Transportation Economics and

Decision Making

Lecture-3
 Arithmetic Gradient Series

A+(n-1)G
Amount increases by
“G” each period A+3G
A+2G
A+G
A

This is equivalent to
 Arithmetic Gradient Series

(n-1)G
A A A A A 3G
2G
G
0
+

P’ P’’
Present worth of base amount + Present worth of gradient amount
Arithmetic Gradient
 Example

 A city department of transportation (DOT) expects

cost of maintenance of a midblock to be $5,000 in
the first year and increase annually by $500 until
year 10. At an interest rate of 10% per year,
determine the present worth of maintenance cost.

𝑃 𝑃
𝑃 = 5000 ∗ + 500 ∗
𝐴 10%,10 𝐺 10%,10
= 5000*6.1446 + 500*22.8913
= $42,269
 Cash Flow Diagrams

Estimate Present Worth

0 1 2 3 4 5 6 7 8 9 10

1.9 1.81 1.72 1.63 1.54 1.45 1.36 1.27 1.18 1.09K

The Present Worth of the above Payment Plan is

PW  1.9PW  1.81PW   1.72PW 
i 9 i 9 i 9
n 1 n2 n 3 
 ....................  1.09PW 
i 9
n 10

 10K
 Geometric Gradient

• g is the geometric gradient over the time period

 (time period: Time 0 to Time n, 1st flow at Time 1)
• P is the present value of the flow at Time 0
 (n periods in the past)
• i is the effective interest rate for each period

Note: cash flow starts with A1 at Time 1, increases by constant g% per period

   (1  g )  n 
P?  1  
  
  (1 i )  
  when i  g
0 1 2 3 n ig
  
( P / A, g , i , n )    

A1 
g=%  n
 when i  g
P = A1(P/A,g,i,n)  (1  i )
 Example

 A state department of transportation has four toll

bridges and combined salaries obtained at the end of
year 1 is $250,000. If the toll booths are expected to
raise revenue 5% each year, what is the present
worth of the revenue in next ten years.

𝑃
𝑃 = 250,000 ∗
𝐴 𝑔,𝑖,𝑛10%,10
𝑃
𝑃 = 250,000 ∗
𝐴 5%,10%,10
= 250,000*3.94005
= $985,015
 Example

 You have just begun you first job as a civil engineer and decide to
participate in the company’s retirement plan. You decide to invest the
maximum allowed by the plan which is 6% of your salary. Your
company has told you that you can expect a minimum 4% increase in
salary each year assuming good performance and typical advancement
within the company. Choose a realistic starting salary and estimate the following:
 Assuming you stay with the company, the company matches your 6% investment in
the retirement plan, expected minimum salary increases, and an interest rate of 10%,
how much will you have in your retirement account after 40 years?

1) Assuming a starting salary of $50,000, A1 = .12 x 50,000 = 6000

P = 6000 [(1 – (1.04)^40 * (1.1)^(-40)) / (.1 - .04)] = $89,392.18
F = 89,392.18 (1.1^40) = $4,045,823.50
 Summary of Gradient Growths

 Arithmetic gradient consists of two parts

 A uniform series that has amount equal to the period-1

 A gradient that has value equal to the difference of cash flow

between period 1 and 2
 Gradient factor is preceded by a + sign for increasing
gradient, and –ve sign for decreasing gradient
 Geometric gradients are handled just by one
equation.
 Basic Characteristics of Methods of Analysis

 The six methods of economic analysis (to be

discussed) have the common objective of
comparing the future streams of costs and benefits in
such a way that for a specific future period of time
the analysis will disclose the probable net return on
the proposed investment, or the most economical
design required to produce the returns.
 Basic Characteristics of Methods of Analysis

 Each method applies the principles and concepts of

compound interest in a way to take into the
calculations the differences in the worth of money
over time.
 Traditional Analysis Methods

 1. Equivalent Uniform Annual Cost Method (EUAC)

 2. Present Worth of Costs Method (PWOC)
 3. Equivalent Uniform Annual Net Return Method
(EUANR)
 4. Net Present Value Method (NPV)
 5. Benefit to Cost Ratio (B/C)
 6. Rate of Return Method (ROR)
 * Incremental Benefit-Cost Ratio
 * Cost/Effectiveness Method
 Traditional Analysis Methods

1. Equivalent Uniform Annual Cost Method (EUAC)

Combines all investment costs and all annual expenses into

a single annual sum that is equivalent to all disbursements
during the analysis period if spread uniformly over the
period

When more than one alternative is being examined, the one

with the lowest equivalent uniform annual cost is the more
economical
 Traditional Analysis Methods

2. PRESENT WORTH OF COSTS METHOD (PWOC)

Combines all investment costs and all annual expenses into

a single present-worth sum, which represents the sum
necessary to finance the total disbursements over the
analysis period.

