WERABE UNIVERSITY Department of Economics

Project planning and analysis has a long history in the financial and business analysis as a
means of checking the profitability of a particular investment activity by private firms. Recent
experiences have shown that project analysis has attracted the attention of development
economists from the economy view point instead of only the firm‘s perspective. Therefore this
course is designed to provide students the basic project concepts and analytical techniques to
prepare and analyze effective projects to contribute for the overall economic development of
the nation.
6.2. Project concept
6.2.1. Definition of Project
Project is defined in different ways by numerous authors. As a result, it is very difficult to find
a single comprehensive definition of project because projects are different in terms of their
nature and objectives. The following are among the most common definitions of project:
Project refers to an investment activity in which scarce resources are committed within
a given time framework, to create assets over an extended time in expectations of
benefits which exceeds the committed resources.
A project is a complex set of economic activities in which we commit scarce resources
in expectation of benefits that exceed the value of these resources. 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. Project, in general,
involves the creation of new and additional fixed production capacity. It requires the
commitment of scarce resources to a specific line of action which prevents the use to
other areas.

Why projects are undertaken

The purpose (goals) to a project depends on the nature of the project. Development projects
(usually undertaken by government or NGOs) may have the following objective.
Projects are very powerful and efficient means to achieve development (growth), rightly
called ‗cutting edge‘ of development.

136
 WERABE UNIVERSITY Department of Economics

They are mechanisms for improving income distribution (as government policy
instrument). Ex. implementing a project that enhances the income of the poor people
that benefit the poor,
They are mechanisms to solve immediate problems. Example: implementing a project
to solve a specific problem in the society such as project to eradicate malaria, prevent
the spreading of HIV,
Project undertaken by business organization have a primary objective of maximizing the wealth
of current shareholders. Other objectives may include maximization of profit, maximization of
earning per share or maximization of return on equity.
6.2.2. Basic characteristics of a project:
Projects in general need to be SMART:
S – Specific
A project needs to be specific in its objective. A project is designed to meet a specific objective
as opposed to a program, which is broad. A project has also specific activities. Projects have
well defined sequence of investment and production activities and a specific group of benefits.
A project is also designed to benefit a specific group of people.
M - Measurable
Projects are designed in such a way that investment and production activities and benefits
expected should be identified and if possible be valued (expressed in monetary terms) in
financial, economic and if possible social terms. Though it is sometimes difficult to value
especially secondary costs and benefits of a project, attempt should be made to measure them.
Measure costs and benefits must lend themselves for valuation and general projects are thought
to be measurable.
A – Area bounded
As projects have specific and identifiable group of beneficiaries, so also have to have
boundaries. In designing a project, its area of operation must clearly be identified and
delineated. Though some secondary costs and benefits may go beyond the boundary, its major
area of operation must be identified. Hence projects are said to be area bounded.
R – Real

137
 WERABE UNIVERSITY Department of Economics

Planning of a project and its analysis must be made based on real information. Planner must
make sure whether the project fits with real social, economic political, technical, etc situations.
This requires detail analysis of different aspects of a project.
T – Time bounded
A project has a clear starting and ending point. The overall life of the project must be
determined. Moreover, investment and production activities have their own time sequence.
Every cost and benefit streams must be identified, quantified and valued and be presented year-
by-year.
6.2.3. Classification of project
Project can be classified based on several criteria
1. Ownership
a. Private sector project: Mostly project undertaken by business enterprise
b. Public sector projects: Under taken by national and local government body
c. NGO‘s development projects: undertaken by non-governmental and not for profit
organization
2. Based on sources of finance
a. Government treasury
b. Government treasury and external sources
c. External sources of finances
3. Based on forces behind
a. Demand driven: based on unsatisfied demand project can be created or unsatisfied
basic needs like food, water and shelter
b. Donor driven: the forces behind the financing organization
c. Political driven
4. Based on sectors
a. Agricultural project
b. Industrial project
c. Service sector project
6.3. The project Cycle

138
 WERABE UNIVERSITY Department of Economics

A project cycle is the different stages through which a project passes or it is a sequence of
events, which a project follows.
There are several models of project cycles. Some of them are: The Most common Models are:
A. The Baum Cycle (World Bank 1970)
B. New Project Cycle (World Bank 1994)
C. United Nations Industrial Development Organization (UNIDO) Project Cycle
A. The Baum Cycle (World Bank 1970)
The first and most well known model is the traditional version of the World Bank developed in
1970s, with four main stages which further developed into five in 1978 to close the cycle and
known as Baum cycle. This traditional project cycle emphasis top down approaches to
development project planning. Community participation in project idea generation, alternative
identifications, project implementation, controlling as well as utilization was marginalized. The
projects were facing implementation problems, and could not be sustained, if ever implemented as
planned. The stages are:
a) Identification

b) Preparation (pre-feasibility and feasibility studies)

c) Appraisal

d) Implementation

e) Evaluation

Identification

Preparation
Evaluation

Implementation
Appraisal

139
 WERABE UNIVERSITY Department of Economics

Source: Baum, 1978

6.3.1. Identification (opportunity study)
Identification is finding potential project which could contribute towards achieving specific
development objectives. It is the identification of investment opportunities. Project ideas may
originate from various sources with the aim of:
 Achieve National and sectoral plans

 Overcoming the constraints to the national development efforts, and/or

 Meeting unsatisfied needs and demands for goods and services.

 Market demand

 Wealth generation potential

 Opportunity to make available resources more profitable

 To make use of available technology

 Intervention against natural calamity such as deforestation, flood or drought

 Political considerations

Identification of promising investment opportunities requires imagination, sensitivity to

environmental changes, SWOT analysis and a realistic assessment of what the firm can do. In
addition assessment of appropriate technology, scale of the project, timing of the project etc. are
important. In general, the following are the major sources from which ideas or suggestions for
project may come:
 Technical specialists,

 Local people and leaders

 Survey conducted by local government and regional organizations, their policies &
plans,

 Review of past projects,

140
 WERABE UNIVERSITY Department of Economics

 State enterprise, corporate, and cooperatives plans,

 Development banks and donors,

 Entrepreneurs,

 Bright ideas etc.

After the project is identified, a complete project idea profile should be specifying. Title,
location, owner, beneficiaries, background and justifications, objectives, costs, financing and
benefits should be briefly stated. Then, preliminary screening/selection of project ideas needs to
be made. It is required to reduce the number of project ideas to a manageable number so that
more working time can be devoted to the remaining alternatives for their feasibility study to
select the most desirable ones. At this stage, the screening criteria are rough and vague.
General considerations at the preliminary screening may include the following:
 Compatibility with the promoter/supporter

 Consistency with government priorities,

 Availability of inputs,

 Adequacy of market,

 Reasonableness of cost,

 Acceptability of risk level

During preliminary screening, the analyst should eliminate project proposals that are:
 Technically unsound and risky,
 Have no market for their output,
 Have inadequate supply of inputs,
 Are very costly in relation to benefits, etc.

141
 WERABE UNIVERSITY Department of Economics

6.3.2. 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, financial and economic
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.
On the other hand, project analysis is a method of evaluating alternative investment projects in
order to maximize the net benefit a society drives from its scarce resources. It involves the
benefits and costs of project and reduces them to a common measure (present value).
Need for project analysis:
For efficient and effective allocation of resources among competing needs to help the
country to achieve the fundamental goal
To assess the benefits and costs of the projects to reduce then common measure
To choice between competing uses of resources/projects
To make appropriate decision because of most of the decisions are irreversible and have
long term effect
In general project preparation and analysis involves two steps:
 Pre-feasibility studies

 Feasibility studies

a. Pre-feasibility Study
A pre- feasibility study should be viewed as an intermediate stage between a project
opportunity study and a detail feasibility study, the difference being in the degree of detail of
the information obtained and the intensity with which project alternatives are discussed. The
principal objectives of pre feasibility study are to determine: (i) whether the project is
preliminary worthwhile to justify a feasibility study and (ii) what aspects of the project are
critical to its unpredictability and demand an in-depth investigation. Some of the main
components examined during the pre-feasibility study include:

142
 WERABE UNIVERSITY Department of Economics

 Availability of adequate market

 Project growth potential

 Investment costs, operational cost and distribution costs

 Demand and supply factors; and

 Social and environmental considerations

If the project appear viable form this preliminary assessment the analysis will be carried to the
feasibly stage.
b. 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 pre-
feasibility suggests that the project is preliminary worthwhile, a detailed analysis of the
marketing, technical, financial, economic, and ecological aspects will be undertaken. 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 need to be obtained
and if the project is viable it should proceed to the project design stage.
The final product of this stage is a feasibility report. The report should provide all data
necessary for an investment decision. The feasibility report should contain the following
elements:
 Background of the project
 Technical analysis (materials & Inputs, Technology and engineering works,
construction,
infrastructure)
 Market analysis

 Institutional and organizational analysis

 Financial analysis

143
 WERABE UNIVERSITY Department of Economics

 Economic analysis

 Sensitivity analysis

 Social analysis, and cross cutting issues (gender, environment, HIV/AIDS)

 Environmental analysis

 Risk analysis

6.3.3. Appraisal

The feasibility study would enable the project analyst to select the most likely project out of
several alternative projects. After a project has been prepared, need to present for a critical
review or an independent appraisal to be conducted. This provide an opportunity to re-examine
every aspects of the project plan to assess whether the proposal is appropriate and sound before
large investment are committed. Strictly apply sensitivity and risk analysis. The appraisal
process builds on the project plan, but it may involve new information if the specialist on the
appraisal team feel that some of the data are questionable or some of the assumption faulty.
Project appraisal needs to address major questions:
 Does the project belong to a sector where the country needs additional
investment?

 Does the project meet the urgent needs of the sector?

 Does the project represent the least-cost alternative?

 Is the project of optimum size (not too big or too small)?

 Is the timing of the project right?

 Is the project well designed with reasonably accurate cost and benefit estimates?

 If the proposed project is not implemented, what other opportunities do exist to

use the same resources?

