Project evaluation and cost benefit analysis

1. PROJECT EVALUATION
AND COST-BENEFIT
ANALYSIS
BY JAMES MAHONDO

2. CHAPTER OUTLINE:
Part 1:
1. Introduction to project evaluation.
2. Stages in project evaluation.
3. Methods of evaluation.
4. Cost-Benefit analysis.
5. Evaluation on the basis of cost benefit criteria.
6. The Net Present Value criteria ( NPV).
7. The internal Rate of Return (IRR).
Part 2:
1. Relationship between NPV & IRR.
2. The Social Rate of Discount.
3. Evaluation on the basis of Benefits.
4. Evaluation on the basis of costs.
5. Importance of data for evaluation.
6. Limitation of Cost- Benefit analysis.
7. Use of Cost-Benefit analysis in Developing
Countries.

3. PART 1:
PROJECT EVALUATION AND COST-BENEFIT ANALYSIS

4. Introduction to project evaluation:
 Meaning: ( What, How, Who, Why)
 What: It is a specialized planning process which involves systematic, objective and comprehensive
appraisal of development programmes for individual commodities and/or projects.
 How: it is conducted by assessing or apprising it's operational efficiency; technically, economically,
financially and managerially.
 Who: It is usually conducted by a group of outside experts
 Why? It is done in order to find out projects achievement and weaknesses and to suggest (
recommend) ways and mean to overcoming the weakness and to improve its operation
In summary: It is a process of evaluating the rate of return on a project, its social profitability and its side
effects on the growth rate of population, on employment , on labor and management training and on
rate of reinvestment.

5. Stages in project evaluation:
 Project evaluation involves 4 stages:
1. Review: Review of the situation before the project is actually started
2. Appraisal: This is done in order to find out how much has ben accomplished
and what remains to be accomplished
3. Recommendation: Suggestions on ways and means to improve its operation
further and to plug loopholes
4. Evaluation: Evaluation of the end achieved by the project when it is complete
and is in full operation

6. Methods of evaluation:
 This involves 4 areas:
1. Description: of the technical and economic characteristic of each project.
2. Estimation: of the influence of project on the economy , both during
construction , operation period and when the investment is completed and the
newly productive capacity is in operation.
3. Evaluation: of the project’s consequences both direct and indirect
4. Formulation: of the criterion for the selection of the project.

7. Cost-Benefit analysis:
 It is the most popular and appropriate method of apprising projects from the
national stand point of view
 It helps the planning authority in making correct investment decisions to achieve
optimum resource allocation by maximizing the difference between the present
value of benefits and cost of a project
 It purports to describe and quantify the social advantages and disadvantages of a
policy in terms of the common monetary unit.
 Its objective function, Net Social Benefit , NSB, is expressed as:
NSB= Benefits – Costs
Note: Benefits and cost are expressed in terms of ‘Shadow’ or ‘accounting’ prices of
inputs and outputs

8. Evaluation on the basis of cost benefit
criteria:
 There are 4 benefit-cost criteria;
1. B-C
2. B-C/I
3.
4. B/C
Note:
I relates to direct investment and is increment or marginal change
B/ C

9. Evaluation on the basis of cost benefit
criteria:
B-C Criterion
 This favors large projects and makes
small and medium size projects less
beneficial.
 Therefore, can only be used in the
determination of the scale of the project
on the basis of the maximization of the
difference between B & C
B-C/I Criterion
 Used in determining the total annual
returns on a particular investment to the
economy as a whole irrespective of the
those accrue
 Note: I does not include the private
investment that my have to be incurred
by the beneficiaries of the project

10. Evaluation on the basis of cost benefit
criteria:
B/C Criterion
 This is the best criterion.
 This benefit-cost ratio is the measure for
evaluation of a project.
 If B/C= 1, the project is marginal
 If B/C > 1, the benefits are more that the
cost
 If B/C< 1 , the benefits are less that the
cost
Criterion
 This is meant to determine the size of a
project that has already been selected and
is not for selecting a project

11. Evaluation on the basis of cost benefit
criteria:
Note:
 The benefit cost ratio formula does not take into account the time horizon of the project
.
 Future benefits and costs cannot be treated at per with present benefit and costs
 Therefore , the need for discounting the future benefits and costs because society
prefers the present to future.
 For this reason economist have come up with a number of ‘decision rules’ or criteria.
 For this course we will focus our attention on 2 criteria;
1. Present Value criterion
2. Internal rate of return.

