PROJECT APPRAISAL

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Introduction to Project Appraisal

Project appraisal means the assessment of a
project.

It is made for both proposed (Ex-ante analysis)

and executed projects (Post-ante analysis).

For an financial institution project appraisal is a

process whereby a leading financial institution
makes an independent and objective assessment of
the various aspects of an investment proposition
for arriving at a financial decision and is aimed at
determining the viability of the project
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Project Appraisal
Project appraisal is the process of assessing and
questioning proposals before resources are
committed.
It is a means by which partnerships can choose the
best projects to help them achieve what they want
for their community.

But appraisal has been a source of confusion and

difficulty for projects in the past.
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Meaning of Project Appraisal

Project Appraisal is the analysis of costs and benefits of
a proposed project with a goal of assuring a rational
allocation of limited financial resources amongst
alternate investment opportunities with the objective of
achieving specific goals.

Project Appraisal is mainly the process of transmitting

information accumulated through feasibility studies into
a comprehensive form in order to enable the decision
maker undertake a comprehensive appraisal of various
projects and embark on a specific project or projects by
allocating resources.
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Objectives of Project Appraisal

To extract relevant information for determining the

success or failure of a project.
To apply standard yardsticks for determining the
rate of success or failure of a project.
To determine the expected costs and benefits of the
project.
To arrive at specific conclusions regarding the
project.
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Significance of Project Appraisal

It helps in arriving at specific and predicted results.

It evaluates the desirability of the project.
It provides information to determine the success or
failure of a project.
It employs existing norms to predict the rate of
success or failure of the project.
It verifies the hypothesis framed for the project.
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What can a Project Appraisal deliver?

Be consistent and objective in choosing projects
Make sure their program benefits all sections of the
community
Provide documentation to meet financial and audit
requirements
Appraisal justifies spending money on a project.
Appraisal is an important decision making tool.
Appraisal lays the foundations for delivery.
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Essentials of a Good Appraisal Systems

Project application, appraisal and approval functions are
separate
All the necessary information is gathered for appraisal
Race/tribal equality and other equality issues are given
proper consideration
Those involved in appraisal have appropriate technical
expertise
There are realistic allowances for time involved.
Decisions are within a implementers powers.
There are appropriate arrangements for very small
projects.
There are appropriate arrangements for dealing with
novel, contentious or particularly risky projects.
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Limitations of the Project Appraisal

Quality of project analysis depends on the quality of data and forecast
made about costs and benefits. Over-estimation of benefits and
underestimation of costs is quite common to get the project approved.
In view of the uncertainty about the future it is impossible to quantify
completely the risks.
Project analysis is a partial analysis where it is assumed that project will
not change the macro economic variables.
It is a useful device where benefits can be quantified.
Project analysis is useful when there is a definite starting and finishing
points.
Project analysis is a useful tool only if major part of benefits are
quantifiable. In cases where non quantifiable externalities (e.g. job
creation, regional development, development of skill, transfer of
technology) are substantial, project analysis becomes less formal.
There is a conflict of evaluation in project analysis. Political, social,
economic, financial valuation, most often are conflicting.
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Methodologies of Project Appraisal

Appraisal of a proposed project includes:
1. Financial Appraisal

2. Market / Commercial Appraisal

3. Technical Appraisal

4. Managerial Appraisal

5. Economic Appraisal or Social Cost Benefit Analysis

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1. Financial Appraisal
The basic purpose of financial appraisal is to assess
whether the unit will generate sufficient surplus so as
to meet the outside obligations. Financial appraisal
usually examines two aspects of finance:
The cost of the project i.e., the amount required to
complete the project and bring it to normal
operation
The means of financing the cost i.e. the sources
from which the required funds are to be raised.
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Capital Investment Process

Selection Implementation
Identification Evaluation & Follow up

Type of Investment Performance Evaluation

Required Decision Rule

Monitor magnitude and
Investment Input timing of cash flows
Replacement Net Present
Check project still meets
Value
Investment Expected cashflow selection criterion
Expansion Profitability Index
stream Decide on continuation
Internal rate of
Investment Discount rate or abandonment
Diversification return
Review steps if failure
investment Payback period
rate is high
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Financial Appraisal
Project Cost Estimation- It is the process of
determining the total cost of the project
which is supported by long term funds.
Land and site development
Building and civil works
Plant and machinery
Technical know how and engineering fees
Expenses on foreign and local technicians
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Financial Appraisal
Working Capital Requirement- It is the
difference between current assets and
current liabilities.
Raw material and components
Stocks of goods in process
Stocks of finished goods
Debtors
Operating expenses
Consumable stores
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Financial Appraisal
Sources of Funds
Share Capital- equity capital and preference capital
Term loans- Loans provided by the banks and financial
organization. (Rupee and Foreign currency loans)
Debenture capital- Capital produces by Debentures. (Non
convertible and Convertible)
Deferred Credits- Credit taken from suppliers.
Incentive Sources- Financial support provided by the
government agencies.
Miscellaneous sources- Public deposits, unsecured loans,
Leasing and hire purchase finance. ( Unsecured loan is
given by promoters for maintain a connection between
promoters and equity capital the promoter can promise)
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Financial Appraisal
Appropriate composition of Funds (Capital
Budgeting)
Material Cost- Cost of raw materials, chemicals,
components, and consumable stores necessary for
production.
Utilities- Utilities Cost include the cost incurred on power,
water and fuel.
Labour- Labour Cost is the cost of manpower employed in
a factory.
Factory overheads- It includes the repair and maintenance,
rent , taxes, insurance on factory assets.
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2. Market / Commercial Appraisal

