Department of Agricultural Economics

Lecture on
Agricultural Project Planning and Analysis (3 CrHrs.)

By: Melesse Z. (MSc.)

December, 2020
D/Markos, Ethiopia
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 CHAPTER ONE: INTRODUCTION
1.1 Project Concept: Definitions
1. Policy: A statement of course of action set by the Government in
the management of development affairs towards an aspect of the
economy, including the goals that the government seeks to achieve,
and the choice of methods to pursue those goals (Ellis, 1991; p. 8)

• Policy is Formulated and implemented at different levels of Government.

– broad, goal-oriented expressed in the form of laws, rules and regulations
and guiding declarations.

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2. Strategy: The route (means) to achieve the desired policy goals via
specific elaborations of the resources to be mobilized.
– Strategies link policy goals to programs that are set in a given plan
period.

3. Program (A development plan): is a framework that contains similar

activities designed to bring development changes (result-based).
– It is a general statement of economic policy.
– A program is a group of related projects managed in a coordinated way
to obtain benefits

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4. Project: An investment activity where resources are used to create capital
assets & produce benefits over time and has a beginning and an end with
specific objectives (Gittinger, 1982) .
a project is an investment activity which logically lends itself to planning,
financing, and implementing as a Unit.
A proposal for investment where a cost stream results in a certain flow of
benefits over a specified period.
‘The whole complex of activities for which money will be spent in
expectation of returns’ (ibid).
• The smallest operational element prepared and implemented as a separate
entity in a national plan

• In general, project involves the creation of new and additional fixed

production capacity.

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 1.2. The linkage between projects and programs
 A program is a wider concept than a project.
 It may include one or several projects at various times whose specific
objectives are linked to the achievement of higher level of common
objectives.
 Projects, which are not linked with others to form a program, are sometimes
referred to as “stand alone” projects.

 A program is an ongoing development effort which may not necessarily be

time bounded however project produces benefits over time and has a
beginning and an end with specific objectives

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Cont…

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E.g. Livestock improvement program, a health improvement program, a
nutritional improvement program, a rural electrification program, a
road development program, etc.

Livestock Improvement
Program

Poultry Veterinary Cattle breeding Dairy project

project service project project

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Program   Projects
i 1
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 1.3. Characteristics of Projects
 There are 5 basic characteristics of projects distinguishing them from
programs.
 Projects in general need to be “SMART”.
 Specific: Projects should be specific in its objectives, activities, benefits for
a specific group of people.

 Measurable: Projects are designed in such a way that investment and

production activities and benefits expected in financial, economic and if
possible social terms should be identified and be valued (expressed in
monetary terms).
 Area bounded: In designing a project, its area of operation must clearly be
identified and delineated.

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 Real: Planning of a project and its analysis must be made based on real
information.

 Planner must make sure whether the project fits with real social,
economic, political, technical, etc situations.

 T–Time bounded: A project has a clear starting and ending point.

 The overall life of the project must be determined.

 Moreover, investment and production activities have their own time

sequence.

 Every cost and benefit streams must be identified, quantified and valued
and be presented year-by-year.

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 1.4. Types of projects
• Understanding the menu of project types will give us prior information to
analyze properly during project appraisal,
 projects varies according to a number of criteria;
• According to complexity
– Easy: A project is easy when the relationships between tasks are basic
and straightforward; detailed planning are not required
– Complex: The project network is broad and intricate

• According to source of capital

– Public: Financing comes from governmental institutions
– Private: Financing comes from businesses or private incentives
– Mixed: Financing comes from a mixed source of both public and private
funding

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• According to project content
– Construction: to do with the construction of a civil or
architectural work.
– IT: Any project to do with software development, IT system etc.
– Business: involved with the development of a business,
management of a work team, cost management, etc., and usually
follow a commercial strategy
– Service or product production: those involved with the
development of an innovative product or service,
– They are often used in the R & D department.

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• According to those involved
– Departmental: When a certain department or area of an
organization is involved
– Matriarchal:When there is a combination of departments involved
– Internal: When a whole company itself is involved in the project’s
development
– External: When a company outsources external project manager or
teams to execute the project.
• According to its objective
– Financial: oriented seek of profit
– Social: Oriented at the improvement of the quality of life of people.
• Educational: Oriented at the education of others.
• Community: Oriented at people too, with their involvement.
– Research: Oriented at innovation and the gaining of knowledge
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• Other classifications

i) New and Rehabilitation/Maintenance projects

ii) Single Vs Multiple-intervention projects

iii) Productive, Social and infrastructure projects

iv) Single and Multi-purpose projects

v) Slow and quick benefit yielding projects

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 1.5. Project Analysis, Pros and Cons
 There are different uses of resources, all countries; but particularly the
developing countries, are faced with the basic economic problem of
allocating resources
– A choice therefore has to be made among competing uses of resources based on the
extent to which they help the country achieve its fundamental objectives.
Project analysis is a method of presenting this choice between competing
uses of resources in a convenient and comprehensible fashion.
It is a method of evaluating alternative investment projects to maximize the
net benefit of a society drives from its scarce resources.
– If a country consistently chooses allocations of resources that achieve most in terms of
these objectives, it ensures that its limited resources are put to their best possible use.

In essence, project analysis assesses the benefits and costs of a project and
reduces them to a common denominator.
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 Advantages of project analysis
• It coordinates efforts of various responsible organization b/c it provides
costs and benefits year by year.

• It shows possible problems that may be encountered in the implementation.

• It encourages conscious and systematic assessment of various alternatives.

• It serves as source of data; It sets better criteria for monitoring and

evaluation.

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 Limitations of project analysis
 The poor quality of the data used: Unrealistic assumptions about market
shares, future prices, yield potentials, relevance of inflation, the quality of
project management, etc., can make garbage out of the project analysis.
 the reliability of the results of project analysis depends upon the extent to
which the data, assumptions, and forecasts diverge from the reality.

• Project planning is a forward looking; The realization of the expected

net benefits of the project depends on the extent that actual future
circumstances deviate from the expected future circumstances.
• limited usefulness in judging risk: the technique of project analysis
provides limited support in judging the risk and uncertainty surrounding the
project
– Though there are techniques as sensitivity analysis, simulation analysis, decision tree
analysis, etc. used to incorporate the risk element in the analysis and choice of projects,
these techniques can never avoid the risk problem.

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 project analysis is a ‘partial analyses; As a species of development
planning models, project analysis treat each project independent of the
whole economy and may lacks consistency and overall feasibility.
 The apparent interconnection of a project with the other projects and
with the whole economy cannot be assessed.

 Therefore, it is advisable not to translate the benefits of projects to the

overall economy directly.

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 1.6. Aspects of project preparation and analysis
Project analysis can be divided into seven major modules or elements:

A. Technical Aspects: examine the technical relations in the project.

– concern the physical inputs and outputs of real goods and services

– These will vary from project to project.

– Experts need to provide information on all major elements technical

input/output coefficients.

– Project analysts have to make sure that technical estimates and

projections relate to realistic conditions regarding input/output of
existing technology.

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Eg . For agricultural project:

 the soils and their potential for agricultural development

 the availability of both natural and supplied water, the crop varieties and
livestock species suited to the area

 the production supplies and their availability, the potential and

desirability of mechanization; and pests endemic in the area and the kinds
of control that will be needed.

 the coefficients of production, potential cropping patterns, and the

possibilities for multiple cropping.
• technical analysis will determine the potential yields in the
project area,

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 B. Commercial and/or Business Aspects
 Commercial and Business Aspects include

Input supply and demand issues include: securing supplies

(fertilizer, pesticides, and seed) and financing etc.

 market demand for the product, effects on prices, processing

and value added effects, and

 effects on the domestic and/or export market and quality of

the product.

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 C. Institutional-Organizational-Managerial Aspects
 Appropriateness of the institutional setting (i.e. rules of
conduct) is important for the success of the project.

 The organizational structure, inter-organizational linkages and efficient

management of the organizations are crucial for success.

 participants have to be understood and accounted for to avoid

disruptions and hence, increase the possibility of adoption and success.

 Some important aspects include land tenure, indigenous farmer

organizations, authority, and responsibility.

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 D. Financial Aspects
 Financial aspects include the monetary effect of the project on
participants; farmers, firms, public corporations, project agencies, and
the national treasury.

– most data have to be translated into financial forms for

comparability.

– Organizations usually have formalized systems of financial

accounting and reporting which may have to be further
manipulated to fit into the project format.

– mostly market prices are used and profits are important.

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E. Economic Aspects: Economic aspects lead to economic efficiency
and impact of the project on development of the total economy, vis-
à-vis the allocation of scarce resources, i.e. Economic efficiency.

determine the value of the project from the viewpoint of national

income

 In economic analysis the concept of opportunity costs are used.

 we need to adjust market price in to economic price because market

price may not reflect true value of goods and services.