Of the alternatives compared, the one with the lowest

present worth of cost is the more economical.
 Traditional Analysis Methods

3. Equivalent Uniform Annual Net Return Method

(EUANR)

Is the equivalent uniform annual cost method plus the

inclusion of an income factor or benefit factor.

The answer indicates the amount by which the equivalent

uniform annual income exceeds (or is less than) the
equivalent uniform annual cost.
 Traditional Analysis Methods

4. Net Present Value Method (NPV)

This method gives the algebraic difference in the

present worth of both cost and benefits.

The alternative having the greater net present value is

the one with greatest economy.
 Traditional Analysis Methods

5. Benefit to Cost Ratio (B/C)

This method expresses the ratio of equivalent uniform annual

benefit (or its present worth) to the equivalent uniform
annual cost (or its present worth).

Any alternative that has a benefit/cost ratio greater than 1.0

is economically feasible and the alternative that has the
highest incremental benefit/cost ratio is indicated as the
preference
 Traditional Analysis Methods

6. Rate of Return Method (ROR)

This method determines the interest rate, which will equalize

the negative costs and the positive rates returns or benefits.

While comparing the alternatives, the higher the rate of

return, the greater the economy
 Economic Analysis

 EUAC = -I(CR)in + T(SF)in - K - U

I = Initial cost
T = Terminal value
K = Total uniform annual costs
U = Uniform annual road user costs
 PWOC = -I + T(PW)in - K(SPW)in - U(SPW)in
 EUANR = -I(CR)in + T(SF)in - K + R
R = Uniform annual gross benefit
 Economic Analysis Example

Cash Flow Item Alternative 1 Alternative 2

Initial Investment 140,000 160,000

Terminal Value 40,000 50,000

Total O&M annual cost 7,000 8,000

Uniform Annual Road 74,000 70,000

User Cost

Interest Rate 8% 8%

Analysis Period (years) 10 10

 EUAC Method

EUACA1= -140,000 * (CR i=8n=10 )+ 40,000 *

(SF i=8n=10)- 7,000 - 74,000
= - 140,000 *(0.149029) + 40,000*
(0.0629) - 81,000
EUACA1= - 99,103

EUACA2= -160,000 * (CR i=8 n=10)+ 50,000 *

(SF i=8 n=10)-8,000 - 70,000
= -160,000*(0.149029) + 50,000*
(0.069029) -78,000
EUACA2= - 98,394
 EUAC Method

EUACA1 - EUACA2 = +99,103 - 98,394

= 709
A2 Alternative has $709 less annual costs

A2 is better than A1.

 PWOC Method

PWOCA1 = - 140,000 + 40,000 PW810 -

7000 * SPW810 - 74,000 * SPW810
= -140,000 + 40,000*(0.46319) -
7,000 * (6.710081) - 74,000*
(6.710081)
PWOCA1 = -664,989
 PWOC Method

PWOCA2 = - 160,000 + 50,000 (PW810) -

8000 * (SPW810) - 70,000 * (SPW810)
PWOCA2 = -660,227

PWOCA2 - PWOCA1 = -660,227 - (-664,989)

= $4,762
The cost of Alternative A1 is $4762
more than A2
 A2 is better.
Equivalent Uniform Annual Net Return
Method
Alternatively A1 and A2 cannot be examined separately
since they do not have the equivalent of a sales income.
However, reduction in Road user costs is equivalent to
cash income.
EUANRA2 = -(Ip - IB) (CR810) + (Tp - TB) * (SF810) - (Up -
UB) -(Kp - KB)
The subscripts P and B stand for proposed and base
alternatives respectively.
EUANRA2 = - (160K - 140K) (0.149029) +
(50K- 40K) (0.069029) –
(70 K - 74 K) - (8K- 7K)
= $709
A2 is better.
 Net Present Value Method

