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SOCIAL COST BENEFIT ANALYSIS

The economic evaluation of any investment proposal involves an analysis of social profitability arising out of the investment. Apart from the direct financial benefits as a result of revenue which will flow in the national exchequer from duties and taxes levied, there are various indirect benefits which will accrue such as opening up of employment opportunities in downstream/ancillary industries, transport and other secondary and tertiary sectors of commercial activity. This analysis which basically determines whether an investment is worthwhile from the point of view of the society as a whole, involves adjustment on cost and return to the enterprise taking into account the direct and indirect benefits leading to revalued inputs and outputs. Thus, Social cost benefit analysis (SCBA) is a methodology for evaluating project from social point of view. It is also referred as economic analysis and is developed for evaluating investment project from the point of view of the society. In recent years particularly in the developing countries where GOVT is playing significant role in economic development (SCBA) is playing a very important role. It is concerned with tactical decision making within the framework of broad strategic choice defined by planning at the macro level. Rationale for SCBA In SCBA the focus is on social cost and benefits of a project. These often tend to differ from the cost incurred in monetary terms and benefits earned in monetary terms by the project. The principle reasons for discrepancies are -: Market imperfections -: developing countries are Rationing -: rationing means control over the prices and distribution of a commodity. The price paid by the consumer in case of rationing is much less than the price prevailing in the competitive market. Prescription of minimum wage rates - : in case of minimum wage rates the wages paid to the labourers are more than what the wages would be in a competitive labour market free from such wage legislation. Foreign exchange regulations -: the official rate of foreign exchange in most of the developing countries which exercise close regulation over foreign exchange is typically less than the rate that would prevail in the absence of foreign regulation. Externalities: - a project may have beneficial external effects, for e.g. a project may create certain infrastructure facilities like roads which benefit the neighbouring areas, or a may have harmful external effects like it may create environmental pollution. Such benefits/losses are ignored in assessing the monetary The common market imperfections found in

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benefits to the project sponsors but such externalities are relevant in SCBA because in such analysis all cost and benefits, irrespective to whom they accrue and whether they are paid for or not, are relevant. Taxes and subsidies -: in case of monetary cost and benefit of a project taxes and subsidies are to be considered because they are definite monetary gains, however, taxes and subsidies are ignored in case of SCBA because they are considered as transfer payments. Concern for savings -: in case of monetary cost benefit analysis a private firm is least concerned as to how its benefits are divided between consumption and savings, but from social point of view, however, the division of benefit between saving and consumption is relevant because while doing SCBA it is assumed that a rupee of benefit saved is more valuable than a rupee of benefit consumed. Thus a higher concern of society for saving and investment is duly reflected in SCBA where higher valuation is put on saving than on consumption. Concern for redistribution -: while doing monetary cost and benefit analysis a private firm is least concerned about as to how its benefits are being distributed among various groups of the society, but while doing SCBA this factor is kept in mind because it is assumed that a rupee of benefit going to the poor section is considered more valuable than a rupee of benefit going to an affluent section. Merit wants -: while merit wants are not relevant from the private point of view, they are important from the social point of view. E.g. GOVT may prefer to promote an adult education programme even though they are of no benefit to the consumers in market, but from the point of view of the society they are important. APPROACHES to SCBA 1. UNIDO Approach 2. L & M Approach 3. Approach Adopted By Financial Institutions A. UNIDO Approach -: the UNIDO approach was first articulated in the guidelines of project evaluation. It involves five stages : Calculation of financial profitability of the project, measured at the market prices of resources and output. Calculation of the net benefit of project measured in terms of economic prices. Some resources are priced at international prices and for others shadow prices are considered. Adjustment for the impact of the project on saving and investment. Adjustment for the impact of project on income distribution.

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i.

