KENYATTA

UNIVERSITY
INSTITUTE OF OPEN, DISTANCE & e-LEARNING
IN COLLABORATION WITH
SCHOOL OF ECONOMICS
DEPARTMENT 0F APPLIED ECONOMICS

EAE 412: PROJECT APPRAISAL

WRITTEN BY:

NELSON H.W. WAWIRE

AND

PEREZ A. ONONO
Copyright © Kenyatta University, 2012
All Rights Reserved
Published By:
KENYATTA UNIVERSITY PRESS

Page 2 of 126
I. Introduction

The module introduces learners to the theory and practice of benefit - cost analysis and other
similar techniques for evaluating investment projects. Emphasis on sources of divergence
between public and private investment decisions through the estimation of shadow prices, in a
context of market distortions and disequilibria. Case studies applying theoretical and applied
approaches to investment projects.

II: Objective and Purpose of the Course

This course is designed to expose undergraduate students to the subject of rational decision-
making and choice regarding investment projects. Theory and practice of cost benefit analysis
and other similar techniques for evaluating investment projects will be discussed. Emphasis
will be on sources of divergence between public and private investment decisions through the
estimation of shadow prices in the context of market distortions and disequilibria.

III. Coursework and Reading

Several exercises will be assigned covering theoretical and practical aspects of project
appraisal. The continuous assessment will comprise of a timed test and a practical
problem. These will constitute 30% of the final mark. The remaining 70% will be from
the end of semester examination.

IV. References
1. Chandra, P .2005. Projects planning, analysis, financing, implementation and
review. New Delhi: Tata McGraw-Hill publishing company limited

Page 3 of 126
2. UNCRD. 2000. Project planning, implementation and evaluation: a training
manual. UNCRD Africa Office Nairobi
3. Haynes, M. E, 1996. Project management, a practical guide for success, revised
edition. California, Crisp publication, Inc.
4. Irvin G. 1978. Modern Cost-Benefit Methods. London: Macmillan.
5. Little, I.M.D. and J.A. Mirrlees (1982) Project Appraisal and Planning for
Development countries. London: Heinemann Educational Books.
6. Squire, L. and H.G. Vander TAK.1975.Economic Analysis of projects.
Baltimore: John Hopkins
7. Mishan, E. J. 1975. Cost-Benefit Analysis, An informal Introduction (Revision
Edition). London: George Allen & Unwin ltd.
8. Gittinger J. P. 1987. Economic Analysis of Agricultural Projects. John Hopkins
University press.
9. U.N.I.D.O. 1972. Guidelines for Project Evaluation. New York: United Nations.
10. Ray, A. 1984. Cost-Benefit Analysis. Issues and Methodologies. Baltimore: John
Hopkins university press.

V. Course Topics

1. Introduction: Basic concepts

2. Project Identification and selection

3. Project proposal writing

4. Cost – Benefit analysis

5. Project Appraisal Criteria

6. Project Appraisal in Risk and Uncertainty situations

7. Social Cost Benefit analysis

8. Qualitative appraisal of Projects

Page 4 of 126
TABLE OF CONTENTS Page

TOPIC I: INTRODUCTION…………………………………………………………... 8
1.1 Objectives……………………………………………………………………………..8
1.2 Definitions of basic concepts………………………………………………………….8
1.2.1 Project ……………………………………………………………………..8
1.2.2 Project characteristics……………………………………………………..9
1.3 Project evaluation and project appraisal………………………………………………9
1.3.1 Project evaluation………………………………………………………….9
1.3.2 Project appraisal………………………………………………………….10
1.4 Introduction to Project Cycle Management (PCM)………………………………….10
1.4.1 The Project Concept………………………………………………………..10
1.4.2. The Link between Projects and Programs………………………………...11
1.4.3. Project Parameters………………………………………………………...12
1.4.4. Project Cycle………………………………………………………………12
1.4.5. Project Cycle Management………………………………………………..17
1.5 Topic summary………………………………………………………………………18
1.6 Work to do…………………………………………………………………………...19
1.7 Further Reading……………………………………………………………………...19

TOPIC 2: PROJECT IDENTIFICATION AND SELECTION

2.1 Topic Objective ……………………………………………………………………..20
2.2 The Project Cycle Management (PCM) Method…………………………………….20
2.2.1 Characteristics of the PCM method………………………………………..21
2.2.2 The Project Cycle Management Workshop………………………………..21
2.3. Participation Planning Approach……………………………………………………22
2.3.1 Participant Analysis……………………………………………………….22
2.3.2 Problem Analysis………………………………………………………….24
2.3.3 Objective Tree Analysis …………………………………………………..27
2.3.4 Alternatives Tree Analysis and Project Selection…………………………28
2.4 Conclusion…………………………………………………………………………...29
2.5 Topic summary………………………………………………………………………30
2.6 Work to do…………………………………………………………………………...31
2.7 Further Reading……………………………………………………………………...31

Page 5 of 126
TOPIC 3: PROJECT PROPOSAL WRITING………………………………………32
3.1 Topic Objectives……………………………………………………………………..32
3.2 Definitions and reasons for writing a project proposal………………………………32
3.3 Qualities of a good Project Proposal…………………………………………………33
3.4 Project Proposal Outline……………………………………………………………..33
3.5 Topic summary………………………………………………………………………44
3.6 Work to do…………………………………………………………………………...44
3.7 Further reading……………………………………………………………………….45

TOPIC 4: COST-BENEFIT ANALYSIS……………………………………………..46

4.1 Topic objectives……………………………………………………………………...46
4.2 Definition of CBA……………………………………………………………………46
4.3 Types of Benefits…………………………………………………………………….47
4.4 Types of Costs………………………………………………………………………..48
4.5 Measurement of costs and benefits…………………………………………………..49
4.6 Discounting cash flow………………………………………………………………..50
4.7 Conditions which make CBA desirable in LDCs……………………………………52
4.8 Strengths and Limitations of CBA…………………………………………………..53
4.9 Topic summary……………………………………………………………………....55
4.10 Work to do………………………………………………………………………….56
4.11 Further reading……………………………………………………………………...56

TOPIC 5: PROJECT EVALUATION CRITERIA…………………………………..57

5.1 Topic Objective………………………………………………………………………57
5.2 Types of Project Appraisal Criteria………………………………………………….57
5.2.1 Non – Time Adjusted Investment Criteria…………………………………58
(a) Urgency ……………………………………………………………..58
(b) Payback period …………………………………………………….58
(c) Returns on investment (ROI) criteria………………………………..60
5.2.2 Time Adjusted Investment Criteria………………………………………...63
(a) Net Present Value Criteria……………………………………………63
(b) Internal Rate of Return………………………………………………67
(c) Benefit Cost Ratio (BCR)……………………………………………71
(d) Discounted Payback Period………………………………………….72
5.3 Topic summary………………………………………………………………………73
5.4 Work to do…………………………………………………………………………...74
5.5 Further reading……………………………………………………………………….75

Page 6 of 126
TOPIC 6: UNCERTAINTY AND RISK……………………………………………...76
6.1 Topic Objective………………………………………………………………………76
6.2 Definitions: Uncertainty and Risk situations………………………………………...76
6.3 Project decision rules under uncertainty……………………………………………..77
6.4 Project decisions making under risk…………………………………………………80
6.5 Topic summary………………………………………………………………………97
6.6 Work to do…………………………………………………………………………...98
6.7 Further Reading ……………………………………………………………………..99

TOPIC7: SOCIAL COST BENEFIT ANALYSIS………………………………….100

7.1 Topic Objective……………………………………………………………………..100
7.2 Definitions and Rationale for social cost benefit analysis………………………….100
7.3 UNIDO Approach to SCBA………………………………………………………..102
7.4 Little-Mirlees Approach to SCBA………………………………………………….114
7.5 Topic summary……………………………………………………………………..118
7.6 Work to do………………………………………………………………………….119
7.7 Further reading……………………………………………………………………..120

TOPIC 8: QUALITATIVE APPRAISAL OF PROJECTS………………………...121

8.1 Topic Objectives……………………………………………………………………121
8.2 Qualitative Factors………………………………………………………………….121
8.3 Strategic Aspects……………………………………………………………………123
8.4 Organizational Considerations……………………………………………………...124
8.5 Topic summary……………………………………………………………………..125
8.6 Work to do………………………………………………………………………….126
8.7 Further Reading…………………………………………………………………….126

Page 7 of 126
 TOPIC ONE
INTRODUCTION

In this introductory topic we define some of the terms we will use frequently through the
course and also introduce project cycle management.

