Lecture Notes

PROJECT APPRAISAL

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COST-BENEFIT ANALYSIS:

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• Project appraisal is the process of
assessing, in a structured way, the case for
proceeding with a projector proposal, or
the project's viability.
• It often involves comparing various options,
using economic appraisal or some other
decision analysis technique.

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 The Role of Project Appraisal

• To stop bad projects – bad policies

• To prevent good projects from being destroyed
• To determine if components of projects are consistent
• To assess the sources and magnitudes of risks
• To determine how to reduce risks and efficiently
share risks

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 Questions addressed by a Project Appraisal

• Is the project financially viable or fiscally sustainable?

• Does the project contribute to the economic growth of the country?
i.e., positive expected economic NPV?
• Who are beneficiaries of project and by how much?
• Who are the interest groups (stakeholders) who could distort the
investment decision or affect the project’s performance?
• What are the sources and magnitudes of risk?
• What are the risks associated with the benefits accruing to the
stakeholders? Sources of political risks?
• Are poverty alleviation goals being addressed?

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 Impact of Analysis
• Quality of analysis has been shown by the World Bank to
be a key determinant of the success of a project’s
performance.
• A proper analysis will cause the project to be redesigned
so that it is less likely to fail.
• World Bank experience shows that the probability of
failure for poorly prepared projects within 3 years of a
project’s life is 7 times that of well-prepared projects.
• Poorly prepared projects have 16 times as high a
probability of failure within 5 years as compared to well-
prepared projects.

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 Incrementality of Projects
• One of the important concepts when defining a project is to measure the impact of the
project’s cash flows and net benefits and costs on an incremental basis.
• We should carefully identify the benefits and costs that are only associated with the
project, and not include any other benefits that would exist “WITHOUT” the project
being undertaken.
• It is normal for the benefits and costs to change over time for the “WITHOUT”
project case.
• The “WITHOUT” project scenario must be properly defined before using it as the
base case from which to measure incremental benefits and costs produced by the
“WITH” project case.
• It is an optimized “WITHOUT” project situation that should be compared with the
“WITH” project situation to calculate the incremental benefits and costs.
• There is another perspective “before the project” versus “after the project” scenarios.
“Before the project” is NOT the appropriate base case from which to measure
incremental benefits and costs.
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 Project Cycle:
Stages in Project Appraisal

A. Idea and Project Definition

B. Pre-Feasibility Study
C. Feasibility and Financing
D. Detailed Design
E. Project Implementation
F. Ex-Post Evaluation

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 A. Key Questions at Idea Stage

a. Where is the demand?

b. Is this project consistent with the
organization’s expertise, current plans and
strategy for the future? Can the project be
implemented and operated in a reasonably
efficient matter?

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 Project Definition

• Project definition is defined broadly to include the scope and

specification of the objectives of the project, its output, its
different stakeholders, its economic and social benefits, and
the data requirements.
• Most of the project’s data requirements are identified in the
pre-feasibility and feasibility stages of the project where the
project’s variables and parameters are analyzed in detail.

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 B. Pre-Feasibility Study
• Prefeasibility studies are an early stage analysis of a potential
project. They are conducted by a small team and are designed to give
company stakeholders the basic information they need to green light
a project or choose between potential investments
• Examines overall potential of project
• Should maintain same quality of information across all variables
• Wherever possible should use secondary information

Key questions:
a. Is this project financially and economically feasible throughout the
project’s life?
b. What are the key variables?
c. What are the sources of risk?
d. How can the risk be reduced?
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 C. Feasibility Study

• feasibility Study is an assessment of the practicality of a

proposed project or system.
• Focus is on improving accuracy of the key variables
• Alternatives for reducing risk are examined in detail
• Some primary data may be needed

Key questions:
a. Is project financially attractive to all interested parties in
activity?
b. What is level of uncertainty of key variables?
c. How is the project financed?
d. Can final decision for approval be taken?
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 Modules of Pre-Feasibility
and Feasibility Studies
The data for a pre-feasibility study are generally arranged in what
is referred to as “building blocks” because they constitute the
foundation for the different types of analyses.

Building Blocks:
A. Demand Module
B. Technical Module
C. Environmental Assessment Module
D. Human Resources and Administrative Support Module
E. Institutional Module
Analysis Modules:
F. Financial/Budget Module
G. Economic Module
H. Social Appraisal or Distributive and Basic Needs Analysis
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 Building Block A: Demand Module
• Study of sources of demand, nature of market, prices and
quantities
• Major distinction between domestic versus internationally
traded goods and services
• For internationally traded goods, prices are given to the
project by world markets
– Secondary information most important
• For domestic market, primary research more important
Output of Module:
a. Forecast of quantities and real prices for project life
b. Taxes, tariffs, subsidies, public regulations, technological
trends
c. Environmental impacts
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 Building Block B: Technical Module
• A study of input requirements for investment and
operations and their costs
• In this module, secondary information can be used very
effectively
• Need to avoid conflict of interest between supplier of
technical information and seller of investment equipment,
or contractor for construction
Output of Module:
a. Technology and life of project
b. Quantities of inputs by type needed for investment and
operation
c. Labor required by type and time
d. Input prices and sources of supply
e. Environmental impacts
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Building Block C: Environmental Assessment Module
• Environmental assessment augments information for the
economic analysis
• Identification of environmental impacts and risks
• Where possible, quantify the environmental impacts

