Lecture Notes on Project Planning and Analysis

By

Assefa Admassie (Ph.D)

Department of Economics
Addis Ababa University

CHAPTER 1 AN OVERVIEW OF PROJECT ANALYSIS

1
1.1 The project concept

Project planning and evaluation has a long history in financial and business analysis. Project
planning has always been used as a means of checking the profitability of a particular investment
by private firms. Recent experiences show that project analysis has attracted the attention of
development economists. But the inclusion of project analysis in development economics did not
necessarily amount to a new analytical discovery, rather to a new approach. Projects are now
assed from the economy’s viewpoint instead of only from the firm’s perspective. The selection
criteria have also included economic criteria on top of financial criteria.

A project is a complex set of activities where resources are used in expectation of return and
which lends itself to planning, financing and implementing as a unit. It is the smallest operational
element unit. A project usually has a specific starting point and a specific ending point, intending
to accomplish specific objectives. Projects usually have well defined sequence of investment and
production activities and a specific group of benefits that can be identified, quantified and valued,
either socially or monetarily. Projects are temporal and spatial units each with a financial and
economic value and a social impact that make up the continuum. Projects also have boundaries,
which make them distinguishable from each other. In addition to its time sequence of investment,
production and benefits, the project normally has a specific geographical location with
identifiable targets and benefits. Has specific beneficiaries or clientele group.

The Importance of project planning:

An insurance company is planning to install a computer system for information processing; the
government of Ethiopia and the Sudanese government are thinking of an ambitious plan to link
Port Sudan with the town of Moyale; Abebe a graduate student is planning to buy a book on
econometrics. All these situations involve a capital expenditure decision. Each of them represents
a scheme for investing resources, which can be analyzed and appraised reasonably independently.
The basic characteristics of capital expenditure (also referred to as a capital investment or capital
project or just project), is that it typically involve current outlay (or current and future outlays) of
funds in the expectation of a stream of benefits extending far into the future. Capital investment
decisions often represent the most important decisions taken by the firm or other decision maker.
Current capital expenditure decisions provide the framework for future activities. Capital
investment decisions have far reaching impact into the future. They are also characterized by
irreversibility. Thus, a wrong capital investment decision often cannot be reversed without
incurring substantial loss. They also involve substantial outlay of capital. Capital tends to
increase with advanced technology.

There are four reasons for project planning:

(i) (a)to eliminate uncertainties
(ii) (b)to increase the effectiveness and efficiency of the operation
(iii) (c)to identify and work towards a common goal
(iv) (d) to establish a means of project monitoring and control.

Planning is obtaining answers to the questions what, when, how, by whom in order to attain the
specified aims and objectives.
There are 9 steps involved in proper project planning:
(i) Aims and objectives: The actual aims / quotas / milestones to be reached within a
specified time, according to client requirements specified.

2
 (ii) Path (Strategy) to be followed and actions to be taken to reach the aims and objectives.
(iii) Schedule. This is a plan showing when individual / group activities will start and end
(iv) Budget (Expenses) involved in order to reach the specified objectives.
(v) Estimate When each activity will take place
(vi) Organizing and Assigning specific people to a specific objective, as well as the specific
responsibilities for each task
(vii) Policy and General guidance for decision making and individual actions
(viii) Strategy and Detail plan to execute the actions
(ix) Standards and Determining quality for each action

Limitations of a project

Investment decision is also confronted with several difficulties. The first problem is measurement
problem. Identifying and measuring the costs and benefits of a capital expenditure proposal tends
to be difficult. Another problem is the uncertainty issue. A capital outlay decision involves cost
and benefits that extend far into the future. It is impossible to predict exactly what will happen in
future. Hence there is usually a great deal of uncertainty characterizing the cost and befits of a
capital expenditure decision. The last issue relates to the temporal spread. The costs and benefits
of a capital expenditure decision are spread out over a long period of time, usually 10 - 20 years
for industrial projects and 20 - 50 years for infrastructural projects. Such temporal spread of
creates some problems in estimating discount rates and establishing equivalences.

1.2. The linkage between projects and programs

Most developing countries in general have some sort of national planning. Of course the degree
and complexity of such development plans vary form country to country and even in a particular
country form time to time. For instance in Ethiopia Planning was much most centralized in the
1974-91 periods compared to either before or after this period. Project formulation is an integral
part of amore broadly focused and continuous process of development planning.

Nevertheless, it is necessary to distinguish between projects and programs because there is

sometimes a tendency to use them interchangeably. While a project refers to an investment
activity where resources are used to create capital assets, which produce benefits over time and
has a beginning and an end with specific objectives, a program is an ongoing development effort
or plan which may not necessarily be time bound. Examples could be a road development
program, a health improvement program, a nutritional improvement program, a rural
electrification program, etc. A development plan is a general statement of economic policy.
National development plans are further disaggregated into a set of sectoral plans.

A development plan or a program is therefore a wider concept than a project. It may include one
or several projects at various times whose specific objectives are linked to the achievement of
higher level of common objectives. For instance, a health program may include a water project as
well as a construction of health centers both aimed at improving the health of a given
community, which previously lacked easy access to these essential facilities. Projects, which are
not linked with others to form a program are sometimes referred to as “stand alone” projects.

Projects in such context are the concrete manifestations of the development plans in a specific
place and time. One can think of projects as subunits and bricks of programs, which constitute
the national plan (usually the direction is from plans to projects). We have to note that projects
could be either public or private. Projects can also be understood and an activity for which more

3
will be spent in expectation of returns and which logically seems to lend itself to planning,
financing, and implementing as a unit. It is the smallest operational element prepared and
implemented as a separate entity in a national plan or program. In general, thus, sound
development plans require good and realistic projects for the latter are the concrete manifestation
of the pan as noted above.

1.3. The project format: advantages and limitations

1.3.1. Advantages of the project format

To enable analysis of projects a project format is conventionally used. This format provides an
analytical framework for a proposed investment in which the cost and benefit accounts are
prepared year by year in the form of a project cost and benefit stream. The project format, which
is an analytical tool, has some advantages. It establishes the framework for analyzing information
from a wide range of sources. Information from a wide range of sources feed into the framework
(framework to analyze information from many sources). Since a good plan depends on
accuracy of information, the framework enables various specialists to judge the accuracy of the
information provided and the appropriateness of the assumptions (framework to involve many
specialists). The format gives an idea of costs year after year, so that those responsible for
providing the necessary resources can do their own planning (cost year by year). The project
analysis tells us something about effects of a proposed investment on the participants in the
project, whether they are farmers, small firms, government enterprises, or the society as a whole
(Estimate effects on participants)

The administrative and organizational problems likely to be encountered during the

implementation of the project are also detailed in the project format (judgment about
administrative and organizational problems). This enables the planners to make arrangements
for strengthening the project management if this appears weak. At the same time managers
planners and stake holders are given better criteria for monitoring the progress of implementation
as the objectives (criteria for monitoring progress of implementation), targets and work plans
are set out at the onset of implementation. The project format also enables us to systematically
examine different alternatives (encourage systematic examination of alternatives). Alternative
formulating of the same project or formulation of other projects, etc. are important. The project
format facilitates systematic and objective examination of results of alternatives. For instance, the
effects o a proposed project on national income and other objectives can be compared with the
effects of projects in other sectors or other projects in the same sector, or alternative formulations
and designs pf the same project including not undertaking the project altogether.

Another advantage of the project format will be to help contain the data problem. Once a
project has been initiated local information on which to base the analysis can be efficiently
gathered, field trials can be conducted and judgment can be made about the institutional and
cultural factors that might influence the choice of project design and its space of implementation.

1.3.2. Limitations of the project format

Although the project format has so many advantages the result of project analysis must be
interpreted with caution. The first limitation is about the quality of the data used. The quality of
project analysis depends on the quality of the data used and of the forecast of costs and benefits
(depends on the quality of data used). Unrealistic assumptions about market shares, future

4
prices, yield potentials, relevance of inflation, the quality of project management, etc., can make
garbage out of the project analysis.

The technique of project analysis provides limited support in judging the risk and uncertainty
surrounding the project (limited usefulness in judging risk). However, projects could be tested
for sensitivity to changes. Another limitation of the project format is its partiality. Projects are
often too small in relation to the whole economy and assumptions have to be made about prices
and other variables.

The greater the difference among alternative projects the more difficult it would be to use formal
analytical techniques to compare them (difficult to compare widely differing projects). Project
analysis is more useful when it is applied to unique and clear investment return cycle and a
defined geographical area of clientele (best for unique investment activities).

Another limitation of the project format is the underlying conceptual problem about the valuation
based on the price system (Limitations of prices as indicators of value). The relative value of
goods and services depends on the relative weights that individuals participating in the system
attach to the satisfaction they can obtain with their income. Difficulties of dealing with non-
quantifiable objectives, unsuitability for many key development activities and political decision-
making are among the other limitation of project analysis.

1.4 ASPECTS OF PROJECT PREPARATION AND ANALYSIS

The project analyst must consider several aspects when carrying project analysis. The major
aspects of project preparation and analysis are outlined bellow:

a) Demand and Market Analysis

The study of this aspect need to ensure the existence of effective demand at remunerative price;
the size of market which will absorb the output without effect on price and if it does affect the
price by how much. Similar arrangements need to be done on the input side too (including
procurement of equipment and intermediate input supplies).
Market analysis is basically concerned with two questions:

1. What would be the aggregate demand of the proposed product/service in future?

2. What would be the market share of the project under appraisal?

To answer the above two questions the project analyst requires a wide variety of information and
appropriate forecasting methods. The kind of information required is:

1. Consumption trends in the past and the present consumption level

2. Past and present supply positions
3. Production possibilities and constraints
4. Imports and exports
5. Structure and competition
6. Cost structure
7. Elasticity of demand
8. Consumer behavior, intentions, attitudes, preferences, and requirements
9. Distribution channels and marketing policies in use
10. Administrative, technical, and legal constraints

5
The market analysis is also concerned with the arrangement for marketing the output to be
produced and the arrangement for the supply of inputs needed to build and operate the project.
Given the importance of market and demand analysis in project analysis it should be carried out
in an orderly and systematic manner. The key steps in such analysis are as follows.

 Situational analysis and specification of objectives

 Collection of secondary information
 Conduct of market survey
 Characterization of the market
 Demand forecasting
 Market planning
Situational analysis and specification of objectives
In order to get a feel for the relationship between the product and its market, the project analyst
may talk to consumers, competitors, middlemen, and other in the industry. He/she may also look
at the preferences and purchasing power of consumer’s ´, actions and strategies of competition
and practices of the middlemen.
Key steps in market and demand analysis and their inter-relationships.
Demand
Collection of forecasting
secondary data

S ituational analysis and charactrization of

specification of objectives the market

market
Conduct of planning
market survey

If such a situational analysis generates enough data to measure the market and get a reliable
projection of the demand and revenues a formal study may not need to be undertaken. In order to
carry out such a study it is necessary to spell out its objective clearly and comprehensively. A
helpful way of spelling out the objectives would be to structure the objective in the form of
questions.

Example: suppose a given project aims at producing wheat in a given locality. The project
initiator and implementer need information about where and how to market their product. The
objective of the market and demand analysis in this case may be to answer some of the following
questions.

 Who are the buyers of this product? (Consumers)

6
  What is the total current demand for wheat?
 How is the demand distributed temporally /pattern of sale over the year and
geographically?
 What price will the consumers be willing to pay for the product?
 How can consumers be convinced that wheat could be substituted for other foodstuffs?
 What channels of distributions are most suited for the product?
 What trade margins will induce distributors to carry it out?
 What are the possible immediate sales?

Collection of secondary information

In order to answer the questions listed while delineating the objectives of the market study
information may be obtained form secondary or primary sources. Secondary information is
information that has been gathered in some other context and is already available. Secondary
information provides the base and the starting point for market and demand analysis. In induces
what is known and often provides leads and clues for gathering primary information required for
further analysis. Several sources of information including census data, national sample survey
reports, plan reports, statistical abstracts, industry specific sources of data etc.

Conduct Market study

Secondary information though useful, often does not provide a comprehensive basis for market
and demand analysis. It needs to be supplemented with primary information gathered through a
market survey, specific to the project being appraised. The market survey may be a census or a
sample survey. The information sought in market survey may relate to one or more of the
following.
 Total demand and rate of growth of demand
 Demand in different segments of the market
 Income and price elasticities of demand
 Motives for buying
 Purchasing plans and interventions
 Satisfaction with existing products
 Attitudes towards various products
 Socio economic characterization of buyers

Characterization of the market

Based on the secondary sources and through the market surveys the market for the product
/service may be described in terms of the following
Effective demand in the past and present
 Breakdown of demand
 Prices
 Methods of distribution and sales promotion
 Consumers
 Supply and competition
 Government policy

Demand Forecasting

7
After gathering information about various aspects of the market and demand from primary and
secondary sources, an attempt may be made to estimate future demand. A wide variety of
forecasting methods is available to the market analyst. The methods may be divided into
qualitative methods, time series projection methods and causal methods.

Market Planning

To enable the product to reach a desired level of market penetration, a suitable plan should be
developed. Broadly it should cover pricing, distribution, promotion and services.

b) Technical Aspects

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 projects inputs (supplies) and
outputs of real goods and services and the technology of production and processing. Analysis of
the technical and engineering aspects of a project to be done continuously when a project is
formulated. Technical analysis seeks to determine whether the prerequisites for the successful
commissioning of the project have been considered and reasonably good choices have been made
with respect to location, size, process, etc. This is crucial because the rest of the project analysis
cannot be conducted without information form the technical study.

In general the technical analysis is primarily concerned with

 Material inputs and utilities

 Manufacturing process and technology
 Product mix
 Plant capacity
 Location and site
 Machines and equipment
 Structure and civil works
 Project charts and layouts
 Work schedule

c) Institutional-Organizational-Managerial Aspects

This basically incorporates the socio-cultural patterns and institutions or 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 disturb the accepted patter? If so how should this be included as part of
the project design?

To have a chance of being carried out, a project must related properly to the institutional
structure of the country or region where the project is to be carried. Examples include the land
tenure system, use of local institutions such as Idir or Debbo

Similarly, managerial issues are critical for successful completion of projects. Thus, the project
analyst must examine the ability of available staff to identify whether they have the capacity to
carry out the managerial needs of the project.

8
d) Social Aspects

Project analysts are expected to examine the broader social implications of the proposed project.
This is particularly related to the income distribution implications of the project, which very
much related to employment creation. Such social goals might also include issues of balanced
regional development, the displacement impact of the project (the Wonji-Methara sugar
plantations displacement is a good case in point); the gender implication of the adopted
technology; environmental impacts etc.

e) Financial Aspects

Financial analysis seeks to ascertain whether the proposed project will be financially viable in the
sense of being able to meet the burden of servicing debt and whether the proposed project will
satisfy the return expectations of those who provide the equity capital. Here the project analysts
is concerned with the financial effects of the proposed project on each of its various participants
(firms, framers/workers, government etc.). By examining the financial implications for these
parties the analysts need to identify the projects financial efficiency, incentive impact to the
participants in the project, creditworthiness and liquidity (say, could firms have enough working
capital?). For instance projections of receipts of one particular participant may help to identify
the possibility of/or the demand for credit for that participant.

The aspects which have to be looked into while conducting financial appraisal are:

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 worthwhile ness judged in terms of various criteria of merit
8. Projected financial position
9. Level of financial risk

f) Economic Aspects
The economic aspect of project preparation is primarily concerned with the determination of the
likelihood of the proposed project, and hence the committing of scares resources, by justifying
the significance of the project from the whole economy point of view (the society as a whole). In
such evaluation 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 form the
participants (or owners) point of view, while the economic analysis form the society’s point of
view.

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 re a return/income. The
reason for this distinction is basically the point of view (society as opposed to firm).

9
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 ‘accounting prices’ or ‘economic accounting prices’.

3. Treatment of interest on capital: in economic analysis interest on capital is never separated

and deducted from the gross return since 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.

g) Ecological analysis

In recent years environmental concerns have assumed a great deal of significance. Ecological
analysis should be done particularly for major projects, which have significant ecological
implications like power plants and irrigation schemes, and environmental polluting industries.
The key questions raised in ecological analysis are:

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

(i) What is the cost of restoration measures required to ensure that the damage to the
environment is contained within acceptable limits?

10
CHAPTER 2. THE PROJECT CYCLE

A project cycle is a sequence of events, which a project follows. These events, stages or phases
can be divided into several equally valid ways, depending on the executing agency or parties
involved. Some of these stages may overlap. Capital expenditure decision is a complex decision
process, which may be divided into six broad phases:

1. Identification
2. Pre-feasibility Study
3. Feasibility (technical, financial, economic)`
4. Selection and project design
5. Implementation
6. Ex-post evaluation

1. Identification: the first stage in the project cycle is to find potential projects. Identification of
promising investment opportunities requires imagination, sensitivity to environmental changes,
and a realistic assessment of what the firm can do. This phase may take two forms. If the project
is largely a private venture in a widely market economy context the initiating entity will define
the concept, expectation and objectives of the project. On the other hand the project idea can also
immanent form government agencies in the context of government development plans. In the
latter case sectoral information (i.e. the direct and indirect demands of sectors) is an import ant
source of identification. In market economy context anticipated demand for the projects output is
important. In addition assessment of appropriate technology, scale of the project, timing of the
project etc. are important. All types of specialists’ input are required at this stage.

The planning phase of a firm’s capital investment is concerned with the articulation of its broad
investment strategy and the generation and preliminary screening of project proposal. The
investment strategy of the firm delineates the broad areas or types of investment the firm plans to
undertake. This provides the framework, which shapes, guides, and circumscribes the
identification of individual project opportunities.

In general there are four major sources from which ideas or suggestions for project may come:

 Project ideas from technical specialists

 Project ideas from local leaders
 Project ideas from entrepreneurs
 Project ideas from government policy and plans

Note that sometimes at identification stage there could be a number of alternatives that could be
examined. Some of these projects may appear for reasons nothing to do with the national plan. In
such circumstances its advantageous to understand the ‘political history’ of the project.

The identification of project ideas is based on several aspects of development.

 Need - a need assessment survey may show the need for intervention
 Market demand - domestic or overseas
 Resource availability - opportunity to make available resources more profitable
 Technology - to make use of available technology
 Natural calamity - intervention against natural calamity such as flood or drought

11
 Political considerations

Project preparation and analysis phase

Once project ideas have been identified the process of project preparation and analysis starts.
Project preparation must cover the full range of technical, institutional, economic, and financial
conditions 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. Different alternatives may be available and therefore, resource endowment (labor or
capital) would have to be considered in the preparation of projects. Preparation thus require
feasibility studies that identify and prepare preliminary designs of technical and institutional
alternatives, compare their costs and benefits, and investigate in more details the more promising
alternatives until the most satisfactory solution is finally worked out. It involves generally two
steps:

 Pre-feasibility studies
 Feasibility studies

2. Pre-feasibility Study: The identification process will give the background information for
defining the basic concept project, which leads to the feasibility study stage. Once a project
proposal is identified, it needs to be examined. To begin with, a preliminary project analysis is
done. A prelude to the full blown feasibility study, this exercise is meant to assess (i) whether the
project is prima facie worthwhile to justify a feasibility study and (ii) what aspects of the project
are critical to its variability and hence warrant an in -depth investigation. At the pre-feasibility
study stage the analyst obtains approximate valuation of the major components of the projects
costs and benefits. Some of the maincomponents examined during the pre-feasibility study
include:

 Availability of adequate market

 project growth potential
 investment costs, operational cost and distribution costs
 demand and supply factors; and
 social and environmental considerations

Using this preliminary data supplied by the various discipline specialists a preliminary financial
and economic analysis will be conducted. If the project appear viable form this preliminary
assessment the analysis will be carried to the feasibly stage.

3. Feasibility Study: the major difference between the pre-feasibility and feasibility studies is the
amount of work required in order to determine whether a project is likely to be viable or not. If
the preliminary screening suggests that the project is prima facie worthwhile, a detailed an
analysis of the marketing, technical, financial, economic, and ecological aspects is undertaken.
Feasibility study or appraisal provides a comprehensive review of all aspects of the project and
lays the foundation for implementing the project and evaluating it when completed. The focus of
this phase of capital budgeting is on gathering, preparing, and summarizing relevant information
about various project proposals, which are being considered for inclusion in the capital
investment. Based on the information developed in this analysis, the stream of costs and benefits
associated with the project can be defined. At this stage a team of specialists (Scientists,
engineers, economists, sociologists) will need to work together. At this stage more accurate data

12
need to be obtained and if the project is viable it should proceed to the project design stage.
Appraisal should cover major aspects like technical, institutional, economic and financial.

