ECONOMIC COST BENEFIT ANALYSIS

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Lecture Notes

ECON 437/837: ECONOMIC

COST-BENEFIT ANALYSIS

Lecture One

COST-BENEFIT ANALYSIS:

An Integrated Approach

The Role of Investment Appraisal

• To stop bad projects – bad policies

• To prevent good projects from being destroyed

• To determine if components of projects are consistent

• To assess the sources and magnitudes of risks

• To determine how to reduce risks and efficiently

share risks

Questions addressed by an Integrated

Investment Appraisal

• Is the project financially viable or fiscally sustainable?

• Does the project contribute to the economic growth of the country?

i.e., positive expected economic NPV?

• Who are beneficiaries of project and by how much?

• Who are the interest groups (stakeholders) who could distort the

investment decision or affect the project’s performance?

• What are the sources and magnitudes of risk?

• What are the risks associated with the benefits accruing to the

stakeholders? Sources of political risks?

• Are poverty alleviation goals being addressed?

• What are the fiscal impacts?

• What is the personality of the project?

• Quality of analysis has been shown by the World Bank to

be a key determinant of the success of a project’s

performance

so that it is less likely to fail

failure for poorly prepared projects within 3 years of a

project’s life is 7 times that of well-prepared projects

probability of failure within 5 years as compared to

well-prepared projects

Impact of Analysis

Incrementality of Projects

• One of the important concepts when defining a project is to measure the impact of the project’s cash flows and net benefits and costs on an incremental basis.

• We should carefully identify the benefits and costs that are only associated with the

project, and not include any other benefits that would exist “WITHOUT” the project

being undertaken.

• It is normal for the benefits and costs to change over time for the “WITHOUT”

project case.

base case from which to measure incremental benefits and costs produced by the

“WITH” project case

“WITH” project situation to calculate the incremental benefits and costs

• There is another perspective “before the project” versus “after the project” scenarios

“Before the project” is NOT the appropriate base case from which to measure

incremental benefits and costs.

• Stages in Project Appraisal and Approval

A Idea and Project Definition

A Key Questions at Idea Stage

a Where is the demand?

b Is this project consistent with the

organization’s expertise, current plans and

strategy for the future? Can the project be

implemented and operated in a reasonably

efficient matter?

Project Definition

specification of the objectives of the project, its output, its

different stakeholders, its economic and social benefits, and the data requirements

pre-feasibility and feasibility stages of the project where the project’s variables and parameters are analyzed in detail

B Pre-Feasibility Study

• Examines overall potential of project

• Should maintain same quality of information across all

variables

• Wherever possible should use secondary information

Key questions:

a Is this project financially and economically feasible

throughout the project’s life?

b What are the key variables?

c What are the sources of risk?

d How can the risk be reduced?

C Feasibility Study

• Focus is on improving accuracy of the key variables

• Alternatives for reducing risk are examined in detail

• Some primary data may be needed

Key questions:

a Is project financially attractive to all interested parties

in activity?

b What is level of uncertainty of key variables?

c How is the project financed?

d Can final decision for approval be taken?

Modules of Pre-Feasibility and Feasibility Studies

The data for a pre-feasibility study are generally arranged in what

we refer to as “building blocks” because they constitute the

foundation for the different types of analyses

Building Blocks

A Demand Module

B Technical Module

C Environmental Assessment Module

D Human Resources and Administrative Support Module

Building Block A: Demand Module

• Study of sources of demand, nature of market, prices and

quantities

• Major distinction between domestic versus internationally

traded goods and services

• For internationally traded goods, prices are given to the

project by world markets

– Secondary information most important

• For domestic market, primary research more important

Output of Module

a Forecast of quantities and real prices for life of project

b Taxes, tariffs, subsidies, public regulations, technological

trends

c Environmental impacts

Building Block B: Technical Module

• A study of input requirements for investment and

operations and their costs

• In this module, secondary information can be used very

effectively

• Need to avoid conflict of interest between supplier of

technical information and seller of investment equipment,

or contractor for construction

Output of Module

a Technology and life of project

b Quantities of inputs by type needed for investment and

operation

c Labor required by type and time

d Input prices and sources of supply

e Environmental impacts

Building Block C: Environmental Assessment Module

• Environmental assessment augments information for the

economic analysis

• Identification of environmental impacts and risks

• Where possible, quantify the environmental impacts

Key Questions:

a What are the likely environmental impacts from undertaking

project?