144
 WERABE UNIVERSITY Department of Economics

At appraisal stage the team makes any of these three decisions:

Accepted the proposed project if the project is sound
Revised the proposed project to correct some fault
Rejected the proposed project if the team founds serious
6.3.4. Implementation
Project implementation is a phenomenon by which project studies are translated into action
within their specified time and budget. As much, the implementation phase is very crucial to
the success of the project. Project implementation involves a number of activities which are
interrelated. This stage could be divided into scheduling, financing, negotiation and
contracting, discussing, constructor training, erection, installation and commissioning. If any
one of these is not undertaken properly, the progress of the implementation will be affected
adversely.
Project implementation phase covers the period starting from the time decision is made to
invest the project up to the start of normal production. As a result, this phase involves heavy
financial commitment. Moreover, it is understood that the burden of project implementation
depends on the size and complexity of the project to be implemented.
6.3.5. Evaluation
Project evaluations undertake to assess whether the objectives of the original project have been
attained, and if not way. In this phase the project performance is compared with the stated
objectives. The idea is to understand the reasons for the success or failure of the project,
looking at what works and what does not, so that errors are not repeated in future interventions.
The evaluation exercise should look at the impact of the project in target groups and their
environment beyond the stated goals, trying to understand any positive or negative unintended
effects.
B. New Project Cycle
During 1994 the World Bank changed its approach from top down planning to bottom up,
which emphasis on the need of beneficiary participation in project planning. But, what level of
beneficiary participation is required? According to the new project cycle (World Bank 1994),
project cycles have four phases:
Listening to the stakeholders

145
 WERABE UNIVERSITY Department of Economics

Piloting the project

Demonstrating
Mainstreaming the project
C. United Nations industrial Development Organization (UNIDO) Approach
1. Pre –investment phase
The major activities are:
Identification of investment opportunities ( opportunity studies )
Analysis of project alternatives and preliminary project selection
Project preparation (pre feasibility and feasibility studies).
Project appraisal and investment decision (appraisal report)
2. Investment phase
The major activities are:
Negotiation and contracting
Engineering design
Construction
Reproduction marketing
Training
Commissioning and start up
3. Operational phase
The major activities are:
Replacement and rehabilitation
Expansion and innovation
6.4. 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 below:
6.4.1. Technical Aspect

The technical analysis is concerned with the projects inputs (supplies) and outputs of real goods
and services and the technology of production and processing. In this aspect analysis all

146
 WERABE UNIVERSITY Department of Economics

physical quantity of inputs and outputs will be determined for the estimation of costs and
benefits.
Poor technical analysis will result in under- or over- estimation of quantities related to inputs
required by and outputs of the project. Therefore, it requires creative, committed and competent
specialists from different fields. It also requires coordination among these specialists, as every
technical aspect is interrelated and interacting. In general in technical analysis required to take
in to account:
 Work schedule

 Location and site selection

 Project charts and layouts

 Structure and civil works

 Machines and equipment

 Plant capacity

 Manufacturing process and technology

 Material inputs and utilities (water, electric, tele,etc.)

 Product mix

6.4.2. Marketing aspect

This aspect analysis needs to ensure the existence of effective demand at remunerative price.
Market analysis is basically concerned with two questions:
 What would be the aggregate demand of the proposed product/service in future?

 What would be the market share of the project under study?

To answer the above two questions the project analyst requires a wide variety of information
and need to use appropriate forecasting methods. The information required in market analysis
are:

147
 WERABE UNIVERSITY Department of Economics

 Potential consumers or aggregate demand for the output

 Past and present supply positions

 Production possibilities and constraints

 Demand supply gap

 Imports and exports

 Structure and competition

 Cost structure

 Estimate price

 Elasticity of demand

 Consumer behavior, attitudes, preferences, and requirements

 Distribution channels and marketing policies in use

 Administrative, technical, and legal constraints.

All aspects related to demand and supply of inputs and outputs must be examined. In addition
need to undertake demand forecasting.
Demand Forecasting: Basically there are two kinds of techniques of forecasting: the
qualitative and quantitative techniques.
i. Qualitative method
a. Jury of execution opinion technique: involves soliciting the opinion of a group of
high level experts or managers on expected future sales and combining them into
a sale volume. But reliability is in question.
b. Delphi technique: involves eliciting the opinions of a group of experts, who don‘t
interact face to face, usually with the help of a mail survey, into a forecast through
and iterative process. In this method, a questionnaire is sent to a group of experts

148
 WERABE UNIVERSITY Department of Economics

and responses received are summarized without disclosing the identity of the
experts.
ii. Quantitative methods
a. Time series projection method
Historical information can be used as inferences about the future. The value of many
economic variables changes with time and hence time series can be used in forecasting
likely values in the future. The major time series projection methods are:
1. Moving Average Method: As per this simple but commonly used forecasting method, the
forecast for the next period is equal to the average of the sales data for several preceding
periods. Symbolically:
S t  S t 1  ...  S t n1
Ft 1  ----------------------------(1)
n
Where, Ft+1= Forecast for the next period,
St = Sales for the current period
n = Period over which averaging is done

Example: Forecast for period 5 & 6 using Moving Average Method using the sales data
in table below if n is 4 periods

Time (t) Data ( S t )

1 28.0

2 29.0

3 28.5

149
 WERABE UNIVERSITY Department of Economics

4 31.0

Solution

If n is set equal to 4 (n has to be specified by the forecaster), the forecast for period 51, using
the sales data in table above, will be equal to:
S1  S 2  S 3  S 4 28.0  29.0  28.5  31.0
  29.1
4 4

The forecast for period 6 is equal to

S 2  S 3  S 4  S 5 29.0  28.5  31.0  34.2

  30.7
4 4
Other forecasts are shown in the table below.
Time Data Forecast Forecast for t+1
(t) (S t ) ( Ft ) Ft 1  ( S t  S t  S t 1  S t  2  S t 3 ) / 4
1 28.0
2 29.0
3 28.5
4 31.0
F5 = (28.0+29.0+28.5+31.0)/4 = 29.1
5 34.2 29.1 F6 = (29.0+28.5+31.0+34.2)/4 = 30.7
6 32.7 30.7 F7 = (28.5+31.0+34.2+32.7)/4 = 31.6
7 33.5 31.6 F8 = (31.0+34.2+32.7+33.5)/4 = 32.9
8 31.8 32.9 F9 = (34.2+32.7+33.5+31.8)/4 = 33.1
9 31.9 33.1 F10 = (32.7+33.5+31.8+31.9)/4 = 32.5
10 34.3 32.5 F11 = (33.5+31.8+31.9+34.3)/4 = 32.9
11 35.2 32.9 F12 = (31.8+31.9+34.3+35.2)/4 = 33.3
12 36.0 33.3
Semi-averages methods – divide the data into two equal parts and from the data calculate
the slope and intercept

If the model is represented by, say, Yc = a + bx, then,

( S 2  S 1)
The slope = b 
N2

1
Note that if n is equal to 4, then the first forecast can be made only for period 5.

150
 WERABE UNIVERSITY Department of Economics

S1
The intercept = a 
N
2
Where: S1 = Sum of Y values for the first period
S2 = Sum of Y values for the 2nd period
a = Intercept
b = Slope
N = Number of years
2. Trend projection method (least square method): It involves determining the trend
of consumption by analyzing past consumption statistics and projecting future consumption by
extrapolating the trend. When the trend projection method is used, the most commonly
employed relationship is the linear relationship.

Yt    X ,

Where, Yt  demand for year t

X= independent variables

 = Intercept of the relationship, and

 = Slope of the relationship.

Solving the equations, we get the values of  and  (refer econometric course)

b
 XY  n XY
 X  nX
2 2


  Y  X

Where, Y=Demand
n =Number of observation

X  Mean of X

Y  Mean of Y
  Intercept
  Slope

151
 WERABE UNIVERSITY Department of Economics

Example: A maker of sport Shirts Company has been tracking the relationship between sales
and advertising dollars. Use linear regression to find out what sales might be if the company
invested $53,000 in advertising next year.

Periods Sales $ (Y) Adv.$ (X) XY X^2 Y^2

1 130 32 4160 2304 16,900

2 151 52 7852 2704 22,801

3 150 50 7500 2500 22,500

4 158 55 8690 3025 24964

5 153.85 53

Tot 589 189 28202 9253 87165

Avg 147.25 47.25

28202  447.25147.25
b  1.15
 XY  n XY 9253  447.25
2

b
a  Y  bX  147.25  1.1547.25
 X  nX
2 2

a  92.9
Y  a  bX  92.9  1.15X
Y  92.9  1.1553  153.85
Use multiple regressions methods if a relationship between a dependent variable and multiple
independent variables. It is an extension of linear regression. The general formula is:

b. Causal method
These techniques go beyond time series analysis in that they attempt to analyze why variables are
changing over time. Causal model forecasts are based on variations in those factors (the causal
variables) that cause the variable in question to change. These methods seek to develop forecasts on the
basis of cause-effect relationship specified in an explicit quantitative manner. The important methods
under this category are: chain ratio method, consumption level method, leading indicator method, end
use method, and economic metric method.

152
 WERABE UNIVERSITY Department of Economics

6.4.3. Institutional-Organizational, Managerial and Manpower Aspect

Institutional assessment covers both the institution and the environment in which it operates. It
is concerned with two major concepts, namely project management and organization. The basic
point of conducting institutional analysis of a project is to establish a suitable organizational
structure for the purpose that adequately manages the proposed task. This part of the feasibility
study concerned on defining the organization setting and the human resource organization of
the project. It focuses on answering questions such as:
How will the project be organized? Organization structure: General assembly, board,
manager, administration and finance, technical staff.
How the project is managed?
What types of skill and number of employees are required (human resource
requirements)?
What will be the costs of getting the required human resources?
Is local manpower market enough to provide the project with the required manpower
6.4.4. Financial Aspect

Financial analysis seeks to ascertain whether the proposed project will be financially viable or
not. The financial analysis establishes the magnitude of costs of investment, production and
magnitude of benefits. This analysis will be the basis for evaluating the project profitability.
Project profitability depends on a comparison of costs versus revenues using realistic market
prices of materials, labor and outputs. The aspects, which have to be looked into while
conducting financial appraisal, are:
 Costs of the project

 Means of financing; source of finance, credit terms, interest rates, etc

 Projected profitability

 Projected financial position

 Cash flows of the project

153
 WERABE UNIVERSITY Department of Economics

 Break-even point

 Investment worthiness judged in terms of various criteria ( such as benefit cost

ratio(BCR), net present value(NPV), internal rate of return(IRR), profit)

 Level of financial risk

Financial analysis must generate future financial statements such as income statement, balance
sheet and uses-and-source-of-fund statement. After these statements are produced, analysts can
undertake different financial ratio analysis so as to ascertain financial feasibility. The financial
analysis must clearly show fund flows in each period in the project life.
6.4.5. Economic Aspect

The economic aspect of project preparation is primarily concerned with significance of the
project from the whole economy point of view (the society as a whole). It can be distinguished
from financial analysis in that attention is not confined to the costs and benefits affecting a
single group, the focus of economic analysis are on the net return to society. In economic
analysis the most important question is whether or not the project under study is beneficial to
the national economy. In economic analysis the analyst considered:
 Contribution of the project to the GNP of the country
 Significance of the project in creation employment opportunity
 Significance of the project in improving income distribution
 Contribution of the project in solving poverty problem
 Significance of the project in expansion export and import substitution and other
The aims of economic analysis in the context of project preparation are:
 To ensure that public investment funds are used only for economically viable
projects

 To ensure that a convincing economic case can be made for PIP

154
 WERABE UNIVERSITY Department of Economics

6.4.6. Social Aspect

Project planners must make careful consideration of social factors when formulating projects.
Experience has shown that ignorance of these factors can lead to project failure. If social
assessment is primarily concerned with ensuring that project, and consequently the
development process, are „people- centered‟ then the following social aspects must be taken
into account in any project formulation exercises. These are:
 Identifying of stakeholders and target groups.

 Participation issues

 Social impact assessment (SIA)

 Assessing of mitigation measures, strategies and costs of SIA

a. Identification of stakeholders and target groups

Stakeholder analysis is the process of identifying the people, groups, communities and
institutions which are liable to be affected in some way by a proposed project. The first stage in
stakeholder analysis is to identify the various stakeholders who are liable to have an interest in
the proposed project. Stakeholders are normally differentiated as either:
 Primary those affected directly by a project.

 Secondary those engaged as intermediaries in the delivery of project benefits.

 External those who are influenced by or have influence over a project without being
directly affected by it.

Once the various stakeholders have been identified it is then necessary to consider their
interests. When identifying stakeholder interests it is important to keep the following points in
mind:
 Relate the stakeholders‘ concerns to the project objectives.

 Identify direct or indirect benefits which they are likely to receive from the project.

 Consider the costs they are liable to incur directly or indirectly as a result of the project.

