Training on Financial and Economic Project Evaluation
Training on Financialand Economic ProjectEvaluation(cost benefit analysis)May 15th 2013
Learning objectives1. Understand the concept, utility and limits offinancial/private and economic/social projectevaluation (cost benefit)2. Know how to interpret the results of financial/economicevaluations (cost benefit)3. Understand the opportunities of financial/economicevaluation being part of the PCM and its implication forresults based project management4. Identify development projects for which the conceptcan be applied, and for which kind of projects othermethods are more adequate
Group WorkSocial Entrepreneur selling a technology like microirrigation to poor farmers1. What do you need to know to make this business asuccess and not a bankruptcy?
Objective of CBA applied to projectevaluationMake better informed decisions on whether toinvest or notRelying on the necessary information toquantify variables which are related to• investment,• operational costs and• incomes
Market / feasibilityStudyTechnical StudyOrganisational study Financial EvaluationImportant studies needed for projectformulation and evaluationEconomic Evaluation
The different studies provide information forthe project evaluation - business approach -Benefits / Costs Return on investmentMarket StudyObjective: Determine theexistence of the unmetdemand and quantify itTechnical StudyObjective: Verify thetechnical feasibilityOrganisational StudyObjective: define theoptimal organisationalstructure Analysis of demand Analysis of supply Price or fee Marketing strategy Production capacity Technology Infrastructure Human resources Information system Legal aspects
What is cost-benefit analysis (CBA)?The aim of the cost benefit analysis is to assess theprofitability of investments over time, by comparing thecosts of a project with its benefitsCOSTS = investment costs running costs or operational costs financial costs support costsOnly real costs are considered in the CBA, i.e. costs that correspond to flows ofcash, and the costs are computed at the time when they occur during project life.BENEFITS: increased production, project sales reduced costs social benefits, improved livelihood, reduced poverty,…
Quantification is required!CBA requires to quantify all the costs and benefits, which is sometimes ratherchallenging. Where quantification is not possible, benefits and costs should beincluded in the discussion and interpretation of the models, or another methodshould be selected (e.g. Cost effectiveness)Whose costs should be considered ?Beyond financial evaluation: all costs need to be taken into account• SDC project costs• Other counterpart costs• Costs beneficiaries bear (incl. in-kind contributions)
Note: the CBA compares additional costs and additional benefitsfor the users / for the enterprise, etc. i.e. the costs and benefits WITHor WITHOUT the projectExample of a CBANote: year 0 is only virtual, so that the project can start in year 1 it is necessary to have thefunds available on the day before the project startsYear 0 Year 1 Year 2 Year 3 Year 4 Year 5COSTS -100 -12 -13 -11 -13 -12Investment -100Operations -10 -10 -10 -10 -10Other costs -2 -3 -1 -3 -2BENEFITS 0 12 20 50 50 100Sales 12 20 50 50 50Residualvalue50CASH FLOW -100 0 7 39 37 88
DISCOUNTINGPrinciple:1 dollar today is worth more than 1 dollar tomorrowQuestion: what is the value today of the money you will earn next year,or in 2, 3 or 10 years from now?Example: on your savings account you have 5’000 CHF earning 2% per yearHow much will you have on your account after 5 years? (assuming thatyou have no transaction costs and that the interest rate remainsunchanged)Interest 1st year = 5’000 * 2% = 5’100 CHFInterest 2nd year = 5’100 * 2% = 5’202 CHF Etc…
Compound interest Discountingcapital (P) = today 5000 capital (P) = today 4’528interest (r) 2% interest (r) 2%time (years) (n) 5 time (years) (n) 5accumulated capital (A) 5’520 accumulated capital (A) 5’000A = P(1 + r)n P= A(1+r)-n
Net Present Value and Internal Rate of ReturnNet present value (NPV) = value today of the cash flow ofeach year of the analysed periodIn Excel, use +NPV(10%;year1...year5)+year 0 (here = 15.00)Internal Rate of Return (IRR) = rate that the project generatesover time (this rate can be compared with interest rate of banksor alternative use of the capitalIn Excel, use +IRR(year0 ... Year5) (here = 13.81%)Year 0 Year 1 Year 2 Year 3 Year 4 Year 5COSTS -100 -12 -13 -11 -13 -12BENEFITS 0 12 20 50 50 100CASH FLOW -100 0 7 39 37 88
Evaluation criteriaNet present value (NPV)• Expresses the differencebetween totalexpenditure and incomeof the project (cash flow)but discounted to thevalue of money atproject start.• Shows the surplus afterhaving received thedemanded profitability(discount factor) andhaving retrieved the totalinvestment• The convention is toaccept the project if theNPV is bigger or equalto 0.Internal rate of return(IRR))• Shows the maximalprofitability that can beexpected of theinvestment.• The project is acceptedif the IRR is bigger orequal to the discountfactor.• IRR only tells us if theproject is better than thealternative use of funds(IRR does not allow tocompare differentproject)Benefit – Cost Relation(BC)• Compares the presentvalue of the benefits withthe present value of thecosts including theinvestment, shown as aratio• The project is acceptedif the ratio is bigger orequal to zero.one
EXTERNALITIESExternalities are “side effects” of projects or enterpriseswhich are not included in the costs and benefits; they can bepositive (external benefits) or negative (externals costs). In thecase of negative externalities, the costs are usually paid by thesocietyExamples of external benefits Access to electricity for villagers after a factory was installed inthe neighbourhood After a village installed electricity supply, an enterprise decidesto settle in the neighbourhood ( job creation)Examples of external costs Pollution, noise, traffic, etc.