1.1 Topic Objective

Objectives
By the end of the topic, the student should be able to:
 Define Project, project evaluation and project appraisal
 Differentiate between project evaluation and project appraisal
 Explain important project parameters
 Describe the project cycle

1.2 Definitions of basic Concepts

1.2.1 Project
Project: Any scheme or part of a scheme for investing resources which can be
reasonably analyzed and evaluated as an independent unit. Resource includes money,
labour, and capital goods. Independent means it can be done regardless of other things.

Project can be classified by:-

(a) Size
- Large
- Medium
- Small
(b) Agents - Who are investing resources
- Public
- Private or

Page 8 of 126
 - Mixed
(c) Sector
- Agricultural
- Industrial
- Service

1.2.2 Characteristics of a project

(a) Have two basic economic flows;
(i) Costs which must be minimized
(ii) Benefits which must be maximized
(b) They are complex because their creation requires examination of many factors of
interdisciplinary character, for example, climate, environment, social, political,
technical, etc.
(c) Materialization of a project takes time and conditions may change e.g. Inflation,
change in exchange rate e.g. inflation may set in
(d) Capital expenditure on project are irreversible e.g. roads, ports
(e) They have considerable external effects that are positive and even negative, which
spill over (affects) into the economy. For example building a highway which
promotes trade but may destroy fertile land that can be used for farming. It can also
increase landlessness.
(f) Projects are tied to certain locations and influence the lives of inhabitants thereby
attracting the public‟s attention and opinion. This implies accepting the opinions of
the people.
(g) Projects can be broken down into smaller parts for separate considerations and vice-
versa.
(h) Projects have a long life span
(i) Projects decisions are taken at all levels.

1.3 Project Evaluation and Project Appraisal

1.3.1 Project Evaluation
This is an examination of the achievement of the project or the examination of the
productive performance and therefore viability of a project. It is aimed at getting
feedback for decision making. Evaluation may also imply a comparison of project under
consideration to another one used as standard or (norm). it is conducted after a project has
started (ex-post)

Page 9 of 126
1.3.2 Project Appraisal
It is the ex-ante examination of the overall soundness of the project at its planning stage.
The major objective is to examine whether the project is economically, technically,
managerially, or socially feasible.
Technically - Employees
Economically - Spending, how are the returns?
Managerially - Is management okay
Socially - How will the project affect people around?
Ex-ante means before start of project. It involves carrying out evaluation to arrive at a
pre-choice situation. This type is characterized by uncertainties.
Ex-post means an after choice type of evaluation. It‟s kind of monitoring of a given
operation. This is after the project has started. Here people learn from what is
happening.

1.4. Introduction to Project Cycle Management (PCM)

1.4.1 The Project Concept

A project is a complex set of activities where resources are used in expectation of returns
and which lends itself to planning, financing and implementing as a unit. A project
usually has a specific starting point and a specific ending point, intending to accomplish
specific objectives. It usually has a well-defined sequence of investment and production
activities and a specific group of benefits that can be identified, quantified and valued,
either socially or monetarily (Gittinger, 1982). As a comparison, if development can be
thought of as a progression (with many dimensions temporal, spatial, socio-cultural,
financial and economic), meant to improve the quality of life of people, projects are
temporal and spatial units, each with a financial and economic value and a social impact,
that make up the continuum. Projects also have boundaries which make them
distinguishable from each other. In addition to its time sequence of investment,
production and benefits, the project normally has a specific geographic location, with
identifiable targets and beneficiaries (Little & Mirrlees, 1974).

To enable analysis of projects as defined above, a project format is conventionally used.

This format provides an analytical framework for a proposed investment in which the
cost and benefit accounts are prepared year by year in the form of a project cost and
benefit stream. Information from a wide range of sources feed into the framework. Since
a good plan depends on accurate information, the framework enables various specialists
to judge the accuracy of the information provided and the appropriateness of the

Page 10 of 126
assumptions. The format gives an idea of costs, year by year, so that those responsible for
providing the necessary- resources can do their own planning.

The administrative and organisational problems likely to be encountered during

implementation are also detailed in the project format. This enables the planners to make
arrangements for strengthening the project management if this appears weak. At the same
time managers, planners and stakeholders are given better criteria for monitoring the
progress of implementation as the objectives, targets and work plans are set out at the
onset of implementation.

The project format facilitates systematic and objective examination of results of

alternatives. For instance, the effects of a proposed project on national income and other
objectives can be compared with the effects of projects in other sectors, or other projects
in the same sector or alternative formulations and design of the same project including
not undertaking the project altogether.

Once national objectives are known, unreliability of data at the national level can be
overcome by confining the project meant to achieve a national objective in a specific
location with a specific target and beneficiaries. Thus, local information on which to base
the analysis can be efficiently gathered, field trials undertaken and judgement can be
made about social and cultural institutions that might influence the choice of project
design and its pace of implementation.

1.4.2 The Link between Projects and Programs

It is necessary to distinguish between projects and program because there is sometimes a
tendency to use them interchangeably. While a project refers to an investment activity
where resources are used to create capital assets which produce benefits over time and
has a beginning and an ending with specific objectives, a program is an on-going
development effort or plan.

A program is therefore a wider concept than a project. It may include one or several
projects at various times whose specific objectives are linked to the achievement of
higher level of common objectives. For instance a health program may include a water
project as well as construction of a health centre both aimed at improving the health of a
given community which previously lacked easy access to these essential facilities.
Projects which are not linked with others to form a program are sometimes referred to as
"stand-alone" projects.

Page 11 of 126
1.4.3 Project Parameters
During a project's life; management focuses attention on three basic parameters: quality,
cost and time. A successfully managed project is one that is completed at the specified
level of quality; on or before the deadline; and within the budget. In addition, client
satisfaction will indicate success and possibility for replication or sustainability.

Each of the parameters is specified in detail during the planning phase of the project.
These specifications then form the basis for controlling the project during the
implementation phase. Chart 1-1 gives the relationship among these parameters.

Project

Quality Cost Time

Specification Budget Schedule

Chart 1-1: Project Parameters and Specifications

1.4.4 Project Cycle

A cycle is a sequence of events which a project follows. These events, stages or phases
can be divided into several equally valid ways, depending on the executing agency or
parties involved. Some of the stages shown in chart 1-2 may overlap but for our
purposes, the following stages can be identified.

1. Project Conception 6. Negotiation and Financing

2. Project Identification 7. Planning for Implementation
3. Project Preparation 8. Implementation
4. Project Appraisal 9. Monitoring and Reporting
5. Project Selection 10. Evaluation

Page 12 of 126
 Terminal Project Idea and Proposal Identification
Evaluation
(Project conception)

Preparation
On-going Evaluation
and
Feedback Appraisal

Selection
Participatory
reporting
Negotiation
and
Planning for
Implementation Financing
Implementation

Chart 1-2 Project Cycle

Stage 1: Project Conception

At this stage, an idea regarding a required intervention in a specific area to address an
identified problem is formed or developed. This idea is usually hatched through
discussion by specialists and local leaders in a community as a need-based issue and
crystallised into a proposal.
The project can therefore be conceived on the basis of:
 Needs - to make available to all people in an area, minimum amounts of certain basic
material requirements or services. A needs assessment survey establishes the urgency
for intervention:
 Market demand - domestic or overseas;
 Resource availability - opportunity to make profitable use of available resource;
 Technology - to make use of available technology:
 Natural calamity - hedging against the adverse effects of natural events as drought or
floods; and
 Political consideration.

Stage 2: Project Identification

Potential projects arising from the ideas crystallised in the first stage above are
determined. The information in the proposal from project conception may be submitted

Page 13 of 126
by an individual or community representative to an agent or agency capable of
identifying an institution to provide the necessary support to realise the expectation. The
type of information provided at this stage is usually general and descriptive.

The information is basically provided to justify an intervention through an expression of

a felt need in the area. Usually some objective judgement is applied to assess the proposal
or set of proposals to establish if the proposal can proceed to the next stage in the cycle.
In many ways, stages 1 and 2 are so interlinked that some prefer to consider both as
forming the "identification phase".

Stage 3: Project Preparation

This stage involves a more thorough exercise of collection of data and information on the
proposed project. The exercise is conducted by personnel with technical and analytical
skills in consultation with the target and beneficiary community.