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 F. Social Aspects
Determine the value of the project from the viewpoint of society at large

Broader social implications, particularly resource and income distribution

impacts are important.

also other aspects such as,

– Target population
– Household characteristics
– Age group and dependency ratio
– Cross-cutting issues (population, gender and HIV/AIDS issues)

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G) Environmental Aspect

• Environmental impact of a project refers to the effect of a project on

the world of animals, plants, water, air, and humans existing in the
project area.

• Ecological analysis should be done particularly for major projects,

which have significant ecological implications like power plants and
irrigation schemes, and environmental polluting industries.

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 1.7. Project Quality Factors
Quality factor Description

Ownership • involvement of target groups and beneficiaries in

by beneficiaries project design and project execution

• quality of the relevant sector policy within a

country
Policy support
• commitment of government to continuation of
project services after external/donor finance

Appropriate whether technologies applied in the project can be

technology maintained in the long run
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 • does the project take account of local cultural norms
and attitudes?
Socio-cultural
issues • do project beneficiary groups have appropriate
access to project services and benefits during and
after project implementation?

• how does the project take into account the specific

needs and interests of women and men?
Gender
equality • is there sustained and equitable access by women
and men to services and infrastructure as well as
contributing to the reduction of gender inequalities?

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 • the extent to which the project will preserve
Environmental
or damage the environment and therefore
protection
support or threaten longer term benefits

• the ability and commitment of the project

Institutional
implementation agencies to deliver the
and
project/programme and to continue providing
management
products and services beyond external
capacity
finance/donor support
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 CHAPTER TWO: PROJECT CYCLE
 project cycle are the different stages through which a project passes
 It is a sequence of events,/phases/which a project follows.
• Project cycle the life cycle through which a project advances from
infancy to maturity.
 The main features of the cycle are
information gathering,
analysis and
decision making

– the preoccupation of the project analysis is to consider alternatives, evaluate

them and decisions on which of them should be advanced to the next stage.

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• The two common approaches are

• UNIDO project life cycle.

• World Bank project life cycle

• According to UNIDO, project cycle involves three major phase

– pre-investment phase (includes identification, preparation and appraisal)
– investment phase (implementation phase)
– operation phase (operation and ex-post evaluation)

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 Project cycle…..(WB approach)
• According to World Bank, project cycle involves five stages, namely,
1. Project Identification
2. Project Preparation (Pre-feasibility And Feasibility Studies)
3. Project Appraisal (selection of Project Design)
4. Project Implementation
5. Project Ex-post Evaluation

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1. Project Identification: project planning concerned with the
generation and preliminary screening of project proposal and the
articulation of its broad investment strategy.

– This provides the framework, which shapes, guides, and

circumscribes the identification of individual project
opportunities.

– All types of specialists’ input are required at this stage.

– It is all about generation of projects ideas.

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In general there are four major sources from which project
ideas/suggestions/ may come:

technical specialists

local leaders

Entrepreneurs

government policy

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The identification of project ideas is based on several
aspects of development:
Need - a need assessment survey may show the need for
intervention
Market demand - domestic or overseas
Resource availability- opportunity to make available resources
more profitable
 Technology - to make use of available technology
Natural calamity - intervention against catastrophe such as flood
or drought
Political considerations

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2. Project preparation and analysis: Once project ideas have been
identified, the process of project preparation and analysis starts.
Project preparation must cover the full range of aspects of projects.
 Different alternatives may be available and therefore, resource
endowment would have to be considered in the preparation of projects.

 thus it require feasibility studies that identify and prepare preliminary

designs of technical and institutional alternatives, compare their costs and
benefits, and investigate in more details, the more promising alternatives
until the most satisfactory solution is finally worked out.

Project preparation involves generally two steps:

Pre-feasibility studies
Feasibility studies

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i. Pre-feasibility Study: Once a project proposal is identified, it needs
to be examined.
To begin with, a preliminary project analysis is need to done.
A prelude to the full blown feasibility study, this exercise is meant to
assess
(i) whether the project is prima facie worthwhile to justify a
feasibility study and
(ii) what aspects of the project needs critical to its variability and
hence warrant an in -depth investigation.

At the pre-feasibility study stage the analyst obtains approximate

valuation of the major components of the projects costs and benefits.

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 Cont…
Some of the main components examined during pre-feasibility study
include:
Project growth potential
Availability of adequate market, Demand and supply factors;
Investment costs, operational cost and distribution costs
Social and environmental considerations

If the project appear viable form this preliminary assessment the

analysis will be carried to the feasibly stage.

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ii. Feasibility Study
 If the preliminary screening suggests that the project is prima facie
worthwhile, a detailed analysis of the marketing, technical, financial,
economic, social, and ecological aspects will be undertaken.

 Feasibility study provides a comprehensive review of all aspects of the

project and lays the foundation for implementing the project
and evaluating it when completed.

 Based on the information developed in this analysis, the stream of

costs and benefits associated with the project can be defined.

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 the major difference between the pre-feasibility and feasibility studies
is the amount of work required in order to determine whether a
project is likely to be viable or not.
 Feasibility study requires broader time than pre-feasibility
 Detail analysis and more accurate data need to be obtained and if the
project is viable it should proceed to the project design stage.

 At this stage a team of specialists (Statisticians, engineers, economists,

sociologists……Scientists) will need to work together.

The final product of this stage is a feasibility report which

contain project elements:

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3. Selection of Project /appraisal/ phase
 this stage would enable the project analyst to select the most likely
project out of several alternative projects.
 It addresses whether the project is most worthy or not with either of
Non-discounting Criteria and Discounting Criteria.

• Non-discounting Discounting Criteria

– Ranking by inspection NPV
– Accounting Rate of Return IRR
– Payback Period Benefit Cost Ratio

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4. Project Implementation: implementation is the translating of an
investment proposal in to a concrete project.
After the project design is prepared negotiations with the funding
organization starts and once source of finance is secured
implementation follows.
The better and more realistic the project plan is the more likely it is
that the plan can be carried out and the expected benefits realized.
Timely implementation is very critical.
Delay of implementation would bring substantial cost over-run.
At the project implementation phase tenders are let and contracts
signed.

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 Project implementation must be flexible since circumstances change
frequently.
Technical changes are almost inevitable as the project progresses
price changes may necessitates adjustments to input and output
prices;
 political environment may change.

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5. Ex-post evaluation: It is an assessment of project impact after
implementation.
 Evaluate the success and/or/failure of project
 Compare actual performance with projected performance.
 It examines the project plan and what is really happened.
 It is a final phase of project cycle and gives lesson for revising of a
project.
Why evaluation??? A feedback device is useful in several ways
1. It tests the assumptions.
2. It provides document for future decision.
3. It provides corrective actions which can go with real.
4. It shows attainable assumptions.
5. It induces a desired care among sponsors.

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 2.2. Approaches to Project Planning
 Top-down approach – by central agencies which is best for new
endeavors.

 Bottom-up approach – people centered or starts from the

grassroots and it is community based approach.

 Participatory approach – it is a blended top-down and bottom-up

approaches and it is a balance to strike between the two extremes.
This approach brings about ownership feeling, commitment
and confidence of stakeholders.

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2.3 Techniques of Project Proposal preparation
2.3.1 Introduction to the Logical Framework Approach (LFA)
What is the LFA?
• Developed in the late 1960s for USAID
• Use was quickly extended to around 35 countries
• Until that time many projects:
 were poorly planned
 took little notice of the needs of end-users
 went off-track
 could not meet unexpected changes
 Over spent
 failed to have much positive impact

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 LFA is the Log frame Matrix which summarise a project in a
widely accepted format Using 4*4 Matrix

 Using LFA helps to …

 Analyse the existing situation (problem to be addressed by the project)
 Develop a logical hierarchy to reach your objectives
 Identify the potential risks in the external environment – things that need
to be taken into account over which you have little influence
 Plan how Outputs and Outcomes can be best monitored and evaluated
 Monitor and review the project as it is implemented
 Lays the foundation for implementing a monitoring and evaluation
system

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What's a Log frame?

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2.1.2 Elements of LFA
 Activities –these are the things we do using the resources we have – time,
people, money, equipment etc.
 Directly within our control,
 Outputs – Again, at the operational level, these are the immediate end
results of our Activities
 Outcomes/Purpose – This is what the project’s intermediate end results
following outputs.
 If possible, outcome is One.
 Goal – This is the ‘higher impact’

 OVIs: indicators describing “milestones” of progress of the goal, the

outcome and the output in terms of quality or quantity for monitoring.
 MOVs: data sources needed to verify progress of achieving the goal,
outcome and the outputs.
 Inputs: resources needed to carry out the planned activities.
 Assumptions: crucially important external factors which will determine
project success or failure.

