development plannIng and

project analysIs -II

Course Code: Econ-3132
LECTURE NOTE

Compiled by: Tesfaslassie Hagos (MSc.)

Lecturer, Mekelle University

April, 2020
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 Chapter I: Basic Concepts

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1.1. The Project Concept
Definition: What is a Project?
 Different organizations and authors provide different
definitions for the concept project.

 A project is a proposal for an investment to create, expand

and/or develop certain facilities in order to increase the
production of goods/services/during a certain period of time in
a community, region, country, market area and/or certain
organization (firm, public organization, NGO, etc).

 A project is defined as a complex economic activity in which

scarce resources are committed in the expectation of benefits
that exceed these resources(costs).
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 According to Little and Mirrlees, a project is a scheme, or part
of scheme, for investing resources which can reasonably be
analyzed and evaluated as an independent unit.

 A project is an investment activity upon which resources are

expended to create capital assets that will produce benefits
over an extended period of time and which logically lends
itself to planning, financing and implementation as a unit. A
specific activity, with specific starting point and specific
ending point, intended to accomplish a specific
objective.(Gittingger,1982)

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Generally, a project is:-
 An investment activity which lends itself to planning,
financing and implementation as a unit;
Expressed in terms of definite location, time and target
group or beneficiaries;
Expected to generate specific output(benefit) after its
completion;
Managed by a separate administrative structure or
operated through the existing structure

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Basic characteristics of a project
1. A project involves the investment of scarce resources in the
expectation of future benefits.

 Projects have specific benefits that can be identified, quantified

and valued, either socially or monetarily/commercially/.

2. Projects have measurable objectives

 Projects have specific beneficiaries which needs to be specifically

spelt out during project planning.

3. A project is the smallest operational unit.

 A project can be planned, financed and implemented as a unit.

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 Despite the fact that a project constitutes many activities
and tasks, it is defined as the smallest operational unit.
 Because, it is bounded by different factors. These are:

 Projects are conceptually bounded.

 The problem and specific objective of a project involves

conceptual delimitations.
 Projects are geographically bounded.

 Projects are organizationally bounded.

 There should be certain organizational unit responsible

7 for project implementation.

 Projects are time bounded.

 Projects have specific lifetime, with a specific start and end time.

4. Uncertainty and risks is inherent in any project.

 Achieving project objectives can not be predicted in advance

with accuracy.

 The factors that make project risk are:

A. Significant and multiple types of scarce resources are

committed today expecting outcome in the future;
B. Benefits are expected to be generated in the future, which is
less predictable;
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C. Capital investments are irreversible, i.e. exit has its own costs.
5. It has a scope that can be categorized into definable tasks.

 Projects usually have well defined sequence of investment and

production activities

6. It may require the use of multiple resources.

 This has an implication on management of project implementation.

 The more diverse the types of resources are mobilized, the more

complex will the management be.

 The outcome of project and hence development endeavor is

sensitive to the management of each type of resources.

 Ill managed resource can contribute more to cost than to benefit.

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Why Project Planning?
 There is basic economic problem of scarcity in
the face of unlimited needs.
 This leads to make choices on the means and ends
of development, which involves the rational use of
limited resources to attain the economic ends.
 Thus, investment decisions are an essential part of
the development process.
 The more sound the investment decision is, the
more success will be in the development endeavor.

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 The need for project planning, preparation and study emanates
from:
A. The quest for change: dissatisfaction with the present
and/or pressure or incentive for improvement in the future

B. Change involves investment/commitment of resources to

realize the objectives.

C. The scarcity of investible resources and unlimited

development/business needs;

D. Investment is all about resource commitment into the future,

which is less predictable;
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 E. An investment schemes have an inherent high
risk
F. The costs and benefits are temporally spread
and particularly the large part of the costs are
incurred earlier and the benefits are generated
later on.
 This raises the question of comparing and
equating the future and present values.

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G. Decision-making is not simple and perfect as it is assumed in
orthodox economics.
 These features of investment decisions constitute:

 the reasons that justify the significance and relevance of

project planning and

 the major constraints and challenges faced by any project

planner and decision maker in project viability studies.

 Thus, decision makers have to make every effort to

systematically rationalize their decisions by undertaking
rigorous viability studies.

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 Types of Projects

 There are different types of projects. That is; a project

can be;
– New, updating and / or expansion
– Market based, Resource based, Felt need
– Private, NGOs, and/or government/public
– Industrial, Agricultural and Service

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 1.3. The Project Cycle
• Project cycle is the different stages, phases, levels, steps,
events or sequences that a project follows.

• There are several models of project cycle but the most

important ones are:

• Baum Project Cycle Model- developed by WB

• The UNIDO project cycle model

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 PROJECT CYCLE (W.C BAUM)

Identification

Evaluation Interaction Preparation

Implementation Appraisal
 UNIDO P.C. Model
Identification

Post-evaluation Pre-feasibility

Implementation Feasibility

Appraisal
 Alternatively, we can categorize project cycle in to three

main phases (UNIDO, 1991)

1. Pre-investment phase

A. Identification/opportunity study/

B. Pre-feasibility study/ pre-selection/

C. Feasibility study

D. Support study;

E. Appraisal study

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2. Investment phase

A. Negotiating and contracting;

B. Engineering design;

C. Construction;

D. Procurement

E. Erection and installation

F. Pre production marketing;

G. Manning and training

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3. Operation phase

A. Commissioning and hand over and starting of operation

B. Post project evaluation/appraisal/

C. Replacement/rehabilitation

D. Expansion/innovation

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1. Identification (Opportunity studies)

 The first stage in the project cycle is to find potential projects.

 It is the identification of investment opportunities.

 Project ideas can emanate from a variety of sources.

 In general, one can distinguish two levels where project ideas

are born: The macro level and the micro level.

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 At the macro level, project ideas emerge from:

1. National policies, strategies and priorities as may be

initiated from time to time;

2. National, sectoral, sub-sectoral or regional plans and

strategies

3. General surveys, resource potential surveys, regional

studies, master plans, statistical publications which indicate
directly or indirectly investment opportunities;

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4. Constraints on the development process due to shortage
of essential infrastructure facilities, problems in the balance
of payments, etc.;

5. Government decisions to correct social and regional

inequalities or to satisfy basic needs of the people through
the developments of projects;

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6. A possible external threat that necessitates projects aiming at
achieving, for example, self sufficiency in basic materials,
energy, transportation, etc;

7. Unusual events such as draughts, floods, earth-quake,

hostilities, etc.;

8. Government decision to create project-implementing

capacity-Example- in construction

9. Project ideas can also originate from multilateral or

bilateral development agencies

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 In addition individual/entrepreneurial/ inspiration, institutions,

workshops, trade fairs, development experiences of other

countries may point to some interesting project ideas.

 At the micro-level-Project ideas may emanate from:

1. The identification of unsatisfied demand or needs

2. The existence of unused or underutilized natural or human

resources and the perception of opportunities for their efficient use

3. The need to remove shortages in essential material services,

or facilities that constrain development efforts

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4. The initiative of private or public enterprises in response to
incentives provided by the government.

5. The necessity to complement or expand investments

previously undertaken, and

6. The desire of local groups or organizations to enhance their

economic status and improve their welfare

 Project proposals can also originate from foreign firms

seeking for their profit

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2. Preparation and Analysis
 Once project ideas have been identified and selected, the process
of project preparation and analysis starts.

 Project preparation must cover the full range of technical,

institutional-organizational-managerial, social, commercial,
financial, economic and environmental analysis which are
necessary to achieve the project’s objective.

 Critical element of project preparation is identifying and

comparing technical and institutional alternatives for achieving
the project’s objectives.
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A. Technical Aspects
 Since a technically unfeasible project cannot be promoted,
technical study of a project provides the technical basis for all
other aspects of a project study.
 The main and challenging task in technical analysis is to
identify the appropriate technology for the objective that the
project is intended to meet.
 In general, this part of project study address issues related to:

A. Project design and processes: to ensure that there is

appropriate technology and engineering work, the study
should consider and evaluate alternative technologies and
alternative machines and equipment;

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B. The input – output relationship
 This aspect may include the works of engineers, soil
scientists and agronomists in case of, say, agricultural
projects.
 The technical analysis is concerned with the project’s
inputs (supplies) and outputs of real goods and services and
the technology of production and processing.
 This is crucial because the rest of the project analysis cannot
be conducted without information from the technical study.

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 In general the technical analysis is primarily concerned with

1. Material inputs and utilities

2. Location, site and environment
3. Manufacturing process/technology/ and engineering

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B. Institutional-Organizational-Managerial Aspects

 This basically incorporates the socio-cultural patterns and

institutions of the population that the project is believed to

serve.

 Does the project takes into account the cultural setup and

customs of the beneficiaries?

 Or will it disturb the accepted pattern?

 If so how should this be included as part of the project design?

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 To have a chance of being carried out, a project must be
related properly to the institutional structure of the country
or region where the project is to be carried out.
 Examples include: the land tenure system, use of local
institutions such as Idir etc.
 Similarly, managerial issues are critical for successful
completion of projects.
 Thus, the project analyst must examine the ability of
available staff to carry out the managerial needs of the
project.
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 Organization and Manning

 Dividing the project into organizational units in line with the

marketing, supply, production and administrative functions is

necessary not only from the operational point of view, but also
during the planning phase, to allow the assessment and
projection of overhead costs.

 The organizational set-up depends to a large extent on the size

and type of the industrial enterprise and the strategies, policies

and values of the organization.

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 Plant organization and management
 Organization is the means by which the operational
functions and activities of the enterprise are structured and
assigned to organizational units.
 This represents managerial staff, supervisors and workforce,
with the objective of coordinating and controlling the
performance of the enterprises and the achievement of its
business targets.
 The organizational structure of an enterprise indicates the
assignment of responsibilities and delegation of authorities to
the various functional units of the company.
 The organizational functions are the building blocks of the
company.

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 They may be grouped into the following organizational units
in line with the specific requirements of the individual
company:
 General Management
 Finance, financial control and accounting
 Personnel administration
 Marketing, sales and distribution
 Supplies, transport, storage
 Production:
 Main plant
 Service plants
 Quality assurance
 Maintenance and repair
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 The organizational structure of the company can also take a

number of shapes, the most common being the pyramid shape,

which has the following three organizational levels:

 Top management

 Middle management, and

 Supervisory management

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C. Social Aspects
 This aspect is more important to public projects.

 Project analysts are expected to examine the broader

social implications of the proposed project.
 That is; sufficient attention should be given to the social
soundness of a project.
 This is particularly related to:

1. The attitude and the likely response of the beneficiary groups;

2. The existence of potential implementation capacities or
organization within communities;
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3.The cultural factors related to the implementation and
outcomes of the project;
4. The political factors;
5. Income distribution implications of the project,
6. Employment creation: income distribution could be related to
employment creation.
7. Issues of balanced regional development,
8. The displacement impact of the project
9. The gender implication of the adopted technology;
10. Environmental impacts etc.
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D. Commercial aspects

 The commercial aspects of a project include the arrangements for

marketing the output produced by the project and the arrangements

for the supply of inputs needed to build and operate the project.

 On the output side, careful analysis of the proposed market for the

project's production is essential to ensure that there will be an

effective demand at a remunerative price.

Questions that must be addressed include:

 Where will the products be sold?

 Is the market large enough to absorb the new production without

39 affecting the price?

 If the price is likely to be affected, by how much?

 Will the project still be financially viable at the new price?

 What share of the total market will the proposed project supply?

 Are there suitable facilities for handling the new production?

 Is the product for domestic consumption or for export?

 Does the proposed project produce the grade or quality that the
market demands?
 What financing arrangements will be necessary to market the
output?
 What special provisions need to be made in the project to finance
marketing?
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 On the input side-appropriate arrangements must be made so as to

create adequate input supply to the project.

 Questions that must be addressed include:

 Do market channels for inputs exist?

 Do market channels have enough capacity to supply new inputs on time?

 What about financing for the suppliers of inputs and credit for the

farmers to purchase these supplies?

 Should new channels be established by the project or should special

arrangements be made to provide marketing channels for new inputs?

 Commercial aspects of a project also include arrangements for the

procurement of equipment and supplies.

