MID 8203:Engineering

Economics

Masters of Science in Irrigation and Drainage

Engineering
 Course Content/Outline
1.0 General principles of project evaluation;
2.0 Private and social cost and benefit of irrigation and drainage projects.
3.0 Distinction between economic and financial analysis;
4.0 Techniques for analyzing farm accounts for preparing farm plans and making
financial projections.
5.0 Fixed and variable cost; Nature of cost and benefits; Calculation of future/present
values and annuities; internal rate of return and net benefit-investment ratio.

6.0 Sensitivity and risk analysis; treatment of uncertainty

7.0 Replacement analysis, Reasons for replacement analysis, Factors that must be
considered in replacement studies
Engineering Economics
• Decisions made by engineers, managers and individuals are commonly the result
of choosing one alternative over another.
• Decisions often reflect a person’s educated choice of how to best invest funds;
capital
• Amount of capital is usually restricted (how to invest to add value?)
• Engineers play a major role in capital investment decisions based on their analysis
• Fundamentally, engineering economics involves formulating, estimating and
evaluating the economic outcomes when alternatives to accomplish a defined
purpose are available.
 Engineering Economics

• A collection of mathematical techniques that simplify economic

comparison and assist people in making decisions
• Since decisions affect what will be done, the time frame of
engineering economics is primarily the future
• Numbers used in engineering economic analysis are best estimates of
what is expected to occur
• Estimates often involve three essential elements:
• cash flows
• time of occurrence
• interest rates
WHAT IS ECONOMICS?

• “Economics is the study of how people and society choose

to employ scarce resources that could have alternative uses
in order to produce various commodities and to distribute
them for consumption, now or in the future, …”
from Paul Samuelson and William Nordhaus, Economics, 12th
Ed., McGraw-Hill, New York, 1985.

WHAT IS ENGINEERING ECONOMICS?

• The application of economic principles to engineering
problems, for example in comparing the comparative costs
of two alternative capital projects or in determining the
optimum engineering course from the cost aspect.
Basic Instruments for measuring public investments
(Cost and Benefits)
• Private cost and social cost: Cost of transporting goods for a farmer is a private
cost while depreciation of a road may be the social cost. In the construction of a
hydropower project, the number of households to be displaced/resettled and the
hardship associated with it may be the social cost.

• Marginal/incremental cost: When a project expands, some additional costs are

incurred. For example, if output is increased from 100 units to 102 units and the
cost may increase from UGX 2m to UGX 3m, then the marginal cost of producing
2 additional units would be UGX 1m.
 Opportunity Cost:
• Resources have to be utilized where gains would be maximum.
• For example, land can be used to produce crop A or crop B. The
return for crop A is UGX 200,000 and crop B is UGX 150,000, which
means the land is used for crop A.
• If yield of crop A declines to UGX 125,000, then it is wise to use land
for growing crop B. Thus the concept of opportunity cost is important
in making rational decisions about public investments e.g. in irrigation
projects with alternatives like dam construction, digging tubewell,
multipurpose project including irrigation.
• Education project (Free education to poor household children).
Opportunity cost of school education or working on farm/looking
after cattle.
 Benefits
• Private and Social Benefits: Main distinction here is between the gains achieved
by private individuals and the benefits accruing to society. For example a good
housing scheme would improve the health of the people and increase labor
efficiency in the society. There are direct and indirect benefits which should be
valued
• Intangibles
• Tangible benefits can be measured in monetary units. For example, benefits in
crop production through irrigation project, electricity units sold by HEP project,
etc. can be measured. But due to construction of reservoir, local population may
be affected by malaria disease for which monetary measurement is very difficult
to make. This is an indirect cost. For benefits, external economies generate some
benefits for which an estimate may be made. Inclusion of benefits and costs
arising from indirect sources are always debatable.
Cost categories
Major costs categories are the costs for:
1.planning and design
2.land purchases
3.salaries and wages
4.materials and equipment
5.borrowing costs (interest)
6.environmental losses

Main benefits categories are the benefits of:

1.increased water supply
2.enhancements to recreation
3.flood control
4.Hydropower
5.Navigation
6.water quality
 Shadow Prices/Accounting Prices
• As the market imperfections may not reflect true scarcity of some resources, e.g.
foreign exchange, shadow prices are used. The market price of foreign exchange
based on supply and demand is called the shadow price of foreign exchange.

