Highway economic analysis, also known as highway project appraisal, involves quantification of the costs of and benefits from a scheme over a selected time horizon and evaluation by a common yardstick. The technique is also known as benefit-cost analysis.
Such economic evaluation serves a number of purposes:
(i) To rank different schemes within the highway sector.
(ii) To assist in phasing the programme over a period of time.
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(iii) To determine the best alternative among available choices.
(iv) To evaluate alternative strategies like stage-construction, alternative specifications, alternative design standards and alternative policies such as reduced initial outlay and increased maintenance.
Basic Concepts of Economic Analysis:
Economic analysis of highway projects is a multi-disciplinary activity involving highway engineers, economists and statisticians. Construction and maintenance of highways are financed by the Government, whereas the highway user is the general public. Costs go to the Government and the benefits go to the public.
The construction of a highway or an improvement may affect another mode of transport, such as the railways; this calls for an in-depth analysis from the national perspective.
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Economic Analysis and Financial Analysis:
Financial analysis focuses on the ways and means of financing a project and the financial profitability.
Economic analysis, on the other hand, is not concerned with the sources of financing, but only with an analysis of the costs and benefits to the road-user and the consequences to all sections of the society of a scheme, and establishing its economic viability.
Economic analysis is essentially a study for the future; the analysis should, therefore, estimate the future traffic, costs and benefits.
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A number of possible alternatives should be evaluated including the basic alternative of ‘doing nothing’, or maintaining ‘status-quo’. Such comparison of the different courses of action would help one to select the best alternative. As part of the study, environmental impact assessment of the proposed scheme is also needed.
The analysis period should be limited to one of reliable forecasts. A period of 15 to 20 years beyond the completion of the project is considered appropriate.
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There may be some cost and benefit components that are equal in magnitude; they may be omitted.
Money appreciates in course of time due to the interest it earns. Thus, a certain amount at the end of a particular period is equivalent to a smaller amount now. This concept helps us in reducing all future costs and benefits to a common date, which affords a common basis for evaluation. Interest on a capital, annual interest rate, simple interest and compound interest are well understood.
Present worth is the present value of a future payment or a series of such payments. Discounting is the process of calculating the present worth of a future payment.
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Discount rate is the interest rate at which future payments are reduced to common time. Rate of return is the term commonly used in economic analysis for the rate at which economic benefits are obtained by a project. Though it generally means the same as interest rate, the terms rate of return and discount rate are more appropriate in economic analysis. The term interest rate is more commonly used while borrowing capital.
Minimum Attractive Rate of Return (MARR) must be assumed if a project is to be implemented.
The problems involving compound interest are greatly simplified by using six standard equations and ready-made tables. In these,
P = present sum of money
i = interest rate (compound) per annum.
n = number of years
F = sum of money at a future date.
A = equal annual payments for n years.
The six equations and their specific use are given in Table 12.1.
(Problems involving all these six equations can be easily solved, making use of the compound interest tables).
The tables contain the factors – CA, PW, SCA, SF, SPW and CR – for number of years, n, ranging from 1 to 50 years, for different rates of interest from 1 to 15 (1,2,3,4,5, 6, 7,8,9,10, 12, and 15).
For example – for 10% compound interest, for 15 years:
The convenience of using these tables is obvious. A few simple examples are given in the Numerical Examples.
Total Transportation Cost:
The total transportation cost is composed of:
1. Initial cost of construction
2. Periodic maintenance cost over the design life.
3. Road-user cost.
These three are interdependent, and the designer has to choose that alternative which makes the sum of these three (or the total transportation cost) a minimum.
The road-user cost is composed of:
(i) Vehicle operating cost
(ii) Time cost
(iii) Accident cost.
Highway Costs:
The sum of the first and second components of total transportation cost is known as highway costs. The initial cost of construction has to be appropriately phased over the period of construction.
Similarly, the cost of maintenance involving routine annual maintenance, patch-repair, and periodic renewals (say, after 5 years) has also to be phased year by year. The cycle gets repeated until the end of the highway’s design life.
Economic Costs and Financial Costs:
Financial costs represent the actual cost of construction and maintenance. Economic costs are based on the opportunity cost of each constituent, such as labour, materials and machinery. In order to desire the economic costs, these constituents have to be isolated, quantified and adjusted.
Shadow Pricing:
The domestic prices of many commodities are administrated by the government and are out of line with rates in the international market. Adjustments needed in the prices of goods and wages to make them truly reflect their market value comprise shadow pricing.
Cost Escalation and Inflation:
Since relative prices remain constant, escalation and inflation are disregarded both on costs and benefits.
Interest on Capital Cost of Construction:
This is included only when the capital is borrowed.
Determination of Economic Benefits:
The quantification of economic benefits from highway projects is usually much more difficult than the determination of costs.
The reasons are:
(i) Some benefits like reduced vehicle operating costs are easily measured while indirect benefits such as improved agriculture and accelerated economic growth cannot be measured easily.