155
 WERABE UNIVERSITY Department of Economics

 Relate one stakeholder to the other stakeholders as well as how this stakeholder will be
affected by the benefits gained/costs incurred by other stakeholders.

 Identify the type and quantity of expected resources that can be committed by the
stakeholder to achieve the project‘s objectives.

 Determine interest of the stakeholder

b. Participation issues
The aim of participation is to produce a situation where stakeholders are willing to contribute to
the successful implementation of the intended project and its future sustainability. Participatory
approaches, which create awareness amongst stakeholders of their own situation, of the socio-
economic environment they live within, and of measures they can take to begin changing their
environment, should be considered during project formulation. When dealing with participation
as an element of project formulation it is important to think in terms of both quality and
quantity that should be related to project objectives.

c. Social impact assessment

Social impact assessment (SIA) is a term used to classify the process of assessing how the
benefits and Costs of a project are distributed amongst various stakeholders over time. SIA is
often used in evaluating the ‗winners‘ and ‗losers‘ of proposed policy reforms but its
techniques can also be applied to project analysis. SIA is essentially concerned with three
distinct areas:
 Impact of the project on its stakeholders.

 Impact of the stakeholders in terms of achieving the project objectives.

 People‘s response to the opportunities created by the achievement of the project

objectives.

d. Assessment of mitigation measures, strategies and costs

156
 WERABE UNIVERSITY Department of Economics

The success of this stage of the social assessment process is largely dependent on the quality of
stakeholder analysis and social impact assessment carried out previously. The assessment of
mitigation measures, strategies and costs will form the social impact management plan
produced along with the SIA report. The analytical work carried out in previous stages of social
assessment (stakeholder analysis, participation and gender analysis etc.) is likely to have
identified potential options to limit the negative impact on stakeholders. These options now
need to be studied in more detail in order to develop a comprehensive strategy to mitigate
negative impacts. Stakeholder consultation is essential in order to suggest both feasible and
desirable mitigation measures. Both costs and benefits of mitigation strategies should be
calculated.
6.4.7. Environmental Aspect

Environmental analysis is a field of growing importance in project preparation.

Underestimation of the environment has resulted in negative outcomes such as poor human
health, social disruption, reduced productivity and, ultimately, the undermining of
development. When considering environmental aspects into project formulation exercises there
are a number of issues that should be taken into considerations, these include:
 A clear understanding of the meaning of Sustainability

 Assessment of the potential environmental impact of the project.

 Ways in which that impact could be reduced at a reasonable cost.

 Mitigation strategies and a plan of action.

6.4.8. Cross-Cutting issues

Cross- cutting issues, recently, have received great attention in preparing any development
projects. Underestimation of these issues have resulted in undesirable outcomes which include
the loss of active human labor, reduced productivity, under or over utilization of the intended
output/inputs, social disorder, poor human health etc. Currently, project
promoters/implementers and policy makers are initiating these points to be entertained in any
development projects preparation and implementations. In this context, cross-cutting issues

157
 WERABE UNIVERSITY Department of Economics

impacts have come to play a determinant roll in the project formulation exercises. The major
aspects considered in cross-cutting issues are:
 Widespread diseases ( like HIV/AIDS, Malaria, etc)

 Disability

 Population

 Gender issues

6.5. Sensitivity Analyses

Sensitivity analysis is a technique applied to uncertainties. These uncertainties- are factors
affecting project outcomes which cannot be quantified. The purpose of sensitivity analysis is to
tell us the major factors which are liable to have the greatest influence over project success and
failure. Once these factors have been identified it is then - possible to design appropriate
mitigation measures. Three common approaches for sensitivity analysis:
“What if” analysis approaches: shows how the NPV or other criteria of merit changes
with variations in the value of any variable (sales volume, selling price per unit, cost
per unit, etc.). Example: If fuel price increases by 5-10 birr by how much sales volume,
selling price per unit, cost per unit, NPV, internal rate of return(IRR), benefit cost ratio
change, etc

Fixed percentage variation approaches: used to test each important variable for fixed
percentage change. Example: If sales volume decreases by 5% by how much percentage
NPV, internal rate of return (IRR), benefit cost ratio, profit, etc change.

Switching value approaches: used if a linear relationship exists between variables,

then we can use Switching value formula to calculate the change in the value for the
variable concerned: When, NPV1 is the base value for the project NPV and NPV2 is the
new value resulting from an assumed change in price (or quantity) from P1 to P2, the
switching value (SV) for the item being tested is given by:

158
 WERABE UNIVERSITY Department of Economics

 NPV 1   P1  P 2 
SV    
 NPV 2  NPV 1   P1  * 100%
There are two major limitations of sensitivity analysis. These are:
 It is partial. The study of the impact of variation is normally undertaken one factor at a
time, holding other factors constant. This may not be very meaningful when the
underlying factors are likely to be interrelated.

 It says nothing about the possibility of the tested changes happening. Any judgments
about likelihood will necessarily be qualitative.

Both of these limitations can be overcome through the application - of risk analysis techniques.
6.6. Risk analysis
Risk analysis is used to determine the probability of different factors in terms of project
outcomes. It is the application of probability estimates associated with each variation that
represents the essential feature of risk analysis. The process of undertaking risk identification
can be defined in a number of steps. These are:
1st identify major factors

2nd Find probability of occurrence

3rd construct probability distribution of factors

4th examine the implication.

Following these steps will enable the planner to obtain the frequency distribution for the NPV.
Once this is known it will then be possible to calculate:
 The mean (or expected) value for the NPV.

 The variance, or the standard deviation, of the distribution for the NPV.

 The expected magnitude of possible positive and negative NPVs.

For the detail of risk analysis refer microeconomics I or economics of agriculture course
materials

159
 WERABE UNIVERSITY Department of Economics

Chapter Seven

7. Financial Analysis and Appraisal of Projects

Financial analysis and final project appraisal involves the assessment , analysis and evaluation
of the required project inputs, the outputs to be produced and the future best benefits, expressed
in financial terms . The objective is to measure the financial viability of the project under
prevailing market conditions.
7.1. Project Scope and Rationale

Project Scope refers to coverage of the project in terms of objectives, target group expected to
benefit, geographical location, and time. Any project is expected to provide its stakeholders
with certain outcome, which is commonly termed as project deliverables (something that has
been promised to the customer). These project deliverables depends on the scope of the project.

160
 WERABE UNIVERSITY Department of Economics

Analogically, defining a project scope is like drawing a map. In the map, the boundaries are
drawn to indicate extent of a given territory; similarly project scope outlines the extent of
project deliverables.

Project Rationale (Justification): Selection of good projects is of great strategic importance.

Sound projects should not only be sound technically but should also generate adequate returns
to both the investor and the economy. In addition to be economic return, the financial return
may be of importance to ensure proper financing of the project or to avoid drain on the
government budget. They should produce products, which in terms of quality as well as
quantity have adequate markets (at home/ or aboard) and under normal circumstances also have
a perspective advantage in production costs compared to its competitors (local and foreign).
Further it should not only fit into the existing phase of the economy but should also not violate
its next phase. This would be possible if and only if need are properly justified the reasons for
established. Otherwise, there could be possible wastage of both human and natural capital and
frustration to resource owners and policy makers. Through projects it is possible to ensure
proper allocation and utilization of resources and could also give a chance to measure the
efficiency of scarce resources used for some intended purpose.

7.2. Identification of Project Costs and Benefits

The cost and benefit of the proposed project must be identified:
To value the project in terms of market price,
To adjust the market price for their economic value and
Finally to determine which project among alternative projects have an acceptable return.
7.2.1. Classification of Costs and Benefits
There are alternative ways of classifying costs and benefits of a project. One is to categorize
both costs and benefits into: tangible and intangible once.

7.2.1.1. Classification of Costs

I. Tangible costs: These refer to costs incurred by the company in the project from project idea
identification throughout the implementation and operation phases and that can be quantified
directly and easily in monetary value. Includes cost categories such as:

161
 WERABE UNIVERSITY Department of Economics

a. Direct transfer payments

Some entries in financial accounts really represents shifts in claims to goods and services from
one entity in the society to another and do not reflect changes in national income. The term
‗direct transfer payment‘ is used to identify payment that show up directly in the project
accounts but that do not affect the national income account. Common transfer payments in
projects cost are: taxes and debt services (the payment of interest and repayment of
principal).

Taxes: Payment of taxes is clearly cost in financial analysis. When a firm pays a tax, its net
benefit is reduced. But the firm‘s payment of tax doesn‘t reduce the national income. Rather it
transfers 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 investment) had the firm retained the amount of the tax. Thus, in economic
analysis we would not treat the payment of taxes as a cost in project accounts.

Debt service: debt services are the major form of direct transfer payment in projects. From the
standpoint of the project owner, receipt of a loan increases the production resources he has;
payment of interest and repayment of principal reduce them. But from the standpoint of the
economy, these are merely transfers of control over resources from the lender to the borrower.

162
 WERABE UNIVERSITY Department of Economics

b. Costs of inputs
Includes: Cost of physical goods (raw materials), Labor, Land, etc.
Note: Included both in financial and economic analysis. But in financial analysis find the
market price to estimate the cost whereas in economic analysis need to adjust to efficiency
price.
c. Contingency allowance: 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
costs.
d. Sunk (irrecoverable) costs: Sunk costs are those costs incurred in the past upon which a
proposed new investment will be based. Such costs cannot be avoided however, poorly advised
they may have been. When we analyze proposed investment, we consider only future returns to
future costs; expenditures in the past, or sunk costs do not appear in both financial and
economic analysis.

Examples of Sunk Costs

Marketing study: A company spends birr 50,000 on a marketing study to see if it‘s the new
products going will succeed in the market place. The study concludes that the new product will
not be profitable. At this point, birr 50,000 is a sunk cost. The company should not continue
with further investments in the newly project, despite the size of the earlier investment.
Training: A company spends birr 20,000 to train its sales staff in the use of new tablet
computers, which they will use to take customer orders. The computers prove to be unreliable,
and the sales manager wants to discontinue their use. The training is a sunk cost, and so should
not be considered in any decision regarding the computers.
II. Intangible costs: Almost all projects have costs that are intangible. These may include
displace workers, increase disease incidences, increase regional income inequality, destroy or
reduce the scenic beauty of an area, etc. All these are intangible costs of the project, which are
not captured by or not reflected in the market prices. All these intangible costs must be
carefully identified and where possible, be quantified. These costs usually excluded from
financial analysis. However, they should be included in the economic analysis at least in

163
 WERABE UNIVERSITY Department of Economics

qualitative terms if they are significant and not measurable. Whether or not externalities are
quantified, they should at least be discussed in qualitative terms.
7.2.1.2. Classification of Benefits
I. 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
II. Intangible Benefits

Almost all projects have costs and benefits that are intangible. These may include creation of
job opportunities, better health and reduced infant mortality, better nutrition, reduced incidence
of disease, national integration, national security, etc. Similar to intangible cost intangible
benefit excluded from financial analysis. However, they should be included in the economic
analysis at least in qualitative terms if they are significant and not measurable.
7.3. The valuation of financial costs and benefits

Once costs and benefits have been identified, if they are to be compared, they must be valued.
Since the only practical way to compare different goods and services directly is to give each a
monetary value. We must find the proper prices for the costs and benefits in our analysis. In
valuation of costs and benefits finding the market prices for the inputs and outputs is the first
steps. But if the commodity is internationally traded need to use financial export and import
parity price in financial analysis.

