A Primer on Project Appraisal

Page 1

A Primer on Project Appraisal By Muhammad Akram Khan Former Deputy Auditor General of Pakistan makram1000@gmail.com

_________________________________________________________ Abstract Public sector projects involve large sums of money. Many of these projects cannot be appraised like private sector projects where estimates of rate of profit or rate of return provide unambiguous criteria for comparison of various proposals. The public sector projects are generally justified on the basis of their net social benefits which requires valuation of social benefits and social costs that do not have a ready market. The project appraisal in the public sector uses the tool of benefit-cost analysis. Despite its limitations, it is the most systematic approach available to compare various options and to base the final judgement for making decision about investment. The present paper presents an elementary discussion of the concept and application of project appraisal techniques in the public sector. Section one introduces the concept of project appraisal; section two discusses criteria for project appraisal; sections three and four are devoted to benefit-cost analysis and various issues relating to it. Section five discusses methodology for decision once options have been analyzed. The last section makes some concluding remarks.

___________________________________________________________________________ 1. Introduction (a) What is project appraisal? Governments around the globe allocate resources and implement development projects for achieving their policy objectives. However, demand for public resources invariably exceeds the available resources. The governments must prioritize the proposed projects to decide which of them should be funded. The options for the government range from not doing anything to implementing the projects directly through public sector entities. In between are various options, involving combinations of public-private sector partnership. The decision would depend upon the government assessment of the market failure or urgency for action for meeting distributional priorities. Besides, the government intervention in the economy may, at times, lead to distortions in the operation of free market. A decision whether to intervene or not requires consideration of the proposed project on some rational criteria. Thus, there is need to answer at least two questions before the government intervention is considered justified. These are: (i) Are there better ways to achieve the objectives of the proposed intervention? (ii) Are there better uses of the resources that would be deployed in this intervention? Project appraisal is a systematic way of finding answers to these questions. (b) Scope of project appraisal A sponsoring agency (usually a government department in the public sector) undertakes project appraisal whenever it plans to initiate a new project or expand an existing one. Public sector projects differ in objectives, scope, size and complexity. Some projects are fairly straight forward and involve small sums of money. A formal detailed project appraisal for such projects may involve unnecessary costs. Most of the organizations follow certain


monetary thresholds for considering a formal and detailed project appraisal. In case of minor projects, preliminary assessment in light of proposed objectives and costs and benefits suffices. However for large projects involving significant capital outlays, detailed and indepth appraisal is considered justifiable. If a project is below the financial threshold set by the government, the sponsoring agency will undertake a preliminary appraisal only. Generally, it will include a clear statement of the needs which the project would meet. The preliminary appraisal identifies realistic options, including the option of doing nothing and, where possible, quantifies the key elements of all options. It contains a preliminary assessment of financial costs and benefits of all options, chooses the preferred one, and makes a judgement on whether its benefits are sufficient to warrant incurring the costs. One of the recommendations of the preliminary appraisal could be to undertake a detailed assessment, if the life cycle of the project is likely to exceed the financial threshold or the economic and social costs and benefits require detailed consideration. If the capital value of the project is higher than the threshold, the proposal would require detailed appraisal. The purpose of the detailed appraisal is as follows: [European Union, 2005, 14] • It provides a basis for making a decision whether it is appropriate to proceed further with project planning and implementation. • It enables the approving authority to take an informed decision. • It serves as a business case and can be used as benchmark for subsequent audit and evaluation. As a matter of general practice, the project appraisal is the responsibility of the sponsoring agency. But sometimes, the sponsoring agency may not have the capacity to carry out project appraisal. In such situations, outside help from other departments or consultants is taken. In many developing countries, project appraisal is done at the level of central planning agency or ministry of finance. The reason is that the sponsoring departments and agencies do not have the capacity to carry out project appraisal themselves. The sponsoring agencies, in these cases prepare a simple project proposal and rest of detailed analytical work is done centrally either by the planning agency or the ministry of finance, etc. Rest of the paper discusses the methodology of detailed project appraisal. It is written from the perspective of the sponsoring agency, assuming the project appraisal would be presented to the sanctioning authority for approval. Project appraisal can become quite complex, if we include various socio-economic and regularity details. However, the present paper gives an elementary and broad introduction to the subject of project appraisal and leaves out technical details. It is intended for general readers who do not have background of technical details of project data analysis. (c) Elements of appraisal A project appraisal document has following segments: • Needs and objectives • Constraints • Options • Analysis of options


