Question

10. a. A commonly used benefit-cost rule is to undertake a program if and only if its ratio of benefits to cost (both in present–value terms) is greater than 1 (B/C > 1). Does this rule make sense?

b. A city is deliberating what to do with a downtown vacant lot that it owns. Should it build a parking garage or a public library? According to its studies, the benefit-cost ratio for the garage is 2 and the ratio for the library is 1.5. Accordingly, the city decides to build the garage. Is this conclusion justified, or is additional information needed? Explain carefully.

c. A state must decide which of its deteriorating bridges to repair within its limited budget. The total number of such bridges (some currently closed for safety reasons) is between 450 and 500. The state has gathered estimates of repair costs and projected traffic benefits for each bridge. It has decided to repair those bridges with the greatest benefit-cost ratios until its budget is exhausted. Does this strategy make sense? Explain carefully.

Answer 1

A. The Benefit - Cost ratio, to be stated in simple terms, summarizes the relationship between cost of the spoken project and the benefits arrivng out the project. BCR is calculated by dividing the proposed cash benefits of the program by the proposed cash cost of the program. Before this calculations the redemption or salvage values of the should also be considered. Considering all the components used to conclude the BCR:-

1. If BCR > 1, the Net Present Cash Flow of the program will outweigh the Cash Cost of the Program.

2. If BCR = 1, the Net Present Cash Flow of the program will equal the Cash Cost of the Program.

3. If BCR <1, the Cash Cost of the program will outweigh the Net Present Cash flow of the program.

Hence, the rule to consider the program if the BCR >1 is justified. However BCR does has its limitations. Big projects involve not only cost and cash flows but also many other factors. Thus while considering bigger projects that would run for a longer term, BCR should be used as another tool with all the other analysis tools to get a mote accurate analysis.

B. Lets understand this particular scenario with a proper comparison between garage and library

When we look at the above comparison we can understand why the BCR of the Garage is better than the BCR of the Library. Thus the decision to build a garage is justified.

C. The Benefit - Cost ratio, to be stated in simple terms, summarizes the relationship between cost of the spoken project and the benefits arrivng out the project. If the BCR is more it means that the Cash flow outweighs the Cash cost. When the budget is strained we must priortize the project inorder to ensure the effective use of the given budget. BCR does points out that the cash flow is more than the cash cost. Thus, the decision to prioritize the building of bridges with higher BCR is justified.