Votume 2 ADVANCED MANUAL ON ProJect EVALUATION Philippine¢Copyright @ 2006 by the Natiétial Economic and Development AuthorityTaBLe oF ConTENTS VoLume 2 Apvancep MANUAL ON ProJect EVALUATION 1 Provect EVALUATION OBJECTIVES: 44 12 13 14 Inodution Efficient Use of Resources 124 ThePareto-Optimaliy Criterion 4.22 ThePotenfalPareto Optimality Criterion Box 1-1 Pareto Optimality 4.23 Problems with Using the Potential Pareto Improvement Criterion 1.24 Potential Pareto Improvementin he Presence of Distorbons Box 1-2 Market Failures Sustainable Development Social Objectives 1.41 Distibusonal Analysis 142 Meeting the Basic Needs ofthe Most Needy 2 Proyect EvaLUATION CRITERIA 2A 22 23 24 25 “The Net Present Value (NPV) Criterion Intemal Rate of Retum (IRR) Criterion BenefCostRaio (BCR) Criterion Ranking Mutually Exclusive Projects wit Diferent Lives Optimizing Project's NPV 251 Optimal Timing 252 — Optimal Scaleofinvestment 3 ConcEPTS IN FINANCIAL ANALYSIS 3a ‘The Use of Consistent Prices in Financial Appraisal: Infition Treatment 3.11. Conceptof Nominal and Real Prices 34.2 — Useof Nominal Prices in Financial Analysis 3421 Directetlects 3.1.22 _Effectontaxrelated factors ‘Annex to Chapter3: Guide to Financial Ratios A31—LiquidtyRatos 832 Assot Utilization Ratios 833 CoverageRatios ‘834 Leverage Ratios 435. Proftabity Ratos ‘Tans oF Conrents 2 SRRs SESRABSSARSVoume 2, Apvaycep Manual. on Prosser EVALUATION 4 PRINCIPLES UNDERLYING THE Economic ANALYSIS OF PROJECTS 44 Iniroducton 42 Postulates Undertying the Eoonomic Evaluation Methodology Box4-1 Harberger's Three Postulates 43 Estimation of Economic Prices 43.1 Undistorted Markets 43:4 Analyzing the economic costs and benefits in an existing industry (nonew projec) 43.1.2 Analyzing the economic benef of an output produced bya project inan undistorted market 4.3.13 Analyzing the economic cost of aninput demanded by a projectin anundstorted market 44 Marketswih Distortions orExtemaities Box 4-2 Accounting for Taxesin Economic Appraisal 48 Definition ofthe EoonomicExtemaity 454. Environmental Externalities Box 4-3 Sources of Environmental Exteralty 45.1.1 Accounting for environmental extemaltiesin project appraisal 452 Congestion Extemalies m geese 8 SBBIB BB Box4-4 Measuring Congestion in Road Transportation m 453 Common Property-Resources Externalities B 454 Monopoly Externalities %4 455 Tax, Taiff,and Subsidy Extemalties 7 455.4 Taxand subsidyin the market of non-radable goods 6 4552 _Importduty and exporttaxin the market tradable goods 7 458 Foreign Exchange Externalty 8 457 — LaborExtemaity 2 458 BasicNeeds Externalities 9 48 Economic Benefits Including Exteraltios 80 47 Economic Costs Including Externalities 81 48 Conclusions @ 5 Estimatinc Economic Oprortuniry Cost oF CAPITAL 8 54 Empitical Estimation 8 6 Esimatinc Foreign EXxcHANGE PREMIUM % 6.41 BasicConoept % 62 Detaled Framework 8 63. Empirical Estimation 103 7 Estimation oF Economic Prices For Traoas.e Goons AND SERVICES 106 7.1 Iiroduion 106 72 Tradable and Non-Tradable Goods 107 73. Estimation of Economic Prices at the Port: Adjusting for Trade 110 Distotions and Foreign Exchange a Tanti or Contents734 74 Estimation of Economic Prices athe Project Adjsting for Handing and Transportation Costs 112, Estimating Commodity-Spectic Conversion Factors 75 Eoonomic Prices atthe Projector the Phippines 754 752 753 8 Estimation oF Economic Prices For Non-TRADABLE Goons AND SERVICES Project Uses An Importable Input Projet Produces An Exportable Output (Tomato Paste) Project Produces An impor Subsitude Output (Tomato Paste, Year One ofthe Project) 84 Inroduction ata 82 Case! 824 322 83 Case2: at 832 84 Cased 844 842 85 Cased: 854 852 86 Cases: 861 862 Economic Prices for Non-Tradable Goods in Distorted Markets 81.1.1 Analyzing the economic benefits ofan output produced bya projectinacstored market 8.1.1.2 Analyzing the economic costs of an input demanded bya projectina distorted market ‘AProject Producing ANon- Tradable Output Estimation of Economic Prices IMustrative Example: Project Providing Campsite Nights ‘Project Producing ANon- Tradable Output Economic Price of Non: Tradable Ouput with Adjustment forthe Foreign Exchange Prerrum ltustaive Example: AProject Providing Hote Room Nghis 832.1 Esimatinofthe economic price ofhotloom rights indomesticcurency Project Using ANon- Tradable Intermediate Good Estimation ofthe Economic Pre ofan Intermediate Good Used AsAn Inputof aProject Husraive Example: AProject Using Bricks ASAn Input 8421 _ Estimation ofthe economic price ofbricks ‘A Projet Using ANon Tradable intermediate Good As An Input Esmaton ofthe Econorrc Price of An Intermediate Good vith Dstrionsin Bot the Marke for tre nlemediate Good andits Factors Markets usratve Example: AProject Using Bick as an input when Distoions Exstn he Market Clay and Furace Oi 852.1 Estmatonofthe economic price ofbriksin domesiccurency [AProject Using A Non-Tradable Intermediate Good As An Input Estimation of Economic Price of An Intermediate Good wit Distorfonsinthe Market ofthat Good llustaive Example: Project Using Elect As An Input ‘when Distortions Exitn the Mark forts Subst: Diesel Oi 8621 Estimation of heeoonomicprceofelectiaty 87 Economic Prices for Non-Tradables inthe Philippines a4 872 873 874 Transportation Services Communicaons Consirucion Electcity 88 Measuring the Economic Value of Potable Water ‘Taaue oF Contents tt 112 13, 115 118 21 tat 121 121 123 125 12 wr 128 12 132 132 133 135 135 136 137 139 40 “2 143 144 145 146 “ar 187 169 161 164Voume 2, Apyancep Manual on Prosucr EVAWuaTiON 88.1 The Economic Benefits of Wash Water for Paying Consumers 882 The Economic Value of Drinking Water for Paying Consumers 883 The Economic Benefits of Water for Non-Paying Consumers 884 Numerical llustration ofthe Economic Benefits of Water Supply 9 Estimation oF Economic Opportunity Cost oF Labor oa 92 93 94 95 97 Inroducon 9.1.1. Estimation ofthe Economic Opportunity Costof Labor 9.1.1.1 Value ofmarginl produc ofabor foregone approach 9.1.12 Supply price oflabor approach 9.42 Structure of Analysis ‘The Economic Opportunity Costof Unskiled Rural Labor 9.2.1 Introduction 922. Supply-Price Approach: Calculations ‘The Economic Opportunity Costof Skilled Labor 93.1 Introduction 932 Supply-Price Approach: Calculations 932.1 Labormarketwithoutdstortions or regional migration 9.322 Workers migrate to project rom cistorted regional labor markets 9323. Labormarketesteralties Economic Opportunity Cost of Labor with ntemational Migration Flows, ‘The Eoonomic Opportunity Costof Foreign Labor EOCL When Labor s Not Employed Full Time 96.1 Labor Employed Lessthan Full Yearin MarketActhites 9.62 Permanent and Temporary Jobs with An Unemployment Insurance System and Labor Migration Conclusion ‘Annexto Chapter9: Estimation of the Economic Cost of Labor Applications forthe Philippines ASA Reallnorease inWage Rate A92 The Economic Opportunity Cost of Unskiled Labor Case 1: Projecthires unskited rural labor and pays prevailing market wage 165 165 16 166 12 172 173 173 173 175 7 1 7 180 180 181 182 182 184 185 186 188 188 189 12 14 14 195 1% Case: Projecthires unskiled rurallabor and pays wages higher than market 196 Case: Projecthires unskied rua laborin region where market wage rate varies seasonally 1% Case 4: Project demands unskilled workers for ciilworks n an ubanregion 197 93 The Economic Opportunity Cost of Skies Labor Case':_ Projecthies skied lborin the National Capital Region NCR) and pays market wage Case6:_Projecthires skied labor nthe NCR and pays wages above the market rate Case’: Projectirs skied iabor outside NCR and pays nancial wages above the market rato 9.4 Economic Opportunity Cost of Laborif Project tracts Overseas Fliinos Case 8: Hing by projctinduces the retum of Fipino workers employed overseas 95 Economic Opportunity Cost of Foreign Labor Employed the Phifppines Case 8: Projectires foreign technical advisorin Ease Visayas 197 1% 8 BB RR OB ‘Tase oF ContextsVowwme 2. Apvaxcen Masvat. on Prorgcr Evanuarion 10 DEALING witH UNCERTAINTY IN PRoJEcT DEVELOPMENT AND APPRAISAL 205 101 Incremental Cashflow Projections with Uncertainty 25 4041 Trend, Cycle, and Error Terms 206 1012. The'Whte Noise” Mode! an 1013 Random Walk 23 410.4 Random Walk with Drift 213 1015 Autoregressive Models 24 104.6 Projecting Revenues and Costs with Uncertainty 218 402 Using Contracts to Manage Risk 224 1021 RiskRe-Alocation 224 4022 Contracting Risk a 1023 Inventive Elects 28 ‘Annex A Pustic Provision oF Goons AND SERVICES 228 AA Inoducton 9 2 _Notesonthe Allocation Function 2 Annex B A Summary oF THE INTEGRATED PROJECT PROPOSAL 245, Appraisat MetHopoLocy B41 Introduction B2 Integrated ProjectAppraisal B3 Conclusion ‘Annex C Tue Economic Aspect oF FOREIGN FINANCING C4 nroducion C2_—_Measurement ofthe Benefits from Incremental Foreign Investment C3. The Benaftfom Reallocating Foreign Investment Already Presentin the Host Country C4 Conclusion ‘Annex D ‘Tue Economic Cost oF Risk D4 Inroducion D2 Accounting for Riskin a Projects Retun D3 Incorporating Riskin Financial Analysis D1 —Costof Funds Demanded by Investors D32 Using CAPM 33. Working with Certainty Equivalent Cashfiows, D4 Economic Costof Risk DAA Risk-Sharing Argument D42 —_Risk-Pooling Argument DA3__ Risk-Neutalty Argument DS Conclusion 285 25 28 285 285 286 2 20 me 22 28 25 25 296 296 aT 28 29 29 29 ‘TaBLe oF CowrentsVowe 2, Apvanceb Manual ox Protect EVALUATION ‘Annex E PROJECT FINANCE AND PRIVATE SECTOR PARTICIPATION 301 ww Pustic Sector Activimies 1 Inoducon ao 2 — WhatisProjectFinance m2 E3 Why ProjectFinance 3 E4 —_ProjectRisks, Contractual Arangements 06 and Other Mitigation Mechanisms £5 _ProjectFinance issues and Considerations forthe Host County 313 E6 Private SectorPartcipationin Public Sector 34 Actives: The Buil-Operate-Transfer (BOT) ‘Approach to Infrastructure Projects E61 GovemmentRole 316 E62 Concessionaire's Perspective 317 E63 Funders’ Perspective 317Vous 2. ApvaNcep Mavuat ox Prosscr Evatvaniox List oF Tastes Cuapter 2 — ProJect EvALuaTiON CRITERIA Table 2-1 Problems wit the IRR Citron 8 Table 22 Problems with Mutually Exclusive Projects 8 Table23 Problems wth Mul-Period rojacts “4 Table 24 Problems with Projects of Diferent Scale 6 Table 25 Net Cashfiows of Mutualy Exclusive Projects a Table 26 Repeating Project Lives to Equalize Mutually Exclusive Projects a Table27 Determination of Optimum Scale of An Irigaton Dam 2 CuapteR3 — ConcerTs IN FINANCIAL ANALYSIS Table 41 Project XYZ Financing 2 Teble32 Project XYZ Cash Balance 8 Table3-3 ‘Cash Balance with 25% Infation 8 Table34 ‘Accounts Receivable 4 Table 35 Accounts Payable 4% Table3-6 Nominal Interest Rate ofS a Table 37 Nominal nterestRte of31.25% a Table 38 Comparison ofRealCashfows 48 Table 39 interest Expense ry Table 3-10 Project XYZ: Depreciation Allowance ry Table 3-11 Inventory and Cost of Goods Sold- FIFO 50 Table 3-12 Inventory and Cost of Goods Sold-LIFO @ Cuapter5 — Estimating Economic Opportunity Cost oF CAPITAL TableS-1A —_RetumtoDDomesticInvestmentinthe Philippines, 1946-1996 Expressed in Nominal Terms TabieS-1B Capital Stock Expressedin Real Pesos 8 ‘Table52 Economic Costof Capital Estimation for 1996, % Cxapter6 — Estimarinc Foreicn ExcHaNce Premium Table64 ‘Trade Statistics, 1902-1904 104 Table62 Domestic Sales and Excise Taxes 105 Table63 Decompostion of FEP 105 Chapter 7 — Estimation oF Economic Prices FOR TRADABLE Goons Table 7-1 Project Uses An Importable Good (Packaging Material) 116 Table 7-2 Project Supplies An Exportable Good (Tomato Paste, Year 2 onwards), 7 Table 73 Project Supplies An Importable Good (Tomato Paste, Year One) 10 List oF TaBLesoun 2. Apvaxcep Manual. ox Proskr EVALAIATION Chapter 8 — Estimation oF Economic Prices FoR Non-TRADABLE Goons AND SERVICES Table 6-1 Relationship between Market Prices and Demand and Supply 131 Prices with Various Types of Distortions. Table8-2A National Transport Demand, 1994 148 ‘Table8-28 Average Growth Rates of Freight and Passenger between 1987-1994 148 ‘Tabie8-2C Wale Transport and Average Growth Rates of Cargo and Passenger 149 between 1987-1997 Table83 Cost Structure of Road Transport Services, 1990 149 Tableb4 Estimaton of Conversion Factor. Road Transport Services 190 Table8s Cost Structure of Philippine National Raiways, 1994 ‘61 Table8 6 Estimation of Conversion Factor Railway Transport Services 182 Table 87 Cost Structure for Water Transport and Related Services, 1990 13 Table8S Estimaton of Conversion Factor Water Transport and Related Services 14 Table8 9 Cost Structure fort Transporation, 1200 155 Table 8-10 Estimation of Conversion Factor: Air Transportation 186 Table 8-11 Cost Structure for Communications, 1990 157 Table 8-12 Estimation of Conversion Factor Communication 188 ‘Table 8-13 Cost Structure for Construction, 1990 189 Table 8-14 Estimation of Conversion Factor: Construction 100 Table 8-15, Cost Structure ofthe National Power Corporation, 1985 162 Tableb16 Estimation of Conversion Factor: Electcity 163 Cxarter9 — Estimation of Economic Opportunity Cost oF LaBor Tablet Project Hires Unskiled Laborina Rural Area 179 Table92 UnemploymentRates 192 CwaPTER 10 DEALING WITH UNCERTAINTY IN PROJECT DEVELOPMENT AND APPRAISAL Table 10-4 Forecast of Real Raw Sugar Prices 210 Based on Estimated Trend & Cycle of Past Prices (1997-2001) Table 10-2 ‘Simulaon Resuits forthe “White Noise" Modelof Real Raw Sugar Prices 22 Table 10-3 Forecast ofReal Raw Sugar Prices 24 Based on a Random Walk Mode with Drift (1997-2001) Table 10-4 Forecast of Real Raw Sugar Prices Based on Estimated First-Order 216 ‘Autoregressive Model of Past Prices (1997-2001) Table 105 Forecast of Real Raw Sugar Prices Based on Estimated Second-Order aT Autoregressive Model of Past Prices (1997-2006) Table 10-6 Observationon P, Q, and Q, 219 Table 10-7 Joint Probability Distribution of Pand Q, 2 Table 10-8 Joint Probability Distribution of Pand Q, 2 Awnex A, Puatic Provision of Goons AND SERVICES Tablet Possible Sources of Economic Benefits and Costin Various Projects ca IST OF TABLESAnnex B Table 1. Table 1.8 Table 1.C Table2 Table3 Tabled TableS.A TableS B Tables Table7 Tables Tableg Table 10 Table 11 Table 12 Table 13 Table 14 Table 15 Table 16 Table 17 Table 18 Table 19 Annex E Tablet TableE2 List oF Tastes ‘A Summary OF THE INTEGRATED PROJECT PROPOSAL APPRAISAL METHODOLOGY Table of Parameters, Table of Parameters Table of Parameters for Economic Analysis Inaion Rates, nfation Indices and Exchange Rates Production and Revenue Schedule Direct Cost Schedule Investment Table Depreciation Schedule ‘Working Capital Schedule Grants (in milion Pesos) Nominal Nominal Net Beneft Statement Cashviow ‘Total Investment Perspective Real Net Beneli Statement Cashow Totalinvestment Perspective ‘Nominal Net Beneft Statement Cashflow Ezquity Holder's Perspective Real Net Benefit Statement Cashiow Equity Holder's Perspective Conversion Factors ‘Statement of Economic Resource Flow Slatementof Extenalies Distibution of Extemalies Reconciiaton ofthe Economicand Financial Statements ‘Sensitivity Analysis Risk Analysis of Hospital Project Risk Analysis of Hospital Project Risk Analysis Results Provect FINANCE AND Private SECTOR PARTICIPATION IN Pustic Sector Actives Defriton Spectrum for Project Finance Main Reasons forthe Emergence and Use of Project Finance SSS 8 8 8 YPSRPSBBVVwwList oF Figures Charter 2 Provect Eva.uarion Criteria Figure 2-1 “Time Profies ofthe Incremental Net Cashflow for Various Types of Projects 1 Figure2-2 Mutually Exclusive Projects withthe Same Scale 15 Figure2-3 Timing of Projects when Potential Benefts Are a Continuously Rising Function ofCalendar 28 Time butAre Independent of Time of Starting Project Figure24 Timing of Projects When Both Potential Bnefts and investments, a ‘Are Function of Calendar Time Figure25 Timing of Projects Wen Potential Benefits Rise and Decine with Calendar Time 2 Figure 2-6 Timing of Projects Wnen Patems of Both Potential Benefits and Costs 0 Depend on Time of Starting Project CuaPTeR4 —- PRINCIPLES UNDERLYING THE Economic ANALYsis oF PROJECTS Figure 4-1 Evonomic Costs and Benefits (No New Project in Undstorted Market e Figure4-2 Economic Benefits ofANew Projectn An Undstoted Market a Figure4-3 Economic Cost ofAn Input Demanded by AProjectn An Undistorted Market 6 Figured-4 Market or Fish without Environmental Exteralty 70 Figure 4-5 Market for Fish wth Poltoninthe Lake 7 Figure 4-8 Congestion on Aad or Bridge 2 Figure4-7 Private Ownership vs. Common Property Arrangement 7% Figure4-8 Monopolistic Markt % Figure4-9 Taxon Non-radable Goods 7 Figured-10 Subsidy on Non-Tradable Goods 7 Figure4-11 _Distotion Due toAn port uty 7% Figure4-12 Distortion Caused by An Export Tax 78 Figure4-13 Basic Needs Externalities @ Figure4-14 Economic BeneilofA Project the Presence of Externalities at Figure4-15 Economic Costs of AProjectin the Presence of Extemalies, 2 Cxapter6 — EsTIMATING ForeIGN EXCHANGE PREMIUM Figure 6 Deteminationof p, 9 Figure 6-2 Foreign Exchange Market Determinationof p, % Figure 6-3 Determinationof p, 100 Cuapter 7 — Estmarion oF Economic Prices For TRADABLE Goons Figure 7-1 Tradables and Non-Tradables 108 Figure 7-2 Example ofA Project that Uses An Importable Good (Packaging Material) 114 Figure 7-3 Example ofAProjec that Produces An Exportable Good (Tomato Paste) 116 Figure 7-4 Example ofA Projectthat Supplies An Importable Good (Tomato Paste, Year One) 119 List oF FicusCuarter 8 Figure 8-1 Figure 8-2 Figuree-3 Figure 8-4 Figure 8-5 CHaprteR 9 Figure 9-4 Figure 9-2 Cuaprer 10 Figure 10-1 Figure 10-2 Figure 10-3 Figure 10-4 ‘ANNEX A Figure A-t Annex B Figure B-1 Figure B-2 Figure B-3 Figure B-4 Figure B-5 Figure B-6 ‘Annex E Figure E-1 List oF Fiovass EstimaTion oF Economic Prices FOR NON-TRADABLE Goons AND SERVICES Economic Benefits ofANNew Projectin A Distorted Market Economic Cost of Input Demanded by AProjectin A Distorted Market Economic Benefts of Project Output (No Distortions) Economic Benefts of Project Output (Taxon Output) The Economic Benefits of Water to Paying Customers Estimation oF Economic Opportunity Cost oF LABOR ‘Seasonal Patter of Agricultural Wages Regional interaction between Skiled Labor Markets DEALING witH UNCERTAINTY IN Prosect DEVELOPMENT AND APPRAISAL. ‘Annual Nominal and Real Sugar Prices (Annual Averages of Monthy Data) (January 1981 -June 1998) Trend ofAnnual Real No. 11 Raw Suga Prices (1981-1996) Trend of Real No. 1 Raw Sugar Prices (1962-1996) Predicted Trend and Cycle for Real No. 11 Raw Sugar Prices (Based on a Si-Year Cycle) (1982-1996) Pustic Provision of Goons AND SERVICES Public and Private Provision with Postive Externalities, A Summary OF THE INTEGRATED PROJECT PROPOSAL APPRAISAL METHODOLOGY Tables for Financial Appraisal Stepsin Economic Appraisal Distributive Analysis of AProject Sensitivity and Risk Analysis RiskAnalysisof Hospital Project Cumulative Distrbuion ofNPV-c0 Risk Analysis of Hospital Project Frequency Distribution ofNPV-Eco PROJECT FINANCE AND PRivaTE SECTOR PARTICIPATION IN Pusuic Sector Actives Relationship Among Principal Parties to A BOT 12 123 126 12 167 178 181 Be 210 230 eT 21 255 28 28 29 315Voume 2. Apvaycen Maxvas, on Prosecr Evawvari Cuapter 1 Provect EvaLuation OpJectives 11 Introduction Project evaluation is a methodological framework designed to assist the national government, as represented by the Investment Coordination Committee (ICC) for major national projects, in deciding ‘whether or not a capital investment is in the best interests of the country. It is the task of the ICC to review and evaluate major capital projects with respect to technical, financial, economic, social and institutional feasibility and viability, as well as from the context of sectoral plans and geographical strategies, and to recommend approval to the NEDA Board. Major capital projects are currently defined as those investments with total costs of PhPS00 million and above regardless of financing. These also include projects to be implemented in partnership with the private sector and the local government units (LGUs). The ICC Guidelines and Procedures provides detailed information on the coverage of ICC review of public investments. ‘The economic and social objectives of project evaluation are to identify and promote the approval of investments that: a)_use resources efficiently (refer to Section 1.2), 'b) promote sustainable development (refer to Section 1.3), ©) treat individuals equitably by ensuring that no specific group is materially disadvantaged as a result of an investment (refer to Section 1.4.1), and, 4) improve the level of basic needs of the most needy (refer to Section 1.4.2). A indicated above, the various objectives are examined in detail in subsequent sections 1.2 Efficient Use of Resources In order to ensure that only those capital investments that make efficient use of the scarce ‘economic resources, both in the private and public sectors, are approved and promoted, itis necessary to adopt a set of suitable criteria, The theoretical basis and practicality of the different possible criteria are discussed below.’ 1 The eriteria discussed here are from Welfare Economics. See Layard PR.G and A.A, Walters, “Microeconomic Theory,” ‘McGraw-Hill (1978) for a detailed discussion. Giapran 1.” Proseer Evaiuanion Onmonves i1.2.1 The Pareto-Optimality Criterion One criterion used by economists to determine if resources - land, labor, capital, and natural resources - are allocated efficiently is the Pareto-optimality criterion. A project that alters resource allocation by drawing resources away from their altemative uses can be said to improve economic efficiency if at least one individual is made better off and no one else is made worse off. A Pareto ‘optimum occurs when resources can no longer be reallocated to make some economic agents better off without making one or more individuals worse off. This is a very rigorous standard. Since it would be difficult to find projects that do not have any detrimental effects even for one person, itis not a practical standard for real-world applications. Pareto optimality and the premise underlying it are presented in Box 1-1? 1.2.2 The Potential Pareto Optimality Criterion An alternative criterion used more often is the potential Pareto improvement criterion in resource allocation. A potential Pareto improvement occurs when the gains to those who benefit from a project are sufficient to compensate those who are made worse off and still leave a residual benefit. This residual benefit is the net gain to society as a whole. Only if this net gain is positive can a project claim to make efficient use of resources. Ideally, we would like the net gain to be as large as possible. If the net gain is negative, then the winners would not be in a position to compensate the losers, and society as a whole would be worse off. Box 1-1 Pareto Optimality Pareto optimality is criterion used to evaluate a change in resource allocation. A Pareto ‘optimum occurs when resources can no longer be reallocated to make some economic agents better off without making one or more individuals worse off. The changes that make some better off without making anyone worse off are referred to as Pareto improvements. Although it might be difficult to design a single change to constitute a Pareto improvement, package or packages of changes together may meet this criterion. The belief that any such improvernent should be instituted is referred to as the Pareto principle. An important property of the Pareto optimality criterion is its individualism. Firs, itis concemed only with each individual's welfare, not with that of different individuals. It does not look at ‘inequality, or the gap between the rch and the poor. Therefore, there would still be a Pareto improvement in the case of a change that makes the rich much better off and leaves the poor ‘unaffected, which would ultimately result ina bigger gap between the two. Second, it iseach individual's perception of his/her own welfare that counts. Another criterion in evaluation of changes in resource allocation is the potential Pareto ‘optimality, or the compensation principle. Itevaluates whether the peso value of a change to ‘those who benefit from this change exceeds the peso value of the loss to those who become worse off. If it does, then the residual benefit is a net gain to the society as a whole. This principle makes the implicit assumption that a peso’s worth of gain to one individual should weigh the same as a peso’s worth of loss to another. ¥ See Sugita, Joseph E., "Economics ofthe Public S Pareto Optimal improvements or (chapter 3)" fora discussion of Pareto Optimality and Potential (Cuaeren 1.” Prosser EVAUsATION OBJECTIVESVounse 2. Apvaxcep Maxvat, ox Prosecr EVALUATION 1.2.3 Problems with Using the Potential Pareto Improvement Criterion One of the main problems with the potential Pareto improvement criterion is that it aggregates the changes in well-being or welfare experienced by individuals in different groups in the society, such as consumers, workers, owners of productive resources, owners of natural resources, taxpayers, cetc., who may either gain or lose as a result of a project. This criterion also requires that the loss in welfare of any group be compared to the gains experienced by other groups. ‘These interpersonal comparisons of welfare are complicated by the fact that the additional utility of an extra peso to someone who is poor may be greater than its value to someone who is rich. To avoid having to make such value judgments, we employ the operational rule that when measuring the net benefits of a project, a peso is valued as a peso no matter who receives it or who loses it. This convention greatly facilitates communication and understanding of the meaning of the results of the analysis as it will allow us not only to add up the changes in well-being for individuals ina given group, but also to net out the gains and losses across groups. 