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The Log frame Columns

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OVIs

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MOVs

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Assumptions

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Preconditions

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 Diagonal Logic
 Activities will lead to Outputs
 The Assumptions at the Outputs level must hold true for the Outputs to
lead to achieving the Outcomes
 The Assumptions at the Outcomes level must hold true for the
Outcomes to lead to achieving the Goal

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Diagonal Logic

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Four Core Areas of the Log frame

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 2.1.3 Steps in Logical Framework Approach

1. Analysis Stage

 Analyse the situation/problem

 Create a problem hierarchy (ProblemTree)

 Create an objectives hierarchy (Objectives Tree)

 Analyse the stakeholders - identify their stakes in the problem and

modify the problem analysis if needed

 Analyse alternative strategies and select an approach or combination of

approaches

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Analysing the Situation:
The Problem Tree

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 How to Develop a Problem Tree????

1. List all the problems

2. Identify a Core Problem
3. Decide which problems are
causes and which are effects
4. Arrange the causes and effects
in a hierarchy

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Setting Objectives
1. Restate the negatives from the ProblemTree as positives
2. Review your objectives
3. Test the Objectives Tree

• Points to be Considered
 Effects after restated, will be project goal
 Core Problem, when restated, will, in most cases, become our project
Outcome/main objective
 Causes after restated will be project outputs/specific objectives

 Not all negatives can be turned into positives as they will usually turn up
later as Assumptions

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 Stakeholder Analysis
1. Identify the stakeholders
2. Prioritise the stakeholders
3. Determine the needs of the stakeholders
4. Document the results in a stakeholder analysis plan

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 Designing a Strategy
1. Identify the different approaches we can take
2. Draw up a range of criteria
3. Analyse each approach against your criteria
4. Compare the approaches

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 Criteria for Strategy Selection

 Likelihood of achieving the project outcome

 Short-term results / medium-term results –
 Sustainability
 Cooperation from key stakeholders
 Cost
 Risk
 Involvement of end-users in decision making, implementation, monitoring
and evaluation
 Involvement of marginalised groups/positive discrimination
 Technical feasibility
 Environmental impact
 Social impact
 Political environment
 Relationship between organisations involved

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SWOT Analysis – alternative analysis

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Review our past & future...

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How can you …
• Use the strengths?
• Address the weaknesses?
• Exploit the opportunities?
• Defend against the threats

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 Develop a Strategy Table

OUTCOME

Narrative
STRATEGY Strengths Weaknesses Opportunities Threats Comments
Summary

Approach 1

Approach 2

Approach 3

Approach 4

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2. Planning stage
– Describe the project effects (Narrative Summary – Outcome and Goal)
– Describe the project operations (Narrative Summary – Outputs,
Activities and Inputs)
– Describe the project context (Assumptions and Preconditions)
– Establish Indicators and define Means of Verification (Project
Monitoring and Evaluation)

• The log frame can be used by researchers and managers to

design projects and programs, to review progress, and to check
that objectives are being achieved.

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Project Effects

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 The Project Goal
Selecting a Goal
• Government policy - it should
reflect national aims and priorities
or, at least, not contradict them
• Donor policy
• Your own organisation’s mission
and purpose
Describing the Goal
• Express the Goal as a desired
end, not as a process.
• Keep your language simple
• Refer to the target group and be as
specific/verifiable as possible
• In the Log-frame, this is entered
into the Narrative Summary
column
• The exact details (quantity, quality,
time, location and target group)
may be expanded later as an OVI
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Describing the Outcome

• Project outcome is the core objective (objective tree) developed from

the core problem (problem tree).
• Who and where are the target group?
• What change will be realised, and by when?
• Your Outcome must be SMART (Specific-Measurable-Appropriate-
Realistic-Time bound)

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Project Operations

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 Outputs
• Immediate, intended changes - measurable, specific results of
Activities conducted
• Together, they lead to the project Outcome
• Within the organisation’s control
• Often correspond to the immediate causes of the Core Problem
 Can be products (goods created, and infrastructure or services provided),
acquired knowledge / learning, or systems established
• Stated as end results, not processes

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Activities
• Actions / work done mobilising resources available (such as time, money,
people) to produce specific Outputs
• Each Output has a group of related Activities, a series of time bound steps
to be conducted by the project
• Keep the level of detail enough that you have outlined the tasks so it is
clear they will lead to the desired Outputs
• Don’t list Activities which are not related to any Output

Inputs
• A summary of the project resources –
– Project cost
– Personnel
– Materials
– Equipment.......etc

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Project Context

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 Preconditions and Assumptions
• At the Preconditions level, what is needed before Activities can begin?
• At the Outputs level, what must be true for Outputs to lead to the
Outcome ?
• At the Outcome level, what must be true for the Outcome to contribute
towards the Goal?
Selecting the Best Response

• Accept it

• Avoid it

• Reduce the Likelihood of the Risk

• Reduce the Effects

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Project Monitoring and Evaluation

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 Project Monitoring: is the regular, systematic collection and analysis of
data on specific indicators to:
 Demonstrate the extent of progress to management and key stakeholders
 Assist in timely decision-making
 Ensure accountability
 Provide the basis for evaluation and learning

 Project Evaluation is the periodic, systematic assessment of an on-going

or completed project, its design, implementation and results. It aims
to:
 Compare actual results with those planned/expected
 Determine the relevance and fulfilment of objectives
 Measure efficiency, effectiveness, impact and sustainability

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 Objectively Verifiable Indicators (OVIs)
• Tell us how the achievement of activity objectives will be measured &
verified.
• Indicators answer the question: “How do I know whether the activities
are leading to the desired change?”
• Are the basis for monitoring the progress towards achieving outputs
and outcomes.

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 Means of Verification (MOV)
• What information do we need to verify the indicators?
• Where do the required information be accessed?
• How much can we get quickly, cheaply and simply (e.g., using a
questionnaire)?
• Which methods should we use for what information?
• How reliable will the information be?
• Are the methods appropriate for the target group? (Can they
complete a questionnaire? Will they be able to fill out questionnaires
correctly, engage in interviews or focus groups? Are they literate? Will they
just give face-saving answers?)?)
• Who should gather the information? Do we have the skills to conduct these
methods?
• When and how often should we collect the information?
• How shall we store the data?
• Can we easily analyse the results?

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 • Selecting Methods
• Survey - questionnaires, checklists, Interview(structured or unstructured,
getting first-hand responses from end-users)
• Desk Study - reviewing existing documentation: reports, publications,
web sites
• Observation - visiting the project site and personally observing what is
happening
• Focus Group Discussion - facilitated meetings with groups of end-users
around a particular issue
• Case Study - an in-depth investigation over time into one particular end-
user’s experience and outcomes of the programme

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 2.3 Why Some Projects Fail?
 A comprehensive list of “where things went wrong” will include
 Non participatory planning: End-users (communities) have not been
involved in planning, implementation, M&E. i.e.
 Lack of local ownership and responsibility
 Problems of project design and implementation- poorly written and hard
to understand (i. e., when writer did not follow the guidelines)
 Problems related to poor project analysis-Problem being faced /need for
the project has not been explained properly
 Inadequate or no infrastructure: Inappropriate technology, cropping
systems and animal husbandry.
 Changing economic and market conditions
 Project proposal asks for more funding than the donor can provide
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 Donor is not assured of the organisation's capabilities- Externally driven
project initiatives
 Project’s outcomes do not reflect the donor's area of concern
 Unsupportive policy environment (i. e., when project is unrelated with
government policy)-
 Failure to appreciate the social and political environment
 Administrative problems: Project has not been coordinated with other
organisations
 Project is too ambitious(unrealistic expectations)
 Inadequate monitoring and evaluation

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 Chapter Three
Identifying Costs & Benefits of Agricultural Projects

 In the appraisal stage of project planning, feasibility and optimal

use of scarce resources by the proposed project intervention should
be appraised.

 Done using Cost-Benefit Analysis (CBA) methodology.

 CBA is a framework where all project benefits and costs are:

 Identified
 Quantified
 Valued for financial and economic feasibility study.

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 3.1. Objectives, Costs and benefits
 The objectives of the project provide the standard against which costs
and benefits are defined.
 A farmer may have the following objectives at certain period of time:
• Increase household income/ Net incremental benefit;
• Educating children;
• Reducing work hours (consuming more leisure);
• Paying debt; Reducing risk; Meet social obligations; etc
 A private business firm can have objectives such as:
Maximizing net income (profit);

 increasing market share;

improving customer satisfaction;

reducing risk, etc. 85

 A society or a nation as a whole may want to achieve the
following objectives as:
Increasing national income (growth objective);
Ensuring equitable distribution between persons, regions,
generations, etc. (distributional objective);
Improving balance of payments;
Improving regional integrity;
Reducing inflation and unemployment and
Maintaining environment, etc.
 Thus, we will take
maximization of net incremental income for a private firm and
maximization of national income for a nation as the fundamental
objectives in the analysis of a project.

