Strategic Resources May 2024 Corporate Presentation
Financial analysis and appraisal of projects.pptx
1. Chapter 2.
Financial analysis and appraisal of projects
1
CONTENT
Introduction
Identification and quantification of costs and benefits
Classification Of Costs And Benefits
Valuation Of Cost And Benefits
Investment Profitability Analysis
Sensitivity Analysis
2. What is financial analysis ?
2
It is all about the assessment &evaluation of the required
project input, output produced and future net benefits
with aim of determining the viability of a project to
executing entity.
It is expressed in financial term
It concerning with assessing the feasibility of anew project
from a point view of financial stand
3. Guidelines for Estimating Financial Costs &
Benefits
3
Some guide line for estimating financial analysis are;
A. Project Inputs, Outputs, and Prices
B. The Impacts of Inflation
C. Estimating Economic Life of a Project
4. A. Project Inputs, Outputs, and Prices
4
Starting point for financial cost-benefit analysis:
Determination of project inputs & outputs
Determination of what price to use in the analysis
Alternative basis for pricing:
– Constant prices … base year prices
– Market (or explicit) prices … current prices
– Shadow (or imputed) prices … economic prices
General principle: Use constant prices for financial
analysis (valuation of project’s inputs & outputs) and also it
is common to use current prices as well.
5. B. The Impacts of Inflation
5
Inflation complicates the process of estimating financial
costs & benefits and difficult to forecast the level of inflation
expected over the planning horizon.
Remedy: Make Simplifying Assumptions
Inflation equally affects both future stream of cash inflows
& outflows.
Price contingency would take care of unforeseen price
increases during the construction period.
If there is strong evidence regarding inflation, examine
its impacts on:
cost of capital (opportunity cost of capital)
opportunity cost of equipments & machineries
level of revenue & operating costs, etc
6. C. Estimating Economic Life of a Project
6
The project planning horizon of a decision maker may be
defined as the period of time over which he/she decides to
control and manage his/her project-related business
activities, or for which he/she formulates his/her investment
or business development plan.
The planning horizon must consider the life time of a
project.
The economic life, that is, the period over which the project
would generate net gains, depends basically on the
technical or technological life cycle of the main plant
items, on the life cycle of the product and of the industry
involved, and on the flexibility of a firm in adapting its
business activities to changes in the business environment.
7. Cont…
7
In general , the factors to be considered in determining
project’s economic life include:
– Physical life (technical life of plant & machinery)
– Duration of market demand (product life cycle)
– Change of taste & preference of customers
– National/international competition
– Technology change (obsolescence)
– Extent or duration of natural/mineral resource
deposits, etc
It is evident that the economic life of a project can never
be longer than its technical life or its legal life; in other
words it must be less than or equal to the technical life.
8. Identification and quantification of costs
and benefits
8
In project analysis, the identification of costs and benefits is the
first step.
The costs and benefits of a project depend on the objectives the
project wants to achieve.
So, the objectives of the analysis provide the standard against
which cost and benefits are defined.
A cost is anything that reduces an objective, and a benefit is
anything that contributes to an objective
9. Cost Classification
9
There are alternative ways of classifying costs and
benefits of a project.
One is to categorize both costs and benefits into:
• Tangible and
• Intangible
Another classification is in terms of:
1. Total investment costs;
2. Operational/running costs;
Another classification:
Total investment costs including:
10. 10
a. Initial investment costs;
• Fixed investment costs;
• Pre-Production expenditures;
b. Investment required during plant operation rehabilitation
and replacement investment costs
c. Net working capital
d. Operating costs/costs of goods sold
11. I)Tangible costs
11
These refer to costs incurred by the company in the project from
project idea identification throughout the implementation and
operation phases and that can be quantified directly and easily in
monetary value.
In general, the cost of a project would be the sum of the total
outlays on the following items.
Initial Fixed Investment costs
Depreciation/Salvage Costs
Investment in Net Working Capital
Costs of Goods Sold
Factory Overhead
Taxes
Sunk costs
Debt service
12. Initial Fixed Investment costs
12
The initial fixed investments constitute the major resources
required for constructing and equipping an investment project.
These include the following tangible initial fixed investments.
