By re-constructing a road, the maintenance costs are substantially reduced. A way
has to be found of setting the cost of reconstruction against the cost of
maintenance, with the road unmodified, in order to determine whether it is
worthwhile to reconstruct
• If the road is not improved, the cost of maintenance increases at an increasing rate.
• In order to make an assessment:
– The costs incurred in the future have to be related to the present day.
– A comparison needs to be made between the costs incurred if the bare minimum
is done, “the do-minimum option” and the costs incurred if the road is improved, a
separate calculation being required for each of the proposed improvement
schemes. ‘do-nothing’ is not really an option.
– The benefits also need to be assessed in monetary terms for each of the
proposed improvement schemes.
 Introduction

• The diagram that follows shows the problem of relating economic

techniques to highway projects. It shows that the main issue is to obtain a
correct relationship between costs incurred at different points in time, but
it also emphasizes the true nature of an economic study.

Figure 1: Highway Operating Costs

 Roading Improvement Benefits

By improving a road, a number of benefits accrue:

• There may be a shorter travelling time for vehicle occupants , vehicles and
freight, and the cost saving can be estimated
• Vehicle operating costs may be less, as often the new road has fewer bumps
and bends and the distance travelled is shorter
• There will be fewer vehicle crashes as ‘crash blackspots’ will be eliminated
or substantially reduced by redesign
• Maintenance costs such as lighting and landscaping will be less.
• Typical benefits are given in Table 1 that follows.
 Improvement
• Pavement surface and
structure upgrading
including improved drainage
• Improved alignment and
road width
• New bridges
• Improved traffic signal
Table 1: Value of Road Improvements
Effect
• Better riding quality
• Better surface grip
• Less road maintenance
• Less likelihood of flooding
• Higher design speed
• Route shortening
• Flatter grades
• General width and alignment
improvement
• Elimination of rail level
crossings
• Elimination of fords
• Idle vs go through
Benefit
• Saving vehicle maintenance
• Saving in accidents
• Saving in annual road costs
• Saving in vehicle and driver
time
• Reduced travel time and cost
• Reduced accidents
• Saving vehicle maintenance
• Saving in accidents
• Saving in annual road costs
• Saving in vehicle and driver
time
• Less operating cost
 Costs

• Costs are broadly divided into roading costs and road user costs. Savings in road user costs are of
equal to savings in roading costs as far as the country as a whole is concerned and are recognized
as benefits.

• Roading costs include:

– Capital construction cost of new projects, including cost of investigation, design, land purchase
and any ancillary works, the costs to be incurred at the end of the financial year
– Maintenance costs, including minor repairs and recurrent maintenance, are included for each year
of the time considered. A major cost, such as a reseal, will appear as a single lump sum for the
particular year.
– Loan repayments on borrowed finance
– Cost of any land purchased for new roading

• Road User Costs include:

– The on-road time for vehicles, occupants and freight
– Accident (Crash) costs to highway users, the highway authorities and others
– Vehicle operating costs, e.g., fuel and maintenance costs.
 References

Zealand, N., & Land Transport, N. Z. (2006). Economic evaluation manual.

Land Transport NZ.