• Conclusion Needs and objectives Why do we need the project in question? What is the justification for the project? While answering these questions, the project document also states why an existing service or facility is inadequate and requires additional investment. Secondly, as far as possible, objectives of the project are stated in a quantifiable and measurable manner so that it is possible at a subsequent date to review and evaluate the performance of the project. For example, if we have to construct a bridge over a canal to reduce distance between two localities, the project document states exactly how kilometres of distance would be reduced and between which points. For purpose of project appraisal, it is not sufficient to state that the bridge would reduce the distance without quantifying the distance. It is now generally accepted that the project objectives should be specific, measurable, attainable, realistic and time-bound (briefly, the acronym SMART). [HM Treasury, 17] The project document should state the benefits of the project and also its direct and indirect beneficiaries. The project benefits could be in terms of financial gains as well as economic outcomes. For example, in case of the bridge on the canal, the direct beneficiaries would be the households living on both sides of the canal in terms of reduced distance. But it may also increase trade between the two sides, leading to commercial activity and higher employment levels in that area. The project appraisal document tries to capture such economic benefits as well. A good project document also states the project objectives in such general terms that would allow consideration for all realistic options. For example, if the project goal is to provide more schooling facilities to the increasing population in an area, the objective should not state: “The objective is to build new schools to meet needs of the growing population in the area”. Such a phrasing locks out consideration of options other than building new schools. Instead, it should say: "The objective is to increase educational facilities for the children of the growing population in the area". The alternative construction of the project objective allows consideration of other options such as increasing the capacity of existing schools, starting evening classes and, of course, building new schools. Constraints All projects have some constraints. Some common constraints are as follows: [European Union, 2005, 37]. • Financial constraints, not having enough budgetary resources • Technical constraints, ruling out some of theoretical options as technically infeasible • Legal or regulatory constraints, such as some laws or regulations may not favor the project • Policy constraints, such as an existing policy may stand in the way • Environmental constraints, such as a negative impact on the environment may not allow approval of the project • Non-availability of physical inputs, for example, raw material • Lack of trained manpower • Lack of administrative ability of the implementing agency • Security situation in a particular area


• Available time • Weather conditions, like rainy season, making the routes inaccessible in certain parts (if project is in Africa, for example) • Land-use planning • Dislocation of population, for example, due to construction of a dam • Social taboos, for example religious beliefs toward family planning • Cooperation from other stakeholders in an international setting Options A properly prepared project document states all realistic ways, including the option of doing nothing, for achieving the objectives. Needless to say, identifying all options may require some research. The project sponsors undertake review of all existing projects, programs, and facilities in the relevant field because projects may have linkages. They consult other knowledgeable persons within the organization and in other government departments. The research may consider such questions: • What if we do not undertake this project? • What is the market and employment situation? • How would broad macroeconomic variables, such as population, service volume, demand, and relative price levels change over the period of the project? • What is the technology forecast? • What will be the nature of the problem over time? How will the profile of beneficiaries change over time? [HM Treasury, 11] At the appraisal stage, value judgements leading to preference for one or the other options can lead to distorted judgements. The stage for such judgement comes later, after the costs and benefits have been analyzed. Options also include outsourcing the task to private sector. While identifying various options, the constraints mentioned above are also kept in view. It reduces the number of options as some options are simply not feasible in view of the constraints. A common risk in identifying the options is manipulation of some options by the sponsors for giving a better appearance over others, thus distorting objectivity. There are techniques to manage this risk. Analysis of options A properly done appraisal evaluates all feasible options in light of the available information. There are various types of analyses that can be carried out. The present paper will discuss these techniques later. Briefly, to complete the argument at this place, the options are analyzed and a preferred solution is identified. The chief criterion for deciding the nature of analysis is whether the project is a commercial proposition or an economic proposition. In case it is being proposed on the basis of economic benefits and not financial benefits the nature of analysis changes, bringing in various risks to the validity of the conclusion. Conclusion The analytical techniques such as benefit-cost analysis help the decision-makers in deciding about the investment. However, the final decision takes in to consideration some other factors as well. These factors could be political considerations, labor market condition, environmental impacts, health implications or affect on other projects and programs, etc. The


present paper would only point toward these considerations and would not delve in detail in them.