• The effect of using shadow price would be to encourage production of important

substitutes or exportable and to discourage expenses involving foreign exchange.
In labor surplus economy, economists may argue that the shadow prices of labor
should be almost zero, therefore, labour intensive projects should be favored.
 Measures obtained from CBA
Three separate measures are usually obtained from CBA to aid
decision making:
• Net Present Value (NPV): This is obtained by subtracting the
discounted costs and negative effects from the discounted
benefits. A negative NPV suggests that the project should be
rejected because society would be worse off.
• Benefit-cost ratio: This is derived by dividing the discounted
benefits by the discounted costs. A value greater than 1 would
indicate a useful project.
• Internal rate of return (IRR): The average rate of return on
investment costs over the life of the project.
Output of a CBA
• The output of a CBA analysis is a comparison of benefits and costs
over the lifetime of a project. One attractive measure that can be
obtained from a CBA is the net present value (NPV). There are two
important issues to consider:
1.A positive NPV does not imply that the project is efficient. There may be an
alternative project for the same budget that has a higher NPV. Hence,
opportunity costs should be accounted for.

2.When a project replaces an existing project (e.g. in the case of a dam that
replaces an old reservoir for water supply for irrigation), then the costs of the
previous project (e.g. maintenance costs) can be double-counted.
 Net Present Value (NPV)

Total Net Discounting Net Present Value

Year Total Cost Benefits Benefits factor (10%) (NPV)

1 50,000 -50,000 0.909 (45,454.55)

2 50,000 -50,000 0.826 (41,322.31)

3 40,000 40,000 0.751 30,052.59

4 60,000 60,000 0.683 40,980.81

5 75,000 75,000 0.621 46,569.10

Total 100,000 175,000 75,000 30,825.64 NPV

Discounted
(86,776.86) costs
Discounted
117,602.50 benefits
 Net Present Value (NPV)
• If NPV is higher than zero, then project is worthwhile
investing in
• The selection process of project should be in terms of
descending NPV
• NPV does not provide information on rate of return on
investments
• For that we use another indicator called Cost Benefit Ratio
 Benefit Cost Ratio (BCR)
• To obtain the benefit cost ratio, the present value of benefit NPV is divided by
present value of cost. The ratio between the two gives us Benefit cost ratio.
• Benefit Cost Ratio = Present Value of Benefits/Present Value of Cost
• If BCR is more than 1, an investment in order. In a single project, the rule is to
select the project if its BCR is worthwhile. Projects with highest BCR are selected
from descending R is higher.

BCR = =1.35523
117,602.50
86,776.86
Internal Rate of Return (IRR)
 Internal Rate of Return
Discounting
Total Net factor Net Present
Year Total Cost Benefits Benefits (10%) Value (NPV) DF 15% NPV DF 25% NPV

1 50,000 -50,000 0.909 (45,454.55) 0.870 (43,478.26) 0.8 -40000

2 50,000 -50,000 0.826 (41,322.31) 0.756 (37,807.18) 0.64 -32000

3 40,000 40,000 0.751 30,052.59 0.658 26,300.65 0.512 20480

4 60,000 60,000 0.683 40,980.81 0.572 34,305.19 0.410 24576

5 75,000 75,000 0.621 46,569.10 0.497 37,288.26 0.364 27,306.67

Total 100,000 175,000 75,000 30,825.64 NPV 16,608.65 362.67

(86,776.86) (81,285.44) (72,000.00)