Market Appraisal of a project relates to find out the
aggregate demand of the proposed product/service in future
as well as the market share of the proposal under
consideration.
A market appraisal reviews the projects demand, number
of local beneficiaries, prices of services or products,
distribution mechanism, future market growth to ensure it
will generate profits or it will able to recover costs.
This requires a description of the products its major uses,
scope of the market, possible competition from the
substitutes, special features of the product proposed to be
manufactured in regard to quality and price which would
result in consumer preference for the product in relation to
competitive products.
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Market / Commercial Appraisal

Appraisal of market or commercial viability means
assessment of marketability of the end product.
Therefore, at the time of assessment of commercial
viability, the following points require consideration.
Demand for the product

Supply position for the product

Distribution Channels

Pricing of the product

Government Policies
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Market Appraisal for Projects

Increase the expected earnings of an
organisation.
Improves the reputation of a business.
Generates sense of competition .
Attracts new customers.
Includes new techniques .
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Market Feasibility
It is the estimation of market size for the
product/service and the anticipated yearly
growth.

In order to conduct the market feasibility of a

project, one should have a clear idea as to what
data is required for market analysis and the
sources of such data.
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Market Analysis
Market analysis include description of
competition, marketing channels, potential
customers and potential for related and new
markets.
It enables the unit to establish pricing,
distribution and promotion strategies that will
enable to become profitable within a
competitive environment.
Market analysis starts by defining target
customer, the resultant market in terms of
size, structure, growth prospects, trends and
sales potential.
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Sources of data for Market Analysis

Market Survey
Market survey is a collection of data and
information from a sample of customers
and potential customers
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Steps in conducting a Market Survey

Defining the target population
Selecting the sampling scheme and sample size
Developing Questionnaire
Recruiting and training the field investigators
Obtaining information as per the questionnaire
from respondents
Scrutinizing the gathered information
Analyzing and interpreting the information
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Steps in Market Analysis

Defining the Market

Positioning the product and pricing

Distribution and promotion strategies

Competitive analysis
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Step 1: Defining the Market

After identifying the target market, the feasible
market has to be selected by concentrating on product
segmentation factors (geographic, demographic and
psychographic).

The unit share in the total feasible market is tied to the

structure of industry, the impact of competition,
strategies for market penetration and continued
growth.

Market share depends on industry growth which will

increase the total number of users.
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Step 2: Positioning the Product and Price

Position strategy will help fulfil the firms

objectives by establishing its identity in the
eyes of buyer.
It is usually the result of analysis of customers
and competition.
Pricing decision has a direct effect on
marketing and financial success of the
business.
Price may be determined on a cost plus basis as
practised by manufacturers to cover all cost
both fixed and variable and a desired profit
percentage.
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Step 3: Distribution and promotion strategies

Choice of distribution channel depends on

channel being used by competitors and the
strategic advantage it would cover.(direct sales,
wholesale distributor, retail, broker, and direct
mail).
It is also based on factors such as pricing
methods and internal resources.
A promotional plan consist of controlled
distribution to sell the product and includes
marketing tools like advertising, packaging,
public relations, personal sales and sales
promotion
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Step 4: Competitive Analysis

The purpose of competitive analysis is to determine the

strengths and weakness of the competitors. Strategies that
will confer a distinct advantage, barriers that can be raised
in order to prevent competitor from entering the market
and any weakness that can be exploited with in the
product development cycle.

Competitive strategies usually fall into product,

distribution, pricing, promotion and advertising. The
competitive advantage has to be clearly established so the
appraiser of the project understand not only how the goals
will be achieved but why the firms strategy will work.
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Competitive Strategy
If the services/ products have to face competition,
is there any plan in the project preparation? Some
competitive strategies are:
Differentiation Strategy
Low cost Strategy
Focus strategy (Serving particular segment with
higher quality)
The preemptive move (moving first to a new
location, hiring prime location so that sustainable
competitive can arise and entry barrier can be
created
Strategic Alliances (Sharing ATM, cheque
payment arrangements between bank)
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Market and Demand

Is the demand expressed a real need or only
demanded for particular benefits of certain group?
Market and demand appraisal reviews how the
demand size, demand growth, number of
populations/organisations that have demand for the
product/service
How much is the unfulfilled demand?
What sources of data were used in analyzing
market.
What price of product/service will be charged?
How it was analyzed?
Analysis of competitors, their strength, weakness
Distribution mechanism etc.
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Market and Demand

The methods to estimate the demand for a product are
Complete Enumeration method: All probable
customers of the product are approached and their
probable demands for the product are estimated
and then summed.