The final product of this stage is a feasibility report. The feasibility report should contain the
following elements:

 Market analysis
 Technical analysis
 Organizational analysis
 Financial analysis
 Economic analysis
 Social analysis, and
 Environmental analysis

4. Selection and Project Design: The feasibility study would enable the project analyst to select
the most likely project out of several alternative projects. Selection follows, and often overlaps,
analysis. It addresses the question - is the project worthwhile? A wide range of appraisal criteria
have been developed to judge the worthwhile of a project. They are divided into two broad
categories, viz., non-discounting criteria and discounting criteria. The principal non-discounting
criteria are the payback period and the accounting rate of return. The key discounting criteria are
the net present value, the internal rate of return, and the benefit cost ratio.

To apply the various appraisal criteria suitable cut off values (hurdle rate, target rate, and cost of
capital) have to be specified. These are influenced by the level of risk pursued. Despite a wide
range of tools and techniques for risk analysis (sensitivity analysis, scenario analysis Monte carol
simulation, decision tree analysis, portfolio theory, capital asset pricing model, and do on) risk
analysis remains the most intractable part of the project evaluation exercise. This exercise also
involves the undertaking of detailed engineering design, manpower and administration
requirement as well as marketing procedures should be finalized.

5. Implementation: after the project design is prepared negotiations with the funding
organization starts and once source of finance is secured implementation follows.
Implementation is the most important part of the project cycle. The better and more realistic the
project plan is the more likely it is that the plan can be carried out and the expected benefits
realized. At the project implementation phase tenders are let and contracts signed. Project
implementation must be flexible since circumstances change frequently. Technical changes are
almost inevitable as the project progresses; price changes may necessitates adjustments to input
ad output prices; political environment may change. Project analysts generally divide the
implementation phase into three time periods.

 The investment phase, where the major investments are made. This may extend from three to
five years.
 The development phase which may also extend from three to five years.
 The project life

The implementation phase for an industrial project, consists of several stages: (i) project and
engineering designs, (ii) negotiations and contracting, (iii) construction (iv) training, and (v)
plant commissioning.

13
Translating an investment proposal into a concrete project is a complex, time consuming and risk
fraught task. Delays in implementation, which are common, can lead to substantial cost overrun.
For expeditious implementation at a reasonable cost, the following are helpful.

1. Adequate formulation of projects. A major reason for the delay is inadequate formulation
of projects. Put differently if necessary homework in terms of preliminary studies and
comprehensive and detailed formulation of projects is not done, many surprises and
shocks are likely to spring on the way. Hence the need for adequate formulation of the
project cannot be overemphasized.
2. Use of the principle of responsibility accounting. Assigning specific responsibilities to
project managers for completing the project within the defined time frame and cost limits
is helpful in expeditious execution and cost control.
3. Use of network techniques. For project planning and control two basic techniques are
available - PERT (program evaluation Review Technique) and CPM (Critical Path
Method). These techniques have of late merged and are being referred to by common
terminology that is network techniques. With the help of these techniques, monitoring
becomes easier.

6. Ex-post evaluation: the final phase of the project is the evaluation phase. Many usually neglect
this stage. The project analyst looks carefully at the successes and failures in the project
experience to learn how better to plan for the future. In this stage it is important to examine the
project plan and what really happened. Performance review should be done periodically to
compare actual performance with projected performance. A feedback device, it is useful in
several ways: (i) it throws light on how realistic were the assumptions underlying the project; (ii)
it provides a documented log of experience that is highly valuable in future decision making; (iii)
it suggests corrective action to be taken in the light of actual performance; (iv) it helps in
uncovering judgment biases; (v) it induces a desired caution among project sponsors. Weakness
and strengths should carefully be noted so as to serve as important lessons for future project
analysis undertaking. Evaluation is not limited only to completed projects. Ongoing projects
could also be evaluated to rectify problems when the project is in trouble. The evaluation may be
done by the project management, the sponsoring agency, or other bodies.

14
 PART II

CHAPTER 3: FINANCIAL ANALYSIS OF PROJECTS

Every project has to be first analyzed in terms of its timely implementation and financing.
Financial analysis of a project amounts to reviewing it from the angle of the entity (private or
public) that will be responsible for its execution. It aims at verifying that under prevailing market
conditions the project will become and remain viable. A comprehensive financial analysis
provides the basic data needed for the economic evaluation of the project and is the starting point
for such evaluation. In fact economic analysis consists mainly of adjustment 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. There are however, some
differences between the two.

3.1. When to undertake financial analysis.

A financial analysis must be undertaken if it is necessary to determine the financial profitability

of a project to the project implementer. 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. This
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 it undertake an
economic 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 it is undertaking. Even non-commercially oriented government
institutions 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
may be required to provide the cheapest services. Under such circumstances a cost minimization
or cost effectiveness exercise will be undertaken.

3.2. Identification and quantification of costs and benefits

In project analysis, the identification of costs and benefits is the first step. 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 cost ad 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 and different objectives.

 For a farmer, a major objective of participating may be to maximize family income. But this
is only one of his objectives. He may also wish 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. He
may also wish to avoid risk and thus continue cropping a variety, which he knows well.

 For a private business firm or government corporations a major objective is to maximize net
income, yet both have significant objectives other than simply making the highest possible
profit. Both will want to diversify their activities to reduce risk. A bus public corporation
may for instance decide to maintain services even in less densely populated areas or at off
peak hours and thereby reduce its net income.

15
 A society as a whole will have as a major objective increased national income, but it clearly
will have many significant, additional objectives. One of the most important of these is
income distribution. Another may be to increase the number of productive job opportunities
so that unemployment may be reduced - which may be different from the objective of income
distribution itself. Another objective may be to increase the proportion of saving for future
investment. Or there may be other broader objectives such as 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 narrowly defined.

No formal analytical technique could possibly take into account all the various objectives of
every participant in a project. Some selection will have to be made. Most often 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. Anything that reduces national income
is a cost and anything that increases national income is a benefit. Thus anything that directly
reduces the total final goods and services is obviously a cost, and anything that directly increases
them is a benefit. The task of the economic analyst will be to estimate the amount of the increase
in national income available to the society i.e., to determine whether, and by how much, the
benefits exceed the cots in terms of national income.

Quantification: once costs and benefits are enumerated the next step is accurate prediction of the
future benefits and costs which then be quantified in dollars and cents. Thus, quantification
involves the quantitative assessment of both physical quantities and prices over the life span of
the project.

The financial analysis of projects is typically based on accurate prediction of market prices, on
top of quantity prediction. It is worth thinking about the impact of the project itself on the level
of prices; and the independent movement of prices due other factors. The same principle applies
in the case of economic analysis the only difference being the price needs to be changed to reflect
net efficiency benefits to the nations at large. One widely accepted ‘’efficiency’ measure is its
actual or potential value as an import or export; similarly the opportunity cost of any input is
related to the question of its potential contribution to (or claims on) foreign exchange. In other
words world price are considered as efficiency price indicators compared to domestic prices.
However, to take account of the distribution impact of projects further adjustment of such price is
required. This lends itself toe the social cost benefit analysis.

3.3. How to value project costs and benefits in financial analysis.

The financial benefits of a project are just the revenues received and the financial costs are the
expenditures that are actually incurred by the implementing agency as a result of the project. If
the project is producing some goods and services for sale the revenue that the project
implementor expects to receive every year from these sales will be the benefits of the project.
The costs incurred are the expenditures made to establish and operate the project. These include
capital costs, the cost of purchasing land, equipment, factory buildings vehicles, and office
machines, working capital as well as its ongoing operating costs; for labor, raw material, fuel,
and utilities.

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

16
the prices in the local economy, and include all applicable taxes, tariffs, trade mark-ups and
commissions. Since the project implementors 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. In a freely perfectly competitive market, without
taxes or subsidies the market price of an input will equal its competitive supply price at each
level of production. This is the price at which producers are just willing to supply that good or
service. The supply curve will reflect the opportunity cost, or the value in their next best
alternative use, of the resources used to produce that input. In equilibrium the supply price of an
input will equal to its demand price at the market-clearing price for that input.

The financial benefit from a project is measured in terms of the market value of the project’s
output, net of any sales taxes. If the project’s output is sold in a competitive market with no
rationing or price control for the good concerned, and the project is small and does not change
the good’s price, its market price will equal its competitive demand price. This is a minimum
measure of what people are willing to pay for a unit of the good or service (produced by the
project, at each level of output demanded.

3.4. Secondary costs and benefits

We may distinguish between primary and secondary costs. The former is concerned with the
direct project outputs and inputs. The latter, however, exist where the project enables more
efficient use of resources to be made elsewhere or leads to external claims on resources
elsewhere. Project might lead to benefits created or costs incurred outside the project itself. So
project analyst must also consider the external or secondary costs so that they can be properly
attributed to project costs investment. This is more a problem of economic analysis and not a
concern of financial analysis. The tracing through of secondary effects is the proper subject of
economic analysis.

3.5. Tangible costs and benefits of a project

The first question that the analyst needs to know is whether it is one project that is to be
evaluated or several alternatives? Determining the relevant alternative project based perhaps on
technology, size, or length of time required for the phasing out of the project etc. is a critical
problem.

3.5.1 Tangible costs of a project

In almost all project analyses costs are easier to identify (and value) than benefits. In examining
costs the basic question is whether the item reduces the net benefit of a farm or the net income of
a firm. The prices that the project actually pays for inputs are the appropriate prices to use to
estimate the project’s financial costs. These prices may include taxes, tariffs, monopoly or
monopsony (seller monopoly) rents, or be net of subsidies. 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 on the following
items.

The cost of land and site development

 Land charges
 Payment for lease

17
  Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tubes wells

The cost of buildings and civil works

 Buildings for the main plant and equipments
 Buildings for auxiliary services (steam supply, workshops, laboratory, water supply,
etc.)
 Warehouses and show rooms
 Non factory buildings like guest house, canteens, residential quarters, staff rooms
 Silos, tanks, wells, basins, etc.
 Garages and workshops
 Other civil engineering works

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

Technical know how and engineering fees

 Consultants (local or external)

Miscellaneous fixed assets

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

Pre-operative expenses
 Establishment expenses,
 Rents, taxes, and rates
 Traveling expenses interest and commitment charges on borrowings
 Insurance charges
 Mortgage expenses interest on differed payments,
 Miscellaneous expenses

Provision for contingencies

The cost of production

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:

18
 Material cost which 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.

 Utilities consisting of power, water, and fuel are also important cost components.

 Labor: this is the cost of all manpower employed in the enterprise. it will not be difficult to
identify and quantify the labor required for the production process. From the highly skilled
manager to the unskilled factory worker the labor input can easily be identified. Problems in
the case of valuing unskilled labor and family labor might arise in the economic analysis of
projects.
 Factory Overhead: the expense on repairs and maintenance, rent, taxes, insurance on
factory assets, etc. are collectively referred to as factory overheads.

 Land to be used for the project can also be easily identified and quantified. It will not be
difficult to know who much land is need and about the location. Yet problems might arise in
valuing land because of the special kind of market conditions that exist when land is
transferred from one owner to another.
 Contingency allowances are usually included as a regular part of the project cost. In general
project costs estimates are assume that there will be no relative changes in domestic or
international prices and no inflation during the investment period or there will no be any
modification in design, no exceptional conditions such as unanticipated environmental
conditions (flood, landslides, or bad weather). It would be unrealistic to base project cost
estimates only on these assumptions of perfect knowledge and complete price stability.
Sound project planning requires that provision be made in advance for possible adverse
changes in physical conditions or prices that would add to the baseline cost. Contingency
allowances may be divided into those that provide for physical contingencies and those for
price contingencies. In turn price contingencies comprises two categories, those for relative
cages in price and those for 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. 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
implementor in financial analysis. But they are considered as transfer payments in economic
analysis.
 Debt service: the same approach applies to debt service - the payment of interest and the
repayment of capital. Both are treated as an outflow in financial analysis. In economic
analysis debt service is treated as a transfer payment within the economy even if the project
will actually be financed by a foreign loan and debt service will be paid abroad.
 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 however, poorly advised they may
have been. 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.

19
3.5.2. Tangible Benefits

Tangible benefits can arise either from increased production or from reduced costs. The specific
forms, in which tangible benefits appear, however, are not always obvious and valuing them
might be difficult. 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

3.6. Intangible costs and benefits

There may be some costs and benefits that are intangible. These may include the creation of new
employment opportunities, better health and reduced infant mortality as a result of more rural
clinics, better nutrition, reduced incidence of waterborne diseases, national integration, or even
national defense. Such intangible benefits, however, do not readily lend themselves to valuation.
Under such circumstances one may have to resort to the least cost approach instead of the normal
benefit cost analysis.

Although the benefits may be intangible most of the costs are tangible. Construction costs for
schools, hospitals, pipes for rural water supply, etc. are all quantifiable. However, cost such as
the disruption of family life, the increased pollution as a result of the project, ecological
imbalances as the result of the project, etc. are difficult to capture and quantify. But effort should
be made to identify and quantify wherever possible.

3.7. 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. So the definition of
costs and benefits might be confusing. 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. 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. Rather it
transfer income from the firm to the government so that this income can be used for social
purposes presumed to be more important to the society than the increased individual
consumption (or investment0 had the firm retained the amount of the tax. So, in economic
analysis taxes will not be treated as a cost in project account.

No matter what form a tax takes, it is still a transfer payment - whether a direct tax or an indirect
taxes such as sales tax, an excise tax, or tariff or duty on an imported input for production.
Whether a tax should be treated as a transfer payment or as a payment for goods and services

20
needed to carry out the project or merely a transfer, to be used for general purposes, of some part
of the benefit from the point to the society as a whole.

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. If a firm is able to
purchase an input at a subsidized price that will reduce his costs and thereby increase his 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. But a subsidy can
also operate to increase the amount the owner receives for hat he sells in the market, as in the
case of a direct subsidy paid by the government that is added to what the 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 consumer 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 is transferring the claim to the real resource back to the
lender - but neither the loan nor the repayment represent in itself, use of the resources. From the
standpoint of the producer, receipt of a loan increases the production resources he has available;
payment of interest and repayment of principle 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. The loan transaction from one enterprise
to another would not reduce the national income; it is rather, a direct transfer payment.
Repayment of a loan is also a direct transfer payment.
CHAPTER 4 THE CASH FLOWS IN FINANCIAL ANALYSIS

4.1. Introduction

The three basic steps in determining whether a project is worthwhile or not are: (a) estimate
project cash flows; (b) establish the cost of capital; and (c) apply a suitable decision or appraisal
rule or criterion. This chapter deals with the first step.

Whether one is calculating financial or economic rate of return, a key part of the analysis will be
to work out the actual flows of income and expenditure. The financial cash flow of a project is
the stream of financial costs and benefits, or expenditures and receipts that will be generated by
the project over its economic life, and will not be produced in its absence. Note that when one is
working with market prices, the cash flow stream is referred to as financial Cash Flow. When
these prices re adjusted to reflect national efficiency and equity objective (i.e. when shadow

21
prices are used) it is referred to as Economic Net Benefit Stream and Social Net Benefit
Stream, respectively.

Example: Consider a water supply project that has 20 years of estimated life. It is assumed it
will take some years before the project yields some positive returns. The project starts producing
positive results only after year 1. Operation stops with no scrap value at the end of year 20. Total
cost starting year 1 is Br. 945 million, which increases to Birr 1267 Million in year 2. The total
cost stream is subtracted from the total revenue to obtain the net financial flow.

Table: Simple financial cash flow for a water supply project (in million Birr)
Costs Year
1 2 3 4… 20
Capital costs
Fixed assets
…Pipes 400 500 300 0 -70
Pumps 50 100 90 0 -30
Storage tanks 140 230 160 0 -100
Jack hammers 20 10 0 0 -5
Construction 200 250 190 0 0
Total fixed assets 810 1090 740 0 -205
Working capital 20 30 40 0 -90
Total capital costs 830 1120 780 0 -295
Operating costs
Project management 80 100 120 90 90
Fuel 5 7 8 10 10
Maintenance 30 40 50 50 50
Total costs 945 1267 958 150 -145
Benefits (water sales revenue 0 200 250 500 500
Net benefits (benefits – costs) -945 -1067 -708 350 645

In practice the composition of costs is a bit complex and we have discussed that issue below.
Some important points to note are:

Costs are typically broken into investment and operating costs. The former basically covers
capital expenditure (such as plant and machinery) while the latter (incurred only once the project
is underway) is in turn divided in to variable and fixed components. The former covering such
things as raw materials and labour inputs (which varies with output) while the latter includes
items such as maintenance, administration and managerial charges (which will be relatively fixed
with respect to volume of production)

For financial analysis which is carried out form the point of view of the project entity, tax and
subsidy elements in cost (and revenue) components will be left in the calculation. For financial
analysis form national point of view, tax and subsidy elements will normally be netted out of the
calculation (since these are transfer payments to and from the government). Depreciation will
also be omitted, this being no more than an accounting device for putting aside funds for
replacement.

When detailed economic analysis is done the cost breakdown used in the standard accounting
procedure will not be sufficient. We need to reclassify all project inputs and outputs into traded

22
and non-traded goods and basic factors of production. This is one other difficult part in project
analysis.

4.2. Basic Principles for Measuring Project cash Flow

For developing the stream of financial costs and benefits, the following principles may be kept in
mind:
 Incremental principle
o The cash flow of the project must be measured in incremental terms. To ascertain
a project’s incremental cash flows one has to look at what happens to the cash
flows of the firm with the project and without the project. The difference
between the two reflects the incremental cash flows attributable to the project.
That is:

 Project cash flow for year t = cash flow for the firm with the project for
year t - cash flow for the firm without project for year t.

 long term funds principle

o a project may be evaluated from various point of views: total funds point of
view, long term funds point of view, and equity point of view. It is usually
recommended that project be evaluated from the point of view of the long-term
funds (which are provided by equity stockholders, preference stockholders,
debenture holders and long term lending institutions) because the principle
evaluation is long-term profitability. Hence for determining the costs and
benefits of an investment project we will have to ask what is the sacrifice made
by the suppliers of long term funds? And what benefits accrue to the suppliers of
long-term funds?

 exclusion of financing costs principle

o The exclusion of financing costs principle means that: (i) the interest on log term
debt is ignored while computing profits and taxes thereon and (ii) the expected
dividends are deemed irrelevant in cash flow analysis. If interest on long term
debt and dividend on equity capital are deducted in defining cash flows, the cost
of long term funds will be counted twice, which is an error.

 post -tax principle

Tax payments like other payments must be properly deducted in deriving the cash flows. Put
differently cash flows must be defined in post tax terms.

4.2. Components of the Cash Flow Stream

The cash flow stream associated with a project may be divided into three basic components:
(i) an initial investment
(ii) (ii) operating cash inflows, and
(iii) (iii) a terminal cash flow.

23
The initial investment represents the relevant cash flow when the project is set up. The operating
cash inflows are the cash inflows that arise from the operation of the project during its economic
life. The terminal cash flow is the relevant cash flow occurring at the end of the project life on
account of liquidation of the project.

4.3. Biases in Cash Flow Estimation

As cash flows have to be forecast far into the future, errors in estimation are bound to occur. Yet
given the critical importance of cash flow forecasts in project evaluation, adequate care should be
taken to guard against certain biases, which may lead to over statement or understatement of true
project profitability.

24
4.3.1. Overstatement of Profitability

Profitability is often overstated because the initial investment is under -estimated and the
operating cash flow exaggerated. The principle reasons for such optimistic bias appear to be as
follows:

Intentional overstatement: project sponsors may intentionally over-estimate the benefits and
under-estimate the costs.

Lack of experience: inadequate experience on the part of project sponsors generally leads to
over-optimistic tendencies. Inexperience on the other hand may lead to wishful thinking.

Lack of objectivity: individuals responsible for preparing forecasts may become too involved and
lose their sense of proportion unintentionally.

Capital rationing: companies typically operate under capital rationing which may be externally
determined or internally imposed.

4.3.2. Under-Statement of profitability

In the previous section we saw the effect of optimistic bias that ay lead to an over-statement of
project cash flows and profitability. There could be an opposite kind of bias relating to the
terminal benefit which may depress a project’s true profitability. This can happen if:

 salvage values are under-estimated

 intangible benefits are ignored
 the value of the future options is overlooked.

25
Chapter 5. The Hicks – Kaldor Compensation Principle, Time preference and Non
Discounted Measures

5.1 Pareto Optimality and the Hicks - Kaldor Compensation Principle

Once a project’s financial cost and benefits have been identified, valued in market prices and
entered in the cash flow, the remaining task is to use this information to determine whether the
project will be profitable and should be selected for implementation. The basic selection criterion
which is applicable in both financial and economic analysis is that a project should not be
undertaken unless its benefits outweigh its costs. The theoretical justification for this rule is the
Hicks - Kaldor selection criterion.

The standard measure employed in welfare economics to determine whether a change in resource
allocation will result in people being better off is the Pareto welfare improvement criterion. A
Pareto improvement in welfare is said to occur if at least one person is made better off and no
one is made worse off by a given change in economic conditions. When using this criterion it is
unnecessary to make any comparison between the utility (welfare) enjoyed by different people as
a result of any change in their income, since everyone must either be unaffected or made better
off by the change for it to be considered a Pareto welfare improvement.

