Chapter 4: Identifying Project Costs and

Benefits & Financial Analysis

Prepared by: Abdi Shakur M. Hussein Elmi

This chapter focuses on how to evaluate the financial aspects of a project, including
identifying costs, benefits, investment analysis, and financial ratios. It explains methods used
in financial analysis to determine whether a project is financially viable and how to classify
different project costs.

1. What is Financial Analysis & When is it Required?

✅ Definition

Financial analysis is the assessment and evaluation of:

 Project inputs (capital, labor, raw materials, etc.).

 Project outputs (products, services, revenues).
 Future net benefits (profits or financial returns).

📌 Objective: Determine whether a project is financially viable for a private investor or public
entity.

✅ Key Components of Financial Analysis

1. Investment Profitability Analysis

o Measures the return on investment.
o Uses discounted (Net Present Value, IRR) and non-discounted techniques
(Payback Period, Simple Rate of Return).
2. Financial Ratio Analysis
o Examines liquidity, capital structure, and financial stability.
o Ensures the project has enough funds to operate smoothly.

📌 Why is Financial Analysis Important?

 Determines financial profitability of a project.

 Provides the foundation for economic analysis.
 Helps make informed investment decisions.
2. Identifying & Analyzing Project Costs & Benefits
✅ Steps in Identifying Costs & Benefits

1. Define cost and benefit variables.

2. Identify sources of financial information.
3. Collect and assess the quality of data.

📌 Key Principle: A cost is anything that reduces an objective, while a benefit contributes to it.

📌 Different Stakeholders Have Different Objectives:

 Farmers → Maximize income.

 Businesses → Maximize profits.
 Governments → Increase national income.

✅ Cost & Benefit Quantification

 Accurate future prediction of costs & benefits.

 Values are expressed in monetary terms over the project's lifespan.

3. Classification of Project Costs

Costs in a project can be categorized as:

A. Tangible vs. Intangible Costs

Type Definition Examples

Tangible Costs Can be measured in money Cost of land, buildings, machinery
Intangible Costs Cannot be directly measured Loss of reputation, employee dissatisfaction

B. Types of Costs

1. Total Investment Costs

o Initial investment (Fixed costs, pre-production expenses).
o Operational costs (Running costs of the project).
2. Operating Costs
o Material costs (Raw materials, chemicals, inputs).
o Utilities (Water, electricity, fuel).
o Labor costs (Salaries & wages).
o Factory overheads (Maintenance, rent, insurance).
 3. Other Costs
o Contingency Allowances (Unexpected changes in cost due to inflation, price
fluctuations, environmental risks).
o Debt Service (Interest Payments) (Considered as cost in financial analysis but a
transfer payment in economic analysis).
o Sunk Costs (Past expenditures that do not affect future financial decisions).

4. Breakdown of Investment Costs

✅ A. Initial Fixed Investment Costs

These are major costs required to start a project, including:

 Land & Site Development – Buying land, site preparation.

 Buildings & Civil Works – Construction of infrastructure.
 Plant & Machinery – Purchasing necessary equipment.
 Miscellaneous Fixed Assets – Office furniture, tools, vehicles.

📌 These costs are one-time expenses needed to make the project operational.

✅ B. Pre-Production Expenditures

Some costs occur before the project starts generating revenue, such as:

 Licenses, copyrights, goodwill.

 Feasibility studies, engineering fees.
 Marketing & promotional costs.
 Employee training expenses.
 Start-up expenses (trial runs, raw materials for testing production, etc.).

📌 These costs prepare the project for full-scale operations.

5. Terminal Values & Salvage Costs

At the end of a project's life, some costs must be considered:

 Dismantling & disposal costs – Removing buildings, machinery, etc.

 Land reclamation – Restoring the land for future use.
 Resale of assets – If any project assets can be sold.
📌 The "exit cost" of a project should be included in financial planning.

6. Valuing Project Costs & Benefits in Financial Analysis

✅ Market Prices vs. Shadow Prices

Price Type Definition Usage

Market Price Prices in the local economy, including taxes & tariffs Used in financial analysis
Shadow Price The real economic value of an input or output Used in economic analysis

📌 Shadow pricing is used when market prices are distorted due to subsidies, taxes, or
trade restrictions.

✅ Absolute vs. Relative Prices

 Absolute Price – Price of a single product in money terms.

 Relative Price – Value of one product compared to another.

📌 Example: The price of wheat in absolute terms is $200 per ton, while the relative price is 2
barrels of oil per ton.

7. Transfer Payments in Financial Analysis

Transfer payments do not represent real economic costs but affect financial statements.