b What is the cost of reducing the negative impact?

c Evaluation of the environmental impacts and risks with and

without technical measures are taken to reduce these impacts?

d Are there alternative ways of supplying the good or service of project without incurring these environmental costs? What are

the costs of these alternatives?

Building Block D: Human Resources and

Administrative Support Module

• What are managerial and labor needs of the

project?

• Does organization have the ability to get the

managerial skills needed?

• Is timing of project consistent with quantity and

quality of management?

• What are wage rates for labor skills required?

• Manpower requirements by category are

reconciled with availabilities and project timing.

Building Block E: Institutional Module

• This module deals with the adequacy of the institution responsible

for managing the different stages or phases of the project.

• Insufficient attention to the institutional aspects creates serious

problems during the implementation and operations phases of the

project

Key Questions:

a Is the entity that is supposed to manage the project properly

organized and its management adequately equipped to handle the

project?

b Are the capabilities and facilities being properly utilized?

c Is there a need for changes in the policy and institutional set up

outside this entity? What changes may be needed in policies of the local, regional and central governments?

Analysis Module F: Financial Module

What is done:

• Integration of financial and technical variables from demand

module, technical module, and management module

• Construct cash flow profile of project

• Identify key variables for doing economic and social analysis

Key questions:

a What is relative certainty of financial variables?

b What are sources and costs of financing?

c What are minimum cash flow requirements for each of the

stakeholders?

d What can be adjusted to satisfy each of the stakeholders?

Analysis Module G: Economic Module

b What causes these differences?

c With what degrees of certainty do we know values of these

differences?

d What is the expected value of economic net benefits?

e What is the probability of positive economic feasibility?

Analysis Module H: Stakeholders and Basic Needs Analysis

What is done:

• Identification and quantification of extra-economic impacts of project

• Income, cost, and fiscal impacts on various stakeholders

• Poverty alleviation and political necessities

• Basic Needs: Evaluate the impact of project on achieving basic needs

objectives

– Basic needs will vary from country to country

Key Questions:

b What stakeholders could the project impact?

c Who benefit and who pay the costs?

d What are the basic needs of the society that are relevant in the country?

e What impact will the project have on basic needs?

f What alternative ways are there to generate desirable social impacts?

g Is project relatively cost effective in generation of desirable social impacts?

Integrated Projects

• Integrated projects can get very complex and need to be approached

cautiously to avoid costly errors

• It is possible for the bundled project to be financially and economically

viable even though some of the components are not.

• Dropping the components that generate negative returns will maximize the project’s benefits.

• Defining and understanding the objectives of the project is particularly

important when analyzing integrated projects.

• Ultimately, the ‘bundle’ that succeeds the most in accomplishing the desired objectives should be undertaken.

• If the objective of the project is to maximize the wealth of people in country, then the component or bundle that yields the highest economic NPV should

be undertaken.

ECONOMIC VALUE

FINANCIAL

VALUE TAX IMPACT

ECONOMIC VALUE

FINANCIAL VALUE

TAX IMPACT

NET BENEFITS TO CONSUMERS

NET LABOUR BENEFITS

= +

General Relationship

NPVECOeco dr= NPVFINeco dr+  PVEXTeco dr

- Holds when all benefits and costs are

discounted using same discount rate.