The cost of land and site development(Land charges, Payment
for lease, Cost of leveling and development, Cost of laying
approach for road and internal roads. Cost of gates and Cost
of tubes and wells)
The cost of buildings and civil works
Plant and machinery
Miscellaneous fixed assets(Expenses related to fixed assets such
as furniture, office machines, tools, equipments, vehicles,
laboratory equipments, workshop equipments
Pre-production Expenditures( such as cost of license, feasibility
study, copy rights, and goodwill, etc)
13. Depreciation/Salvage Costs
13
During the end of the economic life of a good/machinery,
equipment, building, etc) there is some salvaged value and
the salvation may involve incurring of costs
3. Investment in Net Working Capital
Net working capital is part of the total investment outlays.
It is defined to embrace current assets (the sum of
inventories, marketable securities, prepaid items(prepaid
insurances, prepaid rents, etc), accounts, receivables and
cash) minus current liabilities (accounts payable).
This investment is required for financing the operation of
the plant.
14. 14
Note that any increase in net working capital/NWC/
corresponds to a cash outflow to be financed, and any
decrease would set free financial resources (cash inflow for
the project).
Costs of Goods Sold
Once the project idea has been accepted and the project is
being implemented the cost of production may be worked
out.
Material cost which comprises the cost of raw materials,
chemicals, components, etc
Utilities consisting of power, water, and fuel are also
important cost components.
Labor: this is the cost of all manpower employed in the
enterprise
15. 15
Factory Overhead: the expense on repairs and
maintenance, rent, taxes, insurance on factory assets, etc. are
collectively referred to as factory overheads.
Taxes: payment of taxes including tariffs and duties is
treated as a cost to the project implementer in financial
analysis.
Debt service: the same approach applies to debt service - the
payment of interest and the repayment of capital/principal.
Both are treated as an outflow in financial analysis.
Sunk costs Sunk costs are those incurred in the past and
upon which the proposed new investment will be based.
When we analyze a proposed investment, we consider only
future returns to future costs; expenditures in the past or
sunk costs do not appear in our account.
16. II) Intangible Costs:
16
Negative felling among people belonging to different
department may lead to the disruption of implementation
and failure of otherwise promising projects.
Biasness due to internal policies or any other reasons may
damage industrial relation among workers.
Negative externalities (spillover effects) such as noise,
pollution, and resource degradation are also an example of
intangible costs.
17. 17
III) Tangible Benefits on the other hand are the return of
the project, which are expressed in the cash flow statement
as cash inflow such as revenue of the project.
Iv) Intangible benefits
A project may generate some benefits that cannot be easily
quantified.
It may increase the flexibility of an organization; it may
improve the attractiveness of the product or service; it may
give the organization a sense of pride;
it may make the working environment of the organization
more pleasing;
18. 18
it may strengthen the technological capability of the organization;
it may enhance the moral of employees in the organization; etc.
These benefits referred to generally as intangibles these benefits
cannot be translated into monetary terms.
Yet, they are relevant and cannot be ignored in investment
decision-making.
The quantification of intangible costs and benefits is not
straightforward. They may require the use of different methods
such as the willingness to pay approach.
19. Why one undertakes Financial Analysis? Or When to undertake financial analysis?
19
Commercial/financial analysis applies to private and
public investments.
A private firm will primarily be interested in undertaking
a financial analysis of any project it is considering and
seldom will it undertake an economic analysis.
The issue of financial sustainability of a public project
justifies the need for undertaking financial analysis.
But commercially oriented government authorities that
are selling output such as railway, electricity,
telecommunications, etc., will usually undertake a
financial and an economic analysis of any project it is
undertaking.
20. 20
Even non-commercially oriented government institutions
may sometimes wish to choose between alternative facilities
on the basis of essentially financial objectives.
In the case of a hospital service the management of the
hospital may be required to provide the cheapest services.
Under such circumstances a cost minimization or cost
effectiveness exercise will be undertaken.
The commercial profitability analysis is the first step in the
economic appraisal of a project.
21. 21
A comprehensive financial analysis provides the basic data
needed for the economic evaluation of the project and is
the starting point for such evaluation.
It has to be noted that the financial analyst should be able to
communicate and know what to ask from the different team
members to collect relevant information on:
Revenue, both forecasted sales and selling price;
Initial investment costs distributed over the implementation
of the project; (engineering, site Development as well as
Materials and Inputs);
Operating costs of the envisaged operational unit/firm/ over
its operating life
22. Quantification, valuation of cost and benefit
22
Quantification: once costs and benefits are enumerated the
next step is accurate prediction of the future benefits and
costs which can be quantified in dollars and cents.