However, if projects could only be implemented when they were expected to result in an actual
Pareto welfare improvement, it is obvious that very few, if any, would be approved. This is
because there will always be someone who is made worse off by the improvement of project,
such as a tax payer who does not receive any benefit.

To overcome the restrictive nature of Pareto unanimity rule, the concept of a potential Pareto
improvement or the compensation principle, was developed by Hicks (1939) and Kaldor (1939).
This criterion states that a given change in the allocation of resources will potentially improve
welfare if those who gain could compensate those who lose, and still be better off themselves.
The Hicks-Kaldor compensation principle is central to the theoretical justification for cost benefit
analysis in welfare economics. This criterion provides the rationale for choosing projects whose
benefits outweigh their costs, even if the people who gain from a project are not the same as
those who pays for it. The excess of benefits over costs is called the project’s net benefit.

A crucial element of this criterion is that it is not necessary for the gainers from a project to
actually compensate the losers, only for them to be able to do so if they wished and still remain
better off than if the project had not been implemented. Hence a project that meets the Hicks -
Kaldor hypothetical compensation criterion will not necessarily result in an actual Pareto welfare
improvement, only a potential improvement.

The Hicks - Kaldor criterion can be criticized because of its failure to address the distributional
impacts of projects. Total welfare will not necessarily be increased even if a project meets the
Hicks _Kaldor criterion, unless those who gain receive the same increase in their utility from an
extra unit of income as those who lose from the project. However, it is a basic tenet of welfare
economics that the poor can be expected to receive a greater increase in their utility or welfare
from 1 extra unit of income than the rich. That is, the poor are expected to have higher marginal
utility of income than the rich. Put simply a project that costs the poor 1 unit of income and
increases the income of the rich by 1.5 units will pass the hicks - Kaldor criterion and be
selected, but will not increase total community welfare if the poor value their unit of lost income
twice as highly as the rich value each additional unit of income they gain.

26
Nevertheless, in economic analysis these problem are largely ignored and it is implicitly assumed
that everyone has the same marginal utility of income. However, the rationale for the social
analysis of projects is largely based on this failure of the Hicks - Kaldor compensation criterion
to deal with the distributional issues that will arise if actual compensation does not take place.

5.2 Time Preference and the marginal rate of time preference

Before the Hicks – Kaldor criterion can be used to decide which projects should be selected for
implementation, it is necessary to address the problem of the differences in the timing of a
project’s costs and benefits. If the costs and benefits of a project occur over a number of years,
they will not be directly comparable. It is not possible to just to add all the benefits of the project
and to subtract all the costs, irrespective of when they occur.

Very rarely will all of a project’s benefits and costs occur in the first year of an investment. The
bulk of the project’s costs will be met in the implementation stage. Its operating cots will be
incurred after the project begins and continue throughout the project’s life, and its benefits will
be realized after operation commences, rising to some plateau when the project reaches full
capacity.

For a whole range of reasons, people, enterprises and governments will not be indifferent about
whether they receive income (or incur expenditure) now or in some future period. They are said
to have time preference in that they will prefer to receive income sooner rather than later, and to
pay for expenditures later rather than sooner.

Example: if a person is offered the choice between receiving Birr 10 now or in 10 years time, he
will invariably opt to receive Birr 10 now, even if they do not expect there to be any price
inflation over the period.

Some of the main reasons people will prefer to have income now rather than in the future include
the following:

(i) Uncertainty about the future: Life is always uncertain, and people cannot be sure that they
will be alive in 10 years time to collect their Birr 10s. They may also be uncertain about whether
they really will be paid the Birr 10 in 10 years time, as many factors may change over such a
period. Such risks should be reduced if there is a strong legal system, enforcing contracts. This
factor could be termed pure risk, pure time preference.

(ii) There is an expectation that society and individuals will be better off in the future than
they are now: it could be expected that people would gain less extra utility or enjoyment from
additional Birr of income if they were rich than would the same people if they were poor. An
individual would therefore be expected to get less utility from an extra Birr 10 of income
received in 10 years time, when he or she excepts to be better off, than from Birr 10 of income
obtained now.

Governments and private firms and investors will also prefer to receive income now rather than
in some future period, as income received now could be invested and, at the margin receive back
the marginal return on capital in the economy. These investors will be willing to pay interest to
borrow capital to undertake such investments. If income becomes available from a project in
earlier years than later ones, these funds can be used to reduce the amount the government or

27
private investors will have to borrow for the project. The value of such funds will therefore be
equal to the interest they would otherwise have had to pay to borrow this capital.

For all these reasons, income available from a project today cannot be treated as if it were equally
valuable as income will be more valuable. It is therefore, necessary to find some method of
standardizing the value of the benefits and the costs that occur in different periods over the
project’s life, so that they can be compared and added together. For the reasons outlined above,
income available now is more valuable than future income even if there is no inflation.

The marginal rate of time preference

We need to find out how much more income will individuals need to receive in the future to
make them indifferent to receiving this amount later rather than a given amount of income in the
present. If a person is indifferent to receiving Birr 10 now rather than Birr 11 in 12 months time,
he or she is said to have a marginal rate time preference (MRTP) of 10 percent or more usually
0.1 per annum. This sis calculated from (Birr 11 - Birr 10)/Birr 10. This person would probably
be equally happy to receive Birr 11 1 year from now and Birr 11 * (1 + 0.1) or Birr 12.1, two
years from now.

In general terms if an individual is indifferent to receiving 1 unit of income in period 0 rather

than 1*(1+r) units in period 1, then his or her MRTP is said to be r, where r is a proportion of 1,
or percentage. This person would probably also be indifferent to receiving this 1*(1+r) units in
period 1 and 1*(1+r)2 units in period 2. Hence the individual would be indifferent to receiving 1
units of income in period 0 and 1 *(1+r)2 units of income in period 2. This process could be
continued on and in the most general case we would expect that the person would be equally be
happy to receive 1 unit of income in period 0 and 1 *(1+r)n units of income in period n.

5. 3. Non-Discounted Measures of Project Worth

Projects, which are powerful means of development, have to be appraised by multiple criteria.
Since any national investment decision must be a political act summing up the best judgment of
those responsible, the function of project analysis would be to provide one more tool by which
these judgments can be sharpened.

In order to appraise a project idea we need operational criteria applicable in evaluating

alternatives. Technical criteria are used to compare the merits of alternative technical solutions. It
should be noted that there might be no one best technique for estimating project worth although
some may be better than others. We should also note that these are only tools to improve
decision-making. There are other non-quantifiable and non-economic criteria for making project
decisions. The tools are only used to improve the decision making process. Before we discuss the
discounted measure of project worth we need to consider some common undiscounted measures
and show their limitations and hence require discounting.

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 cash proceeds (financial results or

28
 profits) in subsequent years. The investment with the longer life would be more
desirable.

Example: consider the following hypothetical irrigation project

Investment (project) Initial cost Net cash proceeds per year
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

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.

(ii) Two investments have the same initial outlay (the total net value of incremental production
may be the same), the same earning life and earn the same total proceeds (profits), but one
project has more of the flow earlier in the time sequence, 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 up the difference until year 2.

2. The Payback Period

The payback period also called the payoff period is one of the simplest and apparently one of the
most frequently used methods of measuring the economic value of an investment. The payback
period is defined as the length of time required for the stream of cash proceeds produced by the
investment (project) to be equal to the original cash outlay required by the investment (capital
investment). It is defined as 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 cost of the
projects initial capital investment. This criterion is most often used in the business enterprises.
However, its use in agricultural projects is limited.

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.

Example: consider project C. 10000 - 3762 = 6238. then 6238/7762 = 0.8 so 1.80 years.

Example: consider the previous project

Example: consider the previous project
Investment Payback period Ranking
A 1 1
B 1 1
C 1.8 4
D 1.7 3

29
Investment A and B are both ranked as 1, since they both have shorter payback periods than any
of the other investments, namely 1 year. But investment B which has the same rank as A will not
only earn 10,000 Birr in the first year but also 1,100 Birr a year later. Thus investment B is
superior to A. But a ranking procedure such as the payback period fails to disclose this fact. Thus
it has two important limitations:

(i) it fails to give any considerations to cash proceeds earned after the payback date. It
simply emphasizes quick financial returns.
(ii) It fails to take into account differences in the timing of receipts and earned proceeds
prior to the payback date. For instance, if we have two projects with the same capital
cost and if they have the same payback period then they are equally ranked. Yet we
know by the inspection method the project with more earlier benefits should be
desirable and should be preferred since the earlier a benefits is received the earlier it
can be reinvested or consumed.

3. Proceeds per Unit of Outlay

Under this method, investment are ranked according to their total proceeds divided by the
amount of the corresponding investments. In other words the total net value of incremental
production divided by the total amount of the investment gives us the proceeds per unit of outlay.

Example: consider the following hypothetical example

Investment Total proceeds Investment Proceeds per Ranking
outlay unit of outlay
A 10,000 10,000 1.00 4
B 11,100 10,000 1.11 3
C 11,524 10,000 1.15 1
D 11,524 10,000 1.15 1

Accordingly project C and D must be implemented. However, both projects are given the same
rank. Although we know by inspection that project D is superior because D generates Birr 2000
of proceeds in year 1.

This method is again deficient because it still fails to consider the timing of proceeds. In other
words, the method considers that 1 Birr or proceeds received in year 2 is equal to 1 Birr received
in year 1. This is inconsistent with the generally accepted economic principle that 1 Birr today is
more valuable than 1 Birr at some future date.

4. Output - Capital Ratio

This is another crude index of investment efficiency. It is defined as the averages (undiscounted)
value added produced per unit of capital expenditure. Under this criterion we select the project
with the highest output capital ratio or the lowest capital output ratio (capital coefficient).

The main problem with this approach is that it ignores other factors of production such as labor
and land and concentrates only on the productivity of capital. Accordingly the criterion favors
those projects that use large quantities of labor and land in place of capital.

30
There are two other undiscounted measures of project worth.

(i) the average annual proceeds per unit of outlay

This is similar to the proceeds per unit of outlay except that the average proceeds per year is
expressed as a ratio of the original investment. The total proceeds are first divided by the
number of years during which they are received, and this figure (the average proceeds per
year) is then expressed as a ratio of the original outlay.
This method fails to take properly into considerations the timing of proceeds and exhibits a
built in bias for shortlived investment with high cash proceeds.

Example:
Projects Total Average Original Average annual Ranking
proceeds annual outlay proceeds per unit of
proceeds outlay
A 10,000 10,000 10,000 1.00 1
B 11,100 5,550 10,000 0.555 4
C 11,524 5,762 10,000 0.576 2
D 11,524 5,762 10,000 0.576 2

We know that project D is superior to c although this method gives them equal ranks. Investment
A and B are also incorrectly ranked by ranking A above B in spite of the fact that the latter is
obviously superior. No weight is given to the time distribution. For instance, a project that earns
10000 Birr for 10 years would also have an average proceed of 10000 per year and it would be
given the same rank as project A.

(ii) Average Income on the Book Value of Investment

This is the ratio of the income to the book value of its assets. The value of assets as recorded
in the operation’s financial account books.

31
Chapter 6. Discounting Future Income Flows in Project Analysis

The undiscounted measures discussed so far share a common weakness. They fail to take into
account adequately the timing of benefits. Thus it is an accepted principle in economics that
inter-temporal variations of costs and benefits influence their values and a time adjustment is
necessary before aggregation. Therefore a time dimension should be included in our evaluation.
That means we need to express costs and benefits in terms of value by discounting all items in
the cash flows back to year 0. The need for such a procedure will be apparent if one considers the
following simple argument.

Suppose one is offered the choice between receiving Birr 100 today and receiving the same
amount in a year’s time. It will be rational to prefer to receive the money today for several
reasons.

1. One may expect inflation to reduce the real value of Birr 100 in a year’s time.
2. If there is no inflationary effect (say where the offer is made in real terms) it would
still be preferable to take the money today and invest it at some rate of interest, r.
hence receiving a total of Birr 100 (1+r) at the end of the year.
3. Even if no investment opportunities are available, one might reason that Birr 100
today would still be preferable on the grounds that there is a finite risk of not being
around to collect the money next year.
4. Even where inflation, investment opportunities, and risk are ignored, there is pure
time preference, which would lead one to prefer the immediate offer.

For all these reasons, we say there is a positive rate of discount, which leads us to place a lower
present value on a given sum of money the further in the future one expects it to accrue. The
accepted method for this adjustment amounts to bringing them to a common time denominator.
This principle is called discounting.

Discounting is a technique or a process by which one can reduce future benefits and costs to their
present worth or present value. This is the method used to revalue future cost and benefit flows
from project into present day values so that they are comparable and can be added together. Costs
and benefits are discounted by a factor that reflects the rate at which today’s value of a monetary
unit decreases with the passage of every time unit. Any costs and benefits of a project that are
received in future periods are discounted, or deflated by some factor, r, to reflect their lower
value to the individual (society) than currently available income. The factor used to discount
future costs and benefits is called the discount rate and is usually expressed as a percentage.
Hence, discounting is very important for project analysis. The discount rate is usually determined
by the central authorities (national Bank).

32
6.1 The Discounting Process

In order to clearly understand the principles of discounting it will be helpful to have a clear
understanding of the principle of compounding. Compounding is the technique of calculating
the future worth (F) of a present amount (P) at the end of some period T at a given interest rate.
On the other hand finding the present worth of a future stream of value is called discounting.

Hence, if there is an initial amount P at present, then if this investment was borrowed from the
bank at an interest rate of r Birr then after one period it becomes:

P + Pr = P(1+r)
Since the borrower must also repay the principal.

Thus, if we have Br. 100 in 1990 with annual interest of r (r = 10%) its value in 1991 will be:

Br.1101991=Br.1001990(1+r). Thus, the present value of 110 in 1991 is Br.1001990=

Br.1001991/(1+r) or Br. 100 next year is equivalent to Br. 90.91 of this year (for Br. 90.91 at
10% yields 110 next year.)

After two periods the amount becomes:

P  Pr  r ( P  Pr)
P  Pr  Pr  Pr 2
P  2 Pr  Pr 2
P(1  2r  r 2 )
P1  r 1  r   P (1  r ) 2

In general, the amount accumulated after t periods would be

A = P(1+r)t

Now, given that future value accumulated after t periods as above, if we want to know the
present value of this amount we would be talking about discounting. Hence the present value
would be:

A amount..accumulated ..at..some.. future..date

P t

(1  r ) (1  r )t
 A(1  r )  t

So the discount factor tells us how much Br 1 at a future date is worth today at a certain discount
rate.

Example: The present value of 110 in 1991 is Br Br.1001990= Br.1001991/(1+r) or Br. 100 next
year is equivalent to Br. 90.91 of this year (for Br. 90.91 at 10% yields 110 next year). This
example shows that 100 received in a years time has a present value of Br. 90.91. If we want to

33
work out the present value of Br. 100 to be received in 1992 it will be apparent that Br. 100 1992
will be worth Br. 100/(1+r) in 1991 which in turn will be worth Br. 100/(1+r)2 in 1990.

Writing P0 for the present value and P 1, P2 ....,Pt for the stream of payments accruing form years 1
to t, and the relevant discount rate is denoted by r, then the general form the discounting
expression becomes,

P0 =P1 /(1+r)1+P2 /(1+r)2+...+Pt/(1+r)t

This can further be generalized as

t
Pt
PV  P0     Pt (1  r )  t
t 0 1  r 
t

Note that the above formula, by using a single discount rate (r) assumes that the time preference
of benefits falls at constant rate. If that was not the case the work would have been more
complicated.

In general, it is possible to consider the value people will put on income in different periods, by
working back in time from the future. The person with a MRTP of 0.1 will also be indifferent to
receiving Birr 10 one year from now rather than Birr 10 / (1+0.1), or Birr 9.09 now. The relative
valuation of income in the two periods is the same as that considered in the previous section,
only now the future income, Birr 10 is divided by (1+0.1) to find its equivalent value in current
day Birr, 9.09, rather than multiplying current income, Birr 9.09 by (1+0.1) to find its value in
future Birr which is Birr 10.

The same individual would probably also consider Birr 10 available in 2 years time and Birr 10/
(1+0.1)2 or Birr 8.26, available now as equivalent. As income only becomes available further
into the future, its value will fall in terms of current day Birr. This fits with our intuitive
expectation that future income is considered less valuable than current income.

A person with a MRTP = r would be as indifferent to 1 extra unit of consumption in period 1 as

to Birr 1/ (1+r) of a unit available in period 0. Similarly, 1 extra unit of income in period 2 would
be worth the same as 1/(1+r)2 unit of income in period 0, and so on. The unit of income available
in period 2 would be worth only 1/(1+r) of a unit in period 1, and this would be worth only
1/(1+r)2 of unit in period 0. In the most general case, 1 unit of income available in period n will
only be worth 1/(1+r)n of a unit of income in period 0.

The discount rate and the interest rate are similar. The only variation is that the interest rate used
for compounding assumes a viewpoint from here to the future, while discounting looks backward
from the future to the present. For private companies (and some times even for public projects)
the discount rate r used for financial analysis is the interest rate at which bank loans are available,
or where when the firms own fund is utilized the rate which banks would pay on the deposit of
such funds - their opportunity cost.

Example: Assume that a textile plant is to be established at a costs of 20 million Birr. It is

expected that the annual total cost is 10 million Birr and the sales revenue is expected to be 14
million Birr annually. The operating life of the project is 10 years. If loan is available for the
financing of the project at 10 percent rate.

34
 Undiscounted Discounted
1 2 3 4 5
Year(t) Costs Benefit Net benefits Discount factors (10%)= Discounted net
(Cash flow) (2) 1/(1+0.10)t benefits (cash flow)
– (1) (3)*(4)
0
0 20 0 -20 1/(1+0.10) = 1.000 -20(1.000) = -20.00
1 10 14 4 1/(1+0.10)1 = 0.909 4(0.909) = 3.64
2
2 10 14 4 1/(1+ 0.10) = 0.826 4(0.826) = 3.30
3 10 14 4 1/(1+0.10)3 = 0.751 4(0.751) = 3.00
4 10 14 4 1/(1+0.10)4 = 0. 2.73
5 10 14 4 … 2.48
6 10 14 4 … 2.26
7 10 14 4 … 2.05
8 10 14 4 … 1.87
9 10 14 4 …. 1.70
10
10 10 14 4 1/(1+0.10) = 0.386 4(0.386) = 1.54
Total 120 140 20.00 1/(1+0.10)t = 6.144 NPV = 4.57

The project’s net present value can then be estimated by just adding up these discounted net
benefits. Column 1, 2 and 3 show the non discounted cost, benefits and net benefits (benefits -
costs). Thus 4 million Birr in year 10 is only 3.64 Birr in year 1. The present value of the stream
of payments (future income) realized over 10 years is 24.57 million Birr. The sum is what we
call NPV. In other words, the present worth of 4 million received yearly for 10 years at a
discount rate of 10 percent is 24.57 million Birr. The present worth is the sum of all the present
values for all the years together.

Note: the figure -20 million Birr represent the investment outlay of the project. It is negative
because it has been subtracted from zero revenue in the first (base) year of the project.

Working out the present worth of a future income stream or a given sum of money is this manner
is time consuming and laborious. Thu, discounting tables are normally used. We can use
compounding and discounting tables for project evaluation prepared for the purpose. In this table
the column entitled discount factor shows how much 1 Birr at a future date is worth today at a
certain discount rate (interest rate).

Example: to know the present value of a fixed sum of money say 100 Birr received 5 years in
the future at 10 percent discount rate we multiply the amount due in the future by the discount
factor for the fifth year to get the result. The discount factor at 10 percent is 0.621 which gives
100*0.621 = 62.10 Birr.

On the other hand if we wish to find the present worth (value) of a future stream of income we
can arrive at the result imply by taking the sum of the discount factors and multiply by the annual
income to be received , i.e. simply multiplying by an annuity factor the amount received
annually.

Note: an annuity is an amount payable yearly or at any regular time intervals. It gives the present
worth of future income stream of 1 currency unit a year. The present worth (value) of an annuity
is simply the running subtotal of the discount factors.

35
Example: the discount factor for 10 percent at the 1st year is 0.909, and the discount factor in the
2nd and 3rd years are 0.826 and 0.751 respectively. Thus, the annuity factor for the 2 nd and 3rd
years are 1.735 and 2.486, respectively. Thus we can multiply the income that is to be received
annually for two years by 1.735 and for 3 years by 2.486. Thus we do not need to add the various
discount factors.

Some investments do not begin to repay the first year since the commencement of operation. If a
project begins to produce benefits after n years have been elapsed and continues producing
benefit for t years then we can find the present worth (value) of the future income stream
beginning with the nth year and continuing through the t years.

This is given as the present value of an annuity factor for t years at r percent ( Pt /(1+r)t less the
present worth of an annuity factor for n-1 years at r percent (Pt /(1+r)t equals the present value
(worth) of an annuity factor for the nth through t th years at r percent (Pt/(1+r)t. Thus we can use
this annuity factor to determine the present worth of a stream of income.

