Appraisal of Investments and Projects in The Public Sector

Ministry of Finance and Economic Planning
National Development Planning Directorate

Public Investment Technical Team Unit
Capacity Building to Support the Rwanda Public Investment Program

Investment Appraisal Training Manual for Government Staff
Prepared by Sulaiman Kyambadde P.O. Box 1851 Kigali, Rwanda Tel: +250 255114413 (office)
October 2011
The purpose of this Training Manual is to help PITT implement the use of international best practices of Investment Appraisal techniques in its programming of public sector investments. It describes how public sector investments should be assessed at conception or programming stage. The modules introduce the basic concepts behind the appraisal techniques and their applicability in the Rwandan context. It describes the DCF methodology, the shadow pricing methodology and performance measures and decision criteria, together with financial and economic analysis techniques. By their very nature, public projects involve benefits and costs to society over a number of years into the future, unfortunately, market prices and investment outcomes cannot be predicted with certainty. The manual also introduces qualitative analysis concepts of investments.
Author
Mr. Sulaiman Kyambadde, is an economist, and a business and development consultant working with PPM Consulting Limited. PPM Consulting is a local management and development consulting firm with headquarters in Kigali, the nations capital. In addition, officials from the Ministry of Finance and Economic Planning provided invaluable input on government priorities and requirements to complete the manual.
Disclaimer
The Training Manual is made possible by the support of PITT management and staff. The contents of this manual are the sole responsibility of the author and do not necessarily reflect the views of the Ministry of Finance and Economic Planning or the Government of Rwanda.
Investment Appraisal Training Manual for Public Projects
Investment Appraisal Training Manual
Table of contents
Author ....................................................................................................................................................1 Disclaimer .............................................................................................................................................1 Table of contents ..................................................................................................................................2 1. Overview of the manual ..........................................................................................................4 1.1 Purpose of the manual .............................................................................................................4 1.2 Quality management ................................................................................................................5 1.3 Content ........................................................................................................................................5 1.4 How to use the manual ............................................................................................................6 2. Module 1: Public investment management .........................................................................8 2.1 Investment cycle management ...............................................................................................8 2.2 Planning and management tools ...........................................................................................9 2.3 Government requirements ....................................................................................................12 3. Module 2: Discounted cash flow methodology ................................................................21 3.1 Introduction and overview ...................................................................................................21 3.2 Cash flows, compounding and discounting concepts ....................................................21 3.2.1 Examples to illustrate the difference between compounding and discounting ........ 22 3.2.2 Typical investment considerations ......................................................................................23 3.3 Defining annual cash flows ...................................................................................................24 3.4 Performance measures, decision criteria and the issues involved ............................... 25 3.4.1 Net present value ....................................................................................................................26 3.4.2 Net future value.......................................................................................................................26 3.4.3 Internal rate of return .............................................................................................................26 3.4.4 Benefit-to-cost ratios ...............................................................................................................29 3.4.5 The payback period ................................................................................................................30 3.4.6 The peak deficit .......................................................................................................................30 3.5 Review of DCF performance criteria ..................................................................................31 4. Module 3: Evaluation methods ............................................................................................35 4.1 Introduction and overview ...................................................................................................35 4.2 Shadow pricing methodology, application and the issues involved ........................... 35 4.2.1 Rationale for use of shadow prices......................................................................................37 4.2.2 Determining prices .................................................................................................................38 4.2.3 Review of the application of shadow pricing methodology ..........................................44 4.2.4 Limitations of using shadow prices ....................................................................................51 4.2.5 Best approaches to valuing project benefits and costs ....................................................52 4.3 Financial Analysis ...................................................................................................................57 4.3.1 Requirements ...........................................................................................................................58 4.3.2 Developing financial cash flows ..........................................................................................59 4.3.3 Constructing tables of revenues and expenditures .........................................................61 4.3.4 Evaluation Criteria ..................................................................................................................65 4.3.5 Illustration of cash flows........................................................................................................66
PITT Management Resources
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4.3.6 Points to note............................................................................................................................68 4.4 Economic analysis ...................................................................................................................73 4.4.1 Underlying differences between economic and financial analysis .............................. 74 4.4.2 Economic approach and elements .......................................................................................77 4.4.3 Methods of economic analysis .............................................................................................78 4.4.4 Process of economic analysis ................................................................................................80 4.4.5 Assumptions for economic analysis....................................................................................85 4.4.6 Developing economic cash flows.........................................................................................86 4.4.7 Evaluation criteria ...................................................................................................................99 4.5 Cost effectiveness analysis .................................................................................................. 100 4.5.1 Estimating effectiveness....................................................................................................... 101 4.5.2 Estimation of costs ................................................................................................................ 104 4.5.3 Sources of information ......................................................................................................... 105 4.5.4 Evaluation measures and decision parameters .............................................................. 105 4.5.5 Methods of cost-effectiveness analysis ............................................................................. 106 4.5.6 Limitations of cost-effectiveness analysis ........................................................................ 111 4.6 Cost benefit analysis ............................................................................................................. 113 4.6.1 Input-output model framework......................................................................................... 114 4.6.2 Measuring and valuing benefits and costs ...................................................................... 114 4.6.3 Some important concepts .................................................................................................... 115 4.6.4 Valuing benefits and costs by market prices ................................................................... 120 4.6.5 Consumer surplus and producer surplus as components of value ........................... 120 4.6.6 Developing cash flows ......................................................................................................... 127 4.6.7 Evaluation criteria ................................................................................................................. 129 4.6.8 Limitations of cost-benefit analysis ................................................................................... 130 4.7 Sensitivity analysis ................................................................................................................ 131 4.7.1 Types of sensitivity analysis ............................................................................................... 133 4.7.2 How to conduct sensitivity analysis ................................................................................. 141 4.7.3 Importance of sensitivity analysis ..................................................................................... 145 4.7.4 Sensitivity and decision making ........................................................................................ 147 4.7.5 Determinants of sensitivity and common project risks ................................................ 148 4.7.6 General approaches to uncertainty and risk ................................................................... 149 4.7.7 Decision making when dealing with uncertainty and risk .......................................... 153 4.7.8 Risk preferences in the public sector................................................................................. 154 4.7.9 Limitations of sensitivity and risk analysis ..................................................................... 154 Appendices....................................................................................................................................... 156
Example I: Conversion factors for major transport projects in southern Italian regions ............... 156 Example II: Conversion factors for projects in South Africa............................................................ 156 Case study I: Czeck Republic_Cycling Infrastructure Network in Pilsen ...................................... 157 Case study II: India_Rural Road Project ........................................................................................... 161 Case study III: Cambodia_Health Project ......................................................................................... 165 Glossary............................................................................................................................................... 170 References ........................................................................................................................................... 174
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1. Overview of the manual The National Public Investment Policy adopted by the cabinet on February 10, 2009 outlines the necessary organizational structures, analytical tools and decision-making processes that enable staff to manage public investments in the country. However, the capacity gap assessment conducted in mid 2011 revealed the lack of analytical skills at different levels of the program scale, including; financial and economic analysis, cost-benefit analysis and project cycle management. At the same time, the government needs trained staff that have the capacity to appraise investments and make better informed decisions on a structured and accountable basis with respect to public finances. Subsequently, this capacity must be developed and institutionalized into the mainstream of government practices to ensure sustainability of the effort.
1.1 Purpose of the manual This training manual is aimed primarily at trainers, government staff (working with ministries, public agencies local government entities), and others involved in PIP/PPP program management.
It also serves as a desk reference and as a post-training support to the application of techniques learnt during training. The objectives of this manual thus reflect those of the capacity building effort itself.
By the end of the training workshop, trainees will understand: The role of PIP development, information needs and key activities to be undertaken at each decision gate. The basic concepts of the discounting cash flow methodology and its application when assessing investments. The basic concepts of the shadow pricing methodology and its application when evaluating investments.
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How to use multiple techniques to assess public investments, in particular; financial, economic and cost-benefit analysis.
The importance of the integrated approach and reality checks.
1.2 Quality management At strategic level, investment planning and programming is undertaken by PITT staff or consultants or PITT staff and partner organizations. While at tactical level, investment conception, planning and appraisal is undertaken by staff from line ministries and decentralized local governments. The role of PITT staff is to coordinate the process of investment preparation and appraisal while managing the process of programming. Line ministries and local governments are responsible for the conception and appraisal (including management of feasibility studies) of projects following methodologies laid down by the Public Investment Technical Team Unit. Then, PITT appraises the feasibility studies, ranks and selects among project ideas, and incorporates them into the public investment program.
As process managers at either level, they therefore need tools and techniques which help them to support and control the quality of outputs produced during the process for example, to identify information needs, to quantify and/or verify benefit and cost estimates, to review strategy and plan further appraisals; to check the quality of investment proposals; and to program investments. This process is key to managing quality.
1.3
Content
The techniques delineated in the manual are designed to assist in preparing for training workshops as well as to assess public investments when appropriate: Module 1 introduces the national priorities, PIP management, project selection and investment decision criteria. Module 2 introduces the DCF methodology, explains its role in investment appraisal and describes how cash flows are derived. It also presents the overview of investment appraisal decision criteria.
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Module 3 introduces the shadow pricing methodology, explains how it is used to quantify benefits and costs of specific investment types at project and national levels. It also presents the basic concepts and detailed application of financial, economic and cost-benefit analysis techniques, and the role of every technique in investment appraisal.
1.4 How to use the manual Each module begins by introducing the basic concepts and contemporary issues. Major points are outlined and relevant details on the applications are provided.
During the training, trainees should use the manual as a reference to deepen their understanding of the techniques, issues and concerns raised. Trainees can develop their own notes and observations for each module. The manual will also act as a useful reminder after training, by helping to apply what was learned.
This is a training manual, not a procedures manual. Therefore, it does not address policy, strategy and management issues particular to PIP/PPP program management. It presents the basic concepts and provides techniques that will help to more effectively apply them in investment appraisal tasks. As there are differences between investment management in how issues are dealt with, practice of the investment appraisal techniques will have to be modified to suit the particular circumstances of the operating environment.
Investment appraisal practice follows an evolutionary approach, and new tools could be developed in response to operational requirements or lessons learned. Hence, techniques presented here should be seen as flexible and open to linkage with other management tools. Equally, the manual reflects the current training requirements of government staff. As these requirements evolve, so the manual will be modified to meet these needs. The manual is therefore seen as a resource that will be managed to meet these changing needs.
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Requirements for implementation of the manual Understanding of the basic concepts of welfare economics. Adequate resourcing of the data collection exercise in order to allow the analyst acquire the information necessary for performing economic analysis. Development of national guidelines on shadow pricing to avoid abuse of shadow prices and the methodology at project level. Development of PIP project management implementation manual to ensure uniform application across the board.
Comments on contents, best practices and/or case studies are welcome, and should be addressed to the Coordinator of PITT.
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2.
Module 1: Public investment management
The administration of public investments is under the armpit of the PITT, and is managed under the National Public Investment Policy, consistent with the Rwanda Aid Policy guidelines as well. The national public investment policy was adopted by the cabinet on February 10, 2009. The national public investment policy objective is five-fold, namely to ensure: Alignment of public and private investment to the national medium and long term development goals; Quality, in terms of efficiency and efficacy, of the investment portfolio and increased level of project execution rates; Increased coordination between public and private investment, including Public Private Partnerships; Sufficient resources are allocated to the public investment program; and Public resources are optimally leveraged to attract private investment.
2.1 Investment cycle management Generally, the investment cycle must be consistent with the national budget cycle. In order to harmonize the Rwandas budget cycle with the other member states of the East African Community, the budget cycle runs from July to June of each year.
As part of the larger public reforms, the budget cycle is to help government take stock of: the extent of its multi-year fiscal planning, expenditure policy making and budgeting; organization and participation in the budget formulation process; coordination of the budgeting of recurrent and investment expenditures; and scrutiny of the annual budget law.
PIP programming is grounded on the imperatives of Vision 2020, EDPRS and MDGs, and is subject to the Medium Term Expenditure Framework (MTEF) guidelines. Like PIP, MTEF is a three-year rolling plan that takes into account the countrys needs, priorities and absorption capacity. MTEF was put in place in order to improve on budgetary discipline. MTEF is a
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supplement and not a substitute of PIP, it is simply a more ambitious and comprehensive scheme. In principle, it links policy-making, planning and budgeting, in so doing allows expenditures to be driven by policy priorities and disciplined by budget realities. It injects a medium term perspective into the budget process and allows for policy choices that enhance long term development.
Like PIP, MTEF is a rolling budget that covers the current budget year and the next two budget years. It contains a macroeconomic framework with a forecast of revenues and expenditures in the medium term, a multi-year sector program with cost estimates, a strategic expenditure framework, a plan for allocating resources among sectors and detailed sectoral budgets.
According to the national planning, budgeting and MTEF guidelines of 2008, the annual budgeting processing should be completed within ten months following approval of the new budget by parliament. It starts with a reflection on national priorities based on previous years performance (3 months), followed by a reflection on the national MTEF and a review of expenditure allocations to sectors and budget agencies (3 months), followed by the preparation of budget proposals by relevant budget agencies in consultation with MINECOFIN (3 months), and ends with the review and submission of the national budget proposal to parliament for approval (1 month).
2.2 Planning and management tools The Public Investment Technical Team (PITT) is responsible synthesizing investment information, analyzing and programming public investments. It is also responsible for providing information, strategic research and the necessary advocacy to ensure that government takes the lead role in public investment identification and prioritization.
In the conduct of its responsibilities, PITT works closely with line ministries, provinces and districts. PITT is both a user and custodian of information pertaining to public investments in
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the country. It provides technical support (advisory services) to line ministries, provinces and district contact staff (persons) in the public investment realm.
2.2.1 Planning According to PITT reports, its basic mission is to prepare the Public Investment Program (PIP) in every fiscal year. PIP is a 3 year rolling plan, only the first year is incorporated into the national annual budget. In consultation with other departments of the Ministry of Finance and Economic Planning, and line ministries, it determines which projects are included in PIP and programs the corresponding expenditures and financing flows. PIP programming must be in alignment with Rwandas development goals and objectives, but subject to the countrys fiscal constraints.
At the planning stage, PITT undertakes the following tasks: a) Evaluation of the existing PIPs contribution to attainment of national development goals and objectives. b) Determination of the extent of divergences, in terms of size and structure of expenditure, of existing PIP from what is appropriate. PITT provides recommendations for the realignment of new projects to the PIP, and may, if need be, recommend the reprogramming of on-going and new projects. c) Monitoring the performance of the current PIP. The lessons learned are then used in the formulation of new PIP. d) Ranking and selection of projects to be part of PIP.
2.2.2 Project selection criteria In the normal course of doing business, projects are screened and ranked based on their contribution to EDPRS, job creation, export promotion, and presidential promises. On-going projects are accorded priority over new projects because financial commitments have already been made and spending has occurred, and at this stage government priority is towards project completion.
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Projects are grouped into 10 sectors, categorized in four clusters. The clusters are; 1) infrastructure sector, 2) productive capacities sector, 3) human development and social sector, and 4) governance and sovereignty sector.
The GoR acknowledges the importance of public investment in stabilizing two key macroeconomic variables, trade balance (by promoting export initiatives) and public deficit (reducing the debt burden). As a result, three major criteria for prioritizing projects that would have an impact on different aspects of the economy are considered, namely: Desirability, how well does the proposed project fit into government policy priorities, in terms of strategic importance in accordance with the goals set in key national policy documents (EDPRS, Vision 2020 and other policy documents). The proposed projects impact on poverty and long term transformation of the Rwandan economy, the level of risk associated with the project, and impact on gender inequalities; Achievability, how easily can the proposed project be implemented. For example, in terms of securing the site, planning consent and access, and securing the required funding; Viability, in terms of the likely economic return, as measured by the economic impact assessment and cost-benefit analysis, the projects impact on the balance of payments, jobs, private investment and GoRs fiscal position.
2.2.3 Management The Public Investment Technical Team (PITT) is responsible for managing the public investment program, under the Ministry of Finance and Economic Planning. PITT is one of the units under the National Development Planning and Research Department (NDPR). It was placed under the Ministry of Finance and Economic Planning to help ensure that all public investments are of quality and are oriented towards the GoRs long and medium term goals.
PITT is led by a coordinator, supported by eight (8) full-time staff, all under the supervision of NDPR General Director as presented in the organizational structure.
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National Development Planning & Research Directorate
Public Investment Technical Team
Policy Development, Evaluation and Research
EDPRS Coordination
Investor specialists/ Public Investment Specialists
Experts in Policy Analysis
EDPRS facilitators
Source: PITT
2.3 Government requirements Rising from a tragic past, Rwanda is on a historic journey to become one of the most dynamic and growth-oriented countries in the world. The public expenditure program has played a crucial role in promoting the socio-economic reconstruction of the country. Nevertheless, government is intent on improving both public and private investments necessary to meet the nations medium term and long term development objectives, as stipulated in the Economic Development and Poverty Reduction Strategy (EDPRS) and Vision 2020. Public investments together with Public Private Partnerships (PPPs) projects and private investments are expected to facilitate the achievement of the nations development goals. Although government cannot directly control the level of private investment, authorities recognize that it must provide an enabling environment within which they can thrive. Regardless, public investment has a central role to play mostly for two reasons: first, through the creation of wealth itself, and second, as a stimulus to private investment-through its capacity to facilitate the creation of wealth by the private sector. On the other hand, private investment (including Public Private Partnerships), are also pivotal instruments mainly for three reasons: first, in accelerating the delivery of strategic national infrastructure; second, achieving the required efficiency (facilitating the achievement of value
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for money in the long term); and lastly, facilitating the delivery of quality public services without increasing the size of the nations sovereign debt. With the above in mind, the GoR developed the National Public Investment Policy under the auspices of the Ministry of Finance and Economic Planning, which was subsequently adopted by the cabinet of ministers in February 2009. The policy acknowledges the role of the private sector as prior noted, promotion of private investment is the responsibility of the Rwanda Development Board. RDB is a public authority mandated to lead government efforts to fast track countrys economic development. It is responsible for creating a world-class business climate that will build on national assets, expand the private sector, create jobs, and increase opportunities for all Rwandans. 2.3.1 National priorities Rwandas priorities are defined in the key national policy documents (Vision 2020, EDPRS and the National Public Investment Policy) 1. These national priorities are however, usually reviewed, reaffirmed and/or updated annually by the GoR through the Cabinet. These updates are for the most part based on national strategies, including the EDPRS and current government priorities. The process of updating priorities at national and sector levels is informed by performance assessment results of the previous year, which takes place at sector and district level during joint reviews with the countrys external financing partners, as well as EDPRS Annual Progress Report (APR). Vision 2020 Vision 2020 is a result of a national consultative process conducted between 1997 and 2000. Rwandans of all categories including the leadership of all levels in the business community, government, academia and civil society participated in the process. Therefore, Vision 2020 is
1
Refer to the Republic of Rwanda reports and policies for details Page 13 of 176
not only for government, but it is a shared purpose for all Rwandans. It constitutes a bond that holds Rwandans as a people determined to build a better future.
The Vision stipulates six pillars upon which the countrys future is forged, these include: a) Reconstruction of the nation and its social capital anchored on good governance, underpinned by a functional government and capable state; b) Transformation of agriculture into a productive, high value and market oriented sector, with forward linkages to other sectors; c) Development of an efficient private sector propelled by competitiveness and entrepreneurship; d) Comprehensive human resources development, encompassing education, health, and ICT skills, aimed at public and private sectors and the civic society. To be integrated with demographic, health and gender issues; e) Infrastructural development, entailing improved transport links, energy and water supplies and ICT networks; and f) Promotion of regional economic integration and cooperation.
These pillars have to mirror trends in other national cross-cutting issues, including; gender equality, sustainable environmental and natural resource management, and ICT.
Economic Development and Poverty Reduction Strategy (EDPRS) Upon review of the last PRSP, the EDPRS identifies the following four priorities for national development. a) Increase economic growth, by investing in infrastructure, promoting skills
development and the service sector, and mainstreaming private sector development and modernizing agriculture; b) Slowdown population growth, through reducing infant mortality, promoting family planning and education outreach programs, improving the quality of healthcare and schooling;
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c) Tackle extreme poverty, through improved food security and targeted schemes for job creation and social protection. Special focus is on the creation of new employment opportunities, particularly for the youth just entering the labor market; and d) Ensure greater efficiency in poverty reduction, through better policy implementation, including; enhanced coordination among sectors and between levels of government, sharper prioritization of activities, better targeting of services for the poor, widespread mobilization of the private sector, and more effective use of monitoring and evaluation mechanisms.
The EDPRS somewhat mirrors both Vision 2020 and the United Nations Millennium Development Goals (MDGs), though targets for these policies are set for 2020 and 2015 respectively. EDPRS is a 5-year medium term development plan, that is, the EDPRS is a mechanism for implementing the Rwanda Vision 2020 in the medium term.
Public and private investments are required to achieve the EDPRS. Hence it mandates organization of public expenditure in order to maintain momentum in social sectors while targeting productive sectors to achieve the MDGs and Vision 2020 objectives and targets, and the mobilization of private investment for the same purpose as well. Public expenditure is targeted to: address skills shortages; eliminate the infrastructure backlog (including energy, water, transport, and ICT) to reduce the operational costs of doing business in Rwanda; create the conditions under which science and technology pave the way towards knowledge-based services, employment and poverty reduction; widen and strengthen the financial sector; and improve governance at all levels of government and the community.
The EDPRS is estimated to cost about RWF 5,151 billion over the five years, between 2008 and 2012. The cost includes public recurrent expenditure, public capital expenditure and private
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investments. The public component amounts to RWF 3,434 billion (67% of the total cost), the gap is expected to be narrowed by private investments 2.
Millennium Development Goals As reflected in Vision 2020 and the EDPRS, the government has expressed its commitment to achieving the Millennium Development Goals. Both policy documents mirror the MDGs.
The MDGs are a set of eight development goals inherent in the Millennium Declaration adopted in September 2000 by Member States of the United Nations. These goals strive to: Eradicate extreme poverty and hunger; Achieve universal primary education; Promote gender equality and empower women; Reduce child mortality; Improve maternal health; Combat HIV/AIDS, malaria and other diseases; Ensure environmental sustainability; and Develop a global partnership for development.
Rwandas rationale for investing in MDGs The rationale for GoR to invest in the MDGs and the impetus for involving local governments include the following: MDG 1 Eradicating extreme poverty and hunger; prudent poverty alleviation, employment creation and food production efforts need to be based on local realities and initiatives, and require the participation of and ownership by local governments and communities. MDGs 2, 4, 5, and 6 Service delivery for education, health and sanitation; establishing and maintaining local mechanisms for primary healthcare, education and basic
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infrastructure are the main responsibility of and/or are better managed by decentralized local governments, as long as they are adequately funded and well equipped to perform. MDG 3 Gender empowerment; women are vehicles of change in their households and communities. Therefore, investing in efforts that directly target women and children, such as primary healthcare, clean water, schools and sustainable agricultural practices can immediately improve the livelihood of everyone. Also, it is believed that empowering women at the local level leads to better educated and nourished children, better management of natural resources and promotes local ownership of development results. MDG 7 Ensuring environment sustainability; addressing climate change and environmental sustainability requires community adaptation without compromising the means to earn their living. Hence, community adaptation and mitigation efforts to minimize the negative effects of climate change are effective when implemented at the local level. All public investments in MDGs, whether for employment creation through sustainable agricultural practices, schools and households, can greatly benefit efforts to preserve the environment and protect ecosystems. MDG 8 Develop a global partnership for development; developing local capacity is essential for ensuring sustainability of efforts supported by the central government and its development partners. Partnership becomes a reality by delivering basic services at the local level. Government staff, service delivery officials, civil society organizations and private investors working together is the key to ensuring buy-in and sustainability of local development processes.
It has been proven that while governments are catalysts, local actors (communities, the private sector, and non-government organizations) are also crucial in the achievement of the MDGs. However, successful local partnerships and interventions require balancing in both scale and support in order to make a sizeable and sustained impact. Scaling up must go beyond
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increasing fund allocations for service delivery, it is also necessary to government to provide capacity development support to strengthen local actors. This involves understanding what works at the local or community level and why.
Rwanda Aid Policy The aid policy of 2006 is a child of the realization that the GoR lacked clear structures and guidelines for the mobilisation and management of external assistance. This policy is seen as a vehicle for improving the effectiveness of assistance the country receives and increasing the mobilization of assistance at the same time. Improving aid effectiveness in particular, is expected to equally improve service delivery to Rwandans while accelerating the implementation of EDPRS.
Also, the GoR acknowledges five core issues imperative for effective external assistance management and in tackling the development challenges the country is grappling with in the long run. At the end of the day, external assistance can only support but not supplant local processes. The necessity of good governance; no volume of external assistance can stimulate sustainable growth without a stable and supportive social political and economic climate. Need for long term planning; the Government is committed to promoting long term development of the economy with attention to poverty reduction, job creation and other opportunities. Partnership with the private sector in the fight against poverty; the GoRs medium objectives as outlined in the EDPRS will be achieved through private sector development, supported by government, sound trade practices and a stable macroeconomic environment. Need for public sector reforms; public sector reforms would ensure the country builds efficient and effective organisations ready for the development challenges in the long run. Continuous review of organisational objectives and structures will facilitate the
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definition of the roles and responsibilities of civil servants in a way that meets Rwandas current and future needs. Service delivery is better managed by local actors; the GoR is committed to pursuing the decentralization policy, transferring power, responsibilities and resources to local governments, this is expected to increase local ownership of development activities and sustainability of project outcomes.
Rationale for public investment programming The Public Investment Program (PIP) is an economic programming tool that aims to fit resources into the overall public expenditures and development plans.
PIP programming is important for the following six principal reasons: Interpretation of the countrys medium term policies and priorities; Allows PITT scrutiny of project quality, consistency with government policies and priorities, and alignment with the budgeting of available resources; Informs government of annual project costs, along with the balance of funds required to complete them, and hence affording relevant officials to mobilize resources in time to avoid project delays; Develops debate between PITT, line ministries and decentralized entities on the suitability of projects, government priorities and objectives. It opens up a communication channel for relevant parties to reflect on sectoral priorities; Maintains fiscal discipline at all levels of government. It ensures that: the first year (segment included in the annual development budget) includes only projects for which the financing has already been committed or is under advanced stages of being secured; the second year includes projects for which the financing has clearly been identified; and the third year holds projects for which the financing is probable but the source has not yet been identified. Overall, it ensures that the first year is consistent with the proposed budget; and
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Identifies sound estimates of forward costs of projects (year 2 and 3) and ensures financing needs are compatible with the countrys medium term fiscal framework.
These estimates are not easy, but they are essential. PIP includes investments by the central government, investments by public authorities that are financed fully or partly by the central government, and investments that are financed fully or partly by development partners as well. It also, covers investments of public enterprises and/or local governments that are not financed by the central government. It does not however, cover private investments financed by private enterprises involved in public-private partnerships (projects partially financed by government and private investors).
Overall, the national investment policy document acknowledges the role of and encourages private investments in the quest of developing the country. The government will continue to play a leading role in the development of critical infrastructure and in the provision of services where theres a perceived high risk by private investors.
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3.
Module 2: Discounted cash flow methodology
3.1 Introduction and overview This module introduces the DCF methodology, explains its role in investment appraisal, and describes how cash flows are derived. It also presents the overview of investment appraisal decision criteria.
Analysis of investment projects is typically carried out using the technique of discounted cash flow (DCF) analysis, which recognizes that money has a time value. It is therefore, paramount to introduce its concepts before proceeding to topics that deal with financial and economic analysis. DCF analysis is used to derive investment performance criteria such as net present value (NPV) and internal rate of return (IRR) for example, these are key components to investment performance criteria and the subsequent decision making process. DCF analysis assumes that all cash flows are used, and takes into account the timing of cash flow. Nonetheless it has its shortfalls, including; the difficulty in ascertaining the cost of capital rate or rate of return, which may also vary over the life of the investment/project, and the meaning of some measures (i.e. net present value) are not always clear to users of the information. Indeed, the survey by the International Federation of Accountants (2008) established that the key challenge in using DCF arises from the confusion that often occurs in understanding its theoretical basis and practical applications.
3.2 Cash flows, compounding and discounting concepts Cash flow analysis is simply the process of identifying and categorizing a proposed investment or project and making estimates of its value. For example, when the government is considering to establish a new forest plantation, the analyst would identify and make estimates of the cash outflows associated with establishing the trees (i.e. the cost of buying or leasing land, purchasing and planting seedlings), maintaining the plantation (i.e. the cost of fertilizers, labor, pruning and thinning) and harvesting the trees. Likewise, it is necessary to estimate the cash inflows associated with the selling of trees and other products at harvest.
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The generic discounting cash flow methodology has four stages: 1) projecting revenues (benefits), 2) estimating capital expenditure (investments) and costs of maintaining operations, 3) determining cash flows, and 4) estimating discount rate.
Discounted cash flow analysis is an extension of simple cash flow analysis, unlike the latter, it takes into account the time value of money as well as the risks of investing in the project or realization of cash flows. A number of criteria are used in DCF to estimate performance including NPV, IRR and Benefit-Cost ratios (BCR).
Before dealing with the criteria to measure project performance, it is necessary to introduce the concepts and procedures behind compounding and discounting. To begin with, look at the concept of simple and compound interest. For the moment, consider the interest rate as the cost of capital for the project.
3.2.1 Examples to illustrate the difference between compounding and discounting Suppose a person has to choose between receiving RWF 1,000 now, or is guaranteed the same amount in 12 months time. A rational person will naturally choose the former, because s/he could use the RWF 1,000 for profitable investment (i.e. deposit the money in the bank and earn interest) or use it for desired consumption during the intervening period. Let us assume that the RWF 1,000 is invested at an annual interest rate of 8%, then over the year it would earn RWF 80 in interest. That is, a principal of RWF 1,000 invested for one year at an interest rate of 8% would have a future value of RWF 1,000 (1.08) or RWF 1,080.
Likewise, RWF 1,000 may be invested for a second year, in which case it will earn further interest. If the interest again accrues on the principal of RWF 1,000 only, it is known as simple interest. In this case the future value after two years will be RWF 1,160. On the other hand, if interest in the second year accrues on the whole RWF 1,080, known as compound interest, the future value will be RWF 1,080 (1.08) or RWF 1,166.40. Most investment and borrowing
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situations involve compound interest, although the timing of interest payments may be such that all interest is paid before further interest accrues.
The future value of the RWF 1,000 after two years may also be derived as RWF 1,000 (1.08)2 = RWF 1,166.40.
In general, the future value of an amount RWF x, invested for n years at an interest rate of i, is RWF x times (1+i)n; where x represents the amount involved and i is the interest rate, the interest rate can be expressed in decimal points or as a percentage.
Discounting is the reverse of compounding, i.e. finding the present-day equivalent to a future sum. Recall in the prior example, we established RWF 1,000 invested for one year at an interest rate of 8% would have a value of RWF 1,080 in one year, therefore the present value of RWF 1,080 one year from now, when the interest rate is 8%, is RWF 1080/1.08 = RWF 1000. Similarly, the present value of RWF 1,000 to be received one year from now, when the interest rate is 8%, is RWF 1,000/1.08 = RWF 925.93
In general, if an amount RWF x is to be received after n years, and the annual interest rate is i, then the present value is RWF x / (1+i)n
3.2.2 Typical investment considerations In the two prior examples, discussions have been in terms of amounts in a single year. Investments usually incur costs and generate income in each of a number of years. Suppose the amount of RWF 1,000 is to be received at the end of each of the next four years. If not discounted, the sum of these amounts would be RWF 4,000. But let us suppose the interest rate is 8%. What is the present value of this stream of amounts? This is obtained by discounting the amount at the end of each year by the appropriate discount factor then summing: RWF 1,000/1.08 + RWF 1,000/1.082 + RWF 1,000/1.083 + RWF 1,000/1.084 = RWF 1,000/1.08 + RWF 1,000/1.1664 + RWF 1,000/1.2597 + RWF 1,000/1.3605
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= RWF 925.93 + RWF 857.34 + RWF 793.83 + RWF 735.03 = RWF 3,312.13 The discount factors, 1/1.08t for t = 1 to 4, may be calculated for each year or read from published discounting tables or derived using MS excel functions. It is to be noted that the present value of the annual amounts is progressively reduced for each year further into the future (from RWF 925.93 after one year to RWF 735.03 after four years).
3.3 Defining annual cash flows Typical projects result into the creation of an asset (i.e. forestry plantation, road, plant etc). Therefore, any project may be regarded as generating cash flows. The term cash flow refers to any movement of money to or away from the project sponsor or investor (government, or an individual, company, industry etc). Projects require payments in the form of capital outlays and annual operating costs or cash outflows, which we could refer to as project costs. They give rise to receipts or revenues or cash inflows, referred to as project benefits. For each year, the difference between project benefits and capital plus operating costs is known as the net cash flow for that year. The net cash flow in any year may be defined as NCF = bt - (kt + ct), where; bt are project benefits in year t, kt are capital outlays in year t and ct are operating costs in year t.
Take note that when determining these net cash flows, expenditure items and income items are timed for the point at which the transactions take place, rather than the time at which they are used. For example, expenditure on purchase of machinery rather than annual allowances for depreciation would enter the cash flows. It is also advisable that cash flows should not include interest payments. The discounting procedure in a sense simulates interest payments, so to include these in the operating costs would be to double-count them.
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Hypothetical illustration A project involves an immediate outlay of RWF 25,000, with annual expenditures in each of three years of RWF 4,000, and generates revenue in each of three years of RWF 15,000. The annual cash flow for would therefore, be derived as follows:
Year 0 1 2 3
Benefits (RWF) 15,000 15,000 15,000
Capital outlay (RWF) 25000 -
Costs (RWF) 2,000 4,000 4,000 2,000
Net cash flow (NCF) RWF -27,000 11,000 11,000 13,000
Take note of two points. First, the capital outlay is timed for Year 0. By convention this is the beginning of the first year (i.e. right now). On the other hand, only half of the first years operating costs are scheduled for the Year 0 (the beginning of the first year). The remaining half of the first years operating costs plus the first half of the second years operating costs are scheduled for the end of the first year. In this way, operating costs are spread equally between the beginning and the end of each year. But in the case of project benefits, these are assumed to accrue at the end of each year, which would be consistent with lags in production or payments. These within-year timing issues are unlikely to have significant impact on the overall project profitability, but it is useful to make these timing assumptions clear.
Second, net cash flows (second column less third plus fourth column) are at first negative, but then become positive and increase over time. This is a typical pattern of well-behaved cash flows, for which performance criteria can usually be derived without computational difficulties.
3.4 Performance measures, decision criteria and the issues involved Decision making on investment or project selection and resource allocation is based on approved criteria. Take note that the Rwanda National Public Investment Policy pronounces NPV and IRR, but does not specify the magnitude of these parameters (threshold).
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With that in mind, let us now consider a number of project performance criteria which can be obtained by discounted cash flow analysis. These criteria will be defined, then derived for the cash flow data of our hypothetical illustration.
3.4.1 Net present value The net present value (NPV) is the sum of the discounted annual cash flows. NPV is derived by use of the following formula; NPV = x0 + x1/(1+i) + x2/(1+i)2 + x3/(1+i)3
A project is regarded as economically desirable if the NPV is positive. This means that the project can bear the cost of capital (the interest rate) and still leave a surplus or profit. For the example, if we are to take 8% as our interest rate. NPV = -27,000 + 11,000/(1.08) + 11,000/(1.08)2 + 13,000/(1.08)3 = -27,000 + 11,000/1.1664 + 11,000/1.2597 + 13,000/1.3605 = RWF 2,935.73 The interpretation of this figure is that the project can support an 8% interest rate and still generate a surplus of benefits over costs, after allowing for timing differences in these, of approximately RWF 2,936.
3.4.2 Net future value As earlier established, an alternative to the net present value is the net future value (NFV), for which annual cash flows are compounded forward to their value at the end of the projects life. Once the NPV is known, the NFV may be obtained indirectly by compounding forward the NPV by the number of years of the project life. Using the same illustration, the net future value is NFV = NPV (1.08)3 = RWF 2,935.73 x 1.3605 = 3,994.06.
3.4.3 Internal rate of return The internal rate of return (IRR) is the interest rate that makes the sum of discounted net cash flows zero. If the interest rate were equal to the IRR, the net present value would be exactly zero. Take note, the IRR cannot be determined by an algebraic formula, but rather has to be
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approximated by trial and error methods. Continuing with our illustration, we know that the IRR is somewhere above 8%. Deriving the NPV with a range of discount rates would reveal that the IRR falls between 13% and 14%, but closer to the latter. In practice, a financial function can be called up to perform the trial-and-error calculations. It would be found in this case that the IRR is about 13.8%. Take note, calculation of internal rate of return in fact involves solving a polynomial equation, and efficient solution methods such as Newtons approximation are used in computer packages.
The IRR can also be defined as the highest interest rate which the project can support and still break even. Therefore, in economic terms, a project is judged to be worthwhile if IRR is greater than the cost of capital. In this case, our hypothetical project can support a rate of interest that is higher than 8%, and still make a positive payoff. In other words, the project would be profitable provided the cost of capital was less than 13.8%.
However, the IRR as a criterion of project profitability suffers from a number of theoretical and practical limitations. On the theoretical side, it assumes that the same rate of return is appropriate when the project is in surplus and when it is in deficit. However, the cost of borrowed funds may be quite different to the earning rate of the company. In that case, it could be more appropriate to use two rates when determining the IRR. The actual cost of capital could be used when the project is in deficit, and the earning rate (unknown, to be determined by trial and error) could be applied when the project is in surplus. This would give a better indication of the earning rate of the project to the company or government.
From a practical viewpoint, the IRR may not exist or it may not be unique. Consider a project for which the net cash flow in each year (including Year 0) is positive. Regardless of the interest rate, the NPV will never be zero, so it will not be possible to determine an IRR. Similarly, a project with a large initial capital outlay and for which future benefits are
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relatively small or negative may not have a positive NPV regardless. Hence, the curve for the NPV profile may never cross the interest axis.
In the same vein, if a project generates runs of positive and negative net cash flows, this will generate multiple IRRs. Take note, mathematically, the polynomial equation defining the NPV can have as many roots/solutions as there are turning points in NPV values (changes from positive to negative or negative to positive). A project which has alternating runs of positive and negative cash flows is a candidate for problems with estimation of the IRR. This indicates multiple internal rates of return, one at each interest rate where NPV is zero. It is then by no means clear which if any of the rates we should choose to call the IRR. In addition, when the NPV is properly profiled in these kind of situations, it could be determined that NPV is increasing as the interest rate increases, which would imply that the greater the cost of capital the more profitable the project, this is exemplified by the NPV profile exhibit below. Clearly, multiple internal rates of return and perverse relationships between the NPV and the discount rate are not very satisfactory.
NPV profile exhibit shows the presence of multiple IRRs in a project, IRR is 10.11% and 42.66% respectively.
RWF 4,000
NPV (000's)
RWF 2,000 RWF 0 0 (RWF 2,000) (RWF 4,000) (RWF 6,000) (RWF 8,000) (RWF 10,000) Discount / Inte re st Rate (%) 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
Note: This is a hypothetical project.
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Using excel financial functions to calculate NPV and IRR Microsoft excel has in-built functions that can be used to calculate the two measures. The NPV function calculates the net present value of an investment (i.e. using a series of cash flows annual net cash flows) subjected to a discount rate. The analyst must ensure that the investment costs are negative. The syntax for this function is; = NPV(discount rate, CF0:CFn). While the syntax function for IRR is; =IRR(CF0:CFn). Note, prompt excel by typing the equal (=) sign in the cell before typing the measure (NPV or IRR) and the opening bracket, excel automatically recognizes the action and guides the user.
3.4.4 Benefit-to-cost ratios A number of benefit-cost ratio concepts have been developed in the academic world. For simplicity, let us consider only two concepts, referred to as the gross and net B/C ratio and defined respectively as: Gross B/C ratio = PV of benefits/(PV of capital costs + PV of operating costs). Net B/C ratio = (PV of benefits PV of operating costs)/PV of capital costs.
Continuing with our hypothetical project, the present value of the capital outlay is RWF 25,000, since outlays are often made immediately and as a single amount. The present values of project benefits and operating costs are: PV of benefits = RWF 15,000/1.08 + 15,000/1.082 + 15,000/1.083 = RWF 38,656.45 PV of operating costs = RWF 2,000 + 4,000/1.08 + 4,000/1.082 + 2,000/1.083 = RWF 9,418.38
Hence the benefit-to-cost ratios are: Gross B/C ratio = 38,656.45/(25,000 + 9418.38) = 1.12 Net B/C ratio = (38,656.45 - 9418.38)/ 25,000 = 1.45
In economic terms, a project is judged to be worthwhile if its B/C ratio is greater than 1, which means that the present value of its benefits exceeds the present value of the corresponding costs (either way, in gross or net terms). If one of the above ratios is greater than 1, then the other will be greater than 1 also. In this case, both ratios are greater than 1, implying that the
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project is worthwhile on economic grounds. It is not clear however, which of the ratios is the most useful on logical grounds.
3.4.5 The payback period The payback period (PP) is the number of years it would take the project to break even, that is, the number of years for which discounted annual net cash flows must be summed before the sum becomes positive (and remains positive for the remainder of the projects life). In other words, it indicates the number of years until the investment in the project is recouped. Considering our hypothetical project, it is apparent that the sum of discounted net cash flows does not become positive until Year 3, thus, the payback period is three years.
The payback is a useful criterion for a company with a short planning horizon, but does not take account of all the information available, i.e. the net cash flows generated after the payback period, and it also fails to take into account the timing of the net cash flows.
3.4.6 The peak deficit This is a measure of the greatest amount that the project owes the company or government, i.e. the highest the project goes in the red. In our hypothetical project, the largest negative value is RWF 27,000, and hence this is the peak deficit. Peak deficit is a useful measure in terms of financing a project because it indicates the total amount of finance that will be required.
The following is an illustration of how project balances are derived, and how its payback period and peak deficit are determined.
Year 0 1 2 3 NCF (RWF) -27,000 11,000 11,000 13,000 PV of NCF -27,000.00 10,185.19 9,430.73 10,319.82 Cumulative PV of net cash flow -27,000 -27,000 + 10,185.19 = -16,814.81 -16,814.81 + 9,340.73 = -7,384.09 -7,384.09 + 10,319.82 = 29,35.73
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3.5 Review of DCF performance criteria The most commonly used discounted cash flow performance criteria are NPV, IRR, B/C ratios and payback period. These various criteria are closely related, but measure slightly different things and tend to complement one another. Take note that they are fallible on a standalone basis, in this respect, it is common to estimate and make judgments based on more than one method.
Having said that, the NPV is the most commonly used measure. It tells you the total payoff from a project. The major limitation of the NPV measure however, is that it is not related to the size of the project. If one project has a slightly lower NPV than another, but the capital outlays required are much lower, then the second project will probably be the preferred one. In this sense, a rate of return measure such as the IRR would be also useful.
The payback period and peak deficit are useful from a policy or decision making perspective, they provide supplementary project information. On the other hand, they have greater relevance for private sector investments, specifically for companies which cannot afford long delays in recouping expenditure, and where careful attention must be paid to the total amount of funds that will need to be committed to the project to remain solvent.
The application of investment appraisal techniques is more straight forward to apply in the private sector, unlike in the public sector, their measure of success is profit. Hence, analysts are not required to provide economic costs and benefits, these require more information and research to derive. Investment is defined as real capital formation such as the production or maintenance of machinery or housing construction; these types of investments are expected to produce a stream of goods and services for future consumption. Naturally, investment involves the sacrifice of current consumption and the production of investment goods, which are used to produce goods or services, and it includes the accumulation of inventories.
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Thus, investment appraisal is the evaluation of prospective costs incurred and revenues generated by an investment in a capital project over its expected life. Such appraisal includes the assessment of risks and uses a number of different techniques for deciding whether to commit resources to the project. These techniques have been covered in this module, they include discounted cash flow (DCF) and the calculation of net present value (NPV) and the internal rate of return (IRR). Summary of DCF performance criteria:
xt / (1+i)t; where t is time, xt is the annual CF, i is the discount rate, and t=1 p is the planning horizon
p
Net present value (NPV)
Internal rate of return (IRR)
The value of r such that xt/(1+r)t = 0

