Investment and project appraisal

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Investment and Project Appraisal

© Centre for Financial and Management Studies

SOAS, University of London published 2003, revised 2007, 2010, 2012 All rights reserved No part of this course material may be reprinted or reproduced or utilised in any form or by any electronic, mechanical,

Investment and Project Appraisal Course Introduction

Contents

6
Teaching and Learning Strategy 8

1 What the Course is About

Welcome to the course Investment and Project Appraisal.

This course is concerned with the methodologies used in the selection and

appraisal of investment decisions in both the private and the public sectors

This first section will detail the techniques and issues that you will study

within the eight units of the course

The need for these techniques and methodologies arises from the

import-ance of investment in allocating productive resources over time and

between different sectors and activities in the economy

• Should a new runway to serve South East England be situated at

London’s Heathrow or Stansted airport?

• Should South Africa build more urban motorways, or improve its

rural road networks?

• How quickly should retailers install systems to process payments by

credit cards using chip technology and PIN numbers rather than

customer signatures?

These are typical of some of the questions that might confront investment

and project analysts To tackle these, you need the ability to choose the right

investment packages(s), and to discriminate between them on the basis of

appropriate criteria Sound selection and screening are certain to make a

critical impact on the outcome of an investment

Course themes

The first theme this course addresses is:

• What is needed from the micro, corporate sector, point of view in

order to analyse, assess and gauge investment activities?

These issues are mainly covered in Units 2 and 3, which have an explicit

private sector perspective on investment evaluation These units introduce

and illustrate with practical examples the application of various financial

techniques for investigating the soundness of private investments

The second grand theme is:

• How can we apply cost-benefit analysis to public sector investment

projects?

This takes us through the cost-benefit literature principally developed in

connection with public sector investment in the developed countries

(namely, waterworks and irrigation, transport and communication, health

and education, social services, etc) However, subsequent developments in

the cost-benefit literature were associated with the growth and popularity of development projects in less developed countries (LDCs) The latter part of

the course, therefore, explicitly addresses those issues (in the context of

discussions of shadow pricing, environmental projects and other such

examples) In all cases, to enrich the discussion of analytical methods and

theoretical issues, a liberal package of case studies is provided in order to

illustrate useful real-world applications

2 Aims of the Course

This course aims at introducing you to the main theoretical and practical

issues involved in the appraisal and assessment of investment projects

Private sector investment initiatives have to be assessed against the

widely adopted and prevalent objective of maximising shareholders’

wealth (i.e the value of the enterprise) Public sector projects, including

development projects funded and assisted by donors and international

development agencies, tend to have wider society- or economy-wide

objectives and have to be appraised in terms of their net contribution to

the economy as a whole

Despite this apparent incongruity in objectives, there is much value in a

comparative study of the analytical methods used in either private or

public sector investment appraisal Further, where private sector

com-panies are selected to implement projects on behalf of governments they

will be answerable both to shareholders and also to government

depart-ments or agencies responsible for sectors in which wider social objectives

are of great concern This course deals with investment appraisal methods

in both sectors

The structure of the course

The course units cover the following issues:

• Unit 1 provides an overview of investment and investment activities,

and differentiates private and public sector investments and projects

• Unit 2 deals with basic evaluation techniques covering traditional and

time-value methods of investment appraisal

• Unit 3 extends the discussion of discounted cash flow analysis in Unit

2 by introducing capital rationing, risk and uncertainty, inflation and

depreciation

• Unit 4 is a bridge unit between the first and second parts of the course

It introduces and illustrates the basic tenets of cost-benefit analysis and focuses on the identification of costs and benefits and their valuation