164
 WERABE UNIVERSITY Department of Economics

7.3.1. Finding market prices

Market or explicit prices are those prices present in the market, no matter whether they are
determined by supply and demand or by the government. They are the prices at which the firm
will buy the inputs and sell the outputs. In financial analysis market prices are applied. In
economic analysis, if the market prices are distorted need to adjusting the financial prices so
they better reflect economic values, then shadow or imputed prices will have to be used for
economic analysis. Thus, the first step in valuing costs and benefits is finding the market prices
for the inputs and outputs. To find prices, the analyst must go into the market and consult many
sources such as merchants, consumers, experts, published statistical bulletins, etc. From these
sources the analyst must come up with a figure that adequately reflects the going price for each
input or output in the project.

Note: Since project analysis is about judging future returns from future investment, we have to
judge what the future prices of inputs and outputs may be. The best starting point is to see the
trend of these prices over the past few years. Having this data, the project analyst can forecast
the price with certain degree of precision.

7.3.2. Financial export and import parity price

As indicated earlier, financial analysis will be made base on market price. The project may use
imported inputs and export its output, to foreign markets. If there are domestic markets for
these inputs and outputs, and if the firm is free to sell or buy at the domestic or world market,
we take the domestic price with appropriate adjustment to reflect the price at the project site. If,
on the other hand, commodities of the project are produced only for foreign market or if the
domestic demand cannot absorb the firm‘s output, we will take export-parity and import parity
prices ever in financial analysis. These are the estimated price at project sit or project boundary
which are derived by adjusting the C.i.f. (cost, insurances and freight) or f.o.b. (free on board)
prices by all relevant party.

Parity pricing is used to compare prices across borders. Parity price analysis is a standard
method of equating (or comparing) prices in one place with those in another, typically across
international borders. Parity pricing refers to making prices of a commodity in one location

165
 WERABE UNIVERSITY Department of Economics

equivalent to the same commodity in another location, usually in a different country. There are
two types of parity prices: import parity and export parity.
Import parity price (IPP) is the value of a unit of product bought from a foreign country,
valued at a geographic location of in the importing country. It can help to determine whether
importing a particular commodity is cheaper or more expensive than producing and procuring it
within the country at a given location within the country. Import parity prices are measured as
the Cost, Insurance and Freight (CIF) price i.e. price of a good in the country of destination (at
the border).

Export parity price (XPP) is the value of a commodity sold at a specific location in a foreign
country but valued at a specific location in the exporting country. It measures whether a
country‘s exports are competitive with the same commodity produced in another country.
Exports are valued as Free on Board (FOB) price i.e price of a good in the country of origin.

Which parity price applies to which situation depends on which side of the transaction you
stand or whose incentives you want to consider. An importer is interested in the import parity
price and this will serve as an indicator of whether it is worth it to buy the commodity, pay for
shipping, handling and local transport costs. An exporter is interested in the export parity price
and this will serve as an indicator of whether their commodity is competitive with the same
type of commodity located in a market across the border.
Elements of C.i.f. (Cost, Insurance, Freight) and F.o.b. (Free on Board)
Item Element
C.i.f. Includes:
F.o.b. cost at point of export
Freight charges to point of import
Insurance charges
Unloading from ship to pier at port
Excludes:
Import duties and subsidies
Port charges at port of entry for taxes, handling, storage, agents‘ fees and the like
F.o.b. Includes:
All costs to get goods on board-but still in harbor of exporting country:
Local marketing and transport costs
Local port charges including taxes, storage, loading, fumigation, agents‘ fees and the like

166
 WERABE UNIVERSITY Department of Economics

Export taxes and subsidies

Project boundary price
Farm-gate price

Example: A project produces flower to export it to Canada. The project boundary is at Debere Zeit. The
official exchange rate (OER) is 20 birr = $1. In this case we start with the C.i.f. price at the importing
country, Canada. The export parity price may be derived as follows.

Export parity price determination

Steps in calculation Value per unit
C.i.f. at the point of import (say, Canada port) $60
Deduct -Unloading cost at the point of import $3
Deduct- freight (shipment) to the point of import $15
Deduct - insurance charge $10
Equals f.o.b. at point of export (Addis Ababa Air port) $32
Convert foreign currency to domestic currency at OER ($32*20) 640 birr
Deduct – tariff (export duties) 15 birr
Add- subsidies 10 birr
Deduct- local port charge (port handling cost) 15 birr
Deduct- local transport and marketing cost from project site to 5 birr
the point of export ( from Deber Zeit to Addis Ababa Air port)
Equals export parity price at project boundary ( at Deber Zeit) 615 birr
Deduct – local storage, transport and marketing cost ( if not 7 birr
part of project cost)
608 birr
Equal export parity price at the project sit (farm gate)

Similarly, a parallel computation leads to the import parity price. For example, a project uses
imported inputs, say fertilizer import from Canada. The project boundary is at Deber Zeit. The
official exchange rate (OER) is 20 birr = $1. In this case start with f.o.b. price at exporting
country, Canada. Then import parity price is:

167
 WERABE UNIVERSITY Department of Economics

Import parity price determination

Steps in calculation Value per unit

F.o.b. price at point of export (say, Canada port) $116
Add -Unloading cost at the point of import $30
Add- freight (shipment) to the point of import $10
Add - insurance charges $20
Equals C.i.f. price at point of import (Addis Ababa Air $176
port) 3520 birr
Convert foreign currency to domestic currency at OER 10 birr
Add – tariffs (import duties) 15 birr
Deduct- subsidies 20 birr
Add- local port charge (port handling cost) 30 birr
Add- local transport and marketing cost from project
site to the point of export ( from Deber Zeit to Addis
Ababa Air port) 3565 birr
Equals import parity price at project boundary ( at 7 birr
Deber Zeit) 3572 birr
Add – local storage, transport and marketing cost ( if
not part of project cost)
Equal Import parity price at the project sit (farm gate)

7.4. Project Worthiness Analysis

After costs and benefits have been identified, quantified and priced (valued), the analyst is trying to
determine which among various projects to accept, which to reject. There are several criteria that have
been suggested by different scholars to judge both financial and economic worthiness (feasibility) of
project. The important project worthiness analysis criteria are classified in to two broad categories.
These are:-

7.4.1. Non-discounting criteria including:

Ranking by inspection
Payback period
Simple rate of return/Accounting rate of return.
7.4.2. Discounting criteria including

168
 WERABE UNIVERSITY Department of Economics

Net present value/NPV/

Internal rate of return/IRR/
Discounted benefit-cost ratio (BCR);
Net benefit investment ratio (N/K)
Note: Before embarking on the methods, it is important to note three critical points.
First, there is no one best technique for estimating project worth; each has its own strength &
weakness.
Second, the arithmetic of these methods, and the way we interpret the measures and their
limitations, is exactly the same whether we are using them for financial analysis or for
economic analysis.
Third, these financial and economic measures of investment worth are only tools of decision-
making, i.e., they are necessary conditions & are not sufficient condition for final decision.
There are many other non- quantitative and non-economic criteria for making final decision of
whether to accept or reject a project.
7.5. Non-discounted measures of project worth
I. Ranking by Inspection
It is possible, in certain cases, to determine by simple 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 financial results or profits in subsequent years. The investment with the
longer life in earning profit would be more desirable.
Example 1
Investment (Project) Initial cost Net cash profit per year Total profit
Year I Year II
A 10,000 10,000 - 10,000
B 10,000 10,000 1,100 11,100

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. Project B more desirable since longer life of earning.

Example 2

169
 WERABE UNIVERSITY Department of Economics

Investment (Project) Initial cost Net cash proceed per year Total proceed
Year I Year II
C 10,000 3,762 7,762 11,524
D 10,000 5,762 5,762 11,524

II. Simple Rate of Return Method (SRR) or Accounting rate of return (ARR):

The simple rate of return or ARR is the ratio of net benefit after depreciation and taxes in a normal
year to the initial investment in terms of fixed and working capital. Normal year is a representative year
in which capacity utilization is at technically maximum feasible level and debt repayment is still
underway. The return on total capital is computed by deducting/excluding interest from the net profit
and including loan capital in total capital invested. The simple rate of return can be expressed by the
following formula:
F Y F
R * 100or Re  * 100
I Q
Where,
R = Simple rate of return on total investment;
Re= Simple rate of return on equity capital;
F =Net profit (in normal year) after depreciation and taxes;
Y =Annual interest charges;
I = Total investment comprising of equity and debt; and;
Q = Equity capital invested.

Decision rule:
If R or Re is higher than the rate of interest (r) prevailing in the capital market, the project
can be considered as good and should be accepted. If R or Re < r, Reject the project.

In the case of choosing among several alternative projects, other things being equal, the one
with the highest rate of return either on total or equity investment should be selected for
implementation.

170
 WERABE UNIVERSITY Department of Economics

Example: If investment projects with a life of ten years are considered to reach full capacity in the
fourth year of operation and the integrated financial analysis table of the projects display the data (in
‗000 Birr) represent as follows:

Variables Symbol Project A Project B

Total initial investment I 500 800
Equity capital Q 250 500
Net profit after depreciation and taxes F 85 120
Net profit before interest F+Y 105 144

Then:
(1) Calculate the simple rate of return for both projects.

(2) Based on your answer in (1) are the projects good or not if they were to be evaluated alone?

(3) Which of the two projects should be selected for implementation if they were alternative
projects? Why?

Solution:
(1) The simple rate of return will be:

105 85
RA  x100  21% or ReA  x100  34%
500 250
144 120
RB  x100  18% or ReB  x100  24%
800 500
(2) If the projects are submitted at
different time and evaluated alone both are good because their R and Re are greater than the
prevailing rate of interest (r =8%) in the capital market and hence should be accepted both
project. The rate of interest is obtained by the following formula if not given.

(F  Y )  F 105  85 20 144  120 24

r x100  x100  x100  8% & x100  x100  8%
I Q 500  250 250 800  500 300

171
 WERABE UNIVERSITY Department of Economics

(3) Though both are good projects,

project A should be selected for implementation than project B because its rate of return on
investment or equity (21% or 34%) is higher than 18% or 24%.

Advantages of simple rate of return

(i) It is simple to calculate and considers accounting
benefits (profits) over the entire life of the project.

(ii) It helps to make quick assessment of investment

profitability, particularly for small projects with a short life.

(iii) It is based on accounting information, which is

readily available and familiar to the businessmen and facilitates post-audit of capital
expenditure.

Disadvantages simple rate of return

(I) It is based on one year‘s data and it may be
difficult to find the representative normal year in its computation

(II) Does not take into account (or ignores) the

time value of resources or money overtime

(III) It is based upon the accounting profit, not

cash flow

III. Payback Period (PBP)

The payback period is the length of time from the beginning of the project until the sum of net
incremental benefits of the project equal to total capital investment. It is the length of time that the
project requires to recover the investment cost. It is computed as
Initiall Investment Outlay
PBP 
Annual Cash Inflow

172
 WERABE UNIVERSITY Department of Economics

I
PBP  ; When the projected annual cash inflows (C) are uniform
C
When the projected annual cash flows are non-uniform. It is computed as

PBP =

Where I  initial investment outlay and Cn= annual cash inflow

PBP = Pay back periods expressed in number of years
Decision Rule:
Accept the project if the PBP is equal to or less than the predetermined cut-off PBP set by the
investor.
For competing projects, choose the one with quicker PBP.