1. Taxes – Considered a cost in financial analysis but not in economic analysis.

2. Subsidies – Considered a benefit in financial analysis but not in economic analysis.
3. Loans & Debt Service – Repayment is an outflow in financial analysis but not in
economic terms.

📌 Financial analysis focuses on private cash flow, while economic analysis focuses on
national wealth.

8. Cash Flow Analysis in Project Evaluation

✅ Key Steps in Financial Decision-Making
 1. Estimate Project Cash Flows
o Identify all cash inflows (revenues, subsidies, savings).
o Identify all cash outflows (costs, investments, taxes, debt repayments).
2. Establish Cost of Capital
o Calculate how much financing the project requires.
3. Apply Investment Appraisal Techniques
o Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period.

✅ Components of Cash Flow

Component Definition
Initial Investment Fixed capital required to start the project
Operating Cash Flow Revenue from operations minus operating costs
Terminal Cash Flow Value of remaining assets & salvage value at project end

📌 A good project should generate more cash inflows than outflows over its lifetime.

9. Conclusion & Key Takeaways

📌 Financial analysis is essential to determine the profitability and feasibility of a project.
📌 Different cost types (fixed, operating, pre-production) must be analyzed for proper
budgeting.
📌 Transfer payments (taxes, subsidies, debt service) must be considered differently in
financial vs. economic analysis.
📌 Cash flow analysis helps investors decide if a project is worth pursuing.

Chapter 5: Measures of Project Worth

Prepared by: Abdi Shakur M. Hussein Elmi

This chapter explains the methods used to assess the financial and economic viability of
investment projects. It covers non-discounted and discounted techniques to evaluate project
worth and determine which projects should be accepted or rejected.
1. Introduction to Project Worth Measurement
When evaluating investment projects, different criteria are used to determine which projects are
financially and economically viable. These criteria fall into two categories:

A. Non-Discounting Criteria (Do not consider the time value of money)

✅ Urgency – Prioritizing projects based on their importance.

✅ Payback Period – The time it takes to recover the initial investment.
✅ Accounting Rate of Return (ARR) – Measures profitability based on accounting earnings.

B. Discounting Criteria (Consider the time value of money)

✅ Net Present Value (NPV) – The difference between the present value of benefits and costs.
✅ Internal Rate of Return (IRR) – The discount rate that makes NPV = 0.
✅ Discounted Benefit-Cost Ratio – Compares present value of benefits to present value of
costs.
✅ Profitability Index – A ratio of project benefits to costs.

📌 Objective: These measures help investors, businesses, and governments decide which
projects should be undertaken based on financial viability.

2. Non-Discounted Measures of Project Worth

A. Ranking by Inspection

 If two projects have identical cash flows but one continues generating revenue for a
longer period, the longer-lasting project is better.
 If two projects have the same initial investment, the project with higher early cash
inflows is preferred.

💡 Example: Project B is better than Project A if it generates profits for additional years.

B. Urgency

 Some projects must be implemented quickly due to their importance.

 The challenge: How do we measure urgency?

📌 Example: A water supply project in a drought-affected area may be more urgent than a
luxury housing project.
C. Payback Period

 Measures how long it takes to recover the initial investment.

 Formula: Payback Period=Initial InvestmentAnnual Cash Inflow\text{Payback Period} =
\frac{\text{Initial Investment}}{\text{Annual Cash
Inflow}}Payback Period=Annual Cash InflowInitial Investment
 Decision Rule: Shorter payback periods are preferred.

💡 Example: If a project requires $300 and generates $100 per year, the payback period is:

300÷100=3 years300 \div 100 = 3 \text{ years}300÷100=3 years

Limitations of Payback Period:

❌ Ignores cash flows after the payback period.
❌ Does not consider the time value of money.

3. Additional Non-Discounted Techniques

A. Proceeds per Unit of Outlay

 Ranks projects based on total earnings divided by investment cost.

 Projects with higher earnings per dollar invested are preferred.

B. Output-Capital Ratio

 Measures how much output is produced per unit of capital spent.

 Higher ratios indicate more efficient use of capital.

📌 Limitation: Ignores other factors like labor and land.

C. Average Annual Proceeds per Unit of Outlay

 Similar to proceeds per unit of outlay but considers average yearly earnings.
 Still fails to consider the timing of cash flows.

D. Average Income on Book Value of Investment

 Measures income relative to the book value of assets.

 Used to assess return on investment based on accounting records.

📌 Limitation: Can mislead investors if assets depreciate significantly.

