Being Prepared for IROPS: A Business-Planning and Decision-Making Approach (2014)

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A-1 A P P E N D I X A Business Case Analysis Primer The purpose of this primer is to present a high-level introduction to the key concepts of business case analysis in a way that is meant to be understandable to someone who may not necessarily have any formal business case analysis training. The reason for developing a business case is to justify the resources or capital investment necessary to implement an initiative. Business case preparation is intended to ensure that acquisition preparations are complete to ensure that the airport sponsor receives maximum value for the resources expended. A typical business case analysis begins with identifying a shortfall or technological opportunity. This is followed by the development of one or more strategies for replacing, upgrading, or enhancing the existing operational and technical environment. The next steps are to determine the costs, benefits/effectiveness, risks, and schedule of implementing the initiative(s) and to perform an economic analysis based on those inputs. The economic analysis compares the benefits and the costs for the lifecycle of each initiative, and measures the overall economic value of the investment in terms meaningful to decision makers. The generally accepted industry practice is to use benefit-cost ratio and net present value (NPV) as standard criteria for judging the lifecycle economic value of a program, although other metrics exist that can be used for this purpose as well. The regulatory requirement for airports to conduct benefit-cost analyses generally is triggered only when $10 million or more in AIP discretionary funding is requested (FAA 2011, p. 65769). As a result, the majority of airport projects never trigger the formal requirement. Nonetheless, the principles related to business case analysis described in this document generally still apply to investment decisions made by airport sponsors, even if the formal process is not required. The remaining sections of this document further describe the key concepts of business case analysis including project lifecycle, cost estimating, benefits analysis, risk adjustment, and determination of the overall economic value. Additional references are provided at the end of this document should the reader want to explore these concepts in more detail. The Project Lifecycle Selection of an appropriate project lifecycle enables costs and benefits of various alternatives to be evaluated objectively. Project requirements play a large part in determination of the lifecycle. When the requirements are ongoing in nature, a lifecycle end must still be

A-2 Being Prepared for IROPS: A Business-Planning and Decision-Making Approach Cost Estimating Cost estimating is a dynamic process, encompassing interdependencies and integration with system engineering, benefit analysis, requirements, risks, schedule, implementation planning, etc. Lifecycle cost estimates include the total costs to acquire, implement, operate, maintain, tech refresh, and dispose of the proposed acquisition. Lifecycle cost estimates are constructed depicting the potential future initiative using a lifecycle commensurate with the benefits so an economic analysis can be easily performed. The elements of the cost estimates include costs for both capital and operations and maintenance (O&M) expenses. The organization of cost elements in a cost estimate is called the work breakdown structure (WBS), which is useful because it standardizes the way costs are grouped and presented across various alternatives. The following items illustrate the typical steps for a cost estimate, recognizing that each step may be adjusted as the estimate matures: • Identify the purpose and scope of the cost estimate for each alternative. • Establish general ground rules and assumptions. • Develop the cost-estimating structure by WBS element. • Collect and evaluate cost, schedule, and technical data. • Identify, select, and calibrate (or modify) estimating methods. • Develop a point estimate and phase costs by fiscal year. • Identify, evaluate, and adjust for risk and uncertainty. As a final step, the cost estimates are fed into the overall economic analysis to determine the overall economic value of each alternative. More details on defining and quantifying project costs are documented in the FAA’s airport-specific guidance for benefit-cost analyses (FAA 1999). Benefits Analysis Benefits analysis is the process of identifying the physical or operational values of the goods or services that an initiative will yield over the analysis period. These values are usually defined in physical or operational units (metrics) or in terms that represent enhanced functionality (e.g., reduced aircraft delays, fuel or time saved, or more flights handled per controller), which can then be quantified (FAA 2013a). They can also be qualitative in nature if quantification is not feasible. assigned. Here, the physical life of the asset comes into play. A runway, airport terminal, or bus may vary considerably in durability. Selection of an evaluation period long enough to account for the increasing maintenance costs and periodic tech refresh costs is important. Where a business case analysis is undertaken comparing different technologies with different longevities, a compromise intermediate lifecycle period is typically suggested. Lifecycle periods of between 10 and 20 years are most common for airport projects.