Thus, quantification involves the quantitative assessment of
both physical quantities and prices over the life span of the
project.
The financial analysis of projects is typically based on
accurate prediction- of market prices, on top of quantity
prediction.
It is worth thinking about the impact of the project itself on
the level of prices; and the independent movement of prices
due to other factors
23. 23
The financial benefits of a project are just the revenues
received and the financial costs are the expenditures that are
actually incurred by the implementing agency as a result of the
project.
If the project is producing some goods and services for sale the
revenue that the project implementer expects to receive ever
year from these sales will be the benefits of the project.
24. 24
The costs incurred are the expenditures made to establish and
operate the project.
These include capital costs, the cost of purchasing land,
equipment, factory buildings vehicles, and office machines,
working capital as well as its ongoing operating costs; for labor,
raw material, fuel, and utilities.
In financial analysis all these receipts and expenditures are
valued as they appear in the financial balance sheet of the project,
and are therefore, measured in market prices.
Market prices are just the prices in the local economy, and
include all applicable taxes, tariffs, trade mark-ups and
commissions.
25. Cont….
25
In a freely perfectly competitive market, without taxes or
subsidies the market price of an input will equal its
competitive supply price each level of production.
This is the price at which producers are just willing to
supply that good or service.
The financial benefit from a project is measured in terms of
the market value of the project's output, net of any sales
taxes.
26. Cont…
26
In general, the cost of a project would be the
sum of total outlays on the following items.
The cost of buildings and civil works
The cost of land and site development
Plant and machinery
Technical knowhow and engineering
fees
Miscellaneous fixed assets
Pre-operative expenses
27. Project profitability analysis
Measures of project worth are measures that tell you
whether a project is worth undertaking form a
particular viewpoint.
All such measures are concerned with the question
"are the benefits greater than the costs?"
There are different ways of measuring project worth,
which may fall under two categories,
27
28. discounting cash flow methods
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (Benefit-cost ratio)
non discounted (traditional) methods.
Payback Period (PBP)
Accounting Rate of Return (ARR)
28
29. 2.5.1. NON-DISCOUNTED MEASURE
OF PROJECT WORTH
Payback period
Payback period is one of the simplest methods
to find out the period by which the investment
on the project may be recovered from the net
cash inflows, i.e., gross cash inflow less the
cash outflows.
In short it is defined as the period required to
recover the original investment cost
When the analysis under such system shows
that the payback period is less than such
"specified period", decision may be taken in
favor of the investment for such project.
29
30. The basic drawbacks of this payback period
method
The payback period is a very crude measure of project worth
because it completely ignores benefits/ cash flows after the
period when the initial investment has been repaid.
Hence, it would be a very unreliable means for comparing
two different investments with different time profiles. It
discriminates heavily against projects with a long gestation
period.
It ignores the time value of money
30
31. It is unsuitable while comparing the payback periods of
two or more projects where the net cash inflows are of
widely different amounts for different projects.
Projects with initial lower earnings but with very high
profitability in later years may be rejected as the
payback period will be longer.
It requires an estimation of a safe period, in reality, that
varies between types of industry. For example, in
heavy industry the payback period is very long.
31
32. There are two methods in use to calculate the
payback period.
1. Unequal cash flows
2. Uniform Cash flows
Unequal cash flows: In this situation the payback
period id calculated as:
Payback period = E + B/C, Where
E = number of years immediately preceding the year of
final recovery
B = the balance amount to be recovered
C = cash flow during the final recovery
32
33. Example: A company is considering of investing in a
particular project. The alternative projects available
are: Project A that costs Br. 100,000, and Project B that
Costs Br. 70,000. The net cash inflows estimates are
as follows:
Year Project A Project B
1 30,000 7,000
2 30,000 15,000
3 35,000 20,000
4 35,000 56,000
5 40,000 45,000
33
34. YEAR Project A Project B
Net cash inflow Accumulated Net cash
inflow
Net cash inflow Accumulated Net
cash inflow
1 30,000 30,000 7,000 7,000
2 30,000 60,000 15,000 22,000
3 35,000 95,000 20,000 42,000
4 35,000 130,000 56,000 98,000
5 40,000 170,000 45,000 143,000
34
35. Payback period for Project A:
Payback period = 3 years + 5000*
35,000
= 3.14 year or 3 years and 2 months
Payback period for Project B
PP = 3 years + 28,000
56,000
= 3.5 year or 3 years and 6 months
Note: * represent the balance to be recovered from the
cash inflow in period four; i.e., 100,000 – 95,000 =
5,000
35
36. Uniform Cash flows
Where the annual cash flows are uniform, payback period can
be calculated using the formula:
PP = Original Investment
Annual Cash Flows
Example: A project requires an investment of Br. 200,000. It is
expected to generate an annual cash flow of Br. 50,000 per
year over the life of the project. How long will it take to recover
the investment?
