All project benefits are not created equal
One of the key issues we frequently face as practitioners trying to prioritize the funding of infrastructure projects is the issues related to quantifying the future benefits a project will deliver. The difficulties in this exercise are myriad, but one of the more interesting challenges comes from the difference between tangible and intangible benefits.
First, a little background…
Unfortunately, we live in a world where capital resources are constrained and we have to make choices about the infrastructure projects we choose to pursue. This requires us to prioritize the projects based upon some standardized metric. Usually, this means we conduct a Cost/Benefit analysis and compute the Benefits-to-Cost ratio. This BCR gives us a reasonable metric by which to compare a project to its viable alternatives.
In doing this analysis, we should consider the entirety of the internal and external benefits that a project can/will generate. Internal benefits would be those that directly accrue to the project – toll revenue. External benefits are those that accrue to someone or something that is not the project – cost savings of a business making deliveries using a new road. We assign values to these and calculate a net present value using a suitable discount rate. That NPV of the benefits is divided by the NPV of the costs to give us a BCR ration and that is then used to compare projects.
This is where it gets complicated…
That works great in a textbook. In the real world, the benefits of a project are typically a combination of tangible and intangible, both internal and external.
A tangible benefit is one where a dollar value can be easily assigned. The revenues earned from toll collections are an easily quantifiable example of a tangible benefit.
On the other hand, an intangible benefit is one where it is not possible to assign a meaningful dollar value. There is still “value” to the benefit, just not a value that can be translated into a dollar figure. An example of an intangible benefit would be the reduced emissions or the reduced crime rates that may result from a projects completion.
Although difficult to quantify, these intangible benefits can’t be ignored when prioritizing projects. In fact, for a public sector project sponsor, the intangible benefits of a project may be more critical than the financial returns. So, we do our best to assign a dollar value to these benefits and include them into our BCR analysis alongside their tangible counterparts.
Why does this all matter…
This is where our traditional BCR analysis proves inadequate for the task and lets us down. The NPV calculation used in the BCR analysis does not consider the composition of the stream of benefits and its reinvestment potential.
Let’s consider a hypothetical project that has a cost of $20 million and will generate $7.55 million annually for 5 years in combined benefits. Those benefits are split between $5 million of tangible and $2.5 million of intangible sources. As described, the project has a positive NPV (at an 8% discount rate) and the BCR analysis value is 1.50, indicating that this is a worthwhile project to complete.
Think for a minute though about the composition of the benefits we received in this scenario. $5 million per year was in the form of tangible benefits. Presumably, that is real cash flow that could be reinvested in an interest bearing account or other benefit-producing project. Those benefits can be put back to work to generate other benefits.
If we include the reinvestment potential from the tangible benefits, even at a nominal “safe rate”, the BCR for the project becomes even stronger (1.58), raising its ranking against all other projects.
Now let’s consider a project with the same $20 million cost and $7.5 million of annual combined benefits. This time, assume that the tangible benefits are $4 million per year and the annual intangible benefits are $3.5 million. Again, the NPV is positive and is identical to the first example. And again, we include the potential reinvestment returns from the tangible portion. In this scenario, the BCR drops to 1.56, positioning this project at a lower priority than the previous example.
What becomes clear is that the increase in intangible benefits relative to tangible ones has been punitive to the project. The total benefits are the same, yet the second project is less desirable than the first. That can run exactly counter to reality, especially for public sector project sponsors to whom the intangible benefits are critically important.
When a project includes both tangible and intangible benefits, as all infrastructure projects do, the traditional Cost/Benefit Analysis and Benefits-to-Cost Ratio Analysis are not sufficient tools for project evaluation. All project benefits are not created equal and any strategy to justify or prioritize projects needs to be sophisticated enough to allow for this. Yet, we continue to see this type of analysis used by both public and private sector project sponsors on a daily basis.
Some very good projects are being overlooked not because they don’t generate very real benefits, but because of the inadequacy of our analysis tools.