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 E. Financial Aspects
 In the financial analysis part, analysts should try to identify and
analyze the projects financial efficiency, incentive impact to the
participants in the project, creditworthiness and liquidity.
 The aspects that should be considered during financial analysis
include:
1. Investment outlay and costs of the project
2. Means of financing
3. Cost of capital
4. Projected profitability
5. Break-even point
6. Cash flows of the project
7. Investment worthwhileness
8. Projected financial position
42 9. Level of financial risk
F. Economic Aspects
 The economic aspect of project preparation is primarily
concerned with the impact/contribution of the project to the
whole economy (the society as a whole).
 The focus is on the social costs and benefits of a project,
which may often be different from its monetary costs, and
benefits.
 The financial analysis views from the participants (or owners)
point of view, while the economic analysis from the society’s
point of view.

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 There are three important distinctions between the two types of
analyses
1. Treatments of taxes and subsidies: these items are treated as
transfers in the economic analysis while in financial analysis taxes
are usually treated as cost and subsides as a return/income.
2. Use of Prices: in the financial analysis we will use actual market
prices.
 In economic analysis the market prices are adjusted to accurately
reflect social and/or economic values.
 The latter prices are termed as ‘shadow prices’ or ‘economic
accounting prices’.
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3. Treatment of interest on capital: in economic analysis
interest on capital is never separated and deducted from the
gross return.

 Because, it is part of the return from capital which is

available for the society as a whole.

 Such interest is deducted from benefit stream in financial

analysis whose point of view is the firm and hence interest is a

cost to the firm.

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G. Environmental/Ecological/ analysis
 Ecological analysis should be done particularly for major projects,
which have significant ecological implications like:
 power plants

 irrigation schemes

 environmental polluting industries

 etc.

 The key questions raised in ecological analysis are:

1. What is the likely damage caused by the project to the environment?

2. What is the cost of restoration measures required to ensure that the
damage to the environment is contained within acceptable limits?
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3. Appraisal

 After a project has been prepared, it is generally appropriate for a

critical review or an independent appraisal to be conducted.

 This provides an opportunity to reexamine every aspect of the

project plan to assess whether the proposal is appropriate and sound

before large amount of resources are committed.

 The appraisal process builds on the project plan, but it may involve

new information if the specialists on the appraisal team feel that

some of the data are questionable or some of the assumptions are
faulty.
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 Three decisions

1. Approve-if the appraisal team concludes that the project plan

is sound

2. Amend- appraisal team may request for amendments if there

are some errors which can be corrected easily

3. Reject- appraisal team can reject project proposal if it finds

serious errors or if the project is not worthy totally.

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4. Implementation

 After approving a project proposal, the next step is changing

into action/implementation/.

 Thus, implementation is the most important part of the project

cycle.

 There are some aspects of implementation that are of

particular relevance to project planning and analysis. These
include:

 First, the better and more realistic a project plan is, the more
likely it is that the plan can be carried out and the expected
benefit realized.
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  Second, project implementation must be flexible.

 Circumstances can change, and project managers must be

able to respond intelligently to these changes.
 Technical, economic, political etc. changes can change the
way we should implement the project.
 The greater the uncertainty of various aspects of the
project, or the more innovative and novel the project is, the
greater the likelihood that changes will have to be made.

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 Even as project implementation is under way, project managers

will need to reshape and replan parts of the project, or the

entire project.

 Implementation is a process of refinement, of learning from

experience-in effect, it is a kind of “mini-cycle” within the

larger project cycle we have outlined.

 Project analysts generally divide the implementation phase into

three different time periods.

 First-the investment period- when the major project

investments are undertaken.
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 Second- the development period-it is when the project builds

up its production.

 Third- project life- after full development is reached, it

continues for the life of the project.

 Usually the project life is keyed to the normal life of the major

asset.

 However, for practical reasons, a project life rarely exceeds

25-30 years.

 Both the financial and economic analyses of the project relate

to this time horizon.

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5. Evaluation
 The final phase in the project cycle is evaluation.

 The analyst looks systematically at the elements of success

and failure in the project experience to learn how better to plan
for the future.
 It is important managerial tool in ongoing projects, and rather
formalized evaluation may take place at several times in the
life of a project.
 Evaluation may be done by many different people or
organizations.

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 The extent to which the objectives of a project are being
realized provides the primary criterion for an evaluation.

 The evaluators also evaluates the appropriateness of the

objectives and the plan in light of the objectives.

 Evaluators try to evaluate:

 Was the technology proposed appropriate?

 Were the institutional, organizational, and managerial

arrangements suited to the conditions?

 Were the commercial aspects properly considered?

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 Were the financial aspects carefully worked out on the basis

of realistic assumptions, and were the economic implications

properly explored?

 How did the project in practice compared with each aspect of

the project analysis?

 Did the institutional and organizational structure in the project

permit a flexible response?

 Did management respond quickly enough to changes?

 Finally, evaluators will recommend for improvements for the

future.
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  Review Questions
 Answer the following questions.
1. What is project?
2. What is the importance of project plan?
3. Explain the reasons that makes project risky.

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 CHAPTER -TWO
FINANCIAL ANALYSIS AND
APPRAISAL OF PROJECTS

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2.1. Scope and Rationale for Financial Analysis of
Projects
2.1.1.What is financial analysis?
 It is concerned with assessing the feasibility of a new project
from the point of view of its financial results.
 Financial analysis helps to determine the financial
profitability of a project.
 It will be worthwhile to carry out a financial analysis if the
output of the project can be sold in the market or can be valued
using market prices.
 The project’s direct benefits and costs are, therefore, calculated
in financial terms at the prevailing (expected) market prices.
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 This analysis is applied to appraise the soundness and acceptability
of a single project as well as to rank projects on the basis of their
profitability.
 In other words, financial analysis is all about the assessment,
analysis and evaluation of the required project inputs, the outputs
to be produced and the future net benefits, with the aim of
determining the viability of a project to the private investor or the
executing public body.
 The financial analysis deals with two issues:
1. Investment profitability analysis, with different methods of
analysis;
a. Simple methods of analysis of rate of return/static methods/ non-
discounted techniques/.
This include:
 Simple rate of return;
 Pay-back period;
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b. Discounted-cash-flow methods/dynamic methods

 Net Present Value/NPV/;

 Internal Rate of Return/IRR/

2. Financial analysis/ ratio analysis/

a. Liquidity analysis;

b. Capital structure analysis (debt-equity ratio).

 The two types of analysis are complementary and not
substitutable.

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 The investment profitability analysis is an assessment of the

potential earning power of the resources committed to a project

without taking into account the financial transactions occurring
during the project’s life.

 On the other hand, financial analysis has to take into account

the financial features of a project to ensure that the disposable

finances shall permit the smooth implementation and
operation of the project.

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2.1.2 Why one undertakes Financial Analysis? or When to
undertake financial analysis?
 Financial analysis applies to private and public investments.

 A private firm will primarily be interested in undertaking a

financial analysis of any project it is considering and seldom
will undertake an economic analysis.
 The issue of financial sustainability of a public project justifies
the need for undertaking financial analysis.
 But commercially oriented government authorities that are
selling output such as railway, electricity, telecommunications,
etc., will usually undertake a financial and an economic
analysis of any project that they are undertaking.

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 Even non-commercially oriented government organizations
may sometimes wish to choose between alternative facilities
on the basis of essentially financial objectives.
 In the case of a hospital service, the management of the
hospital maybe required to provide the cheapest services.
 Under such circumstances a cost minimization or cost
effectiveness exercise will be undertaken.
 Financial profitability analysis is the first step in the
economic appraisal of a project.
 A comprehensive financial analysis provides the basic data
needed for the economic evaluation of the project and is the
starting point for such evaluation.

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 In fact, economic analysis mainly involves adjustments of the
information used in financial analysis and of a few additional
ones.
 The procedure and methodology in financial analysis is
basically the same with that of economic analysis.
 Yet one has to recognize and realize the differences between
the two.
 It has to be noted that the financial analyst should be able to
communicate and know what to ask from the different team
members to collect relevant information on:
1. Revenue, both forecasted sales and selling price
2. Initial investment costs distributed over the implementation of
the project;
3. Operating costs of the envisaged operational unit/firm/ over
64 its operating life.
 The issues and concerns of financial analysis are:

1. Identification of required data;

2. Analysis of the reliability of data;
3. Analysis of the structure and significance of costs and
benefits/incomes/;
4. Determination and evaluation of the annual and accumulated
financial net benefits; expressed as profitability, efficiency or
yield of the investment;
5. Consideration of the spread of flows of the costs and benefits
over time, the economic life of the envisaged economic
unit/firm/public entity/;
6. Costs of capital over time;
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Planning Horizon and Project Life
 The project planning horizon of a decision maker can be defined as:

 the period of time over which he/she decides to control and manage
his/her project-related business activities, or for which he/she
formulates his/her investment or business development plan.
 The planning horizon must consider the life time of a project.

 The economic life of a project is the period over which the

project would generate net gains.
 The economic life of a project depends basically on:

 the technological life cycle of the main plant items,

 the life cycle of the product and of the industry involved, and

 the flexibility of a firm in adapting its business activities to

changes in the business environment.
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 When determining the economic life span of the project,
various factors have to be assessed.
 Some of them are:

1. Duration of demand (position in the product life cycle);

2. Duration of raw material deposits and supply;
3. Rate of technical change;
4. Life cycle of the industry;
5. Duration of building and equipment;
6. Opportunities for alternative investment;
7. Administrative constraints (urban planning horizon).
 It is evident that the economic life of a project can never be
67 longer than its technical life or its legal life.
2.3 Identification and Analysis of the Estimates of Costs and
Benefits
 In project analysis, the identification of costs and benefits
is the first step.
 This involves:

 the specification of the costs and benefit variables for which

data should be collected,
 identification of the sources of information,

 collection of the information and

 assessment of the quality and reliability of the collected

information.

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Objectives and the Identification of Costs and Benefits

 The costs and benefits of a project depend on the objectives the

project wants to achieve.

 So, the objectives of the analysis provide the standard against

which costs and benefits are defined.

 A cost is anything that reduces an objective, and a benefit is

anything that contributes to an objective.

 However, each participant in a project has many objectives.

 For a farmer, a major objective of participating may be to

maximize family income.

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  But this is only one of his/her objectives.

 She/He may also wish her/his children to be educated,

which reduces the available labor force for farm work.

 Taste preferences may force the farmer to continue growing

a traditional variety although a new and high yielding
variety may be available.

 She/He may also wish to avoid risk and thus continue

cropping a variety, which She/he knows well.

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 For a private business firm or government corporations, a
major objective is to maximize net income.

 However, both have significant objectives other than simply

making the highest possible profit.

 Both will want to diversify their activities to reduce risk.

 A society as a whole will have as a major objective increased

national income, but it clearly will have many significant,
additional objectives.

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 Example:

 income distribution,

 creating employment opportunities,

 increase the proportion of saving for future investment,

 increasing regional integration,

 raising the level of education,

 improve rural health, or safeguard national security.

 Any of these may lead to the choice of a project that is not the
alternative that would contribute most to national income which is
narrowly defined.
 No formal analytical technique could possibly take into account all
the various objectives of every participant in a project.
72 Some selection will have to be made.

 Mostly, the maximization of income is taken as the dominant
objective of the firm.
 Because, the single most important objective of an individual
economic agent is to increase income and increased
national income is the most important objective of national
economic policy.
 Thus, anything that reduces national income is a cost and
anything that increases national income is a benefit.

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 Quantification:
 Once costs and benefits are listed, the next step is accurate
prediction of the future benefits and costs which then
be quantified in monetary units/Birr/.
 Thus, quantification involves the quantitative assessment
of both physical quantities and prices over the life span of
the project.

74
 2.4.Classification of Cost
 There are alternative ways of classifying costs and benefits of a
project.
 One is to categorize both costs and benefits into:
 Tangible and
 Intangible once.
 Another classification is in terms of:
1. Total investment costs;
2. Operational/running costs;

75
Another classification:
1. Total investment costs including:
a. Initial investment costs;
• Fixed investment costs;
• Pre-Production expenditures;
b. Investment required during plant operation / rehabilitation and
replacement investment costs/
c. Net working capital
2. Operating costs/costs of goods sold

76
Tangible costs of a project
 In almost all project analysis, costs are easier to identify (and
value) than benefits.
 The prices that the project actually pays for inputs are the
appropriate prices to use to estimate the project’s financial
costs.
 Some of the project costs are tangible and quantifiable while
many more are intangible and non quantifiable.
 The costs of a project depend on the exact project formulation,
location, resource availability, or objective of the project.
 In general, the cost of a project would be the sum of the total
outlays.
 These include:
77
Initial Fixed Investment costs
 The initial fixed investments constitute the major resources
required for constructing and equipping an investment project.
 These include the following tangible initial fixed investments.
1. The cost of land and site development
 Land charges
 Payment for lease
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 etc.

