(1)

UNIT-4

SOCIAL COST BENEFIT ANALYSIS (SCBA)

So far, we have studied the commercial feasibility of business through market & demand analysis,
technical analysis and financial analysis. Since a project also affects society, they should also be
studied from point of view of society. Specially, government projects are meant for social welfare
more than the commercial use. Social Costs and Social Benefits are considered for calculating their
net effect on society under social cost benefit analysis.

Social Costs:
All the harmful effects of a project on society as a whole are known as cost to society. Few examples
of social costs are as follows:
 Air pollution
 Water pollution
 Soil Erosion
 Deforestation
 Production of Harmful Products
Social cost is calculated considering all these factors.

Social Benefits:
All the positive impacts of a project on society as a whole are known as social benefits. Few
examples of social benefits are as follows:
 Increase in Employment
 Rise in Per capital income
 Import Substitution etc.
Social benefits are calculated on the basis of all these factors.

Objective of SCBA:
Primary objective of doing social cost-benefit analysis is to choose a net socially beneficial project
i.e. to choose a project in which social benefits are greater than social costs.

UNIDO Approach for SCBA:

Calculation of social costs & social benefits and their comparison is not an easy task. If we go in
depth there can be hundreds of factors on which social benefits and costs can be consider. Therefore,
it become complex to do SCBA.

Few approaches are available which can guide us while doing SCBA analysis and can reduce the
complexities of the problem. One of the available approaches for SCBA is UNIDO approach, which
is commonly used internationally.

This approach has been named after UNITED NATIONS INDUSTRIAL DEVELOPMENT
ORGANISATION, a part of UNO looking after industrial development across the globe. This
approach for SCBA is given by UNIDO. This approach makes it easier to measure and compare
social costs and benefits.
 (2)

This approach is a 5 step process for SCB Analysis. Amongst these five steps first two are having
more weight as these are main scores and next three are adjustments. These five steps or basis are as
follows:

1. Calculating financial profitability at market prices

2. Calculating net benefits at economic prices
3. Adjustment for project’s impact on savings and investment
4. Adjustment for project’s impact on income distribution
5. Adjustment for impact of project on merit and demerit goods

1. Financial Profitability:
First thing under UNIDO is to score the project on the basis of financial feasibility of the project.
Logic behind the concept is that a project having financial losses can not serve society in a better
way. Financial profit is required even for serving the society. Therefore, a project having profit
will be given a high score in SCBA in comparison to a loss making project. Profitability is
calculated on the basis of market price of inputs and outputs i.e. by subtracting expenditure from
revenue. Profitability is calculated as a percentage of capital employed.

2. Net Economic (Social) Benefit:

Secondly, score is given for net social benefits, which is judged on the basis excess of social
benefits (increase in production, increase in exports, import substitution etc.) over social cost
(Pollution, deforestation, harmful goods etc.). If net social benefit is higher, a high score is given
and if it is lower than lower score is given.

3. Adjustment for Savings & Investment:

Saving and investment is a key to economic development of a country. Development of society is
dependent on economic development. Therefore, a project is appraised for its affect on saving
and investment of the country. The impact of saving and investment is measured as:
(∆i) (MPSi)
Where ∆i = Change in Income
MPSi = Marginal Propensity to Save with respect to Income

If a project is contributing a lot in saving and investment process, a higher positive adjustment to
the score is done and vice versa.

4. Adjustment for Distribution of Income

Equal distribution of income is a necessity for having higher living of standard in society.
Therefore, project should also be looked for contribution in this respect. If a project providing
benefit to weaker section of the society, a higher positive adjustment to the score is done and vice
versa.

5. Adjustment for Social Values:

As per social values goods are divided into two categories - merit goods and demerit goods.
Merit Goods are those goods whose Social Value is more than their Economic Value like
Petroleum Products. Demerit Goods are those goods whose Economic Value is more than their
Social Value like Alcohol. A project for producing merit goods is adjusted with a higher positive
value where as project for demerit goods are adjusted with negative values and other project
between them.