86
 In financial analysis, which is conducted from the viewpoints of
the private project-operator, we will evaluate the project in
terms of its contribution to the net income (profit) of the
private owner

 In contrast to this, in economics analysis, which is conducted from

the standpoint of the society as a whole, we will evaluate a
project in its contribution to the national income - the value of all
final goods and services produced during a particular period usually a
year.

87
 Cont…

Accordingly:
o Anything that reduces the profit of the owner is a financial cost
o Anything that increases the owner`s profit is a financial benefit
o Anything that reduce the national income are economic costs and
o Anything that increases the national income are economic benefits

88
3.2 Project Costs and Benefits: In Financial & Economic Analysis
 In FAs we are interested in the items that entail monetary outlays.
– is simply based on the actual prices that the project entity pays for
inputs and receives for outputs,

 however, the prices used for economic analysis are based on the
opportunity costs to the country/willingness to pay/.
– If a project diverts resources from other activities that produce
goods or services, the value of what is given up represents an
opportunity cost of the project to society.
– Even if the project entity does not pay for the use of resources, this
does not mean that the resource is free good.

89
 The economic values of both inputs and outputs usually differ from
their financial value because:
– There are different market imperfections;
– There are government interventions of various kinds (taxes,
subsidies, tariff, price control, etc, and;
– Some goods are public goods by their nature (may not totally have
market or the price consumers are willing to pay are less).
– Externalities,…..
 The projected financial revenues and cost are often a good starting
point for identifying economic benefits and costs but two types of
adjustments are necessary.
i. It is necessary to include or exclude some costs and benefits.
ii. It is necessary to revalue inputs and outputs at their opportunity cost.

90
 3.3 Categories of Costs and Benefits
1. Direct Transfer Payments
 Some entries in financial accounts really represents shifts in claims
to goods and services from one entity in the society to another and do
not reflect changes in national income.
 These are the so-called direct transfer payments,

 Common transfer payments in projects are:

taxes,
subsidies,
loans and debt services
Depreciation allowances.

91
A. Taxes: Tax is transfers of income from the firm to the government so
that this income can be used for social purposes
Payment of taxes is clearly cost in financial analysis.
When a firm pays a tax, its net benefit is reduced.
But the firm’s payment of tax doesn’t reduce the national income.
Thus, in economic analysis we would not treat the payment of taxes
as a cost in project accounts.
B. Subsidies:
Monetary benefit to project owner from government.
Simply direct transfer of payment as opposed to tax.
It is a benefit in financial analysis. However, it will not be included
as a benefit in economic analysis.

92
C. Credit transactions: Credit transactions are the major form of
direct transfer payment in projects.
• From the standpoint of the project owner, receipt of a loan increases
the production resources he has;
• payment of interest and repayment of principal reduce them.

• But from the standpoint of the economy, these are merely transfers of
control over resources from the lender to the borrower.

• The financial cost of the loan occurs when the loan is repaid, but the
economic cost occurs when the loan is spent.

93
D. Depreciation allowances: Depreciation is the amount in
decreasing of the total (initial) value of a material due to its service
value.
• The economic cost of using an asset is fully reflected in the initial
investment cost less its discounted terminal value.
 It is cost in financial analysis.
 It is not considered as a cost in economic analysis.

eg. Suppose the cost of machinery with initial cost 10,000 birr and life
time of machinery is 10 years.
• Annual depreciation cost is 1,000 birr using straight line
method. 1,000 is saved amount of a machine, then we can
replace the machinery after 10 years because we gain and save
1000 birr every year.
94
2. Costs of Inputs
• Physical goods: - construction materials, raw materials, etc. Here valuation
is not a problem but the problem is associated with planning the required
amount of input.
• Labor: - skilled and unskilled. Here the problem of valuation may arise when
the project uses family labor.
• Land: - it is not difficult to identify. The problem is with valuation of land
because of the very special kind of market conditions that exist when land is
transferred from one owner to another.

 In financial analysis, we directly take the market price if the use of these
inputs involves cash outlays. If there are no cash payments for some of these
inputs, it will not be considered as a cost.
 In economic analysis, however, since the use of these inputs is related with
the use of real resources, they will be valued at their economic price and
entered into economic accounts.
95
3. Contingency Allowance: Sound project planning requires provision
that will be made in advance for possible adverse changes in physical
conditions or prices that would add to the baseline costs.
 Contingency allowance may be divided into
a) physical contingencies: A Financial benefit and an economic cost

b) Price contingency allowances

i. relative changes in price and
ii. general change in price

96
i) Relative changes in price
 A rise in the relative cost of an item implies that its productivity elsewhere in
the society has increased, that is, its potential contribution to national
income has risen.
 Relative change in price of inputs affects the relative value of inputs and also
affects value of output.
 Thus, costs that may be incurred due to possible relative changes in prices
will be considered in both financial and economic analysis because it is a real
change.

ii) General change in price (inflation): inflation does not affect national
income in real terms & in project common means is to work in constant
prices, on the assumption that all prices will be affected equally by any rise in
the general price level.
All prices are affected equally
97
4. Sunk Costs: Sunk costs are those costs incurred in the past upon
which a proposed new investment will be based.
• When we analyze a proposed investment, we consider only future
returns to future costs; expenditure in the past, or sunk costs,
do not appear in both financial and economic accounts.

• Money spent in the past is already gone; we do not have as one of our
alternatives not to implement a competed project.

• In project analysis always we have to look in to future earning or

benefit and future cost by forgetting the past cost and benefits.

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3.4Types of project costs and benefits
1) Tangible Costs & Benefits of Projects
• Increased production: Whether the increased output is marketed or consumed at
home, it represents the benefit of a project.
• Quality improvement: reflected in the market price of the good.
• Change in time of sale: benefits will arise from improved marketing
facilities that allow the product to be sold at a time when prices are more
favorable.
– The benefits of these projects arise out of the change in “temporal value”.
• Change in location of sale: investment on transport facilities to carry
products from the local area where price are low to distant market where
prices are higher.
– The benefits of such projects arise from the change in “location value”.
• Change in product form (grading & processing): projects involving
agricultural processing industries expect benefits to arise from a change in
the form of the agricultural products.
99
• Cost reduction (through mechanization): The classical example of a
benefit arising from cost reduction in projects is the gained by investment in
agricultural machinery to reduce labor costs.
– In other industries also use of improved technologies that substitute labor could be an
incremental benefit from the reduction in cost of labor as compared to the 'without'
condition.
• Losses avoided: - The ‘with and’ without’ project analysis tends to point out
such costs avoided by the project.
– Similarly risks avoided or reduced can be considered as benefits; sometimes such
benefits are reflected by output increment through loss reduction.

• Cost of inputs
• Tax
• Interest,,,,,,,, are tangible costs
 Since all these benefits are real increase in value of commodities
or reduction in costs, they will be considered in both analyses.
100
2) Intangible costs and benefits

 Almost all projects have costs and benefits that are intangible.
creation of job opportunities,
better health and reduced infant mortality,
better nutrition,
reduced incidence of disease,
national integration, national security, ,,,,,,,etc.
 These benefits do not however, lend themselves to valuation.

 These are not accounted in financial analysis but have to be

accounted in economic analysis at least in qualitative terms.
101
 Likewise in the cost side, a project may
displace workers,
increase disease incidences,
increase regional income inequality,
destroy or reduce the scenic beauty of an area, etc

All these are intangible costs of the project, which are not captured by
or not reflected in the market prices.

All these intangible benefits and costs must be carefully identified

and where possible, be quantified in Economic Analysis although
valuation is impossible

102
 3) Externalities: internal Vs external (Secondary costs and
benefits)
• Projects can lead to benefits created or costs incurred outside the
project itself.
• Economic analysis must take account of these external/secondary/
costs and benefits
• It is not necessary to add on the secondary costs and benefits
separately; to do so would constitute double counting.

• Thus, instead of adding on secondary costs and benefits, we have to

adjust the market prices into ‘economic’ prices there by in effect
converting them to direct costs and benefits.

103
• Although using efficiency prices based on opportunity cost or
willingness to pay greatly reduces the difficulty of dealing with
secondary costs and benefits, there still remain many valuation
problems related to goods and services not commonly traded in
competitive markets.

• Examples of such costs and benefits are:

– Technological spill-over or technological externalities
– Negative or positive ecological effects in construction of dam: - it
can increase spread of schistosomiasis and malaria, it can
increase/decrease in fish catches, many down-stream effects, etc
– Multiplier effects of projects - if there had been excess capacity

104
• Price effects caused by a project are also part of externalities.
• The project may have wide-ranging repercussions on demands of inputs and
outputs and cause gains and losses for producers and consumers other than
those involved in the project itself.

