Economic Analysis of Projects

Economic Analysis of Projects – Dr. Basil Perera

 Summary

 

Introduction

• Public policy is implemented through programmes consisting of projects.
• Projects are identified as the building blocks of development.
• The objective of every project is to achieve an economic return greater than what is spent for project construction and operation.
• The best tool to use to determine to asses benefits over cost is economic analysis.

The Concept of Economic Analysis

• In the context of public projects it has been said that "economic analysis attempts to address the requirements of the economy in general."
• A development project subscribes in various ways to the country's economy. 
• It may promote poverty reduction, employment generation, rural development, foreign exchange earnings, reducing disparities between social groups and regions etc.

Financial Terms Vs Economic Terms

• Sometimes an investment might not be profitable in financial terms, but may be rewarding in economic terms. 
• Financial terms are the aspects of a project as seen by an investor in the project who is interested in only that project. Economic terms are the aspects of the project as seen from the point of view of the whole economy.
• Assessment in an economic analysis is by determining the real impact of the project on the economy.  In a financial analysis, it is assessed on the basis of market prices.
• However, market prices do not reflect real costs and benefits to the economy as a whole. This could happen due to a number of reasons:
• Market value is subject to taxes and subsidies therefore do not give an accurate picture of the actual value.
• Some commodities cannot be assigned market prices (e.g. defence and infra-structure services)
• External effects that cannot be included within the project cash flow.
• Price distortion due to structural rigidities in the economy.
• Price distortion due to existence of sub-optimal rate of investment.
• Therefore instead of market prices, shadow prices are used

Shadow Prices

• Shadow prices are the values we get when we adjust the financial prices of the inputs and outputs of a project to reflect the value to the society as a whole. 
• The estimation of these shadow prices varies according to the implicit objectives of the analysis. 
• The values used in economic analysis with the objective of maximizing national income are identified as efficiency prices.
• In practice efficiency prices are estimated on the basis of an approximate approach. Under this approach, efficiency cost reflects the opportunity cost of goods or services.

(Opportunity cost – value of good or service in its next best alternative use)

• However, for most final goods and services the concept of opportunity cost is not applicable, as they are meant for consumption. Thus it is the consumption value that sets their economic value.  This is the value in use or willingness to pay.

Valuing Project Items

• In economic analysis of projects, one needs to value individual project items.
• Various economic concepts are used in order to arrive at the value of project items.
• Foreign exchange premium is used to compare values of traded and non-traded goods.

(Traded goods – imported items of which domestic cost of production is less than their f.o.b. price)

Non-traded goods – any item for which domestic cost of production is lower than the c.i.f. price and higher than the f.o.b. price

c.i.f. – cost + insurance + freight i.e. excluding any import duties etc at point of discharge.

f.o.b. –free on board i.e. the price of an exported good when it is leaving the country of origin with all costs up to and including loading on board ship but excluding freight and insurance )

• Application of foreign exchange premium can be done in two ways:
• By multiplying the official exchange rate by the foreign exchange premium to result in a shadow price exchange rate. 
• By reducing the domestic currency values of non-traded goods/services by an amount sufficient to reflect the premium.
• Generally, the cost to the economy of foreign goods is more than what is obtained by converting the import price to SL rupees at the official rate of exchange.
• As a measurement of this difference, the Planning Agency of a country usually works out a ‘foreign exchange premium.
• The official rate of exchange with the foreign exchange premium added becomes the ‘shadow foreign exchange rate.
• This rate is used only for the purpose of analysis. You cannot use it for transactions. You cannot demand an imported good at the shadow foreign exchange rate.
• Economic value of financial prices can be obtained by deleting all direct transfer payments (e.g. taxes, subsidies, credit transactions, etc.)  from the financial statement.
• To obtain the economic value of traded items, you need to adjust its border price (i.e. c.i.f. price or f.o.b. price) to include domestic transport and other costs between the project site and the border point.
• Normally domestic price is used as an estimation of economic value of non-traded items.
• In cases where the project itself affects the market prices (i.e. there is a difference in market prices with and without the project), the differences must be taken into account when determining the economic value of non-traded items.
• The economic value primary factors (e.g. labour, land and capital) are estimated from their opportunity costs.
• The following examples illustrate how opportunity costs can be used to derive economic values of primary factors:
• The economic value of labour can be estimated on the basis of the value of production lost by shifting the labour from its alternative occupation (this can vary according to the category of labour and the geographical origin of labour).
• The economic value of land can be decided by estimating the economic surplus lost by not investing it in the best investment available on the market.
• The validity of the results of an economic analysis of a project depends on the level of accuracy with which the following component steps of the process of economic analysis are carried out.
• Identification of all the significant costs and benefits of the proposed project during its total life period,
• Estimation of economic value of each of the identified costs and benefits,
• Developing the correct economic cash flow of all the identified costs and benefits, and
• Applying appropriate tools of economic analysis to the cash flow.