12. The Net Present Value criteria (NPV):
 NPV = Present value of benefits – (Present value of operating + Maintenance
cost + Initial outlay)
OR
 Net present value of benefits (NPVB)= Gross present value of benefits – Gross
present value of cost
 A project is socially profitable if the NPVB>0 .
 It there are a number of mutually exclusive projects, the project with the highest net
present value of benefits will be choosen.

13. The Net Present Value criteria (NPV):
Backside:
 The explanation of the NPV criterion in terms of benefits and costs is not a correct
method fro project evaluation because it neglects the time horizon.
 Therefore future benefits cannot be equal with the present benefits and costs
Note:
 Since society gives preference to the present over the future, it becomes essential to
discount future benefits and costs of projects.
 The discount factor is expressed as;
D= (1/( 1 + i)^t ; i=social discount rate, t- time period

14. The Net Present Value criteria (NPV):
Thus;
NPV= {B1 / (1 + i) + B2/( 1+i)2 +… + Bn /( 1+i)n }- {C1 / (1 + i) + C2/( 1+i)2 +…+ Cn /( 1+i)n }
Where;
 B1 ,B2,…,Bn are series of gross present benefits in years 1,2,..,n and,
 C1 ,C2,…,Cn are series of gross present costs in years 1,2,..,n, and,
 i is the social rate of discount for annual compounding

15. The Net Present Value criteria (NPV):
In making a choice among projects either of the following two rules may be
followed
 Only those projects should be selected in which the present value of benefits exceed
the present value of costs, i.e.
{B1 / (1 + i) + B2/( 1+i)2 +…+ Bn /( 1+i)n } > {C1 / (1 + i) + C2/( 1+i)2 +… + Cn /( 1+i)n }
 All projects where the ratio of the present value of benefits to the present value of
costs is greater than one, i.e
( {B1 / (1 + i) + B2/( 1+i)2 +…+ Bn /( 1+i)n } / {C1 / (1 + i) + C2/( 1+i)2 +…+ Cn /( 1+i)n })> 1
Note:
NPV criterion is considered as the most appropriate rule for project evaluation

16. The internal Rate of Return (IRR):
 This criterion refers to the percentage rate of return implicit in the flow of benefits
and costs of projects
 Marglin defines it as where the discount rate at which the present value of returns
minus costs is zero, i.e.
{(B1-C1) / (1 + r) + (B2-C2) / (1 + r)2 + … + (Bn-Cn) / (1 + r)n} = 0
Where;
 r is the internal rate of return.
 In the case of mutually exclusive projects , the project which should be selected is
the one which has the highest rate of return

17. The internal Rate of Return (IRR):
Limitations:
1. Once a rate of return is assumed for a project, it cannot be changed.
2. It is difficult to calculate the rate of return on long term projects which only yield
benefits after a number of years.
3. If projects are mutually exclusive, this criterion favors the one with lower cost.
4. IRR used in public investment does not yield the correct decision because from the
definition of IRR.
5. It is difficult to calculate IRR for investment whose entire investment outlay cannot be
made in the first period.
6. This criterion is suitable for projects which are independent of others.
7. Projects cannot be ranked on the basis of ranking in order of returns.Such can only be
selected on the basis of their net present value.

18. The internal Rate of Return (IRR):
Note: IRR depends on the social rate of discount.
Example: If NPV of two alternative projects are given, the choice of the project will
depend on the discount rate.
NPV
A
A
B
0 R1R2R3 R
a
b

19. END OF PART 1:
PROJECT EVALUATION AND COST-BENEFIT ANALYSIS

20. PART 2:
PROJECT EVALUATION AND COST-BENEFIT ANALYSIS

21. Relationship between NPV & IRR:
Note: IRR depends on the social rate of discount.
Example: If NPV of two alternative projects are given, the choice of the project will
depend on the discount rate.
NPV
A
0 R5% 10%

22. The Social Rate of Discount :
Introduction:
 Whether planners use the NPV or IRR criterion, a rate of discount is needed for
discounting all costs and benefits.
 Controversy arises in choosing such a rate because the discount rate is required to
solve two problems;
1. Proper allocation of resources between public and private sector
2. Allocation of resources between the provision of present and future goods and
services
Note:
The rate used to solve the 2nd problem above is called the social discount rate or social
time preference rate

23. The Social Rate of Discount :
 The Social discount rate is the premium which the society puts for preferring the
present consumption to future consumption as explained by the diagram below
0
Future
Present
C1
C2
E
S1