Sample Survey: Some number of consumers out

of their total population is approached and data on
their probable demands for the product during the
forecast period are collected and summed. The
total demand of sample customers is finally
blown up to generate the total demand for the
product.
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Market and Demand

Sales Experience Method: Sample market is
surveyed before the new product is offered for
sale. The results of the market surveyed are then
projected to the universe in order to anticipate the
total demand for the product.

Vicarious method: The consumers of the product

are not approached directly but indirectly through
some dealers who have a feel of their customers.
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Methods of Demand Forecasting

Analysis of demand for the product proposed
to be manufactured requires collection of data
and preparation of estimates.
Estimation of demand requires the
determination of total demand for a product
and the share that can be captured by the unit
through appropriate marketing strategies
The commonly used methods for demand
forecasting are Qualitative method and Time
series method.
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Methods of Demand Forecasting

Qualitative Method
Executive opinion method- A group of managers
plans for expected future sales and estimates the sales that
need to be achieved.
Delphi Method- A panel of experts make there opinion
through a questionnaire for a given situation. These
responses are summarized by a central coordinator and
again sent back to panel for refinement.
Time Series Method
Trend Projection Method- Past consumption trends are
used for future demand projection.
Moving Average Method- Sales forecast for next period
is done on the basis of average sales of the past several
periods.
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3. Technical Appraisal
Technical appraisal determines the pre-requisites
for the successful commissioning of the project
and the choice of location, size and process.
It primarily concerned with the project concept
covering technology, design, scope and content of
the plant as well as the input and infrastructure
facilities envisaged for the project.
A project is considered to be technically feasible, if
it is found to be sound from technical and
engineering point of view.
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Objectives of Technical Appraisal

To justify the present choice and provide an insight
into future technological developments;
To justify the goal compatibility of a project with
the preferred technology;
To seek a better available alternative technology
which is both cost effective and efficiently
manageable;
To seek such a technology that can go with
existing skill levels of team members or requires
little orientation and training programmers;
To seek a better technology that is not detrimental
to the overall environment.
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Essential of Technical Appraisal

While performing a technological appraisal some of the vital
ingredients that need attention are:
The state of existing the available technology
Training needs of personnel for the present technology
and for the new technology
Availability of technical know-how;
Input base for the technology or its compatibility with
the input substitutes;
Future progressive integration of the technology for
modifications or refinements;
Wider product-mix and its by-products;
Minimization of waste, loss or scrap in the process or its
development;
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Essential of Technical Appraisal Contd..

Factor intensity
Stability to changes and its relative obsolescence
rate;
Other techno-economic considerations (side effects
of technology transfers on the labour lay-off etc.)
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Technical Appraisal
Generally, while appraising technical feasibility of
any project, the following points are carefully
considered:
Capacity of the plant

Flexibility of the plant

Evaluation of Technology

Availability of critical inputs

Plant the Machinery

Project planning and scheduling

Cost of Production
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Capacity of the Plant

These call for careful consideration regarding
choosing right size of the plant, proper layout and
correct technical design.
The capacity of the plant should be neither too low
rendering it uneconomic nor too high to keep it
idle.
In traditional manufacturing system capacity is the
maximum output attainable .The operating
condition which influence capacity are
Product specification

Product mix

Raw material composition

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Flexibility of the Plant

While assessing a project flexibility should be
allowed in design of individual pieces of
equipment.

Flexible manufacturing systems are the emerging

systems to manufacture what the customer wants.

These systems help in production of large variety

of products in small batch sizes and imparts
strength to project to withstand market
fluctuation.
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Evaluation of Technology
Out standing feature of technology process, engineering
design and plant and machinery are the established facts
and can be checked from published information on the
process or from prospective consultant and on the basis of
similar plant in operation else where .