PP = Original Investment
Annual Cash Flows
= 200,000 Br
50,000
= 4 Years
36
37. Discounted method
What is discounting and compounding?
Money is one of the basic resources of an
organization that has a time value.
Why we discount and compound the
future benefit and cost?
The time delay between an outlay and its
effect is the main reason for discounting and
compounding future benefits and costs.
37
38. To allow for the changes in the time value of money,
the terms "present value" and "future value" are
used.
To calculate the present value of future costs and
benefits their future values are "discounted" – reduced
from constant price values – back to the present using
a discount rate.
The concept of compounding is the opposite of
discounting whereby in compounding, the present
value grows to a future value because of the
38
39. Compound Interest; Compound interest can be
calculated using the following formula: FV = PV (1 + r)t
Where
r = annual interest rate
t = time in years
Fv = future value
PV = present value
Future value = Present value x Compound factor
39
40. The discount rate is the reciprocal of the compound factor
and it is given by the following formula:
PV = FV or FV (1 + r)-t
(1 + r)t
Example: what will be the present value of the profit of Br.
100,000 generated in the third year of a project if the
discount rate is 10%?
Solution: Fv = 100,000 Br. r = 10%
t = 3 years Pv =?
PV = 100,000 (1.1)-3
= Br. 75,000
40
41. Net Present Value (NPV):
The basic tenet of the net present value method is that a
dollar in the future is not worth as much as one dollar
today.
Thus, net present value calculates the present value of
future cash flows in excess of the present value of the
investment outlay.
NPV is the net sum of total discounted benefits (cash
inflows) and total discounted costs.
The NPV method is a system of finding out the excess
(or short) of the present value of the earnings from the
41
42. Net Present Value (NPV):
NPV is simply all future net income streams from the
practice discounted to reflect their current or present
value
Suppose you have an opportunity to invest $15,000 to
expand your business. You believe that this investment
will generate $3,000 in cash flow for the next 10 years.
Your capital cost is 10% per year.
The table below shows the cash flows (positive and
negative) that we expect this project to create, and
present value of each cash flow over the 10-year
42
44. By discounting every future $3,000 cash flow back at a rate
of 10%, and subtracting the initial cash outlay of $15,000,
we arrive at a net present value of $3,433.70 for this
project. (18433.70-15000=3433.70)
Under the NPV method, you should choose to do this
project, since the net present value is positive.
Cash inflows are treated as positive cash flows and cash
outflows, including the initial investment as negative cash flows.
44
45. cont…
If the NPV of all cash flows is positive at the
assumed minimum rate of return, the actual rate of
return from the project exceeds the minimum
desired rate of return.
On the contrary, if the NPV for all cash flows is
negative, the actual rate of return from the project
is less than the minimum desired rate of return
45
46. Cont…
This calculation can be represented algebraically as:
NPV =
Where:
CF = Cash inflows at different periods
r = discounting rate
C0 = cash outflow in the beginning
NPV = Net Present Value
t = time period
46
47. ADVANTAGE AND DISADVANTAGE
The net present value (NPV) method can be
a very good way to analyze the profitability of
an investment in a company, or a new
project within a company.
But like many methods in finance, it is not
the end-all, be-all solution it carries a few
unique advantages and disadvantages that
may not make it useful for some investment
decisions.
47
48. Advantage Of The Net Present Value Method
The NPV is easy to understand and calculate from
the figures available in the project schedule.
The obvious advantage of the net present value
method is that it takes into account the basic idea
that a future dollar is worth less than a dollar
today. In every period, the cash flows are discounted
by another period of capital cost.