2. Criteria for Project Appraisal In private sector, project appraisal focuses on financial costs and benefits. However, in the public sector, many projects are justified on the basis of broader economic and social benefits. Assessment on mere financial benefits and costs may not justify many public sector projects. Project appraisal in the public sector, therefore, may take into account economic and social costs and benefits as well. It would involve attributing monetary values to economic and social benefits and costs which in turn would require a series of assumptions. These assumptions may influence the validity of overall conclusion of the appraisal. However, there are techniques available to minimize these hazards. OECD Glossary of Key Terms (2002, 16) defines the term 'appraisal' as follows: "[Project appraisal is] an overall assessment of the relevance, feasibility and potential sustainability of a development intervention prior to a decision of funding."

It means even if there is adequate justification for economic considerations such as market failure or distributional priorities, project appraisal would require consideration of the broader criteria of relevance, feasibility and sustainability. Taken together, these factors provide multiple criteria for project appraisal. However, the question remains: how do we prioritize these factors? Several approaches have been adopted by practitioners for this purpose. However, the most systematic and practical approach is to prioritize these factors by assigning weights and a scoring system to arrive at a summary figure. In the following discussion we shall illustrate the method of using the complex criteria for appraisal. [HM Treasury, 39] (a) Relevance Relevance refers to the extent a project is consistent with the country’s development priorities. Generally, the government defines its priorities for investment in a five-year plan or annual budget document. A project that does not fall in the framework of these plans is not considered feasible to begin with. However, within the five-year plan or annual budget itself, there could be areas of high or low priority. While considering a project for appraisal, the assessment would take into consideration the policy guidelines. For making an assessment of the relevance on a scale of 0-3, for example, the projects can fall in any of these categories: highly relevant (3), moderately relevant (2), least relevant (1), and not relevant (0)1. (b) Feasibility Feasibility of the project is determined with reference to its benefits and costs. Benefit-cost analysis or least-cost methods are standard techniques to determine the feasibility of the project. We shall discuss these techniques in the next section. Suffice to say at this point that the feasibility of project can also be translated into a score. For example, if the internal rate of return (IRR) is higher than the government's prescribed rate for project appraisal by 20%, the project can score 3 at a scale of 0-3, if it is between 11-20 %, it could score 2, if it less than 10 %, it could score 1 and it will score zero if the IRR is lower than the government's prescribed rate. (c) Sustainability Sustainability refers to the probability that the human, institutional, financial, and natural resources are sufficient to maintain the outcome over the economic lifetime of the project and that any risks can be managed. Important factors affecting sustainability are the project’s 1

The figures in the bracket indicate, for sake of illustration, score on a scale of 0-3.


financial arrangements, such as tariffs and other cost-recovery arrangements or budget allocations for maintenance, performance of any operating or service entity, and profitability of beneficiaries’ enterprises along with changes in the competitive environment and environmental impacts. For purpose of assessment, on a scale of 0-3, projects could be classified as most sustainable (3), moderately sustainable (2), least sustainable (1) and not sustainable (0). (d) Applying the appraisal criteria The next step is to decide the importance of various elements of the criteria as compared to one another. It means, we should prioritize these elements. In this example, suppose, using our judgement, we assign the following weights to these elements: Relevance (30%), Feasibility (50%), Sustainability (20%) Table 1 below illustrates application of the scoring scheme and weights discussed above in one of the options of a hypothetical project. Assuming the option scores as in column 3 of the Table, the assessment would be as in column 4. Table 1: Project Appraisal Criteria Illustration Criteria Element

Weight

Score

Assessment (column 2x column 3)

Relevance

0.30

2

0.60

Feasibility

0.50

3

1.50

Sustainability

0.20

1

0.20

Total

1.00

2.30

In this manner all realistic options are appraised and sorted in descending order. The option scoring the highest would be the first candidate for selection. However, the final selection is, generally, made by the sanctioning authority with exercise of judgement that may consider other factors not included in the above criteria. It is important to note that the above illustration only explains the appraisal criteria and its application. In practice, it will require detailed guidelines and benchmarks for classifying the variables and assigning the scores. For example, the guidelines can determine the conditions for assigning a particular score. There should be guidelines for assign weights on a government-wide basis for a consistent application of the criteria. 3. Analysis of Options The above discussion shows that project appraisal in public sector involves consideration of multiple factors. Out of the three elements of the criteria, relevance and sustainability can be estimated qualitatively by exercise of judgement in light of available information. But feasibility can be estimated through quantitative technique of benefit cost analysis. There are several complexities in conducting this analysis, since many of the costs and benefits do not have a market and a monetary value has to be judged only through indirectly.