117,602.50 97,894.10 72,362.67

IRR Estimation with Excel NPV
11.64711362

Year Capital Cost O&M Total Cost Benefit Benefit-Cost Present Value Factor Benefit -Cost
1 71,500 - 71,500 - -71500 0.89568 (64,041)
2 21,500 2,400 23,900 17,000 -6900 0.80224 (5,535)
3 - 2,400 2,400 18,000 15600 0.71855 11,209
4 - 2,400 2,400 20,000 17600 0.64359 11,327
5 - 2,400 2,400 20,000 17600 0.57645 10,146
6 - 2,400 2,400 20,000 17600 0.51632 9,087
7 - 2,400 2,400 20,000 17600 0.46245 8,139
8 - 2,400 2,400 20,000 17600 0.41421 7,290
9 - 2,400 2,400 20,000 17600 0.37100 6,530
10 - 2,400 2,400 20,000 17600 0.33230 5,848

Total 93000 21600 114600 175000 60400NPV 0.036

 Lwoba Irrigation Scheme -5551068039
Without Project Discounting Present Value of
Year Investment Cost Annual O&M Replacement Costs Benefits Total Project Costs With Project Benefits Net Benefits Factor project costs

1 (5,697,512,964) 84,737,654 146,444,925 (5,551,068,039) - 5,551,068,039 0.89286 (4,956,310,749)

2 84,737,654 146,444,925 146,444,925 770,404,700 623,959,775 0.79719 116,744,998

3 84,737,654 146,444,925 146,444,925 1,232,647,520 1,086,202,595 0.71178 104,236,605

4 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.63552 93,068,397

5 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.56743 83,096,783

6 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.50663 74,193,557

7 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.45235 66,244,247

8 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.40388 59,146,649

9 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.36061 52,809,508

10 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.32197 47,151,346

11 84,737,654 354,661,182 146,444,925 (208,216,257) 1,540,809,400 1,749,025,657 0.28748 (59,857,198)

12 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.25668 37,588,765

13 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.22917 33,561,397

14 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.20462 29,965,533

15 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.18270 26,754,940

16 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.16312 23,888,340

17 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.14564 21,328,875

18 84,737,654 146,444,925 146,444,925 1,540,809,400 1,394,364,475 0.13004 19,043,638

Example Problem on Economic Analysis of Drainage Projects
Problem:

• The following data are given for land drainage systems

• Total costs of drainage systems = 520 £/ha
• Maintenance costs of drainage systems = 5 £/ha
• Rate of interest = 10 % /year
• Repayment period = 10 years
• Inflation rate = 5 %
• Life of drainage project = 20 years
• Total benefits = 90 £/ha
Solution: The solution to the above problem is presented in Table below
Results of the cost and benefit analysis of a drainage project
 Costs and Benefits at Actual Actual Future Costs and Benefits with 5%
Present Values of Future Sums (£/ha)
Prices (£/ha) Inflation (£/ha)
Molin
Inflat g
Year
Maintenanc Benef ion Main Benefit Discount Factor Benefits -
Loan Loan Benefits - Costs NPV
e of Moling its Facto - s 10% Costs
r tenan
ce
1 84.60 90 1.05 84.60 94.50 9.90 0.91 9.00 9.00
2 84.60 90 1.10 84.60 99.00 14.40 0.83 12.00 21.00
3 84.60 90 1.16 84.60 104.40 19.80 0.75 14.90 35.90
4 84.60 90 1.22 84.60 109.80 25.20 0.68 17.10 53.00
5 84.60 15 90 1.28 84.60 19.20 115.20 11.40 0.62 7.10 60.00
6 84.60 90 1.34 84.60 120.60 36.00 0.56 20.20 80.30
7 84.60 20 90 1.41 84.60 28.20 126.90 14.10 0.51 7.20 87.50
8 84.60 90 1.48 84.60 133.20 48.60 0.47 22.80 110.30
9 84.60 90 1.55 84.60 139.50 54.90 0.42 23.10 133.40
10 84.60 15 90 1.63 84.60 24.50 146.70 37.60 0.39 14.70 148.10
11 90 1.71 153.90 153.90 0.35 53.90 202.00
12 90 1.80 162.00 162.00 0.32 51.90 253.90
13 90 1.89 170.10 170.10 0.29 49.30 303.20
14 20 90 2.00 40.00 180.00 140.00 0.26 34.40 335.60
15 15 90 2.08 31.20 187.20 154.50 0.24 37.10 376.70
16 90 2.18 196.20 196.20 0.22 43.20 419.90
17 90 2.29 206.10 206.10 0.20 41.20 461.10
18 90 2.41 216.90 216.90 0.18 39.00 500.10
19 90 2.53 227.70 227.70 0.16 36.40 536.50
20 15 90 2.65 39.80 238.50 198.70 0.15 29.80 566.30
B–C ratio after 10 years is (555.44+148.10)/555.44 = 1.27 while after 52 years is (566.30+581.90)/581.90 = 1.97
Example
• Background Information: Given the estimated profits, tax, and
depreciation of hypothetical project detail below. The likely
investments on project is UGX1,400,000.00. It is expected to take 2
year for implementation of project and the project is expected to
earn profit from the third year onwards.
• Calculate the Payback Period for the project? Explain the drawback of
using this method?
• Means: Different project evaluation methods broadly fall under two
categories: non-discounted cash flow techniques and discounted cash
flow techniques.
• The further subdivisions within these two techniques were also
discussed.
• Payback period is one of non-discounting techniques, which
calculates the length of time required to recover the original
investment on the project, through cash flows earned.
• The cash inflow includes operating profit, less income tax payable,
plus depreciation.
• The initial investment of 1,400,000.00 UGX is likely to be received after the
sixth year (i.e., four year after the project implementation period).
• Cumulative profit (4 year after implementation): UGX 1,295,000.00
• Cumulative profit (5 year after implementation): UGX 1,494,000.00
• Difference: UGX 199,000.00 i.e. 1494000-1295000
• Payback period = 4 year + 12 (1,400,000 – 1, 295,000)/199,000 months =
4year +6.33 months or 4year and 6 months