Considerable skill is required in evaluating the claims of

emergent technology, product and equipment design.
The design and layout of plant in technical appraisal
should ensure ease of operation, convenience of
maintenance and un accomplished establishment of stream
capacity.
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Availability of critical inputs

The critical inputs mean all the basic location and operational requirements
which make the project viable. These include:
Raw materials. For instance, sugar factories are situated near
sugarcane producing areas.
Availability of land.
Nearness to market for finished product. The units producing
heavy bulk finished goods are always situated near the regional
market.
Availability of essential utilities like water, power and fuel.
Availability of skilled/unskilled labour in the proximity.
Facility for disposal of effluents
Availability of suitable technical and administrative personnel.
Adequacy of arrangements for pollution control and for
environment protection.
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Plant the Machinery

In this regard careful consideration should be given to the
following aspects.
Suitability of plant and machinery for the manufacturing
process to be adopted
Name and reputation of the supplier of plant and
machinery
Their availability in time so as to avoid any time and
cost overrun
Reasonableness of their cost
Provision for performance guarantee the after sale
service y the suppliers.
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Project Planning and Scheduling

Planning should be pragmatic and proper so that
the construction and gestation period are estimated
properly and there are not time and cost over-run.

Of late, many of the projects have failed because

of faulty planning at the initial stage and
subsequent delay in sanction/release of more funds
by banks/financial institutions.

Generally, the PERT / CPM techniques are used

for net-work scheduling.
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Cost of Production
Cost of production is worked out taking into
account the build up of capacity utilisation,
consumption norms of various inputs and yield
and recovery of by-products.

Cost of production and profitability estimate take

into account the level of production in different
years and product mix.

In a competitive market penetration price for new

product will have to be lower than the current
price of an established manufacturer.
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Assessing competitive status of a project unit

Determined by the following performance measures

1. Manufacturing lead time(MLT) The total
time required to process the product through the
manufacturing plant.
2. Work in progress (WIP) Quantity of semi
finished product currently lying on the factory
floor.
3. Machine utilisation - Machine should be run to
manufacture exactly the right quality of exactly
the right things at exactly the right time.
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Contd
4. Throughput Hourly or daily production rate.
5. Capacity Possible output the plant is able to
produce over a specific duration.
6. Flexibility- Ability of system to respond
effectively to change.
7. Performability Influenced by unscheduled
downtime of the equipment.
8. Quality Depends on integrity of the material
and integrity of manufacturing processes.
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Methods to improve Quality and Productivity

This will strengthen the competitiveness of the

industry.

Among the methods used to improve productivity

and strengthen competitiveness are
1. Expert systems
2. Enterprise resource planning[ERP]
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Expert System
To improve productivity and flexibility.
Used along with capacity planning to
ensure that parts are manufactured to
meet due dates and optimise use of
production equipments.
Used for simulation of scheduling system
and to assist the machine learning of
scheduling procedure.
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Enterprise resource planning(ERP)

It is the toolkit that spreads lean thinking
throughout the company.
A company using ERP can know how efficiently
its various resources, people, money, machines are
being used to satisfy its customers.
The integration of all aspects of company data into
the same software help to keep manufacturing
operations in balance and to keep work flowing
smoothly through the factory.
Bottlenecks and imbalances show up quickly and
can be set right.
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4. Managerial Appraisal
This is most difficult job to evaluate the MAN or
MEN behind the project.
It has been the practical experience of the
bank/financial institutions the even the most
technically feasible and financially/commercially
viable project has been a total failure because of lack
of management experience.
The problem may become all the more serious if the
management is dishonest/delinquent rather than
inefficient and ineffective.
Unfortunately, there is no scientific yardstick by
which managerial competence can be judged
objectively.
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Managerial Appraisal
If the management is incompetent, even a
good project may fail. So financial
institutions/donors very carefully appraise the
managerial aspects before sanctioning
assistance for a project.
Background of the promoters
Their academic qualification, and experience
Their past performance
Assessment of other specific skills required for
the project
Training arrangement
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Managerial Appraisal
For an established group of industrialists floating a
new company unit, the banker can have at least, an
idea of the background of the promoters.
Much also depends whether the existing promoters
belong to the Blue Chip group or not.
But, in case of a new promoters floating a new
project, the problem of judging managerial
competence induces some kind of subjectivity in the
decision of the banks/financial institutions.
In appraisal parlance, such evaluation is known as
Principle of three Cs i.e. Character, Capacity and
Credit worthiness.
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Principle of Cs in Managerial Appraisal

Cs Attribute How Measured

Character Will the borrower repay the Previous experience, Credit
loan according to the reference, Market integrity
schedule?
Capacity Does the borrower have the Viability of the project,
ability the loan? Generation of surplus

Credit Is the borrower creditworthy Educational and family

for the amount of loan background, credit Reference
worthiness applied?
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Principle of Cs Contd.

Cs Attribute How Measured

Capital How much liquid assets the Net worth of the borrower;
borrower has for investment capacity to raise loans from
in the business? friends and relatives.