36
Example: if we want values for the fifth through the ninth project year, we subtract the figure for
the 4th year from the figure for the ninth year.

Consider the previous example

Year Cash flow
T5 4.00
T6 4.00
T7 4.00
T8 4.00
T9 4.00
T10 4.00
24.00

Present worth of an annuity factor for 10 years at 10 percent = 6.145.

Present worth of an annuity factor for four years at 10 percent = 3.170
Equals present worth of an annuity factor for 5th through 10th years = 2.975.

Thus an income stream of 4 million Birr received annually from the 5th through the 10th years at
a discount rate of 10 percent has a present worth of 4.00* 2.975 = 11.9 million Birr.

6.2 Discounted Project Assessment Criteria

In the previous sections we have seen why individuals and governments may have time
preference, and how time preference is accommodated in project analysis by discounting future
income flows. The various non-discounted measures of project worth that were examined were
found to be inappropriate methods of choosing between different projects.

Now we turn to the important discounted measures of project worth and examine them in detail.
The most important discounted cash flow measures include the net present value, the internal rate
of return and the benefit cost ratio.

6.2.1. The Net Present Value (NPV)

The most widely used and straightforward discounted measure of project worth is the net present
worth or the net present value (NPV). This value is obtained when a stream of cost and benefits
accruing over a period of time are discounted to the present is called the present value of the
stream. The NPV is defined as the difference between the present value of benefits and the
present values of costs. The NPV can be obtained by discounting separately for each year, the
difference of all cash outflows and inflows accruing throughout the life of project at a fixed, pre
determined interest rate.

37
The net present value formula is:

n
( Bt  Ct )
NPV  t
t 0 (1  r )

Where Bt are the project benefits in period t

Ct are the project costs in period t
r is the appropriate financial or economic discount rate
n is the number of years for which the project will operate.

The discounted rate should be equal either to the actual rate of interest on long term loans in the
capital market or to the interest rate paid by the borrower. However, since capital market do not
usually exist in developing countries, the discount rate should reflect the opportunity cost of
capital i.e., the possible return of capital invested elsewhere. This is the minimum rate of return
below which the planner considers that is does not pay for him to invest.

The discounting period should normally be equal to the life of the project. This period is the
economic life of the project and varies from project to project.

During the implementation period the net benefits are usually negative since costs, mainly
investments costs may be greater than benefits. However, the interest should be on the present
value of net benefits over the entire life of the project.

Having set the discount rate, an investment project is deemed acceptable if the discounted net
benefits (benefits minus costs) is positive. The economic criterion of project appraisal is to accept
all projects that show positive or zero NPV at the predetermined discount rate and reject all
projects that show negative NPV.

Thus, the decisions is to accept if NPV > 0. We can also discount benefits and costs separately,
and if B > C then NPV = B - C > 0

But if one of several project alternatives has to be chosen, the project with the largest NPV
should be selected. But we should know how much investment would be required to generate
these positive NPVs if there are two or more alternatives. The ratio of the NPV and the present
value of investment (PVI) should be considered and we get the net present value ratio (NPVR)
when comparing alternative projects.

NPV
NPVR 
PVI

Given alternative projects, the one with the highest NPVR should be chosen. When comparing
alternative projects, care should be taken to use the same discounting period and rate of discount
rate for all projects.

Example: Consider the following Discounted Cash Flow for the Fertilizer Project in m. Birr)
Year Cash flow Discount Discounted Discounted Discounted
factors for 10 cash flow factor for 20 cash flow
percent (10%) percent (20%)

38
0 -20 1.00 -20.0 1.00 -20.0
1 4 0.909 3.64 0.833 3.33
2 4 0.826 3.30 0.694 2.78
3 4 0.751 3.00 0.579 2.32
4 4 0.683 2.73 0.482 1.93
5 4 0.621 2.48 0.402 1.61
6 4 0.564 2.26 0.335 1.34
7 4 0.513 2.05 0.279 1.12
8 4 0.467 1.87 0.233 0.93
9 4 0.424 1.70 0.194 0.78
10 4 0.386 1.54 0.162 0.65
NPV 4.57 -3.21

Note: the values stated under “discount factors for 10% and 20% can be obtained from any
standard set of discount tables.

Since discounting the cash flow at 10 percent produces a positive NPV of 4.57 million Birr we
conclude that the project should be undertaken. Suppose now that cost of capital were to be
raised to 20 percent, the project produces a negative NPV of 3.21million Birr. In this event the
project would have to be rejected.

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 is greater than or equal to 0(approve
any project for which 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.

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.

Example: Consider two dams which may be proposed for one prime site in a locality in a fast
flowing river (in million Birr).

Years
Dam A 1 2 3 4 5 6 7 8 9 10
Costs 3
Benefits 0 1 1 1 1 1 0.5 1
Net benefits -3 1 1 1 1 1 0.5

39
 NPV $1m
PV (benefits/costs)1.37
Dam B
Costs 500
Benefits 0 100 100 100 100 100 100 100 100 100
Net benefits -500 100 100 100 100 100 100 100 100 50
NPV $33m
PV (benefits/costs)1.07

Dam A is small but has a high ratio of discounted benefits to costs (1.37). However, the total
benefits it produces and hence its NPV are quite small only 1 million Birr. The alternative dam B
is much larger and has much larger benefits as well as higher costs. Although NPV is large 33
million Birr its ratio of discounted benefits to costs is much lower than project A’s only 1.07.

If the two propjets were independent and the country could therefore construct both, then it
should do so as they both have positive NPVs. However, since the projects are mutually
exclusive the dam with the higher NPV should be selected, that is dam B. If dam A were
constructed a gain of only 1 million Birr would be realized, and the community would be
prevented for ever from gaining the much greater net benefits of 33 million Birr, which dam B is
expected to produce. The opportunity of gaining the other 32 million Birr of benefits from this
unique dam site would be lost forever. Consequently in choosing between mutually exclusive
projects the one with the highest NPV should always be selected.

It is also possible to discount costs and benefits separately (individually) and now the decision
rule becomes that the discounted benefits should exceed the discounted costs, i.e.,
B > C and NPV = B - C >0.

Example1: what would be the present value of 1000 Birr received five years in the future
assuming a 9 percent discount rate?

We consider the discount factor for the 5 th period under the 9 percent table. The discount factor is
0.6499. Then we multiply the amount due by the discount factor.

1000 * 0.6499 = 649.90 Birr

Example2: what would be present value of a stream of income of 5000 Birr received each year
for nine years assuming a discount rate of say 10 percent?

We use the table that gives the annuity factors to be used to derive the present value of a stream
of uniform values over a number of years. Thus the annuity factor for 9 years at 10 percent
discount rate is 5.759.

Now the annual income to be received is multiplied by the annuity factor.

5000 * 5.759 = 28795 Birr.

Thus if the going rate of interest is 10 percent then we could afford to invest Birr 28795 in an
enterprise that would yield us an annual return of Birr 5000 for each of the 9 years.

Practical application for the present value method

40
The practical application of the present value criterion as a means of evaluating investment
proposals for project planning implies the following assumptions.

(i) Annual outlays and receipts from each investment are known for the entire life of the
project.
(ii) That the project life span is known.
(iii) That there is a rate of discount, which can be applied to every proposal and for every
tie period.

However, the information required (the assumptions) made above is not always available for
every project. That means the NPV criterion may be applicable only to a limited number of
project proposals on which relevant data as indicated above could be computed or imputed. Is
some projects investment outlays are difficult to estimate.

Advantages of NPV Approach

The major advantage of the NPV selection criteria is that it is simple to use and does not rely on
complex conventions about where costs and benefits are netted out, as do some ratio measures. In
addition it is the only selection criteria that can correctly be used to choose between mutually
exclusive projects, without further manipulation.

41
Limitations of the Net Present Value Test

Like all discounted measures except the IRR, the use of the net present value criterion relies on
the prior selection of an appropriate discount rate. Although it is simple to use, its meaning may
not be intuitively obvious for non economists and politicians. Furthermore, although it can used
when there is budget constraint, it is not the simplest method for this situation, especially for a
large and complex investment budget. If the budget constraint is long term, it will be necessary
to raise the discount rate being used or the size of the budget, so that only projects with a positive
NPV will be selected, in which again the NPV will be the most useful criterion for deciding
whether to accept or reject projects.

1. Some projects could be deferred from implementation although they show

positive NPVs, due to scarcity of funds. Thus passing the NPV test may be a necessary
condition but not a sufficient condition.
2. if some projects are mutually exclusive then the implementation of one would
naturally exclude the execution of the other. This will lead both the central authorities
and the sponsoring agency into a dilemma which project should be implemented. If
funds are unlimited then both could be implemented, but this is not always the case.
3. The selection of an appropriate discount rate is another limitation.
4. It does not show the exact profitability rate of the project.

The treatment of Inflation

It is misleading to think that inflation can be ignored in discounting net flows since inflation
affects both costs and benefits and that the effects cancel out each other. This is not true as the
following example shows. Suppose benefits and costs of next year are discounted at the rate r.
Suppose further, in another scenario, price has increased at rate p. If the above assertion is right
the discounted net benefit of the two scenarios should yield identical value of NB.

NB=[B/(1+r)]-[C/(1+r)]= [B-C]/(1+r)

NB’=[B(1+p)/(1+r)]-[C(1+p)/(1+r)]={(1+p)[B-C]}/(1+r)

As the above computation shows the NB computed in the two scenarios are different. Note,
however, that discounting NB’ by a discount rate which incorporates the inflation rate. This rate
is usually called the real discount rate and can be given as r*, the nominal rate r,

1+r = (1+r*)(1+p)
r*= (1+r)/(1+p)]-1
1  r 
r*  1
1  p
In general one must either estimate the rate of inflation (assuming it is identical for cost and
revenue) and add it to the appropriate discount rate, or one must express all flows in constant
prices before discounting. In most of the cases it is preferable to do the latter since it is non
usually the case that costs and revenues will be affected identically by inflation.

6.2.2. The Internal Rate of Return of a Project (IRR)

42
This is a second measure of profitability. It is also called the yield of an investment method or
simply the yield method. The IRR of a project is probably the most commonly used assessment
criterion in project appraisal. This is because the concept of an IRR is in some way comparable
to the profit rate of a project and is therefore; say for non-economists to understand. Furthermore
it does not rely on the selection of a predetermined discount rate. The method utilizes present
value concept but seek to avoid the arbitrary choice of a discount rate. Hence an attempt is made
to find that discount rate which just make the net present value of the cash flow equal to zero. It
is possible to think a level of interest rate that could result in NPV of zero. This rate of interest
rate is termed as the Internal Rate of Return (IRR). The IRR is the rate of discount, which makes
the present value of the benefits exactly equal to the present value of the costs. Thus, it is the
discount rate at which it is worthwhile doing the project. This is the interest rate that a project
could pay for the resources used if the project is to recover its investment and operating cost and
still can be at the break-even point. Denoting it by R, it is the solution to the definition of the
NPV when the latter is set to zero,

t
Pt t
( Bt  C t )
NPV  P0  0 
t 0 1  R  t
t 0 1  R t
For financial analysis it would be the maximum interest rate that the project could afford to pay
on its funds and still recover all its investment and operating costs. While calculating the NPV
we have used a pre determined discount rate and a table. But the calculation of the IRR amounts
to searching for the discount rate that gives a zero NPV. This is achieved through trial and error
using the standard discounting table. This rate if determined will represent the exact profitability
of the project.

If the IRR is computed for financial appraisal in which all values are measured in market prices,
it is called the financial internal rate of return (FIRR). When economic prices are used instead, it
will be termed as economic internal rate of return (EIRR)

The calculation procedure begins with the preparation of a cash flow table. Estimated discount
rate is then used to discount the net cash flow to the present value. If the NPV is positive a higher
rate is applied. If it is negative at this higher rate the IRR must be between those two rates.

Example 1: Estimation of the IRR for a road project (Million Birr)

Year
1 2 3 4 5 6 7 8 9 10 11
1. Costs
Land 1000
Earth work 200 600 400
Equipment 190 200
Labor 120 120 120
Total costs 1510 920 520 0 0 0 0 0 0 0 0
2. Benefit from
Time saving 0 0 0 300 300 300 300
Maintenance 0 0 0 100 100 100 100
saving
Car dep.savings 0 0 0 290 290 290 290

43
Total benefits 0 0 0 690 690 690 690
Net benefits -1510 -920 -520 690 690 690 690
NPV at:
Discount rate: NPV (Million Birr
5 1130.6
10 241.9
15 -314.7
12 -12.0
At IRR = 0.00
11.8965

By iterations it is possible to determine the discount rate that just makes the project’s NPV equal
to zero. This rate is the IRR of the project. Fortunately spreadsheet programs such as Lotus 123
and excel can calculate the IRR of project’s net benefit flow once starting value for the iteration
is provided.

If the positive and negative NPVs are close to zero, a precise and less time consuming way to
arrive at the IRR uses the following interpolation formula.

PV ( I 2  I1 )
IRR  I1 
PV  NV
Where: I1 = the lower discount rate
I2= the upper discount rate
PV = NPV (positive) at the low discount rate of I1
NV = NPV (negative) at the high discount rate of I2

Note: I and I should not differ by more than one or two percent.

44
Example: consider the previous problem

Another approximate solution to the IRR is to plot the NPVs corresponding to several discount
rates to give what we call the NPV curve. The present values are plotted on the y-axis and the
discount rates on the X-axis. A curve is then drawn to connect the various points on the graph.
The point at which the curve cuts the X-axis represents the rate at which the present value of the
investment is equal to 0.

Example: By experimenting with discount rates between 10 and 20 in our fertilizer project
example, the IRR for the project is fractionally above 15%. The simplest way of getting this is by
plotting the NPV (y-axis) against different level of discount rates (x-axis); three points are
usually sufficient. The point at which this curve (called the NPV curve) crosses the x-axis
provides the IRR value.

Diagram : The NPV Curve for The Fertilizer Project

5

4 (4.57)

3
2
1 IRR
NPV in million Birr

0 Discount rate
2 4 6 8 10 12 14 16 18 20 22
-1

-2

-3
(-3.21)

Decision rule for independent projects

45
According to the IRR version of economic criterion we implement all projects that show an IRR
greater than the predetermined discount rate (opportunity cost of capital), i.e., accept all
independent projects having an IRR >= the opportunity cost of capital (cut off rate). The
reference discount rate which is also called the target rate, is predetermined by the Central Bank.

Once the IRR is identified, the decision rule is ‘accept the project if the IRR is greater that the
cost of capital, say r. Note also that:

When NPV > 0 then R > r

NPV = 0 then R = r
NPV < 0 then R < r

Note also the other point that, in the case of our example, if the discount rate is 10% both the
NPV and IRR will suggest to accept the project if the cost of capital is 10% and both suggest to
reject the project when the discount rate and the cost of capital is 20%. As will be demonstrated
below, however, the two methods may not give identical signals.

All projects with an internal rate of return greater than some target rate of return, r*, should be
accepted. The target rate is usually the same rate used as the financial or social discount rate
employed in the computation of the projects net present value. Note that the use of IRR does not
avoid the need for discount rate, as sometimes claimed, but merely delays the need to use it until
the IRR has been computed.

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 f
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. We can examine this at
large using the example of two dams.

46
 Years 1 2 3 4 5 6 7 8 9 10
Dam A
Net Benefits -3 1 1 1 1 1 0.5
NPV $1m
IRR 22.2%

Dam B
Net Benefits -500 100 100 100 100 100 100 100 100 100
NPV $33m
IRR 13.7%

Dam A has higher IRR (22%) than does Dam B (13%). However, since dam B offers higher
discounted benefits it should be chosen. This case is illustrated in the following diagram.

Diagram: Project selection for mutually exclusive projects

NPV

NPVB B

NPVA A

0 Discount rate
Rt Rt Rt

IRRB IRRA

In the above diagram the discount rate and the target IRR is assumed 10%. Given this, the IRR of
the two projects is given as IRR A and IRRB. We have assumed the appropriate discount rate to be
R11 If the discount rate is R’ project A will be the one that should be selected as the NPV of B
will be negative.

Comparison of the NPV and IRR

From the foregoing discussions it is clear that both the NPV and the IRR methods can and do
rank investment projects in more rational manner than the other methods previously considered.
Thus it is advisable to calculate these measures so that easily understandable information is
provided to the authorities. In general it can be said that the NPV method is simpler, easier, and
more direct and more reliable.

47
In some situations both the NPV and the IRR criteria give the same accept -reject decision.
However, there is a probable reason why all acceptable projects cannot be undertaken. The
investible funds (capital funds) may be limited. This will have implication on the discount rate. It
may mean that the discount rate has not been set correctly.

When the capital requirements of all acceptable projects exceed the available funds, the central
authorities (national bank) should raise the discount rate up to that level where the projects
passing the test are just enough to exhaust the available funds. But if too few projects are
acceptable then the discount rate should be reduced. Hence as long as capital funds are
‘unlimited’ it is argued that NPV should be the relevant criterion. But the function of the
discount rate is to ration capital in such a manner, as eventually to pass just sufficient projects as
will use up available investment resources. Hence the argument is not whether NPV or IRR
should be preferred as a criterion, but whether planners have set the discount rate correctly.

As is noted in the pervious section, the IRR and NPV might suggest different projects for similar
level of discount rate. The example below demonstrates this

Example: Cash Flows for Fertilizer Project

Cash Flows

Year Project A Project B Project C

0 -20 -40 -20
1 4 8 14
2 4 8 14
3 4 8 -
4 4 8 -
5 4 8 -
6 4 8 -
7 4 8 -
8 4 8 -
9 4 8 -
10 4 - -
NPV at 10% 4.57 6.08 4.36
IRR 15.1 13.7% 25.8%

As it can be observed ranking the three projects by their NPVs (at 10% discount rate) results in
project B heading the list, while ranking them according to their IRRs would lead the planners to
prefer C. 25.8% is better because a project with 25 % economic rate of return is likely to be a
better investment than with a project with 15% economic rate of return. That is, it contributes
more to the national income relative to the resources used.

If all of the projects are to be undertaken (i.e. there is enough budget/resource) both NPV and
IRR give the same accept-reject decision. However, ranking the projects using the two methods
will lead to the choice of different projects: Project B on NPV basis and project C on IRR basis.

The above projects may not be undertaken because there may not be enough capital funds. In this
case it means the discount rate is not set correctly to reflect this scarcity (i.e. despite the scarcity
capital is cheap, being only obtainable at 10%). So, 10% is not an appropriate discount rate
because it passes all the three projects more than can be accommodate by the given capital (i.e.
the scarcity of capital is not reflected in higher value of discount rate - the discount rate failed to

48
ration). For instance, raising it to 20% would leave us with surplus funds since A and B will have
negative NPV. Only if the rate is set fractionally below 15.1% will the right number of projects
be accepted as shown below:

Project A B C
NPV 15% 0.08 -1.84 2.76
NPV 10% 4.57 6.08 4.36
NPV 20% -3.23 -7.75 1.39

The point contained in the above Table is depicted in the following diagram

49
Diagram: NPV curves for Projects A, B and C
Appropriate Discount rate

10
8
6
4

Project C
2

Discount rate
0

2 4 6 8 10 12 14 16 18 20 24

Project A

Project B

Now if total investment budget is 80 million Birr and that the above projects constitute an
exhaustive list of all feasible projects in the economy. In this case planners could do all three
projects. However, if the budget were only 40 million Birr implying that either B could be
undertaken, or alternatively A and C. Since A and C together yield a total NPV of 8.93 million
Birr planners would choose A and C rather than B which yields only 6.08 million Birr at 10
percent discount rate. But it should be understood that 10 percent is not appropriate rate since it
effectively passes all three projects, more than can accommodated given the capital constraint.

Now if we raise the discount rate to 20 percent we could have rejected A and B, and there could
be simpler investment funds. Thus, if the rate is set at 15 percent then the right number of
projects could be accepted.

Example: Relation between discount rate and the available funds

Project
A B C
NPV 15% 0.08 -1.84 2.76
NPV 10% 4.57 6.08 4.36
NPV 20% -3.23 -7.75 1.39

In some cases it could be possible to find more than one IRR. This happens where a project’s
cash flow changes signs more than once, which could happen when there is a major replacement
investment.

Example
Year Cash flow Discount rate NPV
1-4 100 20 30
5 -1500 30% -11

50
6-10 200 40% -4
10-20 150 45% 6

The resulting NPV curve is perverse. This implies that one should take (undertake) the project if
the opportunity cost of capital is either below 25 percent or above 42 percent. Hence the NPV is
still preferred on this ground.

Diagram: Project having multiple IRRs

IRR

Discount rate
20 24 28 32 36 40 44 48

51
Advantages of the IRR

1. The IRR is used in many projects

2. 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.
3. 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.
4. It is a pure number and hence allows projects of different size to be directly
compared.