t=1
Benefit to cost ratio (B/C)
Present value of project benefits / present value of project costs
Payback period
Number of periods until NPV becomes (and remains) positive
Debt service cover ratio (DSCR) or often referred to as the annual debt service ratio (ADSCR) or simply debt service ratio
It is a measure of cash inflows available to pay debt compared to the repayments that are due. We recommend; (EBITDA tax) (repayments of principal + (interest x tax shield). Where; EBITDA is the earnings before interest, taxes and depreciation
Loan life cover ratio (LLCR)
It is a measure of ability to pay over the life of a loan. We recommend; NPV of cash flows available to repay debt amount of debt outstanding
Notes Typically, the providers of finance (i.e. bankers, investors or government) look to the cash flow of the project as a source of funds for repayments. They therefore tend to focus on cover to the income stream over the term of the loan.
Debt service cover ratio (DSCR) This is often referred to as annual debt service cover ratio (ADSCR). It is a measure of cash inflows available to pay debt compared to the repayments that are due. DSCR is an historic ratio that measures the cash flow for the previous year in relation to the amount of loan
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principal and interest payable for that year. It is also sometimes used to refer to a country's ability to pay foreign debt.
Methods to derive DSCR somewhat vary, we recommend targeting the EBITDA income stream. The advantages of this approach include the following: EBITDA is relatively a good measure of cash flow and it is easy to calculate. It takes into account the impact of the tax deductibility of interest. It is comparatively easy to compare repayments of principal (which are tax deductible) and the post tax income.
Other approaches may use other measures of income stream, and may not adjust of tax shields.
The difference between the DSCR and other measures of financial strength (e.g. interest cover, gearing) is that it takes into account the actual financing arrangements. By taking repayments of principal into account, we can ascertain the ability of the project to repay the loan and thereby gauge the possibility of default.
The loan life cover ratio (LLCR) is somewhat similar to DSCR, the major difference is that while DSCR provides a snapshot of short term ability to pay (i.e. over the next year), LLCR provides a snap shot on a given date of the NPV of the projected cash flows from that date until retirement of the loan relative to the loan outstanding on that particular date (i.e. measures ability to pay over the life of the loan). DSCR is usually used by banks when assessing the borrowers (investor or company) ability to repay debt under specific terms of debt or credit terms. LLCR is also often used by banks, both for corporate loans and project finance. Both ratios (DSCR and LLCR) are used in debt covenants.
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The discount rate used to calculate the NPV is often the weighted average interest rate of all debt, similar to a WACC but only for debt finance. In the case of project finance all numbers, would be those relating to the project, but in most other cases they would be calculated for the borrower. The cash balances available to the project or borrower are sometimes added to the NPV, as they are available to repay debt, if not immediately applied to reduce borrowing. If the latter is the case, it means that these cash balances are therefore no longer available to repay debt.
Nevertheless, although treatment of debt servicing (i.e. interest payments and repayment of principal) is somewhat settled as far as financial analysis is concerned, as it entails cash outlays. Some experts argue that debt service should be excluded from financial and economic analysis because, what matters in both cases, is assessing the quality of the project independently of how it is to be financed (or financing mode). Moreover, from the economic analysis perspective, debt service does not actually entail a use of resources, but only a transfer of resources from the payer to the payee.
Whereas from the standpoint of the investor (i.e. the loan recipient), receipt of a loan increases the investment resources s/he has available; payment of interest and repayment of principal reduce them. But this is not true from the standpoint of the economy (e.g. the loan does not reduce the national income available. On the contrary, it merely transfers the control over resources from the lender to the borrower. Hence 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, s/he is likewise 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, criteria mandated by the economic analysis. That is, the analyst must focus on the use of resources when conducting economic analysis, and not the transfer of resources.
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4.
Module 3: Evaluation methods
4.1 Introduction and overview This module introduces you to the shadow pricing methodology, explains how it is used to quantify the benefits and costs of specific investment types at project and national levels. It also presents the basic concepts and detailed application of financial, economic and costbenefit analysis techniques, and the role of every technique in investment appraisal.
Before undertaking a financial or economic analysis of any proposed investment, there is a need to develop a clear understanding of the expected incremental events and consequences of the investment. In this regard, it requires teamwork, input should be sought from subjectmatter experts with technical knowledge that is specific to the investment/project in question. For example, if the investment is towards construction of a road by-pass, the manager needs a team that includes traffic engineers when conducting the analysis, traffic engineers are well suited to estimate the incremental improvements in safety and travel time that will result.
4.2 Shadow pricing methodology, application and the issues involved Shadow pricing is by definition the pricing of the change in aggregate welfare caused by the supply of a good or service by the public sector. Thus, the shadow price of a good or service is the change in aggregate welfare following a marginal increase in the net supply of that good or service. If this definition is applied consistently, then the shadow profits of a project will be positive if and, only if, the welfare of society as a whole is increased. By extension, the shadow price for a particular good or service equals all changes, valued at consumer prices, in the consumption of goods or services induced by the change in the net supply of that good or service.
Although a multitude of techniques for investment appraisal exist, only a few cover different aspects of the economics of the investment (expectations). Nonetheless, a common thread linking them is that effective project assessment, be it for developmental projects or capital market development initiatives, can enhance decision-making. Experts also agree that missing
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or distorted market prices can lead to sub-optimal investment decisions in a wide range of circumstances and for a wide range of national planning authorities, local governments, and private investors. Therefore, in the midst of limited resources and capital rationing, the appropriate appraisal of public investment projects underlines the need to determine the social value of costs and benefits accruing from these investments. In Rwanda, like most developing countries, social values may diverge from market prices and values. These price distortions may be caused by market imperfections as a result of structural disequilibria in labor markets, government intervention in products and factors, and narrow or missing markets. As a consequence of these distortions, market prices can be unreliable indicators of the real net worth of goods and services.
On the other hand, official trade policy, such as the adoption of various tariff and non-tariff trade barriers, may lead to a distorted market value of foreign exchange. The result is not only a distortion in the domestic price of all tradables, but also of non-tradables which use tradables in their production.
In project appraisal therefore, modifications to market values are essential. A modification is determined by estimating a set of national parameters and conversion factors. The process of estimating these parameters is termed as the shadow pricing methodology, while the parameters themselves are the shadow prices. Conversion factors give the ratio between the price to be used in evaluating an input or output of a project (the shadow price) and the market price of that input or output. In the valuation of inputs used in production, the inherent assumption is that the price of any input should represent the opportunity cost of that input. The opportunity cost reflects the value of output forgone on one project when used on another. Thus, shadow prices are useful when the market price for an input or output is unavailable or when it does not reflect its opportunity cost. For example, labor is an important input in many investment projects and, therefore, should be valued at its economic cost.
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4.2.1 Rationale for use of shadow prices Shadow prices are a crucial link between the macro level and the project level of economic planning, and an important component of the overall process of development planning. Ideally, projects that most efficiently use scarce resources would be selected only when the costs and benefits of all potential projects are valued at their shadow prices. Following this strategy allows the country to maximize the potential net economic benefits accruing from its public investments, thereby improving its potential to pursue broader social and other noneconomic objectives.
The use of shadow pricing and the basic methods needed to determine shadow prices are generally agreed upon by experts. The United Nations Industrial Development Organization (UNIDO) and other authorities in the field, have developed a universally accepted estimation method called the LMST accounting price method.
The LMST method divides goods into two broad categories: Tradable goods: These are consumption goods and productive factors that are
exported or imported, and products that might potentially have an international market. These goods affect, or can potentially affect, a nations balance of payments; and Non-tradable goods: These include all other consumption goods and productive factors (local labor, utilities, services, etc.).
When using the LMST methodology, it is advisable to use world prices (the prices at which goods are bought and sold internationally) to shadow price all project inputs and outputs that are classified as tradable. Non-tradable goods can also be valued if their inputs are tradable. The underlying rationale is not that free trade prevails or that world prices are undistorted, but simply that world prices more accurately reflect the opportunities available to a country.
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4.2.2 Determining prices Again, shadow pricing can be applied to imports, exports and non-tradable goods. In either case, determining the shadow pricing involves multiplying each market price by an accounting price ratio (APR), this formula is derived as follows: APRi = (accounting price of good i)/(market price of good i) = (shadow price of good i)/(market price of good i) Therefore, the shadow price of good i = APRi x market price of good i APR = 1 / (1+t), where t is the tax rate.
Imports An import is taken at CIF price, that is, the cost of an import plus insurance and freight expenses to the port of destination. The CIF price is sometimes called a border price since it corresponds to the foreign currency needed to pay for it at the border. In valuing an import, other costs (such as transportation costs) are added to the CIF price by using their respective shadow prices. However, tariffs are excluded.
In valuing an import, the exchange rate is used to translate foreign currency into local currency. Although official exchange rates often do not accurately reflect the actual value of currency, they can nonetheless be appropriately used to do this, if used consistently. Application of a standard conversion factor (SCF) is also acceptable. This is consistent with the methodology suggested by eminent practitioners like Boardman and others.
As Anneli Lagman Martin (2004) rightly acknowledged, there are several ways to estimate shadow exchange rates (i.e. social conversion factors), they only differ in both their accuracy and conceptual and computational complexity. Common to them, they are generally based on converting the nominal or official exchange rate (OER) to the shadow exchange rate, through a conversion factor (i.e. the shadow exchange rate factor - SERF). Basically, SER = OER x SERF, that is, SER is the weighted average of the demand price for foreign exchange paid by
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importers and the supply price of foreign exchange received by exporters. Hence, taxes and subsidies cause the SER to diverge from the OER. . Although more complex methods of estimating the SERF are generally more accurate, the additional accuracy may not justify the extra effort when foreign exchange markets are not highly distorted. Therefore, a simple method may be sufficient, although simpler methods should be compared at least occasionally with the results of more complex methods.
Experts suggest three alternative approaches for estimating the SCF. The first approach is applicable when the country enjoys balanced trade, then SER is calculated basing on the tariffadjusted OER (weighted according to import-export shares). The second approach takes into account the sustainability of the countrys trade imbalance through an assessment of the equilibrium exchange rate (EER). The use of the EER, rather than the market puts emphasis on the long-term stability of the exchange rate because of its significant effect on project performance this is based on a model developed by Jenkins and El-Hifnawi, and is considered. The approach applicable when tariffs represent the only distortion to trade and there are no distortions in factor or commodity prices. Then SERF can be estimated by one plus the weighted average tariff rate, which is consistent with the accepted definition of the SER the weighted average of the demand price for foreign exchange paid by importers and the supply price of foreign exchange received by exporters. It is also equivalent to the methodology suggested by the United Kingdoms Department for International Development. SCF = (M + X)/[(M + Tm - Sm) + (X - Tx + Sx)]; if tariffs are the only distortions, then SCF = [imports (cif) + exports (fob)]/[(imports + import taxes) + (exports export taxes)] = total trade/(total trade + net trade taxes Where; cif represents cost, insurance and freight, and fob represents free on board.
Alternatively, SERF = 1 + (net trade taxes/total trade).