Benefit cost analysis compares various options by reference to their net social benefits and social costs. Social benefits mean the benefits that would accrue to the society and social costs means the costs that the society would bear for the project. Net social benefits are the difference of social benefits and social costs. The benefits and costs are social in terms of to whom they accrue rather than merely market costs and benefits. However, in many public projects it is difficult to determine all social benefits and social costs because of absence of a market for them. There are alternative methods to overcome this difficulty. Now we shall discuss the generic technique of benefit cost analysis, leaving aside the question of several valuation issues where market values are not available. We shall take up those issues in the subsequent section. Benefit cost analysis is a process. It passes through the following stages: (Commonwealth of Australia, 2006, 24) • Determine objectives: what is the problem? • Determine the constraints • Identify options • Identify benefits and costs • Quantify benefits and costs • Calculate present value of benefits and costs • Test for sensitivity to mitigate risks • Consider other issues: equity, human, political, etc • Take decision The benefit-cost analysis may involve financial analysis or economic analysis. Both techniques use the concept of time value of money. IFAC (2007, 15) says: “In the public sector and not-for-profit contexts, the time value of money recognizes that society generally prefers to receive services now rather than later, so as to defer costs to future generations. This preference, commonly referred to as the Social Time Preference, is the value society attaches to present as opposed to future consumption, and some governments recommend using it as the standard real discount rate. This allows discounting of future benefits and costs, based on comparing utility across different points in time or different generations.”

It means that the costs incurred or benefits received earlier in time have a higher social value as compared to the value of these variables later in time. In financial analysis only financial costs and benefits are considered and in case of economic analysis, economic costs and benefits are also included in the analysis. The reason is that in some public sector projects, it is difficult to determine the financial costs and benefits or at least, the projects cannot be justified in financial terms. For example, in a water supply scheme, it may not be possible to recover all costs of the scheme from the public on human grounds. The project will not be justified in financial terms. In such cases, the economic value of benefits is estimated and taken into consideration. For giving effect to the concept of time value of money, future costs and benefits for the life cycle of the project are taken into account. These values are then discounted at a certain rate of interest and their present values are determined. Discounting is reverse of compounding. It means, what will be the present value of money spent or received in a certain point of time in


future? This is determined by discounting the future series of costs and benefits to the present. It is determined by the following formula: Dn = ______1_________, (1+r)

t

where Dn is the discounted value of the amount n, r is the rate of interest and t is the time.

For example, if we have to determine the present value of $ 1000 received in year 5, and the rate of interest is 10%, the discounted value would be 1/ 1000x (1.10) 5 = $ 621. It means the present value of $ 1000 received in year 5 would be $ 621 if the rate of interest is 10 percent. Once costs and benefits are discounted, they are netted to determine the net present value (NPV) of the project. According to IFAC (2007,7) NPV means “A single value representing the difference between the sum of the projected discounted cash inflows and outflows attributable to a capital investment or other project, using a discount rate that properly reflects the relevant risks of those cash flows.”

A positive NPV means, the option under analysis would generate a positive return, assuming the rate of discount is appropriate. When we determine the NPV for all options, it becomes possible to rank them in terms of their net worth and determine which one would be more beneficial, in financial or economic terms. NPV is a monetary figure and may make comparison difficult in absolute sense. A related concept in this analysis is determination of internal rate of return (IRR) that allows such comparison. Depending upon whether it is financial or economic analysis, the IRR can also be financial internal rate of return (FIRR) or economic internal rate of return (EIRR). According to IFAC (2007, 8) “Internal Rate of Return (IRR): The average annual percentage return expected for a project, where the sum of the discounted cash inflows over the life of the project is equal to the sum of the discounted cash outflows. Therefore, the IRR represents the discount rate that results in a zero NPV of cash flows.”