Example: Assume the firm is considering two projects; project A and project B, each requires an
investment of $100 millions. The summary of expected net cash flows in millions given in the table
below.
Year
Cash inflow of A in Cash inflow of B in
millions millions
1 50 25
2 40 25
3 10 25
4 10 25
5 1 25
6 1 25
Then determine payback periods for project A and B and which project is preferred according to this
criterion.

Solution. First compute cumulative cash inflow

Year Cash inflow of Cumulative cash Cash inflow of Cumulative cash
A in millions inflow of A B inflow of B (capital
(capital recovery) recovery)

173
 WERABE UNIVERSITY Department of Economics

0 Birr (100)
1 50 50 25 25
2 40 90 25 50
3 10 100 25 75
4 10 110 25 100
5 1 111 25 125
6 1 112 25 150

I
Project B PBP  since they have uniform annual cash flow
C

Project A PBP = since they have non- uniform annual cash flow

PBPA ;

Fraction of a year (months) within which a project recovers its initial investment determined using the
formula:

Uncovered cost up to the beginning of the period/ Cash inflows during the period

Example: Cash flow of project A given in the table below

Year Cash inflow of Cumulative cash Cash inflow of Cumulative cash

A in millions inflow of A B inflow of B (capital
(capital recovery) recovery)
0 Birr (100)
1 50 50 25 25
2 40 90 25 50
3 30 120 25 75
4 10 130 25 100
5 1 131 25 125
6 1 132 25 150
Accordingly, the payback period for the project A is: $100-$90/$30= $10/$30=1/3. Thus, the payback
period for Project A: 2 and1/3 years (2.33 years). Project B has exactly 4 years payback period. If the
firm has the policy of employing three years payback period, project A will be accepted but project B
will be rejected.
Note: If yearly cost and benefit given the pay back periods (PBP) determined by cumulative cash inflow
of net benefit of the project.
Advantages PBP criterion:

174
 WERABE UNIVERSITY Department of Economics

1. It is simple, both in concept and application. It does not use difficult concepts and tedious
calculations and has few hidden assumption.

2. It is a rough and ready method for dealing with risk. It favors projects which generate substantial
cash inflows in the earlier years and discriminates against projects which bring substantial cash
inflow in the latter years but not in the earlier years. Now, if risk tends to increase with futurity-in
general, this may be true-the PBP criterion may be helpful in weeding out risky projects.

3. Since it emphasizes earlier cash inflow, it may be a sensible criterion when the firm is pressed
with problems of liquidity.

Limitations of the PBP

1. It fails to take into account (or ignores) the time value of money. Cash inflows, in the payback
calculation are simply added without suitable discounting. This violet the most basic principle of
financial analysis which stipulates that cash flows occurring at different time should be added or
subtracted only after suitable discounting.

2. It ignores cash flows beyond the payback period. This leads to discrimination against projects that
generate substantial cash inflow (wealth generation potential) in the later years.

The payback criterion prefers project A, which has a PBP of 3 years in comparison to project B with
PBP of 4 years, even though B has a substantial cash inflows in the 5th and 6th years.

3. It is a measure of the project‘s capital recovery, not profitability.

4. It discriminates against projects with long gestation/growth period.

Note: The undiscounted measures discussed are a common weakness. They fail to take into account
adequately the timing of benefits and costs. 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. So, to solve this problem advisable to us, discounted measures of project worth.

175
 WERABE UNIVERSITY Department of Economics

7.6. Discounted Measures of Project Worth

Introduction: Time value of money

The saying goes, a bird at hand is better than two birds in the bush!!!
Present values are better than the same values in the future and earlier returns are better than
later. This shows that money has time value. Thus, to include the time dimension in our project
evaluation, we have to use discounting methods. Discounting is essentially a technique that
‗reduces‘ future benefits and costs to their ‗present worth‘. It is present value of future money.
The rate used for discounting is called discount rate.
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.
It is future value of today‘s money. The difference between the two is the time view point; is
that compounding looks from present to future where as discounting looks from future to
present. Compounding methods uses interest rate to find the future values of for a given value
of money at the present. Discounting rate uses discounting rate to find the present value of
money earned in the future.

Note: 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 sometimes 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 firm‘s own fund is utilized the rate which banks
would pay on the deposit of such funds – their opportunity cost. 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 does 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.

176
 WERABE UNIVERSITY Department of Economics

The discount rate is a rate that reflects the opportunity cost of capital. It is the rate at which
streams of expected costs and benefits are discounted in estimating NPV and IRR. It is a
national parameter that should be determined by central authority of a government by
considering several conditions such as international borrowing, returns to past projects,
Commercial bank interest rates, and macro economic analysis.

The relationship between the present and future values can be expressed as:
n
 1 
PVt   FV  t 
t 1  (1  r ) 

Where, PV= Present value of future money

FV= Future values of today‘s money
r = the discounted rate or interest rate expressed as a fraction or percentage
t= is the year 1,2, 3,-----n and n is number of years
, is discounted factor (DF) for each year

Suppose a bank lends 1567.05 Birr for a project at 5% interest rate. The project owner is supposed to
repay the principal & interest rate after 5 years. How much the owner will have to pay at the end of year
5.
FVt -= P(1 + r) t
FVt = total amount after t years
r = interest rate
t = time
FV5 = 1567.05 (1 + 0.05)5
= 2000 B
Suppose again a project is expected to obtain 2000 Birr after 5 years. Value of this money today if
discount rate the same with interest rate can be calculated as:

FVt 2000
PV    1567.05
1  r t 1  0.055

177
 WERABE UNIVERSITY Department of Economics

Some of the main reasons people will prefer to have income now rather than in the future include the
following:
There is an expectation that society and individuals will be better off in the future than they are
now
One may expect inflation to reduce the real value of Birr 100 in a year‘s time
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
Uncertainty about the future
There are four distinct but inter-related measures of project worth based on discounted cost and benefit
streams. These are:
A. Net present value/NPV/
B. Internal rate of return/IRR/
C. Discounted benefit-cost ratio (BCR);
D. Net benefit investment ratio (N/K)
A. Net present value/NPV/
The NPV is defined as the difference between the present values of the future benefits and costs. It is
essentially a measure of the present value of aggregate surplus generated by the project over its expected
operating life. It is calculated by subtracting the present values of costs (PVC)2 from the present values
of benefits (PVB).
n n
NPV   PVB   PVC or
t 1 t 1
n n
Bt Ct
NPV    
t 1 (1  r ) t
t 1 (1  r )
t

Where, n is the life of the project

178
 WERABE UNIVERSITY Department of Economics

Decision Rule:
Accept the project if the NPV is positive, which implies that the net benefits will be created after
allowing for the required rate of return fixed principally to cover the cost of capital in financing or
opportunity cost of a sacrificed investment.
If the NPV is zero, is a marginal case and hence the decision may need to be informed by other
criteria particularly for public sector projects. If the net present value is zero it is a matter of
indifference.
Reject the project if the NPV is less than zero or negative because the project will not recover its
cost at the specified rate of discount.

Example 1: Calculate the NPV for the hypothetical XYZ project with discounted rate of 10% (all
figures in millions)
Year 1.Total 2.Discount 3.Present value 4.Total 5.Discount 6.Present value of
cost factor at 10% of costs (1*2) Revenues/Benefits factor at 10% Benefits (4*5)
1 140 0.9091 127.3 0.0 0.9091 0.0
2 65 0.8264 53.7 100 0.8264 82.6
3 95 0.7513 71.4 150 0.7513 112.7
4 95 0.6830 64.9 200 0.6830 136.6
5 75 0.6209 46.6 150 0.6209 93.1
6 55 0.5645 31.1 100 0.5645 56.5
PVC=395 PVB=481.5

For this project the NPV  481.5  395  86.5

If the information given is only cash flow like under pay back periods (PBP) instead of costs and
benefits then the formula for the NPV will be
n
CFt
NPV    initial investment
t 1 (1  r ) t
Where, CFt is cash inflow at the end of year t,
Example 2: Find the NPV for project X and Y discounted at 10% with four years lifetime if initial
investment cost is $1,000,000 and the project cash flow given in the table.
Project X Project Y
Year Cash Discount PV of cash Cash inflow Discount PV of cash
inflow factor inflow (2*3) factor inflow (4*5)
1 65,000 0.9091 59,091.5 35,000 0.9091 31,818.5
2 55,000 0.8264 45,452.0 45,000 0.8264 37,188.0
3 45,000 0.7513 33,808.5 55,000 0.7513 41,321.5
4 35,000 0.6830 23,905.0 65,000 0.6830 44395.0
 PV of cash  PV of cash
inflow inflow =154723
=162257

179
 WERABE UNIVERSITY Department of Economics

B. Internal rate of return (IRR)

This indicator measures the power of the project to generate return by comparing the result either with
opportunity cost of capital or the bank interest rate.

Internal Rate of Return (IRR) is that discount rate which just makes the net present value (NVP) of
the cash flow equal zero. In calculating the IRR, the discount rate is adjusted until the NPV becomes
zero or at least as close to zero as possible. IRR is the discount rate when NPW=0. It is the project
break-even point where the project could earn backs all the capital and operating costs expended on it.
The IRR concept is used both in financial and economic efficiency analysis to produce either an internal
financial rate of return (FRR), or an economic rate of return (ERR).

Σ (Bn - Cn ) / (1 + i)= 0 i.e. NVP = 0

The problem with this method is that the value of IRR can only be found by trial and error. Thus the rate
is derived by trial and error or interpolation. Interpolation is simply finding the intermediate value
between too discount rates we have chosen. The interpolation is could be done arithmetically using two
discount rates, one which gives a positive NPV and the other which gives a negative NPV. IRR is
expressed by the following formula.

  NPV1 
IRR  r1  (r2  r1 ) *  
  NPV1  NPV 2  

Where, r1 is the lower discount rate

r2 is the higher discount rate

NPV1 is NPV at the lower discount rate and

NPV2 is NPV at the higher discount rate. The IRR calculated in this manner is very close
to the true IRR.

Using the same example in table 6.2, it was found that NPV at 10% discount rate is 86.6 (second
method). Adopting a second trial discount rate of 32% the NPV is found to be negative at Birr 0.3.

Year 1.Total 2.Total 3. Net benefit 4. Discount 5.Net present

cost Revenues/Benefits (2 – 1) factor at 30% value/benefits (3*4)
1 140 0.0 -140 0.7692 -107.688

2 65 100 35 0.5917 20.7095

181
 WERABE UNIVERSITY Department of Economics

3 95 150 55 0.4551 25.0305

4 95 200 105 0.3501 36.7605

5 75 150 75 0.2693 20.1975

6 55 100 45 0.2072 9.324

Total NPV = 4.334

Now the net present value approach to negative, so to get the negative NPV trial again by introducing
other discount rate by increasing in 2%.

Note: r1 and r2 should not differ by more than 2% percent

Year 1.Total 2.Total 3. Net 4. Discount 5.Present value

cost Revenues/Benefits benefit (2 – factor at of Benefits
1) 32% (3*4)
1 140 0.0 -140 0.7576 -106.1
2 65 100 35 0.5739 20.1
3 95 150 55 0.4348 23.9
4 95 200 105 0.3294 34.6
5 75 150 75 0.2495 18.7
6 55 100 45 0.1890 8.5
Total NPV= -
0.3
The IRR therefore lies between 30% and 32%. Using the formula of IRR:

IRR = 30% +[(32% - 30%)*(4.334/(4.33 – (-0.3)))]

= 30% + [2% *(4.334/4.634)]

= 30% + [2% *0.9353]

=30% + 0.0187*100

= 30% + 1.9% = 31.9%

Decision rule:

 Accept the project if the IRR is greater than the discount rate or opportunity cost of
capital. For competing projects choose the one with the higher IRR.