Key Questions:
a. What are the likely environmental impacts from undertaking
project?
b. What is the cost of reducing the negative impact?
c. Are the environmental impacts and risks with and without
technical measures taken to reduce these impacts?
d. Are there alternative ways of supplying the good or service of
project without incurring these environmental costs? What are
the costs of these alternatives?
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 Building Block D: Human Resources and
Administrative Support Module
• What are managerial and labor needs of the
project?
• Does organization have the ability to get the
managerial skills needed?
• Is timing of project consistent with quantity and
quality of management?
• What are wage rates for labor skills required?
• Manpower requirements by category are
reconciled with availabilities and project timing.

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 Building Block E: Institutional Module
• This module deals with the adequacy of the institution responsible
for managing the different stages or phases of the project.
• Insufficient attention to the institutional aspects creates serious
problems during the implementation and operation phases of the
project.

Key Questions:
a. Is the entity that is supposed to manage the project properly
organized and its management adequately equipped to handle the
project?
b. Are the capabilities and facilities being properly utilized?
c. Is there a need for changes in the policy and institutional set up
outside this entity? What changes may be needed in policies of the
local, regional and central governments?

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 Analysis Module F: Financial Module
What is done:
• Integration of financial and technical variables from demand
module, technical module, and management module
• Construct cash flow profile of project
• Identify key variables for doing economic analysis
Key questions:
a. What is relative certainty of financial variables?
b. What are sources and costs of financing?
c. What are minimum cash flow requirements for each of the
stakeholders?
d. What can be adjusted to satisfy each of the stakeholders?

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 Analysis Module G: Economic Module
What is done:
• Examines the project using the whole country as the
accounting entity
• Evaluation of externalities including environmental
Key questions:
a. What are differences between financial and economic values
for a variable?
d. What is the expected value of economic net benefits?
e. What is the probability of positive economic feasibility?

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 Analysis Module H: Stakeholders and Basic Needs Analysis
What is done:
• Identification and quantification of extra-economic impacts of project
• Income, cost, and fiscal impacts on various stakeholders
• Poverty alleviation and political necessities
• Basic Needs: Evaluate the impact of project on achieving basic needs
objectives
– Basic needs will vary from country to country
Key Questions:
a. In what ways does project generate beneficial and cost impacts on stakeholders?
b. What stakeholders could the project impact?
c. Who benefit and who pay the costs?
d. What are the basic needs of the society that are relevant in the country?
e. What impact will the project have on basic needs?
f. What alternative ways are there to generate desirable social impacts?
g. Is project relatively cost effective in generation of desirable social impacts?

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 Integrated Projects
• Integrated projects can get very complex and need to be approached
cautiously to avoid costly errors.
• It is possible for the bundled project to be financially and economically
viable even though some of the components are not.
• Dropping the components that generate negative returns will maximize the
project’s benefits.
• Defining and understanding the objectives of the project is particularly
important when analyzing integrated projects.
• Ultimately, the ‘bundle’ that succeeds the most in accomplishing the desired
objectives should be undertaken.
• If the objective of the project is to maximize the wealth of people in country,
then the component or bundle that yields the highest economic NPV should
be undertaken.

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ECONOMIC VALUE ECONOMIC

= VALUE

FINANCIAL
VALUE =
+
TAX IMPACT
+
NET BENEFITS TO
NET LABOUR
CONSUMERS FINANCIAL TAX IMPACT
BENEFITS

+
NET LABOUR
VALUE NET
BENEFITS TO
CONSUMERS
BENEFITS 23
 General Relationship

NPVECOeco. dr= NPVFINeco. dr+ PVEXTeco. dr

- Holds when all benefits and costs are

discounted using same discount rate.

