ADM 626 Topic 7 Assignment Benchmark Cost Benefit Analysis

ADM-626 Public Budgeting and Financial Management

Topic 7 – Cost Benefit Analysis Worksheet

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Module 17: Cost-Benefit Analysis

• What is cost-benefit analysis? What are the main steps in conducting cost-benefit analysis?

Cost benefit analysis is an economic method that periodically calculates and does the comparison of the benefits and costs of a program for proper allocation of resources.

• Steps of CBA
• Determining standing and perspective
• Determining alternatives or bases for comparison
• Listing impacts
• Monetizing impacts that includes both costs and benefits
• Discounting future impacts
• Calculating program net present value
• Performing sensitivity analysis
• Selecting the alternative with the largest net social impact
• A city has learned that by buying larger garbage trucks, it could reduce labor costs for garbage removal. Note: All the dollar amounts below are in this year’s dollars (constant dollars).
• Cost of the trucks today is $400,000.
• Annual savings in this year’s constant dollars is $90,000.
• Trucks will last for 4 years and then will be sold for $100,000.
• The city can borrow money at a 7% discount rate to purchase the trucks.
• Inflation (for the next 4 years) is expected to average 3%.
• Assuming the costs and benefits are incurred at the end of the year, should the city buy the trucks?
• Solution:

We evaluate the net present value for the project,

Negative cash-flow = $400,000

Positive Cash-flow = $90,000

                                = $100,000

Money rate of interest 7% and inflation rate 3%

Real rate of interest = (0.07+0.03)/1.03

                                = 0.097 = 9.7%

Therefore:

NPV = -400,000 + 90,000(1.097-1 + 1.097-2 + 1.097-3+ 1.097-4) + 100,000*1.097-4

        = -400,000 + 356192.3

         = -$ 43,807.7

According to the net present value, buying the trucks wouldn’t be a good option for the city since there is a negative cash-flow.

• This assignment extends the garbage truck problem from prompt 2. Two other lenders provide alternative scenarios. Alternate lender 1 suggests that the inflation rate will be 4% and offers an interest rate of 7.5%, while alternate lender 2 suggests that the inflation rate will be 1% and offers an interest rate of 6.5%. For all three sources, the interest rates are guaranteed if the decision is made in the next 90 days. Which of the following decisions should be made and why?
• The usual lender should be used because she offers a positive NPV.
• Alternate lender 1 should be used because he offers the highest NPV.
• The garbage trucks shouldn’t be purchased because there is a possibility of a negative NPV.
• Alternate lender 2 should be used because most scenarios have a positive NPV and she offers the highest NPV under each scenario.
• Each solution is as good as any other.

c- The garbage trucks shouldn’t be purchased because there is a possibility of a negative NPV

Module 18: Life Cycle Costing

• What is life cycle costing (LCC)? What are the main issues in applying LCC in the government context?

Life cycle costing is an analytical technique used to determine the total cost of ownership over the lifetime of an asset.

• Main issues;
• The cost of operation and maintenance
• Large disposal liability
• The city administration is considering refurbishing the lighting system of its administration building. After an initial investigation, the city procurement office has narrowed down the choices to the following two options:
• Option 1 is an Ergolight system that costs $500,000 to purchase and install. The energy cost for option 1 is $20,000, and its maintenance cost is $2,000.
• Option 2 is a conventional system that costs $100,000 to purchase and install. The energy cost for option 2 is $50,000, and its maintenance cost is $10,000.Both systems are expected to last for 20 years. Assume that the discount rate is 4% and all future costs are paid at the end of the year.

Option 1:

= $500,000 + 20,000(1.04-1 + … + 1.04-20) + 2,000(1.04-1 + … + 1.04-20)

=$ 798,987.18

Option 2:

=$100,000 + 50,000(1.04-1 + … + 1.04-20) + 10,000(1.04-1 + … + 1.04-20)

= $ 915,400

• Which lighting system should the city select based on LCC considerations?

Based on LCC we should pick the cheapest, which is Option 1

Module 19: Capitalization and Depreciation

• What are the differences in how depreciation is treated by government and by companies in the private sector?

Since the government offers public services to the public, their capital assets tend to be subjected to wear and tear more quickly (depreciation) than the capital assets in the private sector, therefore they are recorded in the organization accounting system and reported financially which is a different case in the private sector.

• A city government purchases a new garbage truck for $120,000 this year. It is estimated that the truck will have a residual value of $20,000 and a useful economic life of 20 years. What would be the depreciation expense each year if the straight-line method were used.

ADE = (C –R)/N

         = ($120,000 – $20,000) / 20

         = $5,000

• Why do organizations, government included, not capitalize all assets that last for more than one budgeting period, despite knowing that doing so would increase the accuracy of the accounting of assets and operations?
• City Hospital paid $500,000 for a piece of advanced diagnostic equipment. The total transportation and installation cost to make the equipment operational is $50,000. The staff-training cost to operate the new equipment is about $10,000. What should be the value of this capital asset?

Value = $500,000 + $50,000 + $10,000 = $560,000

Module 20: Long-Term Financing

• Why do public organizations use municipal bonds to finance long-term capital projects?

One of the major reasons why public organizations use municipal bonds to finance their long term capital budget is because of the cost effectiveness of it, governments or rather public institutions giving out municipal bond sell these bonds directly to individuals and organizations therefore eliminating the occurrence of financial intermediaries who hike the prices.

• A major urban center is planning to issue a $100 million, 20-year, semiannual-interest-paying municipal bond for the construction of a stadium.
• The interest rate is 5.875%, based on the economic and financial conditions of the city and city government.
• The design and issuance costs are estimated to be $10 million and 1%, respectively.
• What is the total interest paid if the city decides to adopt a level debt service structure?

$100 M for 20-year semiannual-interest

 i2 = 0.05875

Interest paid

= ((1.05875)2*20) * 100M – 100M

= $879,301,733.30

• How much will the city still owe on this bond at the end of each year?

Loan Schedule

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This benchmark assignment assesses the following programmatic competencies: 1.5: Use technology to manage data and organize information and 2.1: Conduct a cost benefit analysis to determine the best allocation of public resources.