78
2. The cost of buildings and civil works
 Buildings for the main plant and equipments

 Buildings for auxiliary services (workshops, laboratory, water

supply, etc.)
 Warehouses and show rooms

 Non factory buildings like guest house, canteens, residential

quarters, staff rooms
 Garages and workshops

 Other civil engineering works

79
3. Plant and machinery
 Cost of imported machinery which might include the FOB
value, shipping freight and insurance costs, import duty,
clearing, loading, unloading, and transportation costs
 Cost of local or indigenous machinery
 Cost of stores and spares
 Foundation and installation charges

4. Miscellaneous fixed assets

 Expenses related to fixed assets such as furniture, office
machines, tools, equipments, vehicles, laboratory equipments,
workshop equipments

80
 Pre-production Expenditures
 Another component of the initial investment cost which
includes both tangible and intangible costs is the pre-
production expenditures.
 In every project, certain expenditures are incurred prior
to commercial production.
 This includes the following investment cost items.

 1. Intangible assets: these assets represent expenditures

which yield benefits extending over a long time period.
 These include:
a. Patents, licenses, lump sum payments for technology,
engineering fees, copy rights, and goodwill.
b. Preparatory studies, like specific functional studies and
investigations, consultant fees for preparing studies,
81
supervision costs, project management services, etc.
2.Preliminary expenses: these costs include:
 preliminary establishment expenses, (registration and
formation expenses),
 legal fees for preparation of memorandum and articles of
associations and similar documents.
 In addition, it includes costs of advertisements, brokerage for
mobilizing resources, shareholders, expenses for loan
application and its processing.

3. Other Pre-operation expenses

 These include:
 Rents, taxes etc
 Trial runs, start-ups and commissioning expenditures( raw
materials and other inputs consumed immediately before
82
commercial operation);
 Salaries, fringe benefits and social security contributions
of personnel engaged during the pre-production period;
 Pre-production marketing costs, promotional expenses,
creation of sales network, etc;
 Training costs, including all fees, travel, living expenses etc;

 Insurance charges

 Miscellaneous expenses

83
 Plant and Equipment Replacement Costs
 Every machinery and equipment does not have equal
economic life.
 There are machineries and equipments that productively be
operated for many years.
 On the other hand there are equipments, machinery
components and parts which need to be regularly replaced for
smooth operation of the same technology.
 So, sound project planning work should adequately
provide for replacement of components and parts.
 Thus, it is necessary to identify such items and then estimate
the costs for replacement and then the same should be reflected
in the financial and economic analysis.
84
Terminal Values/End-of-Life Costs/Salvage Costs/
 Though firms may be institutionally organized to live and
operate for unlimited period of time and hence unlimited age,
technologies, machineries and equipment do have limited
operational/economic/ life.
 During the end of the economic life of a good/machinery,
equipment, building, etc) there is some salvaged value and the
salvation may involve incurring of costs.
 The costs associated with the decommissioning of fixed assets
at the end of the project life, minus any revenues from the sale
of the assets, are end-of-life costs.
 Major costs are the costs of dismantling, disposal and land
reclamation.
85
 Net Working Capital
 Net working capital is part of the total investment outlays.

 It is defined as current assets (the sum of inventories,

marketable securities, prepaid items, accounts receivable and
cash) minus current liabilities (accounts payable).
 This investment is required for financing the operation of the
plant.
 Working capital is generally categorized into gross working
capital and net working capital (NWC).

86
 The gross working capital consists of all the current assets,
including:
a. raw materials;
b. stores and spares;
c. work-in-process;
d. finished goods inventory;
e. Debtors/accounts receivable/;
f. Cash and bank balance.
 Net working capital is defined as gross working capital
less current liabilities.
 For the purpose of financial analysis and even financial
management of operational firms, it is net working capital
which is the center of decision makers.
87
Costs of Goods Sold/Operating costs
 Once the project idea has been accepted and the project is
being implemented, the cost of production may be worked out.
 For instance, for an agricultural project the following may be
necessary:
 Material cost- this comprises the cost of raw materials,
chemicals, components, fertilizer and pesticides for increasing
agricultural production, concrete for irrigation canal
construction, material for the construction of homes etc and
consumable stores required for production.
 It is not the identification that is difficult in this case but the
problem of finding out how much is needed from each.

88
 Utilities- consisting of power, water, and fuel are also
important cost components.
 Labor: this is the cost of all manpower employed in the
enterprise.
 Factory Overhead: the expense on repairs and maintenance,
rent, taxes, insurance on factory assets, etc. are collectively
referred to as factory overheads.
 Land-is the cost incurred for the land to be used for the
project.

89
 Contingency allowances- are usually included as a regular
part of the project cost.
 Sound project planning takes into consideration in advance for
possible adverse changes in physical conditions or prices that
would add to the baseline cost.
 Contingency allowances may be divided into physical
contingencies and price contingencies.
 Price contingencies comprises two categories-relative changes
in price and general inflation.
 Physical contingency allowances and price contingency
allowances for relative changes in price are expected and form
part of the cost base when measures of project worth are
calculated.
90
 To avoid the problem of inflation on the other hand it is
advisable to work with constant prices instead of current
prices.
 This approach assumes that all prices will be affected equally
by any rise in the general price level.
 So contingency allowances for inflation will not be included
among the costs in project accounts other than the financing
plan.
 Taxes: payment of taxes including tariffs and duties is treated
as a cost to the project implementer in financial analysis.
 Debt service: the payment of interest and the repayment of
capital.
 Both are treated as an outflow in financial analysis.

91
 Sunk costs

 Sunk costs are those incurred in the past and upon which the
proposed new investment will be based.
 Such costs cannot be avoided.

 When we analyze a proposed investment, we consider only

future returns to future costs; expenditures in the past, or sunk
costs do not appear in our account.

92
 Tangible Benefits
 Tangible benefits can arise either from increased
production or from reduced costs.
 In general the following benefits can be expected:
 Increased production
 Quality improvement
 Changes in time of sale
 Changes in location of sale
 Changes in product form (grading and processing)
 Cost reduction through technological advancement
 Reduced transport costs
 Looses avoided
 Other kinds of tangible benefits
93
Secondary Costs and Benefits
 Projects can lead to benefits created or costs incurred outside
the project itself.
 Incorporating secondary costs or benefits in project analysis
can be viewed as an analytical device to account for the value
added that arises outside the project but is a result of the
project investment.
 If a project has a substantial effect on the quantity other
producers are able to sell in imperfect markets-and most
markets are imperfect-there may be gains or losses not
accurately accounted for.
Benefits:
 Reduction in cost of transport due to improved road/rail
 technological spillover or technological externalities
 Multiplier effect
94
Cost:
 Example: Adverse ecological effects

 pollution

 Irrigation development may reduce the catch of fish

 When these technological externalities are significant and can

be identified and valued, they should be treated as a direct cost
of the project (as might be the case for reduced fish catches), or
the cost of avoiding them should be included among the
project costs.

95
 Intangible Costs and Benefits
 Almost every agricultural project has costs and benefits that
are intangible.
 These may include creation of new job opportunities, better
health and reduced infant mortality as a result of more rural
clinics, better nutrition, reduced incidence of waterborne
disease as a result of improved rural water supplies etc
 Such intangible benefits are real and reflect true values.

 They do not, however, lend themselves to valuation.

 But, since intangible benefits are a factor in project selection,

it is important to carefully identify and, where at all possible,
quantified, even though valuation is impossible.

96
 For example:

 How many children will enroll in new schools?

 How many homes will benefit from a better system of water

supply?
 How many infants will be saved because of more rural
clinics?
 Intangible costs:

 Such costs might be incurred if new projects disrupt traditional

patterns of family life, if development leads to increased
pollution, if the ecological balance is upset, or if scenic values
are lost.

97
 Again, although valuation is impossible, intangible costs
should be carefully identified and if possible quantified.
 In general, every project decision will have to take intangible
factors into account through a subjective evaluation.
 Because, intangible costs can be significant and because
intangible benefits can make an important contribution to
many of the objectives of a project or beyond.

98
The valuation of financial costs and benefits
 This is an issue of pricing/valuing/ of the project’s inputs and
outputs.
 The inputs and outputs of a project appear in physical form
and prices are used to express them in value terms in order to
obtain common denominator.
 For the purpose of the feasibility study, prices should reflect
the real economic values of project inputs and outputs for the
entire planning horizon of the decision makers.
 The financial benefits of a project are the revenues
received and the financial costs are the expenditures that
are actually incurred.

99
 In financial analysis, all these receipts and expenditures are
valued as they appear in the financial balance sheet of the
project, and are therefore, measured in market prices.
 Market prices are just the prices in the local economy, and
include all applicable taxes, tariffs, trade mark-ups and
commissions.
 Since the project implementers will have to pay market prices
for the inputs and will receive market prices for the outputs
they produce, the financial costs and benefits of the project are
measured in these market prices.
 The financial benefit from a project is measured in terms of the
market value of the project’s output, net of any sales taxes.

100
 Prices may be defined in various ways, depending on whether
they are:
1. Market/explicit/ or shadow/imputed/ prices;
2. Absolute or relative prices;
3. Current or constant prices.
Market/Shadow prices:
 Market or explicit prices are those present in the market, no
matter whether they are determined by supply and demand or
by the government.
 They are the prices at which the firm will buy the inputs and
sell the outputs.
 In financial analysis market prices are applied.
101
 In economic analysis we raise the question whether market
prices reflect real economic value of project inputs and
outputs.
 In economic analysis, if the market prices are distorted, then
shadow or imputed prices will have to be used for economic
analysis.
Absolute/relative prices:
 Absolute prices- reflect the value of a single product in an
absolute amount of money
 Relative prices- express the value of one product in terms of
another.
 For instance, the absolute price of 1 tone of coal may be 100
monetary units and an equivalent quantity of oil may be 300
monetary units.
102
 In this case the relative price of coal in terms of oil would be
0.33, meaning that the relative price of oil is three times the
price of coal.

 The level of absolute prices may vary over the lifetime of the
project because of inflation or productivity changes.

 This variation does not necessarily lead to a change in relative

prices.

 In other words, relative prices may sometimes remain

unchanged despite variations in absolute prices.

 Both absolute and relative prices can be used in financial

analysis.
103
Constant Vs Current prices
 Current and constant prices differ over time due to inflation, which
is understood as a general rise of a price levels in an economy.
 If inflation can have a significant impact on project inputs and
output prices, such an impact must be dealt with in the financial
analysis.

 Wherever relative input and output prices remain stable, it is

sufficiently accurate to compute the profitability or yield of an
investment at constant prices.

 Only when relative prices change and project input prices grow
faster (or slower) than output prices, or vice versa, then the
corresponding impacts on net cash flows and profits must be
included in the financial analysis.

 If inflation impacts are negligible, the planner may use either current
or constant prices.
104
 The Treatment of Transfer Payments in Financial Analysis
 Some entries in financial accounts represent shifts in claims to
goods and services from one entity in the society to another
and do not reflect changes in national income.
 These payments are called direct transfer payments.

 These direct transfer payments include taxes, subsidies, loans,

and debt services.
 Taxes: taxes that are treated as a direct transfer payment are
those representing a diversion of net benefit to the society.

105
  A tax does not represent real resource flow; it represents
only the transfer of a claim to real resource flows.

 In financial analysis a tax is clearly a cost.

 When a firm pays taxes its net income reduces.

 But, the payment of taxes does not reduce national income.

 As a result, in economic analysis, taxes will not be treated as

a cost in project account.

 A tax can be a direct tax or an indirect taxes such as sales

tax, an excise tax, or tariff or duty on an imported input for
production.
106
Subsidies:
 Are simply direct transfer payments that flow in the opposite
direction from taxes.
 Direct subsidies represent the transfer of a claim to real
resources from one enterprise, sector or individual to another.
 Subsidies may be open or disguised and are provided on the
input or output side.
 On the input side, subsidies reduce costs to the project, e.g.
subsidies to fertilizers.
 If the subsidy is granted on the output side i.e., increase the
revenue of the project; we should deduct the amount of the
subsidy from the revenue that includes subsidy.

107
 If a firm is able to purchase an input at a subsidized price, it
will reduce its costs and thereby increase its net benefit.

 But, the cost of the input in the use of the society’s real
resources remains the same.

 The resources needed to produce the input or to import it from

abroad reduce the national income available to the society.