1.2.4 Potential Pareto Improvement in the Presence of Distortions Like most countries, the Philippines has a mixed economy. The economic decisions, to a large extent, are made in the private sector where both consumers and producers respond to market prices, which are in tum determined in either domestic or intemational markets. The allocation of resources between different activities depends upon the response of consumers and producers. On account of market failures, however, the public sector represented by the government has to intervene frequently in order to improve the allocation of resources. In addition, governments typically have their own agenda of political, social, and economic objectives they wish to implement. Depending on the criteria used to make these decisions, the resulting reallocation of resources from the private to the public sector can either improve or worsen the economic well-being of society. When there are perfectly competitive, undistorted markets, the private sector will allocate resources efficiently, and market prices will provide a measure of marginal economic benefit and ‘marginal economic cost. The term perfectly competitive, undistorted markets refers to those markets where consumers have freedom of choice and firms have freedom to enter and leave an industry, where exchange is voluntary, where market participants are fully informed (where there is symmetry in the information possessed by economic agents), and where there are no distortions like taxes, subsidies, tariffs, monopoly power, or pollution that drive a wedge between marginal economic benefit and marginal economic cost. Economists describe these conditions as the first-best equilibrium. Ifthey were valid for every industry, then a Pareto optimum would exist, and it would not be possible to improve the allocation of resources. When these requirements are not satisfied, then private markets alone cannot be relied upon to allocate resources efficiently, and market prices may no longer provide a reliable measure of marginal ‘economic benefits and costs. There are many reasons why markets fail to allocate resources efficiently Caabran 1.” Provscr Evaluanion Onsecrives 3‘Voume 2, Apvaxcen Manvat, ox Provact EvaLustion (Box 1-2)2 The ones that are of most interest to us can be grouped under the broad heading of externalities. Box 1-2 Market Failures ‘The term market failure refers to the situations when markets fail to allocate resources: efficiently. There are several sources of market failure, which are used to justify government intervention in the marketplace: 1. Failure of Competition or Monopoly. The market mechanism cannot allocate resources in an efficient way in the absence of competition. When there is only one firm in a ‘market, the monopolist, if unregulated, will restrict output to attain a higher price. A monopolist produces at the point where the extra revenue (marginal revenue) it would receive from producing an extra unit equals the extra cost of producing that unit (marginal cost). Thus, it will produce and sell a quantity Q,, at which marginal revenue equals marginal cost. That quantity is certainly less than the quantity Q_ at which price equals, marginal cost. At the equilibrium quantity Q, under monopoly, the price of the good, which measures how much individuals value an extra unit of the good, exceeds the ‘marginal cost. Thus, a monopolist underproduces and charges a higher price compared to a competitive industry, which results in a welfare loss from the restriction of output, Consumers would benefit more from increased consumption of the units from Q,, to Q, than it would cost the economy to produce them. Hence, there isan inefficient allocation of resources. In the long run and under perfect competition, a firm produces at the point where the marginal cost of production is equal to the average cost of production. This occurs at the lowest point of the average cost curve, thus, there is production efficiency in a competitive industry, This is not the case with a monopoly production, which is why it suffers from a lack of production efficiency. O Gianity "hse reasons ae reviewed in publi finance textbooks like Boadway and Wildasin (1984, Chapters 1 and2) and Stiga (1988, Chapters 4) 4 (Cuapren 1. Prouscr EvaLuxnion OniecrvisVous 2. AD (ce MaNvAl oN Prosper EVALUATION Box 1-2 (cont’d.) 2. Public Goods: The concept of public goods has two properties. First, it does not cost anything for an additional individual to enjoy the benefits of the public good (non-rival in consumption). Second, it is not possible to exclude individuals from enjoying the public ‘good. An example would be national defense. Therefore, itis very difficult or impossible to collect payments from the consumers of public goods. For these reasons, the private sector ‘will not supply public goods or will not supply them in sufficient quantity. The government has to take the role of a supplier of these goods or at least make provision for payment to private suppliers for their production, 3. Externalities: Instances where an individual's activities impose a cost on others are referred to as negative externalities. An example would be the case of environmental pollution, such as water pollution, wherein polluters impose the cost of cleaning the water on the users without compensating the latter for that cost. Positive externalities occur when an individual's actions confer benefits upon others. Government has to intervene in cases of externality to ensure that an optimum level of production is achieved. 4. Incomplete Markets: Whenever private matkets fail to provide a good or service, even ‘though the cost of providing itis less than the price that individuals are willing to pay, there is a market failure called an incomplete market. An example would be the insurance or the capital market where government regulatory or supervisory activities are needed in order to provide these services in an efficient manner, ‘5. Information Failure: Often the market supplies too litte information to consumers on. subjects such as product safety, and itis the role of the government to step in to remedy the information failures. Additional information often has a value to consumers that is greater than its production and dissemination costs. 6. Redistribution and Merit Goods: The government should also be involved in the economy for purposes of income redistribution and for the provision of merit goods. ‘The economy ‘can be Pareto optimal, and at the same time gives rise to unequal income distribution. ‘Therefore, government welfare activities can be designed to assist those in need and reduce the gap between rich and poor. Merit goods are those goods that the government compels individuals to consume, based. on the assumption that the individuals may not act in their best interest, so the government has to intervene because it is in its citizen’s best interest. Economists describe a situation where distortions drive a wedge between marginal economic benefit and cost as the second-best equilibrium (Meade, 1955). Since a Pareto optimum does notexist under these circumstances, iis possible to bring about a potential Pareto improvement in he allocation of resources either through policy changes, such as tax, trade or environmental policy changes, or by undertaking public sector capital expenditures that are designed to offset the distortion. It is important to recognize that these are conceptually two different types of exercise. Gitspran 1.” Paosecr EvaLuanion Oniecrivss 3Vowume 2. Apvancep Manual, on Prosecr Evatuavion Tax, trade and other policies, on the one hand, frequently involve changes in the level of distortions. For example, government employs fiscal instruments to alter the level of different taxes in order to improve the design of the tax system. By the same token, it adjusts the trade tariffs and subsidies to achieve the commercial policy objectives. On the other hand, when it comes to capital expenditure decisions, the standard practice is to take the level of distortions in all markets as given. Recognizing these distortions, project analysts face the challenge of estimating economic benefits and costs in order to determine whether a project is likely to bring about a potential Pareto improvement in the allocation of resources. This challenge is addressed by undertaking an economic analysis of the project. Since project analysts cannot rely on market prices to measure benefits and costs in a second-best economy, they will have to take market distortions into account by estimating economic prices for project outputs and inputs, The economic analysis of project uses these economic prices to determine whether the reallocation of resources brought about by a project creates a net gain or a net loss. ‘The key to this approach is that there is always an alternative use for the resources required for public sector projects, namely, that those resources could be used to pursue other activities in the private sector, 13 Sustainable Development ‘The natural resource base of the Philippines has long been the source of raw material inputs for investment projects. On the other hand, the environment — rivers, lakes, oceans, unused land, and the atmosphere — has often been the dumping ground for the unwanted by-products of economic activity. This type of development strategy is clearly unsustainable over the long run, ‘There is a growing concem in the Philippines and elsewhere about the threat to the well-being of ‘future generations, and more immediately, about whether environmental degradation i likely to impede investment by either putting the supply of natural resources in jeopardy or posing too great a health risk to both local and global populations. It is now recognized that damage to environment caused uring the process of economic and social development is a cost to society and must be accounted for while evaluating investments. There are three different concepts of sustainable development: the economic, ecological, and socio-cultural approaches.’ The economic approach aims to maximize the flow of income while maintaining the stock of capital (which ideally includes physical assets, human and natural resources and the environment). The ecological approach focuses on the sustainability of biological ecosystems that are critical to the maintenance of life. Emphasis is placed on biological diversity and the adaptability of ecosystems to respond to any changes. The socio-cultural approach on the other hand broadens the concept of ecosystems to include social and cultural systems. Issues that arise encompass intra- {generational equity (poverty, tribal rights, community stability and cohesion) and intergenerational equity (well-being of future generations who are unrepresented in today's decision-making). The last ‘wo approaches place more weight on the resilience of systems in being able to adapt to changes on a self-sustaining basis, See Munasinghe, Environmental Economics and Sustainable Development, 1993, p3, for details ofthese thee approaches. (Cuaprer 1.” Paosecr Hivatuation OMECrIVESAs would be evident from the following, the methodology adopted in this manual endeavors to capture the spirit of the approaches outlined above. a) Wherever possible, environmental externalities should be monetized and included in the ‘economic analysis of a project, The important issue is to ensure that non-renewable resources are priced at their marginal resource cost, which recognizes that more expensive resources may have to be accessed as resource utilization increases. b) The over-exploitation of renewable resources is referred to under the heading of common property resource externalities. ) Although this Manual does not adopt a socio-cultural approach to sustainable development, it recognizes the importance of consultation with community groups and other stakeholders in a project. 14 Social Objectives In broad terms, the proposed project should be responsive to the national objectives of poverty alleviation, employment generation and income redistribution.’ These issues fall under the heading of ‘equity considerations and are generally addressed using economic or employment impact analysis. For example, a project’s impact on creation of employment and earings opportunities is not an additional benefit from the project unless those affected are clearly made better off because of the project. ‘This manual, however, adopts a new approach to social objectives of income redistribution and poverty alleviation. First, the distributional analysis helps determine which groups in society are likely to be the main winners and losers from a project. Second, poverty concerns are addressed with a basic needs analysis of the project's impacts. 1.4.1 Distributional Analysis Although itis not realistic to expect that every individual project will cause a significant change in the distribution of income, itis necessary to identify winners and losers and quantify the extent of the gains and losses (o specific groups of stakeholders in the project. This is achieved through the distributional analysis of a project that is conducted from the perspective of each of the major parties affected - consumers, workers, owners of productive resources, owners of natural resources, taxpayers, etc. Where possible, the various groups are segmented by income in order to determine how much of the gain to consumers goes to low-income consumers or how much of the additional employment income goes to low-skilled workers. ‘The distributional analysis is important to decision-makers as it allows them to estimate the impact of particular policies or projects on segments of society and to recognize groups that would be net beneficiaries or net losers. Even though it will not provide a detailed accounting of how the overall income distribution is changed as a result of a project, it helps ensure that a project will not 7 Tavestinent Coordination Committee (CC) “Project Evaluation Procedures and Guidelines.” Gusren 1." Browser Evatvanion OwsecrnvesVouvu 2. place any undue burden on a specific group. If it does, then appropriate compensation may have to be estimated and a mechanism found to determine payment. The distributional or stakeholder’s analysis is discussed in Volume 1. 1.4.2 Meeting the Basic Needs of the Most Needy One of the developmental goals of the Philippine government is to meet the minimum basic needs (MBN) of the most needy. These basic needs mainly consist ofthe fundamental necessities of food and nutrition, health, basic education, water and sanitation. In terms of project evaluation, an emerging approach to integrating basic need concerns parallels the overall approach to poverty alleviation. This is the concept of a basic needs externality introduced by Professor Harberger.* ‘The essence of this approach is that a positive externality is associated with the improvement in the extent to which basic needs of the most needy are met. The externality is enjoyed by donor citizens (e.g., taxpayers) whose altruism is satisfied. This is like a public good and one donor's gratification does not preclude that of another. Services that satisfy basic needs are usually delivered in kind,” as opposed to an income transfer. Including a basic needs externality in project evaluation is equivalent to saying that society may be willing to tolerate a limited excess of economic costs over economic benefits only if the project's ‘outputs will contribute to the fulfillment of some basic needs. Projects having a bearing on basic needs may be viewed more favorably than those that lack this characteristic. ‘Thus, while the distributive analysis secks to allocate the net benefits generated by the project among the various stakeholders, the basic needs analysis further helps focus on the project’s contribution to the well-being of the most needy. Basic needs refer io the most essential needs of people such as nation, health care, education, and housing, The core of povery alleviation programs followed by most developing countries serves these sectors, and therefore the projects catering to those needs are more attractive to society. The concept of basic needs externality is duc to AC. Harberper, “Basic Needs Versus Distributional Weighs in Cost-Benefit Analysis,” in Economic Development and Cultural Change, 1984, Cniarran 3.” Provect Bvaucation OnvecrvesVou 2, Apvanceo Manuat on Proiger EVALUATION Cuapter 2 Provect EvaLuation CRITERIA This chapter covers the details of the various indicators used in project evaluation. ‘The financial attractiveness of a project is determined by the net present value (NPV) of its incremental net cashflows and the economic desirability is measured by the NPV of its incremental net economic benefits. The NPV criterion is widely accepted by accountants, financial analysts, and economists as the only one that yields correct project choices in all circumstances. However, some private investors have frequently relied upon other criteria such as a project's intemal rate of return (IRR) or a benefit-cost ratio, and others have used pay-back period criterion. ‘The strengths and weaknesses of these criteria are examined in this chapter in order to demonstrate why the NPV criterion is the most reliable. This chapter also addresses the topic of optimizing a project's NPV. Itis, generally speaking, most desirable to have a project’s NPV of incremental net economic benefits as large as possible. A number of decisions have to be made about a project that can affect the magnitude of its NPV, such as when it should start, how large the scale of investment should be, and how long a life the project should have. 2d The Net Present Value (NPV) Criterion ‘The NPV is the algebraic sum of the present values of the incremental expected positive and negative net cashflows over a project’s anticipated lifetime. If this sum is equal to zero, then investors ‘can expect to recover their incremental investment and earn a rate of retum on theit capital equal to the private discount rate used to compute the present values.' But if the private discount rate is ‘based on the market cost of capital for a project of equivalent risk, as it should be, then investors ‘would not be further ahead with a zero NPV project than they would have been if they had left the funds in the capital market. Investors are not worse off; they are just not better off. An NPV ‘greater than zero means that investors can expect not only to recover their capital investment and to eam a rate of return equal to the discount rate, but also to receive an addition to their real net worth equal to the positive amount of the NPV. In other words, a positive-NPV project outperforms the capital market and makes investors better off. Finally, if the NPV is less than zero, then investors cannot expect to earn a rate of return equal to the discount rate, nor recover their invested capital Hence, theirreal net worth is expected to decrease. Only projects with positive NPVs are going to ‘be beneficial and therefore attractive to private investors. They are unlikely to pursue a project with a negative NPV unless there are strategic reasons or they receive financial assistance. The recovery of the invested capital is anticipated NPV > 0 because the incremental capital expenditures are included inthe intial negative net cashflows. Gnarren 2.” Phosecr Evatuanion Carrenia‘Vowne 2. Apvancen MauaL ox Prosecr EvaLuarton The formula for computing the NPV of expected incremental net cashflows over n time periods with an annual discounting is nev = & t=0 (tr)! ‘where the incremental net cashflows (C)) could be negative, zero or positive, and r is the discount rate equal to the cost of capital and the sigma sign (5) is symbol for summation. It is today’s cost of capital that matters because that is what it either costs to raise the funds or is being forgone as a result of using available funds for a project rather than putting them to work in the capital market. The NPV formula can be written out in its component present values of the annual net cashflows, as follows G, c c, NPVCH Ee * Cran to Crap ‘The net present value criterion can be stated in the form of a set of decision rules. Decision Rule 1: Do not accept any project ifit generates a negative NPV when di discount rate equal to the opportunity cost of the funds. counted by a Deci mn Rule 2: ‘To maximize net worth, choose from among the various projects of scenarios of projects, the one with the highest NPV. When there is no budget constraint and ‘hen a choice must be made between two or more mutually exclusive projects, e.g, projects being considered for the same building site, then investors who seek to maximize net worth should select the project with the highest NPV. Decision Rule 3: If investment is subject to a budget constraint, then choose the package of projects that maximizes the NPV of the fixed budget. ‘The magnitude of the discount rate obviously plays an important role in the calculation of the NPV. Note that altemative and mutually exclusive projects should have the same length of life if they are to be compared, Also, Rule 3 is stated in terms of the absolute value of the NPV, not in terms of the NPV per peso of investment. Consider two projects, A and B, that are mutually exclusive for technical reasons and have the following characteristics: Project A: NPV of project A= PhP700,000. Present value of capital expenditure = PhP4,000,000. Project B: NPV of project B = PhP600,000, Present value of capital expenditure = PhP1,500,000.‘Vownte 2. AbvaNce Manual, on Paovect EVALUATION According to Rule 3, Project A with an overall NPV of PhP 700,000 should be chosen because it has the higher NPV, even though the NPV per peso of investment is higher for Project B (0.4) than for Project A (0.175). ‘The reason for choosing Project A is that even though it requires an incremental investment of PhP2,500,000, it yields an incremental gain in NPV of PhP 100,000 over and above a rate of return equal to the discount rate on the incremental investment. By choosing Project B, an investor would have a NPV of PhP600,000 and any additional funds are assumed to be invested in the capital market where they would have a zero NPV. Thus, by choosing Project A, an investor would be PhP100,000 better off, and Project A is the preferted choice. The financial attractiveness of a project to private equity investors is measured by the NPV of the incremental expected net cashflows to equity capital. The NPV is computed by using a private discount rate equal to the required rate of return to equity capital for projects of similar risk. This required rate of return should reflect the risk associated with the operating and financial leverage of 1 project as well as the risk due to uncertainty. Note that even though the NPV of the incremental net cashflows might be negative and a project would not appear attractive to private investors, it may create benefits for others in the form of economic externalities that should be captured in an economic analysis. [economic benefits are sufficiently large to outweigh the economic costs, then the government — on the grounds of improving economic efficiency — would have valid reason to offer the private investors some financial assistance to make the project more attractive to them. Figure 2-1 ‘Time Profiles of the Incremental Net Cashflows for Various Types of Projects Incremental Net Incremental Net Incremental Net Cashflow (a) Cashfiow (b) Cashflow (c) Tire Tire Tire Investment projects can exhibit different time profiles of the expected incremental net cashflow (cither to total or equity capital) over a project's life. For example, Figure 2-1 shows time profiles for three types of investment projects, namely: a) The investment expenditures initially cause the net cashflow to be negative, but once the expenditure is incurred, the rest of the net cashflows are expected to be positive over the project's life.Vout 2. Avancen Manual, ox Provact EvaLuation b). This profile is slightly different because after a few years of operations, the replacement of some of the project’s machinery and equipment causes the net cashflow to become temporarily. negative. ©) The last profile also tums negative, but this is due to a major expenditure at the end ofa project, e.g,, environmental regulations require a strip-mining site to be restored to its original condition. The criterion used to appraise investment projects must be applicable to any time profile of net cashflows, Unlike other possible criteria, the net present value criterion is the only one that meets this requirement. Although the NPV ctiterion is used by large companies and by the Philippine govemment, alternative criteria are also being used. Each alternative has serious drawbacks compared to the NPV criterion and is therefore judged not only as less reliable but potentially misleading. When two or more criteria are used to appraise a project, itis always possible that different conclusions are found and wrong decisions could be made. A government project analyst should be familiar with the shortcomings of these alternative criteria. Representatives of a government-owned and controlled corporation (GOCC) or a private company can often be adamant about the efficacy of their criteria as basis for investment decisions. Although these financial managers should not be told how to make decisions, a government project analyst should nevertheless employ the NPV criterion in assessing the gains that private investors stand to enjoy by undertaking a certain project. 