It is arrived at by hit and trial, discounting the costs and benefits at different rates of interest, until we arrive at a zero NPV. Calculating IRR manually is quite cumbersome. However, by using Excel program on computer, it is now easy to determine IRR. It means, in case of financial analysis, for example, the resources to be used for a project should not be borrowed at a rate higher than the FIRR, as it would then produce a negative NPV and the project would not be financially justifiable. But using IRR as a measure to choose a project is not considered a good option as sometimes the IRR may lead to ranking of options differently than NPV, which is a more reliable measure of analysis. [HM Treasury, 43] Before proceeding further to discuss various issues relating to estimation of costs, benefits, discount rate, risk and uncertainty, it seems appropriate to give an illustration of the benefitcost analysis. Illustration of benefit cost analysis A project was planned to construct storage warehouses with the following estimated costs and benefits.


Table 2: Estimated benefits and costs over the project life

Particulars

Years

Cost (million $)

Benefits (million $)

Land

1

2

Construction

1

3

Construction

2

1

Other capital cost

2

1

Utilities

2

1

Equipment

2

2

O&M cost

3-30

3

Revenue receipts

3

5

Revenue receipts

4

6

Revenue receipts

5

7

Revenue receipts

6-30

10

The discount rate for the project was 10%. Table 3: Illustration of Benefit Cost analysis Capital cost

Years

2

O&M cost

Total cost

Benefit s

Net benefits

NPV at 10%2

NPV at 37.3%

1

5

0

5

0

-5

-5

-4

2

5

0

5

0

-5

-4

-3

3

0

3

3

5

2

2

1

4

0

3

3

6

3

2

1

5

0

3

3

7

4

2

1

6

0

3

3

10

7

4

1

7

0

3

3

10

7

4

1

The Excel program provides formulas for calculating NPV. However, if the values are non-uniform, the following formula would help: [1/Power (1+ rate of interest, year) * value to be discounted]


8

0

3

3

10

7

3

1

9

0

3

3

10

7

3

0

10

0

3

3

10

7

3

0

11

0

3

3

10

7

2

0

12

0

3

3

10

7

2

0

13

0

3

3

10

7

2

0

14

0

3

3

10

7

2

0

15

0

3

3

10

7

2

0

16

0

3

3

10

7

2

0

17

0

3

3

10

7

1

0

18

0

3

3

10

7

1

0

19

0

3

3

10

7

1

0

20

0

3

3

10

7

1

0

21

0

3

3

10

7

1

0

22

0

3

3

10

7

1

0

23

0

3

3

10

7

1

0

24

0

3

3

10

7

1

0

25

0

3

3

10

7

1

0

26

0

3

3

10

7

1

0

27

0

3

3

10

7

1

0

28

0

3

3

10

7

0

0

29

0

3

3

10

7

0

0

30

0

3

3

10

7

0

0

10

84

94

268

174

37

0

The NPV at 10% rate of discount was $ 37 millions. The IRR was determined by hit and trial, using increasing rates of discount, until at 37.3%, the NPV became zero. The FIRR was, therefore 37.3%.


4. Issues in Benefit Cost Analysis Estimates of cost and benefits in financial analysis where market prices are available are fairly straight forward. For example, if we are going to construct a power house, the prices of land, building and equipment can be estimated with a fair ease in light of market prices. The estimates of benefits can be determined by multiplying the power produced with its sale price per unit. However, estimation of costs and benefits pose significant problems where market prices are not available. The following discussion presents some of the generally accepted approaches. (a) Estimating costs where market cost are not available [Asian Development Bank, 1997, 14-25; HM Treasury, 26ff.] (i)

Where market costs are not available, opportunity costs can be used. Opportunity cost refers to the value of the asset in an alternative use or the opportunity that would be lost. For example, if market price of land in an area is difficult to determine, then opportunity cost could be a good proxy.

(ii)

Economic costs could be in terms of employees’ time. In such case, the full-time cost, include any pension benefits as well.

(iii) Some projects may have sunk costs in terms of goods and services already acquired. They should be ignored as the project appraisal is concerned with the decision about future investments. (iv) Depreciation of assets should be ignored as the benefit-cost analysis discounts the values of the assets to the present. (v)

Where possible, distinction should be made in fixed, variable and semi-variable costs. The distinction helps in refining the analysis.