Economic analysisSHADOW PRICES / economic prices(also called opportunity costs)Market prices do not always reflect the real value of products. Thisis the case for instance when subsidies or taxes are paid / charged.Example:fertiliser price on the market = 100’000 VNDsubsidy from the Government = 25%real value of fertiliser = 100’000 VND + 25% = 125’000 VNDIn this case, farmers get fertilisers cheaper than the real value, thefinancial value is lower than the economic value
FINANCIAL VS ECONOMIC ANALYSISFinancial EconomicCBA showsthe interestsof ...Private enterprise: isthe project profitablefor the investor?Society: is the projectbeneficial to the society(whole economy)PricesconsideredCosts and benefits atmarket pricesShadow prices(opportunity prices), i.e.prices are corrected fromsubsidies, taxes, etc.Externalities Not considered Considered
Reserve Slide: Structure of the flow offunds statement+ Income (tax relevant)- Expenditure (tax relevant)- Expenditure not implying cash flows, but tax relevant(depreciation and amortization)= Profit before taxes- Taxes= Profit after taxes+ Adjustment for expenditures not implying cash flows(depreciation and amortization)- Expenditure not relevant for taxes (investments)+ Benefits not relevant for taxes (residual value)= Cash Flow
Consideration concerning the cash flowTime horizon of the evaluation• Is highly dependent on the characteristics of each project.• If the project life time can be foreseen, and is not long term, the mostconvenient is to construct the flow of funds for this number of years.• If the enterprise (or structure) the project wants to create will stay inthe market (no exit strategy), the general convention is to project theflow of funds for 10 years.• The expected benefits beyond the 10th year are then reflected in theresidual value.
Risk within projectsWhen preparing and evaluating projects one has to relyon assumptions, e.g. with respect to– population growth,– demand,– supply,– technologies,– availability of inputs,– estimation of costs,– estimation of benefits,– etc., etc., etc.… where there are assumption there are risks
Mainly serves for :a. Determine critical variables and their ranges ofvariation.b. Study and determine the effects of the criticalvariables on the results of the project.c. Evaluate the project with different externalconditions.Sensitivity analysis
Methods for sensitivity analysisSelect the critical variables :Consider the variables that are difficult to predictSelect the variable with the biggest impact on the NPV… or those with the highest uncertainty.Move one variable at a time (Ceteris Paribus)Construct different scenarios for a group of the abovevariables and re-calculate the project criteria.
Possible Alternative: Cost EffectivenessAnalysis• Applied when benefits cannot be quantified (withreasonable effort)• Instrument for comparing different approaches to reach acertain benefit• Choose the approach that creates the biggest and lastingbenefit for the beneficiaries• Used to justify an approach for funding (as compared toalternatives)
Cost Effectiveness AnalysisImpacts that the projectis supposed to reachDistinguish major impactand side impacts (orsecondary impacts)Starting point =project designCOSTS =Direct costsInvestment costs,Support costs(coaching,backstopping, etc.)Maintenance costsCosts for SDC andcosts for partnerorganisationsIndirect costs may alsobe consideredBENEFITS: are thebenefits really the same,how sustainable are thebenefits, etc.
Important to remember1. You need solid numbersa) to construct financial and economicevaluations, evaluate results before, after,duringb) to formulate your project: market studies etc.2. Financial (private) evaluation shows whetherprivate sector part is viable or what the projectneeds to do to make it viable
Important to remember3. Financial and economic evaluation are keytools to improve result management: Identify benefits Quantify benefits Establish causality… even if no precise NPV can be calculated.
Important to remember4. Economic/social evaluation provides valuable,additional decision criteria (not the only ones!)a) to approve or reject projectsb) to identify more objectively and quantifiedwhat works and can be scaled up
1. Reserve Slide: Domains of application ofCBA in development cooperation• CBA can be applied in a wide range of projects, key condition isthe quantification of costs and benefits• CBA can be applied to entire projects or to selected projectcomponentsDifficulty to applyLow Medium HighProjectdealing withIncome generation,livelihood, economicdevelopmentHealth, education,nature conservation,biodiversity, etc.Governance, policydialogue, institutionaldevelopmentExamples ofCBAs (doneor inpreparation)Vietnam, Mongolia,South Africa, LatinAmericaMacedonia,MoldaviaBalkan region
2. Reserve Slide: Basic steps to conductmeaningful CBAs• First step: define the boundaries of the project orcomponent that is to be analysed What exactly is to be analysed? What is the purpose of the analysis?(includes geographic, institutional, topical boundaries, etc.)• Second step: what are the outcome / impact hypotheses? How do costs relate to benefits, what are the expected outcome/impactchains?• Third step: list all the costs related to the selected project /component (including local contributions, investment costs,operational costs and management costs) and the benefits (in threecategories:i) easy to quantify, ii) difficult to quantify, iii) non quantifiable)• Fourth step: assess data availability; plan and implement datacollection• Fifth step: set up CBA model and interpret it