The NPV method also tells us whether an investment
will create value for the company or the investor,
and by how much in terms of dollars.
In the example above, we found that the $15,000
investment would increase the company's value by
48
49. The final advantages are that the NPV method takes
into consideration the cost of capital and the risk
inherent in making projections about the future. In
general, a projection of cash flows 10 years into the
future is inherently less certain than cash flows
projected next year.
Cash flows that are projected further in the future have
less impact on the net present value than more
predictable cash flows that happen in earlier periods.
49
50. Disadvantage to the Net Present Value Method
The biggest disadvantage to the net present value
method is that it requires some guesswork about the
firm's cost of capital.
Assuming a cost of capital that is too low will result in
making suboptimal investments.
Assuming a cost of capital that is too high will result in
forgoing too many good investments.
estimation of a discounting rate, which can be very
much subjective, or need to be obtained externally
such as National Bank
the measure fails to indicate which project uses capital
more efficiently or which projects are closer to the
50
51. In addition, the NPV method is not useful for comparing
two projects of different size. Because the NPV method
results in an answer in dollars, the size of the net present
value output is determined mostly by the size of the input.
For example, a $1 million project will likely have a much
higher NPV than a $1,000 project, even if the $1,000
project provides much higher returns in percentage terms.
If capital is scarce -- and it usually is the NPV method is a
poor method to use because projects of different size are
not immediately comparable based on the output.
51
52. Internal rate of return (IRR)
Ideally, we need an investment appraisal technique
which will incorporate the discounting principle and yet
give percentage rate of return on capital, and such
a technique is the IRR method
IRR is also called the marginal efficiency of capital or
yield on the investment
Naturally, the result of a given project will vary with
changes in the economic life and the pattern of cash
flows.
Infact, the IRR is found by letting it become a variable
that is dependent on cash flows and economic life.
52
53. `
IRR method finds out the rate at which – when applied on
future cash inflows – the present value of such inflows taken
together should equal with the present value of the cost of
investment.
It is called "Internal", as it is purely related to the return of the
particular projected investment only. In other words it is the
rate at which the project investment is just recovered
In the case of NPV and profitability index(PI), we
have employed specified return standard to
discount the investment’s cash flows.
53
54. For the IRR, we switch the problem around to find the one
discount rate that makes cash inflows and outflows exactly
equal
It is the discount factor that sets NPV to zero. Once the IRR has
been calculated, it can be compared with the cost of capital
Accept the project if the IRR exceeds the required return.
Unlike the NPV method, IRR can be used to rank
investments which have different initial costs and lives
Select alternative with the highest IRR.
54
55. IRR is the rate of discount that equates the PV of net
cash flows of a project with the NINV. Or , IRR is the
discount rate at which NPV is zero.
When the cost of capital equals the IRR, NPV=0
When k > IRR, NPV < 0 Î Reject
When k < IRR, NPV > 0 Î accep
K =cost of copital
55
56. Limitations of IRR
As a ranking device for investments, the IRR is not
without problem. There are number of limitation some
of these were;
It does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR, mainly
not typical investments.
Problems with mutually exclusive investments.
The rate of return does not reflect the size of a
project, it is the Scale problem.
The timing problem. The NPV and IRR methods give
conflicting ranking for projects. When comparing
investments with different time horizons, the
corresponding recommendation is to use equivalent
annuity as the choice criterion
56
57. The benefit-cost ratio (BCR)
Benefit cost ratio is the relative measure of
benefits obtained per dollar spent.
It compares the discounted benefits to
discounted costs. project with higher benefit
cost ratio is more profitable.
A benefit-cost ratio lower than 1 means the
project is not profitable in terms of economic
return.
57
58. The benefit-cost ratio (BCR)
Where t=1, 2 … T
r=discounting rate
Bt= total revenue earned from sale of the outputs in
year t
Ct=total cost incurred from the different activities at
the time of production in year t.
58
59. when comparing two land use (AF and monocropping)
profitability
Farmers are often concerned about the costs and
benefits of a farming system to reach a conclusion
whether or not to adopt the system continuously when
comparing two land uses, Agroforestry and
monocropping land uses.
So, the profitability analysis of the agro forestry –based
farming system versus monoculture was based on the
cost benefit analysis.
Benefit cost ratio is the relative measure of benefits
obtained per dollar spent. It compares the discounted
benefits to discounted costs.