 If IRR is equal to the discount rate, it indicates the project has no net return but will

182
 WERABE UNIVERSITY Department of Economics

recover the cost to be incurred. In other word the project is marginal/indifference.

 Reject the project with IRR less than the discount rate because it will not recover its
cost after allowing for the cost of capital.

Advantage of IRR:
The use of IRR as a measure of project worth has the following advantages.

It is more familiar concept and better understood by most people

It takes into account the value of resources overtime.
It considers the net benefit stream in its entirety.
It provides a measure of efficiency of the project in using capital.
The limitations of IRR include:

It does not distinguish between large and small investment and it does not tell anything about
the timing of the net benefits of the project.

It does not show Birr improvement in value of firm if a project is accepted

IRR can be affected by the scale (size) of the project, i.e., initial investment.
he value of IRR can only be found by trial and error
C. The discounted Benefit Cost (B/C) Ratio:

The benefit-cost ratio is defined as the ratio of the discounted values of benefits to the discounted value of
costs. A ratio of least one is required for acceptability and a B/c ratio of one indicates that the NPV of zero
at a particular discount rate. The formula for B/C ratio is expressed as:

PVB
Discounted B / C Ratio 
PVC

For the example illustrated in table 6.2 the B/C ratio is:

481.5
B / C Ratio   1.22
395

Decision rule:

 Accept the project if the B/C ratio is greater than one, which implies that NPV is

183
 WERABE UNIVERSITY Department of Economics

positive.

 B/C ratio equal to 1 implies that NPV is equal to zero, which is marginal/indifference

 Reject the project with B/C ratio less than one, implying the NPV is negative..

Advantage of B/C ratio:

The B/C ratio measures the value of benefits per Birr of expenditure; it is therefore a measure of
efficiency of converting costs into benefits.

The limitation are that in its simplest form it does not give a reliable means of ranking projects
particularly those that differ in capital intensity.

D. The net benefit to investment ratio (N/K):

This criterion is suitable and convenient for ranking projects especially when sufficient budget is not
available to implement all projects that satisfy other criteria. That is, two or more projects may all have
a positive NPV, IRR that exceeds the discount rate, both financial and economic discount rates, and a
benefit-cost ratio of greater than one. In this case, ranking could be made using net Benefit - investment
ratio. The decision rule using N/K is to accept project when the ratio is greater than. This can be
calculated as:

n
( Bt  Ct )
Net benefit - investment ratio =
t 1 (1  r ) t
n

I
t 1
(1  r ) t

Where - Bt Benefits, Ct = costs, I = investment cost, and r = discount rate

Thumb rule for selection of a project:

Pay Back Period should be minimum
Net Present Value should be positive
Benefit Cost Ratio more than one
Internal Rate of return more than the Bank rate of Interest
Net benefit-investment ratio (N/K) more than one.
7.7. Financial and Efficiency Ratios

184
 WERABE UNIVERSITY Department of Economics

From the projected financial statements for an enter prize, the financial analyst is able to
calculate financial ratios that allow him to form a judgment about the efficiency of the
enterprise and its credit worthiness. The figures appearing in the balance sheet, income
statement and the cash flows statements convey a considerable amount of information in terms
of their absolute values. In financial analysis it is usual to refer to several well known ratios that
facilitate the analysis and specially the comparison of projects and alternatives. The ratios that
are most frequently used in evaluating and assessing projects are:
7.7.1. Financial ratio
7.7.1.1. Income ratios

The long-term financial viability of an enterprise depends on the funds it can generate for reinvestment
and growth and on its ability to provide a satisfactory return on investment.
Return on sales
This shows how large an operating margin the enterprise has on its sales.
Net income
Return on sales =
revenue
Return on equity
It is an amount received by the owner of the equity. It is obtained by dividing the net income after taxes
by the equity. Equity - an ownership right or risk interest in an enterprise. Equity capital is the residual
amount left after deducting total liabilities (excluding stockholder's claim) from total assets.
Net income
Return on equity =
equity
This ratio is frequently used because it is one of the main criteria by which owners are guided in their
investment decisions.
Return on assets
Operating income
Return on assets =
Assets
The earning power of the assets of an enterprise is viral to its success. The return on assets is the
financial ratio that comes closest to the rate of return on all resources engaged. A crude rule of thumb is
this value should exceed interest rate.

185
 WERABE UNIVERSITY Department of Economics

7.7.1.2. Creditworthiness ratios

The purpose of creditworthiness ratios is to enable a judgment about the degree of financial risk inherent
in the enterprise before undertaking a project. It also helps to estimate the amount and terms finance
needed.
Current ratio
This is computed by dividing the current assets by the current liabilities. Though it needs caution, as a
rule of thumb, a current ratio of 2 is acceptable.
Current asset
Current 
Current liability

Debt-equity ratio
This is an important ratio for credit agencies. It is calculated by dividing long-term liabilities by the sum
of long-term liabilities plus equity to obtain the proportion that long-term liabilities are to total debt and
equity, and then by dividing equity to obtain the proportion that equity is of the total debt and equity.
These are then compared in the form of a ratio.
Equity
Equity Ratio 
Equity  Longterm liability
Longterm liability
Liability ratio =
Equity  Long term liability
LR
Debt - Equity Ratio 
ER
It tells us, of the total capital, how much proportion is equity & how much is debt. If for example we
have 40 to 60, it means that of the total capital 40% is debt and 60% is equity. In general strong equity
base is good for a project to overcome risk & uncertainty. Especially in some risky projects, high ratio is
a necessary condition.
Debt service coverage ratio
The most comprehensive ratio of creditworthiness is the debt service coverage ratio. This is calculated
by dividing net income plus depreciation plus interest paid by interest paid plus repayment of long-term
loans.
Net income  Depreciation  Interest
Debt service coverage ratio =
Interest  Loan repayment (Pr)
It tells us how a project can absorb only shocks without impairing the firm‘s ability of meeting
obligations. In contrary to this it can also tell us how the firm chose an appropriate credit term.

186
 WERABE UNIVERSITY Department of Economics

7.7.2. Efficiency ratios

Inventory turnover
This measures the number if times that an enterprise turns over its stock each year and indicates the
amount of inventory required to support a given level of sales. It can be computed as:
cos t of goods sold
Inventory turnover =
the inventory
The inventory turnover can also relate to the average length of time a firm keeps its inventory on hand.
A low ratio may mean that the company with large stocks on hand may find it difficult to sell its
product, and this may be an indicator that the management is not able to control its inventory
effectively. Thus a low ratio, though good, may indicate cash shortage & the firm might sometime be
forced to sell by forgoing sales opportunities.
Operating ratio
This is obtained by dividing the operating expenses by the revenue.
Operating expense
Operating ratio = (cost of raw material, labor, etc.)
revenue

187
 WERABE UNIVERSITY Department of Economics

Chapter Eight
8. Economic Analysis of Projects
8.1. An overview of economic analysis
Economic analysis is similar in form to financial analysis. Therefore, once financial or market
prices for costs and benefits have been determined in financial account, then the analyst
estimate the economic values by adjusting market prices for economic analysis. Financial
prices are, therefore, the starting point for economic analysis; they are adjusted as needed to
reflect the value to the society as a whole of both project inputs and outputs. Economic analysis
is an assessment of a project‘s costs and benefits from the national point of view and is
therefore concerned with the impact of a proposed project on the national economy. It can be
distinguished from financial analysis in that attention is not confined to the costs and benefits‘
affecting a single group, the focus of economic analysis is on the net return to society. In
economic analysis the most important question is whether or not the project under study is
beneficial to the national economy.
Economic analysis of projects involves comparing economic costs with economic benefits to
determine which among alternative project proposals have acceptable returns. The costs and
benefits of a proposed project must, therefore, be identified. Furthermore, once costs and
benefits are known, they must be priced, and their economic values determined. In economic
analysis, anything that reduces national income (or a wider definition of public welfare) is a
cost and anything that increases national income/welfare is a benefit. Economic analysis, called
Social Cost Benefit Analysis (SCBA) is a methodology developed for evaluating investment
projects from the point of view of the society (or concern) as a whole.
When the market price of any good or service is changed to make it more closely represent the
opportunity cost (the value of a good or service in its next best alternative use) to the society,
the new value assigned becomes the "shadow price" (sometimes referred to as an "accounting
price").
8.1.1. Purpose of Economic Analysis
Selection of alternatives: The main purpose of project economic analysis is to help design and

188
 WERABE UNIVERSITY Department of Economics

select projects that contribute most to the welfare of a country. A good economic analysis
inquires whether the project can be expected to create more net benefit to the economy than any
other known option for the use of the resources in the question
Identification of winners and losers: who enjoys the music? Who pays the piper? A good
project contributes to the country‘s economic output; hence it has the potential to make
everyone better off. Nevertheless, normally not everyone benefits, and someone may lose.
Moreover, groups that benefits from a project are not necessarily those that incur the costs of
the project. Identifying those who will gain, those who will pay and those will lose gives the
analyst insight into the incentives that various stake holders have to see that the project is
implemented as deigned.
Fiscal impact: How and to what extent will the costs of the project be recovered from its
beneficiaries? What changes in public expenditures and revenues will be attributable to the
project? What will be the net effect for the government?
Environmental impact: A very important difference between society‘s point of view and the
private point of view concerns costs (or benefits) attributable to the project but not reflected in
its cash flows. The effects of the project on the environment, both negative (costs) and positive
(benefits), should be taken into account and if possible, quantified and assigned a monetary
value. The impact of these costs and benefits on spearfish groups within socially be borne in
mind.
8.1.2. Rationale for SCBA:
The principal sources of discrepancy (between economic and financial costs and benefits) and
that necessitate economic analysis are:
a. Market imperfections: Market prices, which form the basis for competing the monetary
costs and benefits from the point of view of the project sponsor, reflect social values only
under conditions of perfect competition, which are rarely, if ever, realized in developing
countries. In other word, when imperfections exist market prices do not reflect social values.
The common market imperfections found in developing countries are:
 Rationing: Rationing of a commodity means control over price and distribution.
The price paid by a consumer under rationing is often significantly less than the
price that would prevail in a competitive market.