2.2 Internal Rate of Return (IRR) Criterion By definition, the IRR is the discount rate (p) that sets the NPV = 0 in the following equation: > —S «1-0 m+ py where C, = the incremental net cashflow in year j to total, or equity capital , 1 = the initial investment , P = the IRR. We have to solve for p . This definition is consistent with the meaning of a zero NPV as explained in the previous section, namely that investors recover their invested capital and ear a rate of retum equal to the discount rate, Which is the IRR. The IRR can be stated in the form of a set of decision rules. Deci in Rule 1: Do not accept any project unless its IRR is greater than the opportunity cost of funds. (Accept project if p> r, the opportunity cost of capital; otherwise, reject). ‘The opportunity cost of capital is measured by the cost of funds or expected rate of return offered by other assets equivalent in risk to the project being evaluated. ‘naeTER 2.” Provecr EvalvaTion CRrvENiaVou 2, Abvaxcep Maxual ox Provuct Evawwarion Decision Rule 2: When a choice must be made between two or more mutually exclusive project, then investors should select the project with the higher or highest IRR Table 2-1 lists the problems with the IRR criterion, We shall discuss them in tur. Table 2-1 Problems with the IRR Criterion ‘The IRR may not be unique. There could be multiple IRs or no IRR. “Mutually exclusive projects, e.g., projects of different scale are ordered wrongly. | TRRs are not additive. - - IRR generally favors projects with shorter lives. IRR is independent of the timing of a project (i. is sensitive to timing, vlsleipl= " project's start date), whereas Te Problem No. 1: The IRR may not be unique, there could be multiple IRRs, of the IRR may noteven exist. ‘The IRRis, strictly speaking, the root of a mathematical equation. The equation is based on the time profile ofthe incremental net cashflows like those in Figure 2-1, Ifthe time profile crosses the horizontal axis from negative to positive only once as in Figure 2-1(a), then the root or IRR will exist, but it may not ‘be positive, However, if the time profile crosses the axis more than once as in Figure 2-1(b) and 2-1(©), then there may be more than one root or there may be no real roots but only imaginary roots. Although this ‘may sound like more of a theoretical concem, it is certainly disconcerting to know that an investment decision criterion may not have a solution. Consider an example like Project B that has the following net cashflow in thousands of constant pesos: ‘Time Profile of Net Cashflow for Project B guerre oe canadaunnacaa | a pa) ae Tw | ale J“ _| Net Cashflows of B in PhP, thousands | -20 Project B has IRRs of approximately 0 percent, 100 percent, and 200 percent (i.e. these roots ‘ill solve the IRR equation and set the NPV equal to ero). Let us assume that the private opportunity cost of capital was 6 percent. Should we accept this project? Let us further assume that we are unaware of the foregoing discussion about multiple IRRs and that we have calculated only the IRR of 100 percent. A project with an IRR of 100 percent sounds very attractive, especially compared to the relatively low 6 percent cost of capital, Should we approve the project? Cuabten 2.” Provect EvasuxTion CrureniaYous 2, Abvanceo Manual. on Prosecr Evausrarion If we did agree to accept the project, the company would be worse off, and we might lose our Jobs. The NPV of Project B calculated at the 6 percent opportunity cost of capital is PhP-1.84 thousand. The investors would have been better off to have left their funds in the capital market rather than to invest in Project B. It is possible, of course, that we might have calculated the IRR of 0 percent. Since this IRR is less than the cost of capital, we would have applied the IRR criterion and rejected the project. This time we would have been correct, but we would not have known that until we had computed a project's NPV. And if we have the NPV, why would we need the IRR? If word gets around that we have just rejected a project with an IRR of 100 percent, or worse, 200 percent, then we are likely to have to provide mote explanations. This may be educational for our coworkers. But at best, the IRR may only introduce confusion, or at worst, may lead to costly mistakes if used as an investment criterion, Problem No. 2: Mutually exclusive projects, e.., projects of different scale are ordered wrongly. ‘The problem of having to choose between two or more mutually exclusive projects arises quite frequently. Examples include two alternative buildings being considered for the same building site, ora new highway that could run through two altemative rights of way. Whereas the NPV takes explicit account of the scale of the project by means of the investment required and the initially negative net cashflows that accompany it, the IRR ignores the differences in scale. ‘The IRR is expressed as a rate per peso of investment and does not indicate on how many pesos that rate can be eared. Forexample, consider two two-period projects (Mand N) with different scales of production. Assume that all the net cashflows are measured in pesos and that the cost of capital is 10 percent, as shown in Table 2-2, Table 2-2 Problems with Mutually Exclusive Projects Time Period t t, IRR NPV (at 10%) Net Cashilows of M =1,000 1,500 50% 363 Net Cashflows of N -10,000 12,000 20% 909 MIRR. ANPV Incremental Project 9,000 10,500 16.70% 546 IfDecision Rule 2 of the IRR criterion were applied, then we would choose the project with the higher IRR. In this case, that would be Project M. Once again, however, this would be a mistake. ‘The NPV of Project N is PhPS46 higher. ‘The problem is that with Project M, the rate of return is higher, but itis only eared on an investment of PhP1,000; whereas with Project N, the rate of return is lower, but the peso return is higher, hence, the higher NPV. Another way to view this problem is to think about how by accepting Project M, the remaining PhP9,000 is going to be invested. Lacking anything more conerete, it is best to assume that the PhP9,000 is invested in the capital market, where it would have a 10 percent rate of return and an NPV of zero, If instead the PhP9,000 were invested in Project N, there would be an additional net ui Harrex 2.” PROJECT EVALUATION CRITERIAVou 2. Abvancep Maxuat, on Provact Evawwanion benefit of PAP546 over and above the 10 percent market return, Clearly, Project N is the better alternative. This is also indicated by the marginal intemal rate of return (MIRR) on the incremental investment of 16.7 percent, which is greater than the cost of capital, The next logical question is whether the IRR criterion could be used to rank mutually exclusive projects with the same scale of investment. The answer is no, because even in this case misleading results are possible. Consider Figure 2-2. The NPV in pesos is on the vertical axis and the discount rate is on the horizontal axis. Whenever the plot of the NPV of a particular project for different discount rates crosses the horizontal axis (at zero), that point will indicate the IRR for a project. Figure 2-2 Mutually Exclusive Projects with the Same Scale Nev Project R a es: m r crossover down ate IRR of Poet R IRRof Poet S| Figure 2-2 depicts the situation for two mutually exclusive projects, R and 8, which can be assumed to have the same scale of investment, The difference between R and $ is that Project R tends to have most of its positive net cashflows later in its life and, therefore, is more attractive at low discount rates than at higher rates, If we were to rely on the IRR criterion’s Decision Rule 2, then we would select Project S because it has the higher IRR. The problem is that we cannot be certain that Project $ will also have the higher NPV at the cost of capital. That will depend on whether the cost of capital lies to the left ‘orto the right of the crossover discount rate r’. If r >, then we would have selected the right project because the NPV of Sis higher than the NPV of R. Ifr p, , Would have been if the NPV of Project S had dominated the NPV of Project R at all discount rates. Chapran 2." Prosect Evatuanion Crrenia,Vous 2, Anvanceo Manvat. os Prossct Evavarion Problem No. 3: IRs are not additive. Larger projects will frequently have a number of separable components. Each of these components should be analyzed on its own merits and then assessed in conjunction withthe other components. Since some of the possible components may be mutually exclusive, those separate combinations have to be examined as well ‘Take for example, a larger three-period Project T that has two mutually exclusive projects, | and 2, and a third project 3 that has independent net cashflows, but which could be undertaken with either one ofthe other two. The question is which is the best package? In the table below all the net cashflows are expressed in thousands of pesos and the cost of capital is 10 percent; all of the separate projects have the same scale of investment. Our objective ought tobe to maximize the NPV of Project. The question is whether that will occur iff we rely on the IRR criterion. According to the latter, Project 3 is the most attractive of the individual projects, and it remains the most attractive even after assessing it in combination with the other two. Hence, based on IRR Decision Rule No. 2, we would select Project 3 by itself. This exampleis illustrated in Table 2-3 ‘Table 2-3 Problems with Multi-Period Projects Time Period t t «| ark | NPvari0%) | Net cashflows Project 1 -100 0 | 550 | 135% 354 Project 2 s10 | 225 0 | 125% 105 Project 3 =100 | 450 0 | 350% 309 Project T Combinations: Time Period (3 j t | mR | NPV at 10%) Projects 1 & 3 ; 200 | 430 | sso | 213% 663 Projects 2 & 3 200 | 675 0 | 238% 414 By assumption, the net cashflows of Project 3 are independent of the net cashflows of the two ‘mutually exclusive projects. In other words, there are no complementarities or substitution possibilities that would cause the combined NPVs of either Projects 1 and 3, or 2.and 3, to differ from the sum oftheir individual NPVs. When either Project | or 2 is combined with Project 3, their combined NPV is substantially higher than Project 3 by itself. Infact, Projects 1 and 3 combined would be the best choice witha combined NPV over twice as high as Project 3 alone. Even Projects 2 and3 combined would have been preferable. Unfortunately, the IRR criterion would nor have resulted in these choices. ‘The reason is that whereas the NPVs are additive, the IRRs are not. When separate projects were analyzed, they all had the same scale of investment, but the combinations increase the scale of investment and, therefore, should not be ordered according to the IRR criterion, In this case, the larger scale of investment lowers the IRRs of the combinations and makes them appear less attractive. The IRR of Projects 1 and 3 combined is less than the sum ofthe individual IRRs of Project | and Project 3. Cuarren 2." Provsct EVALUATION CrivERiAVou 2. Abvancrp Maxuay, ox Provact Evatuarion Problem No. 4: IRR gives wrong results when projects have different lengths of life and are strict alternatives; IRR generally favors projects with shorter lives, Examples of how the IRR is generally higher for shorter-lived projects are provided in Table 2-3. ‘Compare Projects | and 2. The undiscounted positive net cashflow of Project | is twice as high as that of Project 2, except that Project 2's net cashflow occurs one year earlier. Despite the difference in the cash-flow magnitudes, the IRRs are quite close. Also compare the combinations. The total of the undiscounted positive net cashflows of Projects 1 and 3 is considerably larger than that of Projects 2 and 3. Yet the IRR of Projects 2 and 3 is higher because the net cashflows occur earlier. Another concrete example of IRR failing to give correct results can be seen from the following ‘example, Suppose we have two projects A and B under consideration. Project A calls forthe planting of 1 species that can be harvested in five years. Project B plants a type of tree that can be harvested in ten years. The cost is the same for both projects which is PhP1,000. It is also assumed that neither of the projects can be repeated, Given an opportunity cost of 8 percent, the two projects can be analyzed as follows: ProjectA: Investment costs = PhP1,000 in year 0 Benefits = PhP3,200 in year 5 NPV’, = -1,000 + 3,200/(1+8%6)" = PRPI,177.86 Internal rate of return (p,): 0 1,000 + 3,200/(1+P,)* Pa= 0262 Project B: Investment costs = PhP1,000 in year 0 Benefits PhPS,200 in year 10. NPV?, = -1000-+5,200/(1+8%%)" = 1,408.60 Internal rate of return (p,): 0 = -1,000+ 5,200(1+ Ps)" Pa 0.179 ‘The NPV of Project B in year 0 is greater than that of Project A. According to the NPV criterion, Project B is preferred. The IRR of Project B, however, is smaller than that of Project A. Therefore, the IRR is an unreliable criterion for project selection when the choice is between alternative projects having different lengths of life. Ghiapren 2." Provecr Evatuation CerreniaVountr 2. Abvancep Manual, ox Prosect EvaLuation Problem No. 5: IRR is independent of the timing of a project (i. a project’s start date), whereas NPV is sensitive to timing, ‘The following example is an illustration of how IRR criterion can be misleading. Again, suppose two projects A and B started at different times, with Project B starting five years after Project A. Both have investment costs of PhP1,000 and a length of one year. Project A: Investment costs = PhP1,000 in year 0 Benefits = PhP1,500 in year 1 NPV®, = -1,000 + 1,500/(1+8%)! = PhP388.88 Internal rate of return (p,): 0 1,000 + 1,500/(1+P,)! Pyr= 05 Project B: Investment costs = _—_~PhPI,000 in year 5 Benefits PhP 1,600 in year 6. NPV’, = -1000/(1+8%)*+ 5,200/1+896)6 PhP327.68, Internal rate of return (p,): 0 = -1,000/(1+P8)* 1,600/(14P,)° Ps = 06 Using the NPV criterion for evaluating the two projects, Project A is found to be preferable because its NPV is greater. However, p, is smnaller than p,, Here again it is shown how the IRR criterion could lead towards an incorrect choice. 2.3 Benefit-Cost Ratio (BCR) Criterion As its name indicates, the benefit-cost ratio, or what is sometimes referred to as the profitability index, is the ratio of the NPV of the net cash inflows (or economic benefits) to the NPV of the net cash outflows (or economic costs): NPV of Net Cash Inflows (or Economic Benefits) ‘NPV of Net Cash Outflows (or Economic Costs) BCR The benefit-cost ratio criterion can be stated in the form of a set of decision rules. Decision Rule 1: Do not accept any projectif its BCR is less than one. (Accept project if BCR > 1; otherwise, reject.) The NPVs in both the numerator and the denominator of the zatio should be discounted by the opportunity cost of the funds. The opportunity cost of capital is measured by the cost of funds or the expected rate of return offered by other assets equivalent in risk to the project being evaluated. Provect Evaiation CireVou 2. Abs 1p Manual, ox Provct Evatuarion Deci ym Rule 2: When a choice must be made between two or more mutually exclusive projects, then investors should select the project with the higher, or highest, BCR To use the BCR as a measure of economic desirability runs the risk of screening out possible candidate projects according toa faulty criterion. In some instances, worthy candidates could be eliminated from consideration early on based on their BCRs, and in so doing the overall NPV could be lowered ‘unnecessarily. Furthermore, the NPV criterion and the BCR criterion can often draw the opposite conclusion; using the two criteria together then becomes a source of confusion, and possible mistakes. ‘Although the BCR is popular because itis a handy rule-of-thumb and summary statistic, it has two major weaknesses: Problem No. I: The BCR is sensitive to definition of costs. Problem of recurring capital costs. Figure 2-1(b) illustrated the situation where a project had recurring capital costs during its life that caused the time profile of net cashflows to tun negative periodically. The question is: should these periodic negative net cashflows be included in the capital costs in the denominator, or should they be ‘counted as net cashflows (albeit negative) in the numerator? The problem is that the BCR is a ratio. ‘Whereas multiplying or dividing the numerator and denominator ofa ratio by the same number does not alter the size of the ratio, adding or subtracting the same number to the numerator and denominator of a ratio will alter its magnitude. Consider two projects, V and W, where Project W has substantial recurring capital costs in comparison to its initial capital costs. All the NPVs of the cashflows (or economic benefits and costs) are measured in thousands of pesos, and the cost of capital is 10 percent. By applying Decision Rule No. 2 of the BCR criterion to the project with recurring capital costs netted out of net cash inflows (the first approach above), Project W appears to be more attractive than Project V. However, when the NPV of recurring capital costs is instead added to the NPV of initial net cash oueflows (the second approach), then Project V appears to be more attractive than Project W. Which approach is correct? { NPV Project W pes reaiece¥ = NPV of gross net cash inflows 2,000 2,000 | (orgs coonomis ens NPV of initial net cash outlows | 1,200 100 | | Coin apa costs) NPV of eciing net cath oulows | 500 1,800 (or recurring capital cost) | NeVora ne eslows | 300, | go | [_—_Aaere rns t iE BCR when the recurring capital | vy _ 2000-500 w _ 2000-1800 Soets are netted out of the net | Bor” = ST | wer = ash inflows (or gross benefits) | | | — |. ] | BCR when the recurring capital 2000 ww 2000 Coss are added tothe inital net Ses | BOR = | Seok ourlows (or nial eapitl 1200 +500 | 7800 +100 expenditures) | =1.18 I Giarren 2.” Proaver Evauuarion CRrreniaVousme 2. Apvaxcen Manual, on Prosecr Bvatuarion ‘The answer is that they are both arbitrary and could easily be used indiscriminately by different project analysts. The problem is that decision-makers would not necessarily know which approach is being used, and even if they did, they would notknow which was correct until they examined the NPVs of the two projects. In the above example, Project Vis the better project because it has the higher NPV. ‘There is no need to inquire further. Problem No, 2: Wrong ordering of mutually exclusive projects, e.g, projects of different scale. ‘This problem is basically the same as Problem No. 5 with the IRR criterion, namely thatthe BCR is ‘a measure of return per peso of investment. The BCR does not take account of the differences in the scale of investment, As was evident from the example in Problem No. 1 above, the BCR is also very sensitive to the magnitude of the initial investment costs Consider another example of three mutually exclusive projects X, Y, and Z; none of these projects has any recurring capital costs, All the NPVs of the cashflows (or economic benefits and costs) are measured in thousands of pesos, and the cost of capital is 10 percent. Table 2-4 Problems with Projects of Different Scale {Project NPV of NPV of nevot | BCR capital costs | net cash inflows | project x 1,000 1,300 300 1.300 Y 8,000 9,400 1,400 1.175 Zz 1,500 2,100 600 1.400 Decision Rule No. 2 ofthe BCR criterion would rank these projects as follows: Project Z> Project 2X> Project Y. Compare this ranking with the ordering according to their NPVs: Project Y > Project Z > Project X. ‘The reason that Project Y appears to be the least attractive according to the BCRs is that its relatively large initial capital expenditure lowers the retum per peso of expenditure. In fact, however, company would be better off earning a 0.175 peso retum per peso of a PhPS million investment (Project Y) rather than a 0.40 peso return per peso of a PhP1S million investment (Project Z). ‘There are other project selection criteria such as the payback period, the average rate of retum on the book value of the investment, (which is an accounting, rather than a finance concept), and the modified IRR. All of these criteria have weaknesses relative to the NPV criterion that is recommended by this manual and most textbooks in corporate finance theory. 2.4 Ranking Mutually Exclusive Projects with Different Lives According to the third decision rule of the NPV criterion, when there is no budget constraint and when a choice must be made between two or more mutually exclusive projects, then investors seeking to maximize net worth should select the project with the highest NPV. 20 HAPTER 2. "nasecr EVALUATION CRITERIAx Apvancep Maxvat. ox Provscr Evanusniox necnenirar seal a andmusaly xchsive pj shuldhavete ane lengthat life. This section addresses this caveat. The reason for wanting to ensure that mutually exclusive projects ‘have the same length of life when their NPVs are being compared isto give them the same opportunity to accumulate value. One way to think about the NPV is as an economic rent that is eamed by a fixed factor ‘of production. In the case of two mutually exclusive projects, for example, the fixed factor could be the building site, ora right-of-way, or possibly a licence ora copyright. That fixed factor should have the same amount of time to generate economic rents regardless of which project is chosen. ‘What is required is a reasonable and fair method of equalizing lengths of life that can be applied somewhat routinely. This aspect is elaborated with the help of the following three illustrations. Illustration 1: Consider two mutually exclusive projects with the same scale of investment, a two-year Project A and a three-year Project B, that have the following net cashflows. All the net cashflows are expressed in thousands of pesos and the cost of capital is 10 percent. Table 2-5 Net Cashflows of Mutually Exclusive Projects a le ‘Time Period 1s ‘Net Cashilows of A -10,000 6,000 | 6,000 414 Net Cashflows of B 10,000 | 4900 | 4.750 [470 | osm | If we were to overlook the differences in the lengths of life, then we would select Project B because it has the higher NPV. To do so, however, would run the risk of rejecting the potentially better Project A with the shorter life ‘One approach to this problem is to determine whether we might be able to repeat the projects a number of times (necessarily not the same number of times for each project) in order to equalize their lives. To qualify for this approach, both projects must be supra-marginal (ie., have positive NPVs) and should, in fact, be repeatable at least a finite number of times, (e.g. the rebuilding of a dock). Assume that projects A and B above meet these requirements. If Project A were to be repeated three times and Project B twice, then both projects would have a total operating life of six years, as shown in Table 2-6. Table 2-6 Repeating Project Lives to Equalize Mutually Exclusive Projects Time Ls] TTT Project A’s NPV for each repeat’ | 410 j #0 | a0 | 410 Project B’s NPV for each repeat | 500 | I 500 | 500 | Guaprer 2.” Paosecr Evavuanion Crrresia 21Vous 2, Abvaxcen Maxuas ox Provecr Bvanuarion In year t, both projects can start up again, but there is no need to repeat this procedure, Note that the construction of the repeated projects is initiated a year before the expected termintation of the previous project so as to maintain alevel of service, (eg., construction for the second Project B begins in ‘year £3 50 that itis ready to begin operations when the first Project B stops providing service). Given the ‘equal lengths of life for the repeated projects, they can now be compared on the basis of Decision Rule 3: 410, 410 y = AO = pnPi.o29 in 0008) NPV of A's repeats M04 Te ant NPV of B'srepeats = 500 + 2 = PhP876 (én “0008) ap? Given an equal opportunity to eam economic rents, Project A has a higher overall NPV and should be considered the more attractive project. This approach can be generalized by allowing the number of repeats to be equal ton, If j= length of ‘one project, r= the cost of capital, and x =the NPV of one project (at the initial time of investment), the NPV of 2 projects is NPV of nprojects = Gen! Gene Gan (aioe r*) (+n/=1 where the term in square brackets is the formula for the present value of an annuity of w/(/+r)! pet year for m years. Using this formula for a reasonable number of repetitions is acceptable. Illustration 2: ‘The following example illustrates another approach of how to use the NPV criterion in choosing between highly profitable mutually exclusive projects with different lengths of life. Suppose that we wish to use a computer where the following two types of options are to be considered: Duration of Computer Life Alternative A 3 years Alternative B 5 years In this example, suppose there are two viable strategies as follows: Duration of Computer Life () AtAtAHB) 14 years Q) (A*B+B) 13 years PROJECT EVALUATION CRITERIAVouvae 2. _Apvancep Manual, ox Provect EVALUATION In order to make projects comparable for the purpose of evaluation, further adjustments should be made to the 14-year strategy (1) to make it comparable to the 13-year strategy (2). It is necessary to calculate the NPV of the project.in strategy (1) after dropping the benefits aceruing in year 14 while atthe same time reducing the present value of its costs by the fraction PVB14/PVB(1-14). In this way, the present value of the costs of the project is reduced by the same fraction, as is the present value of its benefits (PVB). This makes the longer strategy (1) comparable to the shorter strategy in terms of both costs and benefits. Mlustration 3: This example refers to the case when a choice is to be made between mutually exclusive projects, representing different types of technology with different lengths of life. PROJECT I (TECHNOLOGY 1) Bro Year re PROJECT I (TECHNOLOGY 1) Beck I ve ° 1 2 a 4 5 6 7 8 How can we know which technology to choose using the NPV criterion? Suppose that the present value of the costs of Project I (PV°C!,) is PhP100 and the present value of its benefits (PV°B',.s) is PhP122. Similarly, the present value of the costs of Project II (PV°C",) is PhP200, and ofits benefits (PV'B',,) is PhP225. Ifwe compare the NPVs of the two projects, it would appear that Project Il is preferred to Project 1, because the NPV of Project II is PP25, whereas that of Project I is only PhP22. However, since these two projects represent two different types of technology with different lengths of life, the NPV of Project Il is biased upward. Inorderto make a correct judgment, we need to make them comparable by adjusting the lengths of ite. The first way could be to adjust Project II to make it comparable to Project I The benefits for only the first five years of Project II should be included, and its costs should be reduced by the ratio of the present value of benefits from year 1-5 and year 1-8. This is expressed in the following: NPV!, = PV'BI,,) - VIC) NPV!,S = (PV'BY,) = (PVIC")(PV'B", J/(PVB",,)] Gharren 2.” Pravect Evatuatton CRITERIAApvaxcep Manual, ox Prova Evatwranion Vou 2. Plugging in the values of costs and benefits of the two projects in our example, we have: PVeBY,, = PhP225; PV°C", = PhP200; (PV°B",,) = PhPIS Hence, the NPV', = 122 - 100 = PhP22 ‘The NPV", = 180 - 200(180/225) = 180 - 160 = PhP20 After the adjustment, the NPV of Project I is greater than that of Project I which means that Project Iis better. The second way to make the two projects comparable would be to adjust the length of Project We need to calculate the NPVs of Project I (adjusted) and Project II. We will adjust the NPV of Project I by doubling its length of life. Then the benefits of years 6-8 are included together with the benefits of years 1-5. The costs are increased by the value of the costs to lengthen the project to year 8, which is the present value of the costs in year 5, reduced by the ratio of the benefits of years 6-8 and the benefits of years 6-10. Bice PV°BIg 19 = 10 Ceo PVPBI,. PV°BIy = 60 Year 0 5 $ 0 PV9CIs = 80 PV CIy= 100 This adjustment can be expressed as follows NPV!,. = PV'BI,, - PV'C, + PV'B,,. - PVC! (PV'B',,(PV'B', ,,)) Plugging in the values of costs and benefits of the two projects in our example, we have: NPV", = 225 - 200 = PhP25 ‘The NPV!,* = 122 - 100 + 60 - 80(60/110) = PhP38.36 Using this method, we still have the net present value of Project I greater than that of Project II ‘Therefore, Project I is preferred to Project II. 24 (Cusprax 2.” Puovecr Evanuarion CarreiaVoume 2, Apvaxcep MANUAL ON Prayer EVALUATION 2.5 Optimi: g a Project’s NPV ‘The NPV criterion requires that a project analyst recommend only projects with positive NPV. The next step isto endeavor to maximize the NPV. The reason for trying to maximize the NPV is to extract ‘as much value from the project as possible. Ideally, we should strive to maximize the NPV of incremental net economic benefits. Of course, optimization cannot be pursued blindly; there may be repercussions for other stakeholders and/or changes in the magnitude of the externalities that accompany any changes in parameters like the date of initiation ofa project, its scale of investment, or its length of life 2.5.1 Optimal Timing TInmany cases, the time when a project actually begins isa somewhat arbitrary decision. The starting time, however, may have a significant impact on the NPV of the project. If, for example, a project is intended to add to the existing capacity so thatthe service may be expanded to more individuals or overa ‘wider area, the timing can be very important. If the project was built too soon, then there could be idle ‘capacity; the forgone economic return from leaving the funds inthe capital market could exceed the intial ‘benefits in the early years, which would lower the project’s NPV. Similarly, ifthe project was built too late, then shortages or unwanted congestion could result in a comresponding reduction in the NPV of net economic benefits. The challenge is to add the right amount of capacity at the right time in order to extract the maximum advantage. ‘What needs to be examined is how the anticipated net economic benefits change in relation to their present values as time goes by. Since we are considering net economic benefits the relevant cost of capital is the economic opportunity cost of capital to the country as a whole, or economic discount rate. Two broad classifications of investment projects are discussed, namely: ‘Type I: These projects have anticipated net economic benefits that are a continuously rising function of calendar time, but not of the age of the project. Examples would include natural gas supply, electricity supply, road improvement, and telephone service projects, where net ‘economic benefits rise as population, or any accompanying growth in vehicular traffic etc, increases. (see Figure 2-4) ‘Type 2: The anticipated net benefits are determined by calendar time and not by age of the project, but the anticipated net benefits initially rise and then later decline through time. Examples would include consumer-good projects, where technology, tastes, or styles change through time, ot projects where competition is expected to erode the sales of the project proponent. (see Figure 2-5) “The optimal timing problem for Type-1 projectsis depicted in Figure 2-3. The inital capital expenditures are represented by the area K in the lower (negative) half of the diagram. The net economic benefits, ‘which are independent ofa project's age, are shown as the steadily rising line in the (positive) upper half. ‘Also drawn in the upper half is a line at the level r, that is the annual economic cost of the capital ‘measured in terms of pesos (the economic opportunity cost of capital times the capital expenditure). As drawn, the net economic benefits are initially less than the annual economic cost of capital, but as time passes the net economic benefits rise above the annual opportunity cost (Caaprae 2.” Paosscr Evatuation CrrreniaVoume 2. What is the optimal date of project initiation? If the project were to begin in time period to, then construction would last for a year, and the project would come on stream in time period t, .. The net ‘economic benefits in that year would bethe area B, which is less than rK. Clearly, the funds invested (K) ‘would earn more for the economy in the capital market than ifthey were used to start the project. Since the net benefits continue to grow over time, a project would appear to become more atractive the longer the delay. However, to postpone the start-up too long would be to forfeit some net gains and reduce the ‘overall NPV. Following this logic, the optimal start date would occur when the first period's net economic benefits just exceeded the annual peso cost of capital. In Figure 2-3, this would occur if construction were to begin in time t, so thatthe following year’s net benefit B, is greater than rk. Figure 2-3 Timing of Projects When Potential Benefits Are A Continuously Rising Function of Calendar Time but Are Independent of Time of Starting Project Benefits and Costs Bw ‘k Time PG SBua FK,>Byay » Postpone PKB = Start 26 (Chuapren 2." Prosecr EvaruaTion GeemEnia‘The decision rules for the optimal start date of a Type-1 project are based on the principle that the incremental benefits should exceed or equal the incremental costs. The following rules address various sub-cases: Decision Rule 1: Ifa Type-I project's gestation period is one year and the capital costs (K,) are constant overtime, then start construction in year ‘such that B_ > rK Decision Rule 2: If a Type-1 project’s gestation period is one year and the capital costs (K,) are increasing over time, then start construction in year fsuch that B+ (K_ -K)> 1K. ‘The term in parentheses represents the savings of the increase if capil cbets by commencing in year f, which adds tothe incremental benefits of starting in year. This decision rules illustrated in Figure 2-4. Decision Rule 3: If a Type-1 project's gestation period is j years and the capital costs (K,) Guarsen’ 2) are increasing over time, then start construction in year such that Busjrt +(K%,,-K?) > 1K? The term in parentheses represents the savings of the increase in capital costs that adds tothe incremental benefits of stating in year Figure 2-4 ‘Timing of Projects ‘When Both Potential Benefits and Investments Are ‘A Function of Calendar Time Benefits and Costs rk, Time 1K,>Baos* (Keer Ki) Postpone 1K, Start Provict EVALUATION CerTERIA 27‘The criterion in decision rule 3 is a bit more complicated. The amount K,;,, represents the sum of ‘the future values of the annual capital expenditures initiated in year r+1 and accumulated to the end of the gestation period of j years. Similarly, the amount K ; represents the sum of the future values of the annual capital expenditures initiated in year ¢ and accumulated to the end of the gestation period of ‘years. Since these capital expenditures are assumed to rise over time, the term in parentheses represents a cost-saving that adds to the net benefits of starting in year t. For example, if the investment phase of a project is expected to last j= 3 years, then Ki, = KIO + P+ KR U4N4+Ki9 and KI =Ki(4 rf + K+ + Ke", ‘where the superscript on K indicates the date of initiation. IB, + (Ki,,-K") < FK} continue to postpone th project until the net gain fom undertaking the projet imei positive, ‘The optimal timing for Type-2 projects is made more complicated as a result of the assumption that, net economic benefits that are independent of the age of the project are expected to increase at first, but later to decrease with calendar time. The decision rules for the optimal start would be similar to those for Type-I projects. In Figure 2-5, the correct point to start the project is ty, when rK,< By . The difference here is, instead of being able to assume that a project will last for its anticipated lifetime, however, early abandonment could be optimal. Project proponents will generally want to continue operating a project as long as the incremental benefits from continued operations are greater than or equal to the incremental costs. In this ease, the ineremental costs come from neither being able to liquidate the net working capital nor to scrap the fixed assets and invest the proceeds in the capital market. The return from this investment would be equal to the economic opportunity cost of capital to the economy, times the salvage value of the assets (77), In Figure 2-5, B,>rSV,,, so it would make sense to stay in business during t,, but in t,,,. By, < ‘would make more sense to shut down operations at the end of t, when we have rSV,, >0 ~ Bossy ~ ASVVout 2. Apvaxcep Maxual, ox Provact EvaLwanion Figure 2-5 Timing of Projects When Potential Benefits Rise and Decline with Calendar Time « Start if Ky< Bier Stop If: FSV4.—Boges)- ASV >0 B In general, for Type-2 projects, we should do a project if the following condition is met: 1 mB A NPV = 2 ent * Gael >0 Ifthis condition cannot be met and NPVi = 3 —# Sh + <0, then we should not ree er ary do the project. Ifa project does not fallas type-I or type-2, and there is no set pattern of benefits and costs, then we have a situation depicted in Figure 2-6. In this case, we have to calculate NPV at the beginning ‘of each successive time periods and start when NPV is maximum. Caarnix 2.” Prosact Evatuanion Cammeiia 29°me 2. Apvaxcep Manual. on Prosecr Evatuarion Figure 2-6 Timing of Projects ‘When Patterns of Both Potential Benefits and Costs Depend on Time of Starting Project Benefits and Costs 2.5.2 Optimal Scale of Investment Project managers will also need to decide on the scale of investment (i., on how big a plant to build or how much output capacity the project should have). This question should already have arisen during the technical analysis because many of the issues that determine a project's average ‘costs are technological in nature. Although technological factors may determine many scale issues, the size of the market, the availability of project inputs, and the quality of managerial skills, among, others, will also have a role to play. That is why a general approach to the choice of optimal scale ‘would require that the ineremental net economic benefits of an increase in scale be compared to the incremental net economic costs. I the incremental benefits are greater than the incremental costs, then an increase in scale is warranted. This is consistent with the maximization of the NPV of incremental net economic benefits. The choice of optimal scale is fundamentally an economic question, nota technical one. ‘The goal of maximizing the NPV of incremental net economic benefits may have financial repercussions that need to be taken into account. For example, a government-owned and controlled clectricity-generating corporation may be planning to add a new coal-fired thermal plant to its capacity Froma financial perspective, a400-megawat plant appears to be optimal. The problem is that a financial analysis will normally exclude consideration of any negative environmental externalities duc to pollution, acid rain and deforestation, etc. Since these extemalities are taken into account in an economic analysis, and since the decision of how much capacity to build should be taken in the best interests of Filipinos in general, trying to maximize the NPV of incremental net economic benefits makes sense. However, if this economic analysis yields a conclusion recommending a plant of smaller scale? then the NPV of incremental net cashflows could be lower due to higher long-run average fixed costs. ‘Other conclusions are also possible. It may be more economically beneficial to add emission-control equipment to the stacks of the thermal plant; however, most such measures sill add to financial costs Gnarnin’3.” Baanecr Evatiation CxireniaVoume 2. Apvan Higher costs could result in higher electricity prices that would in tun reduce electricity demand and possibly the NPV of net economic benefits. All of these considerations need to be taken into account in the choice of optimal scale. The distributional analysis may also reveal that specific «groups have been adversely affected by a reduction in scale, and some compensation may be required. ‘The optimal scale of facility can be determined by continuing to add to capacity so long.as the NPV of the incremental economic benefits from the additional scale is greater than or equal to the NPV of the incremental economic costs. This theme is captured by the following decision rules that define the relationship between NPV and optimal scale. Decision Rule 1: Choose the scale of investment that maximizes the NPV of the incremental net economic benefits. Decision Rule 2: The NPV will be at a maximum when the change in the NPV for a given change in scale is equal to zero (this rule is just the first-order condition for a maximum). Decision Rule 3: Set the marginal IRR from an addition to scale equal to the cost of capital for the economy. The marginal IRR (’) is the discount rate that sets the change in the NPV from a given change in scale equal to zero. In this sense, Rule 3 is very similar to Rule 2 ‘The optimal scale of plant is not that scale that maximizes the average IRR. These rules are illustrated in the context of determining the optimal scale for an irrigation dam (ee Table 2-7). The net economic benefits are measured in thousands of pesos and are assumed to be perpetual with no recurring capital costs. The relevant cost of capital is 10 percent. The top half of Table 2-7 presents the net economic benefits associated with each likely scale of dam, based on engineering data from the technical analysis of the project. The last two columns calculate the NPV and average IRR for each scale. ‘The bottom-half of Table 2-7 displays the incremental economic costs and benefits associated with change in scale. After te initial investment, each subsequent addition to scale increases capital costs by PhP million pesos. The net economic benefits also increase with additions to scale, but the increase is lower for each subsequent addition, The last two columns present the change in NPV (ANPY) and the ‘marginal IRR. Chaprer 2.” Prosecr EvatvaTion Crrrania 31‘Voume 2. Apvanceo Maxvat on, Prosecr EvaLuanion, Table 2-7 Determination of Optimum Scale of An Irrigation Dam Time | 0 1 2 3 ats Td Seales: | Costs Benefits Nev | IRR s) 3000 | 20 | 250 | 290 | 290 | 250 500.083 S| 4000 [390 | 390 | 30380 | HP 100 | 008 8, 5000 | 40 | 50) 500 | so | 500 #0__| 0108 Ss, on | 60 | 6m | om | on | 6m m0 ali 8, =| 75_| 75 | 75 | 75 | 7s 750 | 01m 5, 300 | 65 | S| 8S | as | 0] 0108 Time 0 1 3 [| 4 [5 Changes in Costs Incremental Benefits -3000 | 250 | 250 | 250 | 250 | 250 =1000 | 140 | 140 | 140 | 140 | 140 CL =to00 | 150 | 150 | 150 | 150 | 150 -1000 | 130 | 130 | 130 | 130 | 130 -1000 | 105 | 105 | 105 | 105 | 105 { {100 [ 90 [90 [| 90 | 90 | 90 =100 | 0.090 ‘Opportunity cost of funds (Giseount rate) = 10% Depreciation rate ofthe dam =O ‘Amounts in PRP thousands |As indicated above, the marginal IRR (p' ) is the discount rate that sets the change in the NPV froma given change in scale equal to zero. For example, moving from scale S, to Sp has @ ‘marginal IRR of 15 percent that can be solved by using the formula for the NPV of a perpetuity as follows: ANPV(S, ~5)=-1000+ 4 Solve for p'=0.15. By contrast, the average IRR (p) is solved using the evel of, rather than the change in, the net economic benefits. From the top half of Table 2-7, the average IRR for scale S, is 10.8 percent, which was calculated as follows: NPV(S;) ~sa00 + 0 Solve for, 0.108,Vous 2. Apvancep MANvaL on Prouscr Evatvanion ‘We are ready to apply our decision rules to determine the optimal scale forthe irigation dam. Rule | says choose the scale of investment that maximizes the NPV of net economic benefits. That would mean choosing scale S, since its NPV = PhP750,000 is highest. Rule 2 indicates that a maximum NPV will ‘occur when the change in NPV is greater than or equal (close) to zero. AS we increase the dam from S, to S,the ANPV = 50, but the additional investment required to grow from S, to S, would have a negative ANPV. These results indicate that S, must be a maximum, Finally, the optimal scale should ‘occur when the marginal IRR is equal to the cost of capital forthe economy, assumed to be 10 percent. This also occurs at scale S, . Any larger scale of dam would have p'' . Phy Plovcvssee pt This pri e level p* can be calculated for any period (1) as follows: Pi7y, (Pla) Equation 3-1 where: j denotes the individual good or service included in the market basket; denotes the price of the good or service j at a point in time; 4, denotes the weight given to the price of a particular good or service (j); and Ea, =1 The weights used for calculating a price level are defined as of a certain date. This date is referred to as the base period for the calculation of the price level. The weights established at that time will rarely change because we want to compare the level of prices of a given basket of goods between various points in time. Hence, the nominal prices change through time in Equation 3-1, while the weights (0, Ojy..t,) are fixed. Instead of calculating for an entire economy, a price level may be created for a certain subset of prices such as construction materials or consumer goods. It is generally useful to express the price level ofa basket of goods and services at different points in time asa price index P/ The price index simply normalizes the price level so that in the base period, the index is equal to one. In other words, if we wish to calculate a price index that compares the price levels within two distinct periods, we ‘can write the equation as follows: Pie PIPE Equation 3-2 where: P{ denotes the price level in period (1); and P2 denotes the price level for the base period. For example, the consumer price index is a weighted average of the prices for a selecied basket of consumer goods market . The investment price index is created as a weighted average of the prices for goods and services that are investment in nature. The change in the price index for a broad set of goods and services is used to measure the inflation rate in the economy. Garren’ 3." Conceers in Bivanciay ANALiSIS 3512 2. AbvaNceD Manual. ow Prosucr Evatvanion Real Prices Real prices P/, are an important subset of relative prices where the nominal price of an item is divided by the index of the price level at the same time. They express prices of the goods and services relative to the general price level. This is shown by the following expression: Php = PIPE Equation 33 were: Py = nominal price ofa god o sevice atime and FE = price Level index atime period ¢ Dividing by a price level index removes the inflationary component (change in the general price level) from the nominal price. This allows us to identify the impact of the forces of demand and supply on the price of the good relative to other goods and services in the economy. Price Changes The two forms of price changes, which an investment appraisal must account for, are changes in relative prices and changes in the price level, or inflation. The factors which determine the future changes in the general level of prices are quite distinct from those which determine changes in relative prices. Changes in relative prices are determined by changes in the market demand and/or supply for these items. Increases in the general level of prices, on the other hand, are usually determined by the growth of the country’s money supply relative to the growth of its production of goods and services. This process is generally beyond the responsibility of the project analyst. However, trends in the growth of prices and the recent history of monetary policy will often provide a substantial basis for the construction of forecasts of the general rate of inflation and future prices. Changes in Real Prices The percentage change in the real price of a good or service can be expressed as; 1 Pin Pin AP = fot Equation 3-4 Pa where Pl, denotes the real price of good j as of a specific period. ‘Aset of projections for each input and output must be prepared in the path ofits real price over the project’ life. For items where rapid technological change takes place, such as computer technology, real prices are expected to fall. For goods such as copper, whose primary use was dramatically reduced by the introduction of fiber optics and microwave transmission, real prices are expected to dampen over time. The real wage for labor of most types almost increases if the country sees an economic development. With development taking place, the value of labor rises relative to other goods and Ghunoren’3."” Conceers iN Financial ANAivISVouwwe 2. Apvancen Manual. ox Provecr Evanvariox services. Hence, in forecasting real prices for a project, the potential for real wages to rise should be considered and built into the cost of inputs over a project’ life, Changes in Price Level (Inflation) Inflation is measured by the change in the price level divided by the price level at the beginning of the period. The price level at the beginning of the period becomes a reference for determining the rate of inflation throughout that particular period, Hence, inflation (gP*) for any particular period can be expressed as: gs = Pi-PS x 100 Equation 3-5 Inflation is more difficult to forecast than changes in real prices because it is primarily determined by the supply of money in an economy, relative to the availability of goods and services. Money supply, in turn, is often determined by the size of the public-sector deficit and how it is financed. ‘When governments finance their deficit by borrowing heavily from the Central Bank, inflation is inevitably the end result. In evaluating an investment, an accurate forecast of the inflation rate is not needed. What is essential is the consistency of all other assumptions about the project’s financing and operation with the assumed rate of inflation. In most countries, inflation rate isa risk variable that must be considered in the project’s financial design. The historical rate of inflation may only be 5 percent or 6 percent, but itis better ifa project can survive with a higher inflation rate. Ifthe analysis demonstrates that the project would be severely weakened, it could be redesigned to better withstand such unanticipated rates of inflation. In sum, accurate forecasts of inflation rates are beyond the project analyst's responsibility. ‘Hence, variations in the inflation rate should be tested using sensitivity and risk analyses to determine ‘whether or not the project is strong enough to withstand a possible range of inflation rates. Inflation-Adjusted Values Inflation-adjusted values for prices of inputs and outputs are the result of our best forecast of how real prices for particular goods and services are going to move in the future. This forecast is then adjusted by an assumed path of the general price level over future periods. In other words, we are producing a set of nominal prices which are built from their basic components of areal price and 1 price level. These inflation-adjusted values are generated consistently. Project evaluators often ‘wrongly assume that many of the prices of a project's inputs and outputs are increasing relative to the rate of inflation, which is unlikely. The price level itself is a weighted average of prices of individual goods and services. Hence, in the forecast of the real price of goods and services, expect about as many real prices to be falling as they are rising. ‘To forecast the movement of the real price of a good or service, we need to consider factors, such as anticipated change in the demand for the item over time, available supplies, and forces that would affect production cost. This analysis is very different from the one used in the forecast of the Giiseren’ 3.” Concerts in Facian Axarsis 37Vouume 2, ApvaNcep MaNuaL ox Provecr EvaLuation ‘general price level. This forecast is nota prediction, but set of consistent assumptions. The inflation- adjusted values are used in the estimation of the project’s nominal cashflows. They can be estimated using the following equatio PE = Pes gyi ter9 Equation 3-6 Where P41 denotes the estimated nominal price of good j in year +1; P! denotes the nominal price of good in year f; fi, denotes the estimated growth in real price of good; and gP denotes the assumed growth in price level index from year to year +1 ‘Nominal Interest rate ‘The most important feature for integrating expectations about the future rate of inflation (gP,*) into the project evaluation is to ensure that such expectations are consistent with the projections of ‘the nominal rate of interest (), In the absence of fixed nominal interest rate loan agreements, lenders will increase the nominal interest rate on the loans to compensate for the anticipated loss in the real value ofthe loan caused by inflation. As the inflation rate increases, the nominal interest rate increases. This is to ensure that the present value of the interest and principal payments will not fall below the initial value of the loan, ‘The nominal interest rate (), as determined by the financial markets, is made up of three major components: (a) the real interest rate (7) which reflects the real time value of money that lenders require in order to be willing to forego consumption or other investment opportunities; (b) a