At this stage of the cycle; the objective of the project is defined and alternative solutions
described. The project preparation contains the design of a set of operational proposals
that are technically, financially and economically feasible. Decisions are made on the
scope of the project; location, site, and size, among others. The detail of a feasibility
study depends on the complexity of the project and on how much is already known about
the proposals.

In fact a succession of increasingly detailed feasibility studies are sometimes called for in
complex projects. The feasibility studies provide an opportunity to shape the project to fit
its physical and social environment and exclude relatively poor alternative ways of
achieving the project goal. A careful preparation may cost up to 10 percent of the total
project investment but this is absolutely necessary to ensure the project's efficiency.

Stage 4: Project Appraisal

Project appraisal involves a further analysis of the proposed project. At this stage, a
critical review of the proposal is undertaken. The systematic and comprehensive review
is usually undertaken by an independent team of experts in consultation with the
stakeholders of the project. This provides an opportunity to re-examine every aspect of
the project plan to assess whether the proposal is justified before large sums are
committed. The appraisal process builds on the project plan but may involve new
information if the appraisal team feels that some of the data used at preparation or some
assumptions are faulty. The implications of the project on the society and the
environment are also more thoroughly investigated and documented. Similarly, the
technical design, financial measures, commercial aspects, incentives, economic

Page 14 of 126
parameters are thoroughly scrutinised. On the basis of an appraisal report, decisions are
made about whether to go ahead with the project or not. The appraisal may also change
the project plan or develop a new plan.

Stage 5: Project Selection

After appraisal, the viable project proposals are chosen for implementation on the basis of
the priorities of the stakeholders and the available resources. For instance, Treasury may
impose a ceiling on the ministries with a big portfolio of investments, calling for
prioritisation of the core and lower priority projects.

Stage 6: Negotiation and Financing

Once the project to be implemented is agreed on, for donor funded projects, discussions
are held on funding and associated aspects of funding such as conditionals for grants,
repayment period and interest rates of loans, flow of funds, contributions from
stakeholders and if there is co-financing or not. This culminates into an Agreement
Document for the project which binds all the parties involved during implementation of
the project.

Stage 7: Planning for Implementation

This is the stage either before actual implementation begins or before the start of a new
implementation phase of the project. The exercise is conducted at the level of the project
and involves the implementers; the beneficiaries and the funding agency or all
stakeholders. The exercise involves enabling the project management to address the
important implementation issues including the realism of project objectives, scope,
financial arrangements and implementation schedule, given the overall resource structure
of the project and the working environment. The likelihood of further changes occurring
either in design or physical and policy environment to affect the project are also
discussed.

During the exercise, the team should define, as clearly as possible, the objectives and
hierarchy of objectives. One technique for defining and analysing the objectives is the
Logical Framework Approach or Goal Oriented Project Planning (ZOPP). It allows
definition of activities, or inputs, outputs; and objectives with corresponding verifiable
indicators and assumptions to attain the goals of the project. A plan of operation for a
specified period is usually desirable to form a basis for activities to be undertaken during
the plan period.

Page 15 of 126
Stage 8: Implementation
This is the crucial stage of any project since the objective of the earlier effort in the stages
above was to have projects to be undertaken. At this stage, activities of the project are
actually carried out, and funds are disbursed to facilitate the activities. The management
should ensure that the project is carried out according to the design. However, depending
on the physical and policy environment, there may be need for flexibility in response to
the reality on the ground. Monitoring of progress and reporting, therefore, becomes
crucial. Implementation is a process of refinement, or learning from experience and can
actually be considered as a "mini cycle" within the larger project cycle.
The implementation period usually has three phases: the investment period, the
development period and full development. This forms the life of the project. The
investment period refers to when the major project investments are undertaken and could
take one to three years, depending on the nature of the project. The development period
occurs as the production builds up, while the full development is reached when the
production peaks up and continues until the project ends. Both financial and economic
analyses of the project relate to the time horizon.

Stage 9: Monitoring and Reporting

This should be an on-going activity during implementation. Monitoring can be carried
out by the beneficiaries, the implementing staff, supervisory staff and the project
management staff. The aim should be to ensure that the activities of the project are being
undertaken on schedule to facilitate implementation as specified in the project design.
Any constraints in operationalising the design can quickly be detected and corrective
action taken. This would enable the management to be proactive rather than being
reactive in correcting mistakes during implementation. The channels of communication
should also be clear and easy to allow transparency and accountability for all staff
involved. Thus relevant actions, results and barriers to implementation should be
monitored for smooth implementation.

Stage 10: Evaluation

This stage involves a systematic review or examination of the elements of success and
failure in the project experience during the project life to learn how better to plan for the
future. This implies that evaluation is a continuous exercise during the project life and is
very related to project monitoring. Monitoring provides the data on which the evaluation
is based. However, formalised evaluation is undertaken at specified periods. There is
usually a mid-term and a terminal evaluation. Evaluation can also be undertaken when
the project is in trouble as the first step in a re-planning effort. Careful evaluation is also
undertaken before any follow-up project.

Page 16 of 126
Evaluation can be done internally or by external reviewers. Some organisations have
monitoring and evaluation units. Such a unit can provide management with useful
information to ensure efficient implementation of projects, especially if it operates
independently and objectively, because what the unit needs is to judge projects on the
basis of objectives, original project design and the reality on the ground (the operating
physical and policy environment). With no free hand, the feedback mechanism will be
stifled and information be "held-back" instead of being "fed-back". Some projects may be
subjected to external evaluation. The aim of evaluation is largely to determine the extent
to which the objectives are being realised.

1.4.5 Project Cycle Management

Project Management can be defined as the realisation of concepts and goals through
efficient, effective, transparent, accountable and responsible administration of a given set
of activities to the satisfaction of stakeholders. All stakeholders should be regularly
consulted in matters affecting a project to ensure co-ordination in project activities.
Project cycle management, therefore, implies a process-oriented project management
system covering the whole project cycle from project conception to project completion. It
involves a combination of the various project cycle phases with corresponding
management tasks. It is an effective decision-making process to ensure certain actions
occur at the right time within the life of a project so as to attain the desired and specified
quality- output within the budget.

Page 17 of 126
1.5 Topic Summary

 Project is any scheme or part of a scheme for investing resources which can be
reasonably analyzed and evaluated as an independent unit.
 Project evaluation is an examination of the achievements of the project or an
examination of the productive performance of a project aimed at getting feedback for
decision making.
 Project appraisal is the ex-ante examination of the overall soundness of the project at
its planning stage with the objective of examining whether the project is
economically, technically, managerially, or socially feasible.
 People often use the terms Project and program interchangeably. However, while a
project refers to an investment activity where resources are used to create capital
assets which produce benefits over time and has a beginning and an ending with
specific objectives, a program is an on-going development effort or plan which may
comprise many different projects.
 The three basic parameters that management focuses attention on during a project's
life are quality, cost and time. A project that is completed at the specified level of
quality; on or before the deadline; and within the budget and in addition meets client
satisfaction indicates success and possibility for replication or sustainability.
 A cycle is a sequence of events which a project follows. Some of the stages may
overlap but can be identified as Project Conception, Project Identification, Project
Preparation, Project Appraisal, Project Selection, Negotiation and Financing,
Planning for Implementation, Implementation, Monitoring and Reporting and
Evaluation
 Project cycle management is a process-oriented project management system covering
the whole project cycle from project conception to project completion. It involves a
combination of the various project cycle phases with corresponding management
tasks.

Important concepts
- Project - Project evaluation - Project appraisal
- Decision models - Program - Project parameters
- Project cycle - Project cycle management

Page 18 of 126
1.6 Work to do

Assume you are a project manager, by use of a hypothetical project; outline the activities
you would carry out in each stage of the project cycle to ensure its success

1.7 Further reading

Haynes, M. E, 1996. Project management, a practical guide for success, revised edition.
California, Crisp publication, Inc.

Little, I.M.D. and J.A. Mirrlees (1982) Project Appraisal and Planning for Development
countries. London: Heinemann Educational Books.

UNCRD (1998). "Introduction to Project Cycle Management (PCVI)", Fourth Africa

Training Course on Local and Regional Development Planning and Management: Module 7
Training Material, Nairobi: UNCRD.

Ward W.A. and Deren B.J. (1991). The Economics of Project Analysis: A Practitioner's
Guide, Washington: The World Bank.

Page 19 of 126
 TOPIC TWO
PROJECT IDENTIFICATION AND SELECTION

Introduction

2.1

In topic one, we stated project identification and project selection as distinct stages of the
project cycle. However, we did not describe how they are carried out. In this topic we discuss
how planners identify and select potential projects. The procedure described is based on the
project cycle management (PCM) approach.