189
 WERABE UNIVERSITY Department of Economics

 Prescription of minimum wage rates: When minimum wage rates are

prescribed, the wages paid to labour are usually more than what the wage would be
in competitive labour market free from such wage legislations.
 Foreign exchange regulation: The official rates of foreign exchange in most
developing countries, which exercise close regulation over foreign exchange, is
typically less than the rate that would prevail in the absence of foreign exchange
regulation. This is why foreign exchange usually commands a premium in unofficial
transaction (black or parallel market premium).
b. Externalities (spillover effects): Externalities are costs or benefits caused by a project for
which there is no corresponding payment or compensation. In other words externalities are
costs or benefits, which are felt outside the project but not included in that project‘s valuation.
A project may have beneficial external effect. The basic principle involved in dealing with
externalities is to measure and value effects as far as possible and then include these costs and
benefits in the economic analysis. This process is known as ‗internalizing the externalities‖3.
Following the above principles, negative externalities (external costs) and positive externalities
(external benefits) can be measured, valued, and included in streams of project cost and
benefits.
c. Public goods: There are also goods/services that the private sector is either does not have
interest to deliver them or will expensive to the majority population in LDCs if they deliver
them. Such goods/services to lager extent are supplied by the government and hence are called
public goods. Examples include bridges, asphalt roads, streetlight, securer or police protection,
defense etc. In developed countries there are roads owned by the private sector, where anyone
in need of to use these bridges and roads will be charged a specific rate in tool booths. This
implies that these private bridges and roads exclude those who are not able and willing to pay.
Similarly, today providing personal and property protection services by private sectors are
common in developed countries and some LDCs. Therefore, LDCs are very much concerned
whether the bridges and roads (could be asphalt or gravel road) to be constructed and streetlight
to be installed by development projects will also benefits or do not exclude and the security

190
 WERABE UNIVERSITY Department of Economics

service to be hired for the projects also add value to the security of people living in and around
the project site.
d. Taxes and subsidies: From the private point of view, taxes are defined monetary cost and
subsidies are monetary gain. From the social point of view, however, taxes and subsidies are
regarded as transfer payments and hence considered as irrelevant.
e. Concern for income redistribution: A private firm does not bother how benefits are
distributed across various groups in the society. The society, however, is concerned about the
distribution of benefits across different groups. A Birr of benefit going to an economically poor
section of the society is considered more valuable than a Birr of benefit going to an affluent
section.
f. Merit wants: Goals and preferences not available in the market place but believed by policy
makers to be in the large interest are referred as merit wants. For example, even though they are
not sought by consumers in market places the government may prefer to promote adult
education program or a balanced nutrition program for school-going children. While merit
wants are not relevant from the private point of view, they are important from the social point
of view.
8.2. Identification costs and benefits of economic analysis
The projected financial revenues and costs are often a good starting point for identifying
economic benefits and costs, but two types of adjustments are necessary.
 First, it is necessary to include (or exclude) some costs and benefits.
 Second, it is necessary to revalue inputs and outputs at their social opportunity costs
8.2.1. Costs included or excluded in economic analysis
a. Direct transfer payments

Some entries in financial accounts really represents shifts in claims to goods and services from
one entity in the society to another and do not reflect changes in national income. The term
‗direct transfer payment‘ is used to identify payment that show up directly in the project
accounts but that do not affect the national income account. Common transfer payments in
projects cost are: taxes, subsidies and debt services (the payment of interest and repayment
of principal).

191
 WERABE UNIVERSITY Department of Economics

Taxes: Payment of taxes is clearly cost in financial analysis. When a firm pays a tax, its net
benefit is reduced. But the firm‘s payment of tax doesn‘t reduce the national income. Rather it
transfers 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 investment) had the firm retained the amount of the tax. Thus, in economic
analysis we would not treat the payment of taxes as a cost in project accounts.
Debt service: debt services are the major form of direct transfer payment in projects. From the
standpoint of the project owner, receipt of a loan increases the production resources he has;
payment of interest and repayment of principal reduce them. But from the standpoint of the
economy, these are merely transfers of control over resources from the lender to the borrower.
A loan represents the transfer of a claim to real resources from the lender to the borrower.
When the borrower pays interest or repays the principal, he is transferring the claim to the real
resources back to the lender— but neither the loan nor the repayment represents, in itself, use
of the resources.
Generally the major reason for excluding transfer payment from economic analysis is that does
not entail a use of resources, but only a transfer of resources from the payer to the payee.

b. Costs of inputs
Includes: Cost of physical goods (raw materials), Labor, Land, etc.
Note: Included both in financial and economic analysis. Butin financial analysis find the market price to
estimate the cost whereas in economic analysis need to adjust to efficiency price.
c. Contingency allowance: 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
costs. Physical contingencies represent expected real costs and, unlike price contingencies, are
included in project economic costs in project economic analysis
d. Sunk (irrecoverable) costs: Sunk costs are those costs incurred in the past upon which a proposed
new investment will be based. Such costs cannot be avoided however, poorly advised they may have
been. When we analyze proposed investment, we consider only future returns to future costs;
expenditures in the past, or sunk costs do not appear in both financial and economic analysis. For both
financial and economic analysis, bygones are bygones.
e. Secondary/Intangible costs: Almost all projects have costs that are intangible. These may

192
 WERABE UNIVERSITY Department of Economics

include displace workers, increase disease incidences, increase regional income inequality,
destroy or reduce the scenic beauty of an area, etc. All these are intangible costs of the project,
which are not captured by or not reflected in the market prices. All these intangible costs must
be carefully identified and where possible, be quantified. These costs usually excluded from
financial analysis. However, they should be included in the economic analysis at least in
qualitative terms if they are significant and not measurable. Whether or not externalities are
quantified, they should at least be discussed in qualitative terms.
Example: Negative Externalities: A project may have a negative impact on specific groups in
society without the project entity incurring a corresponding monetary cost (or enjoying a
monetary benefit). For example, an irrigation project may lead to reduced fish catch. The
reduction in fish catch would represent a cost to society that would be borne by fishermen, yet
it would not be reflected necessarily in the monetary flows of the project entity. These external
effects, known as ―externalities,‖ need to be considered when adjusting financial flows to
reflect economic costs.
8.2.2. Benefits included or excluded in economic analysis
a. 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
b. Intangible Benefits: Almost all projects have costs and benefits that are intangible. These
may include creation of job opportunities, better health and reduced infant mortality, better
nutrition, reduced incidence of disease, national integration, national security, etc. Similar to

193
 WERABE UNIVERSITY Department of Economics

intangible cost intangible benefit excluded from financial analysis. However, they should be
included in the economic analysis at least in qualitative terms if they are significant and not
measurable.
Example: Positive externalities: A project may have a positive impact on specific groups in
society without the project entity incurring a corresponding monetary cost (or enjoying a
monetary benefit). So positive externalities included as benefit in economic analysis
c. Subsidies: Subsidies are taxes in reverse and for purposes of economic analysis should be
removed from the receipts of the projects. From society‘s point of view, subsidies are transfers
that shift control over resources from the giver to the recipient, but they do not represent a use
of resources. The resources needed to produce an input (or import it from abroad) represent the
input‘s true cost to society. For this reason, economic analysis uses the full cost of goods, not
the subsidized price.
8.3. Determining economic values/costs
In determining economic values of the project, need to make adjustment financial prices to
economic value in order to investigate the contribution of the project to the national economy.
Economic pricing involves making adjustments to market prices to correct for distortions
and to take in to account consumer‟s and producer‟s surplus. The adjusted price should
then reflect:
the true opportunity cost of an input or output
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. Thus the
economic analysis of projects requires that inputs and outputs valued at their contribution to
the national economy, through economic prices, or alternatively called as ‗accounting prices,
efficiency prices, shadow prices‟.
 Economic or shadow pricing:
Market prices represent shadow prices only under conditions of perfect competition, which are
almost invariably not fulfilled in developing shadow prices. Hence, there is a need for
developing shadow prices and measuring net economic benefits of goods/services in terms of
these prices to guide the allocation of resources.

194
 WERABE UNIVERSITY Department of Economics

Economic or shadow pricing is the price that reflects the true price or true opportunity costs of
goods. It is a set of prices that are believed to reflect better the opportunity cost i.e. the value in
their next best alternative use of different goods and services. These prices are used instead of
domestic market prices in guiding the allocation of resources. The role of shadow prices is thus
to guide efficient resource allocation to achieve improved economic efficiency and it ends
there.
8.3.1. Approaches to measuring economic costs and benefits
Once we have information successive adjustment to value different costs and benefits of the
projects in terms of opportunity costs, the remaining factors are the foreign change and
domestic resources adjustment. In this regards there are alternatives approaches, UNIDO and
Liittle- Mirless (L-M).
8.3.1.1. UNIDO Approach
In this method economic benefits & costs may be measured at domestic prices using
consumption as the numiraire, with adjustment made for divergence between market prices and
economic values, and making domestic and foreign resources comparable using shadow
exchange rate (SER). In this method, if commodities are traded, first all these traded goods will
be adjusted for any distortions in the domestic markets. After this adjustment is made the
adjusted domestic price will be multiplied by SER to make domestic resources be comparable
with foreign resources. But if the goods is non-traded goods, the analyst use the market prices if
the market price reflect the economic values or not distortion. If the market prices distorted
adjust for any distortion by finding the true opportunity cost through using marginal social cost
(MSC) and marginal social benefit (MSB) or willingness to pay. To use UNIDO approach in
economic pricing of specific resources need to give consideration for: Numerair, Shadow
exchange rate and sources of economic price.

a. Numeraire means the unit of account in which the value of inputs and outputs expressed.
In this approach economic benefit and costs may be measured at domestic prices using
consumption as numeraire. This means economic prices are determined in terms of
consumption scarified or consumption gained by the public at large due to the project.

195
 WERABE UNIVERSITY Department of Economics

b. Sources of economic prices: The UNIDO approach suggested three sources of economic
or shadow pricing , depending of the project impact on the national economy
If the impact of the project is on consumption on the economy, the bases for
economic pricing is the consumer willingness to pay
If the impact of the project is on production on the economy, the bases for
economic pricing are the cost of production at the margin.
If the impact of the project is on international trade, increases in export or
import or decreases in export or import
c. Shadow exchange rate
Shadow exchange rate: is the rate used to convert world prices to equivalent domestic prices.
According to UNIDO approach the easiest way for adjusting domestic market distortions is to
use border prices, c.i.f., for imports and f.o.b. for exports and then multiply this border price
expressed in foreign currency by SER to arrive at economic border prices. Whenever serious
trade distortions are present, border prices need to be converted into domestic currency
equivalents using a shadow exchange rate, not the official or market exchange rate. A shadow
exchange rate is appropriate even if there are no balance-of-payments problems, or if the
official exchange rate is allowed to adjust freely. The relevant question is whether there are
trade distortions. In general, the shadow exchange rate equals the market (or official) exchange
rate only if all trade distortions, such as import duties and export subsidies, are eliminated.
Because most countries impose import duties and some grant export subsidies, it is generally
good practice to adjust the market exchange or official exchange rate for these distortions. But,
if the commodities are non-traded and if the market prices are good estimates of opportunity
cost or willingness to pay, we directly take the market price as economic value of the item. But
if the prices of non-traded items (goods and services or factors of production) are distorted, we
will adjust the market price to eliminate distortions and then use these estimates of opportunity
cost as the shadow price to be entered in the economic analysis. The derivation is a follows:
Pd
SER 
Pw
Where Pd - domestic price

196
 WERABE UNIVERSITY Department of Economics

Pw - world price in foreign currency

To derive an average and representative, estimates of SER that can be applied across all
traded goods, we need to take the weighted mean of relative value of all imported & exported
goods. Thus:
n
P 
SER   f i  di 
i 1  Pwi 
f i - the weight of the ith good