• forward linkages effects- The project may lead to higher prices for
inputs it requires and lower price for the outputs it produces; thus may occur
in industries that use or process a project's output, and
• backward linkages in industries that supply its inputs, in that such
industries are encouraged or stimulated by increased demand and higher
prices for their output or lower prices for their inputs.

105
• Conversely, other producers may loose because they now face
increased competition, and other users of inputs required by the
project may have to pay higher prices.
• In practice, it is not feasible to trace all externalities arising from such
market imperfections: the analyst can only hope to capture the grosser
distortions on more immediately affected changes in output.

• Externalities of various kinds are thus clearly troublesome, and there is

no altogether satisfactory way in which to deal with them.
• There is no reason simply to ignore them and if they appear significant,
to measure them.
• In some cases it is helpful to internalize externalities by considering a
package of activities as one project.

106
 CHAPTER FOUR: FINANCIAL ANALYSIS OF PROJECTS
• Financial Analysis is focused on the contribution of the project to the owner
• project profitability in financial terms
• It use market price to value goods and services

4.1 Objectives of Financial Analysis

• Assessment of financial impact: it assess the financial effects of the
project will have on participants (farmer, firms, government, etc).
– This assessment is based on the comparison of each participant’s current
and future financial status with the project against the projection of his
future financial performance as the project is implemented.
• Judgment of resource Use: overall return is important because managers
must work within the market price framework they face.

107
 Assessment of Incentives: critical importance in assessing the incentives for
different participants of the project.
 Will participants have an incremental income large enough to compensate them for
the additional effort and risk they will incur?
 Will private sector firms earn a sufficient return on their equity investment &
borrowed resources to justify making the investment the project requires?
 For semipublic enterprises, will the return be sufficient for the enterprises to maintain a
self-financing capability and to meet the financial objectives set out by the
society?
Provision of sound financial plan: The financial plan provides a basis for
determining
 the amount and timing of investment,
 debt repayment capacity and
 helps to coordinate financial contributions.
 financial analysis will enable the analyst to judge the complexity of the
financial management and what changes in organization and management
may be necessary
108
 4.2 Pricing Project Costs and Benefits
Once costs and benefits have been identified, if they are to be compared they
must be valued.
Since the only practical way to compare differing goods and services directly
is to give each a money value, we must find the proper prices for the costs
and benefits in our analysis.
1) Finding Market Prices: Project financial analysis are built
 first by identifying the technical inputs and output for a proposed
investment, and then
 by valuing the inputs and outputs at market prices to construct the
financial accounts,
Thus, the first step in valuing costs and benefits is finding the market prices
for the inputs and outputs.
The project will have to consult many sources such as merchants, consumers,
experts, published statistical bulletins, etc
109
• Point of first sale and farm-gate price: In project analysis, a good rule for
determining a market price for agricultural commodities produced in the
project is to seek the price at the “point of first sale”.
• if the project includes such marketing services in its design, we can take
these higher prices.
• If the product is sold only in central markets, no local market, then the
analyst must find out the value of marketing service to arrive at price at
project site.

2) Predicting Future Prices: Since project analysis is about judging future

returns from future investment, we have to judge what the future prices of
inputs and outputs may be.
• The best starting point is to see the trend of these prices over the past few
years.

110
• Change in relative price: If relative price of inputs or outputs are variable
over time, i.e.,
PXO P P
 X1  X2    
PYO PY1 PY2

• Changes in relative prices have a real effect on the project objective and must
be reflected in project accounts in the years when such changes are
expected.
• Inflation (an increase in general prices of goods)
• the approach most often taken is to work the project analysis in constant
price.
 It is assumed that inflation will affect most prices to the same extent so that prices
retain their same general relations.
• The analyst then need only adjust future price estimates for anticipated
relative changes, not for any change in the general price level.

111
Financial export and import parity price
– In financial analysis, we use export and import parity prices if the
project will export its output to and import inputs from foreign
markets
– A project for several reasons may use imported inputs or export
outputs even though there are domestic markets
– If a good is cheaper abroad, i.e. the domestic price is higher than
the world price; traders have a strong incentive to import the good.

– In both cases what we need to determine is the amount of income

the project receives from its exports or the amount the project pays
for imports at the project location

112
• The import parity price (IPP) is the price at the border of a good
that is imported, which includes international transport costs and
tariffs.

• OER (official exchange rate) is the rate at which one currency

(say, Birr) is exchanged for another currency (say, Dollar).
– It is official because it is the rate established by monetary
authorities of a country not by the market mechanism.
– In financial analysis the OER would always be used.

– Suppose a project exports coffee to Canada, we start with

c.i.f. (Cost, Insurance and Freight) price at Canada port.

113
Import Parity Price
• F.o.b. price at point of export
• Add-freight charges to point of import
• Add-insurance charges
• Add- unloading from ship to pier at port
• C.i.f. Price at the harbor of importing countries
• Convert foreign currency to domestic one (multiply by OER)
• Add-tariffs (import duties)
• Deduct-subsidies
• Add-local port charges
• Add-transport & marketing costs to relevant wholesale market
• Equal price at wholesale market
– Add-local storage & other marketing cost (if not part of project cost) -this is the
marketing margin between central market and the project site
• Equals import parity price at project location (Farm/project gate price).

114
Export Parity Price
C.i.f. at point of import (say, Canada port)
– Deduct- unloading at point of import
– Deduct- freight to point of import (in this case ship freight)
– Deduct – insurance
• Equals – f.o.b.(Freight on Board/free on board) at point of export (Djibouti port)

• Convert foreign currency to domestic currency at OER

– Deduct –tariff (export duties)
– Add - subsidy
– Deduct - local port charges (If port charge is in terms of foreign currency, we
deduct it before it is multiplied by OER.
– Deduct - local transport & marketing costs (if not part of project)

• Equals export parity price at project boundary

– Deduct - local storage, transport & marketing costs (if not part of project cost)
• Equal export parity price at project location (farm gate)

115
 5.3 Time value of money and Computing Debt service
 The time value of money is the idea that “Money now is more valuable than
money later on”.
• it is the opportunity cost of passing up the earning potential of a currency
today.
– Present values are better than the same values in the future and
earlier returns are better than later..
– ‘100 birr’ now is different from ‘100 birr’ next year. Why?????
Reason: because,,
 you can use money to make more money!
 Investment makes money to have return in the future.

• The first basic point in the concept of the time value of money is
to understand the meaning of interest.

116
• Interest is the cost of using money over a specified time.
• In many farm budgets there will be a credit element, and the analyst will
have to calculate the amount of the debt service and/or/interest.

 There are two basic types of interest:

A. Simple interest rate: is payment of the same value of principal over the
number of years
 Commonly applied for short-term credits lent for seasonal expenses.

– Pt = Po (1+rt)
• Po - initial loan(principal)
• r - Interest rate
• t - Time
• Pt - final amount
117
B. Compound interest : is common in long-term credits which are lent by
formal finical institutions;

• The basic difference between simple and compound interest is that in the
latter, the calculation of interest after year one will be based on the total
outstanding principal plus interest of the previous year.

t
Pt  P0 (1  r)
– Po - Principal
– r - Interest rate per period
– t - Period or time
– pt - total amount

118
 The above calculation is on the assumption that the compounding
period is a year. But if the compounding period is less than year; such
as monthly, quarterly or biannually, the formula may be formulated as:

r t c
At  P0 (1  )
c
• At = total amount including principal
• r – Interest rate per year
• c – Compounding period
• t – Number of years

• Grace periods: a period in which the borrower need not pay

principal & sometimes the interest depending on their agreement.