Land use with higher ratio is more profitable. A benefit-
59
60. sensitivity analysis:-
There are several different ways of undertaking
sensitivity analysis:- one-way sensitivity analysis
and multiway sensitivity analysis.
One-way sensitivity analysis is way of examining
the impact of the change of one value or inputs in
the model.
One-way sensitivity analysis is useful in indicating
the impact of one parameter varying in the model.
Multiway sensitivity analysis examines the impact
of the change of two or more key parameters (for
example, input price and interest rate change), in
the model.
60
62. Chapter -3
3. ECONOMIC ANALYSIS OF PROJECTS
Objective
After the end of class the students should able to:
define economic analysis
differentiate economic and financial analysis
outline the reasons of using economic analysis in
project appraisal process
Define shadow prices and how it is used to adjust
distortions in domestic prices of resources or inputs
of a project.
63. 3.1. INTRODUCTION
Financial analysis aim at assessing the financial viability
a project from point view of executing entity of project
But the investment projects should also be justified
within the wider context of the national economic and
social environment.
This is the economic analysis of projects or sometimes
called Social Cost Benefit Analysis (SCBA).
64. Introduction…
Social Cost Benefit Analysis (SCBA is a methodology
developed for evaluating investment projects from the
point of view of the society (or concern) as a whole.
It can be distinguished from financial analysis in that
attention is not confined to the cost and benefits
affecting a single group (usually the company who
proposed the project), the focus of economic analysis
is on the return of the project to society.
65. Distinction Between Financial and Economic Analysis
The reason for conducting both financial and economic
analysis is to view the project from various angles and to
obtain different perspectives.
Decision makers need both profiles in order to evaluate the
project and to design the necessary fiscal and monetary
measures to meet its financial requirements.
66. Distinction b/n FA and EA…
Even though the tools of analysis are the same,
financial analysis is concerned with private profitability
and is based on financial flows which relate to:
Market prices for products and inputs
The terms of credit and borrowing in general
Tax and subsidy policy
Financial depreciation and other financial
conventions.
67. Distinction b/n FA and EA…
The financial analysis focuses on money profits
accruing to the project entity.
Various financial indicators are used to evaluate the
entity's ability to meet its financial obligation and to
finance future investment.
Economic analysis, on the other hand, is concerned
with public "profitability" which is based on economic
resource flows.
68. Distinction b/n FA and EA…
It measures the project's effect on the efficiency of the
whole economy.
In economic analysis shadow prices (set of prices that is
believed better reflect the opportunity cost) are used.
69. Economic resource flows relates to:
a. Social opportunity costs (shadow prices) which adjust
market prices to take into account differences based
on
tax and subsidies,
external costs and benefits,
monopolistic pricing,
price control and rationing, quantitative trade
restrictions,
over-valued (or under valued) exchange rate and
labor opportunity costs.
b. Divergence between real rate of interest and
nominal (financial) rate of interest, and difference
70. Cont…
Economic analysis consists mainly of adjustments to
information used in financial analysis and of a few
additional ones.
The methodology and the criteria used to evaluate a project
using financial and economic information are the same.
However, the main difference lies in the value that the NPV
and IRR take. This difference occurs because of the
difference of:
The items considered as inputs and outputs of the project
The prices used in the valuation of the project inputs and
outputs
72. Objectives/Reasons For Economic Analysis
In project planning there are two main objectives to
economic analysis. These are:
to provide information for making decisions on the
acceptability of projects from the national point of view,
and
to provide information of value for project design and
planning, macro economic planning and economic
research.
73. Social Cost Benefit Analysis/Economic
analysis is done because of the following
reasons.
Inflation: is a general price increase of commodities
(Inputs and outputs).
When high degree of inflation prevails in any economy,
the project's inputs and outputs do not reflect their real
value.
Therefore, the price of these inputs and outputs should
be adjusted using the world price by conducting
economic analysis.
74. Cont..
Currency over valuation: when the foreign
currency is over valued (eg., dollar), most developing
countries are exercising devaluation of their
currency in order to reflect the world price.
For example, our birr is depreciated from time to
time whenever the value of dollar is appreciating. ($1
= Br. 8.00, $1 = Br. 8.65, $1 = Br. 21.00 etc.)