4. Discounted Project Assessment Criteria
A. Why Discounting is Necessary?

 Time Value of Money: Money today is worth more than money in the future.
 People prefer immediate income because:
✅ Future wealth is uncertain.
✅ Inflation reduces purchasing power.
✅ Investing money today can generate returns.

📌 Example: $100 received today is more valuable than $100 received five years later.

B. Discounting Process

 Converts future cash flows into present values.

 Formula: PV=Future Value(1+r)nPV = \frac{\text{Future Value}}{(1 +
r)^n}PV=(1+r)nFuture Value Where:
o r = Discount rate.
o n = Number of years.

📌 Example: If $1,000 is received in 5 years at a 9% discount rate, its present value is:

1000×0.6499=649.901000 \times 0.6499 = 649.901000×0.6499=649.90

5. Net Present Value (NPV) Method

A. Definition & Formula

 NPV is the difference between the present value of benefits and present value of costs.
NPV=∑Bt−Ct(1+r)tNPV = \sum \frac{B_t - C_t}{(1 + r)^t}NPV=∑(1+r)tBt−Ct Where:
o B_t = Benefits in year t.
o C_t = Costs in year t.
o r = Discount rate.
o t = Time period.

B. NPV Decision Rule

✅ If NPV ≥ 0, accept the project (Profitable).

❌ If NPV < 0, reject the project (Not profitable).
📌 Example: A fertilizer project has an NPV of $4.57 million at 10% discount rate, so it
should be accepted.

Limitations of NPV:
❌ Requires a known discount rate.
❌ Does not show the exact profitability percentage.
❌ Sensitive to changes in discount rates.

6. Internal Rate of Return (IRR)

A. Definition & Formula

 IRR is the discount rate that makes NPV = 0. ∑Bt−Ct(1+IRR)t=0\sum \frac{B_t -

C_t}{(1 + IRR)^t} = 0∑(1+IRR)tBt−Ct=0

B. IRR Decision Rule

✅ If IRR > Required Rate of Return, accept the project.

❌ If IRR < Required Rate of Return, reject the project.

📌 Example: If a project has IRR = 15.37%, and the required rate is 12%, it should be
accepted.

C. Advantages & Disadvantages of IRR

✅ Easy to understand as it represents return on investment.

✅ Useful for comparing projects of different sizes.
❌ Complex to calculate.
❌ Multiple IRRs may exist for projects with irregular cash flows.

7. Other Investment Criteria

A. Net Benefit Investment Ratio (NBIR)

 Compares net benefits to investment costs.

 Decision Rule: If NBIR > 1, accept the project.

B. Benefit-Cost Ratio (BCR)

  Compares the total benefits to total costs.
 Decision Rule: If BCR > 1, accept the project.

8. Conclusion & Key Takeaways

📌 Non-discounted methods (Payback Period, Urgency, ARR) are simple but ignore time
value of money.
📌 Discounted methods (NPV, IRR, BCR) are more accurate but require complex
calculations.
📌 NPV is the most reliable but depends on the discount rate.
📌 IRR is useful but has limitations with multiple cash flows.

Chapter 6: Economic Analysis of Projects

Prepared by: Abdi Shakur M. Hussein Elmi

This chapter explains economic analysis in project evaluation, how it differs from financial
analysis, and why market prices alone cannot fully determine a project’s economic worth.

1. The Rationale for Economic Analysis

✅ Financial Analysis vs. Economic Analysis

Financial Analysis:

 Focuses on individual profitability (firm’s perspective).

 Uses market prices to maximize income for the company.
 Helps investors decide whether a project will make a profit.

📌 Example: A company invests in a factory, and financial analysis determines whether it will
generate profits for the owner.

Economic Analysis:

 Evaluates a project’s impact on the entire economy.

 Focuses on maximizing national income (not just individual profits).
 Considers social welfare, job creation, and economic growth.
📌 Example: A government infrastructure project may not be profitable for a private firm but
benefits the nation through improved roads, reduced transportation costs, and job creation.

2. Why Financial Analysis is Not Enough

Financial analysis only works under ideal market conditions, which rarely exist in real life. The
limitations include:

A. Market Imperfections

1⃣ Lack of Perfect Competition

 Many industries have monopolies or oligopolies, where a few firms control prices.
 Prices do not always reflect true economic value.

2️⃣ Government Interventions

 Governments subsidize or tax industries, distorting real costs and benefits.

 Example: A government subsidy may make a project look profitable, but without it, the
business would fail.

3️⃣ Market Failures

 Some markets do not work efficiently due to corruption, poor regulations, or lack of
competition.
 Example: A country may artificially lower fuel prices, hiding the real economic cost.