• Unit 5 is concerned with valuation of costs and benefits in the context

of shadow pricing – that is, the use of world prices as benchmarks for

efficiency prices or trade opportunity costs

• Unit 6 covers issues and problems associated with discounting

• Unit 7 focuses on the challenge of accounting for the environment in

project appraisal, and on practical methods used for valuing

3 An Overview of the Course

Unit 1 Introduction and Overview

1.1 Investment – an Overview

1.2 Investment Appraisal – Nature and Scope

1.3 Investment Appraisal and Financial Decision Making

1.4 Cost-Benefit Analysis – Issues and Evolution

1.5 Projects and Project Appraisal

1.6 The Project Cycle

1.7 Public and Private Sector Appraisal

Unit 2 Investment Appraisal – Basic Evaluation Techniques

2.1 Introduction

2.2 Traditional Methods

2.3 The Time Value of Money Methods

2.4 Summary and Conclusions

2.5 Revision Exercises

Unit 3 Cash Flows, Capital Budgeting and Investment Decisions

3.1 Introduction

3.2 Identifying and Using Cash Flows

3.3 Capital Market Imperfections

3.4 Simple Ways to Cope with Risk

3.5 Summary and Conclusions

3.6 Revision Exercises

Unit 4 Social and Economic Cost-Benefit Analysis

4.1 Cost Benefit Analysis – an Illustration

4.2 Identifying Costs and Benefits

4.3 Valuation of Costs and Benefits

4.4 A Case Study in Valuation – Putting Money on Human Life

4.5 Summary and Conclusion

4.6 Revision Exercises

Unit 5 Economic Pricing of Costs and Benefits (Shadow Prices)

5.1 Introduction

5.2 The Underlying Theory of Shadow Pricing

5.3 Pricing in Distorted Markets

5.4 The Use of a Shadow Exchange Rate and International Prices

5.5 The UNIDO and World Bank Models

5.6 Decision-Making with Conflicting Results

5.7 The Impact of Ongoing Global Liberalisation on the Use of Shadow Prices

5.8 Summary and Conclusion

Unit 6 Discount Rate, Risk and Uncertainty in Cost Benefit Analysis

6.1 Introduction

6.2 The Discount Rate

6.3 Theoretical Consistency and Derivation of a Social Rate of Discount

6.4 The Social Discount Rate in Practice: A Case Study on Discount Rate Policy in

the UK 6.5 Risk and Uncertainty

6.6 Methods for Handling Risk and Uncertainty

6.7 A Case Study and Exercise

6.8 Summary and Conclusion

Unit 7 Project Appraisal, The Environment and the Kyoto Protocol

7.1 Introduction

7.2 Addressing Environmental Neglect

7.3 The Importance of Environmental Assets in Project Appraisal

7.4 Integrating Environment into Project Appraisal by using Valuation Methods

7.5 Case Studies for Valuation Methods

7.6 Environmental Constraints on New Investment Projects and Economic Growth

7.7 The Kyoto Protocol

7.8 Summary and Conclusion

Unit 8 Income Distribution through Project Appraisal within and between

Generations

8.1 Introduction – Income Distribution and Thorny Questions

8.2 Diminishing Marginal Utility of Income and Intergenerational Welfare Weights

8.3 Income Classes for Distributional Weights

8.4 Further Issues

8.5 Intergenerational Distribution

8.6 Two Case Studies

8.7 Conclusion

4 The Course Authors

Hassan Hakimian is currently working at the City University in London,

after several years as Senior Lecturer in Economics at SOAS He has

co-written several courses for CeFiMS, and has also co-written and taught at

Wye College, where he was centrally involved in their distance learning

programme Dr Hakimian has written widely on economic development

and economic reform, with an emphasis on Iran and the Middle East His

books include Labour Transfer and Economic Development and The State and

Global Change: The Political Economy of Transition in the Middle East and North

Africa, both co-edited with Z Moshaver

Erhun Kula was born in Constantinople and did his first degree in

econom-ics at Marmara University in the same city His MSc is from the University

of Wales and PhD from University of Leicester His teaching interests

include introduction to economics, microeconomics, investment and project

appraisal, environmental and resource economics, business economics and

public sector economics

Dr Kula has published seven books and numerous journal articles in these

fields He has taught at the University of Wales, University of Ulster,

Uni-versity of London, UniUni-versity of New Mexico USA, UniUni-versity of Bosphorus

and University of Mumbai, and is currently Adviser to ESRC on the creation

of genomic research centres in the UK

Sonja Ruehl, who is the Academic Editor of this course, is Fellow in

Finan-cial and Management Studies; and Deputy Director, CeFiMS

To support your studies on this course, you are provided with the following

The Course Units

As always, this text guide is specially prepared to help you navigate through your other study material, and also to help you understand difficult con-

cepts and issues in the course You may think of it as equivalent to the

University’s course lectures

Course Textbooks

There are five of these

The first is by Steve Lumby and Chris Jones: Corporate Finance: Theory &

Practice, and you will be reading the eighth edition, which was published in

2011 As the title suggests, this is mainly concerned with the financial

analysis and appraisal of private sector investments This will be your main

textbook for the first three units of the course

HM Treasury (2003) The Green Book, a UK government publication detailing

the methods it uses in evaluating public service projects

David Potts (2002) Project Planning and Analysis for Development, a

particu-larly useful account of techniques and, as its title promises, the book deals