Combined effect of all five steps is seen with the help of resultant score. If this score is higher than
acceptable level that project should be accepted as per SCBA else it should be rejected
 (3)

Risk & Control

RISK
Risk is the possibility of outcome being different form the expected outcome. Risk arises because
of uncertainty in future. For our purpose we can define Risk as the variability of actual returns from
the expected returns associated with a project. The greater this variability, riskier the project will be.

As whole Feasibility Analysis is future oriented, that too for a long period and future is uncertain.
Therefore, we can not forecast any factor exactly like we can not forecast exact demand used demand
forecasting, we can not exactly predict the price and availability of raw material. There are always
certain chances or probability of variation in forecasted demand, cost or profit etc. Therefore, risk
lies almost in all projects. More finely, Risk can be defined as:

“Variability of actual net cash inflows from the expected net cash inflows associated with a given
project can be defined as Risk”

Risk vs. Uncertainty:

If the probabilities of possible outcome of a given problem are known, we can conclude that the
problem contains risk; in other words, problem is risky. On the other hand, I the probabilities of
possible outcomes of a given problem are not known, wee can conclude that the problem has an
element of uncertainty i.e. the outcome can not be predicted.

Types of Risk:
Risk can be as many as there are factors affecting business and there are thousands of factors which
affects the business. Therefore, we can not list out all the risks here, but listing some important types
of risks:

1. Completion Risk: In the planning phase of project life cycle schedule for whole project is
designed i.e. projected time is estimated. There are chances that project may not be completed
within that pre-decided time frame. This will increase the cost of setting up the project in form of
increased cost of capital and opportunity cost (loss of business).

2. Technical Risks: It refers to the failure to meet a particular performance requirement. Failure of
the feasibility of a design, changes in technology and non-availability of raw-material are some
of the sources of technical risk.

3. Social Risks: Social risk refers to risks arising from changes in the needs and changing
preferences of target customer. Lack of necessary natural resources, labor unrest, agitation and
social movements against the project also constitute social risks.

4. Economic Risks: It refers to an increase in the rate of inflation, changes in the economic policies
of governments, and distribution of income. Since the project manager does not have any control
over these risks, he should carefully assess such risks and should ensure that the project is not
going to suffer because of these risks.

5. Political Risks: Nationalization or privatization or a particular industry, political instability,

change in policies of government, trade restriction are some examples of political risks. The
project manager should ensure that the project does not go against the political interest of the
country.
 (4)

6. Production Risk: It refers to shortage of necessary raw material, sudden break-down of key
machinery, and exponential rise in installation and maintenance costs. As these risks can be
controlled to some extent, the project manager should try to reduce the effect of these risks on the
project.

7. Marketing Risks: Marketing risks refers to failure of the developed product or service in the
market due to changes in market demand, errors in forecasting of demand, or difficulties in
distribution. The project manager should change the market strategy to deal with these risks and
generate more revenues.

8. Financial Risks: It refers to bad debts, change in the interest rates, wrong choice of investments
and mistakes in the accounting procedures. Consistent financial performance assessment of the
project will give the project manager a clear picture of financial condition of the project.

Risk Analysis:
Risk Analysis can be defined as: “A process of identifying and quantifying the Risk involved in a
Project and developing measures to avoid and manage such risk”.

As while selecting a project profit can not be the sole criteria. A good business opportunity is always
defined as a trade-off between risk and return. Therefore, it is immense necessary to analyze the risk
involved in a project along with profits, before selecting it.

Objectives:
 To see whether Project should be accepted or not seeing its Risk Profit
 Taking steps to avoid and minimize the risk
 Developing measures to manage the risk in future.