2.1 Topic Objectives

By the end of the topic the student should be able to describe the following in the process of
project identification and selection using PCM
 Project cycle Management method
 Participant analysis
 Problem analysis
 Objective analysis
 Alternative analysis

2.2 The Project Cycle Management (PCM) Method

The PCM method, which is a tool for managing the entire cycle of a development project,
shows the logical interrelationship among the components of a project: Goals, objectives,
outputs, activities and inputs as well as important assumptions related to the project. Two
steps are important in PCM:
(a) Participatory planning; and

Page 20 of 126
 (b) Monitoring and evaluation.

2.2.1 The Characteristics of PCM method

(a) Consistency: by use of project planning matrix to cover the entire project cycle
(b) Logicality: by having logical analysis of situations in terms of cause and effect and
means and end relationships
(c) Participatory approach is ensured at the planning stages where stakeholders positively
participate.

2.2.2. The Project Cycle Management Workshop

Effective planning requires participatory planning where all identified stakeholders in a
potential project positively participate. In each stage of project planning, a meeting or
workshop is convened with the stakeholders. The duration, frequency and the number of
participants varies depending on the nature and scale of the project. However, the
composition of the participants should include all the affected stakeholders of the project,
who include:
 Representatives of relevant government and non-government agencies
 Communities benefiting from the project
 Implementing agency and experts.

The workshop is presided over by a moderator who promotes discussions while

maintaining a neutral position. Each participant writes his or her statement on a card to be
posted on a board to visually clarify the statement. All participants then participate in the
analysis of the statement as a team. The following nine workshop rules are observed
(a) Each participant writes his/her own statement on a card without consulting the
neighbour
(b) Only one statement in a full sentence is written per card ;
(c) The statement should be brief and specific;
(d) Participants stick to facts while avoiding abstracts and generalisations;
(e) The statements are written on the cards before discussing them;
(f) Each participant posts his/her card on the board and does not remove it before a
consensus is obtained;
(g) The identity or origin of a particular statement should not be revealed;
(h) Co-operation of all participants is desired for successful participatory planning;
(i) If there is a prolonged discussion on a particular topic; the participants should
write their opinions on cards for co-ordination.

Page 21 of 126
NB: The implementation plan, showing the detailed components of the project and plan
of operation may be drawn up by a smaller project team from the PCM workshop.

2.3 The Participatory Planning Approach to project identification and selection

Participatory planning approach consists of analysis around four sequential areas,

namely:
a) Participant analysis;
b) Problem analysis;
c) Objective analysis; and
d) Alternative analysis or project identification step.

These steps precede the development of the Project Planning Matrix or Logical
Framework Matrix and are undertaken by workshop participants. The analyses are
described in the sections which follow.

2.3.1 Participant (stakeholder) Analysis

Participation or stakeholder analysis seeks to identify

1. The major interest groups involved in (all those affected by) the project.
2. The conditions and characteristics of local community groups and organisations
likely to be affected. These are identified and analysed to establish whose problems
merit priority solution.

The idea is to involve at least a representative of each interest group, if possible, in the
subsequent analysis of problems. If not possible, the workshop should try to perceive
problems from each of their perspectives.

NB:
 Even if people come from a particular area, their interests and problems may differ,
depending on the organisation and on social classes to which they belong.
 Even within a group, men and women can have different problems.
 Several groups with conflicting interests may exist within a community and in
extreme cases some groups may even be anti-development.

Therefore, it is desirable at the outset to identify or clarify different social, political,

economic, cultural and religious background of potential target group members.

Page 22 of 126
(b) Group Categorisation and Detailed Group Analysis
The following is an example of how the stakeholders can be categorised into groups
before subjecting them into a detailed analysis.

(i) Target Group Identification

A target group is the main group for which positive change is desired and intended by
implementing the project. Usually, it is selected from among the groups identified in the
group categorisation stage of participation analysis. Selection is through a process of
considering which groups' interests should be given the highest priority or which group is
the most deserving. Once a target group is identified, their unique or core problems, the
causes of the core problem and impact of the core problem can be identified and easily
analysed.

NB: In cases where a consensus is hard to reach on the deserving target group, a tentative
group can be selected for the purpose of initial analysis and be changed later during the
workshop if an alternative group is found to deserve a higher priority.

(ii) Group Categorization

Group categorization can be done in many ways but the following is the generally
accepted one:
Beneficiaries: - groups likely to benefit from the expected project;
Negatively affected groups: - groups likely to be adversely affected by the expected
project;
Decision-makers:- groups with decision-making authority;
Funding agencies: - groups which can bear expenses;
Implementing agencies:-groups which can implement the expected project;
Community leaders: - groups representing the community;
Potential opponents: - groups which may oppose or obstruct a project because of its
design;
Supporting groups: - groups likely to co-operate with the expected project

(iii) Detailed Group Analysis

Detailed group analysis is done using several factors. Characterise the community
members to be affected by the project by considering the following major issues:
 Interests:

Page 23 of 126
  Potential or actual conflicts;
 Inter-dependencies; and social relationship (social capital).
 Structure, organisation, size, and leadership are important aspects in a group.
 Social, religious and cultural backgrounds and gender issues as well as economic,
political and institutional aspects should be given consideration.
 Problems, needs and demands of the group should be identified and be related to the
group.
 Also to be identified are: potentials, strengths, weaknesses; constraints and
opportunities:
 Strengths of the group, and abilities and potentials that can be developed;
 Constraints and weaknesses of the group that may hinder development of such
potential;
 Implications for project planning should also be established;
 Roles and positions of groups within the expected project should be carefully
examined;
 Benefits and adverse effects of the expected project should be spelt out; and
 Factors that could possibly impede implementation of the expected project,
glaring or hidden opportunities should be anticipated.

2.3.2 Problem Analysis

Planners use a problem tree analysis technique to identify all the problems surrounding a
given problem condition and displaying this information as a series of cause and effect
relationship. A problem tree approach can also be used for general diagnosis of a problem
in some situation or organisation.

In this case no specific problem needs to be taken as the starting point. Instead all
existing problems are identified and then interrelated in the cause and effect linkages for
the situation as a whole.

The problem analysis begins with identifying a core problem (the trunk). The tree is then
expanded upwards and downwards as the causes and effects of the problem are identified.

a) Procedure of a problem analysis

Begin with the specific problem or need to be solved then list all other interdependent
conditions and problems. Brain storming or other group's idea generating techniques can
be used, or simply ask the following questions for each problem as it is identified:
 What is this problem caused by?
 What does this problem cause?

Page 24 of 126
To assure a more complete diagnosis, include as many relevant perspectives as possible
as discussed in the participation analysis earlier.

b) The clientele - those affected by the problem:

 Top decision-makers;
 Ordinary people within the organisation or setting;
 Appropriate experts;
 National or regional planning organisations;
 The view of unbiased outsiders: and
 Others involved.
Using separate sheets of paper for each, arrange identified problems and interdependent
conditions in their logical, cause and effect relationship, in the form of a "tree". Make
sure all elements are correctly connected by arrows indicating the directions of causal
linkage. The resulting diagram represents a rough but effective causal "model" of the
complete problem environment from the root cause of the problem to the impact of the
problem. For easy reference, the main procedural elements are stated below as a sequence
of analytical steps.

c) Problem Tree Steps:

i) Identify major interest groups involved (all those affected by or involved in
the project);
ii) Involve a representative of each, if at all possible, in your analysis of
problems. If not possible, try to perceive problems from each of their
perspectives as described in the participation analysis section;
iii) List as many problems as possible from each of the above perspectives,
remembering that a problem is not the absence of a solution but the difference
between what is desired and what the current state of affairs is;
iv) For each of the problems you have listed above ask yourselves what are
(could be) the major causes. Add any new problems that you have discovered
to the list;
v) For each of the problems on the list ask: what are the most important problems
that it in turn causes (these are the effects)? Add any new problems to your
list;
vi) Structure the above problems in cause-effect relationships, checking to see
that you have not overlooked linkages or other important causes or effects:
vii) Review your logic to see if your cause-effect relationships are correct and to
see if you have omitted any linkages or major causes or effects. (It may help
to show it to someone who has not been involved in its development for an
objective critique); and

Page 25 of 126
 viii) Change as needed.

EXAMPLE
The main problem identified for solution is: Low effectiveness of executive training
offered by the central agency of the government.