Problems with the IRR

1.The IRR is inappropriate to use for mutually exclusive projects and independent
projects when there is a single period budget constraint.
2.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.
3.Another problem with the IRR is that in some cases it my be possible to compute
more than one IRR for a project. For instance, the net benefit stream of an oil-
drilling project become negative half way though the project’s life because it is
necessary to replace rigs after a number of years. If a project has more than one
IRR, then neither an be reliably used and another decision rule such as the NPV
must be used rather than the IRR.
4.Finally prior to the advent of business calculators and computers software programs
like Lotus and Excel estimation of the IRR was a tedious process involving
interpolations. However this not anymore a problem.

52
6.3 Other Investment Criteria

6.3.1. The Net Benefit Investment Ratio (NBIR)

Is one of widely used and the most convenient selection criteria to use when there is a single
period budget constraint.

It is the ratio of the present value of the projects benefits, net of operating costs, to the present
value of its investment costs. This is given by,

( Bt  OCt )
n

 (1  r )t
NBIR  t 0
ICt

t 0 (1  r )
t

Where OC is operating costs I period t; IC Investment costs in period t; r the appropriate discount
rate, and B the benefits in period t.

The NBIR shows the value of the projects discounted benefits, net of operating costs, per unit of
investment.

The decision rule using NBIR is to accept project when the ratio is greater than 1. This criterion
is especially important for ranking independent projects since it shows the benefit per unit of
investment. When we have a single period budget constraint projects with the highest NBIR
should be selected up to the point where the budget is exhausted.

The main advantage of the NBIR is its capacity to determine the group of priority projects if
there is a single period budget and investment constraint. Its limitation is, however, that it is not
suitable for choosing between mutually exclusive projects, for the same reason that the IRR
cannot be used for this purpose. That is a project with highest NBIR could have the lowest
absolute net present value. The other disadvantage of NBIR is that the convention used for
dividing costs (for example maintenance) into operating and investment may vary form
institution to institution and may render problems of comparability.

6.3.2. The Domestic Resource Cost Ratio (DRCR)

This ratio is often used in trade oriented projects or trade policy. In its simple form the DRCR
(sometimes referred as Bruno ratio (Bruno, 1967) is an undiscounted measure of project worth
calculated for a single typical year of project operation.

DRC is a measure of the economic efficiency of production of a commodity or in other words the
national comparative advantage in its production. It is defined as the value of domestic resources
(primary, non traded factors of production) in domestic currency units required to earn or save a
unit of foreign exchange, that is the cost per unit of foreign exchange saved for imported
competing goods and the cost per unit of foreign exchange earned for exports. The DRC
coefficient is a cost benefit ratio and it is essentially a measure of the efficiency of domestic
production relative to the international market.

53
If the DRC for a commodity is less than the appropriate accounting price of foreign exchange
(OER or SER) a comparative cost advantage exists in producing the commodity in question and
vise versa. From this:

DRC < 1 implies that the productivity is economically profitable because its production yields
more than enough international value added to compensate for the cost of domestic factors used.

DRC = 1 implies a break-even situation, where it is only just economically worthwhile to

produce the commodity.

DRC > 1 indicates that the cost of domestic resources needed to generate one unit of foreign
exchange exceeds the value of the foreign exchange. This means the country is internally not
competitive in the production of the commodity or the country is better off to import rather than
to produce the commodity.

Undiscounted measures, as we noted, are excessively crude and most invariably inaccurate. Thus,
the discounted version is the most appropriate one. It is given as,

( Ctl  BCtl )
n

 (1  r ) t
( Br .)
t 0
DRCR  n
( C  BC )
 (tf1  r ) t tf ($US )
t 0

Where:
Btl are the benefits of the project obtained in local currency
Ctl are the costs of the project incurred in local currency
Btf are the benefits of the project obtained in foreign exchange
Ctf are the costs of the project incurred in foreign exchange

The Decision rule for DRCR

When undertaking a financial appraisal a project should be accepted if its DRCR is less than or
equal to the official exchange rate, OER. This means a project should proceed if it uses less
domestic resources, measured in local prices, to earn 1 unit of foreign exchange than is the norm
for the whole economy (the norm here being represented by the official exchange rate). In
economic analysis, however, a shadow exchange rate (as oppose to OER is used). The modified
DRCR (modified because it is discounted which traditionally was not the case) is sometimes
referred as the internal exchange rate approach to emphasize the fact that the computation of
DRCR is independent of any predetermined exchange rate as that of IRR, which do not,
immediately, require a discount rate. It produces own internal exchange rat, which is internal to
the project.

Example: Estimation of the domestic resource costs ratio, special economic zone project - local
cost component (numerator) in million Birr
Years
1 2 3 4 5 6 7 30
Local costs
Investment 40 60 30 10
Production 0 50 75 90 100 100 100 100

54
Total local costs 40 110 105 100 100 100 100 100
Local sales 0 0 20 25 25 25 25 25
Net local costs 40 110 85 75 75 75 75 75
PV of net local costs Birr 712 million

Estimation of the DRCR, special economic zone project - Foreign exchange component
(denominator) Million US$)

Years
1 2 3 4 5 6 7 30
Foreign exchange earnings
Exported output 0 3 20 30 30 30 30 30 30
Foreign exchange costs
Imported investment goods 20 40 12 2
Other imported items 0 5 7 8 10 10 10 10 10
Net foreign exchange earnings (export – -20 -42 1 20 20 20 20 20 20
imports)
PV of net foreign exchange earnings US$ 86.7

DRCR = PV net local costs/PV of net forex earnings = Birr 711.6/US$86.7= 8.21 Birr per US$.

The main advantage of this approach is that non-economists can readily understand its decision
rule. More substantially in economies with serious balance of payment problem the DRCR
clearly show the potential of a project to earn foreign exchange. It also avoids the need to
compute the shadow exchange rate in advance.

However, its disadvantages includes, like that of IRR it cannot be used to rank projects. It cannot
also be used to choose between mutually exclusive projects if both use less domestic resource to
earn a unit of foreign exchange. This is because it doesn’t show which of the two, or more,
mutually exclusive projects will generate the greatest net benefits for the country.

6.3.3. The Benefit Cost Ratio (BCR)

The benefit cost ratio is the earliest discounted project assessment criterion to be employed. The
BCR is defined as the ratio of the sum of the project’s discounted benefits to the sum of its
discounted investment and operating costs. This is given as,

n
Bt
 (1  r ) t
t 0
BCR  n
Ct
 (1  r ) t
t 0

The Decision rule for BCR

A project should be accepted if its BCR is greater than or equal to 1 (i.e. if its discounted benefits
exceed its discounted costs). But if BCR is less than 1 , the project should be rejected. The BCR
will be less than, equal to, and greater than one when the discount rate used is greater, equal to,
and less than the IRR.

55
One possible advantage o the BCR, on top of being easy to show to non-economists is that it is
easy to show the impact of a percentage change in cost or benefits on the projects viability.
Its major disadvantage is the need to specify and adhere to conventions regarding the designation
of expenditures as costs and benefits.

Example cost of transporting finished goods (say Br. 25) may be figured as cost in one project
(other costs are Br. 25 + transport cost Br. 25 = Br. 50; if sales price is Br. 100 the BCR will be
2) but price may be given net of transport cost (Br.100- Br.25=Br.75; compare to cost Br. 25 will
given a BCR of 3) in the other and the two projects, thus, are incomparable. Clear convention on
such issues will be necessary for comparison purposes.

56
 Part III:

CHAPTER 7. THE ECONOMIC ANALYSIS OF PROJECTS

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. In financial analysis the analysis is done by
applying market prices. Given the prevailing market prices the financial analysis will tell the
project analyst whether a project will be financially profitable. Thus governments and individuals
can pursue only limited objectives when they choose projects on the basis of financial appraisal.

From the standpoint of the economy as a whole, however, 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. Only in very unlikely conditions of perfect competition
and absence of externalities, government interventions, taxes and other market distortions, will
financial analysis of a project indicate whether or not a project will make a positive contribution
to society’s welfare. In the absence of these conditions, a financial analysis will only tell us
whether a project is profitable or not.

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. Making that assessment is the task of economic analysis.

What is the starting point for this analysis? The starting point for the economic analysis would be
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.

7.1. The Rationale for Economic Analysis

The objective of any legitimate government should be the promotion of community welfare.
They will be more concerned with their public work programs to promote community welfare
than they merely maximize financial profits at distorted local prices.

The basic question here is whether it is possible to use market prices to assess the economic
worth of projects. The answer is obviously no. 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. So governments must choose projects on
the basis of an economic analysis if they wish to promote the community’s welfare.

It is useful to have a fuller understanding of the areas where government intervention and market
failure result in serious distortion in market prices. This will help in understanding the process of
correcting for these distortions when economic prices are used. The major conditions under
which it is impossible to use market prices to assess the economic worth of projects can be
grouped under three or four 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 labour, capital, and
foreign exchange.
3. The existence of externalities, public goods and consumer and producers surplus.

57
 4. Imperfect knowledge, which the neoclassical model assumes that consumers and
producers have full knowledge of 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.

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, which can be called its marginal social
benefit, or how much it will add to community welfare, 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 the
quantity of the good that is demanded by consumers must equal the quantity supplied by
producers, and the price of the good must be its competitive demand price.
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 income in 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). And these are not uncommon. In many developing countries at least some prices
are set by government regulatory agencies. As these prices are usually set below market clearing
levels and therefore, at less than people are willing to pay, such controlled prices underestimate
the true value of these goods to consumers.

for example, the existence of controlled prices that are set below the amount that people are
willing to pay for a given quantity of output will frequently results in the rationing of limited
supplies, either formally or via queuing as well as corruption and black markets.

Alternatively, governments may enforce compulsory deliveries of goods and services at

artificially low controlled prices.

Figure: Goods market distortion price fixing

58
 D Sg

P=P=P
d s e
(Equilibrium price)

P Fixed price
mf

S Ds

Q Excess demand Q Quantity good

s d

In the figure, the price of controlled commodity is set at P MF, below the market clearing price
(equilibrium price) Pe. This results in excess demand for the commodity (Q d – Qs). So the
existence of controlled price will result in rationing of the commodity.

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. For instance, South Africa and
India are thought to be high protection countries.

Tariffs and quotas will cause a divergence between local market prices and the world prices of
internationally traded goods. The extent of this divergence will vary from industry to industry.

Diagram: Traded goods market distortions – import quota

59
 Price import

D Sg domestic supply curve

P
md

P
w World supply curve

Domestic demand curve

S Ds

Q Quantity import
s
Import quota

An import quota will push the domestic market cost of the input to P md, well above the foreign
exchange cost to the economy of importing the input, which is the world price P w .Such import
quota overvalue the social cost of the traded input used by the project.

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 labour,
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.

a) Intervention in the market for labour

Labour 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

60
labour. I the case of skilled labour, fixed wage rates may actually be set below market clearing
levels causing an artificial shortage of skilled labour.

Figure: Labour market distortions - fixed wage rates

Wage

D S
l

Wm fixed
Government fixed
wage

Wd = Ws = We
(Equilibrium wage =
shadow wage rate)

S Ds

Workers D Workers S Quantity labour

Unemployment

The government fixed wage Wm fixed above the market equilibrium wage W e. This will result in
unemployment of labour (unskilled) with the number of such workers offering themselves for the
formal sector jobs, Workers S exceeding demand, Workers D. The existence of open
unemployment or underemployment will indicate to the project analyst that market wage for the
categories of labour concerned is greater than its marginal social cost. The project analyst will
need to adjust these wage rates downwards until they reflect the true social cost of labour in the
country, the shadow wage rate.

b) Intervention in/or failure of capital market

Another important factor market in which governments often intervene by fixing prices is the
capital market. In order to encourage investment interest rates are often kept low.

Figure: Capital market distortions - fixed interest rates

61
 Interest rate

I S

Equilibriuminterest rate

I mf
Fixed interest rate

S I

supply savings demand for Quantity investible funds

investible funds

excess demand for credit

The interest rate paid for investible funds is held down to I mf 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. It will then be necessary 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
project.

62
c) Intervention in foreign exchange markets

Many countries often peg or manage their foreign exchange arte. Often the exchange rate is set
significantly above its free market level in terms of say a US dollar per unit of local currency.
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 unattractive to producers. The price that exporters receive in local currency
for a given dollar value of exports is reduced if the exchange rate is overvalued.

Diagram: Foreign Exchange Market Distortions

Exchange rate

S fe

SER

Equilibrium exchange rate

OERm Fixed exchange rate

S D
fe

Q Q Quantity of foreign exchange

fes fed

excess demand for foreign exchnage

The official exchange rate is fixed at OER. This will result in excess demand for foreign
exchange Qfed – Qfes 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
Qfes. 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.

3. Externalities and public Goods

63
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, therefore, will fail 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, or its
production, that are not directly felt by the people who buy it and hence may not be reflected in
the price they are willing to pay for it.

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.

Example:

1. The costs incurred in providing the project area with infrastructure inputs, e.g. access
roads, energy lines, sewerage services, etc. Although these inputs are required by the
project their cost is often met by the government rather than the enterprise, because often
they serve other purposes too.
2. Flood control measures (benefits) resulting from a hydroelectric dam are real benefits to
downstream farmers and the economy but external to the power authority.
3. Pollution created in the production of a commodity may be a cost to the society but
external to the project.

b). The existence of public goods

Public goods are goods and services whose use by one person does not reduce their availability
to others. Non-exclusion goods.

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. 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
will have to be valued at the amount that it is estimated people will be willing to pay for them.

64
7.2. The Essential Elements of an Economic Analysis

The economic analysis of a project has many features in common with a financial analysis.

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.

But an economic analysis goes beyond a financial analysis appraisal, as it will also involve all or
some of the following adjustments. In other words the essential elements of economic analysis
include:

a) The elimination (deduction) of transfer payments within the economy from the project’s
cash flow. Transfer payments are payments that transfer the command over the use of resources
but do not, themselves use resources.

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

b) The estimation of economic or shadow prices for project outputs and produced inputs
(included internationally traded and non-traded goods) to correct for any distortions in their
market prices. In financial analysis inputs and outputs are valued at actual market prices while in
economic analysis accounting (shadow) prices are employed. Thus because of using different
prices different economic and financial NPV and IRR are obtained even if the inputs and outputs
are identical in physical terms.

Example: enterprises will pay workers the market wages and in real Birr (not shadow ones)
irrespective of what is believed to be their opportunity cost from the economy’s
viewpoint.
Similarly, the enterprise will collect for its exports the equivalent of local
currency calculated at the official exchange rate, even when the foreign currency is
undervalued.

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 inputs such as public goods or social
services.

65
 CHAPTER 8
DETERMINING ECONOMIC VALUES

As indicated earlier according to the classical approach (financial analysis) inputs and outputs of
a project are valued at prices prevailing in the domestic market with occasional adjustments for
transfer payments such as subsidies and taxes. The rationale for using market prices lies in the
assumption that these prices reflect both marginal utilities of consumption and marginal
production cots. But this assumption may only hold true under the ideal condition of perfect
competition and therefore, the optimality of resource allocation depend on whether such
conditions actually prevail in the market.

It now generally accepted that market prices are very far from this ideal. For social, political,
historical, and economic reasons the markets are distorted and consequently the signals they give
in the form of prevailing prices are also distorted and do not reflect marginal product ivies and
marginal utilities. All sections of the domestic market are distorted due to a variety of reasons.
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.

The key to understanding of economic analysis is the concept of opportunity cost. When a
commodity or service is used for one purpose we must give up the benefit we could have
received had we used the good or service for the next best good or service. The opportunity cost
is equal to the marginal value product (the contribution of an additional unit of a commodity to
output) and the market price of the item in a relatively competitive market. In financial analysis
the price is the opportunity cost because we give up what we could have done with the money we
paid for an item if we had used it for some other purpose.

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. When the market price of any
good or service is changed to make it more closely represent the opportunity cost to the society
the new value assigned becomes the Shadow Price also called the accounting price. The shadow
price is what we call the economic price.

8.1. Adjustment for Transfer Payments

It is important when undertaking a project appraisal to identify the major distortions that will
create the mot serious divergence between market (financial) and economic prices in the market
for a project’s outputs and inputs. 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. When an individual pays taxes
his net benefit is reduced. But this payment does not reduce national income. Rather it is transfer

66
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. Thus economic analysis, which assesses the impact
of a project on national income, we would not treat the payment of taxes as a cost in project
accounts. Taxes remain a part of the overall benefit stream of the project that contributes to the
increase in national income.

B) Production Subsidies are simply direct transfer payments that flow in the opposite direction
from taxes. Different from of subsidies may exist ranging from lowering the selling price of
inputs below what otherwise would be the market price to the raising or increasing of the price
received by the producer. Subsidies do not increase or decrease national income. It merely
transfers control over resources from a taxpayer to another individual. Of course the subsidy
increases the individual’s income, so it is revenue for the receiver.

c) Credit Transactions are also transfer payments because the lender transfers control over
resources to the borrower. 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.

Examples: a depositor in the bank ho enables the banker to make a loan to a farmer to purchase
fertilizer is simply transferring control of resources to the farmer. Repayment of the loan does not
also reduce national income. It simply transfers control of resources from the borrower back to
the lender.

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.

8.2 Efficiency or Economic shadow Prices

Once it is decided that market prices are inappropriate in project selection, the question arises
how the necessary accounting prices should be estimated. Thus the economic analysis of projects
requires that inputs and outputs 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. Generally market prices do not represent the opportunity cost values. 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.

Definition of shadow (accounting) prices

67
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 non 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. 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. An accounting or
shadow prices reflect the increase in welfare resulting from one more unit of an output or input
being available.

Example: shadow wage rate set by estimating the marginal value product of labor.
Shadow exchange rate reflects the foreign exchange premium.

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. Shadow pricing corrects for any divergence between economic and market prices
due to market failure, government interventions, externalities, public goods, etc. in practice
economic pricing involves making adjustments to market prices to correct for distortions and to
take account of consumer and producer surplus. The resulted adjustment price should reflect the
true opportunity cost of an input (its marginal social cost or people’s willingness to pay for an
output (its social marginal benefit).

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) Either they can all be expressed directly in foreign exchange units - valuing all project
effects at world prices termed as the world price numeraire. If a world price numeraire is
adopted then the domestic market price of the import substitute needs to be adjusted
downward to its world price.
b) They can be expressed in domestic price units termed using a domestic price numeraire.
Conversely if a domestic price numeraire is adopted the border price of export products
need to be adjusted upwards by a certain factor (conversion factor).

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 also is considered. In social analysis growth and income distribution objectives are
pursued. In practice estimates of the parameters needed for a social analysis are relatively rare.

68
8.3. Traded and Non Traded Goods

Once it is agreed that market prices are inappropriate in project selection the question that arises
would be how the necessary accounting prices should be estimated. The valuation of goods and
services depends on whether the good can be traded in international market or whether it is
consumed locally such as in a closed economy.

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

The 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 directly. Some also consider goods which do not enter
into trade because of protection is presently instituted (trade barriers).

Example: Electricity is only rarely transmitted across frontiers. Unskilled labor is also another
example of non-traded commodity. Inland transportation and cement or 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.

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.

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

69
decomposition might be sufficient. 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.

70
Traded Goods

In almost all projects many of the inputs will be traded goods and a large number of projects will
also have trade-able outputs. 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

Agricultural goods
Intermediate goods
Raw materials
Some services such as tourism and consultancy services

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.

Domestically produced good is an exportable.

Price

Sd
D

D Dw
Pw

P
d

Dd
S

Quantity
Qd Exports Qs

The domestic equilibrium for the commodity is Pd, is below the world price, Pw that is
determined by the world demand curve DDW. This makes it profitable for domestic exporters
(producers) to export and receive higher world price. Domestic producers will produce Q s of
which Qd will be sold locally and Qs – Qd will be exported.

71
Importable are goods whose landed CIF import cost is less than the domestic cost of producing
these goods.

Domestically produced good is am importable

Price

Sd
D

P
d

Pw S Sw

Dd
S

Quantity
Qs Imports Qd

The domestic equilibrium price Pd is above the world price Pw, which is determined by the
world supply curve SSw. This will make it worthwhile for domestic consumers to attempt to
import the commodity at the lower world price. Qd - Qs would be the demand for imports.

Measurement of the economic value of tradeables (Valuation of Tradeables)

In almost all cases, the economic benefits of producing tradeables outputs and costs of using
tradeables 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 dock or other entry point in the receiving country includes the cost of international
freight and insurance and often includes the cost of unloading onto the dock. But this excludes
any charges after the import touches the dock 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 tradeables inputs
can be understood in terms of the assumption that the international markets are comparatively
competitive and free of distortions. 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.

72
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. 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. However, export taxes should not be
deducted from the FOB price. 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.

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 as explained earlier. 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. but potential or expected
imports and outputs should be treated a with caution. One should check whether a commodity
used as project input or output is actually or would definitely be exported or imported.

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 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.

73
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 therefore, 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 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.