Existence of under employment: in developing
countries like Ethiopia, the domestic prices are
distorted and do not reflect the real value of inputs
and outputs
In other words, the market prices and economic
prices are not the same. One of the highly distorted
75. Unskilled and semi-skilled labor market is highly
affected because workers are paid less and the
payment is employees not the same for all doing the
same job.
Therefore, for economic analysis purpose this
distortion should be adjusted.
76. . Externalities:
Externalities: are costs and benefits to the economy
as a whole and that are attributed to the project but are
not taken in to account in estimating quantities and
values for the project inputs and outputs.
Since they are not paid for by a particular firm,
financial analysts ignore them. But someone has
covered their cost (government), thus their value
should be included in the economic pricing technique.
77. .Existence of tariffs, customs and
duties:
Existence of these restrictions and impositions by the
government may increase the price of commodities.
This cost needs to be excluded in the economic
analysis because it does not reflect the commitment of
real resources.
78. A frequent cause of confusion is that project analysis
can be applied in different ways, from different
perspectives.
This may give the impression that there are conflicting
measures of project worth.
The following table attempts to clarify the techniques
used to analyze projects, their objectives and
indicators that can be calculated at each analysis level.
80. 3.4. DETERMINING ECONOMIC VALUE :
3.4.1. SHADOW PRICES
Shadow prices are a set of prices that are believed to
better reflect the opportunity cost of resources in their
best use
They are employed instead of domestic market prices
in guiding the allocation of resources since the later is
distorted and using them would lead to resource
misallocation.
Shadow prices for economic analysis are based on the
opportunity costs.
If costs can be broken down into basic resource
categories on an opportunity cost basis, all that
remains to be done is to value the basic categories
81. Opportunity Cost
Before we proceed to the discussion of shadow price and
its calculation, let us first outline the opportunity costs of
resources because opportunity cost is the most important
concept underlying economic analysis
It is defined as the next best alternative foregone in
undertaking a course of action.
Whenever, there is an opportunity cost, there is an
argument for using shadow prices.
Opportunity cost can best be explained by reference to
examples commonly used in the economic analysis of
projects: land, labor and capital.
82. Opportunity Cost of Labor
Opportunity cost of labor is the value of the worker's output
in the next best alternative.
It usually varies significantly between occupational groups
and often between regions.
In determining the opportunity cost of labor it is important
to identify the potential source of labor (urban or rural).
83. Project appraisal also distinguish between skilled and
unskilled labor.
The most common assumption is that skilled labor is in
scarce supply and has an opportunity cost equal or
greater than its market price,
while unskilled labor is in excess supply and has an
opportunity cost below its market price.
The first assumption implies that skilled workers
are able to obtain the same salary whether they
work on the project in question or on another
84. Opportunity Cost and Traded
Goods
Traded goods are those items, which can be imported
or exported.
Examples traded goods include all kinds of:
Manufacturing
Agricultural goods
Intermediate goods
Raw materials
Some services such as tourism and consultancy
services
85. Opportunity Cost and Traded
Goods……
The opportunity cost of traded goods to an economy is
defined by their border prices (CIF for imports and
FOB for exports).
Assume that the country produces sugar to satisfy the local
market. The alternative to production of the sugar is to
import the sugar.
The value of the sugar produced is then the Cost
Insurance and Freight(CIF) price, which has been saved.
86. Opportunity Cost and Traded Goods….
Similarly, if a textile factory use locally produced cotton as
a raw materials the alternative is to export the raw material
(cotton).
The opportunity cost of using the cotton for the textile
project is the export price (FOB) foregone.
87. The non-tradable goods are goods that do not enter into
the international trade because of their:
Nature or physical characteristics: Perishable and/or bulky
goods, goods for which there is only endogenous
taste/demand/ (Like Teff in Ethiopia);
Economics of trading: cost and/or quality performance of
products;
Policy barriers that affect international trade.
Non-Traded Goods
88. Cont…
In principle, a good falls into this category if:
CIF>Market Prices: If the CIF cost or landed price of a
good is greater than the local cost/market prices/,
importation of the same is precluded.
FOB prices <Market Prices: If the local costs are
greater than the FOB price, then exportation is
precluded.
In Ethiopia many goods fail to enter into the
international trade because of cost/price in
competitiveness.
89. So the non-tradable inputs and outputs of a project
cannot be valued directly at border or world prices.