• Critical in analysis to evaluate financial outcome of project from the point of view of each interested party

• Conventional analysis considers:

a Point of view of owner

b Point of view of all investors combined

(Banker’s point of view or total investment point of view)

c Point of view of economy

Other Perspectives

• Point of view of government budget

• Point of view of suppliers of inputs

• Point of view of downstream processors

• Point of view of competitors

Alternative Points of View

Analyses of Investment Decisions from

Alternative Points of View

Economic (II) No/Yes No/Yes No/Yes Yes

Stakeholder (III) Yes Yes Yes Yes

Basic Needs (IV) No No No Yes

Type of Analysis

Analyses of Investment Decisions from Different Viewpoints

Note: Exchange premium=10%; Receipts & Equipment 100% tradable; Tradable Operating cost =100

(A)

Owner (B)

Country (C)

Govt Budget (D) 0

-190 -30

0

-100

1

40 -10 95 -50 100

Economic Financial

Summary of Project Decision Criteria

for each of indicators above (risk simulation)

Project Owner’s View Banker’s View

Country’s View Distribution Analysis

Risk Analysis

APPRAISAL OF REGIONAL

AFRICAN SATELLITE PROJECT

RASCOMSTAR-QAF

Objectives of Project

providing an alternative way of connectivity to telecom

operators

ii) Interconnect existing public switch telephone networks

(PSTNs) otherwise known as fixed lines

iii) Provide bandwidth lease service (BLS) to internet providers

and TV broadcasters

Objectives of Appraisal

1) Does project ensure the least-cost way of expanding

telecommunication services in Africa?

2) What is magnitude of financial benefits realized by RSQ and

6) What are risk factors that affect project and how can uncertainty

and risk exposure be mitigated?

Rural Telephony Service (TES)

BBU

12v olts

DC

BBU

12v olts

City PSTN

International gateway

PSTN

PSTN

RT

Village Village

Village

Other Country

COUNTRY X

City Low capacity gateway

RT

RT

BBU

12v olts

DC

BBU

12v olts

DC

BBU

12v olts

DC

BBU

12v olts

City PSTN

International gateway

PSTN

PSTN

RT

Village Village

Village

Other Country

COUNTRY X

City Low capacity gateway

RT

RT

Capital City PSTN

International gateway

PSTN

PSTN

RT

Village Village

Village

Other Country

COUNTRY X

City Low capacity gateway

RT

RT

▪ Allow African telecom operators to expand their coverage

over hard-to-reach rural areas

▪ Telecom operators will deploy terminals in phone booths,

tele-centers, private or residential sites in rural areas

Regional City gateway 2

PSTN

City x gateway

PSTN

PSTN

Regional gateway

Terrestrial Infrastructure

Mission Control Center

Connectivity on-demand (TRS: Trunking Service)

▪ Through satellite, participating

African telecoms can link directly with each other, instead of resorting to costly international satellites

▪ In order to participate in the exchange, telecoms need to install gateways that will link their existing telephone

networks with that of other countries via the satellite

Bandwidth Lease Service (BLS)

GSM Backhaul

▪ This service targets TV broadcasters, internet service

providers and big corporations with fixed annual

subscriptions

▪ Services include trunking, broadcasting, internet services,

global system of mobile communication (GSM) backhauling, private or corporate networks and news gathering services

Project Cost and Financing

• Total capital cost is estimated at US$ 357 m in 2005 prices

- Space segment (e.g., satellite) and ground segment (e.g., gateway)

• Financing

- Equity: US$ 151 m

- Loans

- LAFB: US$ 85 m, nominal interest rate is 4.68% p.a

- AfDB, IsDB, EIB, etc.: US$ 126 m, interest rate is 4.68% p.a

• Timing and Project Life

- Construction of satellite started in June 2003

- Satellite launched in October 2006

- Operation starts in January 2007 for 15 years

Project Cost and Financing (cont’d)