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Exports An export is taken at the free on board (FOB) price, that is, the price of an export at the port of origin before insurance and freight charges are added. The FOB price includes the cost of producing the good, export taxes, and the cost of transportation to the point of origin. Export taxes are included because foreigners usually do not have standing. The shadow price of an export is valued on the basis of each units contribution to the nations foreign exchange.
Some projects use inputs that would be exported if the project was not undertaken. If this is the case, then the shadow price should include the additional costs incurred by diverting the good to domestic use and revenue forgone by not exporting the product, but exclude costs saved by not exporting the product. However, a problem arises when project outputs are substituted for potential imports, as the choice of the world price that would be applied for shadow pricing is complicated by the existence of several substitutes. Picking a high export price or low import price would bias net benefits in the positive direction. In practice, it is usually best to pick values in middle of the range.
Non-Tradables A non-tradable is taken at opportunity cost, inputs for a project might be diverted from other uses. For economic analysis and CBA purposes, this opportunity cost must be made commensurable with traded goods. To do so, the cost of the good can be broken into its traded, non-traded, and labor components. Each non-traded component can then be further broken down. By multiplying each of the components and subcomponents by their APRs, then the opportunity cost of supplying a non-traded good to a project can be evaluated in terms of traded goods.
The APR of a tradable component expressed in CIF prices is 100, while the APR for a domestic transfer (e.g., a tariff on tradable, a tax on non-tradable) is 0. The APR for non-tradables is the weighted average of the APRs of their components, where the weights are the cost of each component as a fraction of total cost.
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Its also acceptable to use conversion factors (CFs), instead of directly computing weighted APRs for small subcomponents. Conversion factors are obtained from previous studies of the economy, for example, through semi-input-output analysis (SIO). The role of CFs in economic analyses of projects in Rwanda, like most developing countries, can be of considerable importance. It is important to note that semi-input-output analysis utilizes national inputoutput tables, national census data, household expenditure surveys, and other national data (on tariffs, quotas, and subsidies) to estimate CFs. An input-output table is constructed by dividing the economy into as many productive sectors as the data allow. It indicates the percentage contribution of the output in each sector to the total market value of the output produced in all the other sectors. The table also indicates the percentage contribution of each primary factor input (labor, capital, foreign exchange, taxes, subsidies) to the total market value of the output produced in each sector. CFs are determined from the table by solving simultaneous equations with matrix algebra.
Semi-input-output analysis can also be used to obtain aggregate CFs such the consumption conversion factor (CCF), which is a weighted average of APRs for a nationally representative market basket of goods, and the standard conversion factor (SCF). The SCF is the ratio of the value of all production at accounting prices to the value of all production at market prices (i.e., it is a weighted average of CFs for all productive sectors, where weights are the contribution each sector makes to total national output). The SCF can be used in computing the shadow price of minor components of non-tradable goods when more specific CFs are not readily available. A crude formula for the SCF is as follows: SCF = (M + X)/[(M + Tm - Sm) + (X - Tx + Sx)]
Where; M is the total value of imports in CIF border prices, X is the total value of exports in FOB border prices, Tm is the total tariff on imports, Tx is the total taxes on exports, Sm is the total subsidies on imports, and Sx is the total subsidies on exports.
In other words, the numerator of the formula values imports and exports at their world prices, whereas the denominator values imports and exports at their market prices. Take note that the
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formula is crude because it ignores transportation and distribution costs, non-traded goods, and distortions in domestic market prices due to import quotas, monopoly power, and externalities. Even so, it is useful conceptually because it implies that tariffs and export subsidies cause market prices to be larger than world prices, whereas taxes on exports and import subsidies have the opposite effect.
Goods which are in fixed supply As already noted, to measure project costs, the LMST approach usually relies on converting the market prices of the inputs required by a project into their shadow prices. An exception occurs when the supply of an input is fixed (e.g., due to an import quota). If the fixed supply is binding, then a project will increase the market price of the input, thereby reducing the consumption of it by current consumers. Therefore, in this case, the opportunity cost of using the input in the project is the consumption forgone by consumers.
Labor Although shadow prices of labor are of critical importance in conducting economic analysis in developing countries. Shadow pricing labor raises some special issues. First, to determine the shadow price, one needs the market wage. This is often difficult to determine for unskilled workers. Second, different types of labor have different APRs. The formula for shadow pricing labor is: APR of type j labor = Shadow price of type j labor/Market wage of type j labor
If you think the labor market for skilled workers is functioning well, then the actual wage is a reasonable approximation of the market wage and, therefore, the social opportunity cost of hiring workers for a project. If a conversion factor is available, the shadow wage can be obtained by multiplying the CF for skilled workers by the project wage. If a CF for skilled workers is unavailable, then one can use a sector specific CF or the standard conversion factor.
A special case occurs however, when the project must hire skilled workers from a foreign country:
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Ideally, foreign workers would not be given standing (e.g. in the absence of distortions in the foreign currency market).
The shadow cost of hiring foreign workers depends on the fraction of earnings they remit back home. Because earnings sent out of the country result in a direct loss of foreign exchange, they have an APR of 1.
In principle, the value of each item that foreign labor purchase in the country should be multiplied by its APR, but this is usually impractical because the necessary information is unavailable. Thus, all earnings that remain in the country would be multiplied by the economy-wide CCF.
Consequently, the shadow wage for foreign workers = [h + (1-h) x CCF)] PW, where h is the fraction of wages repatriated. CCF is the consumption conversion factor, and PW is the project wage.
Unskilled workers for a project might ultimately be drawn from upcountry. Even when a project is located in an urban area or city, workers could be drawn to the urban area or city for employment. If this happens the analyst must investigate the consequences before asserting the job creation claim and the subsequent benefits and costs. That is, establish if; the project is not creating labor shortage at the source, increasing the unemployment rate in the urban area or city, the effect of workers migration in both the rural areas (push factors) and the urban area or city (pull factors) analyze levels and differences between the rural market wage and the urban market wage, and pin down the wage migrating workers expect to receive. Take note, if the project is located in the rural area, the analyst has nothing to investigate because migration is not an issue. In the latter case, the appropriate shadow wage is obtained by simply multiplying the rural wage by the appropriate CF. If the former is the case, then in determining the shadow wage account must be taken of the number of workers who would leave the rural areas for each job created. This can be done by simply multiplying the urban market wage by the CF. It is more practical, because calculating the Rural Marginal Wage (RMW) is difficult to determine. The analyst needs to determine first, how a typical rural
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worker, who is affected by the project, allocates his productive time. And then, estimate the value of the workers output.
When dealing with migrant labor, in principle, two additional factors should also be taken into account. First, moving to the urban area or city may result in a less satisfactory life style (working for longer hours and greater stress). The shadow wage should be adjusted upward to account for this loss of utility. Second, if a migrating worker belongs to a large family, then the effects of the migration on the remaining family members should be taken into account. Although they lose the migrants output, they gain because the migrant no longer consumes the familys output. It is possible for the latter to be greater than former.
4.2.3 Review of the application of shadow pricing methodology In a nutshell, national parameters to be estimated for economic analysis are divided into five categories, namely; primary factors, traded goods, non-traded goods, average estimates, and the discount rate. Primary factors cover different categories of labor, the value of domestic resources, and foreign exchange. Traded goods are goods for which the economic cost or benefit derived from their use is determined by their international prices. Shadow price estimation is only essential where there is a significant difference between the border price and the local market price. Deriving the shadow price is also a necessity in situations where a benefit is likely to feature prominently as an input or output for a number of projects. Nontraded goods are items that, by their nature, cannot be traded across borders, or may not be economically viable for trade. The estimation of a shadow price is prompted by a situation where there is a significant difference between the local market price of a resource and its economic value, or where, as for traded goods, a benefit is likely to feature prominently as an input or output for a number of projects. Whereas, average estimates relate to sectors where cost data do not allow for further breakdown. The most important of such estimates, the standard conversion factor, describes the value of a unit of domestic resources in terms of a unit of foreign exchange. The standard conversion factor, in the case of average estimates, is derived indirectly through conversion factors for traded goods. Discount rates quantify the
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effect of time on a projects cost and benefit values. According to UNIDO models, at the national level, classic shadow pricing estimation would involve deriving a general equilibrium economic optimization model, with the following three specific features: 1) an objective function, describing the effects of the use and generation of resources on a measure of economic value such as the gross domestic product (GDP); 2) constraints on the use of resources (technological coefficients for each economic activity and a limit for the resource as a whole), and 3) non-zero constraints for the value of resources, and non-negativity constraints for resources.
The shadow price is then the effect on the value of the objective function resulting from an increase or decrease by one unit in the availability of a scarce resource. However, the estimation of nationwide shadow prices in this way is fraught with complexities and numerous constraints, and is usually infeasible in practice.
Experts agree that all shadow prices are interdependent because their value depends on the value of inputs from other sectors. Therefore, these interdependencies should be accounted for through conversion factors, derived by solving a series of simultaneous equations using an inputoutput approach. This is the principle upon which the semi-inputoutput analysis is conducted, and is useful for non-traded sectors where the output from each sector may appear as inputs into others.
Take note that in estimating shadow prices, the choice of methodology is primarily determined by the nature and extent of available data. Readily available data is hard to find in Rwanda, hence this is likely to constrain the analyst.
Nonetheless, the analyst would be well advised to start with straight forward analysis, and deal with the more sophisticated models as data comes on board as investments are made in research studies or contributions arise from the academia. In the absence of such national-wide
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standards, the analyst can attempt to derive a set of accounting price ratios (APRs) for the various economic sectors of Rwanda pertinent to the project. An APR is the ratio between the market or financial price and the efficiency or economic value of a specific good/service or sector, which is useful for the economic analysis of investment or development initiatives. The larger set of APRs, can be derived on the basis of nationwide information contained in the national accounting matrix.
Despite the clear importance of shadow pricing for a developing country such as Rwanda, no set of official national parameters exists, nor has any attempt been made to estimate them. The countrys development path is guided by five-yearly Economic Development and Poverty Reduction Strategy (EDPRS), Vision 2020 and the National Public Investment Policy. These documents stress the need for investments and the importance of development projects to spur economic development, job creation and alleviate poverty. Under such circumstances, it is vital that market signals provide an adequate guide for investment planning and project appraisal. There is therefore, an apparent need for a consistent set of prices that reflect the resource costs and the social benefits of proposed investments.
Again, the classical approach to shadow pricing is quite complicated, requiring the solving of a number of simultaneous equations in a full input/output matrix. However, simplified procedures, as described below, are widely accepted and give a good approximation to the more elaborate methods. If the analyst believes that the exchange rate is distorted, then this has to be taken into consideration in the calculation of economic costs. In Rwanda there is an open system of foreign exchange dealing. Hence, it is appropriate to assume that the prevailing exchange rate is a fair reflection of the market rate for foreign exchange.
Shadow pricing labor It is the shadow pricing of labor that is most critical in a developing country like Rwanda. For all the costs judgment has to be made concerning the impact of taxation, and must be adjusted accordingly. Taxes are transfer costs and are not included in economic costings. Usually
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shadow pricing is carried out via the use of accounting ratios. The accounting ratio is the ratio of a shadow price and the market price.
Shadow pricing of unskilled labor In its simplest form the shadow wage rate represents the opportunity cost of labor. In other words, the loss of production which would arise by withdrawing a unit of labor (man or woman) from agriculture, or any other sector of the economy, if the rest did not work harder. In the event of high levels of unemployment and underemployment in rural areas together with the low labor productivity of rural unskilled labor, the shadow wage rate would significantly be lower than the prevailing rates in the labor market. Ideally, the opportunity cost of labor should be based upon the marginal productivity in agriculture, which is usually less than the average productivity. If nothing else is possible, the analyst can take halve the average productivity as a measure of the marginal productivity.
Shadow pricing other costs A reduction must be made to remove taxes. In order to do that, the analyst must know the tax rate per product or simply establish the financial cost and the market cost, the difference will then be the tax. Then the accounting ratios could be derived.
Project contribution to the national economy This can be determined using regression analysis. Also, results could be used to compare investments or projects for decision making purposes. Again, the key national policy documents (Vision 2020, EDPRS and the National Public Investment Policy) aim to enhance economic growth, job creation and poverty alleviation, among others. Hence, implications to the countrys macro-economic framework would be demonstrated by the coefficients of the model, the marginal propensity to consume and the marginal propensity to import for example, then the magnitude of multiplier effects of the investment/project as relates to the benefits to the economy as a whole would be established. Overall, this enables the analyst to recommend a better investment/project strategy to decision makers.
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In modeling, the analyst can illustrate the investment/projects macroeconomic impact on the real sector, fiscal accounts and the external sector, building on the principles of the national income identity. Capturing key macroeconomic variables in the economy, such as; gross domestic product, household income, private investment, public deficit and the trade balance. This is important because no sound economic program should put such key macro-economic variables into jeopardy, be it in the medium or long term. The model should be developed on the following assumptions: There are no changes in foreign transfers and net factor income. These could be excluded. Exports are exogenous. The total public investment in question is also exogenous, as an economic policy variable. Other exogenous variables could include average daily wage rates, the labor component and expenditure on local resources.
Exogenous Variables EXPtot X W L Alp = Public investment in the project or program (agriculture development for example). = Exports = Average daily wage rate = Labor component = Proportion of total public investment expenditure on local resources = Average labor productivity
Endogenous Variables GDP Yh Yhd Yg Ctot Cimp Cloc = National income (Gross Domestic Product) = Household income = Household disposable income = Government revenue = Total private consumption = Consumption of imported goods and services = Consumption of locally made goods and services
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Sh Ptot IPimp IPloc Timp Tinc Tcons Tbal Etot
= Household savings = Total private investment = Proportion of imported intermediate resources in investment = Proportion of local resources in investment = Taxes on imports = Income tax revenue = Tax on consumption (or value added tax) = Trade balance = Employment (man days)
Principal equations of the model Yh Yhd Ctot Sh Ptot Yg Tbal Etot = (Cloc + IPloc + EXPloc) x (1-tc) + (Cimp + IPimp) x (1-tm) + X = (1- ty) x Yh = m x Yhd = Yhd Ctot = I x Yh = tm x (Cimp +Iimp+EXPimp) + ( ty x Yh )+ tc (Cloc + Iloc + EXPloc) = Sh + Yg Ptot EXPtot = (EXPtot) x l)/W + ((GDP EXPtot x + lty + (1-) tm + (-l) tc))/ALp
Supplementary equations of the model Cimp Cloc IPimp IPloc Timp Tinc Tcons = Margimp x Ctot = (1-Margimp) x Ctot = Margimp x Ptot = (1-Margimp) x Ptot = tm x Cimp + Iimp + EXPimp) = ty * Yh = tc x ( Cloc + IPloc + EXPloc)
In a developing country like Rwanda, public fiscal deficit is always a worrying economic indicator because of the inability or limited instruments to raise non-inflationary finance. Similarly, because of the shortage of foreign savings, a public investment program that saves foreign exchange would ideally be preferred.
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Household income is a function of consumption, private investment, public spending, and exports. Disposable income is a function of total household income, provided the income tax rate is known. Therefore, both the marginal propensity to consume and the marginal propensity to import coefficients would be derived through linear regression analysis as follows: C = a + m (GDP); where C = consumption, a = constant, m = marginal propensity to consume, and GDP = Proxy for household income. TB = a n (GDP); where n = marginal propensity to import and TB = trade balance (net exports).
The level of employment creation (man days) could be determined (estimate) by taking the total output generated indirectly (or value added) and dividing it by the labor productivity ratio. To get the equivalent number of fulltime employment days created indirectly, the man days could be divided by 245 days usually the assumed average an employee is expected to work in a full year. The reference labor productivity ratio could be taken from the sector that is expected to benefit the most from the investment. This is because, while employment creation through the indirect effects could be experienced by all sectors, much more would be confined to a particular sector.
The marginal propensity to consume, and to import are useful proxies in impact analysis of the proposed investment on the economy. For example, the marginal propensity to consume can be used as a proxy for the consumption conversion factor.
Take note also that shadow prices based on national data averages have to be distinguished from sectoral, provincial or project specific parameters. Ideally, project specific parameters should be estimated for each individual project because the opportunity costs of the resources used or produced may differ from project to project, due to the specific characteristics of each project. This can be applied, for example, to construction of public housing. The economic
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value of a housing project for lower-income earners may be higher if it is located near a market, school, tax park or main road (bus stop); compared with one located far from such places.
A larger set of APRs is beneficial for project analysis within sectoral projects and, at the same time, would improve overall appraisal results. In general, the APRs for tradables and nontradables are expected to fall within the range close to unity or less than unity, respectively. The following illustrations show how an APR can be derived for one component of a project, as long the analyst can establish the costs with taxes and those excluding taxes. Again APR = 1/(1+t), where t represents tax.
Cost Item Diesel Oil Heavy Equipment Spares and tires Equipment (Total) Cost including tax (RWF) a 50,000,000 10,000,000 1,500,000,000 150,000,000 1,710,000,000 Cost excluding tax (RWF) b 40,000,000 7,500,000 900,000,000 120,000,850 1,067,500,850 Tax (RWF) c (a - b) 10,000,000 2,500,000 600,000,000 29,999,150 642,499,150 Derivatives c/b 1/(1+t) 25.00% 0.80 33.33% 0.75 66.67% 0.60 25.00% 0.80 60.19% 0.62
Note: the overall tax rate for the equipment component of the project is 60.19% (c/b) while the accounting ratio is 0.62 (b/a)
4.2.4 Limitations of using shadow prices Shadow prices are used to account for inaccurate market values, that is, when the market prices are judged to be inaccurate and not providing a true reflection of the economic value of a good or service. In other words, shadow prices are usually used to take into account the major impacts of a project where economic values differ from financial values. The three most important approaches in implementing shadow prices; the world price approach, the opportunity cost approach and the willingness to pay (WTP) approach, all have limitations in their application.
The major limitation of using shadow prices is caused by the inability of calculating shadow prices due to acquisition and availability of data. Also, the determination of shadow prices in itself. This is caused by several problems, including: external factors which might affect the
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general standards of living in a community, fluctuation of inflation values which make it difficult to determine future values, determining the actual influence taxes and subsidies have on the optimal allocation of production factors, variations in the expected economic life of an investment or project, and surrogate prices which do not totally eliminate price distortions caused by imperfect market conditions.
4.2.5 Best approaches to valuing project benefits and costs If the project idea is deemed worthwhile, then the objectives of the proposed new project need to be stated clearly. This would allow for the determination of information requirements and the identification of possible sources, and the full range of possible benefits and costs. The challenge will then be how these are translated into monetary terms. Not knowing or a lack of understanding of the project objectives on the part of the analyst, is an impediment to the process of benefit valuation and cost estimation.
The objectives should be stated so that it is clear what the proposed project is intended to achieve. Objectives could be expressed in general terms so that the range of outcomes to meet them can be considered in the analysis.
Outcomes are the eventual benefits to society that the proposal is intended to achieve. Often, objectives are expressed in terms of the outcomes that are desired. But outcomes sometimes cannot be directly measured, in which case it would be appropriate to specify outputs. At this stage, it must be determined if some of form of research is required (or not) as well as the range of expertise necessary, before proceeding.
Keep in mind that the relevant demand or supply prices can only be adjusted for the effect of trade controls and market structures on the basis of project inputs and outputs stated in the proposal. However, indirect benefits and costs could be uncovered while undertaking the research. Again, the effects of trade controls and market structures are the main causes of the differences between the financial and economic values. Therefore, the shadow price of an
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input or output is the weighted average of its demand and supply prices adjusted for these additional factors.
The basis for valuing incremental and non-incremental of project inputs and outputs is provided is provided below.
Input Output Incremental Adjusted supply price or opportunity cost Adjusted demand price or willingness to pay Non-incremental Adjusted demand price or willingness to pay Adjusted supply price or opportunity cost
Before determining the need for conducting research, the analyst should determine whether impacts can be measured and quantified and, whether prices can be determined from market data. If this cannot be readily done, then use of the willingness to pay approach for measuring benefits would be considered (i.e. by asking people what they would be willing to pay for a particular benefit service or product). Likewise, consider the willingness to accept approach when determining the amount of compensation consumers would demand to accept a particular benefit. An analytical assessment of their ability to pay in appropriate before survey results are confirmed and put to use.
In either case, the relevant benefits and costs to government and society must be valued, and the net benefits or costs calculated. The analyst should avoid use of unauthentic data for sake of accuracy when presenting results of, data generated by the analysis. However, the confidence in the data provided by the analysis must be improved depending on the importance of the decision at hand (e.g. depending on how much resource will be committed by the decision).
With above in mind, some general principles apply in the measuring of benefits and costs expected from the project. It is useful early on in the assessment process for the analyst to consider widely what potential benefits and costs are relevant, informed by project objectives of course.
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Benefits and costs considered should normally be extended to cover the period of the projects lifecycle or useful life of the assets involved.
Benefits and costs should normally be based on market prices because they usually reflect the best alternative uses that the goods or services could be put to (i.e. the opportunity cost).
Wider social and environmental benefits and costs for which there is no market price must also be assessed.
Cash flows and resource costs are important in as far as informing the assessment of the affordability of the proposal, but they do not provide the opportunity cost. Hence they cannot be used to understand the wider benefits and costs of proposals. Proposals are most likely to require resource budgets, and therefore it should be made how they will be funded.
In the absence of existing robust (i.e. reliable and accurate) monetary information, a decision must be made whether to commission a survey/study, and a determination must be made on how much resource to devote to the exercise.
Hints on estimating the value of benefits As a general rule, benefits should always be valued unless it is clearly not practicable to do so. The analyst must therefore, take into account all direct effects of the proposed project or intervention, the wider effects on other areas of the economy should also be considered as well. These effects should be analyzed carefully as there may be associated indirect benefits, which might need to be included in the assessment.
Market prices provide the first point of reference for the value of benefits. There are a few exceptions where valuing at market prices is not suitable, for example, when theres cause to believe that the market is dominated by monopoly suppliers, or is significantly distorted by taxes or subsidies. In all these scenarios, prices will not reflect the opportunity costs and adjustments must be made specialist economic advice is required.
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Even when the assessment covers the full expected period of use of an asset, the asset may still have some residual value, in an alternative use within the sponsoring agency (e.g. line ministry, district etc) or as scrap in the second-hand market. These values should be included in the assessment, however, it may be difficult to estimate the future residual value at the present time. This is calculated based on the remaining useful life of operational assets (buildings, land etc), which is considered to represent the unconsumed cost at the end of the modeling period.
Benefits that might occur without the project (i.e. deadweight) should not be included in the benefits for the proposed project. For example, some proportion of growth in coffee exports could happen, even in the absence of refurbishment of a coffee washing station.
The results of previous targeted studies may sometimes be used to estimate the economic value of the project. However, the analyst must take care and considerable effort to analyze suitability, context, circumstances and characteristics of samples (consumers) before using the information. These factors can limit the extent to which values can be generalized, and hence further scrutiny is required to rule out special cases.
Hints on estimating costs Costs should be expressed in terms of relevant opportunity costs. Costs of goods and services that have already been incurred and are irrevocable (sunk costs) should be ignored. What matters are costs about which decisions can still be made.
It can be useful to distinguish costs between fixed, variable, semi-variable and step costs, this could be useful when conducting sensitivity analysis. The following are definitions of these cost categories: Fixed costs remain constant over wide ranges of activity for a specified time period (e.g. plant or office building). However, they could turn into variable costs in the long run.
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Variable costs vary according to the volume of activity (e.g. operating or packaging or training costs).
Semi-variable costs include both a fixed and variable component (e.g. maintenance costs, where the contract is responsive to variations in activity.
Step or semi-fixed costs, where costs are fixed for a given level of activity but they eventually increase by a given amount at some critical point (e.g. after telephone call volumes reach a certain level, a new call centre may be required).
Although categorization costs in this way might aid sensitivity analysis, the analyst must be careful with the categorization. Indeed, a cost that is fixed relative to one factor may change with another. More complex modeling may be required to describe how costs change over time and with different variables.
For some project proposals, the relevant costs might involve delivery of goods and services to associated projects (e.g. supplying intermediate inputs to another project). For such proposals, the full economic cost should be calculated, net of any expected revenues. Regardless, the full cost of all projects should include both direct and indirect costs, and all attributable overheads. A dual cost analysis of this kind enables opportunity costs to be fully considered, and sensitivity analysis to be conducted later on.
Cost estimation can be difficult, depending on the class of costs under consideration. Therefore, the requisite expertise must be sought at all times. It would require input from engineers, economists, accountants and other specialists, depending on the nature of the project and the type of the assessment. The analyst needs to understand and communicate clearly the scope of the assessment to ensure that specialists provide relevant cost information, at the same time as ensuring that opportunities have been thoroughly explored.
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Depreciation costs should not be included in the assessment, even though they may be important for resource budgeting purposes. Depreciation is an accounting mechanism used to spread the expenditure on a capital asset over its lifetime.
Even when the assessment covers the full expected period of use of an asset, the asset may still have some residual value, in an alternative use within the sponsoring agency (e.g. line ministry, district) or as scrap in the second-hand market. The cost of maintaining or disposing off operational assets at the end of the modeling period should be included in the assessment. However, it may be difficult to estimate the future residual value at the present time.
Some projects expose the government to contingent liabilities (i.e. commitments to future expenditure if certain events occur). These should be assessed and monitored if the proposal is approved. One class of contingent liabilities is the cancellation costs for which a government agency may be liable if it terminates a contract prematurely. Such liabilities, and the likelihood of their occurrence, must be taken into account. Operations and maintenance costs after completion of the project fall into this category. Therefore, life-cycle cost considerations and environmental sustainability should be included in the assessment, particularly the management-in-use (i.e. maintenance and operations) component. If done correctly would address most the under cost estimation associated to these types of projects.
4.3 Financial Analysis The financial analysis of an investment/project determines whether it is financially viable, i.e., if the proposed investment/project is financially attractive or not from the sponsors (government, company and investor) viewpoint. It is a cornerstone of any capital investment project. Unlike the economic analysis, the financial analysis deals with accounting/nominal prices and costs, the unit of analysis is the investment/project and not the entire economy. Therefore, a focus on the additional financial benefits and costs attributable to the project is maintained. The financial analysis approach evaluates the entire project by providing projected balance, income, and sources and applications of fund statements.
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Project revenues, costs and net benefits are determined on an incremental basis, with and without-project basis. Take note, with the project just means that only additional revenues and costs due to the project should be taken into account. Both should be calculated on an annual basis. The analyst could choose to estimate revenues and costs in constant prices to account for inflationary tendencies, in that case, the year of appraisal becomes the base year. However, because of the inability to forecast inflation levels with precision, it is advisable that the analyst uses nominal prices and costs.
4.3.1 Requirements The analysis should start with the projection of the volumes of production (output), purchases and sales that are part of the normal profit and loss statement of a project. Then the analyst proceeds to generate the financial cash flow statement of the project, taking into consideration; the accounts receivable, the accounts payable and the changes in cash balances. This operation produces the expected annual financial receipts generated by the project as well as the expected annual financial expenditures incurred, hence, deriving the net cash flow for the project.
Project receipts could be broken down by sales made domestically and those made abroad, while expenditures on each item (including machinery, equipment, and material inputs) would be categorized using the same criteria. When done this way, it makes it easier when deriving conversion factors, shadow prices and economic value for cost-benefit and economic analyses purposes. In other words, the breakdown is important for analyzing foreign exchange implications in the two analyses. In the same vein, it is essential to classify the categories of labor that will be employed.
Regardless, the analyst must ensure that forecasts of revenues and expenditures over the life of the project are not only accurate, but are supported by sound assumptions as well, i.e. prices, inputs and outputs of the project have been consistently developed. Ideally, these are
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determined by projecting changes in market demand and/or supply of the specific project inputs and outputs.
The analyst must also identify the source of financing. Project financing is a key variable for the commercial viability of a project. Its debt/equity structure and the terms of interest rates impact on the projects tax liabilities and its debt service obligations. Furthermore, the required rate of return as well as the discount rate would be derived using the debt/equity structure, Besides, the required rate of return on equity financing needs must be determined when assessing the viability of the project from the sponsors point of view.
4.3.2 Developing financial cash flows Again, viability 3 is determined by the timing of the projects cash receipts from the sales (revenues) and cash disbursements from its purchases (costs). As a result, the analyst must adjust sales and purchases projections for changes in accounts receivable and accounts payable in order to reflect cash receipts and cash expenditure, respectively. Further still, the analyst must also account for changes in cash balances and working capital when constructing the financial cash flow statement.
As is often the case with long term projects, its life may not coincide with the life of all its assets or the scope of analysis might not match the life of the project. Hence, the analyst must estimate the value of any of the assets remaining at the end of the period, also referred to as the terminal value.
It is only when the financial cash flow statement of the project is completed that its viability can be assessed. For public investment or government sponsored projects, the analyst could develop three distinct financial cash flow statements, reflecting the point of view of the financier, the sponsor and the government budgetary point of view, as follows:
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The financiers point of view deals with total investment, it examines the expected receipts and expenditures, and determines if the net cash flows are sufficient to cover the projects financial obligations (i.e. interest payments principal loan repayments as part of outflows);
The sponsors point of view. These are the same as the financiers point of view, but include loan disbursements (as part of inflows); and
The government budget viewpoint to determine if the relevant line ministries or public authorities have enough resources to finance their obligations to the project. Take note that government is often interested in the amount of taxes collected as well as direct and indirect subsidies provided as a result of project implementation.
When developing financial cash flow statements from the financiers viewpoint, the analyst should begin with the net cash flow before financing and debt service. This is because the financier is very much interested in knowing if the projected net cash flows are sufficient to repay the prospective loan, this is consistent with the basic requirements of credit analysis.
The financial cash flow statements from the total investment point of view can be augmented by the proceeds of debt financing, reduced by the principal interest payments and principal loan repayments to obtain a net cash flow from the sponsors perspective. In principle, the sponsor or investor of the project expects to receive a rate of return greater than the opportunity cost of equity. In other words, the present value of the discounted net financial cash flows over the life of the project should not be less than zero. The required discount rate should also reflect the risk associated with the nature of the project and the degree of financial leverage employed in financing the project.
Governments are often very interested in the impact of a project on their budgets. Therefore, from a government perspective, the analyst should show if the project would add to or subtract from the relevant line ministry or public authoritys overall share of tax
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revenues/budget. If we are to assume that the project is financed by raising taxes or through tax revenues.
4.3.3 Constructing tables of revenues and expenditures Constructing tables for project revenues and expenditures is the most critical aspect of the analysis. If the tables contain wrong figures, the subsequent analyses will be meaningless. That is, decisions made thereof will definitely be embarrassing and may lead to catastrophic events, like bankruptcy for example.
The analyst should therefore endeavor to spend more time in constructing these tables. To construct these tables, the analyst identifies the full set of revenues and expenditures, estimates their quantities for each period, and calculates their values by applying their prices to their quantities in each period. This needs to be done carefully. Any type of analysis is no better than its data.
There are no shortcuts. It is seldom, if ever, accurate to construct one year of revenues and expenditures and to assume that this year is repeated 10 times in the investment horizon. This does not exist in the real world; there are changes in price levels, land becomes expensive, data management becomes cheaper due to advances in technology, goods and services follow a price cycle etc.
One analyst might not have the expertise to estimate all the quantities and prices needed in the analysis and may have to draw upon other specialists for data estimates for a proposed investment/project. Above all, these data often require some adjusting to fit the type of analysis underway.
One financial framework is not better than another is. Each has its own internal consistency, but data from one framework might not fit in another. The greatest difference between financial cash flows and other cash flows, like cost-benefit cash flows for example, is that it
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may include accrued values, depreciation and similar allowances. Other analyses do not use accruals, depreciation allowances or other non-cash items; each cost and benefit is fully recognized at the time it occurs (not accrued beforehand).
There are three types of cash flows; operating cash flows, investing cash flows and financing cash flows. The analyst must discern the inflows and outflows for a particular project.
Operating inflows are revenues generated as a result of project outputs (e.g. sale of products or services), while operating outflows are expenses incurred in the course of realizing project outputs (e.g. salaries, interest payments, administrative costs etc).
Investing inflows are funds generated from monies invested in income generating activities (e.g. interest earned on bank deposits), whereas outflows capture the capital expenditures made (e.g. towards construction of a bridge or procurement of capital equipment).
Financing inflows capture the amount received towards financing the project (e.g. loans or equity), whereas inflows deal monies spend towards compensating financiers and sponsors (e.g. principal repayments or dividend payments).
Overall, for any period estimate, the cash flow would resemble the following: (i) (ii) (iii) (iv) Sales, Costs and thus the profit margin, Capital spending (i.e. construction) and also Net working requirements
Therefore, cash flow from assets = + Operating cash flow - Incremental capital spending - Change in net working capital Where; operating cash flow
= + Earnings before interest and taxes (EBIT)

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+ Depreciation - Taxes 4.3.3.1 Timing of cash flows Timing is dealt with through discounting, and changes in the values of assets are dealt with by including residual values at the investment horizon. In financial analysis, accounts receivable and payable are recognized as they are incurred, not until the cash is actually received or paid. Working capital is not a cost, although the change in working capital during a particular period is either a cost (if working capital decreases) or a benefit (if it increases). Production costs are recognized fully at the time they are incurred. Changes in inventory may signal either costs or benefits, but the actual measurement of these is through production costs and sales. Financial cash flows are simple tables with everything recognized when it is incurred.
4.3.3.2 Accounting conventions The analyst must be familiar with the general form of the financial analysis model, it is useful to think about the conventions that are used to set it up in a standard way. This is not to say that one convention is better than the other, but rather to emphasize the need for standardization in order to provide ground for making comparisons. Conventions are important for many aspects of the model, such as the investment horizon, time of occurrence assumptions, and the common unit of measurement.
The investment horizon The investment horizon is the end of the period over which revenues and expenditures will be compared to ascertain whether the investment is feasible. If costs and benefits can be identified for the whole economic life of the project and uncertainties are low, then the full economic life provides the best investment horizon. If not, there may be logical points in the economic life of the project at which to terminate the investment analysis. For instance, there may be a point at which relatively certain revenues and expenditures are suddenly followed by much less certain values.
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Recapitalization of a power plant for example, tends to occur in 15 years cycles for replacing the system. While recapitalization of a building tends to occur several cycles; 5 - 7 years for repainting and new carpets, 15 17 years for service systems such as electrical and plumbing, and 25 - 50 years for major structural components. These thresholds where major new uncertainties occur might suggest an appropriate investment horizon. It is important, however, that while choosing the investment horizon, the analyst should not deliberately choose the horizon to favor the project. Even the analyst is considering a single alternative, it is advisable to analyze the project within various investment horizons to see whether a change in investment horizon affects the outcome. If s/he is comparing alternatives, s/he should use the same investment horizon in the analysis of each or recognize the differences in the two horizons.
Time of occurrence assumptions Revenues and expenditures attributable to the investment/project usually occur at different points within the standard period being used (within the year, for example).
As a consequence, in addition to observing the principles of time horizon, the analyst needs a convention for establishing where all revenues and expenditures will be assumed to fall within the period. In general, the analyst selects one of three possibilities: 1) either at the beginning of each period, 2) in the middle, or 3) at the end of each period. Underlying this practice is the need to have a reasonably simple pattern of revenues and expenditure over time so that converting nominal francs to present values, is not too difficult. This practice assumes that if all revenues and expenditures are shifted to the same point within each period, then, on balance, the overall outcome will not be affected. This is generally a reasonable assumption, except in cases where there is an unusually large revenues or expenditures being shifted a long way - say from near the beginning of a period to the end.
A typical example of this is a large initial lump sum investment, the analyst using end-ofperiod accounting will assume that this investment occurs at the end of the first year (and
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therefore is not adjusted for inflation and discounted once), when in fact it occurs at the beginning. When adjusted for inflation, this artificial adjustment of a large cost can make a major difference to the outcome of the analysis if there is no comparable revenue being similarly adjusted in the same model.
This sort of problem has led to hybrid conventions, which we are not going to tackle here. Nonetheless, the analyst must be careful of the software s/he is using. It is important to know which period conventions the software uses in order to avoid inappropriate calculations.
Common unit of measurement Before summing up the net cash flows, all revenues and expenditures must be expressed in a common unit of value. This involves two main things: 1) expressing them all in a common unit of measurement (i.e. Rwandan francs, US dollars or Euros of investment funds), and 2) expressing all in present values (adjusting for differences in the time of occurrence of revenues and expenditures). The two must be in a common monetary unit before they can be compared.
4.3.4 Evaluation Criteria Again, in the private sector, the net present value (NPV) is the most used criterion for assessing financial viability of the project. However, there are alternative criteria that are often used, to supplement the NPV criterion. As such, when a project is being appraised from the viewpoint of sponsors, the relevant cost of funds or discount rate or opportunity cost of funds is the return to equity that is being earned in its alternative use. The project will be financially or commercially viable if the present value of the discounted cash flows is greater than zero. If the NPV is less than zero, it simply means that the sponsors cannot expect to earn a rate of return at least equal to the return that could be earned if it were invested elsewhere, thus the project should be rejected.
Other criteria also used to judge if a project is financially viable include the internal rate of return and the payback period. Each of these criteria has its own shortcomings as already
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mention in the DCF section of the manual. Conversely, financiers rely on the use of the debt service capacity ratio when determining the projects ability to pay its operating expenses and to meet its financial obligations - debt servicing. Hence, this is the criterion the analyst must use when analyzing the project from the financiers perspective.
Note however, unlike private investors, the government usually provides a range of key socioeconomic services, including; healthcare, education, roads or other variety infrastructure and facilities. Many of these projects generate low or no cash revenues. Hence, the financial analysis presented above becomes meaningless. In this case, the analyst should rely on other analyses. Financial analysis however, should be used to estimate the yearly requirement of funds for the development and operation of the project. Thus, the analyst would rationalize the project based on other criterion like impact on development, job creation and poverty alleviation. 4.3.5 Illustration of cash flows 4.3.5.1 General Calculation of the net present value for the project revenues (inflows) and expenditures (outflows) is a straightforward matter, when fully grasped. A simplified illustration is contained in the table below, using the concept of variable rates over time methodology with a
discount rate of 10% - escalating by 0.5% each year. We assume that 50% of the capital cost is borrowed at 12% interest rate, payable in 5 equal annual installments.
Year (millions) Investment outlay: Machine cost Shipping cost Installation cost NWC Investment Total net investment Operating cash flows Sales Externalities Net sales Operating costs Costs of NWC (20%) Net operating costs Incremental net revenues Interest payments EBTDA Depreciation provisions (25%) Year 0 (RWF 2,400,000) (100,000) (120,000) (110,000) (RWF 2,730,000) RWF 4,200,000 20,000 RWF 4,220,000 RWF 3,200,000 22,000 RWF 3,222,000 RWF 998,000 157,200 RWF 840,800 655,000 RWF 4,410,000 20,000 RWF 4,430,000 RWF 3,264,000 22,000 RWF 3,286,000 RWF 1,144,000 132,455 RWF 1,011,545 655,000 RWF 4,630,500 20,000 RWF 4,650,500 RWF 3,329,280 22,000 RWF 3,351,280 RWF 1,299,220 104,741 RWF 1,194,479 655,000 RWF 4,862,025 20,000 RWF 4,882,025 RWF 3,395,866 22,000 RWF 3,417,866 RWF 1,464,159 73,701 RWF 1,390,458 655,000 RWF 5,105,126 20,000 RWF 5,125,126 RWF 3,463,783 22,000 RWF 3,485,783 RWF 1,639,343 38,936 RWF 1,600,407 Year 1 Year 2 Year 3 Year 4 Year 5
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Year (millions) Before tax income Corporate tax (30%) Net income Plus depreciation Net operating cash flow Terminal year cash flows Salvage value Tax on salvage value (15%) Total termination cash flows Net cash flow (NCF) Adjusted K PV of NCF (RWF 2,730,000) 10% (RWF 2,730,000) FNPV 895,456 Year 0 Year 1 RWF 185,800 55,740 RWF 130,060 655,000 RWF 785,060 RWF 0 RWF 785,060 10.5% RWF 710,462 FRR 23.25% Year 2 RWF 356,545 106,963 RWF 249,581 655,000 RWF 904,581 RWF 0 RWF 904,581 11% RWF 734,179 Year 3 RWF 539,479 161,844 RWF 377,635 655,000 RWF 1,032,635 RWF 0 RWF 1,032,635 11.5% RWF 744,942 Adjusted FRR 19.70% Year 4 RWF 735,458 220,637 RWF 514,821 655,000 RWF 1,169,821 RWF 0 RWF 1,169,821 12% RWF 743,442 Year 5 RWF 1,600,407 480,122 RWF 1,120,285 RWF 1,120,285 RWF 150,000 22,500 RWF 127,500 RWF 1,247,785 12.5% RWF 692,432
From a financiers perspective

Year (millions) Net Investment outlay Net sales Net operating costs Incremental net revenues Corporate taxes (minus) Operating cash flows Terminal year cash flows Salvage value Tax on salvage value Total termination cash flows Net cash flow before financing Loan withdrawals (plus) Interest payments (minus) Principle repayments (minus) Net cash flow after financing (RWF 2,730,000) Year 0 (RWF 2,730,000) Year 1 RWF 4,220,000 3,222,000 RWF 998,000 55,740 RWF 942,260 RWF 0 RWF 942,260 1,310,000 157,200 206,207 RWF 1,888,853 FNPV 1,127,628 Year 2 RWF 4,430,000 3,286,000 RWF 1,144,000 106,963 RWF 1,037,037 RWF 0 RWF 1,037,037 132,455 230,952 RWF 673,630 FRR 30.70% Year 3 RWF 4,650,500 3,351,280 RWF 1,299,220 161,844 RWF 1,137,376 RWF 0 RWF 1,137,376 104,741 258,666 RWF 773,970 Adjusted FRR 20.02% Year 4 RWF 4,882,025 3,417,866 RWF 1,464,159 220,637 RWF 1,243,522 RWF 0 RWF 1,243,522 73,701 289,706 RWF 880,115 Year 5 RWF 5,125,126 3,485,783 RWF 1,639,343 480,122 RWF 1,159,221 RWF 150,000 22,500 RWF 127,500 RWF 1,286,721 38,936 324,470 RWF 923,314
(RWF 2,730,000)
4.3.5.2 Sponsors perspective Estimated weighted average cost of capital (wacc) is at 13.6%; cost of debt (12%) and the required rate of return (15%).
Year (millions) Net Investment outlay Net sales Net operating costs Incremental net revenues Corporate taxes (minus) Operating cash flows Terminal year cash flows Salvage value Tax on salvage value Total termination cash flows Net cash flow before financing Loan withdrawals (plus) Interest payments (minus) Principle repayments (minus) Net cash flow after financing (RWF 2,730,000) Year 0 (RWF 2,730,000) Year 1 RWF 4,220,000 3,222,000 RWF 998,000 55,740 RWF 942,260 Year 2 RWF 4,430,000 3,286,000 RWF 1,144,000 106,963 RWF 1,037,037 Year 3 RWF 4,650,500 3,351,280 RWF 1,299,220 161,844 RWF 1,137,376 Year 4 RWF 4,882,025 3,417,866 RWF 1,464,159 220,637 RWF 1,243,522 Year 5 RWF 5,125,126 3,485,783 RWF 1,639,343 480,122 RWF 1,159,221
RWF 0 RWF 942,260 1,310,000 157,200 206,207 RWF 1,888,853 FNPV 1,002,263
RWF 0 RWF 1,037,037 132,455 230,952 RWF 673,630 FRR 30.70%
RWF 0 RWF 1,137,376 104,741 258,666 RWF 773,970 Adjusted FRR 21.70%
RWF 0 RWF 1,243,522 73,701 289,706 RWF 880,115
RWF 150,000 22,500 RWF 127,500 RWF 1,286,721 38,936 324,470 RWF 923,314
(RWF 2,730,000)
Note: Both the financier and the sponsor are concerned with both profitability and the liquidity position.
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4.3.6 Points to note 4.3.6.1 Nominal versus real cash flows The standard and recommended approach to evaluation is to use nominal values. In other words, inflation is built into projections of future cash flows. The alternative is to use real values. For consistency, using nominal values requires application of a nominal discount rate, likewise, using real values requires application of a real discount rate.
The use of real values is purposely to eliminate the effects of inflation in the data and, hence enable analysts and sponsors to make sensible comparisons across time periods even as prices change.
There two requirements to transforming a series of data from nominal values into real terms, the nominal data and an appropriate price index. The analyst must generate the nominal data series and, then gather the relevant price indices. Nominal data series is simply the data measured in Rwandan Francs 4. The appropriate price index can come from any number of sources, public authorities (i.e. BNR and NISR) and international bodies like the International Monetary Fund and the World Bank. At project level, among the more prominent price indexes are; the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditure Index (PCE).
Generally speaking, the price index for the base year (i.e. year of the project appraisal) should be set at 100 for convenience and reference purposes. To use a price index to deflate the nominal data series, the index must be divided by 100 (in decimal form). Real values are obtained using the following formula: Real value = Nominal value / Price index (in decimal form); for that same time period. Note however that, at project level, the analyst must account for changes in revenue (benefit) components (i.e. prices, quantity) and match them with the respective cost components (i.e. cost of sales, operating costs).
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Illustrations on how to derive real values