Adjustment for the impact of project on merit goods and demerit goods whose social value differ from their economic values. Financial Analysis -: to judge a project from the financial angle, we need following information. Cost of the project Means of financing Estimates of sales and production Cost of production Working capital requirement and its financing Estimates of working results (profitability projections) Break even point Projected cash flow statements Projected balance sheets

Cost of project -: represent the sum of all items of outlays associated with a project, which are supported by long term funds. It is the sum total of following: Land and site development Building and civil work Plant and machinery Technical know-how and engineering fees Expenses on foreign technicians abroad Miscellaneous fixed asset Preliminary and capital issue expenses Pre-operative expenses Provisions of contingencies Margin money of working capital Initial cash losses

Means of financing -: to meet the cost of the project; the following sources of finances may be available -: Share capital (equity and preference share capital) Term loan (rupee term loan and foreign currency loans) Debenture capital Deferred credit Incentive sources (seed capital, capital subsidy etc ) Tax deferment Miscellaneous sources (unsecured loans, public deposits)

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Estimates of sales and production -: the starting point for profitability projection is the forecast of sales revenues. In estimating sales it is reasonable to assume that capacity utilisation will be somewhat low in the first year and rise thereafter gradually to reach the maximum level in the third and fourth year of operation. Cost of production -: the major components of cost of production are -: Material cost Labour cost Factory overhead cost

Working capital requirement and its financing -: to estimate the working capital requirement and planning for its financing, the following points must be borne in mind -: The built of current assets till the rated level of capacity utilisation is reached. The maximum permissible bank finance. Margin requirement against various current assets.

Profitability projections -: the profitability projections are based on the following lines : Cost of production Total administrative expenses Total sales expenses Royalty and know-how payable Total cost of production Expected sales Gross profit Other incomes Preliminary expenses written off P & L before tax Provision for taxation PAT Dividend Retained profits Net cash accrual

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Break even point -: it is a point at which the project neither make profit nor incur losses it is calculated as follow Fixed cost ________________________________________ Unit selling price unit variable cost The cash flow statement shows the movement of cash into and out of the firm and its net impact on the cash balances of the firm. The balance sheet, showing the balances in various assets means liability accounts, reflects the financial condition of the firm. ii. Net benefit in terms of economic prices Stage two is concerned with determination of economic prices also referred as shadow prices. A key issue in shadow pricing is that in what unit the input or output is expressed i.e. in what unit of currency should benefit or cost be expressed, whether the cost and benefit should be valued at current or constant prices. Shadow price is also known as hidden price, a price that is hidden under monetary cost and benefits. Another issue in shadow pricing is whether a good is tradable or not. For a traded good the shadow price is the border price translated in the domestic currency at market exchange rate. The shadow price in case of non-tradable good is consumer willingness to pay or cost of production depending on the impact of the project on the rest of the economy. Regarding taxes, the UNIDO approach says that if a project result in diversion of non- traded input from the producer or addition of non-traded input, taxes should be included. If a project augment domestic production by other producers, taxes should be excluded and for fully traded goods taxes should be ignored. Sources of shadow pricing
Increase/decrease total consumption Increase /decrease total production Increase/decrease export or imports

Basis of valuation
Consumer willingness to pay Cost of production Foreign exchange value

Shadow pricing for specific resources Tradable input and output -: a good is fully traded if its domestic changes in demand or supply affect just the level of import or export. For a good being tradable the following condition should be met-: The import quota, if any should not be restrictive. The import supply should be perfectly elastic. There is no surplus capacity in the domestic industry.

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If, additional demand exist inland, the imported goods even after taking into account the cost of transport from port to the point of inland demand should be less than the marginal cost of local production. The imported input cost should be less than the domestic marginal cost of purchase.

Non tradable inputs and outputs -: a good is non-tradable if following conditions are satisfied -: If its CIF prices is greater than its domestic cost of production. Its FOB price is less than its domestic cost of production.

For traded goods the shadow price border price translated in domestic currency, at market exchange rate. For non-traded goods the shadow price is measured in terms of consumer willingness to pay or cost of production, depending on the impact of project on the rest of the economy. Externalities -: since SCBA seeks to consider all cost and benefits, to whomsoever they may accrue external effects should also be taken into account. The valuation of external effects is rather difficult because they are often intangible in nature and there is no market price, which can be used as a starting point. Labour inputs -: the principle of shadow pricing may be applied to labour as well, though labour is considered to be services. When a project takes away labour from other employment, the shadow pricing of labour is equal to what other user of labour are willing to pay. The shadow prices associated with inducing additional production of workers consist of the marginal product of labour in previous employment plus certain other costs. The social cost of associated with import of foreign labour is the wage they command. However, a premium should added on account of foreign exchange remitted abroad by these workers from their savings. Capital input -: the shadow pricing in case of capital investment involves -: What is the value of physical assets? What is the opportunity cost of capital? The value of physical assets is determined the way values of other resources are calculated.