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 Alternative Points of View
• Critical in analysis: to evaluate financial outcome of
project from the point of view of each interested party
• Conventional analysis considers:
a. Point of view of owner
b. Point of view of all investors combined
(Banker’s point of view or total investment point of view)
c. Point of view of economy

Other Perspectives:
• Point of view of government budget
• Point of view of suppliers of inputs
• Point of view of downstream processors
• Point of view of competitors
 Analyses of project Decisions from
Alternative Points of View
Type of Analysis
Financial Economic Stakeholder Basic Needs
Viewpoint: (I) (II) (III) (IV)
Banker (Total Investment) Yes No/Yes Yes No
Owner Yes No/Yes Yes No
Government Budget Office Yes No/Yes Yes No
Country No Yes Yes Yes

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 Analyses of Investment Decisions from Different Viewpoints
Note: Exchange premium=10%; Receipts & Equipment 100% tradable; Tradable Operating cost =100

Analysis  Financial Economic Financial

Banker’s (Total
Viewpoints: Investment) Owner Country Govt. Budget
(A) (B) (C) (D)

Year: 0 1 0 1 0 1 0 1

Receipts 400 400 440 40

Operating Cost -140 -140 -150 -10
Equipment -1000 950 -1000 950 -1100 1045 -100 95
Operating Subsidy 50 50 -50
Taxes -100 -100 100
Loan 500 -500
Interest -50
Environ. Externality -190
Opp. Cost of Land -30 -30 -30 -30 -30 -30

Net Resource Flow -1030 1130 -530 580 -1130 1115 -100 175
 Summary of Project Decision Criteria

1. Financial NPV
Project Owner’s View
2. Financial IRR
3. Annual DSCRs Banker’s View
4. LLCRs
5. Economic NPV Country’s View
6. Economic IRR
Distribution Analysis
7. PV of impact on stakeholders
8. Probability of unacceptable outcome
Risk Analysis
for each of indicators above (risk simulation)
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 Project appraisal techniques
• There are two types of measures of project
appraisal techniques I.e. undiscounted and
discounted.
• The basic underlying difference between these
two lies in the consideration of time value of
money in the project investment. Undiscounted
measures do not take into account the time
value of money, while discounted measures do.

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• The time value of money influences many production
decisions. Everyone prefers money today to money In the
future.
• Therefore In order to invest a shilling today, one must be
guaranteed a return In the future that is equal to or greater
than the shilling Invested today. The preference for the
shilling now instead of a shilling in the future arises from
three basic reasons: Uncertainty, Alternative uses and
Inflation.

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 Accordingly the undiscounted measures of project
worth includes

• Ranking by inspection
• Pay back period
• Proceeds per unit out lay
• Average annual proceeds per unit out lay
method

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 Discounted Measures of project worth

• The technique of discounting permits to

determine whether to accept for
implementation, projects that have
variously shaped time streams.
• They include the net present worth, the
internal rate of return and the benefit cost
ratio (profitability index).

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 Net Present Value (NPV)
1. The NPV is the algebraic sum of the discounted values of the incremental
expected positive and negative net cashflows over a project’s anticipated
lifetime.
2. What does net present value mean?
– Measures the change in wealth created by the project.
– If this sum is equal to zero, then investors can expect to recover their
incremental investment and to earn a rate of return on their capital equal
to the private cost of funds used to compute the present values.
– Investors would be no further ahead with a zero-NPV project than they
would have been if they had left the funds in the capital market.
– In this case there is no change in wealth.

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 Benefit-Cost Ratio (R)
• As its name indicates, the benefit-cost ratio (R), or what is sometimes referred
to as the profitability index, is the ratio of the PV of the net cash inflows (or
economic benefits) to the PV of the net cash outflows (or economic costs):

PV of Cash Inflows (or Economic Benefits )

R
PV of Cash Outflows (or Economic Costs )

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Basic rule:
If benefit-cost ratio (R) >1, then the project should be undertaken.
Problems?
Sometimes it is not possible to rank projects with the Benefit-Cost Ratio
• Mutually exclusive projects of different sizes
• Not necessarily true that RA>RB that project “A” is better

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 Pay-back period
• The pay-out period measures the number of years it will take for the
undiscounted net benefits (positive net cashflows) to repay the
investment.
• A more sophisticated version of this rule compares the discounted
benefits over a given number of years from the beginning of the
project with the discounted investment costs.
• An arbitrary limit is set on the maximum number of years allowed and
only those investments having enough benefits to offset all investment
costs within this period will be acceptable.
• Project with shortest payback period is preferred by this criteria

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 Internal Rate of Return (IRR)
• IRR is the discount rate (K) at which the present value of benefits are just
equal to the present value of costs for the particular project
• Note: the IRR is a mathematical concept, not an economic or financial
criterion

Common uses of IRR:

(a) If the IRR is larger than the cost of funds then the project should
be undertaken

(b) Often the IRR is used to rank mutually exclusive projects. The
highest IRR project should be chosen
• An advantage of the IRR is that it only uses information from the project

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 Conclusion
• Financial and economic outcomes indicate that project is a viable
project
• The net cash flows seem enough to service its debts to lenders
• stakeholders should be willing to participate in project
• Net impact on stakeholders is positive, indicating project will
improve the economic well-being of stakeholders as a whole
• Although project is financially and economically viable, there is
risk that project sponsors may not be fully compensated for their
investment

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