Similar to previous comparison

NPVA2 = -(Ip - IB) + (Tp - TB) * (PW810) –
[(Up - UB) + (Kp - KB)] * (SPW810)
= -20 K + 10K (0.463193)-
(-4K+1K)*(6.71008)
NPVA2= 4,762
A2 is better.
 B/C Ratio

B/C = EUAB/EUAC
or
B/C = PWOB/PWOC
Benefit
- Reduction in road user costs and reduction in
annual expenses together is the benefit
- Initial cost and Terminal value should be
considered as costs
 B/C Ratio (Continued)

EUAB = - (UP - UB) - (KP - KB)

= - (70,000 - 74,000) - (8,000 - 7,000)
EUAB = 3000
EUAC = -(Ip - IB)*(CR810) + (Tp - TB)*(SF810)
= -(160K-140K)(0.149029) +
(50K- 40K)(.069029)
EUAC = - 2291
B/C = + 3000/-2291 = 1.31
This is the B/C ratio applied to alternatives A1 and
A2.
 Rate of Return Method

Assume, i = 10% on the basis of present worth

0=B–C
 0 = -(160,000 – 140,000) + (50,000 –
40,000)*(PW1010) – (70,000 – 74,000)

(SPW1010) - (8,000 – 7,000) (SPW1010)

= -20,000 + 10,000*(0.385543) +
4,000(6.144567) – 1,000 (6.144567)
= $2,288
 Rate of Return Method (Continued)

Second Iteration: Assume i = 12%

0 = -20,000 + 10,000(0.321973) +
4,000(5.65023) – 1,000 (5.65023)
= 171
By linear extrapolation, Rate of Return = 12.15%
How?
2228

171
10% 12%
General discussion on the Solutions

The solutions indicate that the incremental

investment of $20,000 in Alternative A2 over A1
will produce a ratio of benefits of 1.31 or a rate
of return on the $20,000 of 12.1 percent

None of the solutions tests the base alternative A1

to see whether it is economically desirable. The
solutions, in each case, compare alternative A2
to alternative A1 and determine the relative
worth of A2 over A1.
 Comparison of the Methods - Group of
Mutually Exclusive Alternatives
 All the method give identical alternative as the
best choice when the proper procedure of
application and calculation are followed.
 Thus in this respect there is no best method of
analysis so far as the final ranking of alternatives
is concerned.
 The basis of choice between methods must be
based on
 The form of available data
 Whether benefit or income amounts are available
 The preferences of the analyst and the decision maker.
Low Cost Improvement Project Example

Traffic signals were redesigned and

implemented in the following intersections in
the city of Detroit.
The cost of implementation and benefits
accrued in terms of accident reductions are
shown in the following table. Perform a
benefit-cost analysis.
Low Cost Improvement Project Example

Project Cost
Location 1 = $ 34,100
Location 2 = $ 35,200
Location 3 = $ 29,400
Total = $ 98,700
Annual Operation and Maintenance cost
= $ 1000 per Intersection per year
Assume i = 7% and n = 15 years
Low Cost Improvement Project Example

Before After Reduction

All/ Year
PDO Injury PDO Injury PDO Injury
Location-1 49 18.67 29 6.5 20 12.17

Location-2 35 16.67 24.57 4.57 10.43 12.1

Location-3 21.67 13.33 12.83 7.01 8.84 6.32

Total 39.27 30.59

 National Safety Council (NSC)

Costs
Injury = $ 34,100
PDO = $ 6,400
Annual reduction in road user costs related to
traffic crashes
= 39.27(6,400) + 30.59 (34,100)
= 251,328 + 1043119
= $ 1,294,447
 PWOC and PWOB

PWOC = -98,700 – (3000)*(SPW715)

= -98,700 – 3000 (9.1079)
= -126,023.7
PWOB = 1,294,447*(SPW715)
= 11,789,693
B/C = 11 ,789,693/126,023.7
B/C = 94:1
 Incremental B/C Ratio
Assume that you want to pick an alternative
amongst 5 solutions.
Say, the alternatives were ranked in increasing
cost. The dolor costs and benefits are in
thousands.
B C B-C
A1 10 2 8
A2 20 14 6
A3 50 25 25
A4 80 30 50
A5 90 45 45
 Incremental B/C Ratio
The method involves examining the ratio
Bi+1 - Bi
Ci+1 - Ci

If it is > 1, then alt. Ai+1 is accepted and compared

with Ai+2
If it is < 1, then alt. Ai is accepted and compared
with Ai+2
 Incremental B/C Ratio