Process of Determining Economic Values

• Step one: separation of project items into tangibles and intangibles.

Intangibles (e.g. roads, health social services, education etc.) are extracted out and are listed separately, without valuing.

• Step two: separation of tangibles into direct transfer payments and other tangible items.

All direct transfer payments have to be omitted from the list.

• Step three: separation of the remaining tangible items into traded and non-traded items.
• Once this is done economic values can be assessed and if followed accurately, the above process will result in a comprehensive list of economic values of all the significant items of the proposed project.

Preparation of an Economic Cash Flow

• Once the economic values of all potential project items have been identified, they can be put into a time schedule, which would give the time table for incurring the potential economic costs and achieving the potential economic benefits, within the total project life.  This is called an economic cash flow.
• The last step of economic analysis is to apply tools of economic analysis to the cash flow.

Tools and Techniques of Economic analysis

• There are two basic objectives of project analysis: 

1. To decide whether a proposed project would be economically rewarding so that it would give a net economic benefit during its project life. 
2. To decide between alternatives on the basis of maximum economic benefit. 
• Various techniques of economic analysis are used to achieve these objectives.

Measures of project economic worth

• The purpose of estimating the project economic worth is to get an indication of the economic profitability of a proposed project. 
• There are two approaches to measure economic worth;
• undiscounted measures
• discounted measures 

• Undiscounted measures of project worth

o   Total net benefits: bigger the benefits the better the project

o   Pay back period: shorter the period, better the project.

o   Rate of return: This can be calculated as the ratio between, average annual net benefits to total investment cost.

o   The pay back period techniques has a major limitation in that it does not take into consideration any benefits received after the repayment  the initial investment

o   The rate of return technique is biased towards projects with a very short life but with a high annual net benefit.

o   Discounted methods of project worth

o   Discounting is a technique that enables project analysts to compare costs and benefits incurred in different time periods on a common basis. 

o   Discount factors are taken directly from discount factor tables.  These are tables available for use like multiplication tables and log tables.  They give discount factors for different rates of interest for different time periods. 

o   There are 3 distinct discounted methods:

§  Net Present Value (NPV)

§  Internal Rate of Return (IRR)

§  Benefit-Cost Ratio (B/C Ratio)

o   All three measures require an annual economic cash flow statement, which gives the economic values of costs and benefits on a year by year basis for the total life of the proposed project.

o   NPV: is calculated by:

§  For each year, subtract the costs from benefits and thus find the net benefit.

§  Multiply the net benefit value for each year by the relevant discount factor (i.e., based on market interest rate and the year). Obtain this discount factor from discount factor tables (i.e the easy way, without calculating it using the formula).  The result is the present value of each annual figure.

§  Add all present values to get the NPV.

o   IRR:

§  Internal rate of return is the discount rate which makes the present value of net benefits equal to zero (NPV = 0)

§  It is calculated in exactly the same way as the NPV.

§  Computer software (e.g. Microsoft Excell) can calculate IRR when provided with necessary data.

o   B/C Ratio:

§  This is obtained simply by dividing discounted benefits by discounted cost.

Use of Above Measures of Project Worth in the Economic Analysis of Projects

• NPV    -           All projects with a positive NPV when discounted at a rate reflecting the economic cost of capital is acceptable.

• IRR     -All projects with an IRR greater than the economic cost of capital are acceptable.

• B/C Ratio        -All projects with a B/C ratio greater than one when discounted at a rate reflecting the economic cost of capital are acceptable.

Dealing with Intangible Items

• The economic analysis of projects could produce a significant amount of intangible benefits.
• In such cases the techniques of cost effectiveness analysis are applicable. 
• There are two methods of cost effectiveness analysis:

o   The constant effect method

o   The constant cost method

o   These methods of cost effectiveness analysis could effectively be applied in the economic analysis of service oriented projected in areas such as rural electrification, road development, public health improvement etc.