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The opportunity cost of capital depends on how the capital required for the project is generated. To the extent that it comes from additional savings its opportunity cost is measured by the consumption rate of interest. To the extent that it comes from the denial of capital from the alternative project, its opportunity cost is the rate of return that would be earned from those alternative projects. This is also called as investment rate of interest. Foreign exchange -: the UNIDO method uses domestic currency as the numeraire. So the foreign exchange impact of the project must be identified and valued. The UNIDO method determines the shadow price of foreign exchange on the basis of marginal social value as revealed by the consumer willingness to pay for the goods that are allowed to be imported at the margin. iii. Measurement of the impact on distribution -: stage three of the UNIDO method is concerned with that given the income distribution impact of the project what would be its impact on saving. To facilitate such assessment, we must first measure the income gained or lost by individual groups within the society. Groups The UNIDO approach seeks to identify income gain and losses by the following. Project Other private business Government Workers Consumers External sectors

Measure of gain and loss -: the gain or loss to an individual group within the society as a result of the project. In case of physical resources is the difference between the shadow price and the market price of each input or output. In case of financial transaction it is the difference between the price paid and value received. iv. Impact on saving -: most of the developing countries face scarcity of capital. Hence, GOVT of these countries are concerned about the impact of a project on saving and its value thereof. It is concerned with the following aspects -: Given the income distribution impact of the project what would be the effect on savings which is equal to-:

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Change in the income of group as a result of the project*Marginal propensity to save of the group. What is the value of such savings to the society -: The value of a rupee of saving is the present value of additional consumption stream produced when that rupee of saving is invested in the margin. The consumption stream starts with r (1 a) and grows annually at the rate of ar forever. Its present value when discounted at the social discount rate k is: r (1-a) r(1-a) (1+ar) I = ______ + ___________ + ---------------(1+k) (1+k)2 r (1-a )/(1+k) = ___________________ 1- (1+ar)/(1+k) = r(1-a) ____________ k ar r (1-a) (1+ar) n-1 _____________ + -----(1+k) n

where

I = social value of a rupee saving r = marginal productivity of capital a = reinvestment rate on additional income arising from investment k = social discount rate

v.

Adjustment for merit and demerit goods -: merit good is one for which the social value exceeds the economic value. For e.g. a country may place a higher social value than economic value on production of oil because it reduce dependence on foreign supplies. In case of demerit good the social value is less than the economic value. For e.g. alcoholic products. The method of adjusting for the difference between social value and economic value is as follow -: Estimate the economic value Calculate the adjustment factor as the difference between the ratio of social value to economic value and unity. Multiply the economic value with the adjustment factor to obtain the adjustment Add the adjustment to net present value of the project.

The stream of social costs and benefits is obtained after the five steps described above. The discount rate at which the present value of social costs=social benefits , is called as social rate of return(SRR). SRR is then compared with the required rate of return. The

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SRR of a project forgone may be taken as the desired rate of return. In absence of the opportunity return, the consumption rate of interest can be taken as the cut-off rate. LITTLE- MIRRLEES APPROACH There is a considerable similarity between the UNIDO approach and the L-M approach as both the approach call for -: Calculating shadow pricing Considering the factor of equity Use of DCF analysis

But despite of these similarities there are some differences also -: The UNIDO approach measures cost and benefits in term of domestic rupees price whereas the L-M approach measures cost and benefit in terms of international prices. The UNIDO approach measures cost and benefit in terms of consumption whereas the L-M approach in terms of uncommitted social income. The stage by stage approach of UNIDO focus on efficiency, saving, and redistribution consideration in different stages. The L-M approach, however, take these consideration together. SHADOW PRICING Traded goods and services -: the shadow prices of traded goods and services are the border price. If a good is exported its shadow price is the FOB price and if a good is imported its border price is the CIF price. If foreign demand is not perfectly elastic the marginal export revenue is substituted for the FOB and if foreign supply is not perfectly elastic, the marginal import cost is substituted for CIF prices. Non traded goods and services : accounting prices for non-traded good are defined in terms of marginal social cost and benefit. The marginal social benefit is the value of an extra unit of good from social point of view and the marginal social cost of a good is the value in terms of accounting prices of the resources required to produce an extra unit of the good. To determine the accounting price of a non traded input the following formula is to be used -: 2/3 marginal social cost + 1/3 marginal social benefit Labour -: the L-M approach suggest the following formula for calculating the shadow wage rate-: SWR = c 1/s (c-m) Where SWR = shadow wage rate C 1/s = additional resources devoted to consumption = value of a unit committed resources