Collateral Is the loan backed by Marketability: Market value

sufficient collateral security? of the collateral

Conditions Do the current economic General economic condition

conditions indicate any of the country; stability of
problems in the borrowers the borrowers income
ability to repay the loan? relative to these conditions.
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5. Economic Appraisal
Economic appraisal examines the projects
contribution to economy of the region or country.
It assesses whether the project increases the net wealth
of a region or country as a whole or not.
A purely financial analysis normally does not provide
an adequate basis for judging a projects value to the
economy, since the financial analysis looks at the
project only from a limited viewpoint of revenues
entering the projects own account.
So the economic appraisal looks at the project from
the view point of whole economy asking whether the
projects show benefits sufficiently greater than project
costs to justify investment in it.
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Concern of Economic Appraisal

Increased output
Enhanced services
Increased employment
Larger government revenues
Higher earnings
Higher standard of living
Increased national income
Increased income distribution etc.
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Social Cost Benefit Analysis (SCBA)

Social cost benefit analysis (SCBA) called Economic
analysis, is a methodology developed for evaluating
investment projects from the point of view of the society
as a whole.
SCBA seeks to assess the utility of a project to society as
a whole. It attempts to separate all the expected changes
viz. economic, social and environmental likely to arise as
a result of implementing the project.
As an aid to planning, decision-making, evaluation and
control, the social cost benefit analysis provides a
scientific and quantitative base for the appraisal of
projects with a view to determine whether the total
benefits of a project justify the total social costs.
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What is Social Cost Benefit Analysis ?

So, to reflect the real value of a project to society, we

must consider the impact of the project on society.
Impact

Positive Negative
(Social Benefit) (Social Cost)

Thus ,when we evaluate a project from the view point of

the society (or economy) as a whole, it is called Social
Cost Benefit Analysis (SCBA)/Economic Analysis.
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Social Cost and Social Benefit

Economists consider externalities as spillover effects, third-party

effects etc. to be more precise, external economies and
diseconomies are social benefits and social costs respectively.

According to Ahmed Belkaoui defined

An externality arises whenever a firms activities have a negative

or positive impact on the environmental for which the firm is not
held accountable. If the impact is positive, it is called an external
economy or social benefit; if the impact is negative, it is external
diseconomy or social cost.

he further stated that if the activities of a firm lead to a

depletion of social resources, the result is a social cost; if they lead to
increase in social resources, the result is a social benefit.
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Scope of SCBA
SCBA can be applied to both Public & private
investments
Public Investment: SCBA is important specially
for the developing countries where government
plays a significant role in the economic
development.
Private Investment: Here, SCBA is also
important as the private investments are to be
approved by various governmental & quasi-
governmental agencies.
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Objectives of SCBA
SCBA focuses on the following objectives:
To contribute effectively to GDP of an economy;
To aid in economic development;
To justify the utilization of economys scare of growth;
To maintain and protect environment from pollution;
To educate new lines of functioning that are simple and
cost effective;
To benefit the rural poor and reduce regional
imbalances;
To justify the risks undertaken to implement and the
sacrifices made in the process.
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Defined Objectives of SCBA

The main focus of Social Cost Benefit Analysis is to
determine:
1. Economic benefits of the project in terms of
shadow prices;
2. The impact of the project on the level of savings
and investments in the society;
3. The impact of the project on the distribution of
income in the society;
4. The contribution of the project towards the
fulfillment of certain merit wants (self-
sufficiency, employment etc).
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Advantages of SCBA
The ability to identify the projects that
maximize the welfare of the country.
The ability to objectively assess and quantify
the purpose projects in relation to community
needs.
Exposure of the basis for decision-making for
projects and opportunity for public criticism.
Ability to rank and prioritize limited resources
so that the maximum benefit is realized.
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Disadvantages of SCBA
Difficulty in measuring social costs and
benefits and converting them in to
monitory term.
Over statement of the value of social
benefits
Complexity
Conflict between social welfare and
financial justification.
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Steps in SCBA
There are five broad steps to be gone through in the process of social cost
benefit analysis of a project.
1. The project must be defined in clear terms. The time-frame of the
project must be specified.
2. The 2nd step in the application of the technique is to list out all
costs and benefits of the project.
3. Similarly there are both explicit and implicit benefits to be listed.
4. The fourth step in computing the SCBA of a project is to
discount the future benefits back to the present in order to
determine the true return on cost.
5. Last steps in SCBA is to make decision in respect of inclusion or
exclusion of a project in the development programmes. Given the
resources constraint, one way out is to list the project in
descending order and implementing them one by one, beginning
with the first till the investment resources are exhausted.
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Rationale for SCBA

SCBA brings out a comparison between the social benefits and
social costs in order to reveal the net return on investment as a
difference quantified.
In such cases, social costs are investment cost that would have
available without the project and the benefits can be defined as
contribution made to the objectives of the economic policy of the
government.
SCBA is a part of feasibility report detailing and justifying
assumptions made about the inputs and outputs and their
appropriate market price.
There could have same factors in an investment decision by the

government in particular instance, which gives rise to a social cost

or a social benefit but this may not have a market.
For example: incase of building a highway, the effect on the
environment to local residents by causing nuisance, would be a social
cost; but the traveling a motor vehicle would be easier through
highway, and will represent social benefit.
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Rationale for SCBA

In SCBA the focus is on the special costs and
Benefits of the project. The principle sources
of discrepancy are:
Market imperfections

Externalities

Taxes and subsidies

Concern for savings

Concern for redistribution

Merit wants.
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Rationale for SCBA Contd.