(ii) Some direct benefits like value of passengers time savings, reduced noise and air pollution, and improved aesthetics are difficult to quantify.
(iii) Future benefits are for future traffic, the forecast of which is difficult.
(iv) Benefits are dependent on the alternatives considered, and unless the best alternative is chosen, real benefits may not be fully quantified. Benefits are derived by normal traffic as also by diverted traffic and generated traffic.
(i) VOC saving
(ii) Travel-time savings
(iii) Savings in accident costs
(iv) Savings in maintenance costs
(i) Improvements in administration, law and order, and defence.
(ii) Improvements in health and education.
(iii) Improvements in agriculture, industry and trade.
(iv) Improvements in environmental standards.
(v) Land appreciation in the vicinity of roads.
Since it is difficult to quantify social benefits, the direct road-user benefits alone are considered.
Where it is possible to predict the reduction in accidents on account of road improvements, the following values (based on 2009 rates) may be assumed [IRC: SP: 30-2009 (Second Revision)]:
These can be used for future years by applying the appropriate WPI.
Benefits from Low-Volume Roads:
Quantification of benefits due to the savings in VOC is not the correct approach for economic analysis of the benefits derived from low-volume roads. A better approach would be on the basis of product surplus – value of net output and income. This focuses directly on farm level changes.
Method of Economic Evaluation:
Three common methods are:
1. Net present value (NPV) method
2. Benefit/Cost ratio method (B/C ratio)
3. Internal rate of return method (IRR)
All these are based on discounted cash flow technique of discounting all future costs and benefits to a common year.
1. Net Present Value (NPV) Method:
In this method, the stream of costs/benefits associated with the project over an extended period of time is calculated and is discounted at a selected discount rate to give the present value. Benefits are considered positive and costs negative, and their summation gives their net present value (NPV). Any project with positive NPV is treated as acceptable. In comparing more than one project, a project with the higher NPV should be accepted.
Where, NPV0 = Net present value in the year
Bt = Value of benefits which accrue in the year t
Ct = Value of costs which occur in the year t
i = discount rate per annum
n = number of years considered for analysis.
2. Benefit-Cost (B/C) Ratio Method:
There are a number of variations of this method, but a simple procedure is to discount all costs and benefits to their present worth and calculate the ratio of the benefits to costs. Benefits are positive flows, while costs are negative flows. Thus, the savings in transport costs are considered as benefits.
If the benefit-cost ratio is more than one, the project is worth undertaking.
3. Internal Rate of Return (IRR) Method:
The internal rate of return is the discount rate which makes the discounted future benefits equal to the initial outlay. In other words, it is the discount rate which makes the stream of cash flows zero.
Equation 12.1 can be rearranged as given below (B0 being zero) –
This equation may be solved by trial and error, but it is rather tedious. With a computer programme, the solution becomes very simple.
If the IRR obtained is greater than the rate of interest obtainable by investing the capital in the open market, the project is considered acceptable.
Comparison of the Methods of Economic Evaluation:
The three methods presented have their own merits and demerits.
The advantage of the B/C ratio method is its simplicity; hence, it is widely used by highway engineers.
The disadvantages are:
(i) It requires an assumption of the discount rate, which should be related to the opportunity cost of the capital; it is rather difficult to know the opportunity cost of capital accurately.
(ii) The significance of B/C ratio is difficult to comprehend; this is especially so when the B/C ratios of alternative proposals differ only slightly.
(iii) It is sometimes difficult to decide which items should be termed costs and which benefits.
The NPV method also suffers from the same disadvantage as B/C ratio method in that a discount rate has to be assumed.
The IRR method is popular with international lending agencies like the World Bank. It lends itself admirably well for use in computer-aided design. It avoids the needs for selecting a discount rate initially.
The rate derived from the calculations can be easily compared with the market rate of interest with which economists, bankers and financial experts are familiar. However, its primary disadvantage is that the computations are tedious and can only be done with trial and error. It needs a computer programme and a digital computer facility for obtaining the solution.
In addition to the three rational methods presented for economic evaluation of highway projects, there is also the annual cost method. This method has been used for its simplicity, compared to the three methods recommended by the IRC in its Special Publication No. 30.
Basis of the Annual Cost Method:
The basis of the annual cost method is that all costs/capital outlays of the different components like highway ownership and operation cost including vehicle operation cost, highway capital cost of components such as right of way, earthwork, drainage and cross-drainage works, pavement cost, interest on investment, and maintenance cost – whichever cost is recoverable in the design life of each at an appropriate rate of interest has to be recovered.
This is based on the capital recovery formula of uniform series.
Here, A stands for annual cost and P, the present capital.
n: Number of years of design life of the component
i: Appropriate interest rate for the component.
The average annual costs of different alternatives/proposals of a highway scheme/project are worked out and compared.
The alternative for which the average annual cost is the lowest is the most economical option.