risk factor (R) which measures the compensation lenders demand to cover the possibility of the borrower defaulting on the loan; and (¢) a factor (I+r+R)gP* which represents the compensation for the expected loss in purchasing power attributable to inflation. The expected inflation rate, gP,*, reduces the future value of both the loan repayments and real interest rate payments. Combining these factors, the nominal (market) rate of interest (i) can be expressed as: ier+R+(+r+R) ere To explain this concept, let us consider the following financial scenarios. When both risk and inflation are zero, a lender would want to recover at least the real time value of money. If the real interest rate (+) is 5 percent, then the lender would charge at least 5 percent nominal interest. However, ifthe lender anticipates that the gP* will be 10 percent, the lender would want to increase the nominal interest rate charged to the borrower in order to compensate for the loss in purchasing power of the future loan and interest rate payments. Maintaining the assumption that there is no risk to this loan, we can apply the above equation to determine what nominal interest rate the lender would need to charge to remain as well-off as when there was no inflation. r+R4(l+r+R) gh (0.05) + (0) + (1+ 0.05 + 0)0.10 = 0.155 or 15.50% Chinen’ 3. Conctrs inv Biwancrar, ANALYSIS‘Thus, the lender will need to charge a nominal interest rate of at least 15.50 percent to achieve the same level of return as in the zero-inflation scenario. Generally, the real rate of interest will bea fairly constant value because itis primarily determined by the productivity of investment and the desire to consume and save in the economy. Also, the value of the risk premium for the various sectors and investors is typically known. Given the real interest rate, the risk premium and the nominal interest rate, the expected rate of inflation which is implicit in the nominal interest rate can be estimated by rearranging the above equation as follows: gah = (i-r- RY br +R) If the rate of inflation is expected to change through time, and refinancing of the project's debt is required, then the nominal interest rate paid must be adjusted to reflect this new expected rate of inflation. This should have little or no direct effect on the overall economic viability of the project as ‘measured by its NPV; however, it may impose very severe constraints on the liquidity position of the project because of its impact on interest and principal payments if not properly planned for. Expected (nominal) exchange rate A key financial variable in any project using or producing tradable goods is the market rate of exchange (E™) between the domestic (pesos) currency and the foreign currency. This market exchange rate is expressed as the number of units of domestic (pesos) currency (#D) required to purchase one unit of foreign currency (F). ‘The market exchange rate is the current nominal price of foreign exchange. The market exchange rate needs to be projected over the life of the project. The market rate between the domestic (pesos) currency and the foreign currency can be expressed at any point in time (1) as: EN = (#D,,,./P), The difference between the real price and the nominal price ofa good at a given point in time, {lies in the cumulative inflation measured from an arbitrary fixed point in time, t,, to the time of interest, t,.. If we were to choose the arbitrary fixed point in time to be the same as the time of interest, there will be no difference between the real and nominal prices. For convenience, when conducting the financial appraisal of a project, we can select the first year of the project, t, ,as the arbitrary reference point. Consequently, the market exchange rate and the real exchange rate will be equal for that year, t, . The cumulative inflation for the domestic country over a period of time is given by the domestic price index IP. If we continue to use the reference year, t,, a3 the base year, the domestic price index at any point in time t, , can be expressed as the cumulative change in the price level from time t, tot, . This is given as follows a+e™* Similarly the foreign price index at any point in time t,, using the same reference year, t, as the base year, can be expressed as the cumulative change in'the price level from time t, to t, This is given as follows: F 17 H+ 2”) tn tal toss Giasten’ 37” Concerts IN Financial ANALYSIS 33°where g* is the rate of inflation in the foreign economy. The real exchange rate, Ey, can be defined as following: ne = Ex x ( where Fi denotes the market rate of exchange in year t, ; and Ex denotes the real exchange rate in year t, From this, we can calculate nominal exchange rate as 7 ze Mores) Equation 3-7 The real exchange rate will move through time by the forces of the country’s demand and supply for foreign exchange. From the point of view of the project analyst, itis very difficult to predict the ‘movement ofthe real exchange rate unless itis being artificially maintained ata given level through tariffs or quantitative restrictions on either the supply or demand of foreign exchange. If the rate is not artificially maintained, the analyst can take the real exchange rate as constant throughout the life of the project. Consequently, the expected market exchange rate in year t, , may be estimated. The ratio of the two price indices is known as the relative price index. If through time the domestic economy faces a rate of inflation different than that of its foreign trading partner, the relative price index will move over time. Ifthe real exchange rate, E", is constant in the presence of inflation, then the change in the relative price index must result in an equal change in the market exchange rate. Since the future real exchange rate is only likely to be known with some uncertainty, and the market exchange rate might not adjust instantaneously to changes in the rate of inflation, it is more realistic to allow some flexibility in the estimation of the market exchange rate. This is carried out by assuming a range for the distribution of possible exchange rates around an expected mean real exchange rate. To incorporate this aspect, we write the above equation as follows: Hog ae) 1 Mog* xaem mY sfe 10 +0 avg, rt where kis a random variable with zero mean, ‘To demonstrate the use of this equation, suppose that the market exchange rate in period t, is PhP10 per US dollar, the domestic price index is 200, and the US price index is 150. The real exchange rate can be calculated as: E*= 10 x (150/200) = 7.5 pesos/dollat.Let us now assume that over a 10-year period of time, the cumulative amount of inflation is assumed to be 60 percent in the domestic currency and 40 percent in USA. Hence, the predicted ‘market exchange rate in 10 years will be equal to: =755 (200/150) [(1 + 0.6)(1 + 0.4)] = 10(1.6/1.4)= 160/14 = 11.4 pesos/dollar 3.1.2 Use of Nominal Prices in Financial Analysis ‘The effects of inflation on a project’s financial condition include: 1. direct impacts from changes in investment financing, cash balances, accounts receivable, accounts, payable, and nominal interest rates; tax impacts including interest expenses, depreciation and inventories; and 3, the impact on the market exchange rate Inflation alters the amount and timing of the financial gains and losses of the various parties involved in a project, including the owner(s), the lender(s) and the government. Correct accounting for those changes is necessary to determine how the overall project, and each of the interested parties, is affected by different levels of inflation 3121 Direct Effects (® Investment Financing When estimating the amount of financing required in an investment project, it is important to distinguish between two types of cost increases. First, there are cost overruns which are caused by incorrect estimates of the quantities of materials required or changes in the real prices of those materials. Second, there is cost escalation which is attributable to general price level inflation. The “escalation” of eosts that stems from pure price inflation should be normal and if possible, should be anticipated and included in the project appraisal. Ifthe project requires a loan or equity financing for fature outlays, the amount of financing needed will be affected by the amount of price inflation that takes place during the time of construction. Cost increases attributable to inflation are not overruns of real costs. Therefore, additional borrowing that simply reflects the rise in the general level of prices should be planned for. Ifthe probability of additional borrowing is not adequately planned for at the appraisal stage, the project may experience a liquidity crisis or insolvency due to inadequate financing, Table 3-1 demonstrates the effects of inflation on investment financing, All values are given in pesos. The project will be built during the first two periods, operated for the following four periods, and then liquidated in the final period. The total cost of construction will be capitalized at the end of the second period to determine the amount to be depreciated. Loans are obtained for 50 percent of the investment in fixed assets. Loan financing will have a nominal interest rate of 5 percent per period if there is no inflation, and interest will begin accruing during the construction period, The loan principal will be repaid at the end of period 5, the last operating year of the project. The rest of theVouse 2 Apvancep Manual. on Prosecr Bvatuanioy financing requirements are covered by the owners’ equity, In this project, an investment of PhP5,000 is made in fixed assets in year 0, and if there is no inflation, a further PhPS,000 investment is made in year 1. If inflation is set at 25 percent a year, the initial year’s investment does not change. However the nominal investment undertaken in year 1 increases to PhP6,250. Table 3-1 Project XYZ Financing 1. Price index 1.00 Investment Outlays | 5,000 inflation = 25% [3. Price tadex |4 Investment Outlays — |S. Tmpact on Financing [Requirements The presence of inflation increases the nominal amount of the investment financing required by PhP1,250 even when there are no increases in material needs or costs. For a 25 percent inflation rate, total nominal project costs increase from PhP10,000 to PhPL1,250 or by 12.5 percent. ‘The increased investment expense has three effects: (a) it increases the interest costs to the project; (b) it increases the nominal amount of loan principal (50 percent of nominal investment costs) which must be repaid by the project; and (c) it results ina larger nominal depreciable expense that will be deductible from future taxes, These effects have positive and negative cashflow impacts which are discussed below. (ii) Desired Cash Balances Cash balances are held by a project to facilitate transactions. A commercial enterprise will need to maintain an amount of cash on hand related to the value of sales and purchases it carries out. Ifthe demand for cash balances is a function only of the level of sales, and sales remain constant with no inflation, then after initially setting aside the desired amount of operating cash, no further investments in the cash balances would be required. However, when there is inflation, the sales, receipts, and the cost of the goods purchased will go up even if the quantities of goods bought and sold remain the same. The resulting loss in the purchasing power of cash balances is referred to as an “inflation tax” ‘on cash holdings." Its primary effect is to transfer financial resources from the project to the banking sector. In such a situation, the project will have to either increase its cash balances in order to conduct operations or to substitute more physical resources (e.g,, labor, etc.) to carry out these transactions. Jenkins, Inflation: Its Financial Impact on Business in Canada, (Ottawa, Beonomic Council of Canada, 1977), p.2s.The effects of an inflation tax on cash balances can be demonstrated using a simple comparison of two cases. The first case (Table 3-2) shows the cash situation for a project operating in an environment where there is no inflation. Sales will be PhP2,000 for each period from 2 through 5, and the desired cash balance is equal to 10 percent of the nominal value of sales. Hence, given the absence of inflation, after the initial PhP200 is placed in the cash account, there is no need to increase that balance. The present value of the cost of holding cash by the project is PAP-41 (Table 3-2, item 6). Table 3-2 Project XYZ Cash Balance Period o fi 2 Stan sae Inflation = 0%; Desired cash balance = 10% of sales 1. Price Index {e1)| 1.00 | 1.00| 1.00 | 1.00 | 1.00 | 1.00 | 1.00_| 2. Sales [0 | 0 [2,000 [72,000 | 2,000 [2,000 0 3. Desired Cash Balance 0 {0 | 200 | 200 [ 200 | 200 [0 4. Change in Cash Balance Tilo {0 | Go| 0 | 0 | 0 | 200 3. Real cashflow impact [r471] 0_|-0 | 200100101300} 6. Present value of holding cash @ 7%= GI) | However, if the inflation rate increases by 25 percent per period (Table 3-3), the cash balances ‘must be increased to keep abreast of the increasing nominal value of sales. For the purpose of this example, we assume that the number of units sold remains the same but their nominal value increases by 25 percent a year due to inflation. As a result, the desired stock of cash balances will increase, requiring an additional investment of cash in the project during each period if the desired level is to be ‘maintained (Table 3-3, item 4). After deflating these costs for inflation and discounting them, we find that the present value of the cost of the cash needed to run the business has increased substantially. ‘Table 3-3 Cash Balance with 25% Inflation Period ofiy2 [3 | | Inflation = 25%; Desired cash balance = 10% of sales 1 Pie index vas] age [195 [aaa [a0 [aan] 2. Sales 0 | 3,125 | 3,906 | 4,883 | 6,104 0 5: pane Ca ate 00 Sets to | £Chanein Cs Bulae [ef] 0-019) 8m) 21a Sper eho ipa [RTD 0-800) a) | GO 16. Present value of holding cash @ 7% = (159) Giiaprag’ 3." Concerts N FINANCIAL ANALYSISWith zero inflation in Table 3-2, the present value of the cost of holding real cash balances was PhP-41, However, when the inflation rate is 25 percent, the present value of the cost of maintaining the same level of real cash balances will be equal to PhP-159 as shown in Table 3-3, item 6. This 288 percent increase in the cost of holding cash demonstrates clearly that in an inflationary environment, the need to continuously add to the stock of cash balances will add to the real cost of the project. Hence, project evaluators should incorporate a number of inflation projections in order to determine the sensitivity of total costs to the impact of inflation on the cost of holding the desired level of real cash balances. (i Accounts Receivable Accounts receivable arise from making credit sales. When goods are sold and delivered but the enterprise is still awaiting payment, the value of this sale is added to accounts receivable. Such credit sales are part of the normal process of conducting business. However, in the presence of inflation, the real value of the amounts owed to the seller decrease the longer they are left unpaid. This creates ‘an additional financial problem for the management of the enterprise, because they must be concerned not only with the normal risk of default but also with the fact that the receivables are falling in real value the longer they are left unpaid. ‘Table 3-4 demonstrates the interaction between inflation and accounts receivable and the impact that the interaction has on cash receipts. As the inflation rate rises, the value of sales increases due to the higher prices of the goods, even when the number of units sold remains unchanged. This generally leads to an increase in the amount of accounts receivable. In this case, it is assumed that receivables will be equal to 20 percent of sales. Table 3-4 Accounts Receivable Period [a [3 tats le [Inflation = 0% [1 Sales 2,000 | 2,000 | 2,000 [2,000 [0 2. Accounts Receivable (AIR) (3. Change in (AIR) 4. Real Receipts [1113] Tnflation = 25% 5. Price Index (6. Sates 7. Accounts Receivable (A/R) 8. Change in (/R) 9. Nominal Receipts [r6+8] TOReal Receipts [9/5] [1-Change in Real Receipts [r10-r4] | 12.Present value of the el 400 | 400 | 400 | 400 | 0 400) | 0 | 0 | 0 | 400 | 1,600 | 2,000 | 2,000 | 2,000 | 400 125 | 156 | 195 [244] 3.125 | 3,906 | 4,883 62s 781_| 977 [1 1625) | 156) | (195) 2,500 | 3.750 | 4,688 1,603 | 1,923 | 1,921 ~ |e) | 9) | 79) | ge in real receipts @ 7% = (233) ‘Gakrnia'3." Concerts in Bisancrar ANatsisIn spite of the fact that the nominal value of sales increases each period when there is 25 percent inflation, Table 3-4 demonstrates that the present value of the real receipts for this project decreases by PhP233 due to the higher rate of inflation, This is because inflation causes the real value of outstanding trade credit to fall. In this situation, businesses selling goods or services the project in this case) will attempt to reduce the length of the terms they give for trade credit, while businesses purchasing the product will have an additional incentive to delay payment. Ifsellers are not successful in reducing the terms they give for trade credit, they will have to increase the price ofthe goods they sell above what would be justified by the rate of inflation. Therefore, itis important to include in a project evaluation the interaction of inflation and accounts receivable to determine how the real receipts of the business are affected by inflation. (iv) Accounts Payable Accounts payable represent the amount of money owed by a business to others for goods or services already purchased and delivered. When there is inflation, the buyer with the accounts payable benefits from having an outstanding balance because the real value of the obligation is falling during the period of time prior to the payment. This is simply the other side of the impact of inflation on accounts receivable because one enterprise’s accounts receivable is another’s accounts payable, Table 3-5 shows how inflation affects a project's financial situation when accounts payable are equal to 25 percent of annual purchases. Once again, we see that inflation increases the nominal value of purchases which leads to greater accounts payable. The increased rate of inflation results in a net decrease of PhP1SS in the present value of real expenditures. As shown in Table 3-5, item 6, inflation increases the nominal value of purchases, and creates a corresponding increase in nominal accounts payable in item 7 of the same table. When converted to real expenditures, the buyer (the project in this case) benefits from the effects of inflation on accounts payable and will have a lower overall level of expenditure, as shown in Table 3- 5, item 11. This gives the buyer an incentive to extend the terms of the accounts payable to benefit from their falling real value. Hence, in the presence of inflation, the longer the outstanding accounts payable are held before being paid, the greater the benefit accruing to the buyer. Table 3-5 Accounts Payable Period oy i 2 J 4 sve] |Unflation = 0% | 1. Purchases of Inputs ino 1,000 [1,000 | 1,000- 2. Accounts Payable (A/P) filo. 250 | 250 | 250 3. Change in (A/P) aaa [si] a0) o | 0 0 [ |_4, Real Expenditures {rl413] __{ré]| 0 1,000 | 1,000_| 1,000 | 250 | 0 | Inflation = 25%, |S. Price Index _ —[r5]|_1.00 1.25_| 1.56 1,95. 6, Purchases {16} 0. 1,250 | 1,563 | 1,953. 0 ts Payable (AR) fe7}_o aia | 301 | age | aio | 8. Change in (A/P) oo . (313) | (78)_| (98) 122) | 610 | 0 9. Nominal expenditures [r6+r8] _[r9]'_ 0 937 [1,485 | 1,855 | 2319 | 610 | 0 | 10.Real Expenditures [19/5] __{rl0]_0 | 750| 951 [951 | 951 | 201 |-0 Change in real expenditures (r10-r4]|_0_| (49) | (49)_|_@9)_| 49) | 0. 12,Present value of the change in real expenditures @ 7%=(155) Gaapran’ 3." Concerts 1N Financial Ananisis 45Vout 2, Apvancen MauaL ox Provicr EVALUATION (¥) Nominal Interest Rates Another way wherein inflation alters the real net financial condition of a project is through its, impact on nominal interest rates. Lenders increase the nominal interest rate on the loans they give to compensate for the anticipated loss of the real value of the loan caused by inflation. As the inflation rate increases, the nominal interest rate will be increased to ensure that the present value of the interest and principal payments will not fal below the initial value of the loan. This results in increased interest payments in the short term that compensate for the decreasing value of the loan principal over the long term, ‘The nominal interest rate i as determined by the financial markets is made up of three major components: (1) there isa factor r which reflects the real time value of money that lenders require in order to be willing to forego consumption or other investment opportunities; (2) a risk factor R which ‘measures the compensation the lenders demand to cover the possibility ofthe borrower defaulting on the loan; and (3) a factor (I + 1-+ R) gP* which is compensation for the expected loss in purchasing power attributable to inflation. Inflation reduces the future value of both the loan repayments and real interest rate payments.? The expected rate of inflation for each period of the loan is expressed as gP*. Combining these factors, the nominal (market) rate of interest i can be expressed as: +R+(+r+R) gr Equation 3-8 Forexample, ifthe real interest rate (r)is 5 percent, the risk premium and inflation are zero, then the lender would charge at least 5 percent nominal interest. If the lender anticipates that the future rate of inflation (gP*) will be 25 percent, then the lender would want to inerease the nominal interest rate charged to the borrower in order to compensate for the loss in purchasing power of the future loan and interest rate payments. Maintaining the assumption that there is no risk to this loan, we can apply Equation 3-8 to determine what nominal interest rate the lender would need to charge to remain as well off as when there was no inflation. r+R4(+r+R) gPt = (0.05) + (0) + (1+ 0.05 + 0) 0.25 0.3125 Thus, the lender will need to charge a nominal interest rate of at least 31.25 percent to achieve the same level of return as in the zero-inflation scenario.’ For the project we are analyzing in this chapter, 50 percent of fixed assets investments are financed by debt and 50 percent by equity. All other investments such as initial supplies are financed 100 percent by equity. In Tables 3-6 and 3-7, the loan schedule for the debt portion of the financing is calculated under the 0 percent and the 25 percent inflation rate scenarios. Fora theoretical and empirical description of how inflation alters nominal intrest rates through time, see GP. Jenkins, p. 73-89 point, the subsequent adjustment of interest rates brought about by the impact of the taxation of interest payments is ignored a is the impact of changes in net-of tax interest rates onthe demand and supply of Toanable funds. Foran excellent discussion of these issues sce Martin Feldstein, “Inflation, Income Taxes and the Rate of Interest: A. ‘Theoretical Analysis,” American Economie Review, 66, No.5 (Dec, 1976), pp. 809-820. Ciikerce’3.” Concerts in FinanchTable 3-6 Nominal Interest Rate of 5% Period ofa 2 3 4 s_le Inflation = 0% - |_1. Loan Principal {r1]] 2,500 | 2,500 0 0 0 o lo "2. Interest 2] 0 | 28) | 250) | @50) | @50) | 250) [0 3. Loan Repayment {3} 0 | 0 0 0 0 | (5,000) | 0 4. Real Cashflow [rl-42+13} | 2,500 | 2.375 | (250) | (250) | (250) | (5,250) 0. 5. PV @ 5%=0 From Table 3-1, we know that the higher rate of inflation will increase both the nominal investment required and the nominal interest rate. The higher initial capital requirement must then be repaid at the higher nominal interest rate as shown in Table 3-7. ‘Table3-7 Nominal Interest Rate of 31.25% Period oti] 2 3 4 s_ le Inflation = 25% “I Price Index Tay] 100 | 125 | 156 [19s | 244 [305381 2. Loan Principal (2/250, 3,25! 0 |~0 |~0 0 10 3. Interest [r3][_0__[C7S13)] 757.8) (L,757S) C758) 0.7370 4.Loan Repayment [rao | 0 [| 0 | 0 | 0. | (5625) ["S-Nominal Cashflow [r2t23+r4)| 2,300 '3,343.7, (1,757.8) (1.7578), 757.8)[ 7382.8) 0 6, Real Cashflow [5/11] 2,500 1,875.0) (1.1268)| (01.4) | (7204) |(2.4206)|_0 1 7.PV @ su=0 i i : ‘Comparing Tables 3-6 and 3-7, we find that the present value of both loans are the same. This demonstrates that a loan with a 31.25 percent interest rate when inflation is 25 percent has the same present value as a loan with an interest rate of § percent when inflation is zero. The crucial differences are the timing and amount of repayment. The higher nominal interest rate of 31.25 percent and higher inflation forces a project to repay its loans faster than ifthe inflation rate and nominal interest rates were lower. Table 3-8 shows the difference in the project’s cashflow in the two scenarios.Voume 2. Table 3-8 Comparison of Real Cashflows i a 1, 31.25% interest with | | 25%infason _e], 2500 | 18751268), COL | 7204)| 20), 0 2, 5% interest with 0% inflation (2 2500 | 2375] 2500) (250.0) | (250.0) | (5.250) | 0 | "3. Difference in Real | Cashflow (1-12) lo | 00) | (8768) | (651 | 704)) 28294 | 0 | In real terms, the higher nominal interest rate increases the cash outflows (or reduces the net cash inflows) of the project during periods 1-4 but decreases the value of the principal that is due at the end of the project by PhP2,829.4. This is important to the evaluation of the sustainability of a project because the higher outflows during the early years of the repayment period could cause liquidity problems if the project is not generating sufficient cash inflows. 