Market Imperfections
When imperfection exits, market price do not reflect social
values. The common imperfections found in developing
Countries are :
Rationing
Prescription of minimum wage rates
Foreign exchange regulation
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Rationale for SCBA Contd.

Externalities
A project may have a beneficial external effects.
For example, it may create certain infrastructural
Facilities like roads which benefit the neighboring
areas.
Such benefits are considered in SCBA , though
they are ignored in assessing the monetary
benefits to the project sponsors because they do
no receive any monetary compensation from
those who enjoy the external benefit created by
the Project. Likewise, a project may have harmful
effect like environmental pollution.
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Rationale for SCBA Contd.

Taxes and Subsidies
From the private point of view ,taxes are definite
monetary costs and subsidies are definite
monetary gains.
From the social point of view, However, taxes
and subsidies are generally regarded as transfer
payments and hence considered irrelevant.
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Rationale for SCBA Contd.

Concern for Savings
A rupee of benefits saved is deemed more valuable
than a rupee of benefit consumed. The concern of
society for saving and investment is dully reflected in
SCBA wherein a higher valuation is placed on saving
and lower valuation is put on consumption.

Concern for Redistribution

The society is concern about the distribution of
benefits across different group. A rupee of benefit
going to an economically poor section is considered
more valuable than a rupee of benefit going to an
affluent section.
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Rationale for SCBA Contd.

Merit Wants
Goals and preferences not expressed in the market
place, but believed by policy maker to be larger
interest.
For ex: Government may promote an adult education
programme or balanced nutrition programme for
schoolgoing children even though these are not
sought by consumer in market place.
 1-75

Approach to SCBA
A. UNIDO Approach
This approach is mainly based on the publication of UNIDO
(United Nation Industrial Development Organization) named
Guide to Practical Project Appraisal in 1978.
B. L-M Approach
I.M.D Little & J.A. Mirlees have developed this approach for
analysis of Social Cost-Benefit in Manual of Industrial
Project Analysis in Developing Countries and Project
Appraisal & Planning for Developing Countries.

C. Approach Adopted By Financial

Institutions
 1-76

UNIDO Approach to SCBA

UNIDO approach was first articulated in the
Guidelines for Project Evaluation which provides a
comprehensive framework for SCBA in developing
countries. UNIDO approach is based largely on the
latter publication though at places we will draw on
the former publication too.
Measures cost and benefits in terms of
domestic rupees
Measures cost and benefits in terms of
consumption.
Focuses on efficiency, savings and
redistribution aspects in different stages.
 1-77

Stages involved in UNIDO Approach

The UNIDO approach of Social Cost Benefit Analysis
involves five stages:
Calculation of financial profitability of the project measured

at market prices.
Obtaining the net benefit of the project at shadow
(efficiency) prices. (Objective of SCBA-1)
Adjustment for the impact of the project on Savings &

Investment. (Objective of SCBA-2)

Adjustment for the impact of the project on Income
Distribution. (Objective of SCBA-3)
Adjustment for the impact of the project on Merit and
Demerit Goods whose social values differ from their
economic values. (Objective of SCBA-4)
 1-78

UNIDO Approach Contd

Stage-1: Calculation of financial profitability of the
project

A good technical and financial analysis must be

done before a meaningful economic (social)
evaluation can be made so as to determine financial
profitability.

Financial profitability is indicated by the Net

Present Value (NPV) of the project, which is
measured by taking into account inputs (costs) and
outputs (benefits) at market price.
 1-79

UNIDO Approach Contd

Stage-2: Obtaining the net benefit of the project at
economic (shadow) prices

The Commercial Profitability analysis (calculated in stage -

1) would be sufficient only if the Project is operated in
perfect market. Because, only in a perfect market, market
prices can reflect the social value.

If the market is imperfect (most of the cases in reality), net

benefit of the Project is determined by assigning shadow
prices to inputs and outputs.

Therefore, developing shadow prices is very much vital.

 1-80

UNIDO Approach Stage 2 Contd

Shadow Prices reflect the real value of a resource (input
or output) to society.
Shadow Prices are also referred as economic prices,
accounting prices, economic/accounting efficiency
prices etc.
Shadow Prices can be defined as the value of the

contribution to the countrys basic socio-economic

objectives made by any marginal change in the
availability of commodities (output) or factor of
production (input).
Example: A project of power station may increase the
production of electricity which contributes to one of the
socio-economic objectives of the country.
 1-81
UNIDO Approach Stage 2 Contd
General Principles of shadow pricing

A. Numeraire
A unit of account in which the values of
inputs and outputs are to be expressed.

Numeraire is determined at-

Domestic currency rather than border price.
Present value rather than future value.