Scenario Period 2011 2014 2011 2014 2011 2014 Price (RWF) 80 96 80 80 80 88 Quantity (units) 100,000 100,000 100,000 140,000 100,000 120,000 Nominal value 8,000,000 9,600,000 8,000,000 11,200,000 8,000,000 10,560,000 Deflating nominal values into real values 9,600,000 (96/80) 11,200,000 (80/80) 10,560,000 (88/80) Real values 8,000,000 = 8,000,000 8,000,000 = 11,200,000 8,000,000 = 9,600,000
1. Price rises 20%, quantity stays same
2. Price stays the same, quantity rises 40%
3. Price rises 10%, quantity rises 20%
Interpretation notes Scenario one Prices are expected to rise by 20% from 2011 to 2014 with no changes in quantity. Result: The nominal value would increase by 20%, but the real value would remain the same.
Scenario two Prices are expected to remain constant between 2011 and 2014, but quantity is expected to increase by 40%. Result: Both the nominal and real values would increase by 40%.
Scenario three Prices are expected to increase 10% and quantity by 20%. Result: The nominal value would increase by 32% while the real value increases by 20%.
Alternatively, the analyst could deflate nominal cash flows by the price index (CPI) of each time period. This can be applied as shown in the following table.
Period 2011 2012 2013 2014
Nominal cash flows (thousands of RWF) 870,000 900,000 1,200,000 1,400,000
Price index 106.01 108.64 109.81 108.92
Re-index to 2011 100 102.48 103.58 102.75
Decimal form 1 1.02 1.04 1.03
Real cash flows (2011 RWF) 870,000 878,212 1,158,474 1,362,596
Notes: Column 2 contains the nominal cash flows and column 3 represents the price series. Column 4 reindexes the price series to the base year 2011 (i.e. year of project appraisal) by dividing all price values by 106.01 and multiplying by 100. Column 5 puts the price index in decimal form and column 6 divides
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nominal cash flows by the price index in decimal form to arrive at real cash flows (i.e. cash flows not affected by price volatility.
4.3.6.2 Discount rate The discount rate used to calculate a net present value is the weighted average cost of capital, the cost of debt or the cost of equity, depending on the type of financing and the debt/equity structure of the project. It is wrong to assume that equity is free money, in practical terms funds are actually tied that could have been used elsewhere. For government projects, the discount rate use is usually the cost of financing, which lies between 5% and 12% (benchmarked to interest rates generally charged by development banks, treasury bills and inter-commercial bank lending rates). It is appropriate for analysts to use the discount rate equivalent to rate of government borrowing, it could be asserted that this is the opportunity cost of investing in a project, i.e. the government could choose to buying back its debt if the funds are not invested in the project. Take note also, that it is acceptable for the government or public authority to provide guidelines or a methodology for calculating a net present value. While the discount rate may change over the lifetime of the project, the rate selected at the beginning of the process should be applied consistently throughout the Project Conception and Development stage.
The NPV results could be subjected to sensitivity testing, to ensure movements in influencing variables or the discount rate do not alter the recommendations.
4.3.6.3 The cash flow model Although cash flow forecasts are unlikely to be accurate predictions of future amounts, the analyst should test for reasonableness before developing his/her recommendations concerning the project. The test for reasonableness must take into account the following considerations: Consistency with government, line ministry/public authority or sectoral strategy and business need; Relationship with similar projects; and
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Awareness of current market conditions, including economic cycles, competitive environment and technological improvements.
4.3.6.4 Common cash flow errors The analyst must avoid the common errors in cash flow forecasts, which include among others: Over optimistic assumptions for key variables, e.g. revenues, costs and time; Inadequate consideration of short term and long term price and cost variances; Not fully accounting for potential variation over time of key components, e.g. capital expenditure and repairs and maintenance; and Failure to recognize the inter relationships between variables, e.g. exchange rate impact on cost of raw materials.
4.3.6.5 Cash flow assumptions Assumptions are a key factor in determining cash flow values, and must be documented for reference purposes. This provides users with greater confidence in the cash flow forecasts and greater transparency of the changes required to the model if assumptions change.
4.3.6.6 Cost Costs include
capital
and
operating
costs
to
government
of
implementing
the
investment/project or delivering the relevant service. It covers investment costs (capital and equipment acquisition), maintenance and operation costs, and service delivery costs over the period of the project. When dealing with costs, the analyst should focus on cash flows and not accruals. Focus should be on two major value measures: Direct costs, which can be assigned to a particular function or activity. For example, labor and materials used to deliver a service; and Indirect costs, which contribute to the service delivery but cannot be assigned to any specific activity. For example electricity or water charges.
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Take note that depreciation expense of government capital expenditure is an accrual measure (i.e. is not a cash flow) and should not be included in the cash flow forecasts.
Direct costs These are costs that can be assigned to a particular function or activity, which may vary depending upon the preferred delivery method of the project. Common project direct costs include: Direct capital costs, specific to product/service production, e.g. raw materials, plant and equipment, land and construction costs, design costs; Direct maintenance costs, clearly linked to servicing the project and/or infrastructure asset, rather than improving or adding to it, e.g. tools and equipment, labor costs; and Direct operating costs, relating to costs for everyday functions of the project, e.g. administrative expenses, employee salaries and benefits, payroll tax, insurance, electricity and water supply costs.
Direct operating costs can also be broken down further into fixed and/or variable operating costs. Fixed costs are not dependent upon product/service volume, while variable costs are dependent upon product/service volume. Recognizing such categories improves awareness and effective use of sensitivity testing of government projects.
Revenues derived from the future sale of project assets at the end of investments life cycle should be deducted from the cost value at the respective point in time. Such revenue should only be included in the cash flows if it can be reliably measured.
Indirect costs These are other costs that contribute to product/service delivery but cannot be assigned to any specific activity. They may include: Construction overheads, e.g. site security; Operating overheads, e.g. postage costs; and
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Indirect capital, e.g. equipment and capital improvements.
Determining the terminal value Ideally, the terminal value of the project or sale value of its assets is calculated as the total of the future cash flows they would be expected to generate at the end of the investment horizon, discounted back to the present value. If the assets have a useful life longer than the term of the project and there is a competitive market for the assets, a terminal value should be calculated in line with acceptable approach and included in the cash flows.
Theres no generic terminal formula in existence. For assets that are expected to generate constant cash flows for the remainder of their useful life, the net present value formula can be used to assess the terminal value. The net present value or net present costs is illustrated in the example below, using a 9% discount rate.
RWF (millions) Net cash flow Discount Factor Present Cost Net Present Cost Year 0 (80) 1.000 (80) (180) Year 1 (50) 0.917 (46) Year 2 (30) 0.842 (25) Year 3 (20) 0.772 (15) Year 4 (10) 0.708 (7) Year 5 (10) 0.650 (7)
4.3.6.7 The discounted cash flow model A DCF model must have two essential components: A forecast of future cash flows over a number of years; and An appropriate discount rate to discount back these future cash flows to their present values or costs. Again, the basic formula to calculate the present value of a stream of future cash flows using DCF is:
Where: PV = present value of the cash flow; CFt = cash flow in year t; r = discount rate; and n = the number of years the cash flow is to be discounted.
4.4 Economic analysis Unlike the financial analysis whose unit of analysis is the project, not the entire economy, and as a result focuses on accounting/nominal prices and costs in determining whether the
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investment/project is financially viable. For a project to be commercially viable, it must be financially sustainable, as well as economically efficient. If a project is not financially sustainable, economic benefits will not be realized. Economic analysis and financial analysis are hence two sides of the same coin and complementary. The principle difference is in the definition of benefits and costs.
The economic analysis approach emphasizes on ascertaining the investment/projects desirability in terms of its contribution to the economic and social welfare of the country as a whole. Economic analysis depends on the results of the market, technical (social acceptability and environmental sustainability) and financial aspects. As such, financial analysis is a critical input to the economic analysis. However, results of financial analysis are usually adjusted to derive most of the estimates for economic analysis. The economic appraisal of a project deals with the effect of the project on the entire society and determines if the project increases the total net economic benefits according to the society as a whole.
Financial analysis is necessary for three reasons, namely to: assess the degree to which a project will generate revenues sufficient to meet its financial obligations; assess the incentives for producers; and ensure demand or output projections on which the economic analysis is based are consistent with available budget resources of financial costs.
4.4.1 Underlying differences between economic and financial analysis Financial and economic analysis can be applied at many different levels, and can be used to assess a wide variety of activities including the use of macroeconomic instruments, sector plans, projects, and programs or policies, to mention a few. Consistent with the theme of the manual (see the Executive Summary), our focus is on the use of these in investment appraisal. This implies a focus on planning and programming public investments.
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4.4.1.1 Definition and concepts Financial analysis Financial (FA) refers to the use of data on the revenues and expenditures associated with the investment/project as these accrue to project participants. In other words, FA refers to the purely money flows associated with a project. Economic analysis Economic analysis (EA) differs from financial analysis insofar as the former represents an analysis of the welfare effects of a project from the perspective of the national economy as a whole. Because the welfare of society is defined as the sum of the welfare of its members, an assessment of the welfare effects of a project implies the summation of its impact on all members of society. However, economic benefits, costs and impacts may be assessed at the provincial and district or community levels as well. Take note that, to further the distinction between financial and economic analysis, the terms revenue and expenditure are used for financial figures that are not adjusted to or do not reflect their economic counterparts. The terms benefits and costs must be applied to those figures which are presumed to be representative of economic benefits and costs. Like with financial analysis, economic analysis provides a means of examining who gains and who loses from a project, though in this case from an economic perspective. In sum, financial analysis tells project sponsors whether the project is viable from the perspective of private investors, while economic analysis (specifically cost-benefit analysis), assesses whether a project would improve the overall economic well-being of a country. DCF analysis and CBA represent just one type of financial and economic analysis, respectively, and are oriented exclusively towards estimates of private and social profitability. 4.4.1.2 Areas of application Financial analysis It may be used for a number of purposes, including but not limited to:
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Projection and monitoring of cash flows for the project to ensure that the sponsor has the financial resources to meet its operating commitments;
Assessment of the financial affordability of the project to those taking a financial stake in the project (i.e. financiers, equipment suppliers, etc);
Determining the prices for goods or services that must be charged given projections of output and demand to ensure financial viability; and
Assessment of the overall profitability of the project (both ex-ante and during operations) for project participants, i.e. as confirmed by the discounted cash flow (DCF) analysis. DCF analysis represents the incentive for specific stakeholders to participate in the project and hence shows the distribution of revenue and expenditure flows across these stakeholders.
Economic analysis It may be used for a number of purposes in planning and project evaluation, including: The identification, quantification and assessment of economic benefits and costs associated with a project; The identification of the distribution of benefits, costs and impacts (i.e. quantities) of a project or sector plan across different actors in society; Assessment of the extent to which a project or sector plan meets specific economic objectives such as job creation (employment), national development (economic growth and social transformation), macroeconomic stability, stabilization of exchange rates, etc; Assessment of risk and uncertainty associated with project benefits, costs and impacts; Assessment of the economic affordability of the project to the economy; Determination of cost-efficiency; and Determination of overall profitability to the economy, i.e. economic cost-benefit analysis.
Take note, that of these purposes, the determination of economic profitability is the focus of this manual. For decision making purposes, it represents the net welfare change to the national
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economy associated with the project. In reality, PIP management uses multi-criteria objectives for project selection and programming in its decision making process, of which economic profitability is one component. Also, note that in practical terms, economic analysis as applied in the analysis of projects, programs, strategic plans, policies, etc. differs from financial analysis in a number of respects, including: Economic or shadow prices are used to value input and output quantities in place of market prices where markets are distorted by policies (i.e. taxes, tariffs, quotas and subsidies) or where markets are imperfect (i.e. monopoly power or common pool resources); Non-marketed goods and services (i.e. health spillovers). These are accounted for through non-market methods of valuation; An economic opportunity cost of foreign exchange is used where the market exchange rate does not reflect the equilibrium between the supply and demand for the currency; and A social rate of discount is used in place of the market-derived opportunity cost of capital. With the above caveat, the manual is designed to orient the analyst to using financial and economic analysis for assessing viability of project cash flows, and financial and economic affordability. 4.4.2 Economic approach and elements The approach is based on methods that would determine the net effect of the proposed investment/project. Economic analysis can also be used to rank projects in their order of contribution and importance relative to the countrys development goals. The analyst is advised to take the following steps when undertaking economic analysis: Define a set of development objectives against which project feasibility is to be assessed;
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Translate development variables (which may be weighted based on importance) into a common denominator by which project benefits could be measured;
Identify and attach value to project benefits and costs; and Determine criteria against which projects will be selected or rejected.
4.4.3 Methods of economic analysis There are various methods and techniques of economic analysis encompassing different degrees of theoretical soundness, sophistication, data requirements, and applicability. In general, the purpose of economic analysis is to ensure: 1) resources are allocated efficiently, the investment/project provides sufficient benefits, 3) sufficient funds and institutional capabilities are available to sustain investment/project operations, 4) the distribution of investment/project benefits and costs is consistent with its objectives, and 5) social and environment concerns are adequately addressed.
Ideally, economic analysis should begin at the early stage of project development. This allows for the conduct of appropriate demand analysis, alternatives and least-cost options. When done correctly, economic analysis provides a strong basis for choosing between investment/project alternatives, approaches and strategies. Then, selected options that are deemed likely to meet the demand for the proposed activities would be further evaluated to examine their worth from the point of view of the national economy and long term sustainability. Attention to the extent of cost recovery and budget implication issues should likewise enhance prospects for investment/project impact and sustainability.
In general, the scarcity of investible resources, competing alternatives and the increased squeeze on public expenditure have provided extra impetus for economic analysis techniques to be more widely promoted in sectoral projects. Economic analysis techniques are therefore, used in looking at priorities and alternatives in a more systematic manner and also in improving efficiency in the allocation and use of scarce resources within targeted sector activities.
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Thus, the parameters behind an economic analysis framework are those of scarcity of resources (i.e. the cost side), and competing needs (i.e. the benefit side). Economic analysis sets out a framework for comparing the resources (costs) used in an investment with the expected outcome (benefits) resulting from it. It takes a view that generally those investments/projects with the highest benefits to costs ratio are the most appropriate to implement. The process is consistent with other analogous approaches to any decision-making system or framework, which compare advantages (benefits) and disadvantages (costs) of alternatives. In addition, the analysis goes beyond just the comparison of benefits and costs of an investment/project to assess equity implications and sustainability issues.
The three most commonly used methods of economic analysis are: Cost-effectiveness analysis; Cost-benefit analysis; and Methods that incorporate broader socio-economic development objectives in the analysis.
4.4.3.1 Cost-effectiveness analysis Cost-effectiveness analysis only requires that a quantitative measure of effectiveness be defined. Monetary assessment of benefit through economic growth, job creation and reduction in poverty levels as a result of an investment/project is known to be very difficult to substantiate based on a single investment/project. There are various possible approaches, however. The most popularly known approaches are the human capital approach and willingness-to-pay approach. In the context of a health sector investment for example, under the former, improvements in health status are viewed as investments that yield future gains in productivity, and the latter is considered an accepted measure of the value of life. This is often estimated by examining earnings premiums for risky jobs or safety expenditures by consumers. However, both approaches are fallible. The former ignores the consumption value of health, and the latter has substantial practical limitations in a developing country like Rwanda, though it may work well in a developed country context. Nonetheless, the basic idea
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behind the cost-effectiveness analysis method is that effectiveness or utility of an investment/project can be measured in terms of nonmonetary values such as years of potential life gained or healthy years of life gained, or disability-adjusted life years or quality-adjusted life years. However, this does not rule out use of the method in health, transport and water projects.
Given that there are difficulties in quantifying economic benefits from public investments, the analyst should concentrate on comparing benefits and costs from different project alternatives already undertaken in the country. However, tentative illustrations will be addressed in the subsequent sub-section of this manual.
4.4.3.2 Cost-Benefit analysis Cost-benefit analysis of investments requires that outcomes be valued in monetary units in order to calculate the net economic benefit of the investment/project. This method will be addressed later in the subsequent sub-section of this manual.
4.4.4 Process of economic analysis The analyst should keep in mind that in principal, theres no guarantee that the economic benefits of investments/projects will be realized over the life of the investment/project. Therefore, a financial analysis of the project is required to ensure that it indeed contributes to the financial soundness of the relevant line ministry/public authority or decentralized entities (districts) and that the project will continue to operate satisfactorily over its life. For revenuegenerating projects, financial internal rates of return should be calculated and financial statements analyzed.
However, many kinds of investments/projects supply public goods that are financed by the government from its budget. The projects are often not revenue-generating and the relevant ministries/public authorities are likely not organized along commercial principles. Therefore, alongside economic analysis, an analysis of public expenditures is critical for determining the
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sustainability of the projects in terms of their respective roles in relevant sectors, in the overall budget process, and in terms of current and future priorities.
4.4.4.1 Assessment of benefits and costs Five concepts are considered when assessing investment/project benefits and costs, as already outlined in the financial analysis section of the manual. These include: 1) choice of the unit of measurement, 2) use of shadow prices, 3) direct costs, 4) direct benefits, and changes in inflation and relative prices:
4.4.4.1.1 Choice of unit of measurement The unit used in measuring benefits and costs is a function of the goals being assessed. Values of benefits and costs are expressed as changes in income, savings, or consumption and in terms of either domestic or world prices. For practical purposes and for purposes of comparability internally, the analyst should value benefits and costs at domestic prices.
4.4.4.1.2 Shadow Prices Benefits and costs appropriate for economic analysis differ from those relevant to financial analysis. While financial analysis requires the use of market prices, economic analysis requires the adoption of economic prices. Such distinction between economic and market prices may arise for two reasons: Market prices may not represent the real scarcity value of production factors of the economy; and Market prices may not reflect the socio-economic policies and objectives of the government.
Take note that conceptually, the economic price of a resource is the value to the economy of the output produced when it is put to its best alternative use. The value of the output foregone by not putting the resources to its best alternative use represents its opportunity cost. In Rwanda, it is difficult to judge the existence of imperfect market conditions in factor markets,
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though understanding targeted government policies involving tariffs and subsidies could help in the construction if surrogates. Hence, national guidelines could be developed for the purpose. Nonetheless, it is an undeniable fact that in most developing countries, market prices frequently fail to reflect the true value of production factors to the economy. Import demands, often in excess of foreign exchange supply, indicate an overvalued exchange rate. High unemployment or underemployment implies an overvalued price for labor, especially unskilled labor. Persistent high demand for credit symbolizes an undervalued price for capital. Accordingly, shadow prices for these resources must be applied in order to ensure proper economic assessment of development projects.
Again, shadow prices are the values of project inputs and outputs reflecting their relative scarcity as well as their relative importance in achieving the various socio-economic objectives outlined in the governments key policy documents.
The analyst should focus on four types of shadow prices in the application of the shadow pricing methodology when undertaking economic analysis, namely shadow prices of; foreign exchange, capital, labor and land. Take note that the shadow prices of foreign exchange and capital are national parameters. As such, they should be estimated by the Ministry of Finance and Economic Planning or the Central Bank. Other shadow prices could be estimated on the basis of the local market situation in a particular project area on a need basis.
Recap on shadow prices Shadow price foreign exchange To convert international prices (c.i.f, f.o.b) of traded goods into domestic prices, an exchange rate must be specified which may or may not coincide with the official rate. Generally, in a flexible managed float, the shadow price of foreign exchange is equal to the official exchange rate if all trade distortions as well as domestic price distortions were totally eliminated. If this is not the case, then the shadow exchange rate becomes a synopsis indicator of the extent of trade distortions prevailing in the economy.
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Shadow price of capital This is defined as the rate of return which the funds would have earned in its best available alternative use. In a competitive capital market, the interest rate prevailing would represent the true scarcity value of capital to the economy. In a fragmented market, the economic value of capital is less reliably indicated due to a wide and fluctuating range of interest rates. The true scarcity value of public investment funds is reflected by the opportunity cost of capital. To a private investor, the opportunity cost of capital is the minimum rate of return at which s/he is willing to invest an additional unit of capital. Given a range of alternative investments, the investors portfolio would initially consist of those investments/projects yielding the highest returns, and subsequently, include projects earning progressively lower returns. Shadow Price of Labor In an economy suffering from high unemployment or underemployment, the economic price of unskilled labor is likely to be lower than the prevailing wage rate. If the project hires a worker who has been unemployed, thus unproductive, the shadow wage may be zero. Note however, the hiring of labor may involve additional costs such as transport and services related to movement of labor. Inclusion of these indirect costs would usually make the shadow price of unskilled labor greater than zero but below the money income received. Shadow price of land The shadow price of land used in a specific project is the value of output foregone had the land been utilized (put to production) in its best alternative use. For example, if the land used by the project would have otherwise remained idle, its opportunity cost from the economic standpoint is zero. Alternatively, if the land could have been used to produce 4.5 tons of beans, per year, this would represent its opportunity cost. 4.4.4.1.3 Direct costs Estimation of direct project costs involves an analysis of the supply-demand situation of the project inputs and, the corresponding price changes resulting from the projects implementation.
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General estimation procedures The analyst must differentiate the entire set of project inputs, between those inputs that reduce the supply to other users and those inputs that would be supplied from increased production.
For inputs resulting in reduced supply to other users, the shadow price is the market selling price appropriately adjusted for; 1) the value of rationed components, 2) the effect of monopoly power in buying and selling, and 3) the actual price impact of the supply reduction.
For inputs obtained from increased/expanded production, the relevant cost estimate is the actual cost of production.
For inputs that are imported or are substitutes for exports, the foreign exchange cost involved should be corrected by the shadow price of foreign exchange, and any transport costs and trade service margin should be added.
4.4.4.1.4 Direct benefits The analyst must differentiate the entire set of project outputs, between those outputs that create additional supply and those that reduce the output of local producers, and those outputs that substitute for imports or add to exports and those that are supplied for free.
General procedures Estimation of direct project benefits involves the following. For outputs leading to additional supply or reducing the output of other local producers, the shadow price is the market price, corrected for the following; 1) effects of any rationing, 2) monopoly power of some buyers, and 3) actual price impact based on the size of the additional supply.
For goods that substitute for imports or add to exports, foreign exchange earnings or savings involved are estimated and corrected by the shadow price of foreign exchange.
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For goods or services that are supplied for free, the value placed by users on the facilities should be estimated, using the willingness to pay approach. That is, what they would pay if they were to purchase the goods or services and/or facilities.
4.4.4.1.5 Inflation and relative price changes The analyst should be careful when dealing with issues concerning inflation. If inflation occurs but is expected to affect all products and services within the economy at approximately the same rate, then such general inflation is unlikely to impact on the project uniquely, i.e. it will not change the relative values of benefits and costs. Therefore, in valuing benefits and costs, constant prices are assumed. However, if price changes were to affect only certain products and services, these should be reflected in the assessment process. Details to which such relative price changes are accounted for would depend on the level of price changes and the value of the inputs to the entire project cost.
4.4.5 Assumptions for economic analysis Economic analysis is rooted on the principles of applied economics. Economic analysis is based on the belief that the market prices of project inputs and outputs do not necessarily reflect the values of economic benefits and costs, particularly when there are distortions in the marketplace. Thus, the analyst must know the three postulates underlying the economic evaluation methodology, which are based on a number of fundamental concepts of welfare economics. The three postulates are: 1) the competitive, demand price (i.e. consumers willingness to pay) for an incremental unit of a good or service measures its economic value to the demander and hence its economic benefit; 2) the competitive, supply price for an incremental unit of a good or service measures its economic resource cost (i.e. input which goes into the production of that unit); and costs and benefits are aggregated without regard to who the gainers and losers are attempting to separate the social aspects of project assessment from the economic efficiency aspects (see Musgrave & Musgrave, 1980; Campbell & Brown, 2003; Hindriks & Myles, 2006; Pigou, 2002).
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In reality, like in most national economies of the world, there are several explicit distortions in the Rwandan economy, including; personal income tax, corporate income tax, value added tax and excise duties, among others. These distortions have considerable impact on the economic valuation of capital, foreign exchange, and goods or services produced or used by any project in the country. Hence, they should be properly assessed and integrated in the economic analysis.
4.4.6 Developing economic cash flows The benefits of a projects output must be measured by the demand price inclusive of a value added tax rather than the market price received by the project in the financial analysis. Then again, if the project receives a production subsidy, the resource cost of inputs used in the production should include those paid for by the subsidy as part of the economic costs. Likewise, any environment externalities (i.e. pollution and the like), must also be assessed and accounted for during the analysis. Note however, that assessment of environment impacts may not be straightforward and may require a special environment impact study. The Rwanda National Policy on Environment (NPE) as well as the law of April 2005 in particular, mandates that environmental impact study is conducted on any development project. The environmental law overall, lays down the modalities to protect, safeguard and promote environment in Rwanda. The law governs environment in its broadest term (i.e. land, agriculture, forests, water, biodiversity etc.), REMA and the Rwanda Bureau of Standards among others, are tasked to enforce the law. Also, the law instructs that the national economic growth must be based on rational use of resources and should take into account environmental dimensions. Therefore, environmental impact studies should also be conducted on private funded projects (e.g. manufacturing, construction, agriculture, mining, waste treatment etc).
For some projects the output is not sold in a competitive market, for example, the benefits of road projects. In this case, the analyst must measure the total economic benefits received by consumers from the output of the goods and services generated by these types of projects.
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Again, financial cash flow profiles provide a basis for economic analysis. The analyst is only required to translate all financial transactions (i.e., receipts and expenditures) into benefits and costs in order to reflect the true value of benefits and costs to society or community as a whole.
For simplicity, goods and services should be classified into internationally tradable and nontradable, and should be assessed and valued accordingly (refer to the shadow pricing subsection for details). A good or service is considered internationally tradable if a projects requirement for an input is ultimately met through an expansion of imports or reduction of exports. On the other hand, the output produced by a project is a tradable good if its production brings about a reduction in imports or an expansion of exports. A good or service is non-traded if the domestic price of the good or service is higher than its FOB export price and it is also lower than its CIF import price. There are also cases where high import duties or restrictive import quotas are imposed on certain goods so that the goods that normally would be considered to be internationally traded cannot be traded.
For non-traded goods and services, the economic price of a project input or output is based on the impact that any additional demand for this input has on the demand as well as the supply of the good in the market. For example, suppose a project increases the production of a good. The additional supply by the project results in a decrease in the market price, which will cause consumers to increase their consumption but at the same time will cause some of the existing producers to cut back their production. In other words, the economic benefits produced by the projects output should be measured by the weighted average of the value of additional consumption enjoyed by consumers, which is the amount consumers are willing to pay to the suppliers (the demand price, VAT inclusive, if any) and the value of resources released by the existing producers (the supply price, inclusive of the subsidy but net of export tax). The demand and supply weights are determined by the response of additional demand and the cutback in supply with respect to the reduction in the market price.
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There are two key players in the marketplace, the consumer (or buyer) and the seller (or supplier) and the two have to interact for the transaction to occur both parties are price takers (i.e. neither of them can influence the price of a product, in competitive market). In a competitive market changes in the equilibria in the supply-demand model are caused by changes in either unit price of a product/service or quantity of product/service supplied, when other factors are held constant (disposable income, consumer preferences etc).
However, there are other variables that effect the supply and demand dynamics in the marketplace (i.e. changes in the price of substitutes, factor prices etc). Taxes for example, reduce the level of disposable income available to consumers and, therefore they can decide to consume less units of a product (e.g. passion fruit) or switch to its substitutes (e.g. orange).
Thus in a micro-economic model, a market value of a product is the price that a buyer is willing to pay, and a seller is willing to accept, with both parties knowledgeable about the prevailing market conditions and neither being under any compulsion to act then we can say that the market that particular product is in equilibrium (i.e. supply equals demand). The macro-economic model is an aggregation of the elementary micro-economic supply and demand model, it deals with aggregate supply (AS) and aggregate demand (AD) and, therefore it is also usually referred to as the AS/AD model. The analyst is expected to deal with the AS/AD model when conducting economic analysis.
In general terms, calculating economic values requires an understanding of how to integrate financial values, tariffs and taxes, handling and transportation costs, and exchange rate distortions. We know that financial prices are market prices, which are affected by the various tariffs, taxes and subsidies. In other words, financial prices are market prices, which incorporate all the tariffs, taxes and subsidies. We also know that economic values may differ from financial prices because: 1) consumers valuation of a product or service may be greater
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than the financial price they pay (e.g. water usage); and 2) financial costs may not be the true costs due to the opportunity cost involved national or international opportunity cost.
Overall, the financial analysis of a project focuses on its financial attractiveness to its private investors, whereas the economic analysis measures the impact of the project on the entire society. Hence, an economic analysis of a project helps determine whether the project increases the net wealth of a countrys society as a whole or not. Therefore, a project with a negative economic net present value will serve to shrink the economy rather than grow it. For example, if RWF 10 billion investment and NPV equals to RWF -1 billion. In that case we can conclude that the project uses RWF 10 billion of resources and only produces RWF 9 billion of value.
Illustration Suppose a project demands an input. The additional demand by the project will result in an increase in price, which in turn will cause the existing consumers to cut back their consumption while producers will increase their production. The economic cost of the inputs demanded by the project should be measured by the weighted average of the forgone consumption (valued by the price, VAT inclusive) and the value of resources costing the society or community (measured by the price, excluding subsidy, if any). Note that, weights (which can also be expressed in terms of demand and supply elasticitys) are determined by the response of consumers and suppliers to the change in market price. Some further adjustments may be made to these values to account for the general equilibrium impacts of these demand and supply improvements on other distorted markets.
Once the economic benefits and costs are calculated, they automatically replace the values contained in the financial cash flows, revenues (receipts) and expenditures (costs) respectively. A conversion factor can be created as the ratio of the economic value of an item to its corresponding financial price or cost. Once these are estimated then the financial receipts or costs of each item can be converted into their economic values (multiplying each item by its corresponding conversion factor).
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In the case of tradable goods, usually customs duties are levied on imported inputs or the imported items that the project output will replace. Also, export taxes or subsidies are levied on exported outputs of the project. Both of these are distortions and should be accounted for in the economic analysis. In general, the economic prices of these tradable goods are all priced at their border price plus the value of the foreign exchange premium. The foreign exchange premium must be estimated within the Rwanda general equilibrium framework (national guideline is required), relative to the market exchange rate, taking into account the sources of project funds raised in capital. A premium on the receipts or expenditures of non-traded goods must also be estimated as well. The analyst must incorporate these premiums in the calculation of the conversion factors for the non-traded goods and services.
There are certain projects in which consumers are willing to pay more than the value of the prevailing market price. In such cases, a consumer surplus will be generated by the project and should be incorporated as an additional economic benefit in economic analysis. This is critical for road enhancement, health and water projects. Conversely, there are also projects that generate negative environment externalities (i.e. pollution). In this case, the additional resource costs that are created by these negative externalities should also be assessed and accounted for. Economic resource statements could be created to guide the analyst, on an item per item basis.
Conversion factors can be updated according to changes in import duty rates, value added taxes, foreign exchange premium, export taxes or subsidies. Conversion factors at the point of entry can be used for the same good or service for different projects. However, conversion factors estimated at the project site are site specific and are dependent on the transportation and handling costs involved in moving the items to the project site.
Labor is generally considered a non-traded good. But, the economic cost of labor varies by occupation, skill level, working condition and location, and hence should be project specific.
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In sum, many international markets are heavily influenced by international trade policies as well the price policies of the industrialized economies (the United States, European Union and Japan). Given the economic and financial crises that have been experienced in the world, experts agree that these markets to some extent, do not operate efficiently from the point of view of allocating global resources to their best advantage. For example, agricultural protection and subsidization in rich countries create excess supplies and force world commodity prices downward to levels substantially below what they would be in the absence of such policies. Regardless, even these distorted international prices provide a useful approximation of the social opportunity cost of importables or exportables in a developing country like Rwanda. If the other countries policies are not expected to change in the foreseeable future, the world prices affected by specific-policies still represent the opportunity costs of Rwandan import substitution or export promotion. In this perspective, efficiency for Rwanda is thus a national concept, not a global one, since Rwandas policies only directly affect domestic prices and not international prices for nearly all tradables.
Therefore, the world price in Rwandan francs is equal to the world price in foreign currency times the foreign exchange rate. Hence, both the world price in foreign currency and the exchange rate are required to calculate the world price in Rwandan francs. If the analysis is addressing the issue of long-run efficiency (or international comparative advantage), it is appropriate to use long-run trend measures of both the world price (in foreign currency) and the exchange rate. Alternatively, if the assessment is looking at the historical experience of a recent period (for which data has been gathered), it is appropriate for the analyst to use recent historical data for both world prices (in foreign currency) and the exchange rate.
Finding prices for tradable inputs and outputs The analyst can find data on comparable world prices for tradable inputs and outputs in published international trade statistics. If appropriate world prices are not available at the Rwanda National Institute of Statistics or the Central Bank (BNR), s/he might explore trade data published by neighboring countries, industry groups, or international organizations (the
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International Monetary Fund, the World Bank, the African Development Bank and United Nations agencies).
In rare cases when world prices cannot be found directly, it is sometimes possible to estimate them indirectly. If there are no market failures and all policies are known and readily measurable, the analyst can adjust the observed private prices for the effects of divergences and find the social prices. However, this procedure can only be done if the effects of divergences are measurable, that is, if there are no quantitative restrictions affecting trade.
The analyst should be cautious when finding comparable world prices for tradable inputs and outputs. S/he should take into account three dimensions (location, time and quality - form) of the tradable. For example, for agriculture projects, the comparison of a domestic price with a world price must be done at an identical location (e.g. the nearby wholesale market), over the same time period (e.g. the main harvest season), and with a comparable quality of product (e.g. corn). Otherwise, prices cannot be said to be comparable, when errors introduced by transportation costs (different locations), the costs of or returns to storage (different time periods), and the costs of processing (different qualities or forms of the product) are not appropriately deciphered. Transformations over location, time and form are key critical points in the agricultural marketing chain. As such, comparisons of domestic with world prices of tradables hence need to be done at an identical point in the marketing chain.
In the event that divergences are not important in post-farm activities (transportation to processor, processing, and transportation to wholesale market), it is acceptable for the analyst to collapse these activities into one, and thus to carry out the domestic and world price comparisons at the farm-gate level. For such a case, the analyst needs to find the import parity prices for goods that substitute for imports and the export parity prices for goods that enter export markets. For import parity prices, the costs of domestic transportation and handling must be added to the import price at the nearest port, because the imports would have to be
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moved from the port to the nearby wholesale market to compete with local production. But for export parity prices, the costs of domestic transportation and handling are subtracted from the export price at the nearest port, because the domestic production would have to be moved from the nearby wholesale market to the port before it could be sold abroad.
Illustration on how to calculate the import parity price for import substitutes (e.g. corn) The import parity price is what a Rwandan importer has to pay to purchase the product in the world market and have it delivered for domestic sale in Rwanda. It is equal to the products border price plus transport costs (including any processing and transformation costs) and all expenses (other than taxes and subsidies) intervening between the point of entry and the place of consumption. It includes all shipping charges, other transactions costs, and import duties and surcharges levied in Rwanda. Hence, import parity prices, in which Rwanda has a surplus, reflects a market distortion for the product.
Adjustment of International Prices to Farm gate (I) Marketing chain Action F.o.b Dubai ($/ton) Take Freight and insurance & handling, Dubai to Mombasa ($/ton) Add C.i.f Mombasa, Kenya ($/ton) Transport and handling to Katuna ($/ton) add C.i.f Katuna ($/ton) Exchange rate (RWF/$) Multiply Exchange rate premium (%) Add to OER Equilibrium rate (RWF/$) C.i.f in domestic currency (RWF/kg) Custom taxes at Katuna (RWF/Kg) Import subsidies (RWF/kg) Transport and handling to wholesale (RWF/kg) Import parity price at local market Add Subtract Add
Financial terms 270.00 10.00 280.00 8.00 288.00 600.00 0.00 600.00 172.80 0.00 0.00 40.00 212.80
Adjustment of International Prices to Farm gate (II) Marketing chain Import parity price at local market Processing conversion (%) Cost of maize milling net of Import parity value (RWF/kg) Import parity value (RWF/kg) Distribution costs to farm (RWF/kg) Import parity value at farm gate(RWF/kg) Action Take Divide Subtract Subtract Financial terms 212.80 0.95 50.00 174.00 20.00 154.00
Note: This is an hypothetical case, but uses actual domestic and actual prices. Domestic prices are based on primary data, while international prices are published by the World Bank; commodity prices and forecasts.
The calculation of that price begins with the free on board (f.o.b) export price in Dubai (e.g. $270 per ton of corn). To find c.i.f (costs, insurance and freight) and handling at Mombasa,
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Kenya (e.g. $10 per ton), one adds international freight and insurance and handling costs to f.o.b Dubai. The same applies to finding the c.i.f import price at the border (e.g. $8 per ton of corn from Mombasa to Katuna, Rwanda). That c.i.f Katuna cost in US dollars is then converted into Rwandan francs with an estimated exchange rate (e.g., RWF 600/US$1). A conversion is made from tons into kilograms. Hereafter, transportation and handling costs from the border post to the nearby wholesale market are added to move the product to that location.
Another set of calculations is made because the desired farm gate price is in a different product form, maize not corn, a processing conversion factor is used to convert from corn to maize (e.g., 1 kg of maize is equivalent to 0.95 kg of corn). Corrections also have to be made for milling costs and losses. The last step is to add transportation costs from the processor to the farm gate.
Take note, an important consideration when calculating parity prices is the level of aggregation the analyst wants to use for each adjustment. By level of aggregation, we mean the extent to which different cost components are lumped together and referred to as one cost component. For example, all customs taxes at the Katuna border, have been lumped together in this case, but can be disaggregate to more than 1 line item.
The availability of data may also determine level of aggregation. If the only data available are aggregated then there is no choice (you may have to report all taxes together). However, if disaggregated data is available, one can present disaggregated information. Aggregation seems appealing because it makes the parity price calculation relatively shorter as it has less additions or subtractions. However, it is imperative that the order of line items from top to bottom follow the geographic movement of the commodity in question.
Sometimes it can be surprising to find that no trade occurs for a particular commodity even if prices suggest that it would be profitable for trade to occur. This could be an upshot of various
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reasons, which might include restrictive policies, conflict and risk. In such cases, calculation of parity prices is not possible since no actual trade occurs though hypothetical parity prices can still be estimated. Hence, it is important for the analyst to analyze and understand the other factors that may be causing the situation. Illustration on how to calculate the import parity price for inputs (e.g. fertilizers)
Import for NPK Fertilizers Marketing chain F.o.b Durban, South Africa ($/ton) Freight and insurance & handling, Durban to Mombasa ($/ton) C.i.f Mombasa, Kenya ($/ton) Transport and handling to Katuna ($/ton) C.i.f Katuna ($/ton) Exchange rate (RWF/$) Exchange rate premium (%) Equilibrium rate (RWF/$) C.i.f in domestic currency (RWF/kg) Custom taxes at Katuna (RWF/Kg) Import subsidies (RWF/kg) Transport and handling to wholesale (RWF/kg) Storage and distribution to farmers Import parity price at local market (RWF/kg) Note: This is a mixture of hypotheticals and primary data. Action Take Add add Multiply Add to OER Financial terms 155.00 20.00 175.00 10.00 185.00 600.00 0.00 600.00 111.00 0.00 0.00 30.00 20.00 161.00
Add Subtract Add Add
Calculation of export parity price for an income earning export crop (e.g. corn) The export parity price is what a Rwandan exporter has to pay to supply the product in the world market and have it delivered for foreign sale to the nearest port at his/her expense. It is equal to the products border price minus transport costs (including any processing and transformation costs) and all expenses (other than taxes and subsidies) intervening between the place of production and the point of exit. It includes all transactions costs, and export duties and surcharges levied in Rwanda. Ideally, corn prices would range between export and import parity depending on the availability of the domestic crop. If Rwanda is in surplus, or has more corn than domestic buyers can use, corn produced by the project must be priced competitively enough to attract export demand. This price level is known as export parity. Conversely, if Rwanda is in deficit, or does not have enough corn to meet domestic demand, then the market will be operating at import parity.
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Investment Appraisal Training Manual for Public Projects Export parity price for corn Marketing chain Action C.i.f Liverpool, UK ($/ton) Take Freight and insurance & handling, Mombasa to Liverpool Subtract F.o.b Mombasa, Kenya ($/ton) Transport and handling from Katuna ($/ton) F.o.b Katuna ($/ton) Exchange rate (RWF/$) Exchange rate premium (%) Equilibrium rate (RWF/$) F.o.b in domestic currency (RWF/kg) Export duties at Katuna (RWF/Kg) Boarder charges (RWF/kg) Transport and handling to wholesale (RWF/kg) Export parity price at local market Note: This is a mixture of hypotheticals and primary data. Add Multiply Subtract from OER
Financial terms 270.00 10.00 260.00 8.00 268.00 600.00 0.00 600.00 160.80 0.00 0.00 40.00 200.80
Subtract Subtract Add
Illustration of cash flows As we have established already, economic and financial analyses have different perspectives, they do not provide the same information but do complement each other or are related. Hence the analyst must construct project accounts of outputs and inputs using financial data. Then, make three corrections to; 1) eliminate fiscal effects, 2) account for external effects, and 3) correct prices using discount coefficients. After, the corresponding economic figures can be subjected to a social discount rate (different from the one used to discount financial figures) in order to derive the economic net present value and the economic rate of return, following the methodology already adopted for the financial analysis. Under ideal circumstances, the economic rate of return is expected to be higher than the rate of financial return. If this is not so, then the investment/project would be more convenient for a private investor than government (unless there are considerable social benefits that are not monetizable).
In constructing the project accounts of inputs and outputs, the analyst should keep in mind that while financial analysis involves examining project activities and resource flows of the main stakeholders or groups of stakeholders separately. Economic analysis involves examining the impact of the project on society (the economy) as a whole.
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Hence, financial analysis calculates the incentives for the main stakeholders, checks the solvency and longer-term sustainability of the project, and helps to design possible cost recovery mechanisms. It prepares the ground for an economic analysis, when the cash flows of the stakeholders are consolidated into a single cash flow. On the other hand, economic analysis provides valuable information on the contribution of the project in the international context as well as domestic effects in the economy. Through shadow pricing, it makes it possible to compare the project to: 1) clearly identified objectives of the countrys macro-economic policy; and 2) competitiveness objectives (or international viability) in the international price system for goods and services (by calculating benefits and costs in equivalent international prices, rather than in the often distorted local prices). Overall, economic analysis can help estimate (quantify) the impact of a project on: 1) economic growth (value added); 2) government funds (taxes and transfers); 3) foreign exchange resources (forex spent and earned); and 4) income distribution (wages and salaries).
It is highly advisable that the analyst should always perform a financial analysis before proceeding to an economic analysis. It is useful to compare the results of the economic analyses (notably shadow pricing) and financial analyses, as it may reveal that some benefits are transferred between certain stakeholders. To do so, the analyst needs to track any positive or negative externality for the country (or region) that may not have been taken into account in the financial analysis. The method used to move from financial prices to economic prices and costs has to be well explained and justified with regard to the political macro-economic policy objectives of the country.
Before conducting economic analyses, the analyst should reflect on which issues are crucial for the success of the project. For example, if a country is facing low foreign currency reserves and budget resources, an analysis of the effects may be useful to select the project that will use the least of these resources. Also, before thinking of applying the effects method, the analyst should first determine what data is available as well as how much time and funding such an
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analysis would require. It may be possible to use sector analyses carried out earlier, for example during programming, if they are recent enough or lean on information that was used by international institutions which may also have performed such analyses.
Take note that financial and economic analysis is based on estimates, but the future cannot be predicted with certainty, and feasibility studies often do not sufficiently explain how the planned results were estimated. This makes it difficult both to assess how realistic the proposed scenario is, and to plan for changes in the project during implementation. Therefore, the analyst should endeavor to understand project strategy at this stage. And, the analyst should spell out clearly the underlying assumptions.
Financial cash flows and analysis of electricity project