 Hence, for economic analysis of a project, we must enter the

full cost of the input.

 Again it makes no difference what form the subsidy takes.

 One form is that which lowers the selling price of the input
below what otherwise would be their market price.
108
 But a subsidy can also operate to increase the amount the
owner receives for what he sells in the market, as in the case
of a direct subsidy paid by the government that is added to
what he receives in the market.

 A more common means to achieve the same result does not

involve direct subsidy.

 The market price may be maintained at a level higher than it

otherwise would be by, say levying an import duty on
competing imports or forbidding competing imports
altogether.

 Although it is not a direct subsidy, the difference

between the competing imports that would prevail without
such measure does represent an indirect transfer from the
109consumer to the producer.
Credit Transactions:
 These are the other major form of direct transfer payments.
 A loan represents the transfer of a claim to real resources from
the lender to the borrower.
 When the borrower repays loans or pays interest he/she is
transferring the claim to the real resource back to the lender.
 From the standpoint of a firm, receipt of a loan increases the
production resources it has available.
 Whereas, payment of interest and repayment of principal
reduces them.
 But from the standpoint of the national economy, loans do not
reduce the national income available.
 It merely transfers the control over resources from the
lender to the borrower.
110
2.5. Investment Profitability Analysis
2.5.1. Non-Discounted Measures of Project Worth
1. Ranking by Inspection
 It is possible, in certain cases, to determine by mere inspection
which of two or more investment projects is more desirable.
 There are two cases under which this might be true.
I. Two investments have identical cash flows each year up to the
final year of the short-lived investment, but one continues to
earn profits in subsequent years.
 The investment with the longer life would be more desirable.
 Accordingly project B is better than investment A, since all
things are equal except that B continues to earn proceeds after
A has been retired.
 More analysis is required to decide between C and D.
111
Example: consider the following hypothetical irrigation project
Investment Initial cost Net cash proceeds per year
(project)
Year I Year II
A 10,000 10,000 ---
B 10,000 10,000 1,100
C 10,000 3,762 7,762
D 10,000 5,762 5,762
II. Two investments may have the same initial outlay, the same earning
life and earn the same total proceeds (profits), but one project has
more of the flow earlier in the time sequence.
 In this situation, we choose the one for which the total proceeds is
greater than the total proceeds for the other investment earlier.
 Thus investment D is more profitable than investment C, since D
earns 2000 more in year 1 than investment C, which does not make
112
up the difference until year 2.
2. The Payback Period
 The payback period is also called the payoff period.
 The payback period is defined as the length of time or the number of
years it is expected to take from the beginning of the project until
the sum of its net earnings (receipts minus operating costs) equals
the project’s initial capital investment cost.
 This criterion is most often used in the business enterprises.
 Example: if a project requires an original outlay of Birr 300 and is
expected to produce a stream of cash proceeds of Birr 100 per year
for 5 years, the payback period would be
 300/100 = 3 years.
 Note: if the expected proceeds are not constant from year to year,
then the payback period must be calculated by adding up the
proceeds expected in successive years until the total is equal to the
original outlay.
113
 Example: consider project C. 10000 - 3762 = 6238. then
6238/7762 = 0.8 so 1.80 years.
 Example: consider the previous project

Investment Payback period Ranking

A 1 1
B 1 1
C 1.8 4
D 1.7 3

 Payback period has two important limitations:

A. It fails to give any considerations to cash proceeds earned after the
payback date.
 It simply emphasizes quick financial returns.
B. It fails to take into account differences in the timing of receipts and
earned proceeds prior to the payback date.
114
 Discounted measures of project worth

Read!!
Why we need to use discounted measures
and how to discount costs and benefits in
project profitability analysis.

115
116
 IRR= =0

117
118
 NPV and Decision Rule for Independent Projects
 Independent projects are projects that are not in any way
substitutes for each other.
 In such cases the decision rule is to accept the project if the
NPV > 0.
 If two projects have positive NPV and there is no budget
constraint both should be accepted and you do not need to
choose the one with higher NPV.
 For example, if two independent projects road and fisheries
development projects in different locations are being
considered and both have a positive NPV, then both should
be undertaken.
 Both will increase community’s welfare if they were
undertaken and hence both should be undertaken.
119
Decision Rule for Mutually Exclusive Projects

 A mutually exclusive project is defined as a project that can

only be implemented at the expense of an alternative project
as they are in some sense substitutes for each other.

 Example of the mutually exclusive projects includes two

versions of the same project, say with different technology,
scale or time.

 The decision rule for such projects is to accept the project

with the highest NPV.

120
Decision rule for independent projects

 According to the IRR version of economic criterion, we

implement all projects that show an IRR greater than the
predetermined discount rate.

 Once the IRR is identified, the decision rule is ‘accept the

project if the IRR is greater than the cost of capital, say r.

121
The IRR and Mutually Exclusive Projects

 While the IRR cannot be directly used to choose between mutually

exclusive projects, it can be employed for further manipulation.

 This manipulation entails the subtracting the cash flow of the

smaller project from the cash flow of the larger one and calculating
the internal rate of return of the residual cash flow.

 If the residual cash flow’s internal rate of return exceeds the target
discount rate, which could only occur if the larger project has a
higher NPV, then the larger project should be undertaken.

 If the analyst encountered with mutually exclusive projects with

IRR greater than the target interest rate, it cannot merely choose
the project with the highest IRR.
122
Advantages of the IRR
 The IRR is used in many projects

 It is the only measure of project worth that takes account of

the time profile of a project but can be calculated without
reference to a predetermined discount rate. (Useful for
international institutions like the WB since they cannot do
with different discount rate for different countries.

 It is a measure that could be understood easily by non-

economists since it is closely related to the concept of the
return on investment.

 It is a pure number and hence allows projects of different size

to be directly compared.
123
Problems with the IRR
 The IRR is inappropriate to use for mutually exclusive projects and
independent projects when there is a single period budget
constraint.
 A project must have at least one negative cash flow period before it
is possible to calculate its internal rate of return.
 This is because the NPV will always be positive no matter how
high the discount rate used to discount it, unless the project has at
least one negative cash flow period.

 Another problem with the IRR is that in some cases it is possible to

compute more than one IRR for a project. If a project has more
than one IRR, it cannot be reliably used.
 Thus, another decision rule such as the NPV must be used rather
than the IRR.

124
2.6. Sensitivity Analysis
 Another method popularly used for analysis of risk is what
is called sensitivity analysis.
 This consists varying key parameters (individually or in a
combination) and assessing the impact of such changes or
manipulation on the project’s net present value.

 It consists of testing the sensitivity of the NPV or IRR to

changes of basic variables and parameters that enter the
project’s input and output streams.
 The common practice is to vary them by fixed percentage
such as 10%.

125
 Exercise
 Given r=10%, find payback period, NPV, BCR and IRR of the
hypothetical project(use three decimal number).
 Cash Flow Projection for Discounting
Descriptio
n/years
0 1 2 3 4 5 6 7 8 9 10

Total - 2,822,400 3,018,528 3,228,838 3,454,493 3,696,660 3,956,340 4,235,028 4,534,056 4,854,920 4,854,920
Revenue

Inflow - 2,822,400 3,018,528 3,228,838 3,454,493 3,696,660 3,956,340 4,235,028 4,534,056 4,854,920 4,854,920
operation

Total Cost 3,040,000 2,310,183 2,468,898 2,638,570 2,820,084 3,014,327 3,243,064 3,465,430 3,703,437 3,958,224 3,973,819

Increase 3,040,000 - - - - - - - - - -
in fixed
assets

Operating - 2,195,912 2,330,174 2,473,657 2,627,094 2,791,224 2,966,685 3,154,415 3,355,258 3,570,157 3,589,841
costs

Income(co - 114,271 138,724 164,913 192,989 223,102 276,379 311,015 348,179 388,067 383,978
rporate)ta
x

Net cash (3,040,000 512,217 549,630 590,267 634,409 682,333 713,276 769,598 830,619 896,696 881,101
flow(PRO )
FIT)
126
 CHAPTER – THREE
ECONOMIC ANALYSIS OF PROJECTS

127
 In financial analysis, the analyst is concerned with the
profitability of the project from an individual point of view
(firm’s profitability).
 The main objective here is to maximize the income of the firm
or to analyze the budgetary impacts.
 The financial analysis is done by applying market prices.

 In economic analysis, the objective is to maximize national

income no matter who receives it.
 But financial analysis will rarely measure a project’s
contribution to the community’s welfare.

128
 Thus, the project analyst must not only be sure that a proposed
project will be profitable enough to attract investment interest
but also that the project will contribute sufficiently to the
growth of national income.

 The starting point for the economic analysis is the financial

prices.

 They are adjusted as needed to reflect the value to the society

as a whole of both the inputs and outputs of the project.

129
3.1. The Rationale for Economic Analysis
 The objective of any legitimate government is promotion of
community welfare.
 Governments are more concerned with their public work
programs to promote community welfare than they merely
maximize financial profits at distorted local prices.
 Prices could be distorted because of failures of markets, the
absence of perfect knowledge, and the existence of
externalities, consumer and producers surplus, government and
public goods, etc.
 As a result, it is not possible to use market prices to assess the
economic worth of projects.
 So, governments must choose projects on the basis of an
economic analysis if they wish to promote the community’s
130
welfare.
 The major conditions under which it is impossible to use
market prices to assess the economic worth of projects can be
grouped under the following major headings:
1.Intervention in and failures of goods markets including the
markets for internationally traded goods.
2.Intervention in and failure of factor markets including the
market for labor, capital, and foreign exchange.
3.The existence of externalities, public goods and consumer and
producers surplus.
4.Imperfect knowledge, which the neoclassical model assumes
that consumers and producers have full knowledge about all
aspects of the economy relevant to their choice of operations.
 This is unrealistic because of poor transport and
communication and low education levels.
131
Government Interventions and/or Failure of Goods Markets
A. Failure of domestic goods markets
 The true economic value of a good produced by a project,
(marginal social benefit), is in general measured by what
people are willing to pay for that good.
 Traditionally this is reflected by the market price of the
commodity.
 But the market price of that commodity will not measure what
people are willing to pay for it unless the following three
conditions are met:
1.There is no rationing of scales or price controls in the market
for the good.
 That is, QD must equal QS and the price of the good must be
its competitive demand price.
132
2.There is no consumer’s surplus from the consumption of the
good.
 If people are willing to pay more than they actually have to pay
for a project output, then these market prices do not reflect the
true value of the good produced by the project.
3.There is no monopsony buyer who is large enough to force the
project to sell its output below the price that the monopsonist is
really willing to pay.
 Unless these conditions are met, the good’s market price will
not reflect people’s true willingness to pay for the good and
will not be a good measure of the welfare or utility that people
will obtain from consuming the project’s output.
 If any of these market imperfections exist, it will be necessary
to use corrective measures (shadow prices).
 Alternatively, governments may enforce compulsory deliveries
of goods and services at artificially low controlled prices.
133
B. Trade protection and intervention in the markets for
internationally traded goods
 Governments frequently intervene in import markets by
imposing quotas and tariffs to protect infant industries or
activities that are internationally competitive.
 Tariffs and quotas will cause a divergence between local
market prices and the world prices of internationally traded
goods.
 The extent of this divergence may vary from industry to
industry.
 An import quota will push the domestic market cost of the
input well above the foreign exchange cost to the economy of
importing the input (world price).
 Such import quota overvalue the social cost of the traded input
used by the project.
134
2. Failures of/or Intervention in Factor Markets
 The true economic cost to an economy of a project’s input, its
marginal social cost, will be measured by its economic
opportunity cost to suppliers.
 The market price of an input will equal to its opportunity cost
of production if the following conditions are met:
1.There are no rationing, price controls or taxes in factor
markets, such as fixed minimum wages, controlled interest
rates, price controls on raw materials or taxes on labor, savings
and profits, raw materials, equipment or other project inputs.
2.There is no producer’s surplus in the market price of the input
3.There are no monopsony buyers who are in a position to force
the factor’s market price below their marginal revenue product
and hence the price they would be willing to pay for it.
135
A. Intervention in the market for labor
 Labor markets are frequently regulated with fixed minimum wage
rates or centrally fixed wages rates for formal sector jobs.
 If these wage rates are set above the market clearing levels, there is
likely to open unemployment or disguised unemployment.
 This is particularly true for unskilled labor.