• Limitation of payback period method: The method ignores the time value
of money, and it fails to recognize the cash inflow beyond the payback
period. Although, the method is simple, lack in-depth analysis and hence
may lead to inaccurate results. However, the method is handy in situation
where projects to be compared rate to industries where the rate of
technological obsolescence is very fast, requiring investment on project to
be recovered at the shortest possible time.
 Profit after tax ( UGX) Book value of investment (UGX)
Project-A Project-B Project-C Project-A Project-B Project-C
Year 1 400,000 300,000 250,000 1,500,000 1,200,000 1,000,000

Year 2 450,000 450,000 300,000 1,350,000 1,080.000 900.000

Year 3 500,000 500,000 400,000 1,215,000 972,000 810,000

Year 4 450,000 550,000 500,000 1,093,500 874,800 729,000

Year 5 - 500,000 300,000 - 787,320 656,100

Year 6 - 250,000 - 590,490

Total 1,800,000 2,300,000 2,000,000 5,158,500 3,047,880 3,786,490

• To illustrate Average Rate of Return (ARR) or Accounting Rate of
return project evaluation technique
• Average Rate of Return (ARR) is also called the Accounting Rate of
Return is second method discussed. The ARR can be calculated using
the following formula: Average rate of return = (Profit after
tax)/(Book value of investment)
• Profit after tax is the average annual post tax benefit over the life of
the project. Unlike payback period method the entire life of the
project is taken into account in this method.
• As per ARR method, project B gives a higher return on investment
than project A and C
Please note the following two limitation of ARR method;
• This method also does not take into account the time value of money.
• This method is based on accounting profit and not on cash inflow.
DISCOUNTING CASH FLOW TECHNIQUE-NPV
METHODS
• Background Information: There are two mutually exclusive
alternative projects to be implemented by Gulu District Local
government of near Gulu town. The first one is construction of dam
across Aswa River and the second one is construction of flood
protection works along the river course. These two alternatives
require different structures: the first one calls for construction of
storage structure (dam) and the second requires construction of
7.5km dykes along the Aringa and Pager rivers. Further, the detail
about the projects is given below, calculate the NPV of each project
and choose the one that is most attractive for implementation by the
Local Government based on the financial return only?
Project-Construction of dam
• Investment on the project :1000,000 UGX in billion
• Assume the Life of the project :5 Years
• Period of implementation :1 year
• Cost of capital :15%
Year 1 2 3 4 5
Cash inflow 200,000 300,000 400,000 300,000 100,000
(Billion UGX)
Project- Construction of flood Protection Works
Investment on the project : 1,000,000 ( UGX in billion)
Assume the life of the project : 5 years
Period of implementation : 1year
Cost of capital :13%
Year 1 2 3 4 5
Cash inflow 300,000 400,000 400,000 300,000 200,000
(UGX in billion)
• Objective: to illustrate NPV Methods of Project evaluation technique.
• Net Present Value (NPV) is one of the discounted cash flow
techniques and it recognizes the time value of the money. The
present value of future cash inflows is arrived at by discounting the
future cash inflow at an interest rate equal to the cost of capital. It
can be computed using the following formula;
 Project- Construction of flood Protection Works