Year / Euro (millions) Total operating revenues Total inflows Total operating costs Total investment costs Total outflows Net cash flow 1 (165) (165) (165) 2 42 42 (56) (4) (60) (18) 3 115 115 (75) (4) (79) 36 4 119 119 (98) (24) (122) (3) 5 126 126 (101) (3) (104) 22 6 126 126 (101) (101) 25 7 126 126 (101) (26) (127) (1) 8 126 126 (101) (101) 25 9 126 126 (117) (117) 9 10 126 126 (117) 12 (105) 21
FNPV FRR Discount rate (74.04) -5.66% 5% Source of figure: European Commission Guide to CBA of investment projects (2008)
Note: At 5% discount rate, both the financial rate of return (FRR) and the financial net present value (FNPV) of the investment are negative.
In order to covert the financial data in the previous table into economic performance indicators (values), four steps were taken; 1) conversion of market to accounting prices, 2) monetization of non-market impacts, 3) inclusion of indirect benefits, and 4) determination of the social conversion factor (SCF).
At the time of the assessment, the following data was available for the Union: Total imports (M) Total exports (X) Import taxes (Tm) Export taxes (Tx) = 2,000 million = 1,500 million = 900 million = 25 million
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The formula used for the calculation of the Standard Conversion Factor is (SCF): SCF = (M + X) / [(M + Tm) + (X - Tx)] SCF = (2,000 + 1,500) / [(2,000 + 900) + (1,500 - 25)] SCF = 0.8. Also, conversion factors specific to project inputs and outputs within the EU were available and hence were applied accordingly, as illustrated in the economic analysis table. Economic cash flows and analysis of electricity project
Year / Euro (Millions Decreased pollution elsewhere External benefits Output X Output Y Total operating revenues Increased noise External costs Labor Other operating costs Total operating costs Total investment costs Net cash flow CF 1 (148.5) (148.5) ENPV 48.30 2 11 11 32.4 16.5 48.9 (12.0) (12.0) (18.4) (36.3) (54.7) (3.6) (10.4) ERR 11.74% 3 11 11 72.0 60.5 132.5 (12.0) (12.0) (18.4) (57.2) (75.6) (3.6) 52.3 SDR 5.5% 4 11 11 76.8 60.5 137.3 (12.0) (12.0) (25.6) (72.6) (98.2) (21.6) 16.5 5 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) (2.7) 39.8 6 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) 42.5 7 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) (23.4) 19.1 8 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) 42.5 9 11 11 76.8 68.2 145.0 (12.0) (12.0) (30.4) (86.9) (117.3) 26.7 10 11 11 76.8 68.2 145.0 (12.0) (12.0) (30.4) (86.9) (117.3) 10.8 37.5
1.2 1.1
0.8 1.1 0.9
Note: Data flows from the financial analysis table. At 5.5% social discount rate (based on EU guidelines), both the economic rate of return (ERR) and the economic net present value (FNPV) of the investment have turned positive. This does not only confirm project viability, but also that the project is more convenient for government than a private investor.
4.4.7 Evaluation criteria Once cash flows of the project have been constructed, the economic discount rate is estimated to convert the projects net economic benefits to the present value. The economic discount rate could be applicable to investments financed by the private sector, and not only to investments financed solely with public funds.
If the economic net present value of the project is greater than zero, the project is potentially worthwhile to implement because the project would generate more net economic benefits than if the resources had been used elsewhere in the economy. On the other hand, if the net present value is less than zero, the project could be rejected on the ground that the resources invested could be put to better use elsewhere in the economy.
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In most cases the economic internal rate of return is expected to be higher than the rate of financial return. If this is not so, this suggests that the project would be more convenient for a private investor than government (unless there are considerable social benefits that are not monetizable).
4.5 Cost effectiveness analysis Cost-effectiveness analysis is an appraisal and program monitoring technique used to determine the least cost way of supplying a good or service. It is used heavily in social programs and projects where identification and quantification of benefits in money terms is not straightforward, but at the same time, the desirability of the intervention is not in question.
The approach embodies assessments that consider both the costs of implementation and consequences of projects (i.e. alternatives). Unlike cost-benefit analysis, it is a decision-oriented apparatus that is designed to ascertain the most efficient means of attaining specific or articulated goals. Moreover, the idea that we are able to pursue a given goal using alternative approaches is undisputable, in practice or real world. The absurdity though, is to expect different results each time you implement the same strategy or use the same means. Therefore, cost-effectiveness analysis is by design, expected to help analysts or decision makers choose or recommend a project or alternative with the largest apparent effect.
As such, cost-effectiveness analysis compares two or more projects or alternatives according to their effectiveness and costs in accomplishing a particular objective (e.g. improving access to portable water, for example). By combining information on effectiveness and costs, the analyst can determine which project/alternative provides a given level of effectiveness at the lowest cost or, conversely, which project/alternative provides the highest level of effectiveness for a given cost.
The approachs key strength is that it can be easily reconciled with standard assessment designs in specific social sectors (e.g. education, health etc). Furthermore, it is useful for
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assessing even a single alternative that have a limited number of objectives and articulated measures of effectiveness. When there are multiple measures, however, a cost-effectiveness analysis becomes cumbersome. It may conclude, in the education sector for example, that one alternative is more cost-effective in literacy achievement, but that another is the most costeffective means of raising numeracy achievement. In such a scenario, without further analytical tools, the analyst will have no decision rule for choosing between alternatives. Thus, the reader should take note that cost-effectiveness analysis is a comparative undertaking. As a result, it is a judgment call and for the most part subjective. In most cases, it is sensitive to three parameters; a) the discount rate, b) measure of effectiveness, and c) the outcome or objective. In other words, it allows the people involved (i.e. analyst, decision maker, sponsor etc) to choose which alternative is most cost-effective, but not whether this or any alternative is worth the investment.
4.5.1 Estimating effectiveness The analyst must consider a similar range of issues subject to the area of interest and, try as humanly as possible to answer the following questions: What measures of effectiveness should be used, and are they reliable and valid? What estimation design should be used to gauge the success of an alternative in altering effectiveness (e.g., experimental, quasi-experimental, or non-experimental)? Will the design be successful in establishing a cause-and-effect relationship between the alternative and the measure of effectiveness? That is, will estimates of effectiveness possess internal validity?
Estimation designs may inspire varying confidence in the existence of causal relationships between alternatives and outcomes. From the perspective of the analyst, two points deserve emphasis. First, a cost-effectiveness analysis is only as good as its various components, including its estimates of effectiveness. The analyst should therefore, be cognizant of the strengths and weaknesses of the estimation design that is being employed, especially regarding their internal validity and, suspicious of secondary sources (i.e. studies) that conceal
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their methods or interpret their results too optimistically. Second, even straightforward evidence on effectiveness provides just a portion of the information needed to make informed decisions. Hence, without a thorough cost analysis of the alternative and a comparison with other alternatives, the analyst or the decision maker is tempted to choose that which provides a given effectiveness at the lowest cost. Keep in mind that being cost-effectiveness does not mean that the strategy saves money, and saving money does not necessarily mean that the new strategy is cost-effective.
Furthermore, most assessment studies in the social sector (i.e. education, health and infrastructure) are limited to a determination of comparative effectiveness. Costs are rarely taken into account (Levin and McEwan, 2000). As such however, many of the choices or recommendations that show promise in terms of greater effectiveness might be costly relative to their contribution to effectiveness, but in the normal course of business they may not be the appropriate choices. In other words, they could require far greater resources to get the same effect than an intervention with somewhat lower effectiveness, but high effectiveness relative to costs.
On the other hand, cost analyzes without measures of effectiveness are equally inappropriate for decision-making. For example, budgetary studies in education might well show that costs per student decrease as the size of schools increase. But it does not automatically mean that youre to recommend big class sizes. It is necessary thereof, to consider the comparative (i.e. big classes relative to small classes) outcomes (i.e. rate of school drop-out, quality of graduates etc). Hence, just as comparing effectiveness without measures of costs can provide inappropriate information for decisions, so can comparing costs without measures of effectiveness.
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Broader questions that must be asked and analysis of evaluation measures Evaluation measures inform the decisions taken against the alternatives or options under considerations, the commonly used are cost per benefit (i.e. number of accidents prevented or number of patients processed within a given time period).
In any case, the analyst must attempt to answer the following broader questions, subject to the norms and practices of the sector in question: What is the least cost way of delivering or supplying a service (i.e. treatment of disease, generation and supply of electricity, distribution of safe water etc) to a community? What is the best way to prevent road accidents, water contamination, malaria cases, heart attacks etc? What drugs are most cost effective in the treatment of specific illnesses? What is the least cost way of providing health insurance to poor households?
The objective is to compare costs per unit of outcome of two or more projects for purposes of capital budgeting. This approach is very useful where the aim is to choose from a set of alternative delivery systems or means that will provide the same service. A couple of useful examples include: Choosing from renovating a failing school or relocation of students to a nearby performing school and provide transportation and lunch services instead. If the system by design, expects the two comparative schools to give the same education benefits (i.e. in terms of quality). Choosing between two or three systems of electricity generation (e.g. hydropower versus solar power versus thermal power). Selecting amongst alternative ways of supplying safe water to communities (e.g. piped versus borehole water). Selecting between two or more programs for HIV/AIDS prevention (e.g. use of condoms versus circumcision versus abstinence).
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All in all, a cost-effectiveness analysis involves a series of steps similar to those of a normal investment appraisal except that the benefits are not measured in monetary values, but in quantitative impacts. The results are then discounted, like in cost-benefit analysis. The focus however, is on assessing the costs of the alternatives. Hence, economic analysis will involve the comparison of economic costs of two or more alternatives or estimating the economic cost per unit of the outcome of a project. Although the analysis in this case, does not place a monetary value on the benefits, the projects benefits (effectiveness) have to be discounted to the same year as the costs. But both the costs and units (i.e. measures) of effectiveness should be discounted by the same rate and, the cost-effectiveness ratios derived for each alternative. Then the analyst should rank the alternatives for decision making purposes, least is better while ranking. 4.5.2 Estimation of costs Every intervention uses resources that have valuable alternative uses. For example, a project for water distribution will require personnel, facilities, and materials that can be applied to other sanitary related and educational undertakings. By devoting these resources to a particular activity, government is sacrificing the gains that could be obtained from using them for some other purpose. Therefore, the cost of pursuing the intervention is the value of what the government must sacrifice by not using these resources in some other way. Technically speaking, the cost of a specific intervention could be defined as the value of all of the resources that it utilizes had they been assigned to their most valuable alternative uses. In this sense, all costs represent the sacrifice of an opportunity that has been forgone. It is this notion of opportunity cost that lies at the base of cost analysis in assessments. By using resources in one way, the government or community is giving up its ability to use them in another way, so a cost has been incurred. Specialized efficiency and societal studies are normally conducted to determine such units or provide tentative guidelines for the same.
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4.5.3 Sources of information It is important for the analyst to be cognizant or obtain a familiarity with the intervention that is being subjected to cost analysis. Only by doing so, s/he is then able to identify and/or specify the costs and benefits and measures of effectiveness for the intervention in sufficient detail, and subsequently attach values to each category.
In practice, knowledge or familiarity with the issues involved can be gained in at least three ways: a) through a review of project documents; b) through discussions with individuals involved in the intervention; and c) through direct observation of the interventions.
Emphasis is selective depending of the investment systems in place. Consideration could be on a single annual cost for the intervention, or successive annual costs of a longer time horizon or the life of the project. That is, projects of longer duration can be analyzed and the time pattern of costs accounted for using a discounting procedure or using a one-time restricted measure. For example, medical equipments can be assessed based on the differing capabilities, in terms of processing patients on a monthly basis for further elaboration refer to the marginal cost analysis in the subsequent sections.
4.5.4 Evaluation measures and decision parameters The approach takes use of discounting and non-discounting measures. The discounting approach is used to account for the time value of money, while non-discounting measures dont.
4.5.4.1 Discounting measures Cost-effectiveness ratio This is typical when the analyst is dealing with new interventions. CE t = PV of costs t PV of effectiveness t
Where CEt stands for cost-effectiveness ratio at time t; PV represents present value while effectiveness is stands for the unit of measurement (e.g. number of accidents or premature deaths prevented).
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Marginal cost-effectiveness ratio This is done when the analyst is comparing a new alternative to the existing situation or current strategy. CE t = C t CO Et EO
Where the numerator contains the difference between the costs of the new alternative and the current alternative, and the denominator is also the difference between the effectiveness of the new alternative and the current alternative.
In both cases, the cost-effectiveness ratio can be interpreted as the cost per unit of effectiveness. When there are more than one alternative, the ratios can be used to rank the respective alternatives. 4.5.4.2 Non-discounting measures This is also done when the analyst is comparing a new alternative to the existing situation or current strategy. Cost of new strategy Cost of current strategy Effect of new strategy Effect of current strategy
The new strategy could be recommended if the resultant outcome is less than zero. This simply means that the analyst expects the government to spend less on the new strategy to achieve the same outcome. Cost of current strategy Cost of new strategy Effect or outcome Effect or outcome 4.5.5 Methods of cost-effectiveness analysis As most social interventions need to be continued through time (e.g. drugs for the health sector or the movement of people and luggage for the transportation sector), the discount rate is not too critical because most costs and benefits occur in the same period. However, discounting is very important when capital expenditures are involved such as construction, specialized and general equipment etc.
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Cost-effectiveness analysis is principally conducted through two methods, namely, least-cost analysis and cost-effectiveness ratio analysis.
4.5.5.1 Least-cost analysis Least-cost analysis is used to determine the lowest cost alternative for meeting the same level of benefits, including intangible benefits. It is applied on projects whose costs are defined and benefits known, but whose benefits cannot be quantified by both natural and proxy measurements. The selection criterion is to choose the alternative that has the lowest present value of costs (PVC).
Illustration on a case of alternative water delivery systems to the community Consider two alternatives with alternative X supplying piped water directly to individual households, while alternative Y is to use boreholes at designated centers. Alternative X
requires RWF 1.3 billion to develop the necessary infrastructure and a further RWF 460 million to support operations during the first year. While alternative Y calls for a RWF 2.2 billion of investment in infrastructure development and will incur RWF 280 million during the first year of operations. The planning horizon for both alternatives is 10 years, and their respective annual operating costs are expected to escalate by 2% per annum. The alternatives are subjected to a 12% social discount rate.
Alternative X RWF (millions) Development cost Operating expenses Total cost PV of total cost Alternative Y Development cost Operating expenses Total cost PV of total cost 0 1,300 1,300 4,095 2,200 2,200 3,901 1 460 460 2 469 469 3 479 479 4 488 488 5 498 498 6 508 508 7 518 518 8 528 528 9 539 539 10 550 550
280 280
286 286
291 291
297 297
303 303
309 309
315 315
322 322
328 328
335 335
Note: Alternative Y is preferred by the least-cost analysis method. It needs a higher investment but would incur lower operating costs compared to alternative X. Judgment is then place on the quality of outcome relative to the objective value.
4.5.5.2 Cost-effectiveness ratio Cost-effectiveness ratio analysis is used to determine the lowest cost alternative for meeting the same level of benefits. It is applied on projects whose costs are defined and benefits known
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but can be quantified by proxy measurements (i.e. number of patients attended to, number of road accidents prevented, number of premature deaths prevented etc) at the same time. The selection criterion is to choose the alternative that has the lowest cost-effectiveness ratio (CER) or defined measure of cost-effectiveness (i.e. cost per each premature death prevented).
The method calculates the cost per unit of benefit, whether both benefits and costs are varying across alternatives or not.
Illustration on a case of alternative healthcare service delivery to the community Consider two programs with program A vaccinating against measles, while program B treats patients suffering from tuberculosis. Program A requires RWF 2.4 billion of capital investment and about RWF 1.4 billion to support operations during the first year, and is expected to save or prevent 500,000 children under the age of 5 years from pre-mature deaths over ten years. While program B needs RWF 1.45 billion of capital investment and will incur about RWF 1.1 billion during the first year of operations, and is expected to save 250,000 people infected the TB virus. The planning horizon for both alternatives is 10 years, and their respective operating costs are projected to increase by 2% every other year. The programs are subjected to a 12% social discount rate.
Program A RWF (millions) Premature deaths prevented Capital costs Facilities Equipments Vehicles Operating expenses Staff salaries and benefits Supplies Training Maintenance Others Total costs PV of total benefits 250 600 150 310 75 1,385 255 612 153 316 77 1,413 260 624 156 323 78 1,441 265 637 159 329 80 1,470 271 649 162 336 81 1,499 276 662 166 342 83 1,529 282 676 169 349 84 1,560 287 689 172 356 86 1,591 293 703 176 363 88 1,623 299 717 179 370 90 1,655 0 1 50,000 2 50,000 3 50,000 4 50,000 5 50,000 6 50,000 7 50,000 8 50,000 9 50,000 10 50,000
1,500 750 150
2,400 282,511
PV of total costs 10,814 Cost per unit of premature death prevented 0.04 Program B Premature deaths prevented Capital costs Facilities Equipments Vehicles Operating expenses Staff salaries and benefits Supplies Training Maintenance 250 450 200 100 255 459 204 102 260 468 208 104 265 478 212 106 271 487 216 108 276 497 221 110 282 507 225 113 287 517 230 115 293 527 234 117 299 538 239 120 900 500 50 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000
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RWF (millions) Others Total costs PV of total benefits 0 1,450 141,256 1 75 1,075 2 77 1,097 3 78 1,118 4 80 1,141 5 81 1,164 6 83 1,187 7 84 1,211 8 86 1,235 9 88 1,260 10 90 1,285
PV of total costs 7,981 Cost per unit of premature death prevented 0.06
Note: Program A has the least CER equivalent to about 0.04, which implies that it will cost government about RWF 38,279 to save each child from premature death, while program B would cost about RWF 56,477 to save each TB patient. Program A needs a higher of both the investment and cost but its reach is larger compared to program B. Judgment is then place on the quality of outcome relative to the objective value and subject to fiscal space. In other words, the analyst cannot necessarily recommend program A over B, the life of TB patients also matters. However, from analytical perspective, program A yields more value per franc of expenditure.
4.5.5.3 Marginal cost-effectiveness ratio Marginal cost-effectiveness ratio analysis is used to compare effectiveness of new measures against current strategy in order to determine the lowest cost alternative for meeting the same level of benefits to a target clientele. It is also applied on projects whose costs are defined and benefits known but can be quantified by proxy measurements (i.e. number of patients attended to or processed, number of premature deaths prevented, number of road accidents prevented etc) at the same time. The selection criterion is to choose the alternative that has the lowest marginal cost-effectiveness ratio (MCER). The ratio could as well be interpreted as the incremental cost per unit of effectiveness. In case of multiple alternatives available, the ratio can be used to rank the new measures relative to current measures. This method is useful when the analyst is not interested in the time span of the alternatives but rather for snap shot of the likely status or when dealing with equipments of continuous usage (i.e. medical equipments, MRI scan for example). However, these snap-shots must be informed by specialized and/or systematic studies on costeffectiveness. In analyzing the alternatives, the analyst must be cognizant with the effectiveness parameters of the service in question (e.g. the cost-effectiveness of cancer screening, its methods, strategies and options). This confirms internal validity of the assessment results derived by the analyst. The method calculates the cost per unit of benefit, focusing on variations in costs and capabilities.
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Illustration on a case of medical equipment with divergent delivery capabilities Consider the hospital administration has to make a decision of medical diagnostic equipment on two mutually exclusive alternatives. Equipment A costs RWF 175 million and is capable of diagnosing 500 patients a month. While equipment B which costs RWF 970 million can diagnose up to 1,200 patients a month.
Alternative Equipment A Equipment B Patients served (a month) 500 1,200 Total cost (RWF million) 175 970 Cost per diagnosis (CER) 0.35 0.81 EC ratios 2.86 1.24 Ranking 1 2
Note: Equipment A has the least CER equivalent to about 0.35, which implies that it will cost the hospital about RWF 350,000 to serve each patient, while equipment B would cost about RWF 808,333 to serve the same. In this case however, internal validation of the results is necessary before a choice is made. Unless faced with limited fiscal space for procurement of equipment B, it could be justified even if its average costs are relatively higher. Moreover, a detailed needs and capability analysis could reveal that the total benefits equipment B generates are much larger when compared to the benefits of equipment A.
Like the marginal cost-effectiveness analysis could as well be expanded to cover the incremental analysis of the current strategy (i.e. from an incremental perspective relative to the existing strategy). Again, the ratio can be interpreted as the incremental cost per unit of effectiveness.
Take for example, the traffic police enforcement case, whose objective is to reduce the number of accidents on the main highways and, by implication, minimize the number of fatalities resulting from road accidents. Consider the authorities are about to take a decision on four strategies. Studies show that the current strategy (i.e. strategy A) being implemented can save 600 lives a year but costs the department RWF 150 million to implement. The second strategy (B), which includes an additional component of law enforcement, would cost RWF 175 million but will also save 700 lives if implemented. The third strategy (C) includes an additional campaign component to raise awareness about safety to both drivers and passengers, it is expected to save 750 lives and costs RWF 170 million to implement. Lastly, the fourth strategy (D) costs RWF 185 million and would save 900 lives a year when implemented. It also provides instructions to road users in terms of signals and speed limits.
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Investment Appraisal Training Manual for Public Projects Options A B C D Policy measures Current strategy Current and enforcement Current and awareness campaign Current and road safety instructions Total lives saved (road accidents) 600 700 750 900 Incremental (lives saved/year) 600 100 150 300 Total cost (RWF million) 150 175 170 185 Incremental cost 150 25 20 35 Marginal CE ratios 250,000 250,000 133,333 116,667 Ranking
3 2 1
Note: Strategy D has the least marginal cost-effectiveness ratio, the department will spend RWF 116,667 to save the life each road user. Hence, the strategy yields more value per franc of expenditure as it allows the department to save money compared to other strategies. Moreover, it would also help save 300 additional lives compared to the current strategy. Strategy C and B are also preferable to the current strategy. Although strategy C requires the same amount of funds as the current strategy for its implementation, it would save additional 100 lives.
4.5.6 Limitations of cost-effectiveness analysis The major limitation of cost-effectiveness analysis (CEA) concept can be grouped into three categories, namely; 1) poor measurement of the consumers willingness to pay, 2) not accounting for some external benefits and costs, and 3) the problem of scale. Poor measurement of the consumers willingness to pay It confines the analyst from exploring the full extent to which consumers are willing to pay for the service or product in question. For example, the taxpayers, most probably, would be happy to pay for additional number of deaths prevented on the roads, as a measure of effectiveness. Hence, the number of accidents prevented or lives saved may not be the best approximation of the value of the final outcome. Also, the link between the intermediate measure of effectiveness and final output, such as number of lives saved or reduction in the number of traffic accidents is blurred. Hence, when faced with these kinds of situations, the analyst must make sure that these links are properly established and settled in terms of professional norms and practices and entrenched in sectoral standards (based on practice and empirical evidence). Not accounting for some external benefits and costs The concept of CEA excludes most externalities on the benefits side and the costs side as well. On the benefit side, it looks only at a single benefit and all other benefits are essentially ignored during project selection. For example, in healthcare, there are external benefits associated with such treatments as the vaccination of children (i.e. children or other people do not catch the infection diseases). Furthermore, an improvement in education will not only increase life-time earnings of the students but also most likely to contribute to a reduction in the rates of unemployment and associated crime. Therefore, it is better for the analyst to
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explore the possibility of conducting a full scale cost-benefit analysis before settling for costeffectiveness analysis. However, if a complete cost-benefit analysis does not seem possible, the analyst doing the assessment should be careful not to exclude important benefits arising from a particular project.
On the cost side, the analyst should scrutinize the way costs are treated while computing the cost-effectiveness ratio. In other words, attention should be paid to the treatment of costs, which may include not only financial but also social costs. For example, in the education sector, the enhancement of primary schooling is sometimes viewed in terms of the additional number of classrooms and/or improvement of their physical condition. However, in reality, many other costs must be included to get the desired outcome (i.e. textbooks, monetary and non-monetary incentives for teachers, desks etc). Indeed, different types of projects often have some of the costs in non-monetary terms (i.e. waiting time, enforcement costs, regulatory costs, compliance costs etc). Thus, when economic cost-effectiveness analysis is administered for such projects, it must account for all costs and should be based on the economic instead of the financial prices of goods and services. The problem of scale The concept of CEA is also faced the problem of difference in investment or capital cost. Scale differences may distort the choice of an optimal decision from the welfare economics perspective. As a result, an investment/project with smaller size but higher efficiency level may get accepted, while another which provides more quantity of output at a reasonable cost is rejected (refer to the medical equipment case, in the marginal cost-effectiveness ratio section for details). A strict cost-effectiveness analysis fails to overcome this problem, when the analyst is fixated on snap-shots instead of painting a complete picture.
On the other hand, a complete cost-benefit analysis does not have the scale problem because the net present value concept already accounts for the differences in size among alternative investments/projects.
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4.6 Cost-benefit analysis Cost-benefit analysis is one of the three methods of economic analysis. The other two are costeffectiveness and socio-economic impact analyses. The use of one or more of these methods is subject to the scope and objectives of the analysis as well as the available data.
Cost-effectiveness is the least comprehensive analysis, it simply identifies the least costly method for achieving specific physical objectives. Socio-economic impact analysis is broader in scope than economic analysis, it identifies the direct and indirect (secondary), positive and negative effects of a project or program.
Cost-benefit analysis determines whether the direct social benefits of a proposed project outweigh its social costs over the analysis period. Such a comparison can be displayed as either the quotient of benefits divided by costs (the benefit/cost ratio), the difference between benefits and costs (net benefits), or both. A project is economically justified if the present value of its benefits exceeds the present value of its costs over the life of the project.
Economic analyses generally focus on the primary (direct), effects of a proposed project or plan, which form the basis of project benefit-cost analyses. However, these direct effects can have ripple (indirect) effects throughout the economy. The input/output (I/O) model is useful when conducting cost-benefit analysis. Input/output analysis is a quantitative description of the relationship among industries within the economy, and therefore an excellent tool for providing a comprehensive description of the economy and identifying secondary economic impacts.
Note however, cost-benefit analysis requires teamwork, that is, two subject-matter skills will always be needed before valuation of project benefits and costs. The expertise in estimating expected frequency of events and the expertise in assessing the potential consequences of events. The cost-benefit analyst brings two additional skills to bear on the information
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provided by the subject-matter experts. Expertise in valuing outcomes in a monetary value and the expertise in making fair comparisons between benefits and costs.
Managers or immediate supervisors to the analyst must not exaggerate the difference between the two sets of skills. Both the specialist and the generalist rely on similar analytical skills, but the important point is that team effort is often required for a full cost-benefit analysis.
4.6.1 Input-output model framework The spending on the project, construction and operation of a power plant for example, affects the local (provincial) or national economy through several different channels. Construction and operations expenditures impact the economy directly, through the purchase of goods and services locally, and indirectly, as those purchases, in turn, generate purchases of intermediate goods and services from other, related sectors of the economy. In addition, the direct and indirect increases in employment and income enhance overall economy purchasing power, thereby inducing further spending on goods and services. This cycle continues until the spending eventually leaks out of the local economy as a result of taxes, savings, or purchases of non-locally produced goods and services.
The economic modeling framework that best captures these direct, indirect and induced effects is called input-output modeling. Input-output models provide an empirical representation of the economy and its inter-sectoral relationships, enabling the analyst to trace out the economic effects (impacts) of a change in the demand for commodities (goods and services).
4.6.2 Measuring and valuing benefits and costs Again, measuring benefits or costs and valuing them in francs or any other international monetary unit requires many different skills. For example, consider the case of a waste management project borne out of the need to reduce the Nyabarongo river pollution caused by manufacturing industries. Three subject matter experts could be required to inform the costbenefit analyst: an industrial chemist is needed to calculate the incremental change in the
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amount of pollutants entering the river; a biologist is needed to determine the effect of this change on bacteria in the river; and a health scientist is needed, in turn, to evaluate the effects of that change on the health of residents. In addition, an economist could also be required to work with the health scientist, in case recreational opportunities exist in the area. It is only after all those specific efforts are made that a cost-benefit analyst is needed to estimate in monetary terms the value of these benefits and costs to the community. This narrative makes it abundantly clear that it is not numbers that matter, but how they are derived and the justifications behind them. Therefore, the cost-benefit analyst is not only one that deals with calculations, after all, it is not necessarily the most difficult task.
4.6.3 Some important concepts Even when the analyst knows how to count in standard units, s/he needs to be careful about what s/he counts. In particular, incrementality, transfers, opportunity cost, sunk cost and terminal value are important concepts in cost-benefit analysis. Only incremental benefits and costs caused by the project should be compared, not those merely associated with the project in some way. For example, if the analyst is dealing with an export promotion or competitiveness project aimed at encouraging exporters, in the conduct of cost-benefit analysis of this type of project, the analyst needs to estimate not just the export sales that could be made, but specifically what sales could be made that might not be made in the absence of the project. To avoid double counting, the analyst must maintain a consistent point of view.
Consistence in ones point of view is not the only requirement. The analysis team also needs an in-depth understanding of the proposed investment to be able to identify a coherent set of benefits and costs without double counting. For example, suppose a new sewage-treatment plant is installed. The recreation value of the river improves, land values in the neighborhood increase, and health problems decrease. However, if all these effects are counted as benefits there is probably double counting. The increase in land values is probably a measure of the other benefits, not an additional benefit.
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4.6.3.1 Transfers compared with true benefits and costs The analyst counts resources that will be created or used up. Resources that are simply transferred from one section of society to another are not counted as benefits or costs. For example, income taxes are transfers from the point of view of the whole country. Taxes move resources around, but, apart from administrative and disincentive costs, nothing is used up. The point of view establishes whether a transaction is a transfer or not. It determines whether resources are passed from one section of society to another (a transfer) or passed out of the group or used up (a cost). From the point of view of a private business, for example, income taxes are definitely a cost.
In certain circumstances, tariffs, grants, taxes and many other items can be considered transfers. What is important here is whether resources are gained by or lost to the stakeholder(s) from whose point of view the analysis is being done.
4.6.3.2 Opportunity cost and sunk cost In calculating the benefits of public projects, the proper valuation to use is the price consumers are willing to pay for the output, that is, producers price plus taxes minus subsidies. In assessing costs, the correct approach is less straightforward. Consider, for example, taxes and subsidies on intermediate inputs. Taxes increase the cost of inputs to users above the value of real resources expended in producing them, while subsidies have the opposite effect. In assessing these costs, the proper measure critically depends on whether the projects demand for the inputs is met by new supplies, or by diversions from other uses. If the inputs come from new supplies, the correct measure is the value of real resources expended, which is equivalent to the price paid by other users minus taxes plus subsidies. If the inputs are obtained by depriving other uses, the correct measure is the value of the inputs in alternative use, or the producers price plus taxes minus subsidies.
The opportunity cost is the true value of any resource foregone. It must be counted even if explicit cash transactions are not involved. For example, if farmers could sell their organic
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manure for RWF 10 million but instead they use it on a project, the opportunity cost of the organic manure (to be counted against the project) is RWF 10 million, although there is no cash transaction involved. Another classic example is the use of land by the project, the opportunity cost of land is not actually the value land in the locality, but what that piece land can generate when put on alternative use, say cultivation of a given crop, quantity of harvest and how much it would be sold at.
A cost is sunk if it is irretrievably made or committed. A sunk cost is not to be counted, a sunk cost does not matter because it cannot be affected by the decision in question. For example, if the government originally paid RWF 100 million for a building but its market value at the time of the analysis is RWF 30 million, then RWF 30 million is the opportunity cost if government decides to use the building on a proposed project rather than sell it, and the remaining RWF 70 million is a sunk cost that is no longer relevant.
4.6.3.3 Externalities The analyst should make every effort to take into account all of the allocative effects in assessments of the efficiency of government expenditures, some of which may be less obvious than others. Such implicit effects may be internal (to direct actors in the project) or external (to people not directly acting in the project but included in the group whose point of view is being taken in the analysis). An example of internal implicit effects is foregone salaries during refresher courses (education). Also, the analyst should do his/her utmost best to estimate recurring costs that might actually occur beyond the project life.
External implicit effects (also referred to as spillovers or social effects) are commonly things like pollution or congestion.
Note that ignoring implicit benefits or costs could lead to major errors in the analysis.
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4.6.3.4 Terminal value A terminal value (also referred to as residual value) is the value of an asset at the end of the investment horizon. For example, suppose the government was to invest in a leasing property. At the end of the investment horizon, land is still a valuable asset. The terminal value is a benefit to be counted when the project is appraised. In most cases, the terminal value is the market value of the asset.
However, governments often maintain special-use facilities (research or testing laboratories, for example) for which market value might not be a good measure. The value of a special-use facility may be as little as the market value of the land minus demolition costs to remove the buildings. On the other hand, the true value can be as high as the replacement costs of the buildings and the land.
Therefore, in calculations of terminal value for a cost-benefit analysis, the land and the buildings are often treated separately. The analyst could use an index to estimate the expected market value of the land. The analyst could then estimate the economic life of the buildings and extrapolate the replacement value according to the percentage of economic life that will have passed by the end of the investment horizon. For example, suppose at the beginning of the project a real property consists of land worth RWF 10 million and buildings worth RWF 200 million. By the end of 10 years (the investment horizon in this case), we expect the land value to have increased to RWF 15 million (nominal francs) and the replacement value of the buildings to have increased to RWF 350 million (nominal francs). Suppose also that 10 years is 50% of the economic life of the building. The terminal value of the real property during the 10th year would thus be approximately RWF 15 million (land) plus RWF 175 million (half the replacement value of the buildings).
Several problems can arise in treatments of terminal values. One mistake is to count a terminal value on an already owned asset without counting the balancing opportunity cost at the end of the project. Whether the asset is already owned or not, its full value must be counted as a cost
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at the beginning of the project, if its terminal value is to be counted as a benefit at the end of the project.
Another mistake is to make a conservative estimate of cost and a generous estimate of terminal benefit. The way the cost is computed at the beginning of the project must be comparable to the way the benefit is computed at the end of the project.
A third problem arises if the project itself is not defined correctly. Sometimes a non-essential component has a good terminal value that masks a bad outcome of the essential components. Hence, when the analyst is counting a terminal value as a benefit, s/he must make sure that the asset in question really is an essential part of the project.
4.6.3.5 General administrative and overhead costs When a large organization, like a government, analyzes many possible investments over time, it may have a problem deciding how to treat general costs that are not specific to a particular project. Such costs are sometimes called overhead costs or administrative costs. These are more or less fixed costs, one additional project will often make little difference. The standard practice in cost-benefit analysis is to take the incremental approach to counting benefits and costs, but this approach ignores most of the project and overhead costs. The problem with this as a standard practice, therefore, is that it is too generous to the investments and overstates the true returns. In the extreme, overhead costs never get counted anywhere in the relevant line ministrys decision-making process.
If the relevant line ministry only occasionally makes major investments, it may be reasonable to ignore project and overhead costs; in essence, letting them be borne by the ordinary operations of the ministry. In this case, it is reasonable to take the incremental approach. In contrast, if the relevant line ministry makes many investments, it is preferable to include an average allowance for overhead in the costs, although any single investment has little effect on overhead at the margin. If all investment options bear overhead equally, this factor is unlikely
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to influence the choice among them very much. Even so, it is preferable to have a realistic picture of investment returns, including overhead costs, than to have an unrealistically rosy picture.
4.6.4 Valuing benefits and costs by market prices In cost-benefit analysis, market prices are normally considered as being good measures of the benefits and costs of an investment. When market prices do not exist in usable form, then the analyst has to construct them.
Most often however, the market price is only an approximate measure of a benefit or cost. If one buys an orange for RWF 200, for example, the benefit to the buyer of the orange is at least RWF 200, otherwise s/he would not have purchased it. Visibly though, the benefit could be much higher than the concept leads us to believe. The orange might be worth RWF 300 to the buyer, that is, the buyer might be willing to pay RWF 300 for it if necessary. If s/he only has to pay RWF 300, then s/he has a total benefit of RWF 300, a cost of RWF 200, and a surplus of RWF 100. Therefore, when we use market prices as measures of benefits, we are ignoring the consumer surplus, which might be important in some cases.
4.6.5 Consumer surplus and producer surplus as components of value The concepts of consumer surplus and producer surplus are basic to modern cost-benefit analysis. Jules Dupuit, a French engineer, first stated them clearly in 1844. Jules pointed out that the market price is the minimum social benefit produced by the output of a project. According to the concept, in fact, some consumers would be willing to pay more for the outputs than they actually have to pay.
Following the same trend of reasoning, in determining the consumer surplus and valuing consumer benefits of transportation projects for example, the benefits of additional trips (T2 T1) are given by the summation of the total amount that each new trip maker would be willing to pay to travel, less the cost of the trip C2. It is the area CED (shaded consumer surplus). If
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the change in trip cost is small, then it may be assumed that the demand curve section CE is linear and that CED is a triangle.
Therefore, generated benefits = (T2 T1)(C1 - C2).
Cost (RWF)
C C2 C1 E
T1
T2
Number of trips
Consumer surplus for goods Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyers willingness to pay and the price paid. It is a measure of the benefit a buyer has when participating in the market. Aggregate consumer surplus is the welfare consumers get from the good.
Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. It is the sum of the difference between the value to buyers of a level of consumption of a good and the amount the buyers must pay to get that amount. The term is often used to refer to both individual and to total consumer surplus, from a project perspective. The analyst should focus on total surplus.
RWF 300
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Producer surplus Producer surplus is the difference between the lowest price a farmer/company would be willing to accept and the price he/it actually receives. It is the difference between the revenue sellers take in from sale of a good and the minimum amount they would accept to produce it. Producer surplus is the welfare sellers get from selling a good. The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price, as shown by the colored area below.
Economic surplus Economic surplus is the sum of consumer surplus and producer surplus. In a perfectly competitive market without government intervention, the total economic surplus is expected to be at its maximum and in equilibrium as shown in the next graph.
Note that in dealing with economic surplus issues, the analyst should watch out for two principals. First, s/he needs to know the quantity and price to compute either surplus. A lower price will always increase the consumer surplus, and a higher price will increase the producer
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surplus. And second, in a competitive market, equilibrium price and quantity will also be the price and quantity that maximize the total surplus.
All in all, economic surplus can be estimated by drawing the demand and surplus curves of a product, in this case oranges, reflecting the relationship between the price of oranges and the quantity of oranges demanded at each price. The total possible benefit to the community from orange production could be deduced from the area under the demand curve, this area is easy to calculate if the demand curves are approximated by straight lines, because the area under the curve is a triangle formed by the two axes and the demand curve.
The same must be done for the producer surplus. For example, if the producer is prepared to produce a certain quantity of oranges at RWF 100, and the market price is RWF 200, then obviously for this quantity of oranges, at least, the producer will gain a windfall of RWF 100. The total producer surplus is the area between the price line and the supply curve. Economic surplus is the sum of A (consumer surplus) and B (producer surplus).
300
A = CS
B = PS
The analyst must decide whether price multiplied by quantity is a decent approximation of value. If the simplification is off the mark, more detailed calculations of value are needed.
4.6.5.1 Consumer surplus when a public investment changes the price of a good Public investments in power generation, water and sanitation (and many others) may lower the price of the output. If so, valuing the benefits of the project at the new lower price
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understates the projects contribution to societys welfare. With a lower price, more consumers have access to the product or service, established consumers pay a lower price and consume more. A special case of this general rule is when supply is rationed at a controlled price below that which consumers would be willing to pay. This situation is common in Rwanda (user charges in rural water supplies and community insurance are good examples). In such cases, an increase in supply at the same controlled price involves a gain in consumer surplus over and above what consumers actually pay for the increased quantity of the good or service.
In some cases, part of the increased consumer surplus is offset by a decrease in revenues to the existing producers. For example, if an export promotion project reduces the average cost of processing an exportable product (i.e. corn) and increases the amount available, the market price of corn might fall. The established consumers save an amount equal to area A, but this is offset, from the point of view of the whole economy, by a corresponding loss of revenues to the established agro processers (or producers). The net benefit of the change is therefore only area B.
In contrast, if corn was previously imported (as is the case now) and the project is substituting domestic processed corn for imported processed corn, then the gain to consumers should theoretically be the whole change in consumer surplus (area A + area B). In reality, however, the outcome is more often different. Although the above is accurate but simplified, in the real world, consumer responses are complicated by substitutions among goods when relative prices are affected.
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Note should be taken however, that if a public investment depends for its viability on estimates of consumer surplus, and is not viable on a strictly commercial basis, then the analyst must state clearly the amount of the financial shortfall and the source of funds to finance it. In case the shortfall is expected to be offset by a subsidy. The analysis should also explicitly address the benefits that the government subsidizing the shortfall will derive from the arrangement, this could be crucial to the projects sustainability. If a subsidy is necessary to keep the project operating, then even if the project has a high economic NPV, there might be a significant risk of running out of funds for proper operations. The analyst should also be careful and analyze the impact of government decision or intervention aimed at protecting the project. In particular as relates to price interventions, i.e. setting price floors and ceilings targeting specific project outputs. Price floor; this is a legally determined minimum price that sellers may receive. Usually, price floor is set above the equilibrium price to protect the benefit of sellers. This could reduce the quantity demanded relative to the quantity supplied. If this actually happens, it may cause a surplus in the market. Let us assume the government imposes a market price for beans which is higher than the equilibrium price to assist farmers. Welfare analysis of price floor shows that farmers will be enticed by the higher price and more likely to supply more (Qs). On the other hand, buyers would switch to substitutes and demand less (Qd) or cut on the quantity consumed because of the high prices. As result, we shall have a market surplus equivalent to the difference between the quantity supplied and the quantity demanded (Qs Qd) as reflected in the graph below.
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The table below summarizes the impact of this kind of government intervention.
Welfare category Consumer Surplus Producer Surplus Economic Surplus Deadweight Loss Transferred Welfare Competitive equilibrium A+B+C D+E A+B+C+D+E None None A B+D A+B+D C+E B is Welfare transferred from consumer to producer Price floor
Price ceiling; is legally determined maximum price that sellers may charge. Generally the price ceiling is set below the equilibrium price to protect the benefit of buyers. This could cause shortage in the market, where the quantity demanded exceeds the quantity supplied. For example, let us assume the government imposes a minimum rent upon a construction project to protect middle income earners. As a policy it also puts a ceiling on the maximum rent that landlords can charge.
Welfare analysis of price ceiling shows that renters (middle income earners) will be enticed by the lower price and more likely to demand more (Qd). On the other hand, renters would switch to alternative investments or transform buildings from residential structures to commercial structures and in so doing supply less (Qs) because of the low rents. As result, we shall have a market shortage equivalent to the difference between the quantity demanded and the quantity in supply (Qs Qd) as reflected in the graph below.
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The following table summarizes the impact of this type of government intervention.
Welfare category Consumer surplus Producer surplus Economic surplus Deadweight loss Transferred welfare Competitive equilibrium A+B C+D+E A+B+C+D+E None None Price ceiling A+C E A+C+E B+D C is welfare transferred from producer to consumer
4.6.6 Developing cash flows Cost-benefit analysis (CBA) is a method of assessing the net economic impact of a public investment/project. In principle the same methodology is applicable to a variety of interventions, for example, subsidies for private projects, reforms in regulation, new tax rates etc. It measures the net benefit of the project to social welfare of the community and/or country by means of the algebraic sum of the time-discounted economic benefits and costs of the project. The technique used is based on four critical iterative steps: 1) forecasting the economic effects of a project; 2) quantifying them by means of appropriate measuring procedures; 3) monetizing them, wherever possible, using conventional techniques for monetizing the economic effects; and 4) calculating the economic return, using a concise indicator that allows an opinion to be formulated regarding the performance of the project.
Benefits and costs can be directly expressed in quantitative economic terms. However, the analyst should not be obsessed with quantification by all means, after all it is not everything that can be counted counts. Therefore, benefits and costs that cannot be quantified in economic terms should be identified and included in the qualitative analysis of the project. It is important here to understand that by quantitative, we mean quantified in monetary terms. We also acknowledge that even though something can be expressed numerically, it may not necessarily be able to be quantified in the economic sense by the assignment of a monetary value. However, as mentioned in the previous sub-sections of this manual, there are many
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variables that are not sold in any market for which it is still possible to estimate values and thereby represent them in monetary terms.
Only those quantified benefits and costs directly attributable to the project are subject to the discounted cash flow analysis. However, all qualified benefits and costs should be identified and described (including the identification of the affected parties and the nature of the impacts involved) in the report as this could be important information for the decision makers.
A class of enabled benefits can be considered in the report though not included in the discounted cash flow analysis of benefit streams. As opposed to actual (or delivered) benefits realized from the project, there may be a number of enabled benefits that only materialize if another project (enabling project) is carried out. These enabling projects should be clearly identified and described in the report as should projects that are dependent on the enabling project. In the same way, as qualitative benefits should be identified and described in the report, so too should enabled benefits be presented separately to decision makers.
Generally, cost-benefit analysis is one of the methods of economic analysis. Let us derive the cost-benefit ratio using the same European Union electricity project example in the economic analysis section. Economic cash flows and analysis of electricity project
Year / Euro (Millions Decreased pollution elsewhere External benefits Output X Output Y Total operating revenues Increased noise External costs Labor Other operating costs Total operating costs Total investment costs Net cash flow CF 1 (148.5) (148.5) ENPV 48.30 Discounting factors 0.948 2 11 11 32.4 16.5 48.9 (12.0) (12.0) (18.4) (36.3) (54.7) (3.6) (10.4) ERR 11.74% 0.898 3 11 11 72.0 60.5 132.5 (12.0) (12.0) (18.4) (57.2) (75.6) (3.6) 52.3 SDR 5.50% 0.852 4 11 11 76.8 60.5 137.3 (12.0) (12.0) (25.6) (72.6) (98.2) (21.6) 16.5 B/C ratio 1.06 0.807 0.765 0.725 0.687 0.652 0.618 0.585 5 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) (2.7) 39.8 6 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) 42.5 7 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) (23.4) 19.1 8 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) 42.5 9 11 11 76.8 68.2 145.0 (12.0) (12.0) (30.4) (86.9) (117.3) 26.7 10 11 11 76.8 68.2 145.0 (12.0) (12.0) (30.4) (86.9) (117.3) 10.8 37.5
1.2 1.1
0.8 1.1 0.9
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Year / Euro (Millions Benefits Costs PV of benefits PV of costs Sum of PV benefits Sum of PV costs BCR CF 1 (149) (141) 924.8 876.5 1.06 2 60 (70) 54 (63) 3 144 (91) 122 (78) 4 148 (132) 120 (106) 5 156 (116) 119 (89) 6 156 (114) 113 (82) 7 156 (137) 107 (94) 8 156 (114) 102 (74) 9 156 (129) 96 (80) 10 156 (119) 91 (69)
Note: Data flows from the financial analysis table. At 5.5% social discount rate (based on EU guidelines), both the economic rate of return (ERR) and the economic net present value (FNPV) of the investment have turned positive. This does not only confirm project viability, but also that the project is more convenient for government than a private investor.
4.6.7 Evaluation criteria Once cash flows of the project have been constructed, the economic discount rate is used to convert the projects economic benefits and costs to the present value.
If the benefit-cost ratio is greater than one, the project is potentially worthwhile to implement because the project would generate more net economic benefits than if the resources had been used elsewhere in the economy. On the other hand, if the benefit-cost ratio is less than one, the project could be rejected on the ground that the resources invested could be put to better use elsewhere in the economy.
The Benefit-Cost Ratio (BCR) is the ratio of the present value of benefits to the present value of costs. BCR can be expressed as follows: BCR = PVBenefits / PVCosts Where; PVBenefits is the present value of benefits, PVCosts is the present value of costs, and is a summation sign.
PV Benefits = Bn/(1+r)n; and n= 0 N PV Costs = Cn/(1+r)n n=0 N
A project is potentially worthwhile if the BCR is greater than 1. This simply means that the PV of benefits exceeds the PV of costs. However, it is highly recommended that BCR should not be adopted as the prime decision rule, because BCRs can sometimes confuse the choice process when the projects under consideration are of a different scale, yielding misleading results. For
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example, if project A has a PV of benefits of 300 and PV of costs of 150, it has a NPV of 150 and a BCR of 2. If the alternative project B, has a PV of benefits of 600 and costs of 400, it has a smaller BCR (1.5) but a larger NPV (200). Hence, it would be more efficient to choose project B.
4.6.8 Limitations of cost-benefit analysis As with any analytical technique, BCR is fallible, it has some inherent areas of possible deficiency. Hence, in undertaking cost-benefit analysis, the analyst should be cautious of the following: Misuse of monetary values for benefits and costs including non-monetary items such as values for savings and other intangibles. Bias in assumptions in order to make the project worthwhile. A clear articulation of assumptions is required on the part of the analyst as well as transparency in the actual analysis. Process can be complex and tedious, and requires structured analytical resources and adequate information from several subject-matter experts. Hence, the analyst should endeavor to seek expert opinion and to use a simple framework for less significant issues and of modest cost. Inequitable process as all beneficiaries are treated equal irrespective of the identity of the beneficiaries (e.g. no reflection of socio-economic circumstances in weighting benefits and costs to members of society affected by the project. That is, it takes the existing distribution of income as a given and does not consider the equity implications of the projects that it seeks to evaluate.
The above limitations make it abundantly clear that BCR should be supplemented by other appraisal techniques and decision criteria. And, alignment to country policies, strategy etc should be emphasized, these could be modeled in the form of a multi-criteria decision support system.
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All in all, when undertaking cost-benefit analysis, it is highly recommended for the analyst to clearly articulate all assumptions and to ensure that all analyses involved in the assessment are verbally and numerically explicit about the assumptions on which they are based and the reason for those assumptions. Whenever possible, effort should be made to describe effects in qualitative and quantitative terms, and a description of any unique issues could be provided as well. Note that the objective here, is for the analyst to provide decision makers with as much supplementary contextual information as is both reasonable and practical.
4.7 Sensitivity analysis The rationale of sensitivity analysis is to select critical variables whose variations, positive or negative, compared to the base case value have the greatest effect on the parameters (i.e. NPV or IRR) of the model. Influencing variables cause the most significant changes in these parameters. The criteria for choice of the influencing variables varies project per project and, hence must be accurately assessed case by case before adoption.
The conduct of sensitivity analysis is not unique to a particular investment/project appraisal technique discussed in this manual. It must be applied to all of these analyses; the financial analysis, the economic analysis and the cost-benefit analysis.
The outcome of any of the analyses is typically influenced by several uncertain factors. This is true in fields as diverse as economic development, health, education and employment, to mention a few. In any case, it is important for both the analyst and the decision maker to know how sensitive the outcome is to changes in those uncertain factors. It helps them (the analyst and the decision maker) to determine whether it is worthwhile spending money to obtain more precise data and whether they can act to limit uncertainty. For example, it can help sponsors and other stakeholders to redesign some of the project components or simply closely monitor the project during implementation. In addition, sensitivity analysis helps the analyst to communicate to the decision maker the extent of the uncertainty and risk in the project.
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However, sensitivity analysis is a limited tool. It treats variables one at a time, holding all else constant. Simultaneous actions and interactions among variables in the real world are ignored. Therefore, it can be a mistake to take the results too seriously because a variable that appears to be key when considered in isolation might or might not be key when considered along with other variables that strengthen or weaken its effect on the outcome of the project. Only a serious and functional risk management framework, can help both, during identification and analysis of project risks as well as in the subsequent development of mitigation plans and execution. It could also accurately identify the influence of each variable and setting up risk triggers.
Nevertheless, sensitivity analysis could be helpful in public investment programs in particular and development practice in general. Its importance varies from industry to industry or sector to sector of course.
We therefore, recommend the following procedure when conducting sensitivity analysis. (i) Identify all the variables used to calculate the output and input of the financial and economic analyses, and group them in homogeneous categories, if possible. (ii) Identify possible deterministically dependent variables, which might lead to distortions in the results or double counting. The analyst should consider variables that are independent of each other in order to eliminate internal dependencies. However, if two correlated variables are detected, steps must be taken to eliminate the redundant variable and, thus retaining the most significant of the two. (iii) Carryout a qualitative analysis (if practical) of the impact of the variables in order to eliminate those have little effect and, thus the subsequent quantitative analysis would be limited to the more significant variables. The analyst must verify the variables when in doubt. (iv) Having chosen the significant variables, the analyst can then assess their effect through simultaneous calculations. Each time, it is necessary to assign a new value
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(higher or lower) to each variable and recalculating the parameter, thus noting the differences (i.e. in absolute and percentage terms) compared to the base case value, and pinpointing switching values.
4.7.1 Types of sensitivity analysis It is common knowledge that capital budgeting decisions in the private board rooms or public expenditure decisions in government ministries are made under uncertain environments. That is, people are never 100 percent certain that the decisions will lead to the desired results. This is actually why we engage in planning, otherwise, if we perfectly knew what was to happen in the future, then there wouldnt be need for planning. On the other hand, uncertainty can be reduced with the passage of time as new information comes to our possession about a particular situation of interest. Or executives can decide to invest in targeted studies today, about a particular project to reduce the level of uncertainty before undertaking to design the project in question.
But risk entails both uncertainty and exposure (i.e. possible consequences). Unlike uncertainty which might be reduced with a passage of time in the absence of immediate actions, risk cannot be wished away and, hence it must be managed. Risk can be defined in many ways; the possibility that the desired objective will not be achieved (i.e. the project might not achieve a satisfying performance); the expected loss, the variance of a loss, the probability that a loss will exceed a defined amount, or the average amount by which it does not exceed a defined amount etc. Hence, a risk measure needs to be selected that corresponds to how the risk in question is defined. Risk analysis consists of studying the probability that a project will achieve a satisfying performance (in terms of NPV or IRR), as well as the variability of the result compared to the base case.
Furthermore, the vast expansion in the number of available technologies for use in diverse sectors (manufacturing, healthcare, education etc), coupled with constraints placed on budgets, has increased the importance of decision making with regards to new investments.
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One method to determine the value for money of an investment/intervention is to develop an economic model, predicting the costs and outcomes that are likely to be associated with various different investments.
Therefore, sensitivity analysis is intended to somewhat deal with uncertainty and risk issues surrounding investments.
Fortunately, technology has evolved that allows us to develop models and subsequently test them with ease. Models are a useful tool for representing the complex real world in an abstract form, with a more simple and understandable structure. While we do not intend to claim that models necessarily create an exact replica of the real world, but merely to assert that they can be useful in demonstrating the relationships and interactions between various different factors. Furthermore, models allow the decision maker to combine different types of information and at times from various sources, thereby making an informed decision.
While models tend to report single summary outcomes, such as the incremental cost per incremental benefit, the interpretation of those results will largely depend on the level of confidence or uncertainty in various factors. Hence, users of these models must acknowledge the uncertainty involved in the different stages of modeling. This might involve the methodology that has been used in constructing the model (i.e. model structure) or could be related to the actual values that have been used to populate the model. For example, a reviewer of a model might suspect that one particular value (for example, the probability of realizing the suggested revenues being successful) is too high in the model. In this case, the reviewer may wish to know the likely impact of using an alternative value. Such an exercise would involve examining the sensitivity of the model to changes in its inputs.
There are several different ways of undertaking sensitivity analysis, among which are the following.
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4.7.1.1 Gross sensitivity This can also be referred to as a one-way sensitivity analysis. The simplest form of sensitivity analysis is to simply vary one value in the model by a given amount, and examine the impact that change has on the models results. For example, using economic model results in our illustration, we can show that by changing the capital (investment) cost by 10%, the ENPV falls by 36.5%. This is known as gross or one-way sensitivity analysis, since only one parameter is changed at one time. The analysis could, of course, be repeated on different parameters at different times. One-way sensitivity analysis can be undertaken using various different approaches, each of which is useful for different purposes.
Suppose we would like to determine (test) which parameters have the greatest influence on our model results (ENPV for example). In this case, each parameter in the model (or, at least, each of the key parameters) could be changed by a specific amount. Say, for example, that all parameters (investment cost, operating and external costs, revenues and external benefits and social discount rate) were to be increased and decreased by 10% of their original value. For each parameter change, the analyst might record the percentage impact on the models main outcome, which can be shown in table form or graphically in the form of a tornado diagram or other graph type of choice. Take note that while a tornado diagram is useful in demonstrating the impact that a fixed change in each parameter has on the main outcomes, it is not useful in representing the confidence that a decision maker might have in the models inputs. For example, it might be that the level of confidence in one particular parameter is so low that it is entirely reasonable that the current input may actually be wrong by as much as 100%. This is common in cases where no published data exist to support a particular model input. An example of this could be the marginal impact of RWF 1 investment in rural development. Conversely, some parameters (such as the price of an intervention) may be reasonably well known and, as such, the analyst and the decision maker would have a high degree of confidence in the value. Therefore, one form of one-way sensitivity analysis is to vary each parameter to the highest and lowest possible values. The definition of possible might vary
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from model to model, but it is usually reasonable to vary the parameters according to the confidence intervals of the data (if these are known).
Alternatively, it would be reasonable to vary the parameter across the whole range of values that have been observed in the literature. Finally, a more detailed approach to gross sensitivity analysis on one specific parameter would be to assess the impact of a range of values on the models outputs. In such an analysis, it would be possible to generate a simple graph, plotting the main model outcome against each possible input value. This would demonstrate the relationship between the input value and the models results. This type of analysis can also be used to judge the threshold at which the main conclusions of a model might change.
4.7.1.2 Multi-way sensitivity analysis While gross sensitivity analysis is useful in demonstrating the impact of one parameter varying in the model, it may be necessary to examine the relationship of two or more different parameters changing simultaneously. This approach involves the changing of, say, two key parameters (for example, investment cost and benefits revenues and external benefits), showing the results for each potential combination of values within a given range.
The analyst should note, however, that the presentation and interpretation of multi-way sensitivity analysis becomes increasingly difficult and complex as the number of parameters involved increases. One method that is sometimes used to assess the confidence around all parameters is to undertake extreme sensitivity analysis, by varying all of the parameters in a model to their best and worst case. The best- and worst-case values must be chosen from the perspective of the investment/intervention that is being assessed. For example, in one scenario the most optimistic values would be chosen, while in another, the most conservative figures would be used. Again, the extent to which each parameter should be varied will depend upon the confidence intervals associated with each input.
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In summary, multi-way sensitivity analysis is merely an extension of gross sensitivity. Instead of analyzing one variable at a time, the analyst analyzes two or more variables at a time. Experts believe that scenarios defined by two interacting variables, although still not complete and realistic indicators of sensitivity, are at least an improvement on the single-variable analysis. Under this type of analysis, usage of multiple discount rates is acceptable. However, this type of analysis though more instructive than gross sensitivity, it is more about understanding the workings of the model in a realistic setting than predicting project performance. It is more suitable for evaluating several alternatives or the functioning of machines than a single project or intervention.
4.7.1.3 Probabilistic sensitivity analysis In most models, each parameter (for example, the probability of realizing the suggested benefits being successful) is assigned a point estimate value. As an illustration, we might assume that the chance of realizing the suggested benefits being successful is deemed to be 70%, based on expert opinion and not on published data. However, the expert may also have placed the level of confidence around that estimate. For example, it might be stated that the 95% confidence interval is 45% to 75%.
In probabilistic sensitivity analysis, rather than assigning a single value to each parameter, computer software (such as Crystal Ball, @ Risk, TreeAge or other software) is used to assign a distribution to all parameters in the model. The ranges are determined by three factors, namely; the average value, the standard deviation, and the shape of the spread of data.
Care is taken to ensure that all parameters remain practical. For example, probabilities must always remain between zero and one, while costs can never be negative. Each time the model is run, the software will be able to randomly select one value for each parameter and record the models results. If the model is then run a great number of times (in some cases, more than 10,000 iterations), the software will record the result each time, and present the variation in results.
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The results are typically presented using a cost-effectiveness scatter plane, where each iteration is plotted on a chart showing the incremental cost and incremental effectiveness of the intervention in question.
From the preview on the types of sensitivity analysis, it is abundantly clear that some have little value in public investment appraisal, especially in the absence of rigorous risk management framework. And, in terms of time, effort and resources required for this type of analysis. Refer to the limitations of sensitivity sub-section for details. Our intention is not to rule them out per se in the Rwandan context, say for application in the healthcare and/or manufacturing sector where they might be highly relevant depending on circumstances. For example, they could be required for trial testing in drug usage or treatment in hospitals, or in establishing the product default rate for a specific manufacturing company. In other words, although Monte Carlo simulation applications have been successful in areas outside of project management, primarily in fields related to; modeling complex systems in biological research, engineering, geophysics, meteorology, computer applications, public health studies, and finance. This activity has not yet found a strong footing in the actual practice of project management in the real world. Its use is still limited to cost and time management, to quantify the risk level of a project s budget or planned completion date (see Kwak and Lisa, 2007).
In order to maintain focus of this manual, we shall provide illustrations on how gross sensitivity analysis could be conducted in Rwanda.
Gross sensitivity analysis restated In its simplest form, gross sensitivity analysis involves calculating (one variable at a time) and ascertaining how much the parameter (i.e. ENPV, ERR, BCR) changes if the influencing variable (i.e. investment cost, operating costs and external costs, revenues and external benefits, and social discount rate) changes by a standard percentage, say 10%.
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Graphic analysis of sensitivity restated In practice, it is advisable for the analyst to use graphs when presenting results instead of interpreting tables derived from the analysis, that is, graphs are powerful tools from a presentation perspective. In this case, graphs are meant to show the interaction between the variable and the sensitivity outcome over a range of plausible values, as such the interaction is visible over a reasonable range of values. However, this type of sensitivity analysis is exploratory, not definitive, so making the patterns in the data visible should be the first priority of the analyst.
Generally, a graph is supposed to show changes (a indicated by curves or bars) in different levels of changes in ENPVs or any other performance measure against changes in the risk variable. It is simple and useful because people can easily read the switching values to see how sensitive the outcome is to changes in the variable. If the changes in the variable are presented on the graph in percentages (and thereby standardized), it becomes possible to put the curves for two or more variables (calculated one at a time, of course) on the same graph. This is useful because the slopes of the curves indicate the relative sensitivity of each variable. The more the ENPV changes for a given change in a variable, the more sensitive it is to that variable, volatility being equal.
If the percentage change in ENPV is on the x-axis and the percentage change in the risk variable is on the y-axis, then any flat curves indicate a strong sensitivity.
Also, sensitivity results can be plotted (by way of spider plots) and consolidated to show many input variables on one chart. The centre of the spider plot is the ENPV when all the variables are at their baseline values (base case). The curves on the spider chart show how the ENPV changes as the values of each variable change, all others being held equal.
The lengths of the spider lines vary because each variable has its own plausible range within which it can change. The values of one variable might vary by only 10% up or down from its
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baseline value while another variable might be highly uncertain, varying between +150% and 50%.
Furthermore, tornado charts can also be used to provide another quick, although partial, picture of relative sensitivity. Each bar in the tornado chart shows the range of the ENPV when each variable is allowed to change (one at a time) from its highest to its lowest value.
In conclusion, when making graphic presentations, the analyst should be mindful that the magnitude of the variables range of plausible values is not the only factor that determines sensitivity. The volatility (the probability that the value of the variable will move within that range) is also important to sensitivity, but the analyst cannot see volatility on a tornado chart, for example. The length of each bar is a measure of how much the variable can influence the ENPV. The shading within the bar changes at the ENPV, which corresponds, to the deterministic value of the variable.
In general terms, the basic principles of sensitivity analysis are the same, whether dealing with variable or more variables at a time. The tables, graphs, curves and plots are just presentation techniques. The art of sensitivity analysis is still a work in progress and the level of complexity varies with type of industry, profession, reason for the analysis, work environment, reliability of data, tool/system in use etc. The use of Monte Carlo simulations and Crystal Ball, for example, is common in the engineering profession. However, these tools have little value in the investment appraisal in the development arena relative to scientific based fields or industries. Monte Carlo simulation for example, assumes that the main risks which affect the project have been obtained and also that needed risk response measures are already in place. It also requires a random sampling of values for each probability distribution within the model to produce hundreds or even thousands of scenarios, which are used to create the probability distribution of the model outcome (see Vose, 2000). Also, probability distributions are based on previous actual data of previous experiences. Hence, in the absence a rigorous management
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exercise, the required real time data on probability distribution functions (PDFs) and correlations, simulations could merely mask the wrong analysis results under a perceived layer of sophistication. We have to keep in mind that carrying out probabilistic simulation approaches usually involves high costs. 4.7.2 How to conduct sensitivity analysis In practice, sensitivity analysis involves three basic steps, namely: a) Building a deterministic model using single base values for the input variables. b) Exploring the outcomes sensitivity to each input variable. c) Making full risk analysis using probabilities for many variables simultaneously. However, in order to maintain focus of this manual, we shall deal with the first 2 steps. That is, using our already developed cash flow models and testing for the effect of changes in the essential risk factors (capital-investment cost, operating and external costs, revenues and external benefits, and social discount rate) to project viability (as indicated by ENPV, ERR and BCR measures). Let us take the economic cash flow model to be our base case. Restated cash flow model
Year / Euro (Millions Decreased pollution elsewhere External benefits Output X Output Y Total operating revenues Increased noise External costs Labor Other operating costs Total operating costs Total investment costs Net cash flow CF 1 (148.5) (148.5) ENPV 48.30 2 11 11 32.4 16.5 48.9 (12.0) (12.0) (18.4) (36.3) (54.7) (3.6) (10.4) ERR 11.74% 3 11 11 72.0 60.5 132.5 (12.0) (12.0) (18.4) (57.2) (75.6) (3.6) 52.3 SDR 5.5% 4 11 11 76.8 60.5 137.3 (12.0) (12.0) (25.6) (72.6) (98.2) (21.6) 16.5 BCR 1.06 5 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) (2.7) 39.8 6 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) 42.5 7 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) (23.4) 19.1 8 11 11 76.8 68.2 145.0 (12.0) (12.0) (25.6) (75.9) (101.5) 42.5 9 11 11 76.8 68.2 145.0 (12.0) (12.0) (30.4) (86.9) (117.3) 26.7 10 11 11 76.8 68.2 145.0 (12.0) (12.0) (30.4) (86.9) (117.3) 10.8 37.5
1.2 1.1
0.8 1.1 0.9
Steps taken We deal with one variable at a time while holding others constant, consistent with the ceteris paribus principle, as follows:
Scenario1; is the base case. Scenario 2; we assume a 10% increase in capital (investment) costs.
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Scenario 3; we assume a 10% increase in operating and external costs. Scenario 4; we assume a 10% decrease in revenues and external benefits. Scenario 5; we assume a 10% increase in the social discount rate (interest rate). Scenario 6; we assume the above 4 scenarios (2, 3, 4 and 5), all happen simultaneously.
Sensitivity analysis results