Because, a bird in the hand is worth two in

the bush.
Constant price rather than current price.
 1-82
UNIDO Approach Stage 2 Contd
General Principles of shadow pricing contd
B. Tradability
Tradability refers to whether a good or service is tradable or non-

tradable; if tradable whether is fully traded or non-traded.

A good/service is tradable in the absence of or within limited trade

barriers.
A tradable good/service is actually traded when-

the import (export) supply is perfectly elastic over the relevant range

of volume.
all additional demand (production) must be made (consumed) by
import (export) due to the full capacity in the domestic industry
(fulfillment of demand by domestic consumer).
the import (CIF) price is less or the export (FOB) price is more than

the domestic cost of production.

A good/service is non-tradable; if

its import (CIF) price is greater than its domestic cost of production,

its export (FOB) price is less than its domestic cost of production.

A tradable good/service that is not actually traded is called non-traded.

 1-83
UNIDO Approach Stage 2 Contd
General Principles of shadow pricing contd
C. Sources of Shadow Prices
The UNIDO approach suggests three sources of shadow
pricing, depending on the impact of the project on
national economy. A project, as it uses and produces
resources, may for any given input or output
(i) Consumers willingness to pay: Increase or
decrease the total consumption in the economy.
(ii) Foreign Exchange Value: Decrease imports or
increase imports .
(iii) Cost of production: decrease or increase
production in the economy.
 1-84
UNIDO Approach Stage 2 Contd
General Principles of shadow pricing contd

D. Taxes
When shadow prices are being calculated, taxes usually
pose difficulties. The general guidelines in the UNIDO
approach with respect to taxes are as follows:
If the project augments domestic production,
taxes should be excluded;
If the project consumes existing fixed supply of
non- traded inputs, tax should be included;
For fully traded goods, tax should be ignored.
 1-85

UNIDO Approach Contd

Stage3: Adjustment for the impact of the project on
Savings & Investment
The purposes of this stage are to
determine the amount of income gained or lost because
of the project by different income groups (such as
project other than business, government, workers,
customers etc.)
evaluate the net impact of these gains and losses on
savings
measure the adjustment factor for savings and thus the
adjusted values for savings impact.
adjust the impact on savings to the net present value
calculated in stage two.
 1-86

UNIDO Approach Contd

Stage4: Adjustment for the impact of the project on
Income Distribution
Government considers a project as an investment for the
redistribution of income in favor of economically weakens
sections or economically backward regions.
This stage provides a value on the effects of a project on
income distribution between rich & poor and among
regions.
Distribution Adjustment Factor (Weight) is calculated and
the impacts of the project on income distribution have been
valued by multiplying the adjustment factor with the
particular income of a group. This value will then be added
to the net present value re-calculated in stage three to
produce the social net present value of the project.
 1-87

UNIDO Approach Contd

Stage5: Adjustment for Merit and Demerit Goods
If there is no difference between the economic value of
inputs and outputs and the social value of those, the UNIDO
approach for project evaluation ends at stage four.
In practical, there are some goods (merit goods), social
value of which exceed the economic value (e.g. oil, creation
of employment etc.) and also there are some goods
(demerits goods), social value of which is less than their
economic value (e.g., cigarette, alcohol, high-grade
cosmetics etc.)
Adjustment to the net present value of stage 4 is required if
there is any difference between the social and economic
value.
 1-88

L-M Approach to SCBA

I.M.D. Little and James A. Mirrlees have

developed an approach to SCBA which is
famously known as L-M approach.
The core of this approach is that the social cost of
using a resource in developing countries differs
widely from the price paid for it.
Hence, it requires Shadow Prices to denote the
real value of a resource to society. (mentioned
earlier)
 1-89

Features of L-M Approach

Numeraire:
L-Ms numeraire is present uncommitted social income
measured in terms of convertible foreign exchange of
constant purchasing power

L-Ms Shadow Price:

L-Ms approach measures costs and benefits in terms of
international price as against UNIDO method that measures
costs and benefits in terms of domestic prices.
Why Border prices?
Because the border prices represent the correct social
opportunity costs or benefits of using or producing a traded
goods.
 1-90

L-M Approach to SCBA Contd.