24. The Social Rate of Discount:
Note:
 The slope of the transformation curve represents the rate of return of investment and
the social indifference curve represents the rate of time preference.
 Therefore, the social discount curve rate is determined with the equality of the rate of
return on investment and the rate of time preference at point E.
 The social rate of discount is constant over time.
 The choice of a discount rate affects the project to be undertaken.
 The discount rate of 5% might lead to twice as much investment as one of 10%,
together with equivalent reduction in consumption.
 If the discount rate is high ,short period projects with higher net benefits are
preferred and when it is low, long term period projects with lower net benefit are
considered

25. The problem of choosing a Social Discount
Rate:
 The social discount rate to be chosen cannot be the market rate of interest in a mixed
economy.
 Given there are varieties of securities with corresponding multiplicity of interest rates, the
social discount rate should therefore equal the government borrowing rate on long-term
securities.
Critics agree that;
1. There are numerous borrowing rates on government securities relating to different time
periods, thus presenting a challenge of selecting which one to use arises.
2. Government borrowing is influenced by such factors as monetary policy.
3. The choice of such a social discount rate would lead to very awkward problem that
different rates of interest would be used in the public and private sector.
4. Likelihood of considerable inefficiencies in the allocation of funds inside the investment
sector.

26. Views of different economists on determination
of the Social Discount Rate:
1. Pigou & Dobb :view the society as a continuous entity & has a collective responsibility
for the future generation.
2. Hirschleifer et al : Use the social opportunity cost to measure the social discount rate.
3. Feldstein: Suggests a method of combining social opportunity cost and social time
preference.
4. Mishan: Suggests that if the government has the power to invest in the private
sector, the social opportunity cost rate can be used as the social discount rate.
5. Marglin et al: Argue for synthetic discount rate which is a weighted average of the
social time preference rate and the social opportunity cost rate.
6. Baumol: Regards choice of rates as indeterminate.
7. Pearce: suggests the answer lies in using both the social time preference and the
social opportunity cost.

27. Evaluation on the basis of Benefits:
Introduction:
 Under this, a project is evaluated on the basis of the benefits accruing from it.
 Benefits refer to the addition to the flow of national output accruing from a project.
 A project is beneficial to the extent it tends to increase the income of people.
Increase in income being measured by the actual increase in the production and
consumption.
 Benefits may be real or nominal and direct or indirect.

28. Evaluation on the basis of Benefits:
Note:
 Real Benefits: In cost benefit analysis, we are concerned wit the real rather than
nominal benefits flowing from a project.
 Direct and Indirect Benefits:
I. Direct benefits; are those benefits which are immediate and directly obtained from a
project
II. Indirect benefits or secondary benefits; are the values added to the direct benefits as a
result of the activities stemming from the project.
 Tangible and Intangible Benefits:
I. Tangible benefits; are those which can be computed and measured in terms of money
II. Intangible benefits; are those which cannot be measured in monetary terms.

29. Evaluation on the basis of Costs:
Introduction:
 Project costs are the values of the resources used in constructing , maintaining and
operating a project.
 They relate to the cost of labor, capital, intermediate goods, natural resources etc.
Types of Costs:
1. Associated costs:
2. Real and nominal costs:
3. Primary/Direct costs;
4. Indirect/Secondary costs

30. Importance of data for evaluation:
Introduction:
 In project evaluation, detailed data extending over a long period are required.
 These data can be divided into two categories;
1. Data on investment or gestation period.
2. Data on operation or production period.
 The above date describes;
1. The number of workers and other personnel involved.
2. The amount of raw materials required.
3. The quantity of the products expected to be produced etc.
Note: Data collected are compared with other projects elsewhere and in terms of their
costs and benefits.

31. Limitation of Cost- Benefit analysis:
1. Difficulties in cost assessment.
2. Difficulties in cost assessment.
3. Arbitrary discount rate.
4. Neglects joint benefits and costs.
5. Ignores opportunity cost.
6. Adjustment for risk and uncertainty.
7. The problem of externalities.

32. Use of Cost-Benefit analysis in Developing
Countries :
Benefits of Cost Benefits analysis to LDCs according to Stephen Marglin:
1. It helps in reducing differences in the marginal effectiveness of alternative measures
for accomplishing such objectives.
2. It helps in assessing the costs of facilitating one objective in terms of benefits
sacrificed with respect to others.
3. It has political advantages.
Other benefits:
1. It permits decentralized decision making from the vast technical information needed
to be decided on in a number of specific projects.
2. It is a practical way of assessing the desirability of projects.