Problems listed from various perspectives include:

By the Training Centre Administration:
 No national policy for executive training program:
 Emphasis on quantity rather than quality of training;
 Lack of national training objectives; and
 No co-ordination between executive development and personnel policies.

By the Trainers:
 High rate of absenteeism among participants;
 No evaluation or follow-up of training;
 No audio-visual equipment; and
 Too much work.

By the Participants:
 Daily course interruptions due to office and family needs;
 Courses are only pan-time, not full-time;
 No relationship between training and promotion; and
 Courses are too academic, not practical enough.

From this list of problems, cause-and-effect relationships are identified and the process
for developing a problem tree drawn (Chart 2-1).
The process used after putting down each problem statement is to ask:
 What else causes this problem?; and
 What problems does this problem cause?
In both cases, these conditions are stated at the degree of detail or level of abstraction
needed to "model" this situation adequately. The completed example of a problem tree is
given in Chart 2-1.

Page 26 of 126
STEP EIGHT: Continue up the chain as much as is useful to understand full implications
of the problem.
STEP SEVEN: Repeat Step Five for all Effects" of problem "A"
STEP SIX: Ask the question - What does problem "A" cause?
STEP ONE: List the problem
STEP TWO: Ask the question: What causes this problem?
STEP THREE: Identify key causes and state them
- Trainers do
- Lack of clear etc.
- Poor Job objectives
STEP FOUR: For each cause (B, C, D, etc.) identified in step three, now treat that as a
problem and repeat steps two & three
STEP FIVE: Continue process downwards for as long as useful in analyzing
Overall picture, then go to step six above and work upwards.
Chart 2-1: Example of Process

2.3.3 Objective Tree Analysis

An objectives tree is a technique for identifying the objectives that will be achieved as a
result of solving the problems cited in the problem tree. The objectives are also displayed
as a series of cause and effect relationships.

a) Procedure
 Examine the problem tree to determine which problems can be simply reversed into
objectives by restating negative conditions as positive conditions.
 Recognise that not all causal relationships are simply reversible, so that solving one
problem automatically solves those it caused. For example, although flooding
destroys crops, pumping out the water does not thereby restore the crops to health.
For such problem relationships, other types of objectives must be formulated to
represent solutions.
 Recognise that some problems in the problem tree may actually be symptoms of other
deeper problems. Add new objectives if these appear relevant.
 Determine the cause-and-effect relationships among the objectives and draw the
objective tree.

NB:
The Level of detail required is a judgement that must be made by those developing the
problem tree. In general, it is the amount of detail that permits a clear understanding of
the problem and its environment. If the analysis is too superficial, the solution chosen

Page 27 of 126
could itself cause a whole series of additional problems because the cause and effect
relationships of the first analysis were not well-defined.

2.3.4 Alternatives Tree Analysis and Project Selection

An alternatives tree analysis is a technique for identifying alternative solutions or courses
of action that can be used to achieve the same or alternative objectives, and then display
of this information in a simple format.

a) Procedure
 Examine the objective tree to determine which objectives are perhaps unrealistic due
to resource limitations.
 Using feasibility analysis tools, examine each branch of the objective tree to
determine which alternatives might represent the optimal project strategy in terms of
probability of success, cost/benefit and most effective approach. Sometimes the
branches of an objective tree are already a single project-sized solution sufficient for
attaining the next higher objective.
 An example of an alternative tree derived from the illustration is given in Chart 2-2.
 A strengths, weaknesses, opportunities and threats (SWOT) analysis can be
undertaken to establish the priority options of projects to be subjected to further
detailed quantitative analysis for implementation.

Effective executive
training program
implemented

Participants‟ attendance
increased

Residential training Publicity is given to Supervisors

site outside capital Trainees the course by local requested to
city established motivated media cooperate

Chart 2-2: Example of an Alternative Tree from the illustration

Page 28 of 126
2.4 Conclusion
Once one has gone through the process of using: (1) 'Participant Analysis; (2) Problem
Trees; (3) Objective Trees; and (4) Alternative Trees then, one is ready to select one
branch of the objective tree as a possible project. This becomes the starting point of the
logical framework for project design. Clarifying the project is itself an iterative process.
Adding indicators to measure your objectives may force you to reassess your objectives
and the causal relationships between them. This can result in further clarification and
redefinition of objectives and relationships between them. Branches on the tree that your
project is not addressing should be examined as to their importance and the key
assumptions being made at this point should be made explicit in your project design.

Page 29 of 126
2.5 Topic Summary

 The Project cycle method is a tool for managing the entire cycle of a development
project. It shows the logical interrelationship among the components of a project:
Goals, objectives, outputs, activities and inputs as well as important assumptions
related to the project. The two important steps in PCM are participatory planning and
monitoring and evaluation. PCM is characterized by Consistency, logicality,
participatory approach at all planning stages
 In each stage of project planning, a meeting or workshop is convened with the
stakeholders. These should include; Representatives of relevant government and non-
government agencies, Communities benefiting from the project, Implementing
agency and experts. Each participant in the workshop shares their opinion on each
issue. This ensures that the interests and problems of every group affected by the
project are brought on board
 In the problem analysis approach, planners use a problem tree analysis technique to
identify all the problems surrounding a given problem condition and displaying this
information as a series of cause and effect relationship.
 The problem analysis begins with identifying a core problem (the trunk). The tree is
then expanded upwards and downwards as the causes and effects of the problem are
identified.
 An objectives tree is a technique for identifying the objectives that will be achieved as
a result of solving the problems cited in the problem tree.
 Once one has gone through Participation Analysis, Problem Trees analysis and
objective Trees analysis then, one branch of the objective tree can be selected as a
possible project.

Important concepts
 Project Cycle Management Workshop - Project stakeholders
 Participatory planning - Participant analysis
 Problem analysis - Objective analysis

Page 30 of 126
2.6 Work to do

You have been approached by your Constituency Development Committee to guide the
Youth in the constituency to identify and select a project to implement in the next financial
year. Discuss the various tasks that you would undertake with the youth groups in the
constituency to select a project to implement.

2.7 Further Reading

"Foundation for Advanced Studies in International Development Handbook, 1997

Handbook: Project Cycle Management Tool for Development Assistance", Mimeo: Practical
Concepts Inc.

Practical Concepts Inc. (1997). The Logical Framework: A manager's Guide to Scientific
Approach to Project Design and Evaluation, Mimeo, Rhode Island, Ave. N.W.

UNCRD (1998). "Project Cycle Management", Fourth Africa Training Course on Local and
Regional Development Planning and management. Module 7 Training Material, Nairobi:

Page 31 of 126
 TOPIC 3
PROJECT PROPOSAL WRITING

Introduction

3.1 Introduction

Once a potential project has been selected, there is need to source or negotiate for funds
either from the organization or the organization‟s potential donors, partners and
collaborators. The document usually prepared for the purpose of communicating the needs
of the organization and which often forms a basis upon which potential project sponsors
decide whether or not to fund it is referred to as a project proposal. In this topic we discuss
the importance of a project proposal and important components of a project proposal

3.1 Topic Objective

By the end of the topic the students should be able to;

 Outline reasons for project proposal writing
 Outline important aspects of a project to be described in a project proposal
 write a project proposal

3.2 Definition and reasons for writing a project proposal

A project proposal is a written description of a plan to address a problem. It includes a
summary, introduction, problem statement, objectives, implementation plan, monitoring
and evaluation trends, budgeting, sustainability and appendix.

A project proposal communicates the needs of the organization to its potential donors,
partners and collaborators. It forms a basis upon which potential project sponsors decide

Page 32 of 126
whether or not to fund it. It is a critical key to unlock the doors of potential assistance,
partnership and collaboration. Therefore, a proposal is written in order to:
- Systemize plan of action
- Popularize plan of action
- Raise funds/mobilize resources
- Present an organisation‟s project in an orderly manner

The Questions that need to be answered while writing a proposal include:

 What is proposed to be done?
 Why should it be done?
 When will it be done?
 How can it be done?
 Who will do it?
 What will it cost?
 Who will pay for it?

3.3 Qualities of a good Project Proposal

A Project proposal should be:
a) Clear, systematic and logical in order
b) Convincing
c) Comprehensive
d) Reliable
e) Data based
f) Realistic even in budgeting and the items required to be funded by the donors
g) Time bound
h) Clear about the contributions of the organization seeking for funds.