The resources inputs & outputs of a project

are classified into mainly:
Labor

Traded Goods

Non-traded Goods

Therefore, to find out the real value of these

resources, we should calculate
a) Shadow wage rate (SWR)

b) Shadow price of Traded Goods

c) Shadow price of Non-traded Goods

 1-91

L-M Approach to SCBA Contd.

a) Shadow Wage Rate (SWR)

The purpose of computing the SWR is to
determine the opportunity cost of employing an
additional worker in the project. For this we have
to determine
The value of the output foregone due to the use
of a unit of labor
The cost of additional consumption due to the
transfer of labor
 1-92

L-M Approach to SCBA Contd.

b) Shadow price of Traded Goods

Shadow price of traded goods is simply its border
or international price.
If a good is exported, its shadow price is its
FOB price;
If a good is imported, its shadow price is its
CIF price.

c) Shadow price of Non-traded Goods

Non-traded goods are those which do not enter
into international trade by their very nature. (e.g.
land, building, transportation). Hence, no border
price is observable for them.
 1-93

L-M Approach to SCBA Contd.

Ideally, Shadow price of Non-traded Good is
defined in terms of marginal social cost (MSC) and
marginal social benefit (MSB).
L-M suggest that the monetary cost of non-traded
goods be broken down into
Labor SWR (Shadow Wage Rate)
Tradable International Price
Residual components Social Conversion
Factor (SCF)
 1-94

L-M Approach to SCBA Contd.

Accounting Rate of Return (ARR)

This is the rate used for discounting social profits.

Experience is the best guide to the choice of

ARR.
ARR should be such that all mutually
compatible projects with positive present social
value can be undertaken.
 Similarities between UNIDO approach and 1-95

L-M approach

Calculation of Shadow Prices to reflect

social value
Usage of Discounted Cash Flow
Techniques
Taking into account about the effect of a
project on savings, investment and income
of a society
 Differences between UNIDO approach and
1-96

L-M approach

UNIDO Approach L-M Approach

Domestic currency is International Price is

used as Numeraire used as Numeraire
Consumption is the Uncommitted Social
measurement base Income is the
measurement base
SCBA objectives are met At one place all SCBA
through stage by stage objectives are fulfilled
 1-97

Project Appraisal-an Indian scenario

The project appraisal division (PAD) of the planning
commission follows a qualified version of Litle-
Mirrlees approach of projects appraisal to sit through
the social-cost benefit analysis. Therefore, the
assumptions that are considered in the L M approach
stands valid even for the Indian conditions.
In addition to the above, the PAD grouped the projects
of national importance into three m order to safeguard
from the ever-changing tariff policies and eliminate
trade-offs between growth and equity. These groups
are:
Capital intensive industrial projects;

Infrastructural investments;

Agricultural and rural development projects.

 1-98

Capital Intensive Industrial Projects

The capital intensive industrial projects are
appraised and evaluated on the basis of
efficiency criteria.
The efficiency criteria bases its arguments on
Economic Rate of Return (ERR) of a project.
This approach is generally followed by all
leading development financial institutions of
the country such as ICICI, IFCI, IDBI and
other SFIs.
 1-99

Infrastructural Investments
The infrastructural investments are appraised
based on the net benefits accrued to a country
through the project.
The appraisal division will visualize the
economic situation in the presence or absence
of the project and judge the balance of
payments of the country.
Therefore, here the shadow prices will be of
great concern.
 1-100

Agricultural and Rural Development Projects

Agricultural and rural development projects

bases it arguments on the criteria of shadow
wage rate and social protection rate.
The wage rate is determined by considering the
world prices of labour and the opportunity
costs will be considered to analyse the situation
of the economic costs and benefits of such
developmental undertakings.
 1-101

SCBA By Financial Institutions

Let us briefly bivouac on three important
measures which are widely applicable to
projects of national importance. These are:

Economic Rate of Return (ERR)

Effective Rate of Protection (ERP)

Domestic Resource Cost (DRC)

 1-102

Economic Rate of Return (ERR)

Interest rate at which the cost and benefits of a project,
discounted over its life, are equal. ERR differs from the
financial rate of return in that it takes into account the effects of
factors such as price controls, subsidies, and tax breaks to
compute the actual cost the project to the economy.
The method followed by FIs to calculate the economic rate of
return is a similar approach, which is a simplified version of L-
M approach & is described as follows:
International prices are regarded as economic prices so market
price is substituted with international prices for all non-labour
input and output.
For tradable items where international prices are already given CIF
prices are used for inputs & FOB prices are used for output.
For tradable items where international prices are not directly
available and for non-tradable items social conversion factors are
used to convert actual rupee cost into social cost.
 1-103

Effective Rate of Protection (ERP)

 1-104

Domestic Resource Cost (DRC)

 1-105

Risk Analysis
Projects operate in an environment
composed of uncertainty. Uncertainties
regarding fund, necessary inputs,
potential technical problems, political
disturbance etc.
Project Appraisal examines whether
All the risks are identified and analyzed
Risk mitigation strategies are proposed
Risk monitoring and control plan are
prepared
 1-106

THANK YOU