Activities involved in Risk Analysis:

Activities of Risk Analysis can be classified under two heads:
1. Risk Assessment
2. Risk Management

1. Risk Assessment:
It is the process of identifying and quantifying risk. Identification here means to find out the
reason or source of risk and quantification means to know the probability of occurring of risk
generating event and its financial impact on project. Mainly following are the techniques of risk
assessment:
a. Sensitivity Analysis
b. Scenario Analysis
c. Break-Even Analysis
d. Decision-Tree Analysis

(a) Sensitivity Analysis:

Under this analysis we try to find out the sensitivity of the project to various individual
factors effecting project like change in demand, cost, availability of labor etc. In other words,
we study that what will happen to viability of project when some of the variables understudy
like sales, investment, cost etc. deviates from its expected value (either in positive direction
or negative direction) on which viability is based. It is also known as ‘what if analysis’.

Step 1: Find out the effect of change in each individual variable on our original decision
about the project (which was based on other analysis)
 (5)

Step 2: If effect of change in any variable is opposite to the original decision, it shows the
need of revised study of the particular variable for surety.

Step 3: Finally original decision is revised on the basis of probability of change in such
variable and its calculated impact of project. More sensitive projects are treated as more risky
and vice versa.

(b) Scenario Analysis:

In sensitivity analysis, one variable is varied at a time. But generally, variable are inter-
related. Therefore, studying each variable separately does not seem correct. Therefore, few
scenarios (Scenarios are set of various inter-related variables) are developed. Probability and
impact of each scenario is assessed.
Example - Scenario
Factors Scenario 1 Scenario 2 Scenario 3
Demand M H L
Price M L H
Cost M H H
Probability 0.5 0.25 0.25
Result A B C

Step 1: List out the factor forming a scenario

Step 2: Form Different Scenario (as formed in above example)
Step 3: Estimate the results (NPV etc.) in all scenarios
Step 4: Calculate the Probability for each scenario
Step 5: Select the best-one as per Risk-Return Trade-off

Scenarios can also be developed in following manner:

Best Scenario: High Demand, High Price, Low Cost
Normal Scenario: Avg. Demand, Avg. Price, Avg. Cost
Worst Scenario: Low Demand, Low Price, High Cost
If project is giving acceptable results even in worst scenario – RISK IS MINIMUM

Another Approach can be to have 3 Scenarios:

Boom Condition of Economy
Normal Condition of Economy
Recession in Economy

(c) Break-Even Analysis:

Break-Even point is a point of ‘no-profit no-loss’, Where total revenue of the firm is equal to
the total cost to the firm. For our purpose we will take it in a modified way, as we are talking
about cash inflows and outflows. Therefore, BEP is a point where present value of cash
inflows of the firm is equal to the present value of cash outflows of the firm. BEP can be
calculated in following manner:

BEP = Fixed Cost / (SP – VC)

We can calculate the Break-Even sales and try to find out the probability of achieving the
break-even sales. If probability of achieving break-even sales is high, project is termed as less
risky and if probability of achieving break-even sales is low, project is termed as risky.

(d) Decision Tree Analysis:

 (6)

Decision tree analysis is useful tool for analyzing the situation where sequential decision
making regarding risk in involved. It is a combination of step-by-step decision making with
their probabilities.

Step 1: Identifying the problem and their possible sequential outcomes with their
probabilities.

Step 2: Represent all the outcomes step-by-step in diagrammatic form along with their
individual probabilities.

Step 3: Calculate the combined probability of happening the even and affecting the project by
multiplying the individual probabilities.

For example, if we want to know the risk from ‘Growth in Economy’ to our project, it can be
done in following manner using Decision Tree Analysis:

Less Profit (0.6)

Costly Raw Material

(0.4)

Inflation (0.5) No Change in Profit

Increase in Per (0.4)
Capita Income (0.6)
No Costly Raw
Material (0.6)
Growth in No Inflation (0.5)
Economy

No Increase in Per
Capita Income (0.4)

Now probability of effect on profitability from growth in economy can be calculated as

follows:

Probability of affect = 0.6 x 0.5 x 0.4 x 0.6 = 0.072

If such calculated probability is high project should not be accepted and if it is low it can be
accepted.