119
3) Capitalization
• In some loan transactions, the lender can agree to ''capitalize'' the interest
due during the grace period.
• This means, the borrower need not pay any interest during the grace period;
the interest due is, in effect, added to the principal of the loan.
• When repayment begins, the amount borrowed plus the interest added to
the principal during the grace period is then repaid in a serious of equal
installments.
• The annual repayment can be calculated as follows.
t
P * 1  r   r
Am 
1  r t 1

Where, r - is interest rate

» T - time or period
» Am - annual payment of interest plus principal
» P* - capitalized principal
120
 – At = 5000(1+0.1)2 = 6050
5
6050 1  0 .1  0 .1
Am  5
 1596 .0
1  0 .1 1
• Accordingly, the annual payment will be 1596.0 for 5 years.
• It has the following advantages:
– It balances the interest in that it is in between the two compounding
methods presented in case 1 and case 2.
– It is suitable for both the borrower and the lender because it eases both
computation and the collection and repayment of the loan.
– Increasing balance is preference of lender
– Declining balance is preference of borrower
• Equal installment is a way to balance these two approaches of interest
payment without violating percentage of interest and time.
121
 5.5 Methods of Financial Analysis
5.5.1 Financial Statements
• financial statement are important inputs for financial ration calculations.
• There are three types of financial statement:
1. Balance Sheet Statement: Is the statement of the asset, liabilities and
capital of the project at the end of the accounting period usually a year.
– A=L+K
• Asset = fixed asset + current asset
– Current asset - which can be easily changed in to cash with in short period.
– Fixed asset - at their cost to buy or to build at that time.
• Liability – owned by others or owed by the owner
– Current liability – obligations that should be met with in a year
– Long term liability – loan which paid more than a year
• Capital/equity – owned by the owner;
– Share capital + retained earning = total capital
122
2. Income Statement: It is summary of revenues and expenses of the project
during the accounting period.
• It shows total profit and losses of the project which do not shown by balance
sheet.
3. Sources and uses of fund statement
• Sources - inflow to the project to increase the capital of the project.
• Uses - for what purposes money are out flow from the project
– Net fund flow = out flow - inflow of fund
• It reviews total inflow of funds to the project and out flows of fund from the
project.
– Finally shows us cash position of the project
– It shows what are not seen in the two approaches

 From the projected financial statements for an enterprise, the financial

analyst is able to calculate financial ratios that allow him to form a judgment
123
5.5.2 Financial Ratios
• A financial ratio is the mathematical relationship between two
quantities in the financial statement.

• It is essentially concerned with the calculation of relationships, after

proper identification and interpretation, used to provide indicators of
past performance in terms of critical success factors of a business.

• This assistance in decision-making reduces reliance on guesswork and

intuition, and establishes a basis for sound judgment

124
A) Efficiency Ratios
1. Inventory turnover ratio: Inventories are unsold goods or what
is left over from past year and may be found in store

 ITOR measures the number of times that an enterprise turn over its
stock each year and indicates the amount of inventory required to
support a given level of sales.

– shows the rate at which business inventory is sold and replaced

• High ratio is preferred because it shows inventory management

125
 – For instance: Calculate the inventory turnover ratio of ABC Company for
the year 2010 _____;
• Let cost of goods sold in 2010 is 2,088,000 and the average inventory
of the company in the year 2010 is 294,500
• i.e the inventory turnover ratio of company ABC is 7.09 times
• Therefore,ABC’s inventory is sold out or turned over 7.09 times per year
2. Operating ratio:- shows us the amount of expenditure per one birr
revenue
 Obtained by dividing the operating expenses by the revenue

– Lower ratio is good, it increase profit

– Extremely low OR value tell us that the project is not using
the optimum size 126
B) Income ratios
• Return on sales:-This shows how large an operating margin the
enterprise has on its sales

• The amount of net income for each one sales revenue

• The higher this ratio the higher the income generating

power of the project

127
• Return on equity: -It is an amount received by the owner of the
equity
• it is one of the main criteria by which owners are guided in
their investment decisions.
• It is very important for owners, because equity is the investment for
owners.

– The ratio must be higher than the market interest rate

• Return on assets: The earning power of the assets of a project

– The ratio must be greater than the bank interest rate

128
 C) Creditworthiness Ratios
• Solvency ratios measure the stability of a project and
its ability to repay debt
– It enable a judgment about the degree of financial
risk
– It also helps to estimate the amount and terms finance
needed.
– It is especially important for lending institutions

1. Current ratio

129
2. Debt- equity ratio
 It tells us, of the total capital, how much proportion is equity & how
much is debt.

130
• If for example liability ratio is 0.40 and equity ratio is 0.60,

– it means that of the total capital 40% is debt and 60% is equity.

• Then debt equity ratio is 1.5 to 1.

• For each one birr liability a project has 1.5 birr equity.

• In general strong equity base is good for a project to overcome risk &
uncertainty.

• Especially in some risky projects, low ratio of long-term liability to

equity is a necessary condition

131
 3. Debt service coverage ratio:-The most comprehensive
ratio of creditworthiness is the debt service coverage ratio

• It tells us how a project can absorb any shocks without

impairing the firm's ability of meeting obligations.
• In contrary to this it can also tell us how the firm chose an
appropriate credit term.
– …………Economic Analysis,
– ………………….. Coming Soon!!!
132
 5. ECONOMIC ANALYSIS OF PROJECTS
What is Economic analysis of projects?????

Why do Economic analysis???

How do Economic analysis???

133
 5.1 Purposes of Economic Analysis
• Selection of alternatives: The main purpose of project economic
analysis is to help design and select projects that contribute most to the
welfare of a country.
– When used solely, economic analysis serves only a very limited purpose and
hence should not be the only basis for financial decision.
– Optimal decision must be made based on the relative merit of all aspects
financial, economic, fiscal impact, environmental impact, etc.

• Identification of winners and losers: who enjoys the music?

Who pays the piper?
– A good project contributes to the country’s economic output; hence it has the
potential to make better off.
– Nevertheless, normally not every one benefits, and some one may lose.
Moreover, groups that benefits from a project are not necessarily those that
incur the costs of the project.
– Identifying those who will gain, those who will pay and those will lose gives the
analyst insight into the incentives that various stake holders have to see that the
project is implemented as deigned.
134
• Environmental impact: The effects of the project on the environment,
both negative (costs) and positive (benefits), should be taken into account and
if possible, quantified and assigned a monetary value.
– The impact of these costs and benefits on spearfish groups within socially is
borne in mind.

 Analytical procedure for Economic Analysis:

1. Identify cost and benefit items of the project
2. Inclusion and exclusion of costs and benefits
3. Valuation of costs and benefits
 Market price for Financial analysis and
 Economic price for Economic analysis
4. Economic Analysis/Economic feasibility study/ using
 Discounted measures (NPV, BCR, NBCR, IRR) and
 Non-discounted measures
135
• We do these using financial prices as a starting point and then adjust
them accordingly depending on the value to the national economy of the
item under consideration.

• The term 'market prices' is used to refer to prices actually paid for inputs
or received for outputs, in contrast to economic values estimated for
particular cost or benefit items which are described as 'shadow prices'.

• They are also sometimes known as 'accounting prices' or 'economic

prices' or ‘efficiency prices’ or ‘opportunity costs’ or ‘border prices’
and/or real prices.
• They are in most cases estimated; not observed. That is why the term
shadow is used.

136
 Why market prices and economic prices diverge?
1) Market failure;
• In a perfectly competitive market, the opportunity cost of an item would
be its price, and this price would also be equal to the marginal value
product of the item.
• If a non-traded item is bought and sold in a relatively competitive
market, the market price is the measure of the willingness to pay and is
generally the best estimate of an opportunity cost.

• Basically, one major argument in favor of economic pricing against

financial analysis of projects is that of market failure.

• What do we mean by market failure?

• It occurs whenever the market fails to function effectively; when it can’t
value project costs and benefits appropriately!
137
• why does the market fail? Market failure manifests itself in
different forms:
a. Failures of competition: the existence of various types of monopoly
power in the economy,
b. Failures of provision / incomplete markets / missing markets: the
existence of a class of goods and services that private operators are not
prepared to supply because once they are made available it is impossible
to exclude individuals from making free use of them (public goods) such
as street lighting, police force, road in LDCs, national defense, etc

c. Open access resources: resources of communal access where the private

cost of using more of resource is lower than the social cost incurred by
the community as a whole, resulting in over - exploitation and possible
permanent damage to the resource which is the result of absence of well
defined property rights is another source of market failure.
e.g. forestry for firewood, wild life, fishery, over-grazing, and over-hunting,
over-fishing,
138
d. Failures of information: a tendency to under-produce the type of
information to which everyone should have access if markets are to work
well (e.g. information on prices and technologies)
e. Macro-economic problems: problems that can only be handled by a central
authority, for example, money supply inflation, exchange rate, taxation,
balance of payment problems
f. Poverty and inequality: the market outcome may result in a degree of
inequality or an incidence of poverty that is regarded as socially
unacceptable by the majority of people in society.
g. Environmental problems, futures generation and sustainability: these
are hardly dealt by the interplay of demand and supply.

• Therefore, the market fails due mainly to the absence of

coincidence of national and private objectives.

139
 5.1.2. Externalities and linkage effects
• Externality is an economic problem that arises as a result of relationships
among economic agents whereby agent ‘A’ is benefited or dis-benefited by
other economic agent(s) without being charged for the cost incurred or paid
for the benefit derived.
• Externalities, created by another agent, which have positive production
effect to an economic agent without his/her intention, are called positive
production externalities while externalities of opposite nature are called
negative production externalities.

• Externalities, created by another agent, which have positive utility

(satisfaction) effect to an economic agent without his / her intention, are
called positive consumption externalities while externalities of opposite
nature are called negative consumption externalities.

140
• Eg.
– Smoke coming from a cigarette smoker in your dormitory is a negative
consumption externality.
– A garden freely made available to some one by his / her neighbor is
positive consumption externality.