Since the net present value is positive, construction of flood protection is

comparatively better than construction of dam and hence out of the two projects the
Local government of Gulu should select project for implementation.
Note that: project sponsored by government may take into account social cost benefits
of the proposed projects in such cases, financial return alone need not be the criterion.
DISCOUNTING CASH FLOW TECHNIQUE-
INTERNAL RATE OF RETURN METHODS
• Background Information: Given a Doho Irrigation Project detail below
(Doho Irrigation project was implemented by Government of Uganda, the
project developed 7, 374 hectares of land in Butaleja, which is in Eastern
Uganda. Further, the following basic assumptions are made.
• Assume a development period of 1 years and a production period of 6
years.
• This is an evaluation of the irrigation project. The profit will be the
difference between the realizable value of farm produce and the total cost
to be incurred in the operation of the dam and canals and farm inputs and
operation costs, and assume the cost of capital is 13%.

• Calculate Internal Rate of Return (IRR) of the project?

 Year Cash outflow Cash inflow
0 1000,000 -
1 - 400,000
2 - 250,000
3 - 250,000
4 - 200,000
5 - 200,000
6 - 150,000

Objective: to illustrate Internal Rate of Return (IRR) Methods of Project evaluation technique.
The Internal rate of return (IRR), which is a second method under the discounting cash flow techniques
of project evaluation, is the discount rate that makes the net present value equal to zero.
Let ‘r’ be the internal rate of return. The IRR is arrived at by equating the present value of cash out flow
and present value of cash inflows. i.e.
COMPARISON BETWEEN NPV and IRR
METHOD
• A. Project P & Q are hypothetical Mutually Exclusive Projects and assume the cost of
capital 12 percent for both project. Which method of discounting cash flow technique is
effective to compare such projects and why?
• Project Cash outflow Cash flow
• P -10,000 20,000
• Q -50,000 75,000
• B. Given the following cash flow detail for Project X and Y, and assume the cost of capital
for 10 percent both projects. Which method of discounting cash flow technique is
effective to compare such projects and explain your reason?

• Cash flow Year-0 Year-1 Year-2 Year-3 Year-4

• Project-X -110,000 +31,000 +40,000 +50,000 +70,000
• Project-Y -110,000 +71,000 +40,000 +20,000 +20,000
• Means: a) Calculate IRR and NPV of both projects:
Project-P Project-Q_
• Net Present Value (NPV) 7,857 16,964
• Internal Rate of Return (IRR) 100% 50%
• Both the projects are good, but project Q, with its higher NPV, contribute more as compared to project P, yet from an IRR
point of view Project P looks better than project Q. The difference in the result obtained by NPV and IRR method can arise
due to variation in the size of the two projects, which require different capital outlays. Hence, in such cases NPV method
will be used for comparing such type of Mutually Exclusive Projects.
• b) Calculate IRR and NPV of both projects:
Project-X Project-Y
• Net Present Value 36,613 31,314
• Internal Rate of Return 22% 25%
• Both the projects look good but Project X, with its higher NPV, contribute more as compared to project-Y. Yet from an IRR
point of view, Project Y looks more attractive. The difference in the result obtained by NPV and IRR method is due to the
different in pattern of cash flows over time. Hence, IRR method can be misleading when a choice has to be made between
mutually exclusive projects which have different patterns of cash flow over time.
Financial and Economic Analysis
 Financial Analysis
1 All costs and benefits are
measured in monetary units
2 Micro level analysis
3 Taxes, duties, fees are included on
the cost side as these are financial
costs of a project. Subsidy is
included on the benefit as it is the
financial benefit to the project.
4 All costs and benefits are measured
at market prices
Economic Analysis
Whenever possible costs and benefits are quantified. If not
possible qualitative statements are made.
Macro Level analysis
Taxes, duties, fees, local taxes, subsidy are transfer
payments as they do not use resources or generate output,
they are excluded from benefit and cost sides.
Opportunity cost is taken into account in economic analysis.
Market prices of goods and services may not reflect true
values, thus they may be modified through shadow prices