3.1.2.2 Effect on tax related factors Inflation has three impacts on the tax liabilities of a project: (a) the higher interest payments shown in the previous section increase the amount of tax deduction that can be taken for that interest; (b) inflation reduces the value of the depreciation allowances taken for earlier investments in the project; and (c) the method used to account for inventory has an effect on the nominal earnings that are used to determine the taxable income. These three effects offset each other. However, in most cases where the impact of inflation has been studied empirically, the overall effect of inflation has been to increase tax payments significantly-* @ Interest Deduction Inflation can alter the financial feasibility of a project through the impact that increased nominal interest payments have on the enterprise’s income tax liabilities. In most countries, interest payments are deductible from income for the calculation of taxes. Principal repayments are not. When the expected rate of inflation increases, nominal interest rates rise in order to compensate the lender for the loss in the purchasing power of the principal outstanding and future interest payments. Table 3-9 shows how inflation, through the way it converts some of the real value of the prineipal repayments into interest payments, causes tax payments to fall. The higher nominal interest payments are deductible from taxable income. Hence, they serve to reduce the amount of taxes which the project would otherwise be required to pay. + Sandilands Committe, Inflation Accounting: Report ofthe Inflation Accounting Committee, Command Document 6225 (London: Her Majesty's Stationery Offic, 1975). Also se HJ. Aaron, ed. Irlation and the Income Tax, (Washington, D.C,, The Brookings Instittion, 1976). (Gaikiree'3. "Concepts iv FinaNcIAd AnalisisTable 3-9 Interest Expense Period o 1 2 | 3 4 5 6 Inflation = 0%; Nominal Interest = 5% ; Income Tax Rate = 30% interest Expense [r]_o | (425) | @s0) | (250) | (250) | (250) | 0 2.Real Tax Savings [rl_x .3] 0 37.5 Eat zt r=} ec} 0 Inflation = 25%; Nominal Interest = 31% ; Income Tax Rate = 30% 3. Interest Expense [3][_0 | (781.3) | 4,788) | (1,758) [0,758,758] 0 | 4, Tax Savings [3x 0.3] [ra] 0 234 | 527 S27 S27 0m) 5. Price Index _ [r5}| 1.00 1.25 1.56 1.95 3.05 | 3.81 | 6. Real Tax Savings [r4/r5]_[r6]|_0 | 187.2 | 3378 | 2703 1ms{o | 7. Change in Tax Savings [r6- 2] o | 149.7 | 2628 | 1953 | 1409 | 978 | 0 . PV of increased tax savings @ 7% = 706 Gi) Depreciation Allowance Another factor affected by inflation is the real value of the depreciation allowances for capital goods which are deductible for income-tax purposes. Most countries base the deductions for depreciation expense (capital cost allowances) on the original nominal cost ofthe depreciable assets.* finflation increases, then the relative value of this deduction decreases, causing the real amount of income tax liabilities to increase. In Table 3-10, we see that a 25 percent rate of inflation causes the tax savings from depreciation-expense deductions to fall by PhP1,090. This is equal to approximately 10 percent of the real value of the fixed assets being depreciated, Table 3-10 Project XYZ: Depreciation Allowance Straight Line Depreciation over 4 periods; Income Tax Rate =30' Period — jota 2 3 aisle Inflation = 0%; Depreciable Investment = 10,000 1. Depreciation fy_o [0 | 2500 | 2500 | 2,500 | 2500] 0 2, Real Tax Savings [rl x0.3][2]]/ 0 | 0 | 750 | 750 | 750 | 750 | 0 Inflation = 25%; Nominal Depreciable Investment = 11,250 3. Depreciation [sy] 0 | 0 | 28125 | 28125] 28125] 28125) 0 | 4, Tax Savings (3x03) (r4]|_ 0 | 0 844 e44_| sag | sas | 0 5. Price Index [r5]) 100 | 1.25 | 1.56 | 195 | 244 | 305 | 3.81 [/6. Real Tax Savings [r4/rS] [ro] 0 | 0 | S41 | 433 | 346 | 276 | 0 7, Change in Real Tax Savings T [6-72] 0 ao) | G17y_| ao | a7 | 0 8. PV of change in real Tax Savings @ 7% = (1,090) 1 and their impact on business income are dealt within: HL. Aaron, op. et. and GP. The twxation aspects of in Jenkins, op. it Glink 3°" Concuers IN Financiay ANALHSIS 49Youve 2, Apvancen Manual, ox Provsct EVALUATION Gi) Inventory Accounting a. First-In-First-Out (FIFO) Further tax implications of inflation are experienced by commercial enterprises which must account for inventories of inputs and outputs. In the determination of the amount of taxable profit, ‘many countries require companies to value inventories in their accounts on a first-in-first-out basis (FIFO). This means that the price of the oldest inventories first in) is the value used to determine the cost of the goods sold (COGS). The difference between the COGS and the sale price is the taxable revenue from the project. ‘Table 3-11 Inventory and Cost of Goods Sold - FIFO Income Tax Rat _ a { Period a 2 3 [4 | s le] Inflation = 0% (1. Sales fry 0. 0 | 2,000 | 2,000 | 2,000 | 2,000 | 0 2. Purchase of Inputs [2], 0 | 1,000 | 1,000 [1,000 |" 0 | 0 3. COGS, 3] 0 | o | 1,000 4. Measured Profits [r-13]__[r4]/_0 | 0 | 1,000 5. Real Tax Liability (r4x 0.3} (r5] | 0 | 0 | 300 aflation = 25% —_ — 6. Sale {[r6]| 0 7. Purchase of Inputs| 7] 0 2441 8.COGS _ [rs] 0 | 1.953 | 9, Measured Profits [x6 - r8]_[r9]|_0— 2.930 | 10.Nominal Tax Liability —[r10]| 0 879 U.Price Index [111.00 19s | 2.44 [12.Real Tax Liability [r10/r11] [rij] 0 361 361 [13.Change in tax liability fr12-r5] [0 | o1_| 61 14,PV of change in tax liability @ 7% = 193 ‘Taxable revenue generally increases by the rate of inflation because sale prices are affected immediately by the rate of inflation, while the COGS from inventories are valued using prices of a previous period when the nominal prices are presumably lower. For example, ifthe project has a one- ‘year inventory of final goods at the beginning of the year and the inflation rate for that year is 25 percent, then nominal cost prices of the goods sold will be 25 percent lower than their selling prices one year later, even if no profit margin is added. The result is that the measured profits are artificially 50 Gitarren’3."Concuers iw Bivancrar ANAGysis|Vou 2, Apvaxcen Manual, on Prosscr Evanuarios inflated which increases the tax burden in both nominal and real terms.* From Table 3-11, lines 1-14, ‘we see that by increasing the rate of inflation from 0 to 25 percent, the present value of real tax payments increases by PhP193. ‘Another system for accounting for the COGS is known as last-in-first-out (LIFO). As the name implies, the most recent goods purchased (last in) are used to measure the COGS (first out), and the prices of the project inputs are generally increasing at the same rate of inflation as the outputs sold, During the production eycle of a project, this is a benefit because the profits are not increased atificially by the presence of inflation. As a result, taxes will also be lower. However, LIFO has @ negative aspect as well because as the activity winds down, or if the level of inventories is reduced due to business conditions, the lower prices of the goods that were purchased in earlier years are now used to calculate the COGS, resulting in inflated profits and increased taxes as shown in Table 3-12, row 13 - period 5 ‘The LIFO system for accounting for COGS allowed tax liabilities to remain unaltered until period 5. As the project winds down, the prices used to calculate the COGS for that period are now from period 1. Hence, with 25 percent inflation, profits in period 5 will be greatly inflated, causing the tax burden to increase in real terms by PhP177 (line 13 - period 5) over the no-inflation scenario. 7 This ocours because, na period of apd inflation, the historical est of inventories now being used in production will be substantially less than the current replacement cost ofthese items. Itaxable income i calculated using the historical cost bf the inventory ites, the real cos of goods wll be underestimated and taxable income willbe overestimated. Therefore, eal none tax abilities willbe greater then they would be ino inflation had existed. In 1974, this effet of inflation “lone caused corporate taxable income in Canada to be overestimated by more than 30 percent. GP. Jenkins, op it ‘Ch. 2. Again the higher income taxes onthe spurious income created by the interaction ofthe existing accounting system tnd inflation may cause the project tobe financially weakened; thus, its ability to attain its economic and socal potential is decreased, Garter 30°" Conceors iw Financtat ANALYSIS StVoume 2, Apvance Manuat. ow Prosecr EVALUATION ‘Comparing the effects of inflation on the tax lability in the FIFO and LIFO accounting systems, we see that in both cases, inflation increased the taxes. With FIFO and 25 percent inflation, the present value of the tax liability increased by PhP193 (Table 3-11). With LIFO, the present value increased by PhP126 (Table 3-12) Table 3-12 Inventory and Cost of Goods Sold -LIFO Income Tax Rate = 30% { Period 7 0 1 | 2” 3 [4 [ 5 76} Inflation = 0% 7 1. Sales fr 0 0 2,000 | 2, 2,000 | 2,000. 0 2. Purchase of Inputs (e2]|_0 | 1,000 o fo (3.coGs ~ “eyo 0 1,000 4, Measured Profits [ri-r3] [raj] 0 | 0 1,000 |~0 5, Real Tax Liability [r4 x 0.3) [r5]|__ 0. 0 300 300 300 300. 0 |Anflation = 25% — 6. Sales {[r6]/ 3,906 | 4,883 | 6,104 | |7. Purchase of Inputs _{r7) 1,953 | 2.441 | 0 8.COG (rs) 19531-2441) 1.250 9, Measured Profits [r6-r8] [19] 10.Nominal Tax Liability [+10] L1.Price Index [rt] 12.Real Tax Liability [rl 0/F11] [r12] 13.Change in tax liability [r12-r5] | 14.PV of change in taxes due @ 7% 586_| 732 | 1.456 19s | 244 | 3.05 13, 300_| 300 [477 0 oO y 0 | 1.953 | 2441 | assa [0 0 8 0 0 In addition to the cost difference, the timing of the tax burden is substantially different. Using FIFO, inflation increased the taxes in each period, whereas using LIFO resulted in no increase in taxes in the production period but in a larger tax liability in the last sales period, LIFO defers the increased tax burden attributable to inflation until a period when there is a need to lower the level of inventories. As the lower priced inventories are drawn into the COGS, the difference between inflated sales values and older prices generates larger profits and increases the tax liability. Using LIFO could increase the overall risk associated with the project in a high inflation environment if the reason for the enterprise wanting to lower the level of inventories was financial stress or business slowdown. In such a situation, the increased tax liability is concentrated in a few periods when the project is already facing problems, while with FIFO, the increased tax liability is spread out over each operating period. Hence, when doing the appraisal it is important to consider the type of accounting rules used for determining the COGS to assess how inflation might affect both the timing and quantity of the tax liabilities to be paid by the project.Annex to Chapter 3: Guide to Financial Ratios ‘Summary of Financial Ratios and their Calculations Vowne 2, Apvancep Manvat. on Prager EvaLUarion ‘Current Liabilities [RATIO METHOD OF CALCULATION 1] Liquidity Ratio Current Ratio Current Assets Current Liabilities Quick Ratio Cash and Equivalents + Trade Receivables Asset Utilization Ratios Sales/Receivables Net Sales ‘Trade Receivables, Cost of Sales/Inventory Cost of Sales Inventory Cost of Sales/Payables Cost of Sales Payables Sales/Working Capital Net Sales__ ‘Net Working Capital Sales/Net Fixed Assets Net Sales Net Fixed Assets Sales/Total Assets Net Sales Total Assets Coverage Ratios EBIT/Interest Earnings Before Interest and Taxes ‘Annual Interest Expense Cashflow/CMLTD ___Cashflow __ (Carrent Maturities of Long-Term Debt Leverage Ratios Debt Ratio ‘Total Liabilities Total Assets Fixed/Worth, _Net Fixed Assets Tangible Net Worth‘Voume 2. Anvancep Manvat. ow Proskcr Evaicanion, RATIO METHOD OF CALCULATION Sales/Worth Net Sales \ Tangible Net Worth DebuWorth Total Liabilities Tangible Net Worth |___ Profitability Ratios Gross Profit Margin Gross Profit Net Sales | Net Profit Margin After-tax Profit Net Sales EBIT/Total Assets Earnings Before Interest and Taxes | “Total Assets Return on Assets Aftertax Profit | Total Assets L Return on Equity Afer-tax Profit Tangible Net WorthVou 2. _Anvaxcan Manual, ox Prasecr Evatvation A3.L Liquidity Ratios Accrual-based liquidity ratios are indicators of the ability of the operation to meet its current obligations found in the current liabilities section of the balance sheet, from resources which are cash and easily converted into cash assets found in the current assets section of the balance sheet. Current ratio is used as an indicator of short-term insolvency which reflects the ability to cover current liabilities out of current assets. The ratio is calculated by dividing current assets by current liabilities. Quick Ratio or the Acid Test examines the relationship between the most liquid current assets and total current liabilities. Its calculated by dividing cash and cash equivalents plus trade receivables by current liabilities. AB2 Asset Utilization Ratios Asset utilization ratios are indicators of the firm’s ability to manage its assets effectively. They are designed to show the relationship between an income statement category and a balance sheet category. Sales/Receivables; The sales-to-receivables ratio, or the receivables turnover ratio, indicates the number of times accounts receivables are turned over during an accounting period. Itis calculated by dividing net sales by trade receivables. Cost of Sales/Inventory: Sales-to-inventory ratio, or the inventory turnover ratio, is the indicator of the efficiency of inventory management. It indicates the number of times the investment in inventory turns over during the accounting period. It is calculated by dividing COGS by inventory. Cost of Sales/Payables Ratio looks at the number of accounts-payable tums during the accounting period to track management's use of working capital. It is calculated by dividing cost of sales by accounts payable. Sales/Working Capital Ratio measures how effectively current resources are being used in the firm’s operating activities and how well a firm is generating net sales. Its calculated by dividing net sales by net working capital (current assets minus current liabilities). Sales/Net Fixed Assets Ratio measures the firm's ability to manage its long-term assets. It is calculated by dividing net sales by net fixed asses. Sales/Total Assets Ratio is a measure of total asset utilization or total asset turnover. It provides information on the firm’s effective use of its total assets in generating sales and is calculated by dividing net sales by total assets. Gildan’ 30°" Goscaeis IN Finasciat ANALiSIS|Voune 2. Apvancen Maxvat ow Proseer EVALUATION, A33 Coverage Ratios Coverage ratios measure a firm’s ability to service its debt — interest charges plus principal amortization. They indicate the number of times fixed debt charges are covered out of operation. EBIT/Interest Ratio measures a firm’s ability to meet its annual interest expense. It is calculated by dividing earnings before interest and taxes by annual interest expense. When this ratio is below the industry median, the firm may be experiencing difficulties in adequately covering interest charges. ‘Asa result, the operation is less capable of taking on additional debt than is the median firm in the industry. Cashflow/Current Maturities of Long Term Debt Ratio measures the extent to which the principal on debt is covered by cashflow. Since cashflow from operations is the primary source of repayment of debt, this ratio indicates the firms ability to service the current portion of its long-term debt obligations. It is calculated by dividing cashflow by current maturities of long-term debt. A3.4 Leverage Ratios Leverage ratios are closely related to coverage ratios. They measure the extent to which a firm is capitalized through debt. Highly-leveraged companies will have high coverage ratios. They are more vulnerable to downturns in business activity and have a higher degree of risk associated with their operations. Debt Ratio measures creditors’ claim against total assets relative to total claims. It is calculated by dividing total liabilities by total assets. When liabilities are smaller than the normal percentage of total assets, creditors’ confidence is higher and owners are in a better position to seek additional outside financing, Fixed/Worth Ratio measures the relative degree to which owners have invested their equity in fixed assets, Its calculated by dividing net fixed assets by tangible net worth. The higher the ratio, the more vulnerable the creditors are in the event of @ company liquidation, Sales/Worth Ratio measures the extent to which a firm’s sales volume is supported by equity capital. It is calculated by dividing net sales by tangible net worth, Debt/Worth Ratio shows the relative ownership claims of creditors compared with those of ‘owners. A low value indicates a low level of financial risk and a great degree of flexibility in future financing decisions. Itis calculated by dividing total liabilities by tangible net worth.Apvaxcep MawuaL ox Provect EVALUATION Youve 2. A3.5 Profitability Ratios Profitability ratios are often used to evaluate overall management performance. Gross Profit Margin Ratio, an income statement ratio, is calculated by dividing gross profit (net sales minus cost of sales) by net sales. Net Profit Margin Ratio measures after-tax-profit as a percentage of sales. It is calculated by dividing profit after tax by net sales, EBIT/Total Assets Ratio is the ratio of operating profit to total assets and measures the effectiveness in generating profit from total assets. It is calculated by dividing EBIT by total assets Return on Assets Ratio measures the ability to generate after-tax profit out ofa given total asset base, Its calculated by dividing after-tax profit by total assets Return on Equity Ratio measures the return to stockholders. It shows management's capacity of translating shareholder equity into profit within the business operating environment. Itis calculated by dividing after-tax profit by tangible net worth. Giger 30°" Goncapns i Fixanctat ANALYEISCuapter 4 PRINCIPLES UNDERLYING THE Economic ANALYsIs oF Provects 41 Introduction While a project's financial analysis focuses on its financial attractiveness to private investors, ‘economic analysis deals with its impact on the entire society. An economic analysis ofa project in the Philippines helps determine whether or not the project increases the net wealth of the country’s society as a whole. Economic analysis is concerned about economic benefits and costs, not cash receipts and expenditures. ‘To better understand economic analysis and how it relates to financial analysis, consider the case of a cement plant constructed in the outskirts of a town. In financial analysis, the plant owners determine the project’s profitability and financial attractiveness. If it has a positive financial net present value (NPV) and relatively low risk, the owners would undertake the project because it would increase their net wealth If no one else in the country gained or lost as a result of the project, there would be little difference between financial and economic analyses. Consequently, when conducting economic analysis, ithelps to determine who, in addition to the project sponsors, gains or loses asa result of the project. Ifthe project pays higher than prevailing market wages, workers are benefited and adjustment. would have to be made in the economic analysis. Ifthe cement plant causes other cement producers to cut back on production and lose economic rents, the loss is a cost which should be accounted for {in economic analysis. Ifthe project pays income tax revenues, these would constitute a financial cost to the project owners but would be a benefit to the government. This would cancel out as mere transfer in economic analysis. Finally, if one of the town’s neighborhoods suffers from pollution due to plant emissions, health costs should also be taken into account in the economic analysis, If plant workers, other cement producers, town residents and the government represent all, parties affected by the project, then the net economic benefit or cost would be determined by adding all their gains and losses to the gains and losses of the plant owners. Ifthe final result is a net gain (.e.,if the economic NPV is positive), then the cement plant increases the economy's net wealth and should be undertaken. Otherwise, it should not be undertaken. Note that not everybody needs to benefit from a project for it to be economically viable. Any project may have both losers and gainers However, ifthe gains outweigh the losses, the project is economically viable and should be undertaken. ‘The underlying rationale in this case is that a net gain implies that losers from the project could be compensated. When this happens, the project meets the efficiency criterion of Potential Pareto Optimality (Cuapren'g.”Paivciptes Uxounivine Economic ANatvsts OF PRovscrs‘The simplified example above illustrates economic analysis in its basic form, Further adjustments generally have to be carried out due to differences between the market (or official) price of foreign ‘exchange and its economic value as well as differences between the financial cost of capital and its economic cost. 42 Postulates Underlying the Economic Evaluation Methodology ‘The methodology adopted in evaluating economic benefits and costs of projects in this manual is predicated on three postulates developed by Arnold Harberger. These postulates are based on a number of concepts in welfare economics. The three postulates are as follows: a, The competitive, undistorted demand price for an incremental unit of a good or service measures its economic value to the consumer (demander) and hence its economic benefit b, The competitive, undistorted supply price for an incremental unit of a good ot service measures its economic resource cost. cc. Costs and benefits are added up without regard to who the gainers and losers are. In other words, a peso is valued as a peso regardless of whether or not the benefit accrues to a high- income individual or a low-income individual ‘What are the implication of these postulates for the project's economic analysis? When a project produces a good or a service (output), the economic benefit or the economic price of each incremental unit is measured by the demand price or the consumer’s willingness to pay for that unit. On the other hand, the economic cost ofa resource (input) that goes into the production of the project's output is ‘measured by the supply price of each incremental unit ofthat resource. In other words, the economic cost of cach incremental unit of an input is the cost faced by the supplier of that input. Finally, the net economic benefit of the project is measured by simply subtracting the total resource costs from the total benefits from the project’s output. The implications of these three postulates are further elaborated in Box 4-1 Plarberger AG, “Three Basie Postulates for Applied Welfare Economics,” Journal of Economic Literature IX, No. 3 (September, 1971): 785.97, Carrie 4.” Paincinies Unbuivine Econonte ANALYSIS OF PROJECTSBox 4-1 Harberger’s Three Postulates ‘The first two postulates indicate that if the market fora certain output is undistorted by factors such as taxes, subsidies, import duties and tariffs, or other government regulations, then the market price paid for a unit of that output measures both its marginal benefit to the consumer (demander) and its marginal resource cost to the producer (supplier). These postulates are based on standard economic theory but they involve certain subtleties and | conditions that must be understood, The demand curve represents the maximum willingness to pay for successive units of a good. As such, the demand curve reflects indifference on the part of the consumer between having a particular unit of a good at that price or spending the money on other goods and services. Hence, it becomes clear that any demand curve is derived under the condition that prices of all other goods and services (particularly complements and substitutes) are held constant. Moreover, income levels, tastes and preferences, as well as expectations are held constant when deriving a demand curve for a ‘good. ‘The supply curve represents the minimum prices suppliers are willing to accept for producing successive units of a good or service. These minimum prices represent the ‘opportunity cost of these goods. In other words, suppliers will be indifferent between selling, ‘these particular units of the good at their supply prices or using the inputs to produce these Units for altemative purposes. For this to hold, there should be no change in the prices of other goods and services, and factors of production, and no change in technology. ‘The third postulate concerns the distributional aspects of a project and how they should | be incorporated in economic analysis of projects. Should the project be valued differently depending on who the beneficiaries and the losers are? Should a higher value be attached to the benefits if they accrue to a low-income group and a lower value if they accrue to a high- income group? The methodology in this manual attempts to separate the social aspects of project appraisal from the economic efficiency aspects. By adding up pesos of benefits regardless of who the beneficiaries are, itis possible to determine any net efficiency gains ot losses to the economy resulting from the allocation of resources to the project. This should not imply, however, that distributional impacts should be ignored, Identifying, how a project affects different segments of society is clearly an important part of project appraisal. This is a task performed during distributional analysis. In addition, if the project addresses some “basic needs,” then it would be possible to add some premium to the project’s benefits 4.3 Estimation of Economic Prices In this section, a number of simple examples are presented to illustrate how economic costs and. benefits are estimated using the three postulates. The next section explains how economic costs and benefits of a project are estimated if the markets for the project’s outputs and inputs are not distorted, Distortions or externalities in the context of this manual include taxes, subsidies, trade taxes, licenses ‘GaaPren’4."Pruncrruss Unostvine Ecosoate ANatvsts oF BRorecrsVou 2. AbvaNct Manual, on Prosecr Evatuarion and quotas, monopoly power, and any other price or quantity restriction. Environmental costs such as pollution, ifnot paid for by project sponsors, also constitute an externality ora distortion. The various categories of externalities or distortions are analyzed later in this chapter. Although a market with no distortions or extemalities is hard to find, this analysis nevertheless starts with non-distorted markets so the methodology is presented in its simplest form. The framework for undistorted markets presented below is based on non-tradable goods. This does not imply in any way that the postulates apply only to non-tradable goods. 