3.4 Project Proposal Outline

 Cover letter
 Title page
 Table of contents
 Executive summary
1. Introduction
2. Project Context or Justification
3. Problem Statement
4. Objectives
5. Anticipated Outcomes or Results
6. Work-scope or Implementation Plan
7. Project Evaluation

Page 33 of 126
 8. Project Budget
9. Reporting
10. Project Sustainability – Future funding
11. Appendices, including time-table for activities.

(a) Cover Letter

The Cover Letter serves as an introduction to the project proposal. When possible,
address the letter to a particular person. The letter should establish your organization‟s
credibility, introduce the need clearly, and briefly describe the project and its objectives.
When seeking funds, the total project budget and the amount requested from the agency
should be stated. Also there is need to indicate an offer to contact the agency within a
specific time in case additional information is needed. The cover letter should be typed
on the organizations letter head

(b) Title Page

This summarizes the project and assists the agency in processing the request. The title
should be short and able to evoke the donor‟s attention. It should tell the donor what kind
of project it is and the target group. Title pages need to be well laid out. It should:
- capture the intent and “feel” of the project;
- says something about the work, and location
- have name and address of the organization
- have nature of help requested; the amount if seeking funds
- have name and address of the person who will direct the project (Manager)
- have the date of submission.
NB:
- Don‟t make it too fancy; colourful or decorative.
- Don‟t fill your title page with lots of information.

(c) Executive summary

This tells one what the project is about. It should be clear and interesting, briefly stating
the problem objectives, methods and the amount and type of assistance sought such as
funds, materials, technical information etc. The summary includes the following:
- Organisation or group making the request: address, telephone, fax
- Description of your organization in one paragraph
- Project manager(s)
- Problems Statement
- Goal and Objectives
- The total amount of money requested and one or two lines of what the money
will be used for.

Page 34 of 126
One might add a paragraph on the partner organization, often the implementing agency
(If you are not the implementer). Such information should include the name, address,
telephone, and a two-line description. The summary should be short, preferably one page.

(d) Introduction/Background
This tells the reviewer who you are. Give a brief history of the region, the people, and
your organization‟s involvement. Describe your organization‟s ability to deal with the
problem to be addressed. Establish your credibility here, which includes professionalism,
dependability, and reputation as an agency.

The following questions are helpful:

a) What is the official name of your organization and where is it located?
b) What is the name and address of the organization legally responsible, if
different from the partner?
c) How and why did your organization get started?
d) Is there anything unique about your organization?
e) How long has your organization been in operation?
f) What is the composition of your staff?
g) What are some of your accomplishments?
h) What do you hope to achieve?
i) Who are the members of your board of directors?
j) Who has funded you in the past?

1. Introduce the implementing agency

2. Provide all the relevant information on the problems, which has necessitated
action.
3. Provide a country and organization profile by giving relevant geographical, social-
economic and political data.
4. Attempts made previously to solve the problem

(e) Project Context or Justification

This section should present a brief history of the people, the social, economic, health and
other conditions, highlighting those that the project will impact on. Present your
organization‟s involvement in the project region, in previously addressing this or other
problems (achievements) with the target group and/or other groups. The outline to be
followed is as follows:
 Describe history of the area and people
 Describe social, economic, health and other pertinent conditions

Page 35 of 126
  What has been your organisation‟s involvement in this region: what
achievements?

(f) Statement of the problem

Identify the specific problem your project will address. Give supporting evidence such as
statistics, studies etc. Give a clear and concise description of the felt need, which you
plan to address. Explain the origin of the problem, and its consequences in the lives of
the people. Answer the following questions:
a) What is the specific problem your organization hopes to address in this
proposal?
b) Using available data and/or statistics, state how you know the problem exists.
For example, “of 2,000 women in zone only 14 percent attend adult education
classes”
c) Using credible sources, trace the origin of the problem
(For example, poor attendance of adult education classes in the zone is
attributed to lack of adequate transportation, according to Oromia ( 2007: 3)
(Source)
d) Why does your organization have an interest in solving the problem? (An
obvious connection should exist between your organisation‟s goals and the
problem.)

Data/statistics should come from reliable sources such as the United Nations,
governmental organizations, local diocese, local ministries of education, health, social
security, etc. The problem statement should be a short and concise describing the
statement of the problem(s) and need(s) to be addressed, how the problem impacts the
lives of the people who are the project‟s target group. If data is available, it should be
used (i.e. 70% of the target group of women under 45 years of age is illiterate (name
source). State why this problem has priority over other problems, and why your
organization has a particular role in addressing this problem. State the problems that have
led to the conceptualization of the project and any attempts that have been previously
made to solve the problem. Express the desired change and show clearly how the project
will benefit the organization, firm or community. Indicate whether the outputs will justify
the means.

The following considerations should be made:

 The role of the beneficiaries in the development of the project
 The suitability of the project for the overall development objectives of the
country
 The cost effectiveness of the project in the social-economic terms

Page 36 of 126
  The sustainability of the project

(g) Objectives of the project

The objectives offer a solution to the problem you stated in the previous section. Briefly
list the changes your organization aims to bring about through the project. If the problem
you identified is illiteracy, then the objective is “to reduce that illiteracy”.

The general objective of the project spells out the main purpose of the project and reflects
the title of the proposed project. The specific objectives on the other hand spell out the
expected outcome on the completion of the project and therefore refer to the specific
actions to be taken in the context of the project.

The objectives should be stated in a SMART way i.e. Specific, Measurable,

Achievable/Action-oriented, Realistic and Timebound. For example; To train 50 Trainer
of Trainers in adult education in 10 months in northern Ethiopia.

The objectives should be oriented to the aspirations of the beneficiaries.

(h) Strategies of achieving the stated objectives

The proposal should state what will be done to achieve the stated objectives and describe
the activities that will be undertaken in this connection. All objectives here should be
translated into strategies and work out the time frame for each activity. A plan of Action
should be drawn up detailing sequentially all the activities to be undertaken.

(i) Project duration

The applicant should show how long the project is intended to take and the project‟s
gestation period.

(j) Expected Results & Assumptions

State what is expected to be achieved by the end of the project cycle. The achievement
should be stated in measurable and quantifiable terms. For example, out of our training
program, 30 participants will have acquired the skills in adult education training.

Analyze objectives in terms of tangible results (measurable eg number trained, number

sponsored for further training, reduced adult illiteracy rate etc). Intangible results cannot
easily be measured and may not be captured by the objectives e.g. improved hygiene,

Page 37 of 126
improved communication etc. List the anticipated outcomes. For example, by the end of
the first year, the project may have:
 established 5 adult education centres in 5 villages
 Provided adult literacy training to 10,000 people
 Sponsored 500 adult learners

Assumptions
Examples:
 That the community would provide labour and materials for an adult education
project in order to reduce costs and to show ownership of the project.
 That funds will be found in adequate supply for each centre
 That there will be no political unrest to disrupt the course of the project.
 Make a statement concerning the environmental impact of the project (negative or
positive). For example with increase in literacy rate the people will be aware of the
dangers of deforestation
 Describe the environmental problems the project may cause if any and how you will
go about them.

Expected Impact
The proposal should show the lasting benefits of the project and how they would be
sustained. For example, those who have acquired adult education training skills will be
able to train others and will become increasingly competent as resource persons.

(k) Management of the project

Describe how the project would be managed and how the beneficiaries would participate
in the planning, implementation, monitoring and evaluation of the project. Draw up a
management structure and describe duties of all the personnel.

Monitoring of the project

Explain how the project will be monitored to ascertain to what extent the project has
progressed.

Follow-up Action
Indicate what follow up action will be necessary. If for example, a project did not meet
the intended objectives due to unforeseen unfavorable circumstances, additional funding
should be sort either for completion or renewal of the project.

Page 38 of 126
(l) Work- Scope (or Project Implementation Plan)
Describe how you are going to carry out the project to achieve your outputs and project
objectives. Prepare a plan of action (operation schedule) detailing all essential activities
and estimating the time required for each activity to carried out. Indicate who would be
responsible for each activity. The plan can be presented in a step-by-step fashion of
activities.

Indicate the involvement of local population in planning the project, and how they will
participate in its implementation and evaluation; include their inputs, the number and
kind of personnel needed to carry out the project. Provide their qualifications, whether
they are available locally, and how they would be recruited. Mention whom they would
be responsible to, or report to. Example: Adult educator with ten years experience in
adult education training from the Kenyatta University, Nairobi will conduct the training
workshop.