B. Factor Market Distortions

Markets for labor, capital, and foreign exchange do not always function fairly.

📌 Examples:
✅ Labor Market Distortion: If wages are set too high due to government policies or labor
unions, businesses may struggle to hire workers.
✅ Foreign Exchange Distortion: If a government fixes the exchange rate, imported goods
might be cheaper or more expensive than their real value.

C. Externalities (Hidden Costs & Benefits)

Externalities are effects of a project that are not reflected in its market price.

📌 Types of Externalities:
1⃣ Positive Externalities (Benefits Not Considered in Financial Analysis)

 Example: A new highway may increase business productivity and land values, even
though the project itself does not generate profit.

2️⃣ Negative Externalities (Hidden Costs Not Included in Financial Analysis)

 Example: A factory might generate pollution, harming nearby communities.

💡 Why It Matters?
Economic analysis includes externalities, while financial analysis ignores them.

D. Public Goods & Consumer/Producer Surplus

Public Goods:

 Some projects (e.g., roads, hospitals, and schools) benefit everyone but are not
profitable for private firms.
 Economic analysis justifies government investment in projects that benefit society.

Consumer & Producer Surplus:

 In a competitive market, buyers and sellers get extra benefits not captured by financial
analysis.
 Economic analysis considers these hidden gains.

📌 Example: A cheap public transport system may not make a profit but saves people money
and boosts the economy.

E. Imperfect Knowledge & Information Gaps

Economic analysis assumes people have complete information when making decisions, but in
reality:
✅ Consumers may not know all their choices.
✅ Businesses may lack market research.
✅ Governments may not have accurate economic data.
📌 Example: A farmer may not know global market prices, so he sells his crops at a lower
price than they are worth.

3. Key Takeaways from Economic Analysis

✅ Economic analysis evaluates a project’s impact on national welfare, not just
profitability.
✅ It considers market distortions, government interventions, and externalities.
✅ Public goods, hidden costs, and benefits are included in economic analysis.
✅ Financial analysis alone is insufficient to assess a project’s real economic value.

Final Thoughts

Economic analysis helps governments and policymakers choose the right projects for long-term
growth and social well-being. While financial analysis is useful for businesses, economic
analysis ensures that projects contribute to national development.

Chapter 7: Determination of Economic Price

Prepared by: Abdi Shakur M. Hussein Elmi

This chapter explains economic prices (also called shadow prices), how they differ from
market prices, and their role in evaluating economic projects. It also explores the valuation of
traded and non-traded goods, the shadow exchange rate, and the foreign exchange
premium.

1. What is Economic Price?

✅ Definition of Economic Prices (Shadow Prices)

 Economic price refers to the true opportunity cost of an input or output.

 It reflects:
o The real cost of a resource in its best alternative use.
o The willingness of people to pay for it.
📌 Example: If the government subsidizes wheat, the market price may be lower than its real
cost. The economic price reflects the true value of wheat without distortions.

✅ Why Financial Prices Do Not Reflect True Costs

Financial prices do not always show the real economic cost of goods and services because of:

1. Market Failures – Monopoly, corruption, or lack of competition.

2. Government Interventions – Taxes, tariffs, and subsidies distort prices.
3. Externalities – Pollution or public benefits that markets ignore.
4. Public Goods – Services like roads and healthcare do not have a market price.

📌 Example: If a monopoly controls electricity supply, the price may be higher than its real
cost.

2. Shadow Prices & Numeraire (Measurement Units)

✅ How to Measure Shadow Prices?

Shadow prices can be measured using two approaches:

1. World Price Numeraire

o Uses international (border) prices to value all project inputs and outputs.
o Used when a country has free currency exchange.
2. Domestic Price Numeraire (UNIDO Approach)
o Uses local market prices with adjustments for distortions.
o If a domestic numeraire is used, exported goods must be adjusted upward to
their world price.

📌 Example: If a country subsidizes fuel, the market price may be lower than the world price.
The shadow price adjusts for this.

3. Items That Require Shadow Prices

Shadow prices must be used for inputs and outputs that have distorted market prices:

1⃣ Primary Factors – Labor, land, natural resources, and foreign exchange.

2️⃣ Tradable Goods – If the local price differs significantly from world price.
3️⃣ Non-Tradable Goods – If domestic prices do not reflect economic value.
📌 Example:
✅ Land in a monopoly-controlled real estate market may have an inflated price.
✅ Electricity may be subsidized, making its price lower than the real cost of production.

4. Traded vs. Non-Traded Goods

✅ What Are Non-Tradable Goods?