mainly with projects for developing economies, although much of it is also

relevant to transitional and developed economies You will be reading this

and the following two textbooks from Unit 4 onwards

Pedro Belli, Jock Anderson, Howard Barnum, John Dixon and Jee-Peng

Tan (2001) Economic Analysis of Investment Operations: these authors

present a wide variety of real life examples of projects and their

develop-ment; its subtitle ‘Analytical Tools and Practical Applications’ describes its

content well

Richard Layard and Stephen Glaister, Cost-Benefit Analysis, is a collection of

papers from various scholars covering the main problems encountered in a

cost-benefit undertaking; it was published (in its second edition) in 1994

Reader Articles

To complement the reading material for the course, a carefully selected

collection of readings from journals and books is also enclosed as a separate

volume As with the textbooks, you are prompted by the book symbols and

introductory text to turn to the required readings from this volume, the

‘Course Reader’

6 Teaching and Learning Strategy

This course combines specific analytical issues and models with relevant

applied, or ‘how to’, skills Sometimes key concepts are introduced through

readings or from one of the set texts; on other occasions this is done through the unit text The units set in-text questions or activities to build your learn-

ing of analytical frameworks and concepts and help you apply them to your

own experience

Throughout, when we ask you to apply a diagnostic approach or idea to

your own organisation or experience, you may also do so in relation to

another organisation with which you are familiar, preferably in the public

sector

7 Assessment

Your performance on each course is assessed through two written

assignments and one examination The assignments are written after

week four and eight of the course session and the examination is written

at a local examination centre in October

The assignment questions contain fairly detailed guidance about what is

required All assignment answers are limited to 2,500 words and are marked using marking guidelines When you receive your grade it is accompanied

by comments on your paper, including advice about how you might

im-prove, and any clarifications about matters you may not have understood

These comments are designed to help you master the subject and to improve your skills as you progress through your programme

The written examinations are ‘unseen’ (you will only see the paper in the

exam centre) and written by hand, over a three hour period We advise that

you practice writing exams in these conditions as part of you examination

preparation, as it is not something you would normally do

You are not allowed to take in books or notes to the exam room This means

that you need to revise thoroughly in preparation for each exam This is

especially important if you have completed the course in the early part of

the year, or in a previous year

Preparing for Assignments and Exams

There is good advice on preparing for assignments and exams and writing

them in Sections 8.2 and 8.3 of Studying at a Distance by Talbot We

recom-mend that you follow this advice

The examinations you will sit are designed to evaluate your knowledge and

skills in the subjects you have studied: they are not designed to trick you If

you have studied the course thoroughly, you will pass the exam

Understanding assessment questions

Examination and assignment questions are set to test different knowledge

and skills Sometimes a question will contain more than one part, each part

testing a different aspect of your skills and knowledge You need to spot the

key words to know what is being asked of you Here we categorise the types

of things that are asked for in assignments and exams, and the words used

All the examples are from CeFiMS examination papers and assignment

questions

Definitions

Some questions mainly require you to show that you have learned some concepts, by setting out

their precise meaning Such questions are likely to be preliminary and be supplemented by more

analytical questions Generally ‘Pass marks’ are awarded if the answer only contains definitions

They will contain words such as:

Other questions are designed to test your reasoning, by explaining cause and effect Convincing

explanations generally carry additional marks to basic definitions They will include words such as:

Interpret

Explain

What conditions influence

What are the consequences of

What are the implications of

Do you agree that

To what extent does

Calculation

Sometimes, you are asked to make a calculation, using a specified technique, where the question

begins:

Use indifference curve analysis to

Using any economic model you know

Calculate the standard deviation

Test whether

It is most likely that questions that ask you to make a calculation will also ask for an application of the result, or an interpretation

Advice

Other questions ask you to provide advice in a particular situation This applies to law questions

and to policy papers where advice is asked in relation to a policy problem Your advice should be

based on relevant law, principles, evidence of what actions are likely to be effective

Advise

Provide advice on

Explain how you would advise

Critique

In many cases the question will include the word ‘critically’ This means that you are expected to

look at the question from at least two points of view, offering a critique of each view and your

judgment You are expected to be critical of what you have read

The questions may begin

Questions that begin with ‘discuss’ are similar – they ask you to examine by argument, to debate

and give reasons for and against a variety of options, for example

Discuss the advantages and disadvantages of

Discuss this statement

Discuss the view that

Discuss the arguments and debates concerning

The grading scheme

Details of the general definitions of what is expected in order to obtain a

particular grade are shown below Remember: examiners will take account

of the fact that examination conditions are less conducive to polished work

than the conditions in which you write your assignments These criteria

are used in grading all assignments and examinations Note that as the

criteria of each grade rises, it accumulates the elements of the grade below

Assignments awarded better marks will therefore have become

comprehen-sive in both their depth of core skills and advanced skills

70% and above: Distinction As for the (60-69%) below plus:

