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Economic- Financial - Social Cost Benefit Analysis

Economic- Financial - Social Cost Benefit Analysis

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Published by Professor Tarun Das

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Published by: Professor Tarun Das on Jul 01, 2010
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Economic and Social Cost Benefit AnalysisDr. Tarun Das, Professor (Public Policy),IILM, New Delhi-110003, India.EMAIL:tarun.das@iilm.edu/ das.tarun@hotmail.com
1.Introduction
The starting point of a pre-project evaluation is to make a technical feasibility study bythe engineers and other technical experts to examine whether the project is technicallysound. The technical team then specifies the technical details for the project for its projectspecification, implementation and maintenance over time. After examining the technicalfeasibility of a project, it needs to be examined whether the project is financially viable,economically sustainable and socially (or environmentally) desirable. Accordingly, thereare four basic techniques for the pre-evaluation of a project and a Detailed Project Report(DPR) by any lead investment bank must include the following methods depending onthe purpose of the project, the methods for project financing, policies for recovering of costs and fixing of charges from the users:(a)Technical feasibility analysis;(b)Financial cost-benefit analysis;(c)Economic cost-benefit analysis and(d) Social (or environmental) cost-benefit analysis.This paper focuses on the financial, economic and social cost-benefit appraisaltechniques.
Financial cost-benefit analysis
The traditional financial cost-benefit analysis deals with actual financial transactions andmakes orthodox commercial analysis on the basis of market prices of products and allfactors of production. It does not deal with the questions of distributional equity and doesnot make an analysis of the impact of externalities. The financial analysis generallyestimates the cost/ benefit ratio (CBR), net present value of benefits (NPV) and theInternal Rate of Return (IRR). Financial viability conditions require that CBR<1, NPV>0, IRR>PLR where PLR is the prime lending rate charged by the funding agencies.
Table 1.1: Project Evaluation Criteria:
YearCostBenefitPresent value of costPresent value of benefit1C1B1C1/(1+r)¹B1/(1+r)¹2C2B2C2/(1+r)²B2/(1+r)²3C3B3C3/(1+r)³B3/(1+r)³aCaBaCa/(1+r)ªBa/(1+r)ª
Total
Ca
Ba
Ca /(1+r)ª
Ba /(1+r)ª1
 
1. Benefit/Cost Ratio (BCR) =
Ba /(1+r)ª /
Ca /(1+r)ª
2. NPV =
Ba /(1+r)ª -
Ca /(1+r)ª
3. Internal Rate of Return (IRR)
is the value of r at which the PV of benefits equalsthe PV of Costs or NPV = 0 i.e.
Ba /(1+r)ª =
Ca /(1+r)ª
Economic cost-benefit analysis
In the economic cost-benefit analysis, instead of market prices, the appraisal is based onthe economic costs or the resource costs or opportunity costs of both of the factors of  production and the outputs. This is done on the basis of the following two adjustments inthe financial cost-benefit analysis:(i)All costs are netted out of all indirect taxes and duties and subsidies.(ii) The scarce and surplus factors are shadow priced. In general, one attaches shadow prices to labour, energy and foreign exchange cost to take care of their either scarcityvalues or slack values. Shadow prices for scarce items (i.e. items with excess demandsuch as energy, foreign exchange and skilled labor) will have shadow prices higher than their market prices, whereas items with excess supply (for example unskilledlabour) will have shadow prices lower than their market prices.(iii) Some examples of shadow prices in India:(1)Border prices for tradable items (fob price for exportable items and CIF price for importable items)(2)0.80 for unskilled and 1.20 for skilled labor (3)Black-market rate (1.05) for foreign exchange(4)1.20 for energy and non-renewable natural resources
Social cost-benefit analysis.
Social cost benefit analysis goes further beyond the financial and economic cost-benefitanalysis, and deals with not only efficiency pricing but also takes care of distributionalequity and impact of externalities on the project.The two most prominent methodologies, which address these issues in a systematic way,are the UNIDO (1972) and Little Mirrelees (1968, 1974) book on projects appraisal.Continual discussions and debates on these two approaches have led to a vast literatureon refinements and synthesis of techniques, and more sophistication in comparison withthe conventional commercial profitability analysis.
Table 1.2
below summarizes the basic differences in these three types of cost-benefitanalysis and
Annex-1
provides a numerical example for a road construction project. Itmay be particularly noted that the impact of externalities and indirect costs and benefitsare not considered under financial and economic cost-benefit analysis, but are consideredfor social cost benefit analysis. Major social and environmental costs include costs for 2
 
 pollution control, public health, safety, security, environmental degradation (soil erosion,deforestation), costs for rehabilitation, retraining etc. Major social and environmental benefits include reduction of poverty through income rise, rise in longevity, increase of  prices of land, houses, crops etc.For example, for a road construction project, external costs may include costs due to pollution, accidents, traffic police, street lighting, rehabilitation of displaced people, costof deforestation, if any, etc.; whereas external benefits will include rise of income, property and commodity prices in the hinterland area due to better mobility of workersand enhanced accessibility of agricultural lands and adjacent regions to the commoditymarkets and urban areas.
Table 1.2 Differences in Financial, Economic and Social cost-benefit appraisalItemsFinancialEconomicSocial
1. Project costsActual financial costsSome items are shadow pricedSome items are shadow priced2. Project benefitsActual financial benefitsSome items are shadow pricedSome items are shadow priced3. Indirect taxes,duties, subsidiesAre taken into accountAre excludedAre excluded4. Shadow pricesNot usedUsed Used5. ExternalitiesNot consideredNot consideredConsidered
Table 1.3: Criteria for Acceptance of ProjectCriteriaFinancialEconomicSocial
1. Benefit/ cost
 
ratio (BCR)BCR >1BCR >1BCR >12. Net PresentValue (NPV) NPV > 0NPV > 0NPV > 03. Internal Rate of Return (IRR)Financial IRR > PLR (Prime lending rate)Economic IRR > 6(Real rate of interest or real GDP growth)Social IRR > 12(Social rate of discounting)
2. Project Appraisal Techniques
Given limited public resources and competing sectors needing public funds, it isnecessary to make a comprehensive analysis of social costs and social benefits of a project and to bring its coherence to the list of investment projects. What is needed for that is a technique that would rank projects in order of their economic desirability, so thatthey could be adopted in rank order until the investment budget is exhausted.Previously, development economists had argued the merits of different criteria for deciding on project investment - the degree of capital intensity, the rate of reinvestment,3

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