43.1 Undistorted Markets The framework for analyzing economic benefits and costs of projects producing or using (as inputs) non-traded goods and services is discussed in the following three subsections. The framework is based on Harberger’s three postulates. 43.11 Analyzing the economic costs & benefits in an existing industry (no new project) Figure 4-1(a) presents the demand curve for a good in an undistorted market. The demand curve of a good shows the maximum price that consumers are willing to pay for successive units of the good keeping all other things constant (c.g, prices of all other goods and services and the income of consumers). Ifthe market-determined price of the good is P., and the quantity consumed at that price is Q__, then the economic benefit of the last (marginal) unit Consumed is P. but he benefits of earlier (nframarginal) units will be greater than P,, . The maximum benefit derived from the first unit consumed is P.., as shown in Figure 4-1(a). Applying the first postulate, the benefits ofthe successive ‘units consumed are determined by the corresponding prices on the demand curve. Consequently, the economic benefit of the output of this industry (the quantity Q,) is given by the area P_,, OQ_C. Garni 4.” Princinies UNpuniine Econoamte ANALYSIS OF PROECTS 6Vou: 2. Apvaxcen MaNuat, on Prouser EVALUATION Figure 4-1 Economic Costs and Benefits (No New Project) in Undistorted Market [A Total Eoonerric Benefit Total Econeric Cost Pw Oy c Derren ° . ums cose © Reorente Benefits and Costs Re ‘aaely © Pa Daren Va e ° umeof uae Figure 4-1 (b) presents the other side of the market, which is the supply side. The supply curve or marginal cost curve reflects the resource cost for producing successive units of the good keeping all other things constant (¢.g., production technology). Atthe market-determined price P,,, the quan- tity Q,, is produced. While the resource cost of the marginal unit produced is P,., each of the inframarginal units of inputs used below Q,,is less than P_. Following the second postulate, the economic resource cost of producing Q, is OECQ,,. Figure 4-1(c) combines this market's demand and supply curves. Following the third postulate, economic costs and benefits are added up to determine the net gain or loss inthis industry. Since the benefits are represented by the area P,,., OO,C in Figure 4-1(a) and the costs are given by the area OECO, in Figure 4-1(b), the net economic benefit is given by the triangle P.., EC in Figure 4-1(c), 6a CCuspran 4.” Prancipies UNDERLYING Hoosomic ANALvsis oF ProabersAlthough this industry is determined to be economically viable and is adding to the economy's net wealth, the group which receives this net benefit, P,.,.FC, has not yet been determined. (Return to Figure 4-Ic.) The only price observable in the market is P, and all Q, units are bought and sold at this price. Consumers value cach unit they consume at its corresponding price as given by the demand curve but they pay less than that price for all units consumed except the last one. This difference between how much the consumers value the output and how much they actually pay for it isa net gain to consumers and is known as consumer surplus. Consumers pay an amount equal to P,0Q,C but enjoy a gross benefit of P.,, OQ, C. The amount of income saved by consumers because they are able to purchase all units ata price P, is equal to the triangle PPC in Figure 4-1 (¢). This triangle represents the consumer surplus. ‘The fact that all units are sold ata price P,, implies that industry revenues, P_OQ,C , are larger than the economic costs, EOCQ,C . The excess of revenues over production cost, the triangle PEC in Figure 4-1(c), represents a net profit to the owners of the factors of production. This difference is known as the economic rent or producer surplus. It now becomes evident that the net economic benefit in this industry as determined using the three postulates is shared between the owners of the industry and its consumers. 4.3.12 Analyzing the economic benefits of an output produced by a project in an undistorted market The previous analysis focused on an industry. This section considers the more common case of anew project. Suppose a project produces a non-tradable good such as concrete. Figure 4-2 shows the supply and demand for this non-tradable good. The industry demand and supply curves prior to the introduction of the new project are denoted by D, and S, , respectively. The new project produces a quantity Q, and results in a shift inthe industry supply curve from S, to S,,,. The additional supply by the project results in a drop in the market price from P,, to P,,.Asa result of the decrease in price, consumers demand more, and total consumption increases from Q, to Q,,. Also due to the price decline, some of the existing suppliers can no longer supply the same amount of the good at the new (lower) price P,, and will cut back their production from Q, to Q,,. The quantity produced by the project, is equal to the sum of the two quantities O,- Q, and Q,- Q,. Giinvene 4.” Prascanuss Uspextvine Beowonte ANALISIS OF PROIECTSFigure 4-2 Economic Benefits of a New Project in an Undistorted Market % Pat Since the project sells its output at the new prevailing market price P,, , the gross financial receipts to the project are given by (Q, x P.,.) which is area Q,ACQ,,. To estimate the gross economic benefits of the project, determine the economic value of the new consumption to the demanders and the value of the resources released by existing suppliers. These values are estimated using the first two postulates as follows: (@ The additional consumption is valued, according to the first postulate, by the demand price for each successive unit, or by the area under the demand curve (0,BCQ,.) i) The resources released by other producers ate valued, according to the second postulate, by the supply price (resource cost) of each successive unit or by the area under the supply curve (Q,BAQ,,) ‘The gross economic benefits are given by the sum of the two areas above (Q,,ABCQ,,) . It is important to emphasize that these benefits are gross. In other words, the economic costs of producing these goods have not been netted out yet. Saying that a project has positive gross economic benefits is the economic equivalent of saying that a project has positive gross financial receipts. The positive ‘gross benefits alone do not indicate whether the project is economically viable or not, in the same ‘way that positive gross financial receipts do not indicate whether the project is financially profitable ornot. It is worth noting that the gross economic benefits of the project are equal to the sum of the financial receipts to the projects’ owners (Q,,ACO,,), plus the gain in consumer surplus (P,,BCP.,,), ‘minus the loss in producer surplus (P_,BAP...). In addition to the gross receipts to the project owners, ‘consumers gain and producers lose economic rents due to the price reduction. From a distributional perspective, it is interesting to note that the consumers” gain fully offsets the loss in economic rents to the existing producers. Note that the changes in consumer and producer surplus is due to the price drop. Giiarres 4.” PainciPLes Unpenivine Economic Awatysis oF Baovects|Youu 2. Apvancen Manvat, ox Provucr Evawuariox ‘The quantity produced by a project is often relatively smaller compared to the market size, Thus, no change oceurs in the market price. In such a situation and given that the project is operating in an undistorted market, the gross financial receipts will be equal to the gross economic benefits. In other ‘words, no difference is found between the financial revenues generated by a project and its economic benefits o society. The difference arises only when the project makes a huge impact on the industry. 43.13 Analyzing the economic cost of an input demanded by a project in an undistorted market ‘The following example demonstrates how the economic cost of a non-tradable item demanded ‘by a project can be estimated using Harberger’s postulates. The industry demand-and-supply curves ‘without the additional demand by the new project are denoted by D, and S,, respectively (Figure 4-3) 1,10 Dy. The additional demand by the project results in arse inthe market price from P,,, 10 P,,. ‘AS a result of the price increase, existing consumers will cut back consumption from Q, to O,, and producers will increase their production from Q, to O,, at the new (higher) price Py. The ‘quantity demanded by the project is equal to the sum of the two quantities Q,-O,, and Q,-Q, ‘The project buys its requirement at the new prevailing market price P,,, and incurs a gross financial expenditure of (Q,x P,,) which is the area Q,,CAQ,, . To estimate the gross economic costs of the input demanded by the project, we need to determine the economic value of the consumption that is foregone by the existing consumers, and the value of the additional resources utilized to accommodate the project’s demand. These values are estimated using the first two postulates as follows: i) Cutback in consumption is valued, according to the first postulate, by the demand price for each successive unit given up or by the area under the demand curve (Q,BCQ,,) ii) The additional resources used to accommodate the expansion in output are valued, according to the second postulate, by the supply price (resource cost) of each successive unit or by the area ‘under the supply curve (Q,849,,). Figure 4-3 Economic Cost of an Input Demanded by a Project in an Undistorted Market De Pesoattnis | 0, fy \ Ghaeren 4. ”” Prunciruss Unpentymc 65,Vouume 2, Abvacen MANuaL, ox Paovscr ‘The gross economic cost for this input is given by the sum of the two areas above (0. ABCO,,). [By determining the economic cost of each input used by the project in a similar way and the economic benefit of its output as outlined in the previous sub-section, it is possible to determine the project’ economic viability by subtracting all economic costs from the gross economic benefits. 44 Markets with Distortions or Externalities Markets fora project's outputs or inputs are generally distorted whether they are internationally traded or not. In project appraisal, the type and level of distortions are determined as given when estimating the project's economic costs and benefits. The objective of the project analyst or economist is to select projects that increase the Philippines’ net wealth given the country’s current and expected regime of distortions In the presence of externalities, the estimation of the economic costs and benefits as well as the istributional impacts will be slightly more involved. When dealing with undistorted markets in the examples above, the difference between the financial receipts to the owners and the economic benefits is the gain in consumer surplus minus the loss in producer surplus. Similarly, the difference between the economic cost ofthe inputs used by the project, and the financial expenditures borne by project owners, is the gain in producer surplus minus the loss in consumer surplus. With the introduction of distortions in the form of taxes and subsidies, another stakeholder enters the picture in the form of the government. Again, when other externalities are included, such as monopoly markets, price controls o pollution, the impact of the project on the economy is not as straightforward as depicted in Sections 4.3.1.2 and 4.3.1.3. Consequently, when estimating the ‘economic costs and benefits of goods and services in distorted markets, expect additional benefits or costs and new players added to the project’s list of beneficiaries or losers. VHAPTER 4. PRINCIPLES UNDERLYING connie ANAL}Vouume 2. Apvancen MANUAL oN Prosser Evauuarion It is often stated that local taxes paid are transfers between local nationals and the ‘government and should be excluded in economic analysis. The rationale is that taxes do not reflect any use of resources. Although the statement is correct, qualification is needed. | Accounting for Taxes in Economic Appraisal If an individual values a shirt at PAP3O, the economic benefit of this shirt is PhP30 regardless of what the individual actually pays for the shirt. Suppose the individual pays PhP20, the economic value of the shirt remains PhP30 and the individual enjoys consumer | surplus of PhP10, Ifthe shirt were given free to the individual, the economic value would still be PhP30 and his consumer surplus would also be PhP30. Suppose, the individual pays | PhP20 to the shirt manufacturer but pays an additional PhPS in tax on the shirt, what is the | ‘economic benefit of the shirt? It is still PhP30. The only difference is that the consumer | surplus has dropped from PhP10 to PhPS. The economic benefit of the skirt includes the | ‘amount of tax paid by the individual. How then is tax considered a transfer? On the benefit side of the resource flow statement, total willingness to pay is included as a benefit. This includes the financial price paid to ‘manufacturer, any tax payments on the shirt, and any consumer surplus. However, on the cost side, the tax is excluded in the economic resource flow statement because it is a transfer. This becomes quite intuitive once it is recognized that varying the ‘amount of the tax creates no impact on the economic analysis. The economic benefit of the shirt (the value of the shirt to the individual) is independent of tax; and the tax does not appear as an economic cost in the economic resource flow statement. | Inan ideal economy where taxes, subsidies or market imperfections, such as monopoly, external costs/benefits (pollution, congestion, common property) do not exist, no divergence occurs at the margin between the value of a good or service as manifested by its demand price and the cost of production as represented by the supply price. In this kind of world, the financial and economic prices of outputs and inputs are the same and no difference is found between an investment’s financial appraisal and its economic evaluation. However, these distortions and imperfections exist in real ‘markets and can be the source of extemal welfare effects that should be taken into account when estimating the economic impacts of production or use of a product by the project. Economic externalities are said to exist when a product’s economic value is different from its financial price. Positive externality is created when the economic benefit (value) to the society of a ‘project’s incremental output is greater than the financial price received by the project owners. When economic benefits are being built up from the financial receipts, all externalities should be added to the financial receipts. Similarly, a negative externality is created ifthe economic cost of the resources required by a project exceeds their financial cost. This should be added to the financial expenditures incurred by the project. The next section presents an overview of different types of externalities one 1y meet while appraising a project. It also demonstrates how these externalities are incorporated into project appraisal from financial to economic analysis. Garren 4.” Praveieiis Unpanieno Econostc Paosners 67Apvancep Manval. ox Provscr EVALUATION Externalities sometimes arise due to the project’s impact on other industries, particularly industries producing close complementary and substitute goods. Extemnality might also be created in industries producing inputs to the intermediate goods used by the project. If industries producing complementary or substitute goods experience changes in demand or supply, which in turn lead to a price change or a change in government revenues, an extemnality is created. The situation should be carefully analyzed to determine if the impact on substitutes and complements is expected to be small and could be ignored for practical purposes, or large enough to be included in the analysis Similarly, ifan externality exists in the market for one of the inputs of an intermediate good needed by a project and the externality is sufficiently large, it will have to be considered in the analysis. 45 Definition of the Economic Externality All distortions and imperfections in the markets for both traded and non-traded goods or services may be included in the term economic externality which is defined in a broader sense, Economic externalities arise because ofa divergence between the marginal social value and the marginal social cost of activities whose demand or supply is affected by a project. Physical or technological externalities refer to effects like noise, pollution or congestion. The term economic externality covers all potential sources of external welfare effects and may be defined as follows Anextemality or external economy (dis-economy) is an occurrence or incident that confers benefits (damages) on some persons who are not fully consenting parties in reaching the decision that gives rise to the event in question? It may be noted that an economic externality arises when the persons affected were not fully consenting parties to the decision. For instance, in case of taxes and subsidies, the affected individuals might have been a party to the process leading to the installation ofthe government (voting), but they were not a party to the institutional process through which these measures were approved. As a result, an externality arises each time a project causes a change in the level of a taxed activity that yields more or less tax revenues to the government. Following are some cases of externalities relevant in project appraisal: ) environmental extemnalities b)_ congestion externalities ¢) common property-resource externalities 4) monopoly extemalities ) tax, tariff, subsidy externalities £) foreign exchange externalities 2) laborexternalities h) basic needs externalities * For a detiled analysis of incorporating the impacts of a project on complementary and substitute markets, see Harberger, A. and Jenkins, GP, “Manual for Cost Benefit Analysis of Investment Decisions," Unpublished, Chapter 1, Section 3 (HIID, Harvard University 1991) ? This definition is due to James E. Meade; “The Theory of Economic Extemalities”, Institut Universitaire de Hautes Enides Intemationales, Geneva (1973), Capra 4." Prancipuss UnoesVous 2, Apvaxcep Manvat, ox Paovscr Evatvarion 4.5.1 Environmental Extern: ies Environmental externality is generated when the extemal economy arises as a result of the production process of a project. The different kinds of pollution created by industrial firms and infrastructure projects (power, transport) as they produce goods and services fall under this category. ‘Some projects deposit waste products or effluents in the atmosphere, waterways and the ground, harming people and property that are not directly involved with the output’s production or consumption. Situations in which environmental extemalities arise are discussed in Box 4-3 Box 4-3, Sources of Environmental Externality Environmental externalities arise because of a technical interdependency between a producer and another set of producers or consumers. The waste products emitted by one producer adversely affect the production processes of other firms or the well-being of other consumers. The situation arises when the following two conditions exist: ( Oneeconomiec agent's utility or production function includes a variable whose magnitude is chosen by another economic agent without any consideration for the preference of the first agent. In other words, some output of producer 4 affects the production of other producers or the consumption of other consumers not party to the production process of 4 or the consumption of what 4 is producing. (Gi) The first agent has no control over the chosen variable because it has no explicit exchange value. This is due to the absence of a market for the variable or existence of an imperfect market. As a result, itis difficult to put a value to the impact on the other affected producers or consumers, ‘The cost of the damage is not perceived by producer A who does not have to pay for it. In other words, itis not a private cost and thus is not captured in the project's financial cost. ‘The same thing applies to the product’s consumers whose private benefits are not reduced by this external diseconomy. It is not possible to assign the cost of the diseconomy or the damaging effect (waste product) to the producer because itis difficult to puta valuation on the damage caused. Generally, no system exists for valuing this cost because no market or ‘exchange mechanism is in place ‘Suppose an industrial project discharges wastes or effluents in a nearby lake, adversely affecting the production and quality of fish in the lake. The market for fish without the effluents is shown in Figure 4-4, where the demand and supply curves represent the private marginal benefit and marginal costs of the fish trade, However, when effluents are discharged into the lake, fishers have to treat the water in order to keep the quantity and quality of the fish. This is an external cost or diseconomy imposed by the project on the lake’s fishers. Grapren 4.” Paunermtss UNDeRLvING Beoxontc ANALYSIS oF PkovEcTsVous 2. ApvaNcep MANUAL on Prosucr EvaLuation Figure 4-4 Market for Fish without Environmental Externality Pico on | Rr | D a, entity Where, Mo, dnctes the Marginal Cost of Pate Proton to Socal When this cost is added to the private cost of fish production, the total cost faced by the fishers rises as shown in Figure 4-5. Figure 4-5 Market for Fish with Pollution in the Lake 8+ Externality Cost= SC, ice / S=MG, Where, $6, denotes he Soci Cost of Prato reduton to SodeyThis cost may be internalized into the costs of the industrial project by taxing it or putting a regulation in place that forces the project to take steps to eliminate or reduce the waste production or to bear the costs of treating the lake water. The demand and supply of this pollution after the cost of pollution has been intemalized through regulation or some other mechanism can also be demonstrated in Figure 4-5. The MC, curve represents the private supply curve of the industrial project while the SC, represents the supply of the project after the cost has been internalized. [Note that not only industrial projects are responsible for producing environmental externalities. Infrastructure projects, energy projects in particular, produce a great variety of externalities including atmospheric emissions (sulfur, nitrogen and carbon gases) and damage to forests and ecosystems. In the long run, these environmental externalities may have a serious impact on the well-being of the people within a country and even across countries. 45.11 Accounting for environmental externalities in project appraisal Whenever an investment has an adverse impact on the environment, two steps must be done to incorporate the impact in project evaluation. First, the cost of measures necessary to reduce or climinate the impact should be part of the project and the cost of those measures should be included both in its financial and economic analyses. These measures may include alterations in the existing plant or adding new equipment. Ifthe environmental impact cannot be totaly eliminated, as would generally be the case, the damage caused by the residual impact should be estimated and added as a cost in the project’s economic analysis. This evaluation of the residual impact on the environment and consequently on the people may not always be straightforward and may often require special environmental valuation techniques.