Describe the relationship of this project between the applicant and the implementing or
field agency and the administrative and supervisory responsibilities they will have.

Describe your action plan or methods – how you will implement the project. For
example, in order to increase trained adult educators, a two-day training workshop will
be held in zone A.

Present your project in phases or stages. Describe how and why you selected your target
group, target villages, and so on. Say whether the methods adopted are the most cost
effective to accomplish your objectives.

Describe at each step what resources are needed in terms of materials, vehicles, training
manuals, space, tools and other items. Quantify resource needs e.g. 100 training manuals,
10 trainers

Describe technical assistance inputs.

(m) Project Evaluation

The purpose is to determine how effective your organization has been in achieving the
project objectives. Design a tool that will not only measure the results, but will provide
information that may be needed for future. Say how and when the project will be
evaluated. The evaluation should be designed to determine how well the objectives are
being achieved. The project should be evaluated at certain points during its
implementation, with a final evaluation at the end of the project. For example, in a 3-

Page 39 of 126
year project, evaluations should take place every six months. This section should
include:
 Person(s) who will undertake the evaluation.
 Time periods for the evaluation, eg every 6 months or at the end of each
project stage.
 How data or information will be recorded, analysed, and presented.
 Criteria for evaluating outcomes or achievements, and progress made towards
achieving objectives.
 How and to whom evaluations will be presented.
 How evaluations will be used by the project, the community, the
implementing agency, and the project holder

Operational indicators: Numbers are recorded to describe the project‟s activities. For
example:
 Number of trained adult educators
 Number of adult learners
Performance indicators: These are used to analyze a project for effectiveness and
efficiency. Data is expressed in terms of percentages or ratios. Examples are:
 Percentage of adult educators compared to all educators in a zone
 Percentage of adult learners compared to total zone population

N/B The evaluation section should also address problems, how they were solved or
what can be done to solve them.
Recommended changes in outputs, resources, and administration, modifications or
objectives, other pertinent data.

(n) Costing/Budgeting
It is necessary for the applicant to provide in a systematic and logical order a breakdown
of various cost elements such as personnel, materials, equipment, transport, repairs, etc.

Points to consider while budgeting

Budgets must be realistic to cover project inputs or costs to achieve outputs. Budgets
should:
 Be expressed on a yearly basis.
 For a project to be undertaken over a number of a yaers, each year‟s budget
should be shown in separate columns, with a last column for totals.
 Show costs in dollars and local currency (exchange rate used o be indicated
below the budget).
 Show what local funds and other resources are available.

Page 40 of 126
  Divide expenditures into major sections, such as personnel, travel, equipment
and materials, course costs, office costs, technical assistance, and etc
 Allow for inflation or other currency fluctuations and for unforeseen costs by
adding 10 percent to the cost of the project for these items.
Salary section
 When presenting salary costs, calculate the monthly salary x 12 months to arrive
at an annual amount
 Show fringe benefits in a separate line item from salaries.
 For example:
Salaries Total (US$)
2 Adult educators: US$ 300 x 12 Months 7,200.00

Travel Costs
Show item for: air travel, land travel, vehicle maintenance, per diem or hotel and meals,
other travel.
Office Expenses
Show line items for rent, communication, stationery, office equipment, maintenance, and
others.
Materials
Indicate cost per unit cost i.e.
200 Publications of 20 pages on adult education training manual
Local inputs
 Local labour inputs by determining the number of hours weekly or monthly they
will work on the project over the project‟s lifespan, times the minimum wage
rate in the zone.
 Value of use of vehicles and office space
 Value of donated local materials such as the gravel, wood, sand and hand tools
etc
Equipment
 Indicate values equipment such as a vehicles, computers, etc
 Depreciate them (at 20 to 25 percent per year).
 Indicate how these would be maintained and replaced, and if maintenance is
available locally.
 May set up an equipment replacement fund if the project is an income generating
one.

Page 41 of 126
Cost/ benefit ratio
 Cost/benefit ratios may be added at the end of the budget (Take the total project
amount requested from the donor and divide it by the number of people who will
directly benefit by the project or the combined local and requested financial inputs)
 For example, an adult education budget might require US$ 5,000 to benefit 500
families. It comes out at US$ 10 per family.
 Keep notes to a minimum, no more than 2 or 3 notes.
 Show other grants that are anticipated and what of accounting systems will be used.
 If funds are to be put in an interest bearing account, you should mention this, and
indicate how interest earned will be used.

(o) Reports
 Describe how and when financial and progress reports will be submitted.
 Financial reports might be submitted quarterly or no longer that at 6 months
intervals.
 Reports should monitor how inputs are being made and how outputs or results are
being achieved.
 Financial reports should reflect the budget description/projected costs.
 Finance reports must have an income and an expenditures section;
1. Income
A. Funding Sources
B. Local Sources
2. Expenditures (by line item as per the budget)
3. Balance by donor and line item

N/B: The exchange rate for the report period should always be given.

(p) Project Sustainability

Donors want to know how the activity will be continued once their grant is expended.
Three kinds of sustainability:
(1) Financial Sustainability
(2) Technical Sustainability and
(3) Managerial Sustainability

Page 42 of 126
1. Financial Sustainability
The proposal should indicate how the project can continue or be sustained after
donor funds are expended, i.e. through the use of locally generated funds,
Government funding, etc.

2. Technical Sustainability
The targeted group to provide technical inputs to the project after donor funding
ends, and that they have the training, skills and materials to continue to sustain the
project. Target group or the applicant organization should be able to undertake
this responsibility, even for skilled inputs such as materials design, accounting,
health care, agronomy, etc.

3. Managerial Sustainability
Show that the target group and/or applicant will continue to provide organizational
or managerial inputs after donor funding. Show the capability of the
community/target group to reach a level where it can manage the project. Show
local leadership and organization at the end of the project

Appendices
 There should be very few appendices not to turn away potential funders.
 Only pertinent and very important documents or information should be appended.
 One such appendix might be a time line of activities showing by month or quarter
year what activities will be undertaken.
 Others might be a map of the project region, letter from responsible government
official, information highlighting problems to be addressed, letter of support from
another donor, staff credentials, etc.

Page 43 of 126
3.5 Topic Summary

 A project proposal is a written description of a plan to address a problem.

 A project proposal is written so as to systemize and popularize a plan of action, raise
funds/mobilize resources, or to present an organisation‟s project in an orderly
manner. It thus communicates the needs of the organization to its potential donors,
partners and collaborators.
 The proposal is divided into different sections; a summary, introduction, problem
statement, objectives, implementation plan, monitoring and evaluation plan, budget,
sustainability plan and appendix.
 A good quality Project proposal should be Clear, systematic and logical in order,
Convincing, Comprehensive, Reliable, Data based, Realistic even in budgeting and
the items required to be funded by the donors, Time bound and Clear about the
contribution of the organization seeking for funds.

3.6 Work to do

Suppose that in the project identification process you undertook in topic two, it was
identified that there is a high prevalence of HIV and AIDS among the youth in the
constituency. An Abstinence and Fidelity project is to be funded by the Constituency
development Fund (CDF). One of the youth groups has approached you to write the
project‟s proposal to use in applying for the funding. Write a proposal for this project

Page 44 of 126
3.7 Further reading

Chandra, P .2005. Projects planning, analysis, financing, implementation and review. New
Delhi: Tata McGraw-Hill publishing company limited

UNCRD. 2000. Project planning, implementation and evaluation: a training manual. UNCRD
Africa Office Nairobi

Haynes, M. E, 1996. Project management, a practical guide for success, revised edition.
California, Crisp publication, Inc.

Page 45 of 126
 TOPIC FOUR

COST-BENEFIT ANALYSIS (CBA)

Introduction

Cost benefit analysis (CBA) is a principal basis of appraising public projects. In this topic
we define CBA, and describe what it involves.

4.1 Topic Objective

By the end of the topic the student should be able to

 Define Cost Benefit Analysis
 Give examples of direct and indirect benefits and costs for public projects
 Describe various methods of measuring of benefits and costs
 Describe the three alternative types of discount rates used in CBA
 Explain the conditions that make CBA desirable in LDCs
 Explain the strengths and limitations of CBA in project appraisal

4.2 Definition of Cost Benefit Analysis (CBA)

In appraising projects from national point of view, the most appropriate and popular
method is CBA; which involves enumeration, comparison and evaluation of benefits and
cost. It implies weighing of returns against the cost involved in a project. CBA therefore
purports to describe and quantify the social advantages and disadvantages of a policy in
terms of a common monetary unit. The objective function is expressed as:

Page 46 of 126
Net Social Benefits (NSB) = Benefits – costs
Where the benefits and costs are measured in terms of shadow or accounting prices of
inputs and outputs instead of actual market price.