 In the case of skilled labor, fixed wage rates may actually be set
below market clearing levels causing an artificial shortage of skilled
labor.
 In such situations, wage rate may not reflect the true social cost of
labor.
 Thus, a project analyst should adjust wage rates until they reflect the
true social cost of labor in the country, the shadow wage rate.
136
B. Intervention in/or failure of capital market
 In order to encourage investment, interest rates are often kept low.

 The interest rate paid for investible funds may be held well below
the equilibrium interest rate.
 As more people wish to borrow than to save at this low interest rate,
there will be an excess demand for capital funds.
 This will lead to ration the available credit to preferred borrowers.

 In addition government routinely tax both borrowers and lenders

introducing further distortions into the capital market.
 For these reasons, market interest rates should not be used to
discount future income streams in an economic analysis.
 The government will have to estimate the social discount rate that
better reflects the opportunity cost of using investible funds in a
137project.
C. Intervention in foreign exchange markets
 Many countries often manage their foreign exchange rate.
 Often the exchange rate is set significantly above its free
market level in terms of say a US dollar per unit of local
currency.
 That is; overvaluation of local currency is a common practice
in developing countries.
 Currency overvaluation creates an apparent shortage of foreign
exchange.
 This happens because at the overvalued exchange rate imports
appear cheap relative to locally produced goods unless tariffs
are imposed, demand for imports will rise.
 On the other hand currency overvaluation makes exporting as
compared with supplying the local market, financially
138unattractive to producers.
 This will result in excess demand for foreign exchange.
 In these circumstances, the official exchange rate will
understate the true value of foreign exchange to the country
concerned.
 This is given by the shadow exchange rate, SER, the amount
residents are willing to pay for the fixed quantity of foreign
exchange available.
 Use of the OER in project appraisal will have the effect of
undervaluing projects that produce exportable outputs and
overvaluing those that use imported inputs.
 The overvaluation of the exchange rate must be corrected in an
economic analysis.
 One method of doing this is to employ a shadow exchange rate
to convert foreign prices into local currency.
139
3. Externalities and public Goods
 Another reason why the perfect world of neoclassical theory
fails to represent the real world is the existence of public goods
and externalities.
 A financial analysis of a project that uses or produces public
goods and externalities fails to capture the full impact of a
project on the community’s welfare.
A. The existence of externalities
 Externalities are created in the process of producing,
distributing and consuming many goods and services.
 There are positive or negative attributes or effects of a good or
service.

140
 Some costs and benefits do not appear among its inputs and
outputs when it is analyzed from the enterprises or individual’s
viewpoint and thus do not enter into the financial NPV and
IRR.
 These items are considered as external to the enterprise but are
internal when they are considered from the economy’s angle.
 Somebody pays for the external costs and someone receives
these external benefits even if this is not the enterprise.

141
B. The existence of public goods
 Public goods are goods and services whose use by one person
does not reduce their availability to others.
 That is; they are neither rival nor excludable.

 Example:

 urban road networks

 TV and radio signals

 Disease eradication campaign

 Defense forces

 The legal system

 Public goods are usually provided free by governments and in

a financial analysis would therefore, be priced at zero.
142
 However, they do have a beneficial impact on the welfare of
those receiving them, most of whom will be willing to pay for
such goods through taxation.
 But it costs the society significant sum of money to produce
many of the public goods.
 This is a case where the market price of a good or service will
not reflect its true cost or benefit to the society.
 If the project uses public goods as inputs or produces them as
outputs it would be wrong to value them at their market price
of zero in any economic analysis of the project.
 They have to be valued at the amount that it is estimated
people will be willing to pay for them.

143
3.2. The Essential Elements of an Economic Analysis
 The economic analysis of a project has many features in
common with financial analysis.
 These include:

1.Both involve the estimation of a project’s cost and benefits

over the life of the project for inclusion in the project’s cash
flow.
2.In both, the cash flow is discounted to determine the project’s
net present value, or other measures of project worth
3.Both may also use sensitivity or probability analysis to assess
the impact of uncertainty on the project’s NPV.

144
 But an economic analysis goes beyond a financial analysis.
 That is; the essential elements of economic analysis include:
 A. The elimination (deduction) of transfer payments
within the economy from the project’s cash flow.
 Examples:
 Taxes-Personal and company income taxes, VAT, indirect
taxes, excise and stamp duties.
 Subsidies ---- Including those given via price support
schemes.
 Tariffs on imports and exports subsidies and taxes .
 Producer surplus - gains received by a supplier
 Credit transactions - loans received and repayment of
Interest and principal
145
B. The estimation of economic or shadow prices for project
outputs and produced inputs (including internationally
traded and non-traded goods) to correct for any distortions
in their market prices.
 Since we use different prices, different economic and financial
NPV and IRR are obtained even if the inputs and outputs are
identical in physical terms.
C. The estimation of economic prices for non produced
project inputs (including labor, natural resources and land)
to correct for any distortions in their market prices.
D. The valuation and inclusion of any externalities created
by the project in economic analysis
E. The valuation and inclusion of any un-priced outputs or
146
inputs such as public goods or social services.
3.3. Determining economic values
 Due to social, political, historical, and economic, etc reasons,
markets are distorted.
 As a result, the market prices are also distorted and do not
reflect marginal productivities and marginal utilities.
 Divergence between economic and market prices could be due
to market failure, government interventions, externalities,
public goods and distributional considerations.
 Hence serious distortions exist in the market for labor, capital,
and foreign exchange and efforts are necessary to replace the
signals from these markets by more appropriate measures.

147
 The key to understanding of economic analysis is the concept
of opportunity cost.
 The opportunity cost is equal to the marginal value product
and the market price of the item in a relatively competitive
market.
 Economic pricing involves making adjustments to market
prices to correct for distortions and to retake account of
consumer and producers surplus.
 The adjusted price should then reflect the true opportunity cost
of an input or people’s willingness to pay for it.
 So, we use Shadow Price which is also called the accounting
price.
 The shadow price is what we call the economic price.
148
3.3.1. Adjustment for Transfer Payments
 Transfer payments are defined as payments that are made
without receiving any good or service.
 They involve the transfer of claims over real resources from
one person or entity in society to another, rather than payments
made for the use of or received from the sale of any good or
service.
 So they do not reflect changes in the national economy.

 Some examples of items that are considered as transfer

payments are:
A. Taxes - personal and company income taxes, value added
taxes and other indirect taxes, excise taxes stamp duties, etc.
 In financial analysis a tax is clearly a cost.
149
 When an individual pays taxes his net benefit is reduced.

 But this payment does not reduce national income.

 Rather it is transfer from the individual to the government so

that the income can be used for social purposes that are
important to the society.
 Thus payments of taxes does not reduce national income, it is
not a cost from the standpoint of the society as a whole.
 That is, taxes remain a part of the overall benefit stream of the
project that contributes to the increase in national income.

150
B. Production Subsidies: are simply direct transfer payments
that flow in the opposite direction from taxes.
 Subsidies do not increase or decrease national income.
 It merely transfers control over resources from a taxpayer to
another individual.
 But, subsidy increases the individual’s income, so it is revenue
for the receiver.
C. Credit Transactions: Loans received and payment of interest
and capital when these transactions occur between domestic
borrower and lenders are examples of such credit transactions.
 The payment of interest and repayment of capital (debt
service) is treated as an outflow in financial analysis but
treated as transfer payments and are omitted from economic
accounts.
151
D. Charitable gift or welfare support services: are also
considered as transfer payments.
E. Producer surplus- gains received by an existing supplier of a
factor as a result of an increase in the price of that factor.
 But in an economic analysis of a project, any change in
consumer surplus as a result of the project should be included
in the project’s economic cash flow, because these changes
represent real effects on peoples welfare.

152
3.3.2. Efficiency or Economic shadow Prices
 In economic analysis of projects, inputs and outputs should be
valued at their contribution to the national economy, through
efficiency or shadow prices.
 The application of shadow prices is based on the underlying
notion of opportunity cost.
 From the national economic point of view, it is the alternative
production foregone or the cost of alternative supplies that
should be used to value project inputs and outputs.
 An economic or shadow price reflects the increase in welfare
resulting from one more unit of an output or input being
available.

153
 Definition of shadow (accounting) prices
 Accounting or shadow prices are simply a set of prices that are
believed to better reflect the opportunity cost, i.e. the cost in
their best use, of goods and services.
 It represents all none market prices.
 It is the value used in economic analysis for a cost or a benefit
in a project when the market price is left to be a poor estimate
of economic value.
 It implies a price that has been derived from a complex
mathematical model such as linear programming.
 Efficiency shadow prices are border prices determined by
international trade.
 The project inputs and outputs are thus valued on the basis of
international trade.
154
 The basic assumption here is that international market is less
distorted than the domestic market and thus taking
international price is more realistic to value the true cost of
goods and services.
 It is an estimate of efficiency prices.

 Example: shadow wage rate set by estimating the marginal

value product of labor.
 So shadow prices are used instead of domestic market prices in
guiding the allocation of resources since the market prices are
distorted and using them would lead to resource misallocation.
 In practice economic pricing involves making adjustments to
market prices to correct for distortions and to take account of
consumer and producer surplus.
155
 Shadow pricing and the numeraire
 The implicit objective of project analysis when project items
are valued at opportunity cost is to maximize the net resources
available to the economy.
 For many project items the opportunity cost will be given
directly by its border prices.
 A numeraire is a unit of account.

 Shadow prices can be expressed in two ways:

A. Directly in foreign exchange units - valuing all project effects

at world prices termed as the world price numeraire.
B. In domestic price units using a domestic price numeraire.

156
 The use of different numeraire to express opportunity costs
will not affect the relative value of project outputs and inputs.
 Shadow price estimates can be made at two levels:

 Economic analysis

 Social analysis

 Distinction stems from the objectives pursued in project

appraisal.
 In economic analysis resource efficiency is also considered.

 In social analysis growth and income distribution objectives

are pursued.

157
3.3. Traded and Non Traded Goods
 Goods and services produced by the project or that serves as project
inputs can be classified as:
 Non-traded goods

 Traded goods or

 Potentially traded goods

 Non-Traded Goods

 Non-traded goods are goods that do not enter into the international
trade because of their nature or physical characteristics.
 So the non-traded inputs and outputs of a project cannot be valued
directly at border or world prices.
 Some also consider goods which do not enter into trade because of
protection(trade barriers).
158
 Example: Electricity is only rarely transmitted across frontiers.
 Unskilled labor is also another example of non-traded
commodity
 Inland transportation and cement.
 cement is usually considered as non-traded goods.
 When goods do not enter into trade by their very nature
decomposing is a pre-requisite to their valuation in terms of
world prices.
 For some non-traded goods no reference border prices are
available. Example: Teff.
 For other commodities the local supply price is below the CIF
price of potential imports but above the FOB price of potential
exports.

159
 In both cases the non-traded inputs and outputs of the project
cannot be valued directly at border or world prices.
 So the valuation of non traded goods at world prices consists
of a number of steps.
A. Net out taxes from the domestic market price of the
commodity.
B. The net of taxes price is decomposed into its traded and non-
traded cost elements.
 For the traded components a border price is available by
definition and they are valued at this price.
 The non -traded items are further decomposed into traded and
non traded and the procedure continues until in successive
rounds the original inputs or outputs is developed into traded
components and labor.
160
 Example: consider the production of electricity from coal

 Major cost elements are

 Coal, transport of coal to its site, transmission costs, wages and

salaries, etc.
 But this procedure is cumbersome if not difficult because it
requires detailed production data and cost, which are not easily
available and time consuming.
 Furthermore, the additional accuracy obtained in successive
rounds of decomposition will diminish fast.
 Thus one or two rounds of decomposition might be sufficient.

161
 After one or two rounds the non-traded components will be
valued at the domestic price and multiplied by a conversion
factor.
 Traded components will be valued at border prices and labor at
the shadow wage rate.
 If the output of a project is a non-traded good for which border
prices are however, known and if its domestic supply price is
below CIF but above the FOB, a convenient approximation is
to value it at the average of the two.

162
Traded Goods
 Traded goods are defined as goods and services whose use or
production causes a change in the country’s net import or export
position.
 Traded goods produced or used by a project do not actually need to
be imported or exported themselves, but must be capable of being
imported or exported.
 Examples:
 All kinds of manufacturing
 Most agricultural goods
 Intermediate goods
 Raw materials
 Some services such as tourism and consultancy services

163
 Traded goods are either exportable or importable goods (or
services).
 Exportable goods are those whose domestic cost of production
is below the FOB export price that local producers can earn
for the good on the international market.
 Importable goods are goods whose landed CIF import cost is
less than the domestic cost of producing these goods.