(vi) If the department is already incurring some cost, the marginal cost and not the total cost of the project should be assigned to the project. (vii) The residual values of assets, whether as a scrap, or in the second hand market or as alternative use elsewhere in the department, should be estimated and included in the project appraisal. (viii) Some projects expose the government to contingent liabilities. They should be taken in the economic cost of the project. (ix) Transfer payments in the form of taxes and subsidies are not included in economic analysis as they are compensatory in nature. The government taxes on some assets procured are also income of the government. They are not included in the cost of the assets. (x)

Where non-renewable resources such as minerals and oil are used in the project, the opportunity of these resources in terms of the replacement of these assets by imports etc should be estimated and included in the economic cost for each year. The salvage value of the resource should, of course, be excluded from the total cost.

(b) Estimating benefits [Asian Development Bank, 1997, 14-25; HM Treasury, 26ff.] (i)

All benefits, financial as well as economic, should be taken into account while appraising the project. The best estimate of the cost is the market price of the benefits. For example, in case of a power plant, the rates of power supply as in use


for rest of the country could be a good estimate for arriving at the value of the electricity to be produced. (ii)

Where market is dominated by monopoly, or prices are distorted by taxes and subsidies, specialist advice of the economists would be required to arrive at the opportunity costs of the benefits.

(iii) Where market prices are not available the value of benefits may be determined by ‘willing to pay’ criteria. It means, it should be estimated what the consumers would be willing to pay for a particular benefit or service. This can be estimated from study of ‘revealed preferences’. For example, if a project is expected to create better environments, it should be estimated what higher values consumers were paying for better environments while buying properties in similar other localities. The difference in prices being paid shows the revealed preference for the value of better environment. This can also be ascertained through a survey of the target consumers asking them what they would like to pay for a certain benefit. (iv) The estimation can also be approached from another angle: what would the consumers demand as compensation to accept the project. For example, if a park is being proposed in a neighbourhood for better environments, but would create route diversion for some residents, the question could be asked from those residents: what would you demand as compensation to accept the outcome of this project? It would give an estimated value of the benefits on the criterion of ‘willing to accept.’ Some countries have conducted research in techniques for estimating benefits relating to health, quality of life, prevention of fatality and injury, time saving, design quality, environmental impacts, greenhouse gas emissions, climate change, etc. Discussion of these techniques falls out of the scope of the paper. (v)

If a project is expected to substitute an existing project or supplement an existing facility, only marginal benefits and not the total benefits should be included. For example, if a hydroelectric power plant would substitute a coal-powered plant, only increase in the power to be produced should be evaluated to be included in the project and not the entire production.

(c) Inflation Estimates of costs and benefits are made in constant prices at the level prevailing in the year a project is appraised. In exceptional cases, where expected prices of the project inputs and outputs are likely to rise as compared to other prices, adjustments have to made for the expected inflation. [HM Treasury, 29] (d) Least cost analysis Least cost analysis is used where it is not possible to assign a value to benefits or where we aim to determine the least cost for the same output. For example, if we are aiming to enhance the ability of students in mathematic by a certain percentage, we cannot place a monetary figure on the benefits. However, we can determine the cost per student who achieves the required percentage. The cost effectiveness analysis tries to arrive at the least cost option. It is important to note that the least cost option may not be the most effective option. It may be possible to have another option that is more effective, but may cost more. In such situations, the least cost option is compared with the marginal cost that would be required for the most effective option. The final decision is made by exercising judgement. Another limitation is that since costs and benefits are not directly comparable, it does not provide a criterion for acceptance or rejection of a project or a program. [European Union, 2005, 40; Asian Development Bank, 1997, 31]