2003 2004 2005 2006 2007 Total

Satellite A 35.9 40.7 27.6 15.6 - 119.8

Launcher B - - 2.0 46.0 7.0 55.0

Insurance C - - 4.2 38.2 - 42.5

Ground control system A 4.6 5.2 3.5 2.0 - 15.3

Launch campaign, LEOP, IOT/Scc/ttc (Ariane) A 3.5 4.0 2.7 1.5 - 11.7

Ground design D 1.1 3.2 - - - 4.2

Ground infrastructure development E - - 10.2 33.0 - 43.2

Terminals F - - 20.5 - - 20.5

Other ICS and BLS development - - 4.7 1.6 - 6.3

Pre operating expenses 12.2 4.4 6.3 3.9 4.8 31.5

License fees 3.0 - - - - 3.0

Contingencies - - 0.8 2.3 - 3.0

Key Assumptions

• Decrease in real TES,TRS tariffs per annum at 7.32%

• Decrease in real annual charge for BLS transponders 2.5% per year

• Transponders not used by TES and TRS are sold to BLS

subscribers at a discount: capacity of satellite is fully used at

all times

• US inflation rate 2.5% (base case)

• Daily traffic per terminal 70 minutes/day in 2007 increases to

74 in 2008 and stays constant thereafter

• No liquidation value for satellite

• Real opportunity cost of equity of 15%

RSQ’s Cash Flow Statement Real, 2005 Prices

(US$ million)

ADSCR - - - - - - - - 1.79 2.28 2.48 2.55 2.61 2.66 5.45 - - - -

-LLCR - - - - - - - - 2.76 2.99 3.17 3.38 3.69 4.23 5.54 - - - -

Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 INFLOW

TES - - - - 1.9 29.6 57.9 67.8 66.7 62.3 57.7 53.5 49.6 45.9 42.6 39.6 38.6 37.6 36.7 TRS - - - - 5.3 8.9 16.4 19.8 19.8 19.6 19.5 18.6 17.5 16.5 16.4 16.3 16.0 15.7 15.4 - BLS - - - - 38.2 34.0 28.3 24.9 23.5 22.4 21.4 20.7 20.1 19.4 18.8 18.3 17.7 17.3 16.8 - Change in accounts receivable - - - - -10.5 -6.6 -7.6 -3.2 -0.4 0.3 0.4 0.5 0.5 0.4 0.2 0.2 -0.2 -0.2 -0.2 15.3 Residual value - - - - - - - - - - - - - - - - - 5.0

-Total Inflow - - - - 34.9 65.8 95.0 109.4 109.6 104.7 99.0 93.2 87.6 82.4 78.0 74.3 72.1 70.4 68.7 20.3 OUTFLOW

Investment Costs 63.1 59.2 82.4 140.5 11.5 - - - - - - - - - - -

-Operating Costs

General operating costs - - - - 13.1 12.9 12.9 11.9 10.8 9.7 8.6 7.6 6.6 6.0 5.5 5.0 4.8 4.7 4.5 Labor - - 2.7 2.7 2.7 2.8 2.8 2.8 2.8 2.8 2.8 2.8 2.9 2.9 2.9 2.9 2.9 2.9 2.9 - Change in accounts payable - - - - -1.5 0.0 0.0 0.1 0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.5 Change in cash balance - - - - 2.0 0.0 0.0 -0.1 -0.1 -0.1 -0.1 -0.1 -0.1 -0.1 -0.1 -0.1 0.0 0.0 0.0 -0.7 Income tax - - - - 0.0 1.0 1.7 2.1 2.1 2.1 2.0 1.9 1.8 1.7 1.6 1.6 1.5 1.5 1.5 -

-Total Outflow 63.1 59.2 85.1 143.2 27.8 16.7 17.4 16.8 15.7 14.5 13.4 12.3 11.3 10.6 10.0 9.5 9.3 9.1 8.9 -0.2 NET CASH FLOW