5 The objective of the project is to The objective of the project is its contribution to
maximize profit achievement of national objectives, e.g. increase in income,
employment, poverty reduction, etc.

6 Interest rate is excluded to avoid Interest rate is excluded to avoid double counting
double counting
7 Depreciation is excluded as it is not Depreciation is excluded as it is not the financial cost
the financial cost
Techniques for analyzing farm accounts for preparing farm plans
and making financial projections
BENEFITS OF IRRIGATION DEVELOPMENT PROJECT
• Identifying Project Benefits
Category of Benefits-Irrigation Project
• Increase of Crop Production
• efficient water management by separating irrigation canal and drainage
leading to unit yield increase of crops,
• unit yield increase in association with the prevention of crop damage caused
by extra moisture to crops.
• Change of farmland into a dry one will also enable to introduce second crop
after the harvest of the first crop
• Reduction of Farming Cost
• Change of farming system with the efficient machineries would reduce the
production costs of crops by saving labor and machinery costs.
• Reduction of inputs can also be realized, for example, introduction of seeders
will reduce the required amount of seeds per unit.
Illustration of Basic Benefits
• Reduction of Maintenance Cost
• Reduction of Maintenance cost is the benefit related to the maintenance
work on the fields (this is not counted in production cost) such as clearing
canal, road maintenance, etc.
• When an earth canal is concrete lined by the project, the burden for canal
cleaning or grass cutting will be decreased.
• Or in case of new construction of drainage or extension of farm road will
cause additional maintenance work.
• Hence sometimes the benefit relative to maintenance cost can be minu
 ESTIMATION OF PROJECT BENEFITS
The basic procedure to estimate the benefits would be
• identification of area benefited,
• grasping present condition,
• formulation of farming plan, and
• pricing of benefits
Identification of Area Benefited
Change of Land use
 Grasping Present Condition: Farm Economy (Baseline) Survey

• Farm economy survey will be carried out to grasp the present

condition of the project area.
• Items to survey include:
• family member,
• assets,
• crops,
• yields,
• farm income and non-farm income,
• livestock,
• prices,
• production cost,
• family expenditure etc
 Formulation of Farming Plan

• Farming plan should include

• kind of crops,
• cropping area,
• way of operation (by machine or man-power, individual
work or cooperative work),
• procurement of inputs (individual or cooperative)
Formulation of Farming Plan
Outline Sample Farming Plan
Outline Sample Farming Plan
Sample Outline of Farming Plan
Cropping area with/without project
Estimation of Net Incremental Benefit and Net
Incremental Income
• Net benefit is calculated by gross output minus production
cost, which includes costs of seeds, fertilizers, pesticides,
machinery costs, labor cost etc. Particular aspect in farming
is family labor.
• Family labor can be priced as a part of production cost,
although the farmers actually do not pay cash for
themselves.
• Machinery costs include depreciation cost, which is a special
arrangement in accounting the cost
 Estimation of Net Incremental Benefit and Net Incremental Income

• Definition of Production Cost

• Production cost is defined as total economic value consumed to

produce an output. Household farm management involves rather
particular issues in estimating production cost like family labor or rent
of one’s own farmland. There are several ways of defining agricultural
production cost as below.

• (A): Production cost 1: Farm inputs + Labor

Sample Form of Estimation of Income and Benefit
Sample of Crop Production Model for Estimation of Net Benefit and Income