• shows clear evidence of wide and relevant reading and an engagement with the conceptual issues

• develops a sophisticated and intelligent argument

• shows a rigorous use and a sophisticated understanding of relevant

source materials, balancing appropriately between factual detail and

key theoretical issues Materials are evaluated directly and their

assumptions and arguments challenged and/or appraised

• shows original thinking and a willingness to take risks

60-69%: Merit As for the (50-59%) below plus:

• shows strong evidence of critical insight and critical thinking

• shows a detailed understanding of the major factual and/or

theoretical issues and directly engages with the relevant literature on

the topic

• develops a focussed and clear argument and articulates clearly and

convincingly a sustained train of logical thought

• shows clear evidence of planning and appropriate choice of sources

and methodology

50-59%: Pass below Merit (50% = pass mark)

• shows a reasonable understanding of the major factual and/or

theoretical issues involved

• shows evidence of planning and selection from appropriate sources,

• demonstrates some knowledge of the literature

• the text shows, in places, examples of a clear train of thought or

• misunderstandings are evident

• shows some evidence of planning, although irrelevant/unrelated

material or arguments are included

0-44%: Clear Failure

• fails to answer the question or to develop an argument that relates to

the question set

• does not engage with the relevant literature or demonstrate a

knowledge of the key issues

• contains clear conceptual or factual errors or misunderstandings

[approved by Faculty Learning and Teaching Committee November 2006]

Specimen exam papers

Your final examination will be very similar to the Specimen Exam Paper that you received in your course materials It will have the same structure and

style and the range of question will be comparable

CeFiMS does not provide past papers or model answers to papers Our

courses are continuously updated and past papers will not be a reliable

guide to current and future examinations The specimen exam paper is

designed to be relevant to reflect the exam that will be set on the current

edition of the course

Further information

The OSC will have documentation and information on each year’s

examination registration and administration process If you still have

questions, both academics and administrators are available to answer

queries

The Regulations are available at www.cefims.ac.uk/regulations.shtml,

setting out the rules by which exams are governed

This is a specimen examination paper designed to show you the type of examination

you will have at the end of the year for Investment & Project Appraisal The

number of questions and the structure of the examination will be the same but the

wording and the requirements of each question will be different Best wishes for

success in your final examination

The examination must be completed in THREE hours Answer THREE questions,

at least ONE from EACH section

The examiners give equal weight to each question; therefore, you are advised to

distribute your time approximately equally between three questions The examiners

wish to see evidence of your ability to use technical models and of your ability to

critically discuss their mechanisms and application

P LEASE DO NOT REMOVE THIS P APER FROM THE E XAMINATION R OOM

I T MUST BE ATTACHED TO YOUR ANSWER BOOK AT THE END OF THE

EXAMINATION

Answer THREE questions, at least ONE from each section

SECTION A

(Answer at least ONE question from this section)

1 Compare and contrast financial and economic analysis of investment

projects

Give examples, where necessary

2 Justify the case for project analysis and appraisal as part of the wider

framework of project planning and management

3 In what sense (if any) is the treatment of risk and uncertainty in private

and public sector investment projects likely to be different?

Discuss, giving examples where necessary

4 ‘It is meaningless to try and put value on such intangibles as human life.’

Critically discuss this statement

SECTION B

(Answer at least ONE question from this section)

5 Discuss the theoretical basis for determining a social rate of discount in

investment appraisal, and use this as a framework to assess the current

approach in the UK Treasury’s ‘Green Book’ (2003)

6 Consider the rationale for, and problems involved in, applying welfare

weights in public sector investment projects

7 ‘The impact of global liberalisation has reduced the necessity for shadow

price techniques in project appraisal.’

Critically discuss this assertion

8 Compare and contrast any two methods used for evaluating

environmental attributes of investment projects

[END OF EXAMINATION]

Investment and Project Appraisal Unit 1 Introduction and Overview

Contents

1.3 Investment Appraisal and Financial Decision Making 6 1.4 Cost-Benefit Analysis – Issues and Evolution 8

References 18