The economic principle involved is that production or use of a traded good has a dual effect, both
in terms of direct foreign exchange given by the border price of the good and also in terms of the
resources that go into its distribution and distribution between the project location and the border.

To assess 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 on-traded activities of
transportation and distribution required per unit of output. 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. These later costs must be deducted since real resources are required
before the good can be exported.

Similarly where a project imports an input its border parity price is the CIF price plus transport
and distribution costs. If the project does not actually import or export the goods concerned but
produces that save imports (import substitutes) and uses domestic goods that could have been
exported (exportable) or could have been imported (importable) the adjustment is less straight
forward.

Importable Output

If the projects 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 to the
country from producing the import substitute and is therefore, 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. These are merely transfers between consumers of import
substitutes and the project, and do not represent an economic benefit of producing the commodity
locally. 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, and the economic cost
of any marketing and transport cost incurred in getting the project’s locally produced output from
the produced to the domestic market should be subtracted from these economic benefits.

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 order price
is the free on board price of the export at the dock or airport. This is the actual foreign exchange

74
earned from exporting, the export price minus any marketing margins and transport costs to get
the export item from the project to the border.

Imported Inputs

The full economic cost of an imported project input is the CIF import price at the border (landed
on the dock or at the airport), 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. These are merely
transfers from the project to the government and do not reflect the true economic cost of using
the imported inputs.

Exportable Inputs

Exportable inputs that are inputs into the project are therefore valued at their free on board (FOB)
price at the border (dock or airport). 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 moving the input to the project and to the port for
export. Where it is more expensive to move the import to the project this is an additional cost
that must be added to the FOB price, since more resource go into transport and distribution than
if the input had been exported. Similarly net cost savings be deducted from the export prices.

The net transport and distribution cost = difference between actual costs and those that would
have been incurred if the good was imported or exported.

75
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 included 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. The main reason for imposing prohibitive
import quotas, tariffs and embargoes is to protect the inefficient local producers. The group of
potentially traded goods falls between the traded and non-traded goods. It includes commodities
that are not traded at present but could be traded if the country had followed an optimal trade
policy. If a project uses a potentially traded good as an input or produces one as an output it will
be necessary to be clear about how to measure its value to the economy.

Potentially Traded Input

If the project analyst prices the input at the high cost of a protected industry he is penalizing the
project. If the project uses the lower price he affects the supplier, the high cost industry. . Thus
when the price differential between importing and local supply is substantial the agency
sponsoring the project could ask the government to make an exception and allow the project to
import. Thus if this is done the import should be valued as the CIF price. It should be treated as a
traded good. On the contrary if the input is supplied by the local high cost industry it should be
treated as a non-traded good.

Potentially Traded Outputs

Similarly, 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.

Conversion Factors

It has been already stated that all project inputs and outputs should be valued at the world prices
which are the border prices. World prices are used to measure the opportunity cost to the
economy of goods and services which can be bought and sold on the international market. This
means that the world price reflect the terms on which it can buy and sell on the world market.

However, in practice there are some problems. It is always possible that there will be 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 trading
goods, that is goods which for reasons relating to physical characteristics, costs, or trade policy
do not enter into international trade. Even when non traded goods are decomposed there always
remain items that are non traded and for which there is only domestic market. 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.

76
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 when the latter cannot be
observed or estimated directly. The more the inputs and outputs are traded the less will be the
need to use conversion factors. 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. As it has been
indicated earlier the market distortions vary from commodity to commodity, therefore, the
conversion needed varies from case to case. It is therefore 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.

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 whose markets have however, this is very difficult and we have to resort to
some kind of aggregation despite the shortcomings associated with aggregates. 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.

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. In practice if data permits some five conversion factors
covering major inputs of most projects will suffice. But at least we need one conversion factor to
multiply all the domestic market prices of all no traded components of the input and output of a
project. This parameter is called the standard conversion factor.

The Standard Conversion Factor

This is an all-inclusive conversion factor used in place of commodity - or sector specific

conversion factors, either because they cannot be estimated accurately, or because we believe that
they cannot be estimated accurately or because they do not differ substantially from 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. It is therefore estimated as the ratio of the value of imports and exports of a country at
border prices (CIF and FOB) to their value at domestic prices.

The formula for computing the standard conversion factor is give as:

77
 M X
SCF 
( M  Tm  S m )  ( X  S x  Tx )

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 respectively

All values should refer to the same year or to an average over the same period. As pointed out
earlier 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.

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. In other words, such parameters are national in 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.

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. How many
parameters should be estimated depends upon the economic conditions of the country and the
degree of sophistication desired in project analysis. However, a minimum of three or four
national parameters should be estimated:

 The standard conversion factor

 The shadow wage rate
 The discount rate, and
 The shadow exchange rate

78
CHAPTER 9. THE ECONOMIC VALUATION OF FOREIGN EXCHANGE

In the previous sections we have discussed how border prices are used to value the economic
benefits and the cost of project’s tradeable inputs and outputs. In project appraisal the foreign
exchange earnings and costs are usually converted into local currency so that they can be
included in the project’s cash flow with its non traded inputs and outputs. The OER would be
applied on the border price of exported commodities, X (fob price) and to that of each of the
imported inputs, M (c.i.f. price) to value of them domestically. This is so because we assume that
the official price of foreign exchange reflects its economic benefits to the country concerned.
However this is often not the case and needs to be relaxed and see its effect on the valuation of a
project’s tradeable inputs and outputs.

The official exchange rate, OER will be equal to the true economic value placed on foreign
exchange if it is able to move freely without interventions or control by the government and if
there is no rationing of foreign exchange, no tariffs or non tariff barriers on imports and no taxes
or subsidies on exports. In countries where these conditions hold the market price of foreign
exchange, the OER should be a good measure of people’s willingness to pay for the foreign
exchange needed to buy imported inputs and the economic benefits the local economy receives
from any foreign exchange earnings made by a project.

In very few countries in the world there is little or no government intervention and few
imperfections in the country’s traded goods and foreign exchange markets. There are many
distortions in the market for foreign exchange and traded goods.

a) the market for foreign exchange may be strictly controlled and it may only be possible to
purchase foreign exchange for permitted purposes. These controls may be imposed
because the fixed official exchange rate is overvalued, which results in the demand for
foreign exchange greatly exceeding supply.
b) A currency is overvalued if the official exchange rate understates the amount of domestic
currency that residents of the country would be willing to pay for a unit of foreign
currency if they could freely spend it on duty free goods - goods sold at their border
prices. Trade distortions such as import tariffs and quotas; result in a country’s currency
being overvalued.

79
The shadow exchange rate and overvaluation of a currency

Exchange rate, ER
Sfe
D Official supply Hypothetical free
of FE market supply of FE

Shadow ER
Undistorted
equilibrium ER = R

OER

DFE(demand for FE)

S net of tariff
demand for FE
0 Qd
Qs Qo Quantity foreign
Excess demand exchange

DDfe shows that amount of foreign exchange that local residents would demand in each exchange
rate if there were no tariffs and import quotas on imports or foreign exchange rationing.

SSfe is the hypothetical supply curve for foreign exchange showing the amount of foreign
exchange exporters would be willing to earn at each exchange rate if there were no subsidies or
taxes on exports or tariffs on imported inputs.

The undistorted exchange rate is achieved at the intersection of these hypothetical, distortion free
foreign exchange demand and supply curves. At this exchange rate the DD for and the SS of
foreign exchange will be equal at Q0.

Now if the official exchange rate OER expressed in terms of units of local currency needed to
buy one unit of foreign exchange is fixed below this equilibrium level it is said to be overvalued.
This means that an unrealistic high value is placed on the local currency in terms of how much
foreign exchange can be bought with a unit of currency. At this overvalued exchange rate,
exporters will only be willing to export goods and services worth Qs of foreign exchange rate
because they will receive less in local currency for each dollar of foreign exchange earned than
they would have at the equilibrium exchange rate. On the other hand imports will seem to be
cheap at such a low exchange rate and importers will demand Qd of foreign exchange to purchase
these inputs/ imports. At this artificially low exchange rate, OER the economy will therefore,
experience excess demand for foreign exchange Qd - Qs.

80
Consequently to overcome the resulting balance of trade deficit the government is likely to
impose import tariffs. This will shift the net of tariff demand for importable and hence for foreign
exchange downwards. The tariffs imposed causes a downward shift in the demand curve for
foreign exchange to DDt this will be sufficient to restore an artificial equilibrium in the foreign
exchange market so that the demand for foreign exchange equals supply at the OER.

The foreign Exchange premium

If the official exchange rate, OER, expressed in terms of units of local currency needed to buy
one unit of foreign exchange is fixed below their equilibrium level it is said to be overvalued.
This means that an unrealistically high value is placed on the local currency in terms of how
much foreign exchange can be bought with a unit of currency. Countries that have an overvalued
exchange rate are said to place a premium on foreign exchange or to have a foreign exchange
premium (FEP). A FEP measures the extent to which the OER understates the true amount of
local currency that residents would be willing to pay for a unit of foreign exchange, or its true
opportunity cost to the economy. It is defined as the proportion by which the OER overstates the
real value of local currency or of non traded goods and services relative to traded goods and
services. It is used to calculate the shadow exchange rate and the standard conversion factor for
economic analysis.

The FEP can be measured crudely by the ratio of domestic prices to the border prices. In other
words, the FEP is measured by the ratio of the value of total trade, imports plus exports, values
in domestic prices and therefore including the effect of tariffs and other distortions, to the value
of trade in border prices, minus one, as given in the equation below

 M (1  t )  X (1  d  s) 
FEP    1 100 per cent
 MX
Where:
t = are tariffs, or tariff equivalents of non-tariff barriers, imposed on imports
d = are the export tax equivalent on any restrains and taxes impose on exports
s = are the export subsidy equivalent to any support given to encourage exports
M = is the value of imports in border prices, c.i.f.
X = is the value of exports in border prices, fob.

The numerator measures the total amount in local currency that residents are actually paying to
consume imports (including tariffs and taxes) plus the amount they are actually accepting for
exports (excluding export taxes and including export subsidies). It therefore measures the true
values placed on traded goods produced and consumed in the country. The denominator shows
the actual foreign exchange value of these traded goods when they are measured at their border
prices, converted in local currency at the OER. The ratio of the domestic value to the border
price value, therefore, shows the true value placed on traded goods, relative to apparent economic
values at the official exchange rate. The FEP is usually expressed as % (that is why we subtract 1
and multiply it by 100). The final result show the extra % that consumers are willing to pay over
and above the OER if they were able to buy currency freely and spent it on duty free goods.

When estimating the economic prices of tradeables in countries that have overvalued exchange
rate, it will not be correct to merely value traded goods (which may normally be subject to
tariffs) at their border prices and then convert these values to local currency at an artificially low
exchange rate. Such a process would make them appear unrealistically cheap compared with
locally produced non-traded goods. This is because the local price of non-traded goods will over

81
time, have adjusted upwards to equal the tariff inclusive price of traded goods, which consumers
find equally attractive. Given a choice between a US dollar’s worth of imported goods, valued at
their tariff-free border price and converted into local currency at the official exchange rate an a
US dollar’s worth of locally produced non traded goods valued at their domestic market price the
average consumer would prefer a dollar’s worth of duty free imported goods. The foreign
exchange required to purchase these imported goods will therefore, have a higher value to local
consumer than is indicated by the official exchange rate. OER. Thus the project analyst must
correct these distortions in the foreign exchange and traded goods that result in a premium being
placed on foreign exchange.

Almost all projects include a mixture of traded and non traded inputs and outputs. If no
correction is made for this premium on foreign exchange in economic appraisals, projects that
produce traded goods (outputs) will yield an NPV that is undervalued, compared with those
producing non traded goods. This occurs because the traded goods outputs would be valued at
their FOB (CIF) border prices, converted into local currency at the artificially low official
exchange rate, in terms of the currency per US$. On the other hand, projects that use imported
inputs will appear to have low costs when the border prices of these inputs are converted at the
OER and will therefore, have an NPV that is overvalued compared with projects using non traded
good inputs.

If a foreign exchange premium exists, it is therefore, necessary to take into account of it in all
projects where both traded and non traded goods and services are included among project inputs
and outputs, or when comparing projects producing or using traded and non traded goods and
services. If both traded and non-traded commodities are used or produced in a project, they need
to be valued in comparable prices before they can be added together in net cash flow of a project.

82
The Shadow Exchange Rate

One way to correct for an overvalued exchange rate in project appraisal is to use a shadow
exchange rate, rather than the official exchange rate to value all foreign exchange earned and
used by the project. The SER is that rate of exchange which accurately reflects the consumption
worth of an extra dollar (or other convertible foreign currencies) in terms of one’s own currency.
Thus the SER is the shadow price of foreign exchange and reflects the foreign exchange
premium. Thus one way to adjust for the overvaluation of local currency is to increase the OER
by the foreign exchange premium to obtain a shadow exchange rate.

Example: if consumers in an economy would be willing to pay 20 percent more than the OER to
obtain foreign goods, then the foreign exchange premium is 20 percent and the OER would be
increased by 20 percent to obtain the SER. Thus if the OER were Birr 10 = $US1, then the SER
would be Birr 12 = $US1.

Thus the input which is traded across international borders and is found in the project account it
would be valued not at the OER but at the SER. This will make imports more expensive and
thereby encourage the use of plentiful domestic resources rather than use foreign exchange.

A simple definition of a country’s SER involves addition of the percentage FEP to the OER, or
more precisely, multiplication of the OER by on plus the FEP divided by 100.

FEP
SER OER(  1)
100

Example: if FEP is 100 percent and if the OER is 1US$ is equivalent to Birr 10, then the shadow
exchange rate can be estimated by

SER = Birr 10/US$1 (100/100 +1) = Birr 20/1US$.

The shadow exchange rate would therefore, be Birr 2 per US$. Thus foreign exchange in fact has
twice the value indicated by the official exchange rate.

The SER can also be derived from the definition of the FEP.

value..of ..trade..in..domestic.. prices

SER OER (
value..of ..trade..in..border .. prices
m1  t )  x(1  d  s )
......... OER ( )
mx

Where x, m, t, d, and s are defined as before the value of export (FOB),value of import(CIF),
tariffs imposed on imports, and export subsidy.

Estimation of the Shadow Exchange Rate

One common misconception is that an economy’s shadow exchange rate is equivalent to its
parallel market for foreign exchange. But the two are different. The difference is shown in the
diagram below.

83
The shadow exchange rate and black market rate

Exchange rate, ER
Black market
Official supply supply of FE Sfe
D of FE
Hypothetical free
market supply of FE
D

Shadow ER
Black market ER
Undistorted
equilibrium ER = R
OER

DFE(demand for FE)

S D (net of tariff
Black market demand for FE)
0 Qd
Qs Qo Quantity foreign
Excess demand exchange

As a small residual portion of the total FX of a country is traded; and there is a risk involved in
illegal transaction the parallel market rate will typically be above the undistorted exchange rate.
But it may be below SER if trade distortions stay in place. The smaller the risk the larger that
amount of FX trade in the parallel market; hence, it approximates the distortion free FX supply.

Estimation of SER is usually based on CGE models (we will not discuss that). But this procedure
is expensive both in terms of data and time. There are several alternative partial equilibrium
approaches that can be used under such circumstances. The most simple and widely used formula
in practice is the one developed by UNIDO 1972. It attempts to measure, in local domestic
prices, the increase in welfare in an economy that will be generated form one additional unit of
foreign exchange.

 The UNIDO SER formula is the weighted average of the ratio of the domestic prices to
border prices (c.i.f. or fob) of all goods traded by the country, where the weights reflect how the
next dollar of FX would be spent.

n  Pad  h  Pbd 
SER   f a     xb   OER
a 1  Pacif P
 b1  bfbo 
Where:
fa = is the fractional increase in each of the country’s n imports as a result of a one local
currency (Br.) increase in the availability of foreign exchange

84
 xb = is the fractional fall in each of a country’s h exports in response to a 1 Birr increase
in the availability of foreign exchange
Pad and Pbd = are the domestic market clearing prices of ath importable goods and the
bth exportable good, respectively.
Pacif = is the c.i.f. price of ath importable good, measured in Birr, converted at the
official exchange rate
Pbfob = is the fob price of the bth exportable good, measured in Birr, converted at the
official exchange rate.
 NB the Pad diverges form Pacif because of tariffs and non-tariff prices; while the Pbd
diverges form Pbfob because of export taxes and subsidies.

Example: Assume that 1 Birr of addition FE becomes available as a result of the project. Of this
85% is spent on increase imports of wheat (M) and 15% on purchasing rice, which would
otherwise have been exported (X). The c.i.f. price of M at the OER is Br 3/kg and its market
clearing domestic price is Br. 4/Kg due to tariff and non-tariff barriers with a tariff equivalent of
50%. The fob price of exportable rice is Br 3.kg while its domestic market-clearing price is Br
2/kg, due to an export tax of 33%. The SER in this simple two-good economy would be:

SER=0.85 x (4.5/3) + 0.15 x (2/3)=1.374 x OER

Since the OER in this economy is Br. 10/$US 1, the SER,

SER=Br. 1074/$US 1

The major problem with this approach is it doesn’t provide any guidance about how to estimate
the weights of fa and xb). It could be assumed that the marginal pattern of expenditure reflects
the average pattern of expenditure on traded goods. In practice this is the approach used.

85
Incorporating the Foreign Exchange Premium into the Valuation of Traded Goods

There are two main approaches for correcting for any premium placed on foreign exchange when
valuing traded and non-traded goods in project appraisal. The first is the approach proposed in
the Guidelines for project Evaluation (UNIDO, 1972) and the second approach is that developed
by Little and Mirrlees in Project Appraisal and Planning for Developing Countries (1974) and
later elaborated by Lyn Squire and van der Tak (1975). Both these approaches achieve essentially
the same outcome of ensuring that traded and non-traded goods are measured in comparable
values even though a country may place a premium for foreign exchange.

The UNIDO Guidelines or the Domestic Price Approach

The UNIDO approach values all traded and non-traded goods and services in terms of domestic
price equivalent. Domestic prices are used as the numeraire or the common unit if account in
terms of which all project inputs and outputs are valued. A project’s non-traded inputs and
outputs are simply values in domestic prices. Since they are, thus, valued at comparable prices it
will be legitimate to add them in the projects cash flow. For this reason this approach is called
the domestic price approach.

The project’s traded goods inputs are firstly valued in their FOB and CIF border prices. They are
then converted from foreign currency to local currency using a shadow exchange rate, SER,
rather than the official exchange rate, OER. This is done to better reflect the true economic value
of foreign exchange to the economy.

In a situation where the local currency is overvalued and the foreign exchange premium is
positive, the ratio of the SER to OER will be greater than one (when both are expressed in terms
of units of local currency per dollar or foreign exchange). Use of a shadow exchange rate to
convert the border prices of traded goods into local prices will have the effect of inflating these
border prices until they equal the amount that people are willing to pay, or receive, for traded
goods. As these traded goods will now be values in domestic price equivalent they will be
directly comparable with the project’s non-traded inputs an outputs valued in domestic prices.

The domestic price approach therefore corrects for the FEP by inflating the border price values of
traded goods, using the economy’s estimated SER, until these values correctly reflect the goods’
relative worth compared with the domestic prices of non-traded goods. In sum this approach
values:

86
Traded goods Non-traded goods
@ Border price  SER @ Domestic prices
 Domestic Price Equivalent

Numeraire: Domestic Prices or Domestic Consumption

Simply written it can be depicted as

NB=SER(X) - SER(M) -D or simply NB=SER(X-M)-D

Practical Example: Valuation at Domestic Price

(a) Valuation of Imported inputs

In the Table below it has been estimated that the country has a foreign exchange premium of
30% and the shadow exchange rate is therefore (1+0.30) X OER. All tariffs and taxes are
deducted form the domestic retail price of textile and their tradable (FX) component is inflated
by the SER to obtain the domestic price equivalent of the c.i.f. import price. The economic cost
of domestic transport and handing is the added.

Valuation of imported textile inputs using the domestic price approach (in Million Birr)
Financial cost Economic Cost
CIF import price (@OER) 250 -
( @ SER =1.3 X OER) 325
Import tariff (40%) 100 0
Internal transport 50 50
Handling and distribution* 50 20
Total 450 395
Ratio of economic value: financial value = 395/450=0.88
* 60% of these costs represent rents earned form privileged access to foreign exchange, and
therefore not included in the economic cost of handling and distribution

(b) Valuation of Exported output

The Table below shows valuation of a project’s exported garment output, using the DP approach.
The country again has 30% of FEP. The FX earnings are inflated by the SER and all export
subsidies are deducted form the fob export price to obtain the domestic price equivalent of the
border price.

87
 Valuation of imported textile inputs using the domestic price approach (in Million Birr)
Financial Value Economic Value
FOB output value (@OER) 1200 -
( @ SER =1.3 X OER) 1560
Export tax (10 %) -120 0
Transport to the port* -40 -30
(Including 25% fuel tax)
Total 1040 1530
Ratio of economic value: financial value = 1530/1050=1.47
* The market price of transport includes a 50% fuel tax. Since fuel equals has of total transport
costs it economic value = 40 - (40x0.5x0.5) = 30.