Analysis of ENPV, ERR and BCR to Changes in Risk Factors (Revenue and Cost Variations) No Scenarios Indicators ENPV ERR (%) BCR 1 Base case 48.30 0.1174 1.06 2 Increase in capital (investment) costs by 10% 30.67 0.0921 1.03 3 Increase in operating and external costs by 10% (21.72) 0.0232 0.98 4 5 6 Decrease in revenues and external benefits by 10% Increase in social discount rate (SDR) by 10% Combination of 2, 3, 4 & 5 (44.18) 42.97 (132.00) (0.0130) 0.1174 multiple 0.95 1.05 0.86
Sensitivity analysis show that the project is highly susceptible to changes in the essential risk factors. It is more sensitive to decreases in revenues (benefits) and increases in operating costs, than to increases in investment costs and interest rate. That is, while it remains viable to a 10% increase in investment costs (scenario 2) and interest rate (scenario 5), it exhibits a high level of vulnerability if it was to experience a 10% increase in operating and external costs (scenario 3) or a 10% decrease in revenues and external benefits (scenario 4). Therefore, under these conditions, the project would require close cost control and management has to ensure that the project realizes its revenues and external benefits as expected. Downward deviations need to be minimized. The worst case scenario (6), all the three measures are bad; ENPV is negative, ERR is cagy (it has multiple figures and hence we are unable establish the correct ERR), and BCR is less than unity. Unfortunately, we have no way of ruling out the occurrence of scenario 6. In practice, however, analysts are quick to rule it out, often without tangible data and/or information to that effect. All in all, based on sensitivity analysis results, the robustness of the three parameters to changes in benefit and cost variations is suspect. Also, without establishing switching values
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and using a single value (not a range of plausible values), we can graphically present the above results. Results of parameter changes caused by changes in the influencing variables
Influencing variable Capital (investment) costs Operating and external costs Revenues and external benefits Social discount rate (SDR) ENPV 36.50% 144.97% -191.47% 11.55% 10% decrease ERR 24.87% 66.18% -111.07% 0.00% BCR 1.89% 8.49% -10.38% 0.00% ENPV -36.50% -144.97% 191.47% -11.04% 10% increase ERR -21.55% -80.24% 85.60% 0.00% BCR -2.83% -7.55% 9.43% -0.94%
A tornado diagram shows the changes in ENPV if an input variable is increased or decreased by 10%, as follows.
Note: The length of the bar reflects the sensitivity of the variable in question (e.g. the social discount rate is the least sensitive, followed by capital costs.
Although the investment cost has to change by a much larger percentage to hit a switching value than the value of operating costs or revenues would, it is about equally likely to do so (27% versus 7% or 5%). Although the operating and external costs have to change more than revenues and external benefit to cause a crucial change in the NPV, its volatility makes it equally likely to do so. On this evidence, we would tentatively conclude that the two key variables are equally influential, followed by investment cost while the discount rate is the least influential has little influence on the parameter in the model.
Moreover, when we take the discounted values of each variable over the project period at a5.5% discount rate (the social rate) that is, revenues at 924.8 million, operating costs at 700.2
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million, and investment cost at 176.3 million. The analysis shows the switching value for revenues and external benefits lies between 4 and 6%. That of operating costs and external costs lies between 6 and 8%, while the switching value for investment cost lies between 26 and 28%. Thus, it also confirms that revenues and external benefits and the operating costs and external costs are the two most influencing variable to ENPV (parameter of choice) in the model.
The tables tracking switching values are provided below. Bear in mind that the base value of our economic present value (ENPV) is 48.3 million.
Base value = 924.8 million