Business Case Analysis Primer A-3 A general classification of benefit categories may include cost effectiveness, safety, efficiency, and environment. Each of these categories will be discussed further below. Notice that this is a general classification that can be applied to any benefits analysis, but it does not necessarily follow that each initiative is predicted to achieve benefits in each of these four categories. This is particularly true for IROPS mitigation initiatives, which, for example, are rarely expected to have environmental benefits. Cost Effectiveness refers to benefits that reduce the airport sponsor’s costs or increase labor productivity. Cost-related benefits are measured either as potential cost savings or cost avoidance. Benefits in productivity and efficiency can be measured using a variety of metrics, for example as labor costs monetized using compensation information for employees. Safety refers to benefits that lower the risk of accidents and errors. Safety benefits are typically measured either as a potential reduction in the number or severity of accidents or a decrease in operational errors. Safety-related benefits can be monetized in several different ways. One metric used when the risk of accidents is predicted to decrease, is to consider hull replacement costs, as well as the economic value of fatalities and injuries identified per International Civil Aviation Organization injury classifications. Efficiency refers to benefits that improve aircraft operators’ financial performance, particularly aircraft operating costs. It also refers to benefits that affect passengers’ opportunity costs, monetized through the economic value of time spent traveling. Standard data for the value of travel time is published by U.S.DOT policy, including a methodology for accounting for real growth in income. Finally, in applications where fuel savings are expected beyond those associated with reduced travel time, there is the potential for additional benefits monetized using an average unit fuel cost applied to the quantity of fuel saved. Environment refers to benefits that affect the environment. Typical benefits include decreased noise impact, improved air quality, and reduced emissions of greenhouse gases (GHG). Although there is no FAA-adopted methodology for monetizing GHG emissions reduction for the purposes of a business case analysis, CO2 reduction is often used as a quantitative proxy for total GHG reduction. Based on analysis of the above (or similar) categories, the identified benefits are monetized for each year in the lifecycle. The benefits estimates are then fed into the overall economic analysis to determine the overall economic value of each alternative. Some observed practices for quantifying benefits are presented in ACRP Synthesis 13: Effective Practices for Preparing Airport Improvement Program Benefit-Cost Analysis (Landau and Weisbrod 2009). Additionally, standard economic values used by the FAA Air Traffic Organization to monetize benefits from the categories above are published annually by the Office of Investment Planning and Analysis (FAA 2013b). Risk Adjustment Business case risk analysis is an objective evaluation of the proposed investment to determine the probability that an undesirable event will or will not occur during implementation and the significance of the consequence of that occurrence or nonoccurrence. Risk analysis

A-4 Being Prepared for IROPS: A Business-Planning and Decision-Making Approach provides methods for incorporating the uncertainty inherent in all predictions. Generally, three methods are used (Landau and Weisbrod 2009): • Sensitivity analysis, where variations in the results are observed by changing • Probabilistic methods, where distributions are applied to some or all input • Scenario-based methods, where “low,” “medium,” and “high” scenarios one or several input variables at a time variables and sampling techniques are used to determine distributions surrounding the resulting metrics incorporate varying degrees of pessimism or optimism about growth in demand or savings associated with future projects The Business Case: Lifecycle Economic Value Most airport investments involve the expenditure of large blocks of resources at the outset of the project in return for an annual (usually rising) flow of benefits to be realized in the future. Although these benefits and costs are in the form of dollars, year-to-year benefits and costs cannot simply be summed into totals and then compared. Rather, the analyst must take into account the fact that dollars paid out or earned in the near-term are worth more in “present value” than are dollars paid out or earned in the far-term. This procedure establishes whether or not benefits exceed costs for any or all of the alternatives (thus indicating whether or not the objectives should be undertaken) and which alternative has the greatest NPV. The process of converting future cash flows into present value is called discounting. The opportunity cost of money accounts for the need to discount dollar amounts to account for the passage of time. The opportunity cost of capital reflects the fact that, even without inflation, the present value (the value today) of a dollar to be received a year from now is less than the value of a dollar in-hand today. A dollar in-hand can be invested immediately in an interest-bearing account (or some other investment instrument) and earn interest for a period of one year. A dollar to be received one year from now cannot earn income for the investor during this period. Discounting requires the division of an annual discount rate into future benefits and costs. The annual discount rate (also known as the marginal rate of return of capital) represents the prevailing level of capital productivity that can be achieved at any particular time by investing resources, i.e., the opportunity cost. Because the FAA recommends the use of constant dollar cash streams, the discount rate should be net of inflation. This net-of-inflation rate is called the real discount rate. The real discount rate relevant to all airport projects to be funded with federal grant funds is set at 7% (FAA 2013b). The present value of incremental costs and benefits can be compared in a variety of ways so as to determine which, if any, option is most worth pursuing. In some cases, no alternative will generate a net benefit relative to the base case – a finding that would argue for pursuit of the base case scenario. The following are the most widely used present-value comparison methods: NPV, benefit-cost ratio, internal rate of return, and payback period.