2. Risk Management:
It is the process of avoiding or minimizing the impact of assessed risk. In other words after
assessing the risk, efforts are made to avoid the risk by any means and if it is not possible than
minimize the impact of such risk on business in financial terms and chances of variability. Such
risks can be managed at two stages by following methods:

Risk Management at the time of Project Evaluation:

 Judgmental Evaluation
 Pay Back Period Requirement
 Risk Adjusted Discount Rate
 Collecting more & more Information
 (7)

(a) Judgmental Evaluation: Often managers look at risk and return characteristics of a project
and decide judgmentally whether the project should be accepted or rejected, without using
any formal method for incorporating risk in the decision making process. The decision may
be based on the collective view of some group.

(b) Pay-Back Period Requirement: In many situations companies use NPV or IRR as the
principle selection criterion, but apply a payback period requirement to control for risk. This
method assumes that risk is a function of time. If life of the project is long, more risk will be
involved and vice versa. Therefore, by using Pay-Back along with NPV or IRR risk is find-
out.

(c) Risk Adjusted Discount Rate: The risk adjusted discount rate method calls for adjusting the
discount rate to reflect project risk. Under this method a risk factor is added to normal
discounting rate for the risky projects, so that discounting factor can be inflated and chances
of accepting a project reduce accordingly.

r=i+d
where: r = risk adjusted discount rate
i = normal discount rate
d = risk factor

If the risk of the project is higher this risk factor (d) will be more, if risk involved is less this
risk factor will be less.

(d) Collecting More and More Information: Risk can also be avoided by collecting more and
more information at the time of evaluating the project, so that probabilities can be converted
into certainties and therefore, risk can be avoided.

Risk Management at the time of Project Implementation:

 Converting Fixed Cost to Variable Cost
 Sequential Investment
 Reduced Financial Leverage (using less debt capital)
 Insurance
 Long-Term Arrangements
 Strategic Alliance

(a) Converting Fixed Costs to Variable Costs: A common way to modify the risk of an
investment is to converting fixed cost into variable costs, so that risk which can not be
avoided impact the project at minimum level in worst conditions.

(b) Sequential Investment: This step is based on proverb “don’t test the depth of a river with
both feet”. If you are not sure about the response to your project, than it is better to start small
and later expand. It reduces the risk exposure.

(c) Reduced Financial Leverage: As we know that leveraging is to use more of debt capital for
providing more returns to shareholders. But debt is a risky (fixed obligation) source of capital
because of its fixed legal obligation for interest and capital repayment, therefore always risky.
It is better to use less of debt capital to reduce the impact of risk involved in the project.

(d) Insurance: Risk which can not be avoided on your own can be avoided by getting it insured.
So that loss suffered due to particular risk can be compensated by insurance company and
impact of such risk remains minimal, although it involves cost of insurance.
 (8)

(e) Long-Term Arrangements: Another way to minimize risk is to enter into long-term
arrangements with suppliers, employees, lenders, and customer. Long-term contracts with
these parties will enable the firm with a smooth supply and demand, thus reducing the risk of
unavailability or inflation/deflation.

(f) Strategic Alliance: Another way to minimize risk is to share the risk with some other by
opting for a strategic alliance in form of joint ventures by pooling the resources.

LEASE FINANCING:
A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer
transfers the right to use the equipment to the equipment user in return for a rental.

In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee)
for the right to use the asset during a specified period in return for a mutually agreed periodic
payment (the lease rentals). For examples, Banks generally take buildings on lease rent instead of
owning a building.

The important feature of a lease contract is separation of the ownership of the asset from its usage.

Lease financing is based on the observation made by Donald B. Grant: “Why own a cow when the
milk is so cheap? All you really need is milk and not the cow.”

Lease, as a source of project finance is mainly suitable for expansion projects, as repayment of lease
rent start immediately after acquisition of leased assets.