The cost to the economy is the long run marginal
cost of producing the extra item and the economic
value would be estimated by consumer ‘willingness
to pay’ (WTP) on the assumption that the use of the
item deprives the alternative user of a value
represented by their WTP.
90. Conversion and Adjustment Factors
Shadow prices are often applied using either
conversion factors (CF's) or adjustment factors
(AF's).
Ideally, all project inputs and outputs should be
valued directly at accounting price/shadow price or
boarder prices.
However, this is not always possible because some
of the goods and services are not traded and for
them you know only the domestic price.
This price most of the times is distorted due to
several reasons. Therefore, it should be
91. Conversion factor (CF) is the factor by which we
multiply the actual price(s) in the domestic market of
an input or output to arrive at its economic price, when
the later cannot be observed or estimated directly.
How and How Many CF's Should be Estimated?
A CF is estimated by taking the ratio of border prices to
domestic price/s of the goods.
We can estimate commodity specific, service specific
or sector specific conversion factors, depending on the
degree of aggregation desired.
92. Standard Conversion Factor (SCF): SCF is an all
inclusive conversion factor used in place of commodity
specific CF's or sectoral specific CFs.
It is a summary and approximation of the distortions in
the domestic market. It is estimated as the ratios of the
values of imports and exports of the country at boarder
prices (CIF and FOB) to their value at domestic prices.
Algebraically,
CF = World Price /Shadow Price
Domestic Market Price
93. Shadow Wage Rate (SWR): it is the opportunity cost of
labor or marginal productivity of labor.
In principle shadow wage rate is determined by the
opportunity cost of labor which may be adjusted for any
difference between the shadow price and market price of
the commodities produced by workers in their alternative
occupations.
94. The conventional approach to estimating the shadow
wage rate is to adopt the following procedure:
Determine the opportunity cost of labor (OC) by
finding out the next best alternative occupation for
labor of the category under consideration and the
number of days worked (N).
Estimate the additional costs (AC) associated with
transfer to work with the project from the alternative
occupation.
Estimate a conversion factor for the output of the
worker in the alternative occupation without the
project (CFW)
95. The shadow wage rate is then given by:
SWR = OC.N. CFW + Ac, where:
OC = opportunity cost
N = Number of days
CFW = Conversion factor
AC =estimated additional cost
For example: if the average daily wage rate of a
worker is Birr 3 and workers are able to work for 250
days per year, and if it is estimated that the conversion
factor for the alternative output of the workers is 0.95.
The extra cost of transferring the worker to the new
occupation (to the project) is Birr 150,000 per year,
what is the SWR for the unskilled workers?
96. Solution:
OC = 3 Birr
N = 250 days
CFW = 0.95
A = 150,00 Birr
SWR = 3 x 250 x 0.90 + 150,000
Birr. 150,675 per year
97. In economic analysis the concern of project analysts is
to know the economic price of labor (ERL), which is
calculated as: Market Wage Rate (MWR) times
shadow wage rate. (EPL = MWR x SWR). If there is no
distortion in the market wage rate, there could be
equality of MWR and EPL.
When you estimate the EPL you have to know the
original place or source of labor and the foregone
output.
98. For example, assume if some member of the family
migrates from rural area to the project site (to work) there
is a foregone output that is the output that he/she can
produce in the families plot of land.
In the project he/she is paid the MWR, which may be
higher than the previous work. Therefore, there is some
distortion, which need some adjustment using conversion
factors.
The conversion factor can be calculated as follows:
CF = foregone output = Daily Wage Rate
Market wage rate MWR
99. Example
If a person comes from the rural area where he can
produce from one hectar of land 10 quintal of Teff and
one house hold has 5 members. The price of one
quintal of teff is Br. 250. and assume that a person can
work for 250 days per year. What is the opportunity
cost/foregone output?
The yearly output of the family in their original place
(rural area) is Br. 2500= (250 x 10).
The average yearly price of labor in the family is Br.
500 (2500/5).
100. Therefore, the foregone output of the person is Br.
500/250 = Br. 2 per days assuming that the person can
work for 250 days per year.
Therefore, the opportunity cost or foregone output from
his region is Br. 2 per day. However, if he is paid Br.
6/day or more in the project, this shows that there is
some distortion in the market wage rate.
In order to adjust this distortion you have to calculate
the conversion factor.
CF = Foregone output
MWR
CF = 2
6
CF = 0.333