(C) Non-trade goods: The valuation of the non-traded goods is done straight forward since they
are given at domestic price. If this non-tradable goods supply can increase, its economic value
can be measure by its domestic market supply price (after adjustment for market imperfection
such as taxes, subsidy, price fixing etc. has been made). If the project uses a non-traded goods
(such as electricity) diverted form exiting consumers, then it should be valued at the price that
people were willing to pay for it, its demand price.

The Little and Mirrlees, or The Border Price (BP) Approach

This is an alternative approach. Like that of UNIDO, it also values traded goods at their border
prices. However, these border prices are converted into local currency at the Official Exchange
Rate (OER), rather than SER.

In this approach the projects traded good inputs and outputs are effectively kept in their border
price. However if there is a FEP in the country, the price of non-traded goods will have risen to
match the tariff inclusive price of tradable. The price of non-tradeables therefore overstates the
good’s true value to consumers, relative to the border price of traded goods.

The border price (LM) approach therefore re-values these non-traded goods in border price
equivalents using commodity specific conversion factors. Conversion factors: are the ratio of
the border price equivalent of non-traded goods to its domestic price.

Multiplying the domestic price value of non-traded good by its conversion factor has the effect of
converting the goods domestic price into its border price equivalent. Both non-traded and traded
goods are then valued in the same Numeraire, border price, so it is legitimate to add them in the
computation of the projects cash flow. This is the reason why it can be called the border price
approach.

Note this method makes trade and non-traded goods comparable by the inverse method used by
the domestic price approach. In summary the BP approach values:

Traded goods Non-traded goods

@ Border price  OER @ Domestic price iCFi
 Border Price Equivalent

Numeraire: Border Prices

88
 border price equivalent i
CFi  conversion factor of good i 
domestic price i
Simply written it can be depicted as

NB=OER(X) - OER(M) -D or simply NB=OER(X-M)-D

Where  a conversion factor defined as OER/SER (see below) or as given above.

Example

Valuation of imported textile inputs using the border price approach (in ‘000 Birr)
Financial Value Economic Value
CIF import price (@OER) 250 250
Import tariff (40%) 100 0
Internal transport* 50 40
Handling and distribution** 50 14
Total 450 304
Ratio of economic value: financial value = 304/450 = 0.68
* The conversion factor for transport, which puts the domestic price of transport into its border
price, = 0.8, hence the transport’s economic value = 50X0.8=40.
** 60% of items represent rents earned form privileged access to foreign exchange. In addition,
the conversion factor for handling = 0.7. Hence economic value = (financial value x 0.4) x Cfh =
20 x 0.7 = 14.

Valuation of export garment outputs using the border price approach (in ‘000 Birr)
Financial Value Economic Value
FOB output price (@OER) 1200 1200
Export tax (10%) -120 0
Transport* -40 -24
Total 1040 1176
Ratio of economic value: financial value = 1176/1040 = 1.13
* The 50% fuel tax is deducted (fuel = half transport tax), and the CF=0.8, hence the transport’s
economic value = [40 - (40 x 0.5 x 0.5)] x 0.8 = 24

Finally the non-trade goods, which are given in domestic price will be converted using the
commodity specific conversion factor CFi.

89
Summary of the two alternative methods of incorporating the Foreign Exchange Premium

The domestic and border price approaches therefore, employ different numeraire in terms of
which net benefits are expressed. The domestic price approach uses domestic prices as its
numeraire and the border price approach uses border prices. If the domestic price approach is
used all traded goods are valued at border prices, but are converted into local currency and
domestic price equivalents using a shadow exchange rate. Non-traded goods are valued directly
in their domestic prices adjusted to take account of market distortions. Both traded and non-
traded goods are valued directly in terms of the domestic price approach numeraire.

If the border price approach is used traded goods are valued in border prices converted into
border price equivalents by the use of conversion factors. In this case both traded and non-traded
goods are valued in terms of border price approach numeraire - border price equivalent.

Comparing the Two Approaches

Suppose a project, an oil refinery, produced petrol for export, worth X in border prices, and uses
import crude oil, worth M in border prices, and a non-trade input, construction services, worth N
in domestic prices. The output of the non-trade input can be expanded to meet the projects
requirements.

(I) using the DP approach, we can value it as

B1= (SER)  X - (SER)  M - aN [1]

where :
a is the factor that corrects for domestic distortions and converts the market price of
construction services< N, to its true economic value measure in domestic price. It
corrects foe taxes, subsidies etc.
(ii) using the Border price (LM) approach we will have

B2= (OER)  X - (OER)  M - cN [2]

where :
c is the supply price conversion factor that converts the domestic supply price of
construction, N, into border price equivalent.
The two approaches lead to an identical result if:

c = a  (OER/SER) [3]

Substituting c in the second equation above gives,

B2= (OER)  X - (OER)  M - (OER/SER)  N [4]

Multiplying both sides of the above equation, [4], by (SER/OER) gives,

 SER   SER   SER 

B2   (OER )    X  (OER )    M  a N
 OER   OER   OER 
= (SER)  X - (SER)  m - aN
= B1

90
 This implies that there is a constant relationship between the NB of a project measured by the
two approaches (a positive NPV in one implies a positive NPV in the other approach)

the ratio OER/SER in [3] is called the standard conversion factor (SCF) and is an average
conversion factor for the whole economy. It is different form c, which is a commodity specific
conversion factor for the non-traded goods.

91
Chapter 10. The Valuation of Primary Factors of production (Land, Labor, and Natural
Resource)

Elements of the Shadow Wage Rate

Most people cannot travel freely between countries to sell their labor so it is not possible to
directly establish a border price for most types of labor services. Labor services are therefore, a
form of non-traded primary factor and can be valued in much the same way as non-traded goods
and services. However, labor cannot be treated just like another factor of production and should
be treated uniquely.

The total number of unskilled workers available in an economy cannot normally be expanded in
response to market demand unless there is substantial immigration program in the country
concerned. Labor service can therefore be treated as a non traded primary factor, which is in
inelastic supply. Labor supply can only increase as a result of long run demographic trends
factors and not as a response to a market demand. So unskilled labor cannot therefore, be valued
at its marginal cost of production.

On the other hand, as the supply of skilled labor can be increased by raising training levels its
supply may be more responsive to market demand at least in the medium term. In the short term,
however, it will also be in relatively fixed supply, unless the country concerned has an active
immigration policy that is oriented to labor market /demand. The supply of female labor may be
an exception to this general observations as married women may be more willing to enter the
paid workforce if wage levels are raised.

Distortions in the Labour Market

Distortions in the market for unskilled and skilled labour may result in the wages of such labour
exceeding their marginal revenue product, valued in economic prices. Examples of labour market
distortions are minimum wage legislation, centralized wage fixing and restrictive union practices.
These distortions are usually more common in urban areas because government control and union
activity are stronger there.

Nevertheless, it is believed that distortions exist only in the market for unskilled labour. The
market for skilled labour is taken to be relatively competitive and there may not be the need for
special shadow salaries for skilled personnel. It is assumed that the market for skilled labour
reflect marginal productivities subject to the overall distortions of the economy as expressed by
the SCF.

The terms skilled and unskilled refer to aggregates of questionable homogeneity and one could
argue that more than two categories should be distinguished.
 Rural and urban unskilled labour
 Semi-skilled and unskilled labour

Thus when the conditions of the country indicate that further dis-aggregation of the labour force
is necessary and the relevant data are available one could estimate a set of shadow wages. But for
the sake of simplicity the two groups divisions and because of inadequate data on migration its is
equally accurate and simpler to use a national shadow wage rate, than location specific rates.

The Valuation of Unskilled Labor

92
Since unskilled labor is generally in fixed supply when a project uses labor it will have to draw it
away from other employment somewhere in the economy. This labor may actually come from
another sector such as agriculture. If a non-traded factor is removed away from other users, its
economic cost is what they were willing to pay for it.

If labor markets were generally efficient and there is no government intervention in the form of
minimum wages, wage fixing, hiring constraints or income taxes, the market wage rate paid for
this labor should reflect the contribution the marginal worker makes to the total revenue of the
employer. The market wage rate received by the labor in its previous employment will therefore,
reflect its forgone output. In these circumstances the market wage could be used directly to
determine the economic cost of labor. However, in most countries labor markets are subject to at
least some of the controls and distortions mentioned above. Under such circumstances it would
be necessary to determine the true cost of the project labour requirements to the economy by
calculating the shadow wage rate (SWR) or the marginal social cost of labour. The basis for the
derivation of the SWR is the forgone output or labour’s marginal contribution to the revenue
earned in the occupation from which it has been drawn. The output forgone in the rest of the
economy by employing labour on the project will represent the major component of its economic
cost. If there is no freely operating labour market for the actual labour concerned, or for labour
with similar skills in similar locations, it may be necessary to directly calculate the economic
value of labour on the basis of the forgone output from labour drawn into the project. In other
words, we are searching for the forgone output in the place from where the worker of the project
is ultimately drawn.

Thus even when the project worker is recruited among the urban unemployed as long as he is
replaced by another unemployed coming from the rural area, it is the opportunity cost of the
latter that we should take into account in estimating the shadow wage rate. For rural projects,
where the ordinary labour is provided mainly by rural unskilled workers it is more obvious that
we should estimate the forgone output of rural workers.

As it has been discussed there are two approaches to value the non-traded inputs. We can use the
UNIDO approach or the LM approach. Now, if the project analyst adopts border price approach
the forgone output should be valued in border prices. But if the domestic price approach is
employed the forgone output will be valued in adjusted domestic prices. Thus the cost of labour
is measured in terms of the output a worker would have produced in his alternative activity.

There are many ways of estimating the shadow wage rate. These formulas differ in the degree of
sophistication, data requirements and in what one attempts to achieve though shadow wage rates.
If we use the border prices as the unit of account and thus all output forgone must be valued at
border prices, then the general expression for the shadow wage rate (SWR) is give as:

SWR = aiMi . CFi

Where Mi is the output forgone in alternative employment at domestic market prices.

CFi is the conversion factor required to convert this output to world/border prices
ai is the proportion of new worker of type i coming from activity i.

Thus the conversion factor for labour i is given as:

CFl = SWR/MWR

93
Where the MWR is the market wage rate and the CFl is the labour conversion factor.

The above approach does not mean that international wage rates are used instead of domestic
ones, but that the physical units of output forgone are valued at border prices rather than
domestic prices.

If the domestic price system (UNIDO approach) is used then the treatment of labour is directly
comparable in a domestic and a border price system. Again labour’s shadow wage is the output
forgone, but in a domestic system this must be measured in domestic rather than border price
units. The general expression of the shadow wage rate will be relevant again except now there
will be a new set of CFs for the different commodities forgone so that

DPSWR = ai mi DPCFi

Where DPSWR is the SWR in domestic prices and DPCF is the domestic price conversion factor
for good i.

The Valuation of Skilled Labour

The economic cost of skilled labour is in principle estimated in exactly the same way as for
unskilled labour. The significant difference though, is that there is more general agreement in the
literature that skilled labour’s wage reflect its marginal product reasonably accurately. Two
reasons are often presented to support this argument:

1. Skilled labour is more specific, often being highly mobile in nature and wages tend
to be competitive and full employment is the rule. Thus there sis no problem as
with unskilled workers, of determining what the net effect is of withdrawing a unit
of skilled labour from it present occupation.
2. the supply of skilled labour is increasingly equated to its present and future
demand by the use of manpower planning techniques, which has the virtue of
missing discrepancies between supply and demand and hence relieving the price
mechanism of part of the burden of adjustment.

In sum, although labour is a non-traded input it is singled out for special treatment and an
accounting or shadow wage rate is directly estimated for the unskilled labour. The project analyst
should first divide the labour force into the skilled and unskilled categories on the basis of his
experience and the characteristics of the project. Then he should value the unskilled labour at its
opportunity cost, i.e., at the SWR. Skilled labour should be treated like any other non-traded
input and should be valued at market wages multiplied by the SCF.

The Valuation of Land

The valuation of land is usually omitted from books on project appraisal presumably because
recent works have been concerned with industrial projects. Land is a relatively minor item in
industrial projects but in agricultural and some infrastructural projects it can be far more
significant. For such projects land cost may form significant amount of the total. Moreover, the
generic meaning of land (the term) covers not merely land per se, but other material resources
such as forests, fishery reserves, mineral deposits, etc.

94
Thus it is important to examine economic valuation of land. In principle, the capital value of land
is the discounted value of the stream of future earnings which it can command net of the cost of
purchased inputs and labour. I.e., it is the capitalized rental element. Where there is competitive
land market prices would equal the expected future gain from the purchase or rental of an
additional unit of land. But it is not obvious that existing land markets are sufficiently
competitive for price to be an adequate guide to productivity.

Example: in urban areas land markets may be dominated by speculative purposes while in rural
areas land use may follow from custom rather than economic calculations.

Thus the market price of land is not always useful as a guide to economic valuation. If there is no
freely operating market for land in the vicinity of the project or in similar locations in the country
concerned it will be necessary to directly estimate the opportunity cost of land. The opportunity
cost of land will be the value of the net output that it could have produced in its next best
alternative use. This is normally implicitly achieved by defining net project benefits as the
difference between the “with” and “without” project situation.

Example: where land for a factory site was previously unused its direct opportunity cost will be
zero, since no output would be lost by building the factory on the land, and only land clearing
costs can be properly attributed to the project. If an agricultural land is to be used, its economic
cost will be the sum of the discounted agricultural output value lost over the life of the project,
net of the cost of other inputs, valued either in border prices or in domestic prices.

The Shadow Price of Natural Resources

If the natural resources (mineral deposits, oil, natural gas deposit, etc.) used in the project are
traded they should be valued at their FOB or CIF prices, depending on whether they impact on
exports or imports at the margin.

Example: if imported mineral is used it should be valued at CIF border price. If exported mineral
is used it should be valued at the FOB border price.

If the project uses a non traded natural resource input whose output can be expanded this input
should be valued at its supply price, its marginal cost of production. Its supply price will be equal
to the economic value of the resource that are used to produce it. If the project uses a non traded
natural resource that is in relatively fixed supply, it should be valued at its demand price. If
natural resource required by the project is in short supply it is likely to earn a scarcity rent.

If there is not a free market for the natural resource and it is in relatively fixed supply, an effort
must be made to estimate its opportunity cost in terms of its forgone uses. The economic cost of
the resource will equal the economic value of the best alternative product that could be produced
using the natural resource minus the economic cost of all other inputs. Once the economic price
of the non-traded natural resource has been estimated its conversion factor can be calculated as:

CFnr = Economic price natural resource / market price of the resource.

95
CHAPTER 11. THE SOCIAL DISCOUNT RATE

Functions of the Social Discount Rate

The rate at which the stream of costs and benefits are discounted in estimatimg the NPV or the
rate with which the IRR is compared is the third national parameter that should be determined by
the national bank. Like the other national parameters the discount rate should be taken by the
project analyst as exogenously determined. The social discount rate is the rate used to discount a
project’s economic cash flow to its present value. It is a crucial parameter in cost benefit analysis.

Recall that :
n
( Bt  Ct )
NPV  t
t 0 (1  r )
r is the appropriate social discount rate for use in an economic appraisal of a project.

Why the discount rate is a parameter common to all projects is obvious. If varying discount rates
are employed the NPVs of different projects cannot be compared, and therefore, we will be left
without an economic criterion in project selection. It is only when the IRRS of different types of
projects are compared to a common rate that they are also compared among themselves.

All other things being equal the higher the social discount rate employed, the fewer projects will
be approved. The discount rate indicates the minimum rate of return for a [project to be
acceptable at shadow prices.

In a perfectly competitive capital market the interest rate will equal both the rate of return on an
additional project and the income savers require compensating them for forgoing immediate
consumption. It is well known that capital market do not function in the way described here.
They are not perfectly competitive. They are often fragmented with different borrowers facing
different rates of interest and access to credit. In some countries government intervention to
control interest rates has been significant aimed particularly at keeping down the cost of
borrowing to priority areas or sectors.

Even where capital markets have been decontrolled and rates of interest allowed to rise in line
with the demand for funds this does not guarantee that the resulting rates will equal the marginal
return on capital, since demand for funds is based on expectations of financial net economic
returns.

96
Determination of the Social Discount Rate

The crucial question is how to determine the appropriate level of the social discount rate. In
financial analysis of a project the opportunity cost of capital to the implementing firm is the rate
at which the project implementor could borrow or lend, depending on whether he or she is a net
borrower or lender in the market. In an economic analysis of project the social discount rate
should reflect the social opportunity cost of the capital funds used to the country as whole. The
market interest rate cannot often be employed as the social discount rate because of imperfections
in the capital market. These will derive the wedge between the market cost of capital and its
demand and supply price. In some situation, however, if distortions in the capital market are not
great and are difficult to measure, the market interest rate may be the best approximation of the
social discount rate.

The approach t determining the social discount rate has received significant attention in the
literature. Different authors have interpreted the rate differently, have given different estimation
procedures and have suggested different functions for the discount rate. As a result of the
different interpretations of the rate different approaches have been followed in estimating the
value of the discount rate. Some have conceived the discount rate as the rate of time presence, the
consumption rate of interest, the opportunity cost of capital, and as a device used to screen
projects in allocating investment funds. The various estimation procedures vary in terms of data
requirements, judgments, and in terms of assumptions.

Thus how to estimate the discount rate from available data is still a difficult problem on which
economists have not agreed among themselves. But two interpretations of the discount rate, i.e.,
as

 Opportunity cost of capital

 A screening device

are more generally accepted and easier to comprehend.

When considered as the price of capital, the discount rate sounds like the familiar interest rate
charged by financial institutions on loans they make. But since capital or finance markets of most
developing countries seem to be distorted, it is necessary to estimate a shadow price for the
market interest rate. This shadow price, like any other shadow price is nothing else than an
opportunity cost, i.e. the opportunity cost of capital. Different methods have been proposed to
estimate the shadow price or opportunity cost of capital. But data requirement and assumptions
reduce the practical value of these methods.

If the discount rate is considered as a screening device one is relived of the assumptions and data
difficulties relating to the opportunity cost approach, but is loaded with new ones. Under this
approach the discount rate is set by the central authorities at a level that allows just enough
projects to pass the NPV criterion as are required to absorb all investible funds. The magnitude of
these funds is estimated by the central authorities.

If the discount rate is set too low then too many projects will be accepted, as compared to the
funds available, and it will have to be raised until just enough projects pass the NPV test, and
vice versa when the discount rate is set too high.

97
Under the screening device interpretation, we can say that the discount rate is what the planners
have decided it should be. The central planners need available information and should make a
number of assumptions in estimating the supply of funds and the tentative demand for
investment in the form of forthcoming projects. Only when this information is available can the
planners decide what the discount rate should be. But again these are for the central economic
authorities and not for project analysts.

Like any other national parameter the discount rate is under constant review by the central
economic authorities and is revised to take into account changes in the demand and supply of
investible funds.

98
CHAPTER 12. SOCIAL COST BENEFIT ANALYSIS

The Purpose of Social Cost Benefit Analysis

The previous chapters were concerned with the basic tools required for financial and economic
appraisal of projects. When undertaking 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 appropriate. For a private commercial
entrepreneur project choice is a rather simple exercise. If he knows his objectives, which seems
to be a reasonable assumption, all he has to do is to ascertain which projects satisfy his 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. In most counties
the existing distribution of income is clearly not considered to be ideal by the government or the
population.

When one project is chosen rather than another 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. In a situation where a project is only marginal from the point of view of an
economic analysis but has strong positive distributional benefits, the analyst may consider a
social analysis in addition to the traditional economic analysis.

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
economic 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 or she receives a high income. An economic analysis of
projects A and b would not capture these differences and would merely indicate that both had the
same positive impact on community welfare.

Basic Arguments for the Application of Social Cost benefit Analysis

It has been indicated that commercial profitability is measured in terms of the difference between
the value of earnings and costs in a certain period. Social cost benefit analysis must go deeper
and ask what is the meaning of profits.

1. The price offered in the market is not a god guide to social welfare for it includes
the influence of income distribution on the prices offered. One of the simpler
means of income redistribution may, in fact be project selection. The choice may
be between project A to be located in a poor region or project B to be located in a
rich area or between project X which uses a large amount of poor, unskilled labour
which might otherwise be unemployed and project Y which uses factors of
production supplied by rich people.

99
 2. A project may have influences that work outside the market rather than through it.
These effects are called “externalities”. Externalities are relevant for social choice
and provide a sufficient argument for rejecting commercial profitability as a guide
to public policy. Externalities may arise in the process of production (industrial
pollution) in the process of consumption (private cars causing overcrowding of
roads), and in the process of sales and distributions (shops displays sex shops).
3. Even in the absence of externalities and consideration of income distribution
commercial profitability may be misleading because of consumer’s surplus.