8.3.1.2. Little-Mirrlees (L-M) approach

The objectives of economic analysis in this approach, is to make sure that the society obtains
projects output at a prices not higher than the world market prices. In this approach benefits and
costs may be measured at world price to reflect the true opportunity cost of outputs and inputs
using public saving measured in foreign exchange as the numéraire (that is, converting
everything into its foreign exchange equivalent). The fact that foreign exchange is taken as a
numéraire does not mean that project accounts are necessarily expressed in foreign currency.
The unit of account can remain the domestic currency, but the values recorded are the foreign
exchange equivalent that is, how much net foreign exchange is earned.
If the project produces say import items to substitute imports, we need to make sure that the
project can supply the products to the society at a price lower or equal to the world market
prices. This is because, the opportunity cost, for the society, of producing the items
domestically is the amount the society would have paid to import the product. To use the L-M
approach need to give consideration for: Choice of Numeraire and sources of economic prices.
a. Numeraire :using public saving measured in foreign exchange (world price) as numéraire
b. Sources of economic prices:
If the world price is used, the economic price at which to value a project output are
its export prices if it adds to exports or its import prices if domestic production leads
to a saving in import.
Similarly, on the cost side, the price at which to value a project input is its import
prices if it has to be imported or export price if reduction in export.
Traded goods = world prices *OER

197
 WERABE UNIVERSITY Department of Economics

But if the goods in question is non- traded goods, the analyst use to standard
conversion factors (SCF) to translated domestic prices in to their border prices
equivalent after adjustment for any market price distortion.
A standard conversation factor (SCF) is the ratio of the economic (shadow) price to the market
price, that is:
Economic price
SCF =
Market price
So the economic price for a non-traded good is its market price multiplied by the conversion
factor. How are conversion factors derived? The true cost of any good is its marginal cost to
society. In principle, to find the world price of non-traded goods, each good could be
decomposed into its traded and non-traded components in successive rounds - backwards
through the chain of production. In practice, however, it is not feasible to differentiate
conversion factors between all non-traded goods and only special outputs (and inputs) are
treated this way because the procedure is difficult, time consuming and costly. Shortcuts are,
therefore, needed that provide a reasonable approximation. In essence, all the shortcuts involve
some degree of averaging for a group of non-traded items and, therefore, some degree of error
if average or standard conversion factor is applied to a particular non traded good rather than its
own specific conversion factor. The derivation is as follows:
SCF .Pd  Pw .OER

Pw OER 
SCF 
Pd
Where Pd = domestic price in domestic currency
Pw = world price foreign currency
OER = official exchange rate
SCF = standard conversion factor
1
SCF 
Pd
Pw OER 

Pd
is the shadow exchange rate i.e., the price of goods in domestic currency relative to their
Pw

198
 WERABE UNIVERSITY Department of Economics

world prices

Net Present Value (NPV) = OER (X-M) - SCF.D

Where -OER- official exchange rate
X- exported goods in foreign currency
M- imported goods in foreign currency
SCF- standard conversation factor
D- price of non-traded goods in domestic currency
Differences between the two approaches
a. The UNIDO approach
measures cost and benefits in terms of local price whereas the L-M measures cost and
benefits in terms of international prices (also referred as boarder prices)
b. The UNIDO approach
use SER SER to arrive at economic border prices whereas the L-M OER and SCF
c. The stage-by-stage
analysis recommended by the UNIDO approach focuses on efficiency, savings, and
redistribution consideration in different stages. The L-M approach, however, tends to
view these considerations together.
Similarities between the two approaches:
Both divided items in to traded and non traded
Both uses border prices to value the traded goods
Both adjust market prices of non tradable items in to economic prices using MC, MR and
WTP
8.3.2. Essential issues considered in determining economic values/costs
Step 1. Adjustment for direct transfer payments
Step 2. Adjustment for price distortions in traded goods
Step 3. Adjustment for price distortion for non-traded goods
Step 4.Extend the boundary of the project to include all linkage effects and externalities for
instance environmental effects

199
 WERABE UNIVERSITY Department of Economics

Step 1. Adjustment for direct transfer payments: The first step in adjusting financial prices to economic
values is eliminating direct transfer payments. Transfer payments such as taxes, direct subsidies, credit
transactions loans, repayments of principals, and interest payments. All these entries should be taken out
should be omitted in determining economic value.

Step 2. Adjustment for price distortions in traded goods

In almost all projects many of the inputs and outputs will be traded goods. Tradable goods are
those goods for which the economic/opportunity/costs or benefits derived from their use or creation
is determined by their international price.
In other words, traded items are those for which
 If Exports: F.O.B price is greater than domestic cost of production, or
 Items exported through government intervention by use of export subsidies and the like, or

 If Imports: C.I.F price less than domestic cost of production.

Determining the economic value of tradable (Valuation of Tradable) goods:

The major causes for the differences between the economic value of traded goods and their
domestic market prices are due to the incidence of taxes on trade (these are removed to derive
economic values) and the extent to which the economic value of foreign exchange exceeds its
market price value (i.e. the level of the shadow exchange rate). Therefore, for tradable the
international price is the measure of its opportunity cost to the country. The reason is that for
tradable goods it is possible to substitute imports for domestic production and vice versa; similarly
it is possible to substitute exports for domestic consumption and vice versa. Hence, the
international price, also referred to as the boarder price, represents the ‗real‘ value of the good in
terms of economic efficiency.

The economic value of a traded item either export or import at the farm gate or project boundary is
its economic export or import parity value. The methods for driving economic export or import
parity value are the same with financial export or import parity value. The only difference here is
the use of either UNIDO or Little –Mirlees (L-M) approach.
Example: A project produces flower to export it to Canada. The project boundary is at Bishoftu.
The official exchange rate (OER) is 20 birr = $1, the shadow exchange rate (SER) 21 Birr = $1 and

200
 WERABE UNIVERSITY Department of Economics

standard conversion factors (SCF) 0.95238. In this case we start with the C.i.f. price at the
importing country, Canada. The export parity price may be derived as follows.
Economic export parity price determination
Steps in calculation Using UNIDO Using L-M
C.i.f. at the point of import (say, Canada port)
$60 $60
Deduct -Unloading cost at the point of import $3 $3
Deduct- freight (shipment) to the point of import $15 $15
Deduct - insurance charge $10 $10
Equals f.o.b. at point of export (Addis Ababa Air port) $32 $32
Convert foreign currency to domestic currency $32*SER= Birr $32*OER= Birr
Deduct- local port charge (port handling cost) at their 672 640
economic prices Birr 15 Birr
15*SCF=14.29
Deduct- local transport and marketing cost from project
site to the point of export ( from Bishoftu to Addis Ababa Birr 5
Air port) at their EP Birr 5*SCF= 4.77
Equals export parity price at project boundary ( at
Bishoftu) Birr 652
Birr 620.94
Deduct – local storage, transport and marketing cost ( if Birr 7
not part of project cost) Birr 7*SCF= 6.67
Equal export parity price at the project sit (farm gate) Birr 645
Birr 614.27

Similarly, a parallel computation leads to the import parity price. For example, a project uses
imported inputs, say fertilizer import from Canada. The project boundary is at Bishoftu. The
official exchange rate (OER) is 20 birr = $1, the shadow exchange rate (SER) 21 Birr = $1 and
standard conversion factors (SCF) 0.95238. In this case start with f.o.b. price at exporting
country, Canada. Then import parity price is:

Economic import parity price determination

Steps in calculation Using UNIDO Using L-M
F.o.b. price at point of export (say, Canada port) $116 $116
Add -Unloading cost at the point of import $30 $30

201
 WERABE UNIVERSITY Department of Economics

Add- freight (shipment) to the point of import $10 $10

Add - insurance charges $20 $20
Equals C.i.f. price at point of import (Addis Ababa Air $176 $176
port)
$176*SER=Birr $176*OER = Birr
Convert foreign currency to domestic currency at OER 3696 3520
Add- local port charge (port handling cost) at their Birr 20 Birr 20*SCF=Birr
economic prices 19.06
Add- local transport and marketing cost from project Birr 30
site to the point of export ( from Bishoftu to Addis Birr 30*SCF =Birr
Ababa Air port) 28.59
Equals import parity price at project boundary ( at Birr 3746
Bishoftu)
Birr 3472.32
Add – local storage, transport and marketing cost ( if Birr 10
not part of project cost)
Birr 3756
Equal Import parity price at the project sit (farm gate) Birr 10*SCF = 9.53
Birr 3462.79

Step 3. Adjustment for price distortion for non-traded goods

Non-tradable inputs and outputs: A good is regarded as non-tradable when one or more of the
following conditions are satisfied.
If its import price (C.I.F price) is greater than its domestic cost of production and
domestic cost of production is greater than its export price (F.O.B price) or simply C.I.F
> DCP > FOB.
If it is not traded because of government intervention by means of import bans or
quotas.
If it is not traded either because of its nature (bulkiness) or it is not economical to do so.
A good might also be regarded as non-traded despite being traded if its external DD (for
export) or external SS (for import) could be regarded as fixed.

Valuation of Non-tradable commodities

If the market price reflects the economic values or not distortion use the market price directly to
determine the economic values of the commodity. But if the prices of non-traded items (goods and
services or factors of production) are distorted, we will adjust the market price to eliminate

202
 WERABE UNIVERSITY Department of Economics

distortions and then use these estimates of opportunity cost as the shadow price to be entered in
the economic analysis.

Some goods and services such as land, building, transportation, and electricity are not amenable to
foreign trade. Hence, there is no boarder price for them. Economic prices for non-traded items are
defined in terms of marginal social cost (MSC) and marginal social benefit (MSB) or willingness
to pay (WTP). The marginal social cost of a good is the value in terms of accounting prices of the
resources required to produce an extra unit of the good. The value of a non-traded good thus
should be measured in terms of what domestic consumers are willing to pay; if the output of the
project adds to its domestic supplies or if the requirement of the project causes reduction of its
consumption by others. In other words, the value of a non-traded good should be measured in
terms of its marginal cost production if the requirement of the project induces additional
production or if the output of the project causes reduction of production by other units.
Step 4.Valuing Externalities
Externalities are real costs and benefits attributable to the project. The external benefits and costs
that directly affect - either positively or negatively - the production level, the consumption level,
the price level, the costs of production, etc. can be valued with minor difficulties. Some of these
can even be captured when market prices are adjusted into economic prices.

The financial costs of the project will not include the costs of the externality and hence an
evaluation of the project based on private marginal cost (PMC) will understate the social costs of
the project & overstates its net benefits. In principle, all we need to do to account for the externality
is to work with social rather than private costs. In practice, the measurement difficulties are
tremendous because often the shape of social marginal cost (SMC) curve, & hence its relationship
to PMC curve, is unknown.

Sometimes a project uses resources without paying for them. For example a factory may emit soot
that dirties surrounding buildings, increasing their maintenance costs. The higher maintenance
costs are direct result of the factory‘s use of a resource, air, that from its points of view is free but
that has a cost to society. Likewise, a new irrigation project may lead to reduced fish catch or the
spread of a disease. Sometimes a project makes certain groups better off but the nature of the
benefits is such that the project entity cannot extract a monetary payment from them. These effects

203
 WERABE UNIVERSITY Department of Economics

This and the next method are basically statically technique, which use multiple regression
analysis to 'teas out' the environmental component of value in a related market. The regression
equations allow the analyst to separate out the relationship between property values and
pollution. This relationship can then be used to produce a willingness to pay for pollution
reduction.

Avoidance expenditures: These are expenditures that are designed to reduce the damage
caused by pollution by taking some kind of averting or defensive action. An example would be
to install indoor air purifiers in response to an influx of polluted air or to rely on bottled water
as a response to the pollution of local drinking water supplies, buying ‗tents‘ to protect oneself
from mosquito causing malaria, etc. Since people would not normally spend more to prevent a
problem than would be caused by the problem itself averting expenditures can provide a lower
bound estimate of the damage caused by pollution.

205