Business Case Analysis Primer A-5 Net Present Value: NPV is defined as the difference between the present value of cash inflows (benefits) and the present value of cash outflows (costs). The NPV method requires that an alternative meet the following criteria to warrant investment of funds: • Have a positive NPV. • Have the highest NPV of all tested alternatives. The first condition insures that the alternative is worth undertaking relative to the base case, i.e., it contributes more in incremental benefits than it absorbs in incremental costs. The second condition insures that maximum benefits (in a situation of unrestricted access to capital funds) are obtained. NPV is the most widely used and theoretically-accurate economic method for selecting among investment alternatives. NPV does have certain conceptual and analytical limitations, however, which make consideration of other present-value evaluation methods appropriate in some instances. Benefit-Cost Ratio: The benefit-cost ratio is defined as the present value of benefits divided by the present value of costs. A proposed activity with a ratio of discounted benefits to costs of one or more will return at least as much in benefits as it costs to undertake, indicating that the activity is worth undertaking. The principal advantage of the benefit-cost ratio is that it is intuitively understood by most people. Moreover, this method provides a correct answer as to which objectives should be undertaken (i.e., those with ratios greater than or equal to unity). However, this method often fails to answer correctly the question of how to accomplish the objectives most effectively, particularly when comparing mutually exclusive projects of different scale or different levels of capital intensity and operating expense. Internal Rate of Return: The internal rate of return (IRR) is defined as that discount rate which equates the present value of the stream of expected benefits in excess of expected costs to zero. In other words, it is the highest discount rate at which the project will not have a negative NPV. To apply the IRR criterion, it is necessary to compute the IRR and then compare it with OMB-prescribed 7% discount rate. If the real IRR is less than 7%, the project would be worth undertaking relative to the base case. The IRR method is effective in deciding whether a project is superior to the base case, but it is difficult to utilize for ranking projects and deciding between mutually exclusive alternatives. It is not unusual for a project ranking established by the IRR method to be inconsistent with those of the NPV criterion. Moreover, it is possible for a project to have more than one IRR value, particularly when a project entails major final costs, such as clean-up costs. Although the literature on capital budgeting contains solutions to these problems, these solutions are often complicated or difficult to employ in practice and present opportunities for error.

A-6 Being Prepared for IROPS: A Business-Planning and Decision-Making Approach Payback Period: The payback period measures the number of years required for net undiscounted benefits to recover the initial investment in a project. One characteristic of this evaluation method is that it favors projects with near-term (and more certain) benefits. However, the payback period method fails to consider benefits beyond the payback period. Nor does it provide information on whether an investment is worth undertaking in the first place. More information on these concepts as well as the formulas for all of the techniques and metrics described above can be found in the FAA’s guidance on conducting benefit-cost analyses for airport projects (FAA, 1999). Notice, however, that the focus of the FAA guidelines is on capacity-enhancing projects, because these are the most likely to trigger the project cost threshold for requiring a benefit-cost analysis.