Incremental Incremental Decision in Favor

Comparison Inc. Benefits/ Inc. Costs
Benefits Costs of

A1 to A0 10 2 5.00 A1

A2 to A1 10 12 0.83 A1

A3 to A1 40 23 1.74 A3

A4 to A3 30 5 6.00 A4

A5 to A4 10 15 0.67 A4

Select A4

If benefits and costs are in different units,

this method cannot be applied.
 Nominal and Effective Rates of Interest

 Nominal and effective interest rates have similar

relationship to that of simple and compound interest
rates.
 The difference is that nominal and effective interest rates
are used when compounding period (or interest period)
is less than one year.
 Let i= interest rate per base period conversion; quoted
interest rate
r = nominal rate per annum
j = effective rate per annum
m= times per year, or base period, the nominal rate
is converted
 Effective Rates of Interest

 Let i= interest rate per base period conversion;

quoted interest rate
r = nominal rate per annum
j = effective rate per annum
m= times per year, or base period, the nominal
rate is converted
 Effective Rates of Interest

r
Since i 
m
m
 r
Effective Interest Rate j  1    1
 m
Example :
Find the effective rate of interest for $100 for 1 year
at nominal interest of 12% per year , interest payable
monthly :
12
 0.12 
F  100 * 1    100 * (1 . 01)12
 112.6825
 12 
Effective Interest Rate  (1  .01)12  1  0.1268  12.68%
 Example

 A bank pays 6% nominal interest rate. Calculate the

effective interest with
 a) monthly, b) daily, c) hourly d) secondly
compounding
 i = (1 + r/m)m – 1
 i monthly = (1 + .06/12)12 -1 = 6.1678 %
 i daily = (1 + .06/365)365 -1 = 6.183 %
 i hourly = (1 + .06/8760)8760 -1 = 6.1836 %
 i secondly = (1 + .06/31.5M)31.5M -1 = 6.18365 %
 Engineering Economy in Highways

 Construction should be planned with an eye for the

future
 Roads should be built only to the extent and of such
types as will pay themselves.
 There must be enough traffic and type of
improvement shall be such that the savings in cost of
transportation is at least equal to the cost of
improvement.
Basic Premise of Transportation Economics

1. Instinctive desire to save

- Save for future use
- Save for different use
2. Conservation of commodities
- Future use
3. Conservation of Labor
- Alternative use
 Basic Premise of Engineering
(Continued)

4. Long range result of conservation of resources

- Growth with least amount of resources
5. Public versus Private
- Public viewpoint - Welfare of everyone
- Private viewpoint - Welfare of one
 Principles of Analysis

1. Complete Objectivity
- Selection of Factors
- Selection of Cost
- Selection of Vest Charge

2. Economic analysis is not a management decision

3. “Hunch” has no place in economic analysis

4. Study all possible alternatives

 Principles of Analysis (Cont..)

5. Always consider the “Do Nothing” alternative

6. Separate market and non-market factors

- Factors of general socio-economic consequences are
excluded from calculations

7. The analysis is a study of future conditions

- Careful forecasting is necessary
 Principles of Analysis (Cont..)

8. Past events and investments are irrelevant.

9. Use same time periods for all factors

10. Analysis period should not extend beyond the period of

reliable forecasts.

11. Same time frame for all factors

12. Differences in alternatives are controlling

13. Common factors of equal magnitude may be omitted

 Principles of Analysis (Cont..)

14. Use the net basis for all costs and consequences

15. Analysis for economy is independent of financing

16. Uncertainties need to be acknowledged

17. Separate decisions are made at separate levels of

management

18. Viewpoints should be established before final decisions

are made
 Principles of Analysis (Cont..)

19. Establish criteria for decision making

20. Consider all consequences to whomsoever they may

accrue

21. Final decision should also consider market factors

 Methods of Economic Analysis

 Economic Analysis is an art and not an exact science

 Every method can not be applied to every different
types of proposal, an understanding of the
characteristics and limitations of each of the
methods is essential for the analyst.
 When properly applied in accordance with their
limitations, each method will give a reliable result.
 Methods of Economic Analysis

 Economic Analysis is more commonly being used as

a management tool for decision making

 Economic analysis is performed for

 Project Evaluation

 Project Formulation

 Project Priority Selection

 Project Justification (Relative to other projects)- public

financial policy