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c m

= consumption = marginal product of wage earner

SCBA BY FINANCIAL INSTITUTIONS The all India term leading financial institutions---IDBI, IFCI, & ICICI-- scrutinise projects from larger social point of view. ICICI was perhaps the first financial institution to introduce a system of economic analysis as distinct from financial profitability analysis. IFCI adopted a system of economic appraisal in 1979. Finally, IDBI also introduced a system for economic appraisal of project financed by them. Though there are some minor variations, the three institutions follow essentially a similar approach, which is simplified version of the L-M approach. IDBI, in its economic appraisal of industrial projects, consider three aspects: Economic rate of return Effective rate of protection Domestic resource cost Economic rate of return The economic rate of return is the internal rate of return of the stream of social cost & benefit. The method followed by IDBI to calculate the economic rate of return id 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. Generally, the social cost of tradable component is obtained by multiplying it by a factor of 1/1.5. Social cost of labour cost is obtained by multiplying it by a factor of 0.5. Social cost of the residual component is obtained by multiplying it by a factor of 0.5. Social conversion factors (SCB) or proportion of three components, tradable (T), labour (L), and residual (R) Item SCF or proportions

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Land Building and construction Indigenous equipment Transportation Engineering and know how fees Bank charges Preoperative expenses Labour Salaries SCF = 0.80 Repairs and maintenance Water, fuel, etc. Electricity Domestic stores Other overheads

SCF= 1/1.5 Proportions: t=0.5, l=0.25, r=0.25 SCF = 0.70 proportions: t=0.65, l=0.25, r=0.10 SCF = 1.50 SCF = 0.20 SCF = 1.00 SCF = 0.50 SCF = 1/1.5 Proportions: t=0.50, l=0.25, r=0.25 Proportions: t=0.71, l=0.13, r=0.16 SCF = 8.0 SCF = 1/1.5

Effective rate of protection The extent to which a project is sheltered is measured by the effective rate of protection (ERP). It is calculated as follows: Value added at domestic prices value added at world prices ____________________________________________________________ Value added at world prices The ratio is multiplied by 100 to express the ERP in percentage terms. The data required for calculating the ERP may be arranged as follows: At domestic prices At world prices A. Selling price B. Input cost Traded Non-traded C. Value added The domestic selling price is net of taxes and excise duties but inclusive of a reasonable selling commission. The selling price at world price is the CIF price for import and fob for exports. The input cost consist of the cost of the following inputs: Raw material and stores

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Power, fuel and water Repairs and maintenance Part of administrative overheads and expenses Selling expenses It may be emphasised that when the value added at domestic prices is same as the value added at world prices, the ERP is zero. In such a case it implies that a project does not enjoy any protection from international competition. When the value added at domestic price is higher than the value added at world price, as is often the case, the ERP takes a positive value. Clearly the higher the value of ERP, the higher the implied protection enjoyed by the project. It is generally agreed that the extent of protection given to a project should not exceed 30 per cent. Domestic resource cost The domestic resource cost is calculated as follow -: Value added at domestic price ____________________________________ * Exchange rate Value added at world prices Domestic Selling price Operating costs Raw materials (net of duties & taxes) Power, fuel, and water Repair and maintenance Administrative overheads and expenses Selling expenses Capital costs Charge on capital employed Depreciation The capital employed consists of fixed assets plus working capital. It is broken down into indigenous and imported components. After deducting taxes and duties from both the components, the charge on capital employed is imputed as 10 %. In case of depreciation capital equipment are split into indigenous and imported components. After deducting taxes and duties depreciation is taken as 6%. The relationship between ERP & DRC is -: DRC = (ERP+1) Exchange rate Imported

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