164
 3.3.4. Measurement of the economic value of
tradeables (Valuation of Tradeables)

 In almost all cases, the economic benefits of producing

tradeable outputs and costs of using tradeable inputs are
measured by the border price of these inputs and outputs.
 An importable border price is its CIF import price - its
price landed in the importing country before the effects of
any tariffs or quantitative restrictions have been added to
its price.
 The landed cost of an import on the port or other entry
point in the receiving country includes the cost of
international freight and insurance and often includes the
cost of unloading in the port.
165
  But this excludes any charges after the import touches the port
and excludes all domestic tariffs and other taxes or fees.

 The CIF price represents the direct foreign exchange cost of the
input up to the port or the border.

 The reason for using border prices to measure the economic

value of a project’s tradeable inputs can be understood in terms
of the assumption that the international markets are
comparatively competitive and free of distortions.

166
 The international price paid for goods and services will be a
good measure of the increase in welfare created from
consuming the foreign exchange earned by producing a
particular tradeable goods or service.
 Similarly an exportable good should be valued at a border
price or FOB export price.
 The FOB price is the price that would be earned by the
exporter after paying any costs to get the good to the border,
but before any export subsidies or taxes were imposed.

167
 The border price (FOB price) should be netted from handling,
transportation and marketing expenses to arrive at the project
site price or farm/factory gate price.

 By subtracting these expenses one arrives at the factory or

farm gate value of the exportable output at border prices.

 The FOB border price is the actual foreign exchange earned

from exporting( the export price minus any marketing margins
and transport costs to get the good from the project site to the
border).

168
 Import and Export substitutes
 If the project output substitutes for imports, the relevant
accounting price is the CIF of the substituted import adjusted
for marketing expenses.
 If a project uses as inputs a commodity that could otherwise
have been exported, we should value this input at the FOB
price adjusted for transportation cost, handling, marketing
margins, etc.
 For traded goods shadow prices are based on prices on the
world market, with no reference to value in domestic use or
supply.
 With suitable adjustments world prices provide a norm against
which to assess the costs of domestic production of traded
169
goods.
 But finding an appropriate world price may be difficult since
export may go to different countries or imports may come from
many countries with differing imports or export prices.
 Under such circumstances one approach is to take the lowest
import price and the highest export price (optimal approach).
 Another approach may be to take an average.

 But long run prices instead of temporary prices should be used

in project appraisal.

170
3.3.5. Border Parity Pricing
 World prices are normally measured as border prices
reflecting the value of a traded good at the border or port of
entry of a country.
 Border price is the unit price of a traded good at a country’s
border (FOB for exports and CIF for imports).
 However, values in project financial statements will normally
be at prices received by the project - ex - factory or farm gate
prices or paid by the project for inputs.
 To move from market to shadow price analysis, shadow
prices must be in terms of prices to the project.
 This means that for traded goods domestic margins, relating to
transport and distribution (including port handling) will have
to be added to prices at the border to obtain values at the
171
project level.
 The decomposition of these margins is referred to as border
parity pricing.

 A parity price or parity economic value is the price or value of

a project input that is based on a border price adjusted for
expenses between border and the project boundary.

 Assessing the full economic values of a traded good in a world

price system requires both its foreign exchange worth at the
border, plus the value at world price of the non-traded
activities of transportation and distribution required per unit of
output.

172
  Thus, for goods that are traded directly by a project, the
border parity price for the project output is the FOB price
minus the value of transport and distribution.
 Similarly where a project imports an input, its border parity price
is the CIF price plus transport and distribution costs.

173
Importable Output
 If the project’s output is an import substitute, it should be
valued at the CIF border price of the imported good for which
it is substituted.
 This represents the savings in foreign exchange and the
economic value of the project to the country.
 This CIF import price will not include any import tariffs or the
effect of quantitative restrictions such as quotas.
 The economic cost of any marketing and transport services
necessary to get the imported good from the port to the local
market should be added to this CIF value.
 In addition, the economic cost of any marketing and transport
cost incurred in getting the project’s locally produced output
should be subtracted from these economic benefits.
174
Exported Output
 If a project produces goods for export, the economic benefit of
this good is world demand price, which is the FOB border
price that the project can earn for its export item.
 The FOB border price is the free on board price of the export
at the port or airport.
 This is the actual foreign exchange earned from exporting, the
export price minus any marketing margins and transport costs
to get the export item from the project to the border.

175
Imported Inputs
 The full economic cost of an imported project input is the CIF
import price at the border, including the insurance and freight
costs to get the import to the project.
 These foreign exchange costs and domestic costs represent the
true cost to the economy of using the imported input.
 Any mark up on the cost of using the imported input due to
tariffs or quotas should not be included in the economic cost of
using these inputs.

176
Exportable Inputs
 Exportable inputs that are inputs into the project are valued at
their FOB price at the border.
 This is the foreign exchange that these goods could have
earned if they had not been used in the project.
 This represents their opportunity cost, and hence their true
economic costs to the economy.
 The economic cost of any marketing margin and transport
costs to get the input from its source to the border are
subtracted from this FOB price and the economic cost of any
transport and handling in getting the exportable to the project
should be added.
 Thus if an input is exportable the FOB price must be adjusted
for the difference between transport and distribution costs in
177
moving the input to the project and to the port for export.
Potentially Traded Commodities
 In some cases, the distortion in the trade regime is so great that
they can actually prevent the trade of goods that would
otherwise be tradeables.
 Potentially traded goods includes all those goods and services
currently not traded by a country but would be traded if it
pursued optimum trade policies.
 These are goods that would have been tradeables in the
absence of trade restrictions.
 Many countries impose rigid import quotas, import embargos,
prohibitive import tariffs or export embargoes on at least some
imports and exports.

178
 The group of potentially traded goods falls between the traded
and non-traded goods.

Potentially Traded Input

 When the price differential between importing and local
supply is substantial, the project owner may ask the
government to import.
 Thus, if this is done, the input should be treated as traded good
and be valued at the CIF price.
 On the contrary, if the input is supplied by the local high cost
industry, it should be treated as a non-traded good.

179
Potentially Traded Outputs
 If a project output is potentially importable but not imported at
present because of high import tariffs and if the duties or
quotas are to be removed, the output should be treated as
traded.
 If such removal cannot be foreseen, then it should be treated as
a non-traded commodity.
 The same principle applies to project outputs that could be
exported if the trade barriers were removed.

180
Economic Export and Import Parity Price
Export Parity Price
CIF at point of import ( example Canada port)
Deduct-unloading at point of import
Deduct-freight to point of import
Deduct-insurance
Equals- FOB at point of export ( example A.A)
Convert foreign currency to domestic currency at official
exchange rate( L-M approach) or shadow exchange rate(
UNIDO approach)
Deduct-local port charges
Deduct- local transport and marketing( if not part of
project) at their market price and multiplied it by SCF in L-M
approach
Equals – Export Parity Price at project boundary
181
 Contd---
Deduct-local storage, transport and marketing costs( if not
part of project cost) at their market price and multiplied it by
SCF in L-M approach

Equals- economic export parity price at project location( farm

gate)

182
Import Parity Price
FOB price at point of export
Add-freight charges to point of import
Add-insurance charges
Add-unloading from ship to pier at port
CIF price at the harbor of importing countries
Convert foreign currency to domestic currency( multiplied by
OER) if we use L-M approach and SER if we use UNIDO
approach
Add-local port charges
Add-transport and marketing costs to relevant wholesale
market at market price and multiplied it by SCF in L-M
approach
183
Equals- price at wholesale market
 Cont…

Deduct-local storage and other marketing costs at market

prices multiplied by SCF if the project produces import
substitute product but add if the project uses imported input

Equals- economic import parity price at project location

(farm/project gate price)

184
Conversion Factors
 It has been already stated that all project inputs and outputs
should be valued at the world prices(border prices).
 World prices are used to measure the opportunity cost to the
economy of goods and services which can be bought and sold
in the international market.
 However, in practice, there are significant number of
commodities for which there will be no direct world price to
use as a measure of economic value.
 Example: Teff
 These commodities fall under the general heading of non-
traded goods.
 Even when non-traded goods are decomposed there always
remain items that are non traded and for which there is only
domestic market.
185
 Thus, some world price equivalent figure need to be derived
for these non-traded goods.
 To estimate the accounting prices for all other non traded
goods (inputs and outputs) we use conversion factors.
 A conversion factor is defined as the factor by which we
multiply the actual price in the domestic market of an input or
output to arrive at its accounting price.
 The conversion factor is simply the ratio of the shadow price
of the item to its market price.
 A conversion factor is estimated simply by taking the ratio of
border prices (world prices) to domestic market prices of the
good.

186
 Since market distortions vary from commodity to commodity,
the conversion needed varies from case to case.
 Therefore, it is possible to estimate commodity specific,
service specific, or sector specific like electricity,
transportation, construction etc., or for a basket of goods e.g.
consumption goods for a particular income group conversion
factors depending on the degree of aggregation desired.
 Thus conversion factors can be calculated at different levels:

 For individual commodities. E.g. coffee conversion factor

 For broad sector example: construction conversion factor

 For categories of expenditure. Example investment conversion

factor
 For the economy as a whole example ACF.
187
 In all cases one is comparing a value at world price, which
should reflect the shadow price, with the domestic price.
 In principle we should have one conversion factor for each
non-traded commodity or for each group of commodities.
 Thus, the use of conversion factor is only the second best
approach.
 The best approach is to use the accounting price.

 Thus, for homogenous groups of goods and services it is

convenient to have readily available conversion factors to be
used in all project, instead of decomposing them every time a
project is analyzed.

188
 The question now is how many conversion factors do we need?
There is no definite answer to the question.
 It all depends on the data availability, the variations of market
distortions, the time it takes to estimate conversion factors ,etc.
 But at least we need one conversion factor to multiply all the
domestic market prices of all non-traded components of the
input and output of a project.
 This parameter is called the standard conversion factor.

189
The Standard Conversion Factor
 It is a summary measure to calculate accounting prices for non
traded commodities.
 In the case of Ethiopia, the standard conversion factor is interpreted
as a summary and approximate quantification of the distorted
markets (domestic) as compared to the international market.
 Therefore, it is the ratio of the value of imports and exports of a
country at border prices to their value at domestic prices.
 The formula for computing the standard conversion factor is give
as:

 Where M and X are total imports and exports respectively at world

prices converted at the official exchange rate.
 Tm and Tx are the total trade taxes on imports and exports
respectively
 Sm and Sx are total trade subsidies on imports and exports
190 respectively
 All values should refer to the same year or to an average over the
same period.
 The SCF is a summary measure to calculate accounting prices for
non traded goods.
 This is achieved by multiplying the net of taxes domestic price of
the commodity by the SCF.
 The border price is obtained by multiplying the net of taxes
domestic price of the commodity by the SCF.
 Thus, every effort must be made to decompose the non-traded goods
into traded and non traded elements and apply the SCF only to the
latter.
 The rule for the non-traded goods should be still decomposition and
the SCF should be used only when this is impossible, very difficult
or is not worth the effort.
 The SCF is revised from time to time by the central economic
authorities and adopted by planning bodies.

191
National Parameters
 There are some important parameters that have general applicability
in the sense that they are used in all projects.
 These parameters should take the same value in all projects although
they can change from time to time.
 That is; such parameters are national so that they apply to all
projects regardless of their sector, and they are economic because
they reflect the shadow price of the items concerned.
 For instance, a typical list of national economic parameters may
cover conversion factors for:
 Unskilled and skilled labor
 Some of the main non-traded sectors
 Some aggregate conversion factors such as consumption conversion
factor, a standard average conversion factor, the discount rate, etc.
192
 A project analyst can apply these parameters directly to the
project under analysis.
 They are called national parameters to distinguish them from
the project specific shadow prices.
 They are estimated by the central planners and are taken as
given by the project analyst.
 Some of the important national parameters include:

 The standard conversion factor

 The shadow wage rate

 The discount rate, and

 The shadow exchange rate( SER= Pd/Pw)

 Pd- domestic price, Pw- world price in foreign currency

193
3.4. Social Cost Benefit Analysis
The Purpose of Social Cost Benefit Analysis
 In financial and economic project appraisal, it is implicitly
assumed that income distribution issues are beyond the
concern of the project analyst or that the distribution of
income in the country is considered appropriately.
 For a private commercial entrepreneur project choice is a
rather simple exercise.
 If he/she knows his/her objectives, all he/she has to do is to
ascertain which projects satisfy his/her objectives best.
 But in most countries, governments are not only interested in
increasing efficiency but also in promoting greater equity.
 A financial objective is narrow one for a public agency to
pursue and for public decisions; a broader social objective
would be more appropriate.
194
 When a project is chosen from alternative projects, the choice
has consequences for employment, output, consumption,
savings, foreign exchange earnings, income distribution and
other things of relevance to national objectives.
 The purpose of SCBA is to see whether these consequences
taken together are desirable in the light of the objectives of
national planning.
 Therefore, a social appraisal of projects goes beyond
economic and financial appraisal to determine which project
will increase welfare once distributional impact is considered.
 The project analysts will not be only concerned to determine
the level of project’s benefits and costs but who receives the
benefit and pays the costs.
195
 In an economic analysis of a project, it is implicitly assumed
that a dollar received by any individual will increase the
community’s welfare by the same amount as a dollar
received by any other individual.
 But an extra dollar given to a very poor person will usually
increase the person’s welfare by much more than would a
dollar given to a rich person.
 A rationale in welfare economics for the social analysis of
projects is therefore, quite strong, the marginal utility of
income of a person who receives a low income is expected to
be greater than the marginal utility of income of the same
person if he/she receives a high income.