– Waste disposal by a factory to fisherman’s river is negative production

externality.
– The mutual beneficial relationship between the bee keeper and
horticulture farmer is a positive production externality to both
economic agents.

• These, benefits- positive externalities or costs- negative

externalities’ do not have a market price.

141
 5.1.3. Government intervention
• Government intervention takes different forms –
 protective trade policies (import taxes, subsidies, quotas, and import
licensing);
 unrealistic rates of fixed exchange rates - overvalued currencies;
 government controls of interest rates - subsidised interest rate;
 controls on prices, production, and sales; private monopolist controls
of production prices;
 government or trade union pressure (wage rates exceeding real cost
of labor - minimum wage legislation); and so on.

• Therefore, adjustments for all these failures (market failure,

government intervention and externality) should be made to
market prices.
142
 5.3 Approaches of economic analysis of a project
1) UNIDO Approach
– In this method economic benefits & costs may be measured at
domestic prices using consumption as the numéraire, with adjustment
made for divergence between market prices and economic values,
and making domestic and foreign resources comparable using shadow
exchange rate (SER).

– If commodities are traded,

i. Prices will be adjusted for any distortions in the domestic markets.
ii. the adjusted domestic price will be multiplied by SER to make
domestic resources be comparable with foreign resources.

– The easiest way for adjusting domestic market distortions is to use

border prices, c.i.f., for imports and f.o.b. for exports and then
multiply this border price expressed in foreign currency by SER to
arrive at economic border prices.

143
• SER: is the true exchange rate of currencies in terms of domestic currency.
– People mostly willing to pay an additional premium more than the OER
(assuming the official exchange rate does not accurately reflect the true
value of foreign currencies to the economy).

Pd
SER  • Where Pd - domestic price
Pw
• Pw - world price in foreign currency
– To derive an average and representative, estimates of SER that can be
applied across all traded goods, we need to take the weighted mean of
relative value of all imported & exported goods.Thus:
n
 P 
SER   f i  di 
i 1  P wi  • fi-The weight of the ith good

• The fi are a function of the quantities imported and exported and of the
elasticity’s of demand for the various imports and the elasticity’s of supply for
the various exports. 144
Suppose we have a project that produce export good and that uses both imported and
non traded inputs.
Benefit = output × Pw × SER- we can take border price, no need of adjusting
Costs imported (traded) = Im × Pw × SER
non traded = In × Pde
Where: Im- quantity of imported input
o In- quantity of non traded
o Pde- domestic price economic
o D- non traded input cost (In × Pde) - Adjusted (economic) values of domestic goods
in domestic currency

Net benefit = Benefit – Cost

Benefit = SER . X
Costs = SER . M + D

Net benefit  SER X - M   D

» X=output × Pw
» M= Im × Pw
– SER - is the shadow exchange rate

145
– But, if the commodities are non-traded,
i.e. if f.o.b. prices are less than Pd & Pd < c.i.f. prices and if the market
prices are good estimates of opportunity cost or willingness to pay,
we directly take the market price as economic value of the item.

– But if the prices of non-traded items are distorted, we will adjust the
market price to eliminate distortions and then use these estimates of
opportunity cost as the shadow price to be entered in the economic
analysis.

146
 2) Little-Mirlees Approach (see Little & Mirlees, 1969, 1974)

• In this approach benefits and costs may be measured at world price to

reflect the true opportunity cost of outputs and inputs using public
saving measured in foreign exchange as the numéraire (that is,
converting everything into its foreign exchange equivalent).

• The fact that foreign exchange is taken as a numéraire does not mean
that project accounts are necessarily expressed in foreign currency.

147
• For traded goods
• If world prices are used, the economic price at which to value a
project’s output is its export price if it adds to exports, or its import
price if domestic production leads to a saving in imports.

• Similarly, on the cost side, the price at which to value a project input is
its import price if it has to be imported, or export price if greater use
leads to a reduction in exports.

• A conversation factor (CF) is the ratio of the economic (shadow) price

to the market price, that is:
Economic price
CF 
Market price

• How are conversion factors derived?????

148
• In principle, to find the world price of non-traded goods, each good
could be decomposed into its traded and non-traded components in
successive rounds - backwards through the chain of production.

• In practice, however, it is not feasible to differentiate conversion

factors between all non-traded goods and only special outputs (and
inputs) are treated this way because the procedure is difficult, time
consuming and costly.

• therefore, shortcuts are needed that provide a reasonable

approximation. In essence, all the shortcuts involve some degree of
averaging for a group of non-traded items and standard conversion
factor is applied to a particular non traded good rather than its own
specific conversion factor.
149
• The derivation is as follows:
SCF.Pd  Pw .OER
• Little-Mirlees approach summarize of adjusting domestic prices into
economic prices. A project that produces export goods and uses both traded
and non traded inputs can be assessed as follows.

– Net Benefit= OER (X-M) - SCF.D

Where -OER- official exchange rate
– X- Exported goods in foreign currency
– M- Imported goods in foreign currency
– SCF- standard conversation factor
– D- value of non-traded goods in domestic currency

• To summarize, as long as SCF is the ratio of OER to SER, the two

approaches - UNIDO and Little-Mirless - differ only to the extent that SER
is different from the actual exchange rate.
150
But if all of the goods or inputs in question are non-traded goods,
 The true cost of any good is its marginal cost(MC) to society.

 the Economic analyst needs to use conversion factor to translate

domestic prices into their border price equivalent.

 So the economic price for a non-traded good is its market price multiplied
by the conversion factor.

 Project inputs: should be valued at their opportunity costs and

 Project outputs: should be valued at consumer surplus
(consumers’ willingness to pay).

151
Examples:
1. If the CF for skilled labor @ domestic price is 0.81 and if the wage rate is
3,500birr/month, then how much would be the economic price
(opportunity cost) of skilled labor?
EP
CF 
MP
EP
0 . 81 
3 , 500
EP  2 , 835 birr

 An economic price of 2,835Br implies opportunity cost elsewhere in

the country from skilled worker when the worker is moving to a new
project.

152
2. Compute the gross financial benefit, gross economic benefit and Net social
welfare of Wheat production Project:

Price ($) Supply without project ( S wo )

Supply with project ( S w )

P wo = 10
A
B
Pw = 5

C D

500 1500 Quantity demanded (Quintal)

Q wo Qw

153
 CHAPTER 6: MEASURES OF PROJECT WORTH
• Why measuring project worthiness???????
 Two time values of money:
– Present value and
– Future value of money
 Two basic techniques to compute time value of money:
1. Discounting: is a technique that reduces future benefits and
costs to their present value/worth.
 The interest rate used for discounting is called discount rate.
 The interest rate used for discounting looks back ward form
the future to the present, whereas

154
2. Compounding: It is a technique that increases present benefits and
costs to their future value.
 used to compute future value of money

FVt = PV (1 + r) t………Compounding formula

 The interest rate used for compounding looks forward from

present to the future.

155
• There are two types of measures of project worth

1. Undiscounted and

2. Discounted techniques

 The underlying difference between these two lies in the

consideration of time value of money in the project
investment.

 Undiscounted measures do not take into account the time value of

money, while discounted measures do.

156
1. Undiscounted Methods
A. Payback
• This is literally the amount of time required for the cash inflows from a
capital investment project to equal the cash outflows.
• The usual way that firms deal with deciding between two or more
competing projects is to accept the project that has the shortest
payback period.

• Payback is often used as an initial screening method.

– Payback for an even cash inflow

157
• So, if ETB 4 million is invested with the aim of earning ETB 500,000
per year (net cash earnings), the payback period is calculated thus:
• P = ETB 4, 000, 000 / ETB 500 000 = 8 years

• This all looks fairly easy!

• But what if the project has more uneven cash inflows?

• Then we need to work out the payback period on the cumulative

cash flow over the duration of the project as a whole.

158
 Payback with uneven cash flows
• Of course, in the real world, investment projects by business
organizations don't yield even cash flows.
• Have a look at the following project's cash flows (with an initial
investment in year 0 of ETB 4,000,000):

Year Cash flow Cumulative cash flow

(ETB 000) (ETB 000)
0 (4000) (4000)
1 750 (3250)
2 750 (2500)
3 900 (1600)
4 1000 (600)
5 600 Zero
6 400 400

Computation of the payback period. 159

• The payback period is precisely 5 years.

• The shorter the payback period, the better the investment, under the
payback method.

• We can appreciate the problems of this method when we consider

appraising several projects alongside each other

160
 Consider the following alternative projects
Alternative Year Investment cost Net incremental Commutation net
projects benefits incremental benefits

I 0 20,000 -
1 2000 31000
2 8000
3 12000
4 9000
II 0 20000 -
1 2000 34000
2 12000
3 8000
4 12000
III 0 20000 -
1 1000 37000
2 5000
3 6000
4 8000
5 10000
6 5000
2000
161
Note that the incremental net benefit could be financial or economic incremental net benefits
• Project I & II have a payback period of 3 year.
• But project III has a payback period of 4 years.