Revenues & external benefits 1017.28 1109.76 832.32 739.84 ENPV 140.78 233.26 (44.18) (136.66) Revenues & external benefits 926.88 878.10 829.31 780.53 ENPV 50.38 1.60 (47.19) (95.97) Revenues & external benefits 906.30 897.06 887.81 869.301 ENPV 29.80 20.55 11.31 (7.19)
Base value = (700.2) million

Opex & external costs (735.19) (770.20) (910.23) (980.25) ENPV 13.29 (21.72) (161.75) (231.77) Opex & external costs (735.19) (742.19) (756.19) (770.20) ENPV 13.29 6.29 (7.72) (21.72) Opex & external costs (714.18) (728.18) (742.19) (756.19) ENPV 34.30 20.29 6.29 (7.72)
Base value = (176.3) million

Investment cost (220.40) (229.22) (238.04) (240.00) ENPV 4.22 (4.60) (13.41) (15.38) Investment cost (223.23) (232.53) (241.83) (251.13) ENPV 1.40 (7.90) (17.21) (26.51) Investment cost (215.11) (218.64) (222.17) (225.69) ENPV 9.51 5.98 2.45 (1.07)
Note: Switching variables have been derived using MS Excel on a trial and error basis
Furthermore, when we undertake the multi-way sensitivity analysis on the two most influential variables in the model (i.e. revenues and external benefits, and operating costs and external costs), without considering the extent of the relationship (correlation) between them, the joint influences of the two variables on ENPV is shown in the table that follows. For the combination we can track the influence on ENPV and, hence highlight areas where
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management might be able to maintain the economic viability of the project (i.e. where ENPV remains positive). Uneconomical areas are in red and bold.
Revenues & external benefits 9710.04 Operating costs & external costs (630.16) (700.18) (770.20) (840.21) 164.56 94.54 24.52 (45.50) 924.80 118.32 48.30 (21.72) (91.74) 878.56 72.08 2.06 (67.96) (137.98) 832.32 25.84 (44.18) (114.20) (184.22)
Note: All areas within the demarcated zone are economical (e.g. when revenues and external benefits improve by 5% while operating costs and external costs increase by 10% simultaneously, ENPV stands at about 24.52 million). But if operating costs and external costs were to increase by 10% without a corresponding increase or while revenues and external benefits are held constant (i.e. at base value), the project will lose its viability (i.e. ENPV will turn negative, at -21.72 million). The first column contains operating costs and external cost figures, while the first row contains revenues and external benefit figures. The cells in between the first column and the first row contain ENPVs.
The results in the table can also be presented in a graphic form as shown below.
Note: The red bars represent outcomes of the combinations that render the project not feasible or no longer viable.
4.7.3 Importance of sensitivity analysis Sensitivity analysis gives the people involved (analyst and stakeholders) a better understanding of the analysis (financial, economic etc) models applied. As this understanding develops, they can take action when appropriate. In some cases, the only action that is required is obtaining better data. Especially when the outcome is sensitive to a variable that is beyond their control. In other cases, they might be able to fix or constrain the value of the
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variable in question. For example, if the outcome is particularly sensitive to staff salaries and benefits. These can be fixed by negotiating the rates beforehand. If achieved, it would dramatically lower the sensitivity of the outcome to this variable.
Sensitivity analysis is a useful technique for finding out how important each variable in the model is. Graphic analysis, including the use of sensitivity curves and tornado diagrams, is often useful.
The switching value of a risk variable can be an important consideration in an investment decision. It can help the decision maker weigh the risk. Furthermore, the importance of sensitivity analysis can be specific to its components, risk analysis. Some of the advantages of risk analysis include the following: It can rescue a deterministic analysis (financial and economic etc) that has run into difficulties because of unresolved uncertainties in important variables. It can help bridge the communication gap between the analyst and the decision maker. A range of possible outcomes, with probabilities attached, is inherently more plausible to a decision maker than a single deterministic NPV. Risk analysis provides more and better information to guide the decision. It identifies where action to decrease risk might have the most effect. It aids the reformulation of projects to better suit the preferences of the sponsor/investor, including preferences for risk. It induces careful thought about the risk variables and uses information that is available on ranges and probabilities to enrich the analysis (financial, economic etc) data. It facilitates the thorough use of experts.
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4.7.4 Sensitivity and decision making The analyst should be most interested in the sensitivities that might change a positive decision on the project to a negative decision and vice versa. Four calculations help us estimate the likelihood of such a switch: a) What is the range of influence? In other words, how much does the NPV change when the variable changes from its lowest plausible value to its highest plausible value? b) Does this range of influence contain an NPV of zero? If it does, then the variable has a switching value. That is, a value at which our appraisal of the project switches from positive to negative. c) What is the switching ratio for the variable? That is, by what percentage does the variable have to change to hit a switching value? d) What is the switching probability? That is, how likely is the variable to reach the switching value?
Once the analyst has identified the key sensitivities among the risk variables, one by one (everything else held constant), s/he can start to think about managing risk. The following questions would enhance how risk issues are addressed: Are there input variables in the model that are correlated and therefore dampen or enhance the influence each might have in isolation? Can diversification help? Are there other investments that could be made at the same time where the same variable works in the opposite direction? Can we identify the value of the key variable with more certainty by gathering more information, and if so, is the information collected worth the cost of collecting it?
Once we have answered these questions, we can formulate a mitigation plan to minimize uncertainty and thereby limit the risks.
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4.7.5 Determinants of sensitivity and common project risks 4.7.5.1 What determines sensitivity Effective sensitivity of the outcome to a particular variable is determined by four factors: a) The responsiveness of NPV to changes in the variable; b) The magnitude of the variables range of plausible values; c) The volatility of the value of the variable (that is, the probability that the value of the variable will move within that range of plausible values); and d) The degree to which the range or volatility of the values of the variable can be controlled.
The first of these factors, the responsiveness of NPV to changes in the variable, has two components. The first component is the direct influence of the variable on NPV. The second component is the indirect influence of the variable, through its relationships with other variables that themselves are related to the NPV. Positive correlations with other influential variables will magnify the ultimate influence of both, and negative correlations will dampen their influence. These influences cannot be fully identified until we have set up a simulation model that is capable of dealing with the simultaneous interactions of many variables.
4.7.5.2 Common project risks A variety of risks can affect an investment. Some common sources of risk are the following: Investment lumpiness; can we start with pilot projects and scale-up gradually, or commit the whole investment or nothing? Timing; what if the project is delayed? What if it takes longer than expected? Is there a best time to start the project? Salvageability; how much of the investment can be recouped if things go wrong? Uncertain incremental effect; what will the outputs of the project be? Uncertain parameter values; what discount rate and inflation rates are appropriate? Volatile preferences; are the target beneficiarys needs or preferences unstable?
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An investment decision is highly risky if a big investment has to be made without a chance to pilot (test the waters), delay is highly damaging, little can be salvaged if the project goes wrong, the likely output is uncertain, some of the key measurement parameters are uncertain, and the beneficiarys preferences are unstable.
4.7.6 General approaches to uncertainty and risk Two risk measures are particularly useful summaries of the overall level of risk in a public investment, the expected loss-ratio and the risk-exposure coefficient. The expected loss-ratio is the absolute value of expected loss (all possible losses weighted by their probabilities) as a proportion of the total expected value of all possible outcomes. The risk-exposure coefficient, in most cases, may be an adequate indicator of risk, but it does not capture all aspects of risk. For example, two projects can have the same expected loss-ratio but different levels of risk because ones outcomes are more spread out than the others is or because more of the spread is in the negative NPV area.
Making risk characterizations more complete, subtler and more targeted data would help the decision maker to make more balanced and better informed decisions. Dealing with uncertain data is a very large part of practical analysis (financial, economic or cost-benefit).
4.7.6.1 Approaches to quantifying uncertainty-related risk There are three approaches to dealing with financial and economic risk in the analysis: Expected values (certainty equivalents) of scenarios; Risk-adjusted discount rates; and Risk analysis through simulation.
Given the present state of the art, the first two approaches have limited applicability. Only the third method, simulation, offers a practical technology for analyzing the overall risk of a project, but it is equally unsuitable in the Rwanda public investment program context.
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In conclusion, all the three approaches are founded on the basic idea that there are at least three meanings of most likely outcome: 1) the deterministic value of the NPV (the outcome when one assumes best-guess figures for each input); 2) the mode of the probability distribution of NPVs; and 3) the expected value (the sum of possible outcomes, each multiplied by its probability). The last is the best guide to the choice of investment alternative.
Advocates for simulation techniques believe that they provide a realistic picture of the overall risk in the project because they cover all the items above. Theres a multitude of commercial software programs (@ Risk and Active Risk Manager, for example), which make risk analysis a relatively simple task, once the basic (deterministic) model has been constructed and information about variable ranges and probabilities has been collected.
For academic and intellectual food of thought, let us preview the first two concepts, expected value scenarios and risk-adjusted discount rates.
Expected values of scenarios If an investment has two possible outcomes, RWF 100 million and RWF 1 billion, and their probabilities of occurrence are 30% and 70% respectively. Then the expected value or certainty equivalent of the investment is (0.3 x RWF 100 million) + (0.7 x RWF 1 billion) = RWF 30 million + RWF 700 million = RWF 730 million. If the sponsor/investor has a completely rational attitude to risk, then it shouldnt matter to him/her whether s/he makes the investment or accepts the RWF 730 million instead.
Few analysts take this scenario approach because in most cases there are so many possible outcomes that it is too difficult to think clearly about the probability of each separately. On occasion, however, scenarios can provide useful information about risk. For example, a manufacturing company is trying to decide whether to build a waste treatment plant near a residential area prone to earthquakes. The plant costs RWF 1 billion (present value at t0). The
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managing director (MD) foresees three possible scenarios; and each of these has a predictable outcome for the company.
Scenario 1: No earthquake affects the plant. Outcome: Company savings from the plant: RWF 1.4 billion, t0. Scenario 2: The earthquake affects the plant, but the plant can be repaired before spilling waste into the neighborhood. Outcome: Company savings from the plant: RWF 900 million, t0. Scenario 3: The earthquake affects the plant, and the plant cannot be repaired, causes damage to the neighborhood. Outcome: Company savings from the plant: RWF 20 million, t0.
Now comes the difficult part. Suppose the MD commissions a study by surveyors and earthquake consultants and is told that there is a 70% chance that no earthquake will affect the plant, a 20% chance that the earthquake will affect the plant but the plant will be repairable, and a 10% chance that the earthquake will affect the plant and the plant will not be repairable. Therefore, the expected value of the RWF 1 billion investment is (0.7 x RWF 1.4 billion) + (0.2 x RWF 900 million + (0.1 x RWF 20 million) = (RWF 980 + RWF 180 + RWF 2 million) = RWF 1.162 billion. The MD decides to go ahead with the plant since the expected benefit (RWF 1.162 billion) is greater than the cost (RWF 1 billion). The earthquake affects the plant, but the plant is reparable. The company loses RWF 100 million. The MD, however, had made the right decision, given the information s/he had to work with.
The main worry with this procedure is in the reliability of the estimates of probability they make. Did the surveyors and earthquake consultants really have the expertise to assign probabilities to the likelihood of the earthquake effect to the plant? There were no data. Assigning subjective probabilities to big-picture scenarios is essentially a guessing game. In contrast, it is plausible that an orange pricing expert can forecast orange prices within a
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reasonable range a year ahead, based on historical price data, demand trends, and consideration of factors that might interfere. There is a subjective element in forecasting orange prices, too, but there are data available. Legitimate experts have developed good judgment in the matter, so they are able to express expected orange prices as a range and specify a probability distribution with reasonable confidence.
From the above example, we have illustrated that risk analysis is part science and part art; and part of the art is knowing when and where in the model to use probabilistic data.
Risk-adjusted discount rates The practice of changing the discount rate to allow for uncertainty in project assessment has limited validity too. In effect, it implies that uncertainty compounds itself at a fixed rate over time. This is unlikely to be the case in the real world. Where different degrees of uncertainty can be ascribed to future values of variables, it is preferable to let estimates of future annual benefits and costs reflect these different degrees of uncertainty, and to aggregate present values using an interest rate that has not been adjusted for risk.
The basic idea behind the risk-adjusted discount rates approach is that, in a perfect or competitive market, all investments earn the same rate of return. Otherwise, capital would flow to the high return areas pushing average returns down until the rates equalized. Therefore, visibly different rates of return must incorporate the same basic rate plus a premium for risk so that, in the long run, only the basic return is gathered by the investor. If this is so, then the appropriate discount rate (cost of capital) is the basic rate plus a premium for risk. This combination is the risk-adjusted discount rate.
This approach has three principal flaws. First, we all know that we do not exactly operate in perfect markets, accordingly the differentials observed in rates of return might be due to other systematic or random factors, rather than to project risk. Second, the logic confuses the lenders risk in lending capital to the investor with the risk inherent in the proposed project.
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They are not the same things. Third, the use of a risk premium on the discount rate can lead to embarrassing results. A risk premium on the discount rate means that the absolute value of the risk premium in monetary units (i.e. francs) increases as time goes on, and this does not make sense for many investments that are uncertain for an initial period but tend to settle down to a known pattern of revenues and costs and therefore low risk (most of the social public investments and real estate development, for example). These are somewhat abstract objections to an abstract theory, however. The practical matter is that there is no known way to calculate the risk premium in a specific case. The closest we can come to such a calculation is where there are data for a large number of transactions that can be analyzed statistically, such as in the stock market. Here, the variability of a stock price is a reasonable surrogate for one type of risk, but no one has demonstrated a way to use this concept of volatility risk to adjust the discount rate for a single project investment.
Therefore, making subjective estimates of the risk premium is not a good idea for mainly two reasons: 1) as mentioned already, there are generally no data or clear expertise in the matter; and 2) putting a risk premium on the discount rate obscures the outcome of the analysis. The influence of risk estimates working through a premium on the discount rate is too complex for intuitive understanding. Overall, discount rate adjustment is not a good way to come to grips with probabilities and risk, when we are dealing with public investments in the least.
4.7.7 Decision making when dealing with uncertainty and risk For situations where there is significant uncertainty, the following decision rules apply: If the lowest possible NPV is greater than zero, accept the project. If the highest possible NPV is less than zero, reject the project. If the maximum NPV is higher than zero and the minimum is lower, calculate the ENPV. If the ENPV is greater than zero, accept the project. If the cumulative probability distribution curves for two mutually exclusive projects do not intersect, choose the project whose probability distribution is farther to the right.
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If the cumulative probability distribution curves for two mutually exclusive projects intersect, be guided by the ENPV. If the ENPVs are similar, consider the risk profile of each project.
4.7.8 Risk preferences in the public sector Generally, we have to assume that the decision maker is wholly rational, neither risk seeking nor risk averse. For example, a 50/50 chance of gaining RWF 100 will be valued at RWF 50. This is a reasonable assumption for a decision maker that feels no wealth constraint, especially when the investment in question is small in comparison with his/her wealth. Experts contend that many decision makers in the governments do actually feel a wealth constraint. That is, for example, they will view a 50/50 chance of losing or gaining RWF 2 billion with a lot more anxiety than a 50/50 chance of losing or gaining RWF 10 million, although the NPV of each is the same. We also know that in most cases, governments are risk neutral. In other words, they are rational decision makers. A government has a large portfolio of projects and programs and therefore can act fully rationally with confidence that, on average, things will turn out well if the decision rules are strictly applied. In the case of a single large or politically sensitive project, however, the question of a wealth constraint might arise. 4.7.9 Limitations of sensitivity and risk analysis The major limitation of sensitivity analysis is that it cannot deal with more than two variables at a time, hence it does not tell us much about the projects level of risk. Until all variables are allowed to vary simultaneously, we do not know whether their individual effects on risks are magnified or cancelled out by each other. On the other hand, some of the other limitations of risk analysis include the following: The problem of correlated variables, if not properly contained, can result in misleading conclusions.
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The use of ranges and probabilities in the input variables makes the uncertainty visible, thereby making some decision makers uncomfortable.
If the deterministic analysis (financial, economic and cost-benefit) model is not sound, a
risk analysis might obscure this by adding a layer of probabilistic calculations, thereby creating an unauthentic impression of accuracy.
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Appendices
Example I: Conversion factors for major transport projects in southern Italian regions
The Italian Ministry for transport developed a set of conversion factors for the appraisal of all railway major projects that were to be implemented within the framework of the EUs National Operational Program (2000 2006).
Category Equipment Labor Freights Expropriations Administrative costs Maintenance Extraordinary maintenance Conversion factor 0.9090 0.3480 0.8330 1.0000 0.8330 0.9090 0.9090
Source: European Commission Directorate General Regional Policy, Guide to cost-benefit analysis (2008)
Example II: Conversion factors for projects in South Africa

These are estimates of commodity-specific conversion factors for South Africa tradable goods evaluated at the point of entry and classified according to the Harmonized Classification System. They are as import duty rates, value added taxes and the foreign exchange premium changes. It is also acknowledged that while conversion factors at the port can be used for the same good or service for different projects, conversion factors estimated at the project site are site specific and will also depend on the transportation and handling costs involved in moving them to the project.
Category Foreign exchange premium Truck transportation services Building construction Infrastructure and public works Electricity Telecommunication services Conversion factor 0.06 0.085 0.870 0.876 0.938 0.900
Labor by type
Category Urban project paying unskilled labor the prevailing market wage rate Urban project paying unskilled labor higher than the market wage rate Rural project paying unskilled labor the prevailing market wage rate Rural project paying unskilled labor higher than the market wage rate Urban project paying skilled labor the prevailing market wage rate Urban project paying skilled labor higher than the market wage rate Project hiring non-South Africans to work in South Africa Conversion factor 1.00 0.60 1.00 0.45 0.98 0.88 0.73
Source: Department of Financial and Economic Development (DFED), Limpopo Provincial Government, Cambridge Resources International Inc (2004)
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Case study I: Czeck Republic_Cycling Infrastructure Network in Pilsen

The city authorities planned to improve the cycling infrastructure network in Pilsen. A survey was conducted to analyze the impacts of improved cycling infrastructure on demand for this means of transport. A stated preferences design was used to elicit the willingness to use the bicycle in the event of various improvements to the cycling environment in the city. In the application of CBA, the following three benefits were included: 1) improvements in health by regular physical activity of new cyclists (quantification based on the costs of illness); 2) changes in the number and severity of accidents (based on accident costs); and 3) changes in atmospheric pollution (using the ExternE data). Background The share of cycling was relatively low in most medium-sized and large cities in the Czech Republic. It was about 0.5% in Prague and 0.3% in Pilsen compared to Munich (13%) or Vienna (4.5%) based on existing literature. It was established that to make cycling more attractive, sums invested in cycling infrastructure would gradually rise in the Republic, even if they made up only a tiny part of the public funds expenditures (about 0.2% of total expenditures from the State Transport Infrastructure Fund). Logically, the question of social benefits of these investments and their economic efficiency was obvious. Extensive literature existed dealing with CBA of transportation projects, but substantially less dealt with that of cycling projects. However, the opinion was that measurements for pedestrians and cyclists should apply the same methodology that is used for transport projects in general. But not the same as those in projects which mainly benefit motorized travel.
Demand analysis The approach based on the current transportation behavior of the target population (Over 18 years). Using a questionnaire, respondents (763 in total) were asked about trips made during the previous working day (Tuesday, Wednesday and Thursday). Focus was on each trip on a given working day separately. A quota sample (residential area, age, gender, education level) was used. The daily journeys including purpose, distance, duration and the means of transport were taken for reference values for the state of demand before the change. The demand change itself was estimated from stated preferences. Demand questions involved the following wording: how significantly would the following changes in transport situation in Pilsen influence your willingness to use the bicycle more than currently? Normally, stated preferences are confronted with mutual fulfillment of current preconditions, in this case; for bicycle use such as bicycle ownership/accessibility, at least experimental or recreational use of the bicycle, perception of bicycle use as an alternative (revealed preference) corresponding to the stages in the process of travel behavior change. Two different demand scenarios were estimated for each level of tolerance and each purpose. The change in demand on a given working day was estimated as: 1) a change in the number and/or share of travelers using the bicycle; 2) a change in the number and/or share of kilometers ridden by bicycle; and 3) a change in the amount of time spent on the bicycle and/or its share. The switch from car use to the bicycle was estimated separately. For the estimate of potential demand, the residence, the purposes of the trips and their locations were fixed. On the assumption that the time spent travelling by those who do not switch stays constant. The changes in lengths and durations of the trips were estimated using the CUBE model.
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Estimated benefits Benefits included those derived from improvements in health by regular physical activity of new cyclists, reduction in the number of accidents involving cyclists, reduced external costs in of motorized transport connected to air pollution, and reduced costs of travel time. a) Improvements in health by regular physical activity of new cyclists Because there was no reliable data concerning the impacts of regular physical activity on mortality, a 9% decrease in mortality by cardiovascular diseases was assume, informed by a previous study. The value of a statistical life (VSL) for the Czech Republic was used (18.52 mil). In calculating the benefits of improved health from regular cycling (morbidity), they estimated the cost of illness using the prevalence approach (costs connected to an existing case during the assigned period). This was subjected to only new cyclists regularly cycling to work (the reason is a higher probability of regular everyday trips by bicycle). First, they focused on the coronary heart disease (using the 50% reduction in the risk of coronary heart disease). The costs were calculated separately for in-patient and outpatient treatment. The value of social costs included treatment, drugs and technical treatment, and the loss of productivity. According to existing literature, there is a strong evidence of a relationship between physical activity and colon cancer (an average risk reduction of 40-50%). The social costs again, were estimated separately for in-patient and out-patient treatment. Although, according to existing literature, physical inactivity is a major risk factor for the development of type 2 diabetes and increases the risk of its development by 33-50%. But because of unavailability of data specifying the loss of productivity, this item was not included. b) Reduction in the number of accidents involving cyclists A review of evaluation studies of impacts of separated crossings indicated that the number of pedestrian accidents had reduced by about 80% and the number of accidents involving motor vehicles had reduced by about 10% only. No comparable figures for accident reduction connected to infrastructure improvement were available. Even in the absence of proof for the risk of accidents related to cycling, they assumed a 10% reduction in accidents involving cyclists and no change in accidents involving motor vehicles only. In calculating the impacts of injuries, they used the value of 200 thousand CZK per light injury (as suggested by the survey and the accident statistics of 2005). c) Reduced external costs of motorized road transport connected to air pollution Atmospheric pollution (caused also by emissions from transport) has an inauspicious impact on human health (e.g. on respiratory diseases, cancer, and premature deaths). It is also a cause of material damages on buildings and plants. At the regional level, pollution causes acidification and globally it is a contribution to the greenhouse effect. They applied the ExternE data. The value of external costs of atmospheric pollution included emissions of NOx, SO2, carbohydrates, particular matters (PM10) and their impacts on human health and early death and CO2. The structure of the vehicle fleet was derived from a vehicle census done in Pilsen in 2001.
d) Costs of travel time It was assumed that cycling on a cycle track could reduce travel times by comparison with cycling on an ordinary sidewalk. Similarly, it was assumed that travel times for the already cycling will stay unchanged. Because congestion was not a significant problem in Pilsen, they assumed that even travel times for car drivers who do not substitute cycling for driving would stay unchanged too. Normally, travel times increase for those who make the shift from the car to the bicycle (by about 21 minutes for an average trip made by bicycle instead of by car). If an individual declares the willingness to change the mode of transport even if it would lead to a longer travel time, however, they could only
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assume that the individuals benefit outweighs the private costs connected to choice (as an increase in travel time, for example). That is why this type of private negative benefit does not represent a social cost. e) Benefits from reduced insecurity Although in the survey design the distinction of benefits accruing from reduced insecurity of those who were already cycling and those who were not was made. These benefits were not included in the analysis because these benefits were already internalized in the personal benefits of each cyclist (to avoid double counting). A similar view was taken regarding the costs of travel time.
Estimated costs Costs included infrastructure investments and maintenance costs. Presentation of costs
Category Planned network for cycling (km) Remaining parts of the network (km) Cost estimates for completing the network (millions CZK / Euro) Maintenance costs per year (millions CZK / Euro) Total costs (Millions CZK / Euro) 111.9 76.4 136.2 Cycle path 34.2 26 51.8 Cycle lane 39.2 19 18.6 Combined walking and cycling path 52.2 34 50.4 Total 125.5* 78 120.8 / 4.2 21.6 / 0.7 345.9 / 11.9
Notes: The table shows the existing and planned networks of cycling infrastructure and estimated costs of their construction. The costs of infrastructure construction vary between 1,000 and 2,000 CZK per square meter. Such a difference in costs per square meter is caused by a broad range of materials used, the terrain conditions, etc. The exchange rate is 29 CZK/Euro *calculated construction costs 1,500 CZK/m2
Presentation of analysis results

Benefit and cost components Benefits of cycling infrastructure (present value) Changes in health Accidents Mortality Emissions Total benefits Costs of cycling infrastructure (present value) Capital costs Maintenance costs Tax-cost factor (20%) Total costs Net benefit/costs ratio Source: Hana Foltnov LTNOV and Markta Braun Kohlov (2006) Note: The discount rate applied is 7% and a 25-year lifecycle of the project. 78 km 78 km 181,200.00 8,053.33 37,850.67 227,104.00 -0.62 181,200.00 8,053.33 37,850.67 227,104.00 -0.33 20 persons 4 accidents 0.57 persons 122, 000 km / day 8,596.62 9,533.10 122,201.78 22.93 14,035,443 Assumed as 14,299.65 61,100.89 9.94 75,410.47 Impacts per year Neutral scenario Conservative scenario
Presentation of sensitivity analysis results There are many factors which influence the results of the cost-benefit analysis substantially. Sensitivity analysis was conducted on three influence variables; 1) construction costs, 2) the estimate of change in cycling demand
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(strict versus tolerant levels), and 3) the change in the number of accidents. Plus the inherent discount rate and the lifecycle of the project. First, the costs of construction were allowed to vary between 1,000 CZK and 2,000 CZK. Using the lower costs of construction (1,000 CZK per m2), the net benefit/costs ratio was -0.91, while the higher costs of construction (2,000 CZK per m2) only yielded -0.47 for the neutral scenario. Second, it was established that the level of change in demand influenced the results substantially. Using the tolerant level of demand, the net benefit/costs ratio was 3.08 for the neutral scenario of demand and the lower costs of construction, and 1.59 for this demand and the higher construction costs (2,000 CZK per m2). Using the tolerant level of demand, the present value of benefits overweighed the costs with the exception of the conservative scenario for the higher costs. Third, analysis was conducted on improved cycling infrastructure to the safety of cyclists (focusing on the number and severity of accidents). When the number of accidents decreases by 25%, costs cancel out the benefits for the low construction costs level and strict level of demand. Nevertheless, benefits never exceeded the costs when the average rate of construction costs (1,500 CZK per m2) was applied for the strict level of demand. Fourth, it was established that the discount rate and demand influences results of the model. The change in distribution of benefits during the lifecycle of the project can make the project socially profitable. For example, using a discount rate of 5%, the net benefit/costs ratio shot to 1.1 for the lower construction costs estimate for the strict demand level. When a very low discount rate (nearly zero) was applied, the project became more profitable even for the higher construction costs estimate. In the end, when the demand change was calculated according to the strict level, social benefits did not cover the social costs of building new cycling infrastructure. The net benefit/cost ratio was -0.97 for the neutral scenario and -0.52 for the conservative scenario. Other possible benefits such as noise reduction and further health impacts were not included in the analysis. Overall, the results of this model were very sensitive to a range of factors. Above all, the demand estimate played an important role. Even if the net benefit/costs ratio was -0.91 for the strict level, it was already 3.08 for the tolerant level. These results differed when the higher and average costs of construction were used.
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Case study II: India_Rural Road Project