196
Basic Arguments for the Application of Social Cost benefit
Analysis
 The basic arguments include:

 Existence of market imperfection

 Existence of externalities

 Concern for savings

 Concern for redistribution

 Merit wants

197
3.5. Cost Effectiveness Analysis
 Both cost - benefit analysis (CBA) and cost - effectiveness analysis
(CEA) are useful tools for program and project evaluation.
 Cost - effectiveness analysis is a technique that relates the costs of a
program/project to its key outcomes or benefits.
 Cost - benefit analysis takes that process one step further, attempting
to compare costs with the dollar value of all (or most) of a program ’
s many benefits.
 These seemingly straightforward analyses can be applied anytime
before, after, or during a project/program implementation, and they
can greatly assist decision makers in assessing a projet ’ s efficiency.
 However, the process of conducting a CBA or CEA is much more
complicated than it may sound from a summary description.

198
 Cost - effectiveness analysis seeks to identify and place
dollars on the costs of a project.
 It then relates these costs to specific measures of project
effectiveness.
 Analysts can obtain a project ’ s cost - effectiveness (CE) ratio
by dividing costs by what we term units of effectiveness:

 Units of effectiveness are simply a measure of any quantifiable

outcome central to the project’s objectives.
199
 For example, a dropout prevention program in a high school
would likely consider the number of dropouts prevented to be
the most important outcome.
 For a policy mandating air bags in cars, the number of lives
saved would be an obvious unit of effectiveness.
 Using the formula just given and dividing costs by the
number of lives saved, you could calculate a cost -
effectiveness ratio, interpreted as “ dollars per life saved. ”

200
 You could then compare this CE ratio to the CE ratios of other
transportation safety policies to determine which policy costs less
per unit of outcome (in this case lives saved).
 Although it is typical to focus on one primary outcome in CEA, an
analyst could compute cost - effectiveness ratios for other outcomes
of interest as well.

 Mutually exclusive programmes

 Incremental cost-effectiveness ratios =

ΔC = Cost of new treatment – cost of current treatment

ΔE Effect of new treatment – effect of current treatment

201
Steps in Cost - Effectiveness and Cost - Benefit Analysis
1. Set the framework for the analysis
2. Decide whose costs and benefits should be recognized
3. Identify and categorize costs and benefits
4. Project costs and benefits over the life of the program, if
applicable
5. Monetize (place a dollar value on) costs
6. Quantify benefits in terms of units of effectiveness (for CEA), or
monetize benefits (for CBA)
7. Discount costs and benefits to obtain present values
8. Compute a cost - effectiveness ratio (for CEA) or a net present
value (for CBA)
9. Perform sensitivity analysis
10. Make a recommendation where appropriate
202
 Review Questions
Answer the following questions in a precise way.
1. Assume a project is expected to export its product. Write the
procedures that we should follow so as to get economic
export parity price at project location.
2. Explain the objective of undertaking social-cost benefit
analysis of a project?
3. In economic analysis, the valuation of non-traded goods at
world prices has a number of steps. Write the necessary
valuation steps and procedures precisely.
4. How the existence of public good lead to market price
distortion?

203
 CHAPTER-FOUR

PROJECT MONITORING AND

EVALUATION

204
Introduction: Monitoring and Evaluation- Some Basics
 Nowadays, Monitoring and Evaluation has been given

high importance because:

 Good governance is key to achieving sustainable socio-

economic development
 Governments are increasingly being called upon to demonstrate

results
 Stakeholders are no longer solely interested in organization

activities and outputs rather interested in actual outcomes

205
  The results and sustainability of Program/project requires:
Collection of data/information and analysis in continuous
fashion.
For this, there is a need to establish a Monitoring and
Evaluation system.
That is; a system that
 Establishes a data collection methods,
 Defines data collection periods
 Describes role of the actors in the system
 Establishes accountability
 Segregates report requirements of all the
stakeholders
 Hence, we need to equip ourselves with the basic
Knowledge, Skill and Attitude of M&E.
206
 Traditional Implementation-focused Monitoring And
Evaluation Systems Vs Result Based M&E

 Traditional: implementation-focused M&E

 are designed to address compliance the "did they do it"
question.
 Did they mobilize the needed inputs?
 Did they undertake and complete the agreed activities?
 Did they deliver the intended outputs?

207
Shortcomings
 Completing all of the activities and outputs is not the same
thing as achieving the desired outcomes.
 The sum of all activities may or may not mean that desired
outcomes have resulted.
 A list of tasks and activities does not measure results.

 Even if all activities were completed within a given

timeframe, the desired outcome may not necessarily been
achieved.

208
  The implementation approach focuses on monitoring and
assessing how well a project, program, or policy is being
executed.
 This approach does not provide policy makers, managers,
and stakeholders with an understanding of the success or
failure of the project, program or policy.

209
 Result –Based M&E system

 Results-based Monitoring and Evaluation systems are

designed to address the "So what" question.
 So what about the fact outputs have been generated? So
what that the outputs from these activities have been
counted?
 A results-based system provides feedback to the
stakeholders on the actual outcomes and goals.
 Results based systems help answer the following
questions:
 What are the goals of the organization?
 Are they being achieved?
 How can achievement be proved?
210
 Participatory M & E
 It is a process in which primary and other stakeholders
collaborate and take an active part in assessing &
evaluating the performance and achievement of a
development intervention.

 Uses result based M & E system

211
 4.1. What is Monitoring and Evaluation?
 Monitoring: is a continuous process of gathering, analyzing
and interpreting of information on the daily use of inputs and
their conversion into outputs.
 This enables us to make timely adjustment or correction on
the development program/project when necessary.

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 MONITORING
Start Continuous function End

It is a review by It is concerned with:

management to:

• Assess progress •Ensuring that

[ inputs ]
• Identify difficulties •Through
• Ascertain problem areas [ activities]
• Recommend remedial •Are transformed into
action(s) [outputs]
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 Types of Monitoring (What to Monitor?)

1. Process monitoring and

2. Impact monitoring.
or
1. Physical progress monitoring
2. Financial expenditure
3. Project Quality
4. Project Assumption

214
 Process Monitoring helps to assess:

The progress of activities, the outputs/results achieved

(quantity & quality) while the project is on progress

The use of resources (Human resource, finance,

material & equipments)

 The way the activities are carried out (management

style)
How critical assumptions are addressed

215
 Impact monitoring helps to measure:
 Changes brought as a result of the project/program intervention
while the project is still on progress.
 This might be:

 Economic aspect,

 Social Aspect,

 organizational,

 technological,

 attitude, etc. or other intended and unintended

results over a longer period.

 Impact monitoring is different from impact evaluation or assessment
which is expected some time after the project is completed.
216
 1. Project Physical Progress Monitoring
 It is checking of whether activities in the project & expected
results are up to schedule or not.
 Activity Monitoring - Activity monitoring monitors what
happens during the implementation of the project and
whether those activities which were planned, were carried
out.
 This information is often taken from the progress report.

217
 Items to be considered during program/project
physical monitoring are:-
 Activities executed & inputs utilization
 Results of activities/project outputs/
 Progress of project towards objectives
 The way the project is managed (quality style of
work)
 Problems encountered (variance)
 Etc.

218
 Progress Monitoring

Planned Compared with

Actual results

To identify

Problems and
opportunities

Deviations from plan

Corrective actions
and alternatives
219
  Specific questions to be answered are:
 Is the project physical progress as a whole and its
individual components :
On schedule,
ahead of schedule, or
behind schedule?
If there is a variation, where did it occur, why did it
occur, who is responsible for it, and what would be its
implications?
What are the slipping tasks/activities?
 What is the trend of the performance?
 What would be the likely final output, cost and
completion date of the project and its individual
components?
 What action has to be taken?
220
  Three situations may be considered in
measuring/assessing physical progress
1. Quantifying Output of the activity in absolute terms.
EX: number of wells constructed for a water supply project or number
of houses constructed for housing development project
Work Performed x 100 (%)
Work Planned
2. Valuing the output of the activity
Value of work done x 100 (%)
Total Value of work planned
3. Using time spent
Time spent to date x 100 (%)
Total time to complete
221
 2. Project Financial Progress Monitoring
 Managers are concerned to measure financial
progress to ascertain:
 The cost of individual items and activities within
the project and its comparison with the original
estimate.
 This requires financial plan for the project.
 Once the budget has been prepared and the project
is on progress, the project manager require:
A cost reporting system to provide information
on:
 actual costs incurred in relation to the

222
activities performed and output attained.
 Specific questions to be answered are:

Has the cost of the project as a whole (and its individual

component) been as per the estimated budget, less or
more than the budget estimates?

If there is a variation, where did it occur?, why did it

occur?, who is responsible for it?, and what would be its
implications?

223
 The following must be measured periodically (in
most cases monthly & quarterly) for purposes of cost
monitoring and control:
Costs incurred to date
Budgeted costs to date
Value of work done to date
Cost over–run (under–run) to date
 Costs incurred to date: this can be obtained by summing up
costs incurred in accomplishing various project activities
 Budgeted costs to date: this can be readily obtained from
the cost projections made at the beginning.

224
  Value of work done to date: when costs are measured, an
estimate should be made of the extent of work accomplished.
 The value of work done can then be obtained as follows:

Budgeted costs X % of work accomplished

 Example: to construct a single block of condo has a
budgeted cost of Birr 1.5ml and at the time of the periodic
progress review it is estimated that 60% of the work has been
accomplished.
 Hence, the value of work done is simply (1.5 x 0.6) Birr
900,000
 Cost over–run /under–run to date:
 There is cost over-run when the cost incurred is more than
the value of work done and vise versa.
225
 3. Project Quality Progress Monitoring
 Quality monitoring varies from project to project.
In the case of physical construction there will be
established system of supervision, testing and
checking against the original/given specification.
In projects with institutional outputs such as new
service delivery systems, and the like;
 there is a need to develop specific systems and
specifications/indicators of quality checking.
In all aspects, project managers are responsible to
ensure that the outputs produced by the project are as
per the quality standards or specifications established
in the project design.
226
 4. Project Assumption Monitoring
 Assumption is an event, a condition or a decision which is
necessary for project success, but which is largely or
completely beyond the control of project management.
 Ex: Suitably qualified staff willing to work in
rural areas
 Mothers willing to attend clinics
 Prices of project inputs and outputs
 Project managers should pay critical attention to elements
that are outside the project during the monitoring process.

227
 Evaluation

 Evaluation is a systematical and periodical

gathering, analyzing and interpreting of information
on the operation as well as the impacts of a
development program/project.
It is an assessment of:
 The overall project performance and objective achievement in
light of relevance, efficiency, effectiveness, impact and
sustainability
 Reasons contributing for success or failure

 An in-depth review of the strategy used

 Lessons learned both from on-going &/or completed project
228
 When & What do we Evaluate?
 In addition to determined time, during project
planning/design, evaluation may be carried when:
 Monitoring report indicates an unexpected result which is
positive or negative
 Management requires additional information for decision-
making
 Key questions to be resolved are identified during
monitoring process
 The need to extract key lessons learned arises.