• Thus, based on this criterion, project I & II have equal higher rank than
project III.
• Therefore, the method fails to consider the time & amount of net
incremental benefit after the payback period- project III.

• In addition, the method results equal rank for both project I and II.

• Yet we know by inspection that we would choose project II over

project I because more of the returns to project II are realized earlier.

• This method is a measure of cash recovery, not profitability

162
 Arguments in favor of payback:
• Firstly, it is popular because of its simplicity.
– Research over the years has shown that firms favor it and
perhaps this is understandable given how easy it is to calculate.

• Secondly, in a business environment of rapid technological

change, new plant and machinery may need to be replaced sooner
than in the past, so a quick payback on investment is essential.

• Thirdly, the investment climate, demands that investors are

rewarded with fast returns
– Many profitable opportunities for long-term investment are
overlooked because they involve a longer wait for revenues to
flow.
163
Arguments against payback

– It lacks objectivity.
– Who decides the length of optimal payback time?
No one does - it is decided by pitting one investment opportunity
against another.

– Cash flows are regarded as either pre-payback or post-payback,

but the latter tend to be ignored.
– Payback takes no account of the effect on business profitability;
Its sole concern is cash flow.

164
 B. Rate of return on investment
 Average rate of return

– ARR = (Average annual revenue / Initial capital costs) * 100

• Let's use this simple example to illustrate the ARR:

– A project to replace an item of machinery is being appraised.

– The machine will cost ETB240 000 and is expected to generate total
revenues of ETB45 000 over the project's five year life.

– What is the ARR for this project?

ARR=(£45000/5)/240000*100

=(ETB9000)/240000*100 = 3.75%
165
 Advantages of ARR
• As with the Payback method, the chief advantage with ARR is
– its simplicity.
– relatively easy to understand.
– There is also a link with some accounting measures that are
commonly used. This make it easier for business planners to
understand.

– It is expressed in percentage terms and this, again, may make it

easier for managers to use.

166
 Arguments against ARR
• Firstly, the ARR doesn't take account of the project duration or the
timing of cash flows over the course of the project.

• Secondly, the concept of profit can be very subjective, varying with

specific accounting practice and the capitalization of project costs.
– As a result, the ARR calculation for identical projects would be
likely to result in different outcomes from business to business.

• Thirdly, there is no definitive signal given by the ARR to help

managers decide whether or not to invest.
– This lack of a guide for decision making means that investment
decisions remain subjective.
167
C. Proceeds per unit of outlay: Investments are ranked by the
proceeds (cumulative of net incremental benefits) per unit of
outlay (investment cost).
• It is the total net value of incremental net benefits divided by
the total amount of investment
D. Average annual proceeds per unit of outlay
– To calculate this measure,
• first the total net incremental benefits will be divided by
the time it will be realized to arrive at average annual net
incremental benefits, and then this average value will be
divided by total investment costs

– It failing to take into consideration the length of

time of the benefit stream
168
• Average income on book value of the investment
– This is the ratio of average income to the book value of the assets
(i.e. the value after subtracting depreciation) stated in percentage
terms.

– This measure is useful and commonly used way of assessing the

performance of an individual firm.
– It is also sometimes used as an investment criterion.

– This measure, as the previous one, does not take into consideration
the timing of the benefit stream.

169
 2. Discounted measure of project worth

• These techniques employ the time value of money concept, unlike the
traditional methods.

– Discounting is essentially a technique that reduces future

benefits and costs to their present worth.
– The rate used for discounting is called discount rate.

170
• Suppose a bank lends 1567.05 Birr for a project at 5% interest rate.
• The project owner is supposed to repay the principal & interest rate
after 5 years.
• How much the owner will have to pay at the end of 5 years.
At = P(1 + r) t
At = total amount after t years
r = interest rate
t = time
A5 = 1567.05 (1 + 0.05)5 = 2000 B

 i.e. this shows the future value of money shows the benefit of investing
and earning interest

171
• Suppose again a project is expected to obtain 2000 B after 5 years.
Value of this money today can be calculated as:

At 2000
P t
 5
 1567.05
1  r  1  0.05
• i.e. this shows today's value of money

• The difference between this & the previous is only the viewpoint.

• The interest rate used for compounding assumes a viewpoint from

here to the future, whereas discounting looks back ward from the
future to the present.
172
• Four techniques are discussed in the sections that follow.

A.The discounted Payback period

• Discounted payback period is computed in the same manner as that of

the regular payback period except the discounted cash flows are used
in the case of the former on.

• The expected future cash flows are discounted by the project’s cost of
capital.

173
B. Net present values: NPV of an investment proposal is the present
value of expected future net cash flows, discounted at the costs of
capital, less the initial outlay.
n
At
NPV   1  r 
t 1
t
 I

NPV- net present value

At = net cash flow for the year t
I = Investment Cost
r= interest rate
t= time
n- Life of the project
• If the investment period is longer, the investment cost must also be
discounted.
n j
• Thus the formula must be modified as: At It
NPV  t
 t
t1 1r 
t1 1r
Df = 1/(1+r)t 174
• In the net present value method, the higher the NPV, the more
desirable the project is.

• Accept project that has NPV > 0

• Choosing the discount rate

• To be able to use discounted measures of project worth we must
decide upon the discount rate to be used for calculating the net present
worth.
• For financial analysis, the discount rate is usually the marginal cost of
money to the firm (project owner).
• This often will be the rate at which the enterprise is able to borrow
money.

175
• If the incremental capital to be obtained is a mixture of equity and
borrowed capital the discount rate will have to be weighted to take
account of the return necessary to attract equity capital on the one
hand and the borrowing rate on the other

Equity borrowedcap
r x returnneededto attractcap  x borrowryrate
total cap total Captial

Example:
Total equity = 8,000 birr
Total borrowed fund = 12,000 birr
R = 8000/20000 × 10% + 12,000 / 20,000 × 6%
= 0.074
= 7.4%

176
3. Internal Rate of Return (IRR):
• The IRR is defined as the rate of discount, which brings about equality
between the present value of future net benefits & initial investment.
• It is the maximum rate of return the project can pay and still
be break even.
• It is the value of r in the following equation.

n
At
I  t 1 1  r t
– I – investment cost
– At – Net benefit for year t
– r - IRR
– n - Life of the project

177
Table 10.Illustration: Suppose a project has the following net benefit
flows of its project life of 4 years

Year Net Benefit

0 -1000

1 200

2 400

3 500

4 700

178
 The IRR can be calculated as:
200 400 500 700
1000    
1  r 1 1  r 2 1  r 3 1  r 4
• “r” can be found through trial & error method.
• When r = 23.068 percent (r=0.23) the value in the above equation in the
right hand side will be equal to about 1000.00 which is equal to the value in
the left hand side.
IRR = 23%, it mean up to 23% interest the project can borrow money from
the bank.
• If the actual interest rate (r) is < IRR we accept the project and we reject
otherwise.

When, IRR = r; NPV = 0

IRR > r; NPV > 0
IRR < r; NPV < 0 179
• The problem with this method is that the value of r (IRR) can only be
found by trial and error.

• The procedure can be described as follows:

– Select an arbitrary/by chance value of r;
– Calculate the value of the right hand side equation with this value of r.
– If the RHS value is lesser than the value in the left hand reduce the
value of r.
– If the RHS is greater than the LHS, increase the value of r; continue
until this the RHS is very close to the LHS.

• When the RHS is more or less equal to LHS, it is that value of r, which
is the IRR.

180
• A project may result more than one possible IRR though it is extremely
rare.
• This can only occur when a project has negative net returns after
successive positive returns.
• This can arise, for instance, when there is a replacement investment
around the mid way in the life of the project.
• In such instances, a project will have positive return then after. This
condition may give rise to two IRR.

• This is one of the criticisms of IRR method since no similar problem

exists with the other methods.

181
4. Profitability Index (PI): Profitability index is the ratio of the present value of
the expected net cash flow of the project and its initial investment outlay.
PI=PV/IO
Where; PV is the Present value of expected net flows
IO- is the Initial investment outlay
PI- is the Profitability Index
• PI> 1, accept the project
n
( B t  C t)
5. Net benefit to investment ratio 
t 1 (1  r ) t
NBIR  n

 I (1  r ) t
t 1
– Where, Bt- Benefits,
– Ct - Costs,
» I- investment,
» r- discount rate,
» I- investment cost
NBIR> 1, economically viable; NBIR>0, financially feasible
182
• The end,

Question......
Yes ........
No,
Comments .........

Thank You!!!
183