(e) Capital versus operating costs Benefit cost analysis includes all types of cost flows and does not make the accounting distinction of capital (or one-off) and operating expenses. (f) Rate of discount The question of rate of discount is quite tricky. Projects can be justified or rejected by varying the rate of discount. How do we determine the rate of discount? Theoretically, the rate of discount should represent the opportunity cost of capital. It can be determined by any of the following methods: • the economic rate of return on alternative marginal projects or the economic opportunity cost of capital • the real cost of foreign borrowing • the real rate of return in capital market • the demand and supply of funds to provide an overall estimate of the economic price of capital. These are questions which a project appraiser does not have to decide. They are considered by the central planning agencies or ministries of finance and a rate of discount is generally prescribed for all departments and agencies. [IFAC, 2007, 12; HM Treasury, 30; Asian Development Bank, 1997, 37] (g) Interest on borrowed capital Interest on borrowed capital is an expenditure and is recorded as such when payment is made. However, at the time of project appraisal, this is not recognized as we are recording the present value of all costs and there cannot be an interest due on the capital at the present moment. To include interest on borrowed capital in addition to discounting will be double counting the project costs. (h) Sensitivity analysis At the time of project appraisal, the uncertainty and risk of future events always remains a concrete possibility. A wide variety of risks can create problems in achieving the project objectives. There could be delays in obtaining funds, in getting various approvals, and concluding procurement contracts. The suppliers could delay the delivery, prices of goods and services may shoot up unexpectedly, and so on. Unforeseen events can take place which may lead to increase in capital cost, delay in completion of the project, increase in the variable cost, or decrease in the benefits. Besides, there is a general tendency worldwide for project sponsors to base their proposals on undue optimism. The project sponsors tend to overstate the benefits and suppress the costs to present a rosy picture. This is known as ‘optimism bias.’ [HM Treasury, 36] The project proposals need to be adjusted for uncertainty, risk and optimism bias. Past history of similar projects in the organization and elsewhere can help identifying various risks and potentially adverse events. The appraiser can test the base case against various possibilities. This is done through sensitivity analysis. Sensitivity analysis attempts to determine the effect of adverse effects on NPV or IRR of the project. It tests the vulnerability of options against potential risks. Generally, one variable is tested at a time, keeping the other as constant, although methodology allows testing of more than one variable at the same time. The purpose is to identify the risks that can cause serious harm to the success of the project. It helps in planning the mitigating action at this stage. For example, if sensitivity test indicates


that the project is most sensitive to delay in completion, action can be taken to expedite various approvals or conclude various procurement contracts on an urgent basis to avoid the possibility of delay. In the following discussion, we have taken the base case discussed in section three of this paper and assumed that following potentially adverse events can take place. The purpose is to illustrate application of sensitivity testing to the project base case. • Scenario1: Delay in the completion of the project by two years, leading to delay in the start of benefits-flow by two years. Rest of the assumptions are as they were. • Scenario 2: Increase in the total capital cost of the project by 10 percent. All increase to be in year one. Rest of the assumptions are as they were. • Scenario 3: Increase in the O&M costs by 10 percent from year three. Rest of the assumptions are as they were. Taking the worksheet given in section three above, we worked out the effect of one scenario at a time and determined the effect of that change on the base case. The results are as in Table 4 below: Table 4: Illustration of Sensitivity Testing

Scenarios

Base case NPV

Base case IRR

NPV with change

IRR with change

Delay of 2 years in completion and benefitsflow

$39 millions

37.3%

$29 million

30%

(- 25.64%)

(-19.57%)

Increase in total capital cost in year 1 by 10%

$39 million

$38 millions

36%

(-2.56%)

(3.48%)

Increase in O&M cost by 10%

$ 39 million

$36 millions

35%

(-7.71%)

(-6.61%)

37.3%

37.3%

The above table shows that the project is most sensitive to delay in completion by two years. It would reduce the NPV by over 25 % and IRR by about 20%. It is least sensitive to increase in the total cost by 10% in year one. Such an increase would reduce the NPV by only 2.5% and IRR by about 3.5 %. There are more complex issues which can be considered at the time of project appraisal. For example, thinking of sustainability, the project can be evaluated for financial, environmental or economic sustainability. Similarly, the project may have implications for distribution of income. There could be positive or negative externalities of the project, which means some of the benefits and cost may accrue to those who are not intended beneficiaries of the project. Economic analysis of projects has developed techniques for analyzing such factors. For the sake of simplicity, this paper will not cover these issues.


We 5. Selecting the Best Option It is now time for revisiting section two of this paper where we discussed the appraisal criteria. Once the appraiser assesses all options on the multiple criteria of relevance, feasibility and sustainability, it will be possible to rank various options in descending order according to their respective score. However, the top candidate for selection may not be the project finally selected as there are other considerations which have not yet entered the appraisal process. In light of these considerations, judgement will be exercised for selecting the best options. Following are some of the most commonly used other considerations: (a) Budget constraints If there is a budget constraint that restricts the funds available for investment, the top option may have to be abandoned and second or third best option may have to be selected. It is also possible at this stage to combine more than one option to arrive at the option that matches the budget ceiling. (b) Maximin-return principle The maximin return principles says that the decision should be based on maximizing the outcomes in worst situations. For example, if the government is considering to provide two services (services A and B) which are mutually exclusive, it should consider the least bad outcome if the worst possible conditions prevail. Table 5 below illustrates the application of this principle. [HM Treasury, 42] Table 5: Maximin Principle in Selecting the Best Option Service