229
 Evaluation criteria

Most of the basic evaluation criteria and concepts are

universally accepted and used by all the organisations as
well as by the donors’ community.
The criteria for evaluation addresses five major sets of
issues:
1. Relevance
2. Efficiency
3. Effectiveness
4. Impact
5. Sustainability

230
 Although it varies on the type of evaluation carried
among others, we have to assess:
 Relevance of the project
Did the project address priority problems faced by
the target areas and communities?
Was the project consistent with policies of both
donors and recipient governments (or agencies)?
 Effectiveness
Have outputs and outcomes been achieved?
 Efficiency of resources (availability & utilization)
Were inputs (staff, time, money, equipment) used in
the best possible way to achieve outputs? Could
implementation been improved/ was there a better
231
way of doing things?
  Sustainability factors
Have the necessary systems been put in place to ensure the
project itself and more particularly the project benefits continue
once the project and its (foreign) funding has ended?
 Impact
What has been the contribution of the project to the
higher level development goals?
Did the project have any negative or unforeseen
consequences?

232
 Types of Evaluation
 It can be seen in two ways:
1. In periods/time of evaluation and
2. By persons involved in the evaluation process.
1 - Based on the Period / time
i. Ex-ante / start-up/ evaluation,
ii. On-going or mid-term /formative/
evaluation,
iii. Terminal /summative/ evaluation; and
iv. Ex-post/impact evaluation.
233
 Ex-ante/start-up Evaluation:
It is an evaluation carried out before the implementation
of the program or project activity in order to determine:
 The needs and potentials of the target group and its
environment
 Assess the feasibility and potential effects and impacts
of proposed program or project
 It can be considered as a “baseline” study in which the
situation of the project area , the target group and its
environment is described.
 Hence, at a latter stage, the effects and impacts of the
program or project can be compared with this situation.
234
 On-going/Mid-term/Formative Evaluation:

 It takes place while the implementation of the planned

project is on-progress or in the mid of the project life.
 It primarily focuses on project performance and to see
immediate and intermediate results.
 May help to analyze the relation between outputs and
effects/outcome
 Help to modify the design and implementation strategies.

235
  Major Issues To Be Seen During On-going Evaluation
Include:
 Efficiency in resource utilization

 Procurement of necessary goods and services from national and

international sources (in many projects, procurement delays are a
major obstacle to effective implementation)
 Progress in output or physical work (construction), including the
quality of work
 Progress in financial expenditure

 Volume and quality of inputs and services made available

 Organization structure and management capacities of the project

 Progress and problems in staff recruitment and placement

236
 etc.
 Terminal [Summative] Evaluation

 Known as a project completion report

 Conducted when the funding for the project comes to an
end or certain phase of the project is completed.
 The distinguishing features of terminal evaluation are:
 It examines the initial outputs and effects
 It undertakes a careful examination of implementation
performance
 It assess the sustainability of the benefits accruing to the target
area/group from the project

237
 Ex-post Evaluation
 Often called impact evaluation/ impact assessment
 Designed as in-depth study of the impact of a
project that has been already executed or an
intervention (support) given for certain development
activities.
 Carried some time after the program/project activity
has been terminated (usually 6 months to 3 years
after project completion) in order to determine its
impact on the target group and the local area.

238
 2. Evaluation Based on Evaluating Persons:
1. Internal Evaluation:
 Performed by persons who have a direct role in the
program/project implementation
 Can be done by the management team or persons assigned from
the implementing agency
2. External Evaluation:
 It is carried out by persons / institutions from outside the
program/project implementers
 In most cases, it is conducted by the funding /sponsoring/ agencies
with formally designated consultants/evaluators outside the project
at fixed points in time

 Terminal and ex-post evaluation are often conducted by external

239 evaluators
 Assess Project Assess Project Determine whether
Goals, Objectives Activities
& Strategies implementation is
according to schedule
Mobilize
Stakeholders, Enhance
Teamwork & Build Track
Shared Commitment Progress

Plan/re-plan Purpose
Program/project
Improvement of
M&E Assess Output
/Results
Practice Bench-
Marking Assess as the
targeted
beneficiaries are
reached

Enhance Identify
Accountability Gather Lessons for
Ensure Quality information for change and
Management early warning Improvement
240
 Distinction between M & E
Themes Monitoring Evaluation
Purpose/objective Specific Broad

Scope Narrow Broad

Frequency/Time Continuous Periodic

Data Gathered Primarily Primarily

Quantitative Qualitative
Main Action Oversight / In-depth
supervision analysis
Focus Inputs/Outputs Impact and
Sustainability
241
 Distinction Themes …
Themes Monitoring Evaluation
What does it  Activities performed Why and how
answers?  Outputs achieved results were achieved or not
(objectives)  Resources used Strategy and policy options

 Quality of work performed

 Problems encountered (focuson effectiveness, and
Rectifying measures
relevance or impact)
(focuses on inputs, process,
output and work plan)

Actors Mainly Internal Internal/External

Analysis Simple Comparative Analytical tools

Primary Users Small group/project Managers Large group /Project

Managers, planners,
Financers, stakeholders
etc.)
242
Setting-up Monitoring And Evaluation System
 Establishing M&E system is vital in order to:
 collect data, analyze and interpret in a systematic way to see
The progress of the project
The achievements [output and outcome] and impact/
sustainability of development program or project

Establishing M&E system may differ from sector to sector and

form project to project .

However, having a designed system is required to provide

information at different levels:
National level, line ministries, regional and local level agencies
, project financer, project management and the like
243
Prerequisites for a Successful M & E System
The data to be gathered need to be accurate, with in the
timeframe and should be collected by a reasonable cost.
The system has to be designed at an early stage of project
preparation & baseline data collected well in advance.
Managers should develop and own the system & be
committed to its use
The system designed must ensure gathering of data both
from internal & external sources:
 In an appropriate forms and
 Disseminate the information vertically and horizontally between
the different levels of organizations units for timely and effective
decision making.

244
  Steps in developing M&E system

1. Determine the objectives of M&E

2. Identify and involve the stakeholders
3. Define what should be monitored and evaluated
 Ex: activities, inputs, outputs, results, critical
assumption, impacts
4. Determine the priority areas to be monitored and
evaluated
 Determine the important issues to be considered for
decision making
5. Identify and indicate key elements and indicators to
be focused
6. Design and test M&E instrument
245
 7. Plan how you will execute M&E
8. Determine how data will be collected, processed and
analysed
 Progress report, progress review meeting, field visits, weekly or
fortnightly, Survey, literature

9. Prepare, disseminate and use the M&E report

• determine type of information needed

• Identify who requires the information

• Know why the information is required

• Determine when and how it is needed

• Know how important the information is

246
Commonly Used M & E Tools

1. Logical Framework
2. Report
3. Questionnaires
4. Interview
5. Key Informant Interview
6. Review of Documents
7. Trend Analysis
8. etc

247
 Review Questions
 Answer the following questions.
1. Why we monitor and evaluate projects?
2.What is the importance of having a developed
monitoring and evaluation system?
3. Why we include monitoring and evaluation tools in
project proposals?

248
 CHAPTER-FIVE

EVALUATION: SOME BASICS OF

IMPACT EVALUATION

249
 5.1. Impact Evaluation Basics
 Impact evaluation is an effort to understand whether the
changes in well-being are indeed due to project or program
intervention.
 Specifically, impact evaluation tries to determine whether it
is possible to identify the program effect and to what extent
the measured effect can be attributed to the program and not
to some other causes.
 So, impact evaluation focuses on outcomes and impacts.

250
 Since impact evaluation is time and resource intensive, it
should be applied selectively.
 Policy makers may decide whether to carry out an impact
evaluation on the basis of the following criteria:
 The program intervention is innovative and of strategic
importance.
 The impact evaluation exercise contributes to the knowledge
gap of what works and what does not. (Data availability and
quality are fundamental requirements for this exercise.)

251
 Why Should We Do Impact Evaluation?
 The best way to undertake a particular impact evaluation
depends in part on its purpose and who its primary intended
users are.
 Some common reasons for doing impact evaluation include:

1. To decide whether to fund an intervention– “ex-ante

evaluation” is conducted before an intervention is
implemented, to estimate its likely impacts and inform
funding decisions.

252
2. To decide whether or not to continue or expand an
intervention.
3. To learn how to replicate or scale up a pilot.
4. To learn how to successfully adapt a successful intervention
to suit another context.
5. To reassure funders, including donors and taxpayers (upward
accountability), that money is being wisely invested.
6. To inform intended beneficiaries and communities
(downward accountability) about whether or not, and in what
ways, a program is benefiting the community.

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Quantitative versus Qualitative Impact Assessments
 Quantitative impact assessments use quantitative data and
approaches to determine the effectiveness of programs with
far-reaching goals such as lowering poverty or increasing
employment.
 Qualitative impact assessments use qualitative information
such as understanding the local socio-cultural and institutional
context, as well as program and participant details which are
essential to undertake sound quantitative assessment.

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 But a qualitative assessment on its own cannot assess
outcomes against relevant alternatives or counterfactual
outcomes.
 That is, it cannot really indicate what might happen in the
absence of the program.
 Quantitative analysis is also important in addressing potential
statistical bias in program impacts.
 A mixture of qualitative and quantitative methods (a mixed-
methods approach) might therefore be useful in gaining a
comprehensive view of the program’s effectiveness.

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Quantitative Impact Assessment: Ex post versus Ex ante
Impact Evaluation
 There are two types of quantitative impact evaluations: ex
post and ex ante.
 An ex ante impact evaluation attempts to measure the
intended impacts of future programs and policies, given a
potentially targeted area’s current situation.
 This may involve simulations based on assumptions about
how the economy works.
 Many times, ex ante evaluations are based on structural
models of the economic environment facing potential
participants.
 That is, using the structural models we predict program
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impacts.
 Ex post evaluations, in contrast, measure actual impacts
accrued by the beneficiaries that are attributable to program
intervention.
 One form of this type of evaluation is the treatment effects
model.
 Ex post evaluations have immediate benefits and reflect
reality.
 These evaluations, however, sometimes miss the mechanisms
underlying the program’s impact on the population, which
structural models aim to capture and which can be very
important in understanding program effectiveness.

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  Ex post evaluations can also be much more costly than ex
ante evaluations because they require:
 collecting data on actual outcomes for participant and
nonparticipant groups and
 other accompanying social and economic factors that may
have determined the course of the intervention.
• An added cost in the ex post setting is the failure of the
intervention, which might have been predicted through ex
ante analysis.

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 The Problem of the Counterfactual
 The main challenge of an impact evaluation is to determine
what would have happened to the beneficiaries if the program
had not existed.
 That is, one has to determine the per capita household income
of beneficiaries in the absence of the intervention.
 A beneficiary’s outcome in the absence of the intervention
would be its counterfactual.
 A program or policy intervention seeks to alter changes in the
well-being of intended beneficiaries.

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  Ex post, one observes outcomes of this intervention on
intended beneficiaries, such as employment or expenditure.
 Now , we have to ask:

 Does this change relate directly to the intervention?

 Has this intervention caused expenditure or employment to

grow? Not necessarily.
 In fact, with only a point observation after treatment, it is
impossible to reach a conclusion about the impact.
 At best one can say whether the objective of the intervention
was met.
 But the result after the intervention cannot be attributed to
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the program itself.
  The problem of evaluation is that while the program’s impact
(independent of other factors) can truly be assessed only by
comparing actual and counterfactual outcomes, the
counterfactual is not observed.
 So the challenge of an impact assessment is to create a
convincing and reasonable comparison group for
beneficiaries in light of this missing data.
 Ideally, one would like to compare how the same household
or individual would have fared with and without an
intervention or “treatment.”

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 But one cannot do so because at a given point in time a
household or an individual cannot have two simultaneous
existences.
 That is; a household or an individual cannot be in the treated
and the control groups at the same time.
 Finding an appropriate counterfactual constitutes the main
challenge of an impact evaluation.

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 5.2 Methodologies in impact evaluation

The major impact evaluation methodologies include:

1. Randomized evaluations
2. Matching methods, specifically propensity score
matching (PSM)
3. Double-difference (DD) methods
4. Instrumental variable (IV) methods
5. Distributional impacts
6. Structural and other modeling approaches

NB: Read more on these methodologies!

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 Review questions
Try to answer the following questions
1. What is the difference between evaluation and impact
evaluation?
2. What is the advantage of undertaking impact evaluation?
3. What is counterfactual?

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Assignment- this is a requirement to complete the course.

 Please identify any profit oriented project idea and prepare a

complete project proposal. The project proposal should
incorporate all aspects of project preparation as much as
possible.
 NB: The life of the project should not be less than 7 years
and the proposal should clearly show the payback period,
NPV, BCR and IRR. (Use r=14)

END
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