33. Difficulties of Cost-Benefit analysis in
Developing Countries :
1. Based on conditions of developed countries, this technique is based on the basic
assumptions that investment is made in a framework of ;
I. Economic stability.
II. Steady growth.
III. Predominantly capitalistic competitive economy.
IV. Constant prices.
V. Flexible wages.
VI. Perfect mobility of factors of Production.
VII. Full employment of factors of production.
2. Difficulty in collecting data.
3. Difficulty in cost assessment.

34. Elements to assign weight to in Cost-
Benefit analysis in project evaluation:
1. Variation of inputs overtime.
2. Variation of the range of commodities produced.
3. Scale and location effects.
4. Non-market effects of production differences between projects.

35. Use of Cost-Benefit analysis
in Developing Countries:
FISH FARMING ENTERPRISE PRODUCTIVITY PROGRAM (FFEPP)
HTTP://WWW.UNUFTP.IS/STATIC/FELLOWS/DOCUMENT/MOSES15PRF.PDF

36. The case of implementation of the aquaculture development
component in meru county: Moses Mwangangi Wambua
Research Problem:
 Those with responsibility for spending public money need to know that they are
choosing the best option (FAO, 1986).
 Before massive expansion of the FFEPP project is implemented, various economic
assessments should be made in order to answer vital questions In project evaluation,
detailed data extending over a long period are required.
The project should only continue if its long-term benefits outweigh the costs.
To this end, a Cost Benefit Analysis (CBA) was conducted for this project
General Research Objectives :
 The main objective of this study is to provide an economic analysis of the FFEPP
project as implemented in Meru County and make recommendations based on the
outcomes of the cost benefit analysis.

37. Framework for Analysis:
The study examines the scenario of implementing the FFEPP project against the usual scenario where the
local communities of Meru region continue to use their land for alternative farm activities. This CBA is
premised on the following:
 The lifespan of the project is assumed to be 15 years. This presumes that the 15-year period is long
enough to highlight all of the consequences of changes in land use that promote aquaculture,
 Kenya Shillings (Kshs) have been used to monetize all values in the calculations. Adjustments are made
for inflation and all amounts expressed in their latest value (2016).
 The estimated total amount of funding that was invested in the project is KSh 149 million.
 A social discount rate averaged at 7% after adjustment for inflation is used to calculate the NPV of this
project. This discount rate is equivalent to the real interest rate on Kenya’s sovereign debt.
The rationale for applying this approach in discounting is that it would significantly correspond to the
borrowing cost of the government that would, in most cases, be responsible for funding the project
(Warusawitharana, 2014).
By using the sovereign borrowing rate as the social discount rate enables one to match the projected cash
inflows from the project to the cash outflows for the government responsible for financing it.

38. The case of implementation of the aquaculture development
component in meru county: Moses Mwangangi Wambua

39. The NPV, BCR and IRR of the project
 From the table above ,the payback period of the project is 11 years, occurring in
2019
 The present value of the net benefits (NPV) of the FFEPP project expected in its
15-year lifespan is Kshs 59 million,
 The Benefits to Cost Ratio (BCR) is 1.05
 The Internal Rate of Return (IRR) is 10%.
 If the project is left to continue to infinity, assuming that all factors remain
constant and that there would be periodic costs every 15 years to revamp the
remaining ponds, the project would reach a terminal NPV of Kshs 197.9 million
with a terminal IRR of 13.2%..

40. Interpretation of the NPV, BCR and IRR
of the project
 BCR: The BCR of 1.05 indicates that the project is economically efficient and
beneficial; the stream of benefits exceeds the costs incurred over the project
life.
 IRR: The IRR of 10% for the 15-year period and 13.2% for an infinite period
indicates a good return on the investment into the project compared with the
cost of the funds that the government has invested in to the project.
 Payback: The pay-back period of the project is 11 years.1 This is acceptable as it
occurs within the project period.
 Optimally, in order to determine the extent of success of the FFEPP in Meru, we
would need to compare the current outcomes of the projects with the intended
project outcomes.

41. Direct and Indirect economic benefits of
the program :
 Direct benefits: improvement in livelihoods through creating a new source of income
from revenues of harvests sold. It is also expected to improve food security among
the locals and in the region from the alternative source of food offered by the fish
from the ponds.
 Indirect benefits: Creation of new job opportunities in the aquaculture enterprises,
hatchery production, and trade of fish as well as value addition activities along the
value chain.

42. END OF PART 2:
PROJECT EVALUATION AND COST-BENEFIT ANALYSIS