This was an economic analysis of a rural basic access road project, located in Andra Pradesh and financed by the World Bank under the Indian Rural Travel and Transport Program.
The project area included three selected poor rural districts, Adilabad, Karimnagar, and Warangal, with a total population of 6.8 million. The project proposed to improve the rural road network to at least basic, all-weather passable standard. The rural road network in India by then totaled 15,000 kilometers, most of which were in poor condition. Almost 60% of the network was tracks and earth roads, 10% gravel, and 30% water-bound macadam (WBM) roads. Not all tracks or earth roads were all-weather passable. Both gravel and WBM roads could be allweather passable, but many of them did not meet the all-weather standard due to broken or missing crossdrainage facilities. The demand for network investment greatly exceeded the project budget, hence economic analysis was conducted to assist in the design, prioritization and selections of road works for financing under the project. The key to maximizing investment was to focus on the improvement of a core network that would ensure minimum connectivity for each village to a nearby main road or market center. Road works for candidate roads fall into two major categories: (a) basic accessibility works, including upgrading tracks and earth roads to gravel or WBM roads, and all minor and major cross drainage works on existing gravel and WBM roads; and (b) black-topping works on existing earth, gravel, and WBM roads. Since basic accessibility works are considered as a valuable instrument for poverty reduction, they are given first priority. Black-topping, on the other hand, is carried out primarily for economic reasons. When traffic volume (especially motor vehicle traffic) on an unpaved road reaches a certain level, it is more economical to pave the road rather than to keep restoring the unpaved road to all-weather condition. Economic justification is required for all black-topping works. Both CBA and CEA methodologies are being used for this project. CBA was applied mainly to the black-topping works, the conventional road CBA methodology was used first to determine minimum traffic thresholds. These thresholds were defined as a combination of motor vehicle (MV) and non-motorized vehicle (NMV) traffic levels at which black-topping would be justified at the minimum economic rate of return (ERR) of 12%. The candidate roads with traffic levels significantly below the thresholds were dropped from the list of black-topping works, but they were nonetheless considered for upgrading to basic access standard and subsequently evaluated in the category of basic accessibility works.
Project background
CEA was applied to the selection of basic accessibility road works. All roads proposed for basic accessibility work were ranked by a simple cost-effectiveness measure-total population provided with basic access per US$2,500 equivalent of expenditure. The top ranking least-cost works were to be financed, with a maximum of US$50 equivalent per person served - used as a final restrictive measure to ensure cost-effectiveness. The economic analysis produced a list of basic accessibility road works ranked by cost-effectiveness and a list of black-topping works ranked by ERR. The application of CBA and CEA in this project however, did not deal with the optimal budget allocation between the two categories of road works because the allocation was decided through a stakeholder participatory process. Based on the budget allocation about 1,700km of rural roads was selected for financing to basic accessibility standard, with a cost-effectiveness ratio ranging from US$14 to US$50 outlay per person served. A further total of 1,300km of roads was selected for black-topping. Their ERRs ranged from 12 to 90% with an overall ERR of 24%. A total of 2 million people were expected to benefit from the project.
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The application of CEA for basic accessibility works was supported by an assessment of the likely impact of basic road access on the welfare of rural households (through a small-scale rural household and village transport survey). The survey sampled 40 villages in the project area. For each sampled village, 10 households were randomly selected for the household level survey. The following were the survey results (showing socio-economic indicators between those villages connected with all-weather access road and those unconnected.
Indicators Household income ($/yr) Literacy rate Male Female Total Average distance traveled for: (km) Fertilizer Seeds Pesticides Transport cost ($/ton-km) Fertilizer by bullock cart Seeds by bullock cart Fertilizer by lorry Seeds by lorry Average distance to school (km) Primary education Secondary education 0.2 2.5 0.2 18.0 0.13 0.10 0.16 0.08 0.33 0.26 0.25 0.11 11 11 9 19 19 16 51% 35% 43% 40% 22% 32% Connected 700 Unconnected 275
According to household interviews in the unconnected villages, poor road conditions, seasonal road closures, lack of motorized access, and the high cost of freight delivery were among the major obstacles to village accessibility. Moreover, road closure during the rainy season caused produce spoilage, delays in freight delivery, labor unemployment, and lower school attendance. When asked what impacts they expected from the improvement of roads, most households in both connected and unconnected villages responded with predictions of more seasonal work taken outside villages, higher intensity of cultivation, and expansion of cultivated land. The survey results provided strong empirical evidence to support the social and economic justifications for the provision of basic all-weather access to these villages. The CBA table was designed based on a conceptual structure similar to that of the HDM model, though much simplified for rural road evaluation. The program consisted of five panels. The first was used to record road data and economic input parameters. The value of travel time was estimated using the rural per capita income data from the project area. The annual traffic growth rate was projected based on the areas population and per capita income trends. The second panel contained engineering unit cost data obtained from the field. The third panel presented the estimated unit VOCs and travel speeds by both road type and vehicle type. The average road surface condition for each type of road in the project area was measured by a range of international roughness index (IRI). The unit VOC data for motor vehicles was obtained from the empirical VOC-IRI relationships estimated for a Bank-financed state highway project in Andhra Pradesh, and extended to cover the worst IRI levels typically found on the rural road network. Average travel speed on each type of road surface was estimated by local engineers based on their field experience. The VOC-IRI relationships for bullock carts and bicycles were estimated using the NMV basic cost data collected from the field and the empirical relationships developed by existing studies in South Asia. The fourth panel calculated savings in VOC and value of travel time
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(VOT) for the users of each mode of transport. Finally, the bottom panel calculated the economic cost and benefit streams over the project life, as derived from the other panels. The NMV basic cost data is as follows.
Item Unit Vehicle price US$ Price of a pair of ox US$ Annual cost of feeding the ox US$/pair Annualized maintenance cost US$ Vehicle depreciation US$/yr. Annual average usage km Average year of life years Average VOC per km US$ Note: (a) annual depreciation for the first 3 years. Bullock Cart 62.5 312.5 150.0 75.0 12.5 2,400 5 0.13 Bicycle 30.0 n.a. n.a. 5.0 5.0 (a) 1,000 10 0.01
All other results

District name: Division name: Road length (km): Current road type (enter 0 for 0.5 earth, 1 for gravel, 2 for W BM) Value of travel time (US$/hr) Annual per capital income growth Capital Cost ('000 US$/km) Formation Gravel (when available on site) WBM (each layer) Blacktop Minor CD ('000 US$/each) Major CD ('000 US$/m) Vehicle Type 2 0.06 3% Warangal Warangal 15 Road name: Road No.: Population served: No. of minor CD/km: Major CD (m/km): Annual traffic growth rate Standard Conversion Factor Annualized Maint Cost ('000 US$/km) Financial 5.00 5.00 6.25 7.50 5.00 3.75 Economic 4.50 4.50 5.63 6.75 4.50 3.38 Travel Speed by Road Type (Min./km) Earth Gravel WBM BT IRI=14-18 IRI=9-11 IRI=9-11 IRI=5-7 2.4 2.4 2.4 2.4 3.0 2.4 2.4 2.4 20.0 7.5 17.0 1.7 1.7 1.7 1.7 2.0 1.7 1.7 1.7 15.0 7.0 16.0 1.7 1.7 1.7 1.7 2.0 1.7 1.7 1.7 15.0 7.0 16.0 1.2 1.2 1.2 1.2 1.5 1.2 1.2 1.2 15.0 6.5 15.5 Earth Gravel WBM Blacktop Financial 0.55 0.68 0.88 0.93 Economic 0.50 0.61 0.79 0.83 PW D to Chilpoor L101 12,000 0.5 1.0 5% 0.90
Unit VOC by Road Type (US$/km) Earth Gravel WBM BT IRI=14-18 IRI=9-11 IRI=9-11 IRI=5-7 0.303 0.170 0.170 0.343 0.250 0.170 0.075 0.063 0.147 0.010 n.a. 0.250 0.123 0.123 0.280 0.225 0.123 0.063 0.038 0.129 0.008 n.a. 0.245 0.118 0.118 0.268 0.200 0.118 0.050 0.038 0.118 0.008 n.a. 0.225 0.100 0.100 0.240 0.150 0.100 0.038 0.025 0.115 0.006 n.a.
Buses Mini buses Cars/Jeeps Trucks Tractor /Trailers LCV/Tempo Three wheelers Two wheelers Bullock carts Bicycles Pedestrians
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Vehicle Type Buses Mini buses Cars/Jeeps Trucks Tractor /Trailers LCV/Tempo T hree wheelers Two wheelers Bullock carts Bicycles Pedestrians MVs (2 2w = 1 MV) NMVs
Base yr. Avg. Veh. Traffic Occup. 20 16 40 24 22 37 32 68 60 320 680 225 380 35 10 4 0 5 1 3 1.5 1.5 1 1
VOC(US$/km) w/o. Proj w. Proj. 0.25 0.12 0.12 0.27 0.20 0.12 0.05 0.04 0.12 0.01 n.a. 0.23 0.10 0.10 0.24 0.15 0.10 0.04 0.03 0.12 0.01 n.a.
Speed (Min./km) w/o. Proj w. Proj. 1.70 1.70 1.70 1.70 2.00 1.70 1.70 1.70 15.00 7.00 16.00 1.20 1.20 1.20 1.20 1.50 1.20 1.20 1.20 15.00 6.50 15.50 =
Savings (US$/km) VOC VOT 0.40 0.28 0.70 0.66 1.10 0.65 0.40 0.85 0.15 0.56 n.a. 1868 0.36 0.08 0.08 0.00 0.06 0.02 0.05 0.05 0.00 0.17 0.35 400
Annual sum (325 days/year)
Year
Traffic growth Capital Cost Maint. Cost 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045 0.045
(All in thousand US$) VOC Savings 1.87 1.96 2.06 2.16 2.27 2.38 2.50 2.63 2.76 2.90 3.04 3.19 3.35 3.52 3.70 3.88 VOT Savings 0.40 0.43 0.47 0.51 0.55 0.59 0.64 0.69 0.75 0.81 0.88 0.95 1.03 1.11 1.20 1.30 Net Benefit -18.03 2.35 2.48 2.62 2.77 2.93 3.10 3.28 -3.29 3.66 3.87 4.10 4.33 4.59 4.85 5.13 0.81 12.8%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 NPV ERR
5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5% 5%
20.25
6.75
Source: Liu Z. (2000), World Bank Infrastructure Note RT-5. Note: Three things should be noted; 1) the economic analysis described here requires systematic data collection. This particular experience may not be transferable to other rural road projects; 2) data collection at low cost can be possible with the active participation of the prospective beneficiaries; and 3) where systematic data do not exist or are costly to collect, effort should be made to at least establish a transport/poverty profile through a small-scale household survey, and to collect traffic data on the proposed rural roads. VOC stands for vehicle operating cost, VOT for value travel time, TTC for travel time cost, CEA for cost-effectiveness analysis, CBA for cost-benefit analysis, WBM for water-bound macadam, MV for motor vehicle, NMV for non-motorized vehicle, and IRI represents international roughness index.
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Case study III: Cambodia_Health Project

This is the Cambodia Health Sector Support Project approved by the Asian Development Bank (ADB) on 21 November 2002. Project background There was a strong economic rationale for investing in health in Cambodia, particularly in the expansion of primary and basic secondary healthcare to areas where it was almost nonexistent. Cambodias health indicators were are among the worst in the Asian and Pacific region. Average life expectancy at birth was estimated at only 56.4 years. Infant mortality stood at 95 per 1,000 per live births, mortality rate under the age of 5 at 124 and the maternal mortality rate at 437 per 100,000 live births. Also, malnutrition rates were the second highest in Southeast Asia, 56% of children under 5 were affected by chronic malnutrition. Health care is often characterized by asymmetrical information with respect to medical interventions. Like in many developing countries, this is true in Cambodia as well, where education levels of patients are low and people often do not know about even basic health practices, such as emergency obstetric care and child health. In many areas, private, unregulated health services are the primary source of health care. The lack of regulation and consumer information often puts the health of patients at risk and drives up the cost of health care. However, publicly provided health services can help bridge the gap and provide information about good health practices and alternatives in healthcare. Credit markets are weak in Cambodia and health insurance is virtually nonexistent. A health crisis in a household can lead to a household financial crisis and, for the 80% of the population that lives near or below the poverty line in Cambodia, the threat of such a crisis is ever present. Thus, a formal and transparent fee system for health care reduces uncertainty of health care expenditures and protects the poor from the burden of health care costs. By then, virtually no protection existed for the poor, but with a formal system, authorities though it was possible to establish fee exemptions and social protection funds and, subsequently would be able to establish insurance schemes to protect households in the event of an unexpected health crisis. At the same time, train healthcare providers with the objective of improving sector performance.
The project aim was to improve health, especially of women, children and the poor in targeted regions. The projects specific objectives included: The development of affordable, quality, basic curative, and preventative health services for the population, especially for women, the poor, and the disadvantaged; Increasing the utilization of health services, especially by women and the poor; Controlling and mitigating the effects of infectious epidemics and of malnutrition with emphasis on the poor and disadvantaged; and Increasing the institutional capacity to plan, finance and manage the health sector in line with the Health Sector Strategic Plan (2003-2007). The project comprised of three components: Buildings and civil works, medical and auxiliary equipment, training of health service providers, contracting of services to nongovernmental organizations, and supplies and drugs; Support programs addressing public health priorities such as the control and prevention of communicable diseases and safe motherhood, immunization and nutrition programs; and Strengthening institutional capacity in management, planning and evaluation at the national, provincial and district levels. In the contracting of services to nongovernmental organizations, two approaches were used, contracting-in and contracting-out models. Under the contracting-out model, the contractor has full responsibility for the delivery of
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specified services, directly employing staff, and has full management authority and accountability for the achievement of specific targets. The contractor is accorded full control over resource allocation and disbursement. While under the contracting-in model, contractors provide only management support to the civil service health staff, with recurrent operating costs provided by the government through normal channels. The contractor is accorded full control over allocation and disbursement of the budget supplement, but is obliged to follow government rules and regulations with respect to the government-supplied resources. And the contractor has management authority over staff, though s/he does not directly employ them. Economic benefit assumptions used Basis: The project supports the Cambodian health systems efforts to improve the health status of the population. Economic benefits were divided into 2 categories, resource cost savings and productivity gains. Resource cost savings consisted of reductions in out-of-pocket expenses for healthcare as a result of reforms in health financing. And productivity gains consisted of reductions in the time lost to illness or care for the sick (by family members), time that would have otherwise been utilized either in some economic activity or lead to better learning outcomes of children who will eventually join the labor force. Numerous studies have shown that improvements in health have a significant effect on the populations productivity. This is true for people working, both within and outside the home, and studying. There was also a few studies done in Cambodia on the relationship between health status and productivity, nonetheless, this analysis did not attempt to quantify all economic gains but only provided conservative estimates based on benefit streams that could be quantified. Presentation of economic benefit and cost assumptions under alternate scenarios.
Scenarios Fewer $6 $4 2.3 days 0.8 days 15% 30% 45% 60% $0.15 $0.75
Sick days reduced
Indicator
Base case $6 $4 2.3 days 0.8 days 20% 40% 60% 80% $0.15 $0.75
Low
Less $6 $4
Out-of-pocket expense
Reduction of per capita out-of-pocket expenditures in contracted areas Reduction of per capita out-of-pocket expenditures in non-contracted areas Reduction of per capita days lost due to illness in contracted areas Reduction of per capita days lost due to illness in noncontracted areas Population benefiting from the Project in year 3 Population benefiting from the Project in year 4 Population benefiting from the Project in year 5 Population benefiting from the Project in year 6+ Maintenance cost per dollar of investment Economic value of time (daily)
participation in the project
$6 $0
1.2 days 0.4 days 20% 40% 60% 80% $0.15 $0.75
2.3 days 0.8 days 20% 40% 60% 80% $0.15 $0.75
The evaluation showed that supporting the healthcare system would lead to a decrease in out-of-pocket expenditures for health services along with improvements in health status. This finding was not surprising given that by then, Cambodians depended on pharmaceutical products which were often wrongly prescribed and misused, and the high use of low quality unregulated health services. As a result, spending on health care was inefficient because of a lack of information, provider accountability, and a disorganized health system. For the areas that had been participating in the contracting pilot project, the positive effect was more pronounced. The base case assumed that out-of-pocket spending on healthcare was to be reduced from $22 per year to $16 per year in contracting districts (a savings of $6 per person per year) and to $18 per year in non-contracting districts (a savings of $4 per person per year). This may seem low, but given the low level of income in Cambodia, it was significant for many households.
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Time was valued at $0.75 per day based on prevailing wages. This value of time was assumed to be constant for the entire population, whether people worked outside their home, studied, or worked at home. This is consistent with the practice of valuing the life of people who do not contribute financially to the household. It also reflects the contribution that the non-working population makes to household welfare and is based on the premise that work in the home is a substitute for work outside the home at the prevailing wage. It was expected that improving the health status of the population would lead to fewer days lost due to illness and fewer days needed to take care of ill relatives than without the health interventions introduced by the project. The base case assumed that in contracting districts, an average of 2.3 days per year will be gained per capita due to more efficient treatment and better availability of services. In other districts, the gain was assumed to be only 0.8 days per person-year. At the prevailing wage of $0.75 per day, the monetary value of the productivity gain stood at $1.73 and $0.60 per person-year, respectively. The project targeted areas where the formal health system was not functioning, it was assumed that when the project begins operations, there would be relatively few new beneficiaries but the number would increase overtime. The Cambodian health system is organized around districts that are designed to give relatively equal access to the population, based on distance and population density. Thus, investments would be made to ensure broad access. The base case assumed that in the first two years of the project, there would be no new beneficiaries. The number was expected to grow overtime, as a percentage of the population within the vicinity of the project. These estimates reflect the time required for the investment from the project to reach the local level. Evidence from the contracting evaluation suggested that contracting starts to have a positive effect on the health system within 6 months, nonetheless, the analyst chose to use conservative estimates. Economic cost assumptions Basis: the project would require additional resources to cover operating and maintenance costs. It was assumed that for each dollar spent on investment, an additional $0.15 per year was to be spent on maintenance and providing basic supplies to new facilities. Recurrent costs associated with the purchase of new drugs and supplies were included in the estimate. Training leads to an increase in wages and subsequently to higher recurrent costs. Thus, salaries were expected to increase by 15%. Contracting is essentially a recurrent cost, however, the cost was expected hold steady (constant) in real terms after the project was completed. The cost of administration, including the Ministry of Healths cost in administering the loan, the cost of consultants, and monitoring and evaluation, all were included as components of the recurrent cost. Public funds used for investment come at a premium because of the distortionary effects of the taxes needed to collect them. Estimates in the literature indicate losses are on the order of 30 to 50% in developed countries and even greater for developing countries. But, public investment will not induce this type of effect if the investment is financed through borrowing and the project output is priced to achieve full cost recovery. However, such was not the case with this project. Although the capital investment was to be financed through borrowing, project output would be heavily subsidized and full cost recovery was not planned. It was planned therefore, that debt servicing would be financed through incremental taxation and rightly so, the taxation was anticipated to introduce incremental distortions at some future date. Recurrent costs were also expected to be financed through incremental taxation. Nevertheless, the economic cost of the distortionary effects of the taxes was not included in the economic analysis because of the lack of data to quantify it. Fortunately, the economic cost was likely not substantial because borrowings to finance the project were concessional (IDA loans) with a grace period of 8 years. Thus, any distortionary effects that could occur were heavily discounted and as such, they could not have a significant impact on the economic analysis.
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Presentation of analysis results

Year Economic costs Capital Contracting Incremental cost costs Recurrent costs 1,572,911 4,036,807 5,891,602 2,640,315 655,366 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 2,383,000 4,076,000 1,493,000 2,089,000 2,049,000 1,849,000 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 2,470,800 179,341 830,210 2,015,146 2,748,172 2,470,817 Economic benefits Incremental Cost benefits savings 882,000 1,764,000 2,646,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,528,000 3,000,000 6,000,000 9,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 12,000,000 Net economic benefits (5,828,252) (6,360,017) (6,113,748) 326,513 6,670,817 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200 10,674,200
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
Economic Internal Rate of Return = 30.5% Net Present Value (at a 12% discount rate) = $30.6 million Source: Erik Bloom and Peter ChoynowskiERD (2003), Asian Development Bank Technical note no. 6 Notes: Estimated benefits and costs are presented in millions of UD dollars in 2002 constant prices. Critical ERR is set at 12%. In cases where the economic benefits of a health project may be identified and valued, it is possible to subject the project to a full cost-benefit analysis. The degree of detail in the assessment of benefit incidence will normally vary considerably, depending on the amount of resources available for surveying and data compilation and analysis. In cases where a detailed analysis is not possible, simpler indicators may be used, such as the number of people within a target group that are served by the project, if the project is already being piloted.
Sensitivity analysis results

Scenario Base case Low participation in the project Fewer sick days saved Less cost savings ERR 30.5% 20.1% 26.1% 13.4% ENPV $30.6 million $12.0 million $22.3 million $1.9 million
Notes about the assessment that provided basis for the estimates A preliminary assessment was conducted to establish the incidence of benefits to the prospective beneficiaries and subsequently estimating the proportion of the project benefits that would accrue to the different beneficiary groups. The assessment used the simple indicator approach because of lack of funds to finance a full scale assessment. Also, a more detailed analysis of the incidence of benefits was not possible because of the limited amount of data on beneficiaries in the project area. The approach utilized began with an assessment of poverty in the provinces where the project facilities were to be constructed. Data on the poor and near-poor was obtained from the sources published by the World Food Program. It was assumed that the number of people served by the project facilities varied proportionally with the amount of investment and that the composition of the beneficiaries by income level would be similar to that at the provincial level. Since the project facilities were to serve a significant
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proportion of the population of each province, this assumption was deemed reasonable. Based on these assumptions and data, the distribution of project benefits was estimated. The project area covered more than 5 million people (about 40% of the total population of Cambodia). The poor made up 36%t of the population and the near-poor made up about another 40%t. Thus, about 75% of the project areas population was poor or near-poor. The Project was designed to direct a disproportionate amount of the benefits to the poor segment population and it was estimated that these people would capture at least 47% of the project benefits. Since health problems are normally considered one of the main causes of poverty, the project would also reduce the number of people falling into poverty. It was estimated that about 92% of the beneficiaries (4.2 million people) will come from rural areas. By strengthening safe-motherhood services, improving antenatal care, and providing emergency obstetric facilities, the project was expected to improve access to quality health service for 2.5 million women, or about half of the women in the project area. The Project was also expected to have a major impact on improving the health status of ethnic minorities in the provinces of Mondol Kiri and Rattanak Kiri, which are among the poorest in the country, through measures that bridge linguistic and cultural gaps.
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Glossary
Border price; the unit price of a marketed good at the country's border. For exports this is the f.o.b (free on board) price and for imports it is the c.i.f (cost, insurance and freight) price. Bottom-line; term used in business literature to refer to companies expanding their traditional focus on profit making. Cost-benefit analysis; systematic approach applied assess quantitative dimensions of a public or private project, in order to determine if, and to what extent, the project is convenient from a public or social perspective. The ratio of discounted benefits to discounted costs. Cash flow; the flow of money to and from a company, business or project. Consumer surplus; the additional benefit received over and above the amount actually paid by consumers. Conversion factor; a number that can be multiplied by the national market price or use value of a non-marketed good in order to convert it into a shadow price. Cost-effectiveness analysis; analysis which compares the costs of alternative ways of producing the same or similar outputs. Depreciation; the loss of value of capital goods due to wear and tear, ageing or technical obsolescence. Discount rate; the annual percentage rate at which the present value of a unit of value is assumed to reduce with time. It is used to extrapolate project benefits and costs into the future, but price them with today's value of money. That is, the rate at which future values are discounted. The financial and economic discount rates may differ, in the same way in which market prices may differ from shadow prices. Discounted cash flow; a method of appraising investments based on the idea that the value of a specific sum of money depends precisely on when it is received, under the principle that value reduces with time. Discounting; the method used to discount the future value of money. Distortion; condition in which the effective market price of a good differs from the efficient price it would have in the absence of market failures or public policies. This generates a difference between the opportunity cost of a good and its effective price. for example in a monopoly regime, when there are externalities, indirect taxes, duty, tariffs, etc. Economic analysis; an analysis conducted by using economic values that express the value that society is willing to pay for a good or service. In general terms, economic analysis assesses goods or services at their use value or their opportunity cost for society (often a border price for tradable goods). It has the same meaning as cost-benefit analysis. Economic efficiency; the present value of a projects social benefits less the present value of its social costs. Economic impact assessment; assessment of the impacts of a project on the wider economy, which can be direct, indirect, induced or fiscal. Economic rate of return; the index of the socio-economic profitability of a project. It may differ from the financial rate of return (FRR) due to price distortions. The economic rate of return implies the use of shadow prices and the
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calculation of a discount rate at which the benefits of the project equal the present costs, that is the economic net present value is equal to zero. Environmental assessment; A systematic assessment of environmental quality, and consequences of development interventions, ensuring full integration of relevant biophysical, economic and social considerations. Externalities; also known as spill-over effects and intangible effects. The impacts of a project on third parties or society in general not captured by markets and therefore market prices. That is, the effects of a project that extend beyond the project itself, and consequently are not included in the financial analysis. In general, an externality exists when the production or consumption of a good or service by one economic unit has a direct effect on the welfare of the producers or consumers in another unit without compensation. Externalities may be positive or negative. Financial analysis; the type of investment assessment carried out by profit seeking businesses. It involves the assessment of the prospective costs and revenues generated by an investment in a capital project over its expected life, excluding nonmonetary items and externalities. That is, an analysis conducted by using financial values that express the value that a company is willing to pay for a good or service. In general terms, financial analysis allows for the accurate forecasting of which resources will cover the expenses. In particular it enables one to: verify and guarantee cash equilibrium (financial sustainability); calculate the indices of the financial return of the investment project based on the net time discounted cash flows. Infrastructure projects; infrastructure projects are normally concerned with the provision of roads, airports, sewage and water systems, railways, telecommunication and other public utilities such as schools and hospitals. Such projects are basic to economic development and improvements in infrastructure, and may also be used to attract industry and investment to a particular country. Internal rate of return; the discount rate that produces a NPV of zero. That is, the discount rate at which a stream of benefits and costs has a net present value of zero. We speak of financial rate of return (FRR) when the values are estimated at current prices, and economic rate of return (ERR) when the values are estimated at shadow prices. The internal rate of return is like a reference value to evaluate the results of the proposed project. Investment appraisal; the assessment of the prospective costs and revenues generated by an investment in a capital project over its expected life. Lifecycle assessment; evaluation of the inputs, outputs and the potential environmental impacts of a product system throughout its life cycle. Monte Carlo method; method for estimating probabilities. It involves the construction of a model and the simulation of the outcome of an activity a large number of times. Net present value; the discounted monetary value of the expected net benefits of the project. The economic net present value (ENPV) is different from the financial net present value (FNPV). It is the measure that is often used to determine whether a project is justifiable on economic principals. To calculate NPV, monetary values are assigned to benefits and costs, discounting future benefits and costs using an appropriate discount rate and subtracting the sum total of the discounted costs from the sum total of the discounted benefits. NPV is based on the principle that benefits accruing in the future are worth less than the same level of benefits that accrue now. In addition, it takes the view that costs occurring now are more burdensome than costs that occur in the future. Non traded goods; goods that cannot be imported or exported, for example local services, hairdressing, unskilled labor and land. In the economic analysis non-marketed goods are assessed at the value of their marginal return if
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they are intermediate goods or services, or according to the willingness to pay criterion, if they are final goods or services. Opportunity cost; the value of a resource in its best alternative use. For the financial analysis the opportunity cost of an acquired input is always its market value. In the economic analysis the opportunity cost of an acquired input is the value of its marginal return in its best alternative use for intermediate goods or services, or its use value (measured by the willingness to pay) for final goods or services. Opportunity cost of capital; the next best alternative return available for the funds in the capital markets. Payback period; the period over which the cumulative net revenue from an investment project equals the original investment. Present value; the discounted value of a financial sum arising at some future period. Private costs and benefits; the costs incurred and the benefits received by those producers and consumers involved in a project. Program; a program includes a number of related but distinct projects. Project; a series of activities with set objectives to produce a specific outcome within a limited timeframe. Project stakeholders; those directly or indirectly affected by a project. Public goods; goods that are both non-rivalrous in consumption and no one can be prevented from consuming them (non-excludable). Rate of return; net profit after depreciation as a percentage of average capital employed in the business. The rate of return calculation may be made using profit before or after tax. Relevant cash flows; the cash costs and revenues incurred as a result of an investment. Return on capital employed; ratio of accounting profit generated by an investment project to the required capital outlay, expressed as a percentage. Revealed preference; the method where the value of non-market impacts of a project are inferred from observable behavior in markets for related goods and, in particular, purchases made in actual markets. Risk; a future event or outcome to which some measure of probability can be attached. Risk analysis; the determination of the probability of different outcomes for a project. Sensitivity analysis; the identification of important areas of uncertainty to test key assumptions in a systematic way in order to determine the factors that are most likely to affect project success and to identify possible measures that could be taken to improve the chances of success (e.g. discount rate used, project life, year in which full project revenue is achieved). Shadow price; the opportunity cost of goods, usually different from the actual market price and from regulated tariffs. It should be used when analyzing a project to better reflect the real benefits of the outputs and the real costs of the inputs for the society. Often it is used as a synonym of accounting prices. In other words, benefits or
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opportunity costs for the economy as a whole. They may differ from private benefits and costs to the extent that effective prices differ from shadow prices (social cost = private cost + external cost). Social costs and benefits; the total costs and benefits of a project including both the private costs and benefits and the spillovers (externalities) on third parties and society in general. Social rate of discount; an adjusted discount rate in which the discount rate may be adjusted to take account of time preference (i.e. the importance of the project to future generations). Social welfare; the total wellbeing of a community. Straight-line depreciation; where the residual (scrap value) of an asset is deducted from the original cost and the balance is divided equally by the number of years of estimated life (i.e. capital costs / number of useful life as defined by the taxation law). Switching value; this is a decision pivot point. The percentage change in a project variable (investment costs, revenue etc) required to change the NPV to zero by interpolation. Uncertainty; a future event or outcome to which no probability of its occurrence can be attached. Terminal/residual value; the net present value of the assets and liabilities in the last year of the period chosen for the appraisal. Traded goods; goods that can be traded internationally in the absence of any restrictive trade policies. Weighted average cost of capital; investment projects may be financed by debt and/or equity in the private sector. The respective costs of both types of finance are weighted by the proportions used to finance a particular project in order to calculate that projects cost of capital. Willingness to accept; the compensation required to return an individual to his or her original state of economic well-being following some change (possibly hypothetical) in the world. Willingness to pay; the amount consumers are willing to pay for a good or service. If a consumer's willingness to pay for a good exceeds its price then the consumer enjoys a rent (consumer surplus). Working capital; the cash to fund the inventory of goods/inputs that a business needs to hold in order to operate.
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References
Anthony E. Boardman et al. (2006): Cost-benefit analysis; Concepts and practice, 3rd edition, Prentice hall, Pearson international edition. Anthony E. Boardman et al (2011): Cost-benefit analysis; Concepts and practice, 4th edition, Prentice hall, Pearson international edition. Brent R.J (1996): Applied cost-benefit analysis, Edward Elgar, Cheltenham, United Kingdom. Cullis J. and P. Jones (2009): Public finance and public choice, 2nd edition, Oxford university press. Dinwiddy C. and Teal F. (1996): Principles of cost-benefits analysis for developing countries, Cambridge University Press. European Commission (2008): Guide to cost-benefit analysis of investment projects, Directorate General Regional Policy, European Commission (Cohesion Fund and Instrument for Pre-Accession). Gittinger J.P (1982): Economic analysis of agricultural projects, 2nd edition, John Hopkins university press, Baltimore. Hana Foltnov and Markta Braun Kohlov (2006): Cost-benefit analysis of cycling infrastructure; A case study of Pilsen, Charles university environment Centre, Prague. Harberger A. (1978): The use of distributional weights in social cost-benefit analysis, Journal of political economy. Harry Campbell and Richard Brown (2003): Benefit-cost analysis; Financial and economic appraisal using spreadsheets, Cambridge university press. Hindriks J. and G.D. Myles (2006): Intermediate public economics, 1st edition, MIT press. International Federation of Accountants (2008): International good practice guidance; Project appraisal using discounted cash flow, Professional accountants in business committee, New York. Layard R. and S. Glaister (1994): Cost-benefit analysis, 2nd edition, Cambridge university press. Levin H. M and McEwan P. J. (2000): Cost-effectiveness analysis; Methods and applications; 2nd edition, Thousand Oaks, California. Liu Z. (2000): Economic analysis of a rural basic access road project; The case of Andhra Pradesh, India. World Bank Infrastructure note RT-5, World Bank, Washington DC. Mueller D. (2003): Public choice III, Cambridge university press. Musgrave R.A and Musgrave P. (1980): Public finance in theory and practice, MacGraw hill, New York. Peter Choynowski (2002): Measuring willingness to pay for electricity, Asian Development Bank. Pigou Arthur C (1924): The economics of welfare, Transaction publishers, New Brunswick, New Jersey. Republished in 2002. Potts D. (2002): Project planning and analysis for development, Lynne Rienner publishers, London.
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Potts D. et al (1998): National economic parameters and economic analysis for the public investment program in Ethiopia, Ministry of Economic Development and Co-operation, Addis Ababa. Shofield J.A (1989): Cost-benefit analysis in urban and regional planning, Allen & Urwin, London. Stephen Birch and Cam Donaldson (2003): Valuing the benefits and costs of healthcare programs; wheres the extra in extra-welfarism? Social science and medicine 56, Canada University of Calgary, Ontario, Canada. UNIDO (2003): Investment project preparation and appraisal, UNIDO, Vienna. Vose D. (2000): Risk analysis; A Quantitative Guide, John Wiley & Sons Ltd., Chichester. Young Hoon Kwak and Lisa Ingall (2007): Exploring Monte Carlo simulation application for project management, Risk Management 2007; Risk management, Palgrave Macmillan Ltd.
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Appraisal of Investments and Projects in The Public Sector

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Ministry of Finance and Economic Planning

National Development Planning Directorate

Capacity Building to Support the Rwanda Public Investment Program

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

The importance of the integrated approach and reality checks.

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Module 1: Public investment management

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

National Development Planning & Research Directorate

Public Investment Technical Team

Policy Development, Evaluation and Research

Investor specialists/ Public Investment Specialists

Experts in Policy Analysis

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Refer to EDPRS document for details. Page 16 of 176

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Module 2: Discounted cash flow methodology

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Benefits (RWF) 15,000 15,000 15,000

Capital outlay (RWF) 25000 -

Costs (RWF) 2,000 4,000 4,000 2,000

Net cash flow (NCF) RWF -27,000 11,000 11,000 13,000

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Note: This is a hypothetical project.

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

PITT Management Resources

Investment Appraisal Training Manual for Public Projects

Net present value (NPV)