Distributional Weights

One of the most commonly used methods of undertaking a social cost benefit analysis is to
introduce distributional weights into the cash flow. Distributional weights are attached to changes
in income, costs and benefits, received by different income groups, ensuring that a project’s
impact on the income of the low income groups receive a higher weight than the same dollar
impact of the income of the high-income groups. The introduction of these distributional weights
enables projects to be assessed on the basis of distributional as well as efficiency objectives.

The introduction of distributional weights into the cash flow

In an economic analysis project generated changes in consumption enjoyed by all income group
are weighted at unit. d = 1. In social analysis income accruing to (or being taken from) lower
income groups would typically be given a distributional weight greater than one, d > 1. On the
other hand, income accruing to (or being taken from) a high-income group would be given a
weight less than one, d < 1. A project that benefit a low income group would therefore have a
higher social net present value than one that benefits a high income group, if all other un-
weighted costs and benefits remain the same.

Projects A and B are mutually exclusive projects. Project A’s cost are borne by the rich and its
benefits are received by the poor, while project B is the opposite. Its costs are borne by the poor
and its benefits are received by the wealthy. Since the two projects are mutually exclusive the
project with the highest NPV should be selected. If an economic analysis were undertaken and
distributional weights of unity were applied to the cost and benefits of the two projects, project B
would have an NPV of 80 million and project A an NPV of 50 million. Hence project B should
be selected. However, if the government decides that it values income going to the poor more
highly than income going to the rich and applies a distributional weight of for example d = 2 to
the low income group’s income, A would have a social NPV of 200 million and project B would
have a social NPV of 0. Project A would then be selected on the basis of a social cost benefit
analysis.

Example: The use of distributional weights in social analysis of projects

Project A Project B
Poor Rich Poor Rich
Costs paid by 0 100 80 0
Benefits received by 150 0 0 160
If distributional weights, 1 1 1 1
Economic NPV +50 +80
Therefore do project B
If distributional eights, d 2 1 2 1
Cost paid by 0 100 160 0

100
Benefits received by 300 0 0 160
Social NPV +200 0
Therefore do project A

Methods of estimating distributional weights

Little and Mirrlees (1974) and then Squire and van der Tak (1975) have suggested that the
marginal utilities of income consumption be used to estimate the distributional weights. Among
the many possible alternatives, for the normalization of the distributional weights d, of a group in
the society that receive a per capita consumption level of c is

m arg inal..utility ..of ..income..at..consumption..level .C

d
m arg ina..utility ..of ..income..at..the..average..consumption..level
MU c

MU a

The marginal utility of income of a group in the society that receives per capita consumption
level of C can be expressed as:

MUc = C-n

Where n represents the amount by which the government believes that an individual’s marginal
utility falls as his or her per capita income rises. The higher n is set, the more rapidly the
marginal utility of income is assumed to decline as per capita consumption increases and
therefore the greater is the apparent commitment of the government to egalitarianism. If n is set
equal to zero, the government has no commitment to egalitarianism.

101
The above equation can be modified by substituting the second into the first equation as:

MU c C
d ( a ) n
MU a C

Where MUc is the marginal utility of income of a group in the society that receives a per capita
consumption level of C.
MUa is the marginal utility of income of a group in the society that enjoys the average per capita
consumption level.
 Ca is the average per capita consumption level
 C is the per capita consumption of the group concerned.

If n = 0, that is all d are =1, it implies that the government considers a one dollar addition to the
consumption of one group in society will be equally valuable to a one dollar addition to the
consumption of any other group.

If n =1, d = Ca /C, then d equals the ratio of average per capita income in the economy to the per
capita income of the group whose distributional weight is being assessed. If the target group has
an income level that is only half the national average, the group’s distributional weight would
therefore, be 2. Squire et al, believes that n =1, is the right level for n, but levels of n between
zero and 1 also imply a reasonable degree of commitment to egalitarianism.

Arguments for and against the use of distributional weights

Supporters of the social cost benefit analysis argue that failure to explicitly compare the utility
received by the different income groups within the framework of the project appraisal implies
that the analysts gives equal weight to gains in consumption by all income groups, from the
poorest and most destitute to the wealthiest groups in society. This would be possible if it were
assumed that the marginal utility of income, the change in utility experienced from a given
increase in consumption, of all individuals was equal irrespective of their income levels.

There are several problems for analysts wishing to use this approach. The first is the difficulty of
tracing the net income changes accruing to different income groups as a result of the project,
even in cases of relatively straight forward project. It will be very time consuming and expensive
to identify who will bear the costs of the project and who will reap the benefit, and what income
levels of these different groups are. It has therefore been argued that the introduction of
distributional issues into project appraisal will so increase the complexity of undertaking a cost
benefit analysis that serious inaccuracies could become more common. This argument becomes
very persuasive particularly for large projects with a diverse group of beneficiaries and whose
income level may be difficult to determine.

The second problem with the use of the use of distributional weights relates to how the
government or project analyst can objectively determine the appropriate set of weights to
employ. Even if the distributional impact of a large project can be traced, the marginal utility of
income of these different income groups may be hard to determine.

Another argument advanced by those who opposed to the introduction of distributional issues
into the cost benefit analysis is that projects should be selected in order to maximize national
income and that the taxation and welfare systems should then be used to redistribute this income.

102
But many argue that since the fiscal system is weak and even regressive, large segment of the
population pay no tax; corruption and the power of economic elites often ensure that the wealthy
evade taxation and have sufficient political power to prevent the emergence of governments
committed to egalitarian fiscal policies.

103
CHAPTER 13. HANDLING OF RISK AND UNCERTAINTY IN PROJECT ANALYSIS

Sources of uncertainty in project appraisal

Whether one is apprising a project from a financial point of view or from the nations point of
view, project appraisal remains in essence an exercise in using limited information to make
predictions about the future, contrasting the “with” and “without” project situations. Up to this
point it has been assumed that project input and output prices and quantities are known with
certainty, and can be included directly into the estimated cash flow of the project.

There may be considerable uncertainty regarding the estimated prices and quantities of major
inputs and outputs. The uncertainty will have two major sources:
1. Sources internal to the project, related to doubts regarding the technical or
managerial capacity of the project to produce expected output levels using
projected input levels.
2. Sources external to the project, including movements in local and international
price levels and the level of market demand for the project’s output. These sources
will be influenced by cyclical factors changes in tastes and technological
developments, Such influences are likely to be particularly important sources of
uncertainty if the project’s output will be expected or sold in an unprotected local
market.

Uncertainty regarding the values of such crucial variables is likely to have a major impact on
decision maker’s perceptions of the project’s viability. The problem for the project analyst is how
to handle such uncertainty within the rational framework provided by cost benefit analysis, so
that it can be taken into account when selecting projects.

Handling Quantifiable Risk and Uncertainty in Project Appraisal

In some projects it may be thought that the project variables are known with complete certainty.
For example, the project’s inputs and outputs may be bought and sold on the basis of long-term
contracts or within a group of companies. In other situations the project analyst may have little or
no information about the future value of important variables in which case she or he may operate
under complete uncertainty.

Usually a project will fall somewhere in between these two extremes. There will be some
knowledge on which to forecast future prices and quantities but these variables will not be known
with certainty. When it is possible to assign numerical values to the probability that certain
events will happen it is possible to handle the uncertainty associated with a project much more
rigorously.

Example: the project analyst may be uncertain whether the sale price of coffee produced by a
project will be Birr 1000, 2000 or 3000 a ton. However from historical time series data on coffee
price movements, the analysts my be able to estimate that the probability of being at these levels
is as outlined in the following table.

A simple probability distribution of coffee prices

Price/ ton Probability (%)
Br 1000 20
Br 2000 50

104
Br. 3000 30

If the analyst is able to assign values to the probability of various outcomes occurring more
rigorous method of handling the risk based on probability analysis can be used in project
analysis. This will be considered next.

Probability Distribution and Their Use in Project Analysis

If values can be assigned to the probabilities of various outcomes, the project analyst can employ
probability distribution in the cost benefit analysis. A probability distribution, p (x) shows the
various values Xi, that a variable X may assume, accompanied by an indication of the probability
that each value will occur, (pi).

The mean of the probability distribution called the expected value E (X) of the variate is defined
as:
E(X) = PiXi

Once calculated the expected value of the variate can be substituted into the project cash flow for
the point values of project variables that have been used up to this point. A point value of a
variable is one discrete value of a variable that is known with certainty, rather than a range of
values that the variable may take, such as a probability distribution.

Example: The expected value of coffee prices

Price/ton probability (%) Price * probability

------------------------------------------------------------------------------------
1000 20 200
2000 50 1000
3000 30 900
Total ---- 2100
------------------------------------------------------------------------------------
PiXi = expected value of coffee prices = E(X) = 2100 Birr per ton.

The expected values of the project’s inputs and outputs can be included in the project’s cash flow
to obtain the expected value of the NPV of the project.

There are various sources of data that can help the analysis to assign probabilities to the range of
potential values of a variance. These include:

(a) Extrapolation of historical trends

(b) Experience with other similar projects in the same country or elsewhere
(c) Game theory methods, including interview of major players

The other important parameter that should be estimated is a measure of the dispersions of the
variate values around their expected value (mean). The variate's variance, standard deviation and
coefficient of variation are all useful measures of dispersions of project parameters. Information
on the dispersal of the NPV will show to the analysts how risky a project is, as it indicates the
likelihood that the project will have a negative NPV.

105
 s 2

 (x 
i x) 2
 s
 (x  i x) 2
n 1 n 1

The coefficient of variation = s/X = standard deviation / mean.

Example: The probability distribution of the output levels of a plant (‘000 Birr)
---------------------------------------------------------------------------------------------
Output, Qi probability of occurrence Pi (%) Q i * Pi
----------------------------------------------------------------------------------------------
20 5 1
25 15 3.75
35 50 17.5
50 20 10
60 10 6
sum= E(Q) 38.25
-----------------------------------------------------------------------------------------------
Expected value of output, E(Q) = Qi * Pi = Birr 38 250.
Variance,
(Q  Q ' ) 2
s 2  ..Birr..282580
( n  1)
Standard error= s = Birr 16810
Coefficient of Variation = s/Q = 0.44
------------------------------------------------------------------------------------------

Projects will be perceived as being more risky the greater is the distribution of their input and
output prices and quantities, and hence their NPV around their expected values. On the other
hand the closer the project’s coefficient of variation is to zero the lower is the dispersal of the
values of the variate around its expected value and the more likely it is that the expected value of
the variate E (x) will be achieved.

The most satisfactory method of handling risk in cost benefit analysis is, therefore, to estimate
the expected value and the standard deviation of the project’s net present value E (NPV) by
aggregating distributional information about the input and output variate that enter into the
estimation of NPV.

The choice between risky projects

There may still be difficulty in handling risk systematically even when the expected values of
project’s NPVs and their dispersal are known. This information does not always enable analysts
to choose between alternative projects unless one is clearly superior to its alternative. A good
example of this problem is given by the choice between two project A and B in the following
figure. The expected value of the NPV of project B, B’ is higher than that of project A, A’.
However, project B is also riskier than project A as the projected distribution of its NPV about
the expected value is greater than that of A’s. There is even a risk that project B’s NPV may even
be negative, which is not the case with project A.

The choice between two projects with different levels of risk and E (NPV).

106
F Project A
If varaince of A = X1
If varaince of B = X2

Project B

0 A' B' NPV

107
So, there are situations, however, where the expected value rule cannot serve as a guide to
choice. A typical example is when the two versions have the same expected value of NPV but
different variance. In such situation more powerful tools can be used by using information both
on measures of central tendency [E(NPV)] and dispersion. Such a diagram is referred as The
Gambler’s Indifference Map.

The Gambler’s Indifference Map

Decision makers cannot necessarily decide to choose the project with the highest expected value
of net present value. This selection criterion ignores evidences about the different degrees of risk
associated with projects, which is provided by the dispersal information. One method that has
been developed to handle this problem is to estimate indifference curves for decision makers,
trading off risk as represented by the variance of the NPV against the expected value of NPV.
These indifference curves are called a ‘‘gambler’s” indifference map and are illustrated in the
following figure. They may provide a useful method of analyzing information on both
dispersions and expected values of NPV.

The Gambler’s indifference map

prefer r2to r1to r 0

variance (S2) move to r2 change uility

r0

r1

r
2
X2

X1

A B C E(NPV)

Information on the expected value of the NPV is given on the horizontal axis and the variance of
various projects is given on the vertical axis. Any group of projects can then be represented on
this map once the mean and the variance of their NPV is known. Points on the curve r 2 for a
given level of risk x1 (measured by the variance of NPV) the expected value of the NPV will be
greater. Once the shape of the indifference curve r 0, r1 and r2 are known, it is possible to make a
rational choice between projects of varying risk and expected net present value.

108
Using the example shown on the previous page (see figure) a decision maker with gambler’s
indifference maps shown above (see figure on the gambler’s indifference map) will prefer project
A to project B. Project A’s combination of risk and expected NPV falls on the more desirable
indifference curve, r2 because given the decision maker’s preferred trade offs between risk and
expected NPV, the decision maker would require project B’s NPV to have an expected value of
C to compensate for having to bear project B’s higher risk, X 2 .

While the decision maker will be indifferent amongst al projects lying along any one curve, such
as r0 he will prefer projects lying on a higher value curve (r 2 > r1 > r0 ) since moving from left to
right along the horizontal axis will entail reaching a higher EV for a given amount of variance.
Thus the more risk averse the decision maker, the flatter will be his/her indifference map or
curves. This is because for a small increase in the riskness of the project, the risk adverse
decision maker will require a substantial increase in the project’s expected NPV to feel equally
well off. On the other hand, the indifference map curve of risk lover such as a gambler will be
quite steep. In this case the decision maker will require only relatively small increase in the
expected NPV of a project to compensate for a significant increase in the perceived riskness of a
project.

Indifference Maps of Risk Avoiders and Risk Lovers

variance Varaince (risk)

(risk)

indifference map
of a gambler/risk taker
indifference map of a
risk advrese person

risk lover

Risk adverse

E(NPV) E(NPV)

The main drawback of this method is that the formation of the indifference map of this nature is
dependent on the decision maker being able to conceptualize aversion to risk in this systematic
form. The analyst may be able to assist in the process by devising games in which the decision
maker is helped to reveal preferences. In drawing up an indifference map of this nature, it would
also be necessary to get a repre4sentative cross section of views from all relevant government
decision makers to ensure that the constructed map reflected the true level of risk aversion of the
government. Preferences regarding the trade off between risk and expected NPV could also be
judged ex-post from past projects that have been accepted.

109
Handling Pure Uncertainty in Cost benefit Analysis

In the previous sections we have seen how choice could be made among risky projects if
probabilities could be assigned. In that respect risk analysis was defined as uncertainty that can
be quantified and therefore, offers itself to mathematical treatment. Risk analysis requires the
specification of the probability distribution of the values of each variable that enters risk analysis
and the variance (measure of dispersion). For this reason it is often recommended for large
projects. It is time and data demanding. For small projects second best approaches are frequently
used.

We know that different projects could have different probability of success. While much can be
done by way of systematically organizing and using probabilistic information in project
evaluation, nothing has been said about how to choose between projects under these conditions.
In other words, the most important question is how to make a choice among projects. Let us
illustrate this point using the example in the previous section.

Suppose the information we have about projects A and B is the NPVs of A, B, a and b, and no
associated probabilities are given. Such a situation is one of uncertainty, there being no way of
knowing telling should project A be chosen, which of the two NPVs, A or a, would be most
likely. For example, project outcomes might be conditional on alternative states of nature, which
are unpredictable; viz a fishmeal project on a river depending on the shits in current.

To illustrate this point let us assume that projects A and B represent two different version of an
investment proposal for construction of a fish-meal processing plant.

Table 3.1: Decision making under Uncertainty (in 1000 Birr)

Without big fish catch with big Fish catch

Project A (mean NPV) 20(a) 100(A)
Project B (mean NPV) -10(b) 150(B)

Version B is relatively capital intensive (hence has negative NPV at low level of catch; i.e. more
economical with scale). While A is economical when the level of catch is meager.

Several decision criteria are applicable to make choice under uncertainty in the context of game
theory. The two best know are

(a) The maxmim-returns principle, and

(b) The minimax-regret principle

The Maximin-returns: suggests that alternatives should be evaluated on the basis of the largest
minimum return (maxi-min) which can be secured should things go wrong. On the basis of this
principle project A will be selected because it will guarantee a minimum return of 20,000 Birr in
the event of unfavorable shift in current (cf. to a loss of Br. 10,000 of project B).

This is a conservative principle for it is concerned only on minimization of loss in unfavorable

environment ignoring the possibilities of gains that could have been secured form the choice of
project B in the event of a big fish catch.

110
The Minimax-regret principle: unlike the above principle, this principle takes into account both
potential gains and potential losses under alternative state of nature. In this context

If we opt for B
==>We would encounter the regret of incurring an extra loss Br. 30,000 [20-(-10)] in the without
fish scenario
If we opt for A
==>We would encounter the regret of sacrificing a potential gain of Br. 50, 000 [150-100] in the
with the fish scenario

If no probabilities are attached to these alternatives we can implicitly assume that they have the
same probability of occurrence (i.e. both are equally probable). Under such situation we will opt
for project B since it implies a minimum regret. The choice here is a choice under uncertainty.

In some situations it may not be possible to ascribe numerical probabilities to various values of
variables such as inputs and output values. Many methods have been developed to handle such
uncertainty in project appraisal but none of them have been satisfactory. Two common methods
that will be examined here are the inclusion of risk premium and sensitivity analysis.

Risk Premium

One popular method of treating a high risk project is to included a risk premium in the discount
rate. This will adjust the estimate of the central tendency downwards according to some estimate
of dispersion. This method of handling risk is particularly popular in the private sector and
merely entails adding a premium to the rate of return that must be earned by risky projects before
they will be undertaken. Projects believed to be risky are therefore expected to achieve a higher
rate of return than lower risk projects. Thus a higher discount rate is used to calculate the net
present value of risky projects than is used to assess projects believed to be less risky. This has
the effect of reducing the expected value of the riskier project’s net present value.

One of the problems with this approach is that it will be very subjective unless empirical data is
employed to determine how risky the project actually is and at what level the risk premium
should be set. It is possible to obtain reasonably accurate data on the level of risk attached to
investment in different industries from the average rates of return earned by firms in these
industries either in different countries or within the same country. Capital markets provide a good
source of information on the level of risk premium. On problem with risk premia is that their use
implicitly assumes that risks increase the longer the project operates and therefore discriminates
probably unjustifiably against long gestating projects. In fact most risk associated with projects is
borne during the implementation and start up phase due to cost and time over-runs.

Sensitivity Analysis

Another methods 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 parmeters that enter the project’s
input and output streams. It is the process of seeing what changes in the value of the dependent
variable is consequent on a change in the value of one or more of the variables that determining
it. It generally involves considering the effect on the NPV of plausible variations in some of the

111
assumptions made. The common practice is to vary them by fixed percentage such as 10%
(instead of say by +-1SD). Such measures give us no information about the probability.

The purpose of the sensitivity analysis is:

 To enhance our understanding of the structure and working of the project;
 To guide us in the design of the project so that high NPV or IRR are obtained;
 To suggest areas and means by which risk can be reduced.

The key variables whose variations should be studied will different from project to project, but a
number of standard test will normally be considered. The variable that is most commonly varied
in sensitivity analysis is the discount rate because of the considerable uncertainty that often
attaches to the estimated rate. But total investment costs, implementation times, output levels and
prices, the volume of demand, the level of capacity, and operating coast are commonly varied by
amounts or percentages that seem reasonable on the basis of past experiences. Pessimistic and
optimistic values will be tried and checked. This is done to determine the sensitivity of the
estimated NPV to changes in theses variables. In some circumstances a group of key variables
may be varied together, to form a low case scenario and the impact of these scenarios on the
NPV may be measured to determine the robustness of the project under these circumstances.

The main problem with this approach is that variables are not usually varied by standard amounts
such as one standard deviation, because the probability distribution of the variables is frequently
unknowns. Rather variables are usually varied by random selected percentage values such as 10
percent or 20 percent, etc. if the NPV of the project turns negative when relatively small and
plausible changes are made in the values ascribed to such variables, it is an indication that the
project may be rather marginal. If the NPV is positive even after the changes then it can be
considered quite robust in then face of plausible risks.

We change the values of key variables, one at a time or in combination by a certain percentage
and calculate again the NPV or IRR. A comparison between the previous and new values of the
NPV and IRR shows their sensitivity to value changes in the variable involved.

The variables for sensitivity test should be selected on the basis of (a) the degree of uncertainty
associated with the variable; and (b) the importance of the variable in determination of the NPV
and IRR. Hence it is not advisable to spend time in testing for sensitivity of a variable that has an
insignificant effect on the NPV and IRR. Secondly when we change the value of one or more
variable and re-calculate the NPV and IRR we assume that “all other things are equal”, But some
variables are interrelated and their value tend to move together.

112