NPV if best conditions prevail

NPV if worst conditions prevail (million $)

(million $) Service A

10

5

Service B

12

1

In this example, the NPV of service A is 5 if the worst conditions prevail and that of service B is one in those conditions. Maximin-return principle says that service A should be selected. Service B, otherwise, could be the candidate for selection as it has the highest NPV. (c) Cash flow Cash flow statements of various options indicate the requirement of cash inflows at different points of time. In case the funds are not available during a certain period and have to be borrowed, the cost of funds has to be considered as additional burden and the option should be adjusted for that cost. The adjustment could affect the previous ranking of the options. (d) Funding statement In case a project has to be funded by borrowed funds, the commitments of donors and the conditions on which the donors would provide funds also affect the selection of the project. The conditions by the borrowers (such as repayment period, rate of interest, or grace period, etc) may simply make the best option as impracticable.


(e) Consultation with stakeholders Another important consideration is the result of consultation with various stakeholders, such as general public, users of a particular service, private sector enterprises, labor unions, civil society, NGOs etc. The consultation may bring to light various aspects of the project which the above appraisal has not considered. These considerations may affect the selection of the project. For example, the project may bring to light serious objection from the population which may be dislocated, or cause unrest among a certain province on human rights basis, or questions of provincial autonomy may come up. All these considerations can affect the original ranking of the options. (f) Involving private sector One of the questions is how to implement the project. It is not necessary that the government departments and agencies implement all projects directly. From outsourcing to various types of partnerships with the private sector can affect the selection of the option. For example private sector can be involved in such agreements as built, own operate and transfer (BOOT), build own and operate (BOO), build and transfer (BT), etc. These options can affect the final selection of the project. 6. Concluding remarks Project appraisal uses the concept of benefit-cost analysis or its variation cost-effectiveness analysis. However, the analysis is a tool and provides a basis for intelligent decision-making. It does not substitute the decision-makers' judgement that may include other intangible factors. The project sponsors should remain conscious of the limitations of this tool. It is far from perfect, despite its appearance in quantitative terms. The benefits and costs are estimated on the basis of imperfect information. Despite all care, distributional effects of the project cannot be handled in a manner that may satisfy the long term social and political objectives of the people. Project appraisal is a systematic approach to compare various alternatives and to minimize the unforeseen risks, though it is not a perfect answer to all questions relating to investment decision.


References Asian Development Bank. (1997). Guidelines for Economic Analysis of Projects. Manila: ADB. 215Pp. Asian Development Bank. 2006. Guidelines for Preparing Performance Evaluation Reports for Public Sector Operations. Manila: ADB. 85Pp. Commonwealth of Australia. 2006. Handbook of Cost-benefit Analysis. Canberra. Pp.180. available at: www.ag.gov.au/cca Department of the Auditor General of Pakistan. 1984. Performance Audit Guide. Vol.1. Lahore: AGP. European Union Department of Finance. (2005). Guidelines for the Appraisal and Management of Capital Expenditure Proposals in the Public Sector. Brussels: EU. 51 Pp. HM Treasury. (nd.) The Green Book: Appraisal and Evaluation in Central Government. London: TSO. Available at: http://www.hmtreasury.gov.uk/economic_data_and_tools/greenbook/data_greenbook_index.cfm International Federation of Accountants. 2007. Project Appraisal Using Discounted Cash Flow. New York: IFAC. 27Pp. McCarthy, Colm. 2004. Project Appraisal and Value-for-Money in the Capital Programme. Dublin: Institute of Engineers Ireland. 12 Pp. National Roads Authority. 2008. Project Appraisal Guidelines. Dublin: NRA. 92 Pp. Available at www. nra.ie. New Zealand Treasury. 2005. Cost-Benefit Analysis Primer. Wellington. 52Pp. Office of management and Budget. 1992. Guidelines and Discount rates for Benefit-Cost Analysis of Federal Programs. Washington, D.C.: OMB. Available at: http://www.whitehouse.gov/omb/circulars/a094/a094.html Organization for Economic Cooperation and Development. 2002. Glossary of Key Terms in Evaluation and Results- Based Management. Paris: OECD. 40 pp. Glossary

Terms in Evaluation and Results Based Management

of Key


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