* 4.5.2 Congestion Externalities ‘The issue of congestion becomes relevant in case of services such as bridges, roads, parks, clubs and parking spaces that may be provided either by the private or the public sector. As long as there is no additional cost of providing the services to the next additional user of that particular service, the problem of congestion is non-existent. Ifthe number of users keeps rising while the size ofthe facility is fixed, each additional user after a certain stage begins to impose an external cost on all other users. ‘As roads and bridges become more crowded, all vehicles slow down due to each additional driver joining the traffic. This imposes additional costs in terms of time and money spent in commuting. As parks become erowded, users have less space to enjoy and each additional person imposes an external cost on those already in the park. Similarly, an external cost of waiting occurs when all space in a parking lot is taken, or clubs and playing courts are occupied. ‘A framework for quantifying the externality caused by congestion in transportation is presented in Box 4-45 + Fora discussion on valuation of environmental impacts, see “A guide to the Economic Valuation of Environmental Impacts for Project Development and Appraisal 5 This exposition is explained by Harbeger A. C. See “Cost Benefit Analysis of Transporation Projects,” in Project Evaluation: Collected Papers (The University of Chicago Press, 1972). ‘Princieies UNDERLYING ECONOMIC ANALYSIS OF PROJECTS aVous 2. Apvancen Manual, on Prosecr EVALUSTION ‘The problem of the congestion externality is illustrated in Figure 4-6, The short-run marginal cost is constant up to the quantity Q, and no congestion is shown while the demand is less than Q,, When the demand goes beyond Q, , the marginal cost curve becomes upward sloping. As additional ‘users impose congestion costs on all other users, more users imply increasing costs of congestion ‘Common examples of congestion extemalities are a road, bridge or park that becomes more congested as the number of users increases. Figure 4-6 ‘Congestion on a Road or Bridge Mec rea we DB J mec} WF fe sore | — MPC = Marginal Private Cost MSC = Marginal Sool! Cost, Box 4-4 ‘Measuring Congestion in Road Transportation ‘The value of transportation externality or congestion can be computed by estimating the excess of the marginal social cost of traffic over the marginal private cost of traffie as more and more vehicles are put on the road. As the volume of traffic on a particular road increases, the average speed of all vehicles is reduced. This negative relationship may become operative even at relatively low traffic volumes. As a consequence, an incremental road traffic slows down pre- existing traffic, which increases the cost per vehicle-km in terms of the time spent by vehicle cccupants. Suppose that the relationship between average speed S and traffic volume Vis expressed as S=a-6x V, where a and b are parameters, and the value of the occupants’ time is denoted by Hf per vehicle-hour. The cost of time perceived by the occupants ofa typical vehicle or the private marginal time-cost will be /1/S per vehicle-km. The total time cost will be Vx H/S. The ‘marginal social cost can be calculated by taking the first derivative of the total cost with respect to the traffic volume® and this is equal to ax H/S2 Thus, the congestion or the externality is the difference between the social marginal cost and the private marginal cost. This may be expressed as ‘percentage of the marginal private cost: (MSC - MPCYMPC = [a x H/S? - H/S]/(H/8) = a/S-1=(a-S)/S) This expression may be used to estimate the value of the externality or congestion. If the average speed of vehicular traffic on a particular road is 40 km an hour with congestion and 60 km, fan hour with little congestion (V = 0), a= 60, the marginal social cost exceeds the marginal private cost by a factor of (60 — 40)/40 or 50%. Thus, given the value of marginal private cost, one can estimate the cost of congestion. The first derivative of the total quantity gives the marginal value. In this case itis expressed as: 2 (VHS) av » HS ~ VAStx I8/BV = HIS - VHN $*o) = HIS + VH x WS "Substituting for Vin terms of S{V=(@-S)/], this simplifies to ab/S* a HAPTER 4. PRINCIPLES UNDERLYING BcoNoMic ANALYSIS OF PROMVous 2. Apvancep Maxual, on Prosecr EVvaLarion 4.5.3 Common Property-Resources Externalities’ ‘When resources (such as pasture land, stock of fish, oil/gas pool) have no unique owner and no government planner to allocate them among competing users and when anyone is free to use them ‘we have the common property or open access-extemality problem. Since no single owner claims a resource, no effort will be exerted to maximize its net present value.* Each user will try to maximize its own “take” from the resource. For example, any surplus income above a worker's market wage, ‘of any supra-normal profits to a firm induces outside workers or fitms to come in to exploit the resource and get a share of the surplus wages or profit. In which case, the return per worker will be driven down to the market wage while the return to the firm will go down to the normal return, Agategate employment of labor or firms will increase but the return per worker or firm will decrease {ill it reaches the average return in other sectors of economy. There is no surplus or rent to any ‘worker or firm in this situation. Common property with free entry involves excessive use of variable inputs and excessive production of output. The workers or the firms are not better off although more of them will be employed. Exploitation of land, stock of fish and oil poo! are some of the common examples of open access ‘or common property problem. Figure 4-7 shows the equilibrium of production on land under common property arrangement versus the private ownership. In case of private ownership, the number of ‘workers employed will be N, where the wage is equal to the marginal product of labor. In this situation, a rent of ABC accrues to the owner. If there is no private ownership and entry of workers is free, overutilization of land will happen, increasing the number of labor working on the land to N, At point N,, where the number of labor which will be working on land is represented, the wage will be equal to the average product and there will be no rent. It may be noted that at N,, which is a higher level of production, the corresponding marginal product is less than the marginal cost of production, which is the wage inthis simple mode. If this overexploitation continues, the corresponding ‘marginal product at the competitive equilibrium may ultimately be negative. Ifa project creates this ind of impact on other similar projects inthe locality, this negative overall impact on the economy should be included in its economic analysis. 7” See Harwick, John M. and Olewiler, Nancy D., The Economics of Natural Resource Use, Harper and Row Publishers (NewYork, 1986), Chapter 2and 8 for an excellent discussion + povitive net present valuc implies that arent will acer to the owner of the resource. After each ctor of production thas been paid the value ofits marginal product, what remains isthe rent or excess profit gos to the owner. Ghapren 4.” Princircss UNDeRtyIne Economic ANALYSIS oF PROJECTS 73Abvaxcep Manvat, ox Prosscr Evatuarion Figure 4-7 Private Ownership vs. Common Property Arrangement N frog oat ahr ro Marga! Prout of Labor Oil and gas extraction presents a second example of an externality arising out of a common property problem. Oil and gas tend to seep away from one underground pool or reservoir to another in the same field, because rates of extraction vary across locations. One reservoir owner can increase his/her share of oil or gas by drawing the resource from a neighboring reservoir without paying for it This will lead to accelerated but inefficient extraction of each reservoir as part of a pre-emptive effort by cach individual producer. Existing wells could be extracting oil or gas at a faster pace or more new wells could be drilled. If extraction is excessive, the total stock that could be recovered from the entire oil fields will be lower because the ultimate amount of the recoverable stock is inversely related to the rate of extraction. More oil will also be left underground unnecessarily as a result of rapid extraction. Thus the entire extraction process is economically less efficient than it ‘would have been under a well-defined single ownership of all the ol ina field. Exploitation ofa stock of fish is another example of private versus common property ownership. ‘The more fish everyone catches, the less is available for the next fisher or for the future. The cost of catch also increases. This case differs from the example of oil pool in the sense that the stock of fish may be regenerated if'a minimum level of stock is kept. If the stock of fish were owned by a single owner, it would be exploited efficiently. In a common property ot open access situation, however, they would be over exploited and the stock might be depleted completely. 4.5.4 Monopoly Externalities ‘Sometimes there is only one producer of a good or service in the economy and he/she enjoys a ‘monopolistic power in the market. The monopolist is in a position to set the price and sell the output demanded by the consumers at that price. From an altemative perspective, the monopolist can restrict the output which will raise the price of the good/service in the market over and above its ‘marginal cost of production.’ Compared to the situation in a competitive market, the amount of the good/service transacted in the market is lower and the price is higher. As a result, consumers lose * “This price difference is sometimes referred to as a monopoly tax. The consumers have to pay a higher price than that in ' competitive market as ifthe monopolist is imposing a tax on them Ax « consequence, the consumer surpls declines ‘hile the producer surplus rises. 7 (Chapren 4.” Priciptes UnpuRLVING Economic ANalvsis oF Provecrs‘while the producer gains at the cost of the consumers. The determination of price and quantity in a monopoly market is depicted in Figure 4-8. While the average revenue (AR) is the demand curve facing the market, and the equilibrium quantity that will be produced by the monopolist will be determined at the intersection F of the marginal revenue curve and the marginal cost curve. But at equilibrium quantity Q,, the price is given by point B on the demand curve AR. Thus, adivergence is created between the cost of production given by P* and the price paid by buyers P™, Monopoly may arise due to a variety of reasons. A resource crucial to the production process may have a single owner. Legal or institutional barriers may be working against the entry of other producers. Or a natural monopoly may exist arising from economies of large-scale production that Teaves no scope for more than one producer."® Figure4-8 ‘Monopolistic Market Average Revere NrgoatRevense Marga Cat Pree Pad by Consurer Nera Cont of Prousion Norooly fax Whatever the cause, a monopolistic market causes the selling price to diverge from the ‘marginal cost. How this creates externalities may be seen from analyzing the situation in which the demand for the monopolist’s product increases over time, possibly due to changes in preference or simply due to population increase. The monopolist producer may react in one of the following ways: (a) by producing and selling the same quantity of product as before but at a higher price; or (b) increasing the output and selling a larger quantity at the same price. In the first scenario, income is redistributed from the previous consumers to the producer. With respect to the product, previous purchasers now pay more to buy the same quantity. Thus, the monopolist producer gains at the cost of previous consumers. This happens due to an jnerease in the product’s demand by other consumers, a decision in which neither the previous consumers nor the producer played any part, and to which the previous consumers were not a consenting party. This is an external economy to the monopolist and an equal offsetting external diseconomy to previous consumers."' Transfer from the consumers to the producers is relevant for analyzing the project’s distributional impact. 10The single-ownership situation may arise in case of natural resources. The legaV/institutional barriers often have their origin in some patent law. ‘The natural monopoly occurs in ease of large-scale uilities such as railways and telecommunicatons. » Inthiscase the external effet takes the form of redistribution of income due to an increase in price of the product an this is sometimes refered to as “distributional externality.” aNciPLes UNDERLYING ECONOMIC ANALYSIS OF PROJECTS 75In the second scenario, the monopolist producer sells more atthe same price because of the new set of consumers. Thus, the monopolist benefits without hurting anyone else and because of the decision of new buyers to which he/she was not a party.” Even if this producer was the only monopolist in the economy which exhibits perfect competition in all markets including the labor market, the social cost and social value in the monopolist’s market would stil diverge there but nowhere else. Any development that increases the sale of the monopolist’s output will enhance his/ her total real income without making anyone else worse off, 4.5.5 Tax, Tariff, and Subsidy Externalities ‘Taxes are imposed by government in order to raise revenues for themselves and the public sector. The purpose of this revenue is to achieve some objectives of public expenditure.” Taxes combined with subsidies may be viewed as instruments of redistribution of income in the society. Import duty and export taxes (or subsidies) may serve the purpose of raising revenues and also for giving specific direction to the trade policy of the state, When a tax, a tariff or a subsidy is imposed ‘on any good or service, divergence happens between the marginal value and marginal cost of production, ‘The cases of a tax and a subsidy on non-traded goods or services are analyzed in Section 4.5.5.1 while the cases of import duty and export tax on traded goods are dealt with in Section 4.5.5.2. 4ASS1 Tax and subsidy in the market of non-tradable goods ‘When tax or tariffis imposed, the value to the consumer of the unit of commodity is given by the price of the product inclusive of tax. The cost of production, on the other hand, is the price excluding the tax. A tax (£) or tariff will cause the marginal value of a commodity to be higher than its marginal cost while a subsidy (A) will have an opposite impact (Figure 4-9 and 4-10), Thus, the additional revenues to the government due to the purchase of that item represent the excess of benefit over cost. Also, the beneficiaries of the activities of the government that are financed by these tax revenues have a real income gain. By purchasing an additional unit ofthe taxed item, a consumer creates an external economy that benefits someone else. Ttmay be pointed out that the decision-maker in the case of imposing a tax or extending a subsidy is the government or the legislature. The people affected by this decision could be a party to electing the lawmakers but they cannot bea fully consenting party to the decision-making process for imposing specific taxes and subsidies. * This isthe ease ofa “real income externality” in which the benefit to the producer is not du to transfer from someone else in the economy. » The purpose of raising revenues isto enable the government to perform functions that cannot be undertaken by the private sector due to market failures (See chapter 2). The govenament is also required to adopt appropriate fiscal and ‘monetary policies fo the stabilization of the economy. Also, expenditures in social sectors (healthcare, education) are necessary for reducing income disparities and promoting equity (Cuarrex 4.” Prancipies Unbkiyinc Economic ANALYSIS OF PRorEcTs:Voume 2. Aovaxceo Maxuat, ox Prosser Evanuarion Figure 4-9 ‘Tax on Non-tradable Goods S+Tax Price Parenee Pp i Guantiy Price Paid by Consumer = Price resve by spar Figure 4-10 Subsidy on Non-tradable Goods Price’ Pl PHL + K)= PE 455.2 Import duty and export tax in the market of tradable goods ‘When duty is imposed on goods imported into the country, a divergence is again noted between the item’s marginal cost and its marginal value to consumers. The marginal cost to the economy is the intemational price P_ at which the item is imported while the marginal benefit is the tariff (?) inclusive of price P(1+) paid by the consumers. This is depicted in Figure 4-11. The additional revenue to the government represents the excess of benefit over cost. A similar situation arises when exports are taxed or subsidized. A difference is created between the exported item’s economic benefit and economic cost. The economic cost is P, while the economic benetit is P, (1-1). The case of export tax is shown Figure 4-12. Chasen 4.” Pemvcinuss Unpentvine Econostic ANaLysis oF ProsectsAsa consequence of taxes, tariffs and subsidies, economic externalities also arise in the markets of foreign exchange and labor. These two types of externalities are discussed in the following two sections. Figure 4-11 Distortion due to an Import Duty a s R Wor Supey b Pico Quanity Figure 4-12 Distortion Caused by an Export 1 Price s R ‘Wertd Demand Werld Demand PLPC) ‘Aor Export Tax So ‘Quantity 4.5.6 Foreign Exchange Externality ‘The foreign exchange externality is meant to capture any indirect external welfare effects that result from a project's incremental use or production of foreign exchange. The source of this extemality lies in the divergence that exists between the marginal value of a unit of forcign exchange and the ‘marginal cost of earning that unit. This divergence is ultimately due to market distortions underlying the demand and supply of foreign exchange. Giaonee'4.”Brascieuis UxpeRiviNe‘The market of foreign exchange is a derivative of the markets for imports and exports. Behind the domestic demand for foreign currency is the demand for imports, which in turn depends upon the domestic demand and supply of importable goods. Thus, the demand for imports is translated into the demand for foreign exchange by importers. Similarly, behind the domestic supply of foreign currency is the supply of exports which depends on the domestic supply and demand of exportable goods. Any distortions such as import duties, value-added tax, export tax or subsidy or quantitative control in the ‘markets of importable and exportable goods will distort the demand or supply of foreign currency. 4.5.7 Labor Externality In the labor market, a variety of factors may create a divergence between the market wage and the cost of employment of a worker atthe project. This cost of employment, referred to as the supply price of labor, reflects both the value of the market and non-market activities undertaken by the ‘worker prior to joining the workforce at the project, and all other factors (working conditions, additional cost of transportation or living) that govern the desirability of working atthe project. It will also take {nto account any tax differential that the worker may face as a result of moving to the project from another employment. Sometimes the project has to pay wages that may be higher than the supply price of labor inthe ‘market, especially when minimum wage laws exist or labor is unionized. The labor markets often have other types of imperfections such as protected sectors that offer higher than the prevailing market clearing wage. Other factors in the labor markets are search costs, voluntary unemployment and unemployment insurance. These are also responsible for creating a wedge between the market ‘wage and the cost incurred by the economy when a particular type of worker works on the project. 4.5.8 Basic-Needs Externalities Some projects provide goods and services that cater to basic needs such as nutrition, health care, education and housing for society’s low-income groups. Although the project directly benefits low- income groups, it also confers indirect benefits on other citizens. The basic-needs externality relates to the extemal benefits accruing to society when improvement occurs in the circumstances of individuals of families belonging to these groups. When a project is able to provide food, education, health care and housing to society's deprived members, other citizens also derive an external benefit from these activities. The basic-needs approach is based on “paternalist” elements in society Its key idea is the fact that consumption of specific goods and services by a section of society, which results in the improvement of their state and not an increase in their income, gives rise to an externality forthe donors." The rest of the society wants welfare recipients to spend more to meet the family members” basic needs rather than to spend for other trivial wants. it may be noted that in the base needs approach its not the recipients utility that enters the donor’s utility function Itisin the “distributional weights” approach of looking atthe distributional considerations thatthe recipient's uility is taken into account in the utility function of the donor Carri 4.” Paiscintes Uspeni vino Economic ANALYSIS OF PxovEcTs 79[A typical case of basic needs, for example, basic health care to children of poor families, is illustrated in Figure 4-13. The private demand curve of the beneficiary group is D. Ifthe externality accruing to other members of society is included, the social demand curve becomes D'. The consumption of basic health care increases from Q, to Q, . The net benefit is the difference between the gross benefit 0, Q,£’AE and the additional cost incurred Q, Q,E"E, that is the triangle EAE”. Alternatively, the gain from externality may be seen as EAB” B, offset partially by the efficiency cost of EE’B that will arise from the subsidy provided for achieving this additional consumption. Figure 4-13 Basic Needs Externalities aa Quentiy” Were, (denotes the Pie Derand Cure of he beneeary group denotes the Socal Demand Curve incu base needs externas 4.6 Economic Benefits Including Externalities ‘The framework for estimating the economic benefits and costs of a non-traded good was presented inan earlier section. That framework did not take into consideration the presence of externalities. We describe below how that framework would be modified when externalities are taken into account In order to estimate a project's economic benefit, its overall impact on the economy is examined taking externalities into consideration. As outlined above, in the presence of the externality, the social demand and the social supply are different from the private demand and the private supply, respectively. Thisis illustrated in Figure 4-14. In the presence of an externality that creates a divergence between the social marginal value and the marginal cost, itis the social cost or social benefit curve that has to be taken into account in estimating the benefit of the output of a project or the cost imposed by its use of an input, Before the ‘project, the social equilibrium is at £ with optimal quantity Q, and price P, . With the project, the price Guserex 4.” Princirtes Unpertving Economic ANALYSIS OF PROJECTSis P, and quantity is Q,. Quantity in the market is higher at a lower price. More consumers can enjoy the product and therefore the benefit to consumers has increased by EEQ,Q, . On the other hand, at a lower price, other producers cut back their production to Q, and some resources (EAQ Q) are released to the economy that can be used for other purposes. Thus, the total economic benefit of the project is the sum of additional benefit to consumers and the saving of resources to. the economy due to the project, which is graphically represented by the area EAQ OE” Figure 4-14 Economic Benefit of A Project in the Presence of Externalities Price — MSC+ Project ‘Guantty 4.7 Economic Costs Including Externalities ‘The estimation of economic costs due to the use of an input by a project may be done in a way similar to estimating the project’s benefits. As shown n Figure 4-15, the equilibrium in the market of the input in the presence of externality is £ with an optimal quantity Q, and price P, . When the project uses this input in its production process, the demand moves out and the new equilibrium is at E’ with quantity Q, and price P, . Some new producers begin additional supply of the input because of the higher price and the cost of these resources to the economy is BE’Q,0,. Also, because of an increase in price of the input, some other consumers are pushed out of the market and the benefit foregone is EAQ,O,.. Thus, the project’s total economic cost in the presence of an externality is the sum of these two costs and is equal to EAQ.0,E’. Guarrex 4.” Phincintes UNbertvine Economie ANALYSIS OF PROJECTS aiMarginal pata cost mpc Marga Socal cost nung extrait P Price bore jet Pp ree ate project, 4.8 Conclusions In order to estimate a project’s economic benefits and costs, the impact of externalities has to be taken into consideration because they have real effects on the economy. Extemalities range from environmental externality to taxes and subsidies in the market of the output produced by the project or input used by the project. Externalities create a wedge between the economic value of a good or service and its marginal cost of production. In the estimation of economic benefits and costs, taking into consideration the impact of externalities, the social marginal benefit curve or social demand curve should be used on the benefit side. Similarly, the marginal social cost that includes both the private cost and the externality is the relevant cost curve or supply curve.Cuapter 5 Estimatinc Economic Opportunity Cost oF CAPITAL Different approaches have been used to determine the economic cost of capital.' One of the practical ways to measure this is to use the economic opportunity cost of public funds, where the funds will be drawn from the various sectors of economy according to their response to changes in interest rates due to borrowing in capital markets.” Ina small, open and developing economy like the Philippines, there are normally three altemative sources for these public funds. The first source comes from those resources that would have been invested in other investment activities, but these other activities have been either displaced or postponed. ‘The second source are individual savers who would have spent their resources on private consumption, but whose consumption was foregone due to an increase in domestic savings. The third source are additional foreign capital inflows, Based on these three alternative sources of public funds, the economic cost of capital (EOCK) ccan be estimated as a weighted average of the rate of return on displaced or postponed investments, the rate of time preference to savers, and the cost of additional foreign capital inflows.’ It can be expressed in the following form: EOCK=f,x «+f, 1+f,xMC, Equation 5-1 where 7 the economic cost of funds drawn from the displaced investment 7 the rate of time preference to savers MC_— = the cost of foreign savings Fe ff, = corresponding weights, f+ f+ f= 1 = proportions of funds diverted or sourced from each sector 7” See, for example, Sell, Axel, “Project Evaluation: An Integrated Financial and Economic Analysi 1991), Pare TM 3: Hirshleifer, Jack, DeFlven, James C., and Milliman, Jerome W, “Water Supply: Economies, Technology, and Policy.” (Chicago: University of Chicago Press, 1960); Little EMLD_ and Mirrlees J.A., “Project Appraisal and Planning for Developing Countries,” (London, Heineman Educational Books Lid, 1974). > Harbeger,A.C.,“On Measuring the Social Opportunity Cost of Public Funds,” Project Evaluation — Collected Papers, (Chicago! the University of Chicago Press, 1972), Chapter 4 » This approach follows the framework (discussed in previous chspters) for estimating the economic price of goods, that {sa weighted average of the demand and supply prices. In this ease, the demand price for capital isthe marginal rate of return on displaced postponed investments and the supply prices are the rate of time preference (cost of additional Stvings) and cost of additional foreign capital inflows. * (Avebury, England GhivieR’ 5." Estate Bconontte Orroxruntry Cost OF Carta