Non-tradable goods cannot be traded internationally because of:

1. Physical Nature – Bulky or perishable items (e.g., fresh vegetables, local transport).
2. Economic Factors – High transportation costs.
3. Government Policies – Trade restrictions or regulations.

📌 Examples of Non-Tradable Goods:

 Electricity – Rarely transmitted across borders.

 Water Supply – Limited to local use.
 Construction Services – Real estate, hotel accommodations, haircuts.

Characteristics of Non-Tradable Goods:

 CIF Price > Market Price (Import Cost is higher).

 FOB Price < Market Price (Export Price is lower).

✅ What Are Tradable Goods?

Tradable goods are imported or exported by a country.

📌 Examples of Tradable Goods:

 Manufactured Products – Cars, electronics.

 Agricultural Goods – Wheat, rice, coffee.
 Raw Materials – Oil, metals, chemicals.
 Services – Tourism, consulting.

Characteristics of Tradable Goods:

 CIF Price < Market Price (Import Cost is lower).

 FOB Price > Market Price (Export Price is higher).
📌 Example:
✅ Coffee is a tradable good because it is exported worldwide.
✅ Local restaurant services are non-tradable because they cannot be exported.

5. Valuation of Tradable & Non-Tradable Goods

✅ Valuing Tradable Goods

 Imported goods → Valued at CIF price (Cost, Insurance, Freight).

 Exported goods → Valued at FOB price (Free on Board).

✅ Revaluation of Non-Tradable Goods (Conversion Factors)

Since non-tradable goods do not have world prices, we use conversion factors to estimate their
economic value.

📌 Formula for Conversion Factor:

CF=Shadow PriceMarket PriceCF = \frac{\text{Shadow Price}}{\text{Market

Price}}CF=Market PriceShadow Price

📌 Example: If the shadow price of labor is $5 per hour, but the market price is $3 per hour
(due to minimum wage laws), the conversion factor is:

CF=5/3=1.67CF = 5 / 3 = 1.67CF=5/3=1.67

6. National Economic Parameters

Some national factors affect all projects in a country, such as:
✅ Shadow exchange rate – The real value of foreign exchange.
✅ Shadow wage rate – The real cost of labor.
✅ Standard conversion factors – Average ratios to estimate shadow prices.

📌 Why Is This Important?

Governments use standard conversion factors to simplify project analysis across different
sectors.
7. Shadow Exchange Rate (SER) & Foreign Exchange
Premium
✅ What Is the Shadow Exchange Rate (SER)?

 The real value of foreign currency in local terms.

 Adjusts for government controls, tariffs, and trade restrictions.

📌 Example: If the official exchange rate is $1 = 50 local currency, but due to trade distortions,
the real value is $1 = 60 local currency, the shadow exchange rate is 60.

📌 Formula for SER Calculation:

SER=Foreign Exchange at Market PriceForeign Exchange at Official PriceSER =

\frac{\text{Foreign Exchange at Market Price}}{\text{Foreign Exchange at Official
Price}}SER=Foreign Exchange at Official PriceForeign Exchange at Market Price

✅ What Is the Foreign Exchange Premium?

 The extra amount people are willing to pay for foreign exchange due to shortages or
trade restrictions.

📌 Formula for Foreign Exchange Premium:

FEP=(Tariffs+Export Taxes−Subsidies)Total Trade VolumeFEP = \frac{(\text{Tariffs} +

\text{Export Taxes} - \text{Subsidies})}{\text{Total Trade
Volume}}FEP=Total Trade Volume(Tariffs+Export Taxes−Subsidies)

📌 Why Is It Important?

 Helps adjust traded and non-traded goods to comparable values.

8. Methods for Valuing Traded & Non-Traded Goods

✅ A. UNIDO Approach (Domestic Price Approach)

 Uses domestic market prices adjusted with shadow exchange rates.

 Useful for countries with regulated exchange rates.

✅ B. Border Price Approach (Little & Mirrlees Method)

  Uses international prices to estimate economic values.
 Best for countries with open trade policies.

📌 Key Difference:

 UNIDO Approach adjusts prices using domestic market factors.

 Border Price Approach uses global trade values.

9. Conclusion & Key Takeaways

📌 Economic prices (shadow prices) reflect the real opportunity cost of resources.
📌 Market prices are often distorted by government policies and market failures.
📌 Traded goods are valued at world prices (CIF & FOB), while non-traded goods require
conversion factors.
📌 The shadow exchange rate helps correct currency distortions.
📌 Governments use national economic parameters to standardize project evaluations.