4.3 Types of Benefits

Benefits refer to the additions to the flow of National output accruing from a project

4.3.1 Real vs. Nominal Benefits

In CBA, we are concerned with real not nominal benefits.
Example; a river valley project may increase irrigational facilities to the cultivators. If the
state levies heavy betterment levy on them, the benefit is nominal because the benefits
goes to the treasury. But, if the same project besides increasing irrigational facilities,
raises the productivity of land per acre, and leads to a number of other external
economies whereby the level of real income of the farmers rises, then it is said to lead to
real benefits.

4.3.2 Direct vs. Indirect Benefits

Direct benefits are those benefits which are immediately and directly obtainable from a
project. These are also referred to as Primary benefits.
Example; in the River Valley project there is
 Flood control
 irrigation and navigation facilities
 development of fisheries
 Hydro electric power
Indirect benefits – are side effects (or secondary benefits). They are values added to the
direct benefits as a result of the activities stemming from or induced by the project.
Example;
 employment of people
 development of a market centres
 road transport
 acquisition of skills and Managerial talents by local people
 etc.

4.3.3 Tangible and Intangible benefits

Tangible are those that can be computed and measured in terms of money. Intangible are
those that cannot be measured in monetary terms. They enter into individual valuations
for which there is neither a market nor a price. They may be positive (e.g. scenic beauty
and recreational value of the river project) or negative (e.g. resettlement of people).

Page 47 of 126
4.4 Types of Costs
4.4.1 Project Costs
Are value of resources used in constructing, maintaining and operating the project.
Relates to costs of labour, capital, intermediate goods, etc, including allowance for
induced adverse effects.

4.4.2 Associated Costs

Refers to value of goods and services needed beyond those included in the cost of a
project, to make intermediate products or services of the project available for use or sale.
For example, in the River Valley Project, the farmers‟ cost of producing the irrigated crop
other than any charge for water (cost of digging up the project).

4.4.3 Real vs. Nominal Cost

If Block Samiti borrows from the people of the area resources to dig a canal, it is a case
of nominal cost because there is no real sacrifice involved in the part of the people,
money having been transferred from the people to Block Samiti. But if the people are
asked to dig the canal themselves, that constitutes real cost for them.

4.4.4 Primary vs. Secondary Cost

Primary (direct) costs are those incurred for construction, maintenance and execution of a
project.

Secondary (Indirect) Cost are value of goods and services incurred to provide indirect
benefits of a project e.g. hospitals, schools, etc for the people working at the project site.
They also include cost of processing the immediate products of the project

4.4.5. Other categories of benefits

(a) Pecuniary benefits and costs

These arise because of changes in relative prices which occur in secondary markets as the
economy adjusts itself to the provision of the goods and services. As a result gains
(benefits) or losses (costs) accrue to some individuals but are offset by gains or losses
experienced by others. They do not reflect net gains or costs to the society as a whole.
They must therefore not enter into project valuation.

(b) Intermediate vs. final benefits

Intermediate benefits: those that furnish goods, which enter into the production of other
goods. Final benefits: Those that furnish benefits to consumers directly by providing final
goods.

Page 48 of 126
(c) Inside vs. outside
Inside - benefits and costs, which accrue within the jurisdiction in which the project is
undertaken.
Outside - benefits and costs, which accrue outside the jurisdiction in which the project is
undertaken, e.g. flood control project, which benefits people downstream. They
constitute spillovers from one jurisdiction to another.

Example 1: Irrigation Project

Real Benefits Costs

Direct Tangible: Increased farm output Cost of pipes
Intangible: Beautification of area Loss of wilderness

Indirect Tangible: Reduced soil erosion Diversion of water

Intangible: Preservation of rural society Destruction of wildlife

Nominal: Relative improvement in position of farm equipment industry.

Example II: Education Project

Real Benefit Costs
Direct Tangible: Increased future earnings Loss of students' earnings,
Teachers, salaries, cost of
buildings and books

Intangible: Enriched life foregone leisure time.

Indirect Tangible: Reduced cost of crime prevention.

Intangible: More intelligent electorate

Nominaly: Relative increases in teachers incomes.

4.5 Measurement of costs and benefits

(i) Valuation of social benefits and costs (intangible non-market items).
The value of intangible benefits and costs are derived through a political process
by voting e.g. defense, clean or etc.
(ii) Cost saving: estimates benefits in terms of costs saved e.g. reduced hospital costs,
reduced school dropouts.
(iii) Tangible costs and benefits

Page 49 of 126
 Tangible benefits: measured by the price, which the output or service fetches in
the market.
Tangible cost - measured by the price which must be paid for the product or by the
cost which must be incurred in foregoing the alternative private use of
resources.
(iv) Shadow prices; This is the true or intrinsic prices which reflect the scarcity of
resources in the economy i.e. it is the time value for a factor or a product

Circumstances when shadow pricing should be used

(a) Imperfect market- Prices and costs don‟t reflect true social valuations and
adjustments are needed
Example: If market costs of a given product is Ksh. 1000, but in a competitive
market would have cost Ksh. 800. The opportunity cost is Ksh. 800 hence its
price is Ksh. 200 becomes a pecuniary gain to the monopolist but not a real
cost to the society.
(b) Taxes- market prices may include taxes. But taxes do not reflect a social cost (it is a
transfer from purchases to government) and should therefore be disallowed in
computing the cost of the project
(c) Unemployed resources- the cost to be accounted for in public resource use is the lost
opportunity for putting the resources to alternative uses. This reason breaks down if
the resources are otherwise unemployed and the opportunity cost is zero.
(d) Developing economies- developing economies experience unemployment, labour
cost is too low, hence does not reflect their time social cost. Some even overvalue
their currency hence need for shadow pricing.

4.6 Discounting cash flows

4.6.1 Meaning and importance

It means translating future benefits streams into present values. That is we discount
benefits to base year equivalent. This is because; future benefits are less valuable than
the present ones. The opportunity cost of resources withdrawn from the private sector
should be measured in terms of the present value of private consumption foregone, where
future consumption losses (due to forgone investment) are similarly discounted to their
present values.

Given B0 , B1 , B2 ,..., BN are Benefits in year 0, 1, 2,.., N then

B0 B1 B2 BN
Pr esent Value ( PV )     ... 
(1  r ) 0
(1  r ) 1
(1  r ) 2
(1  r ) N

Page 50 of 126
Where
1
r = discounting rate and = discount factor.
(1  r) n
N
Bn
PV  
t 0 (1  r ) n

Example:

Investment ($) Year

0 1 2 3
A +1000 +500 +600 0
B +2361.60 +1000 1000 1000

With a discount rate of 10%;

t n Bn  1000  500  600  0
PV A  
t 0 (1  r ) n (1  .1) 0 (1  .1)1 (1  .1) 2 (1  .1) 3

= 1000(1.00) +500(0.909) + 600(.826) + 0(.751)

= 1000 + 454.5 + 495.60 + 0
= $1950

PVB = 2361.6(1.00) + 1000 (.909) + 1000 (.826) +1000 (.751)

= 2361.60 + 909 + 826 + 751
= $4847.60

4.6.2 Choice of Discount Rate

(a) Private rate of discount rate

The discount rate used should be equal to the time preference of consumers in the private
sector provided that this may be derived from observed market rates. The rationale for
using private rate of discount is that it reflects consumer choice between present and
future consumption. In a perfect market, this interest rate will be equal to the marginal
efficiency of investment.

Page 51 of 126
Difficulties in the use of private discount rate
1. Capital market imperfections such as differential access to credit and investment
institutions make different individuals be confronted with different costs and returns
to borrowing and lending. Hence no single rate may be obtained.
2. Uncertainty of future level of interest rate hence short and long term rates in the
capital market differ.
3. Some investment projects are risky than others hence gross rates of return differ by
the amount by risk premiums.
4. Income tax- lenders pay income tax on their capital. Proper measure of their time
preference is therefore the net or after-tax rate of return and not the gross market rate.
5. Macro-policy – the presence of unemployment and inflation hence need for
intervention policies to rectify the situation. Therefore, the market does not reveal
correct level of interest by which time consumer time preference is reflected.

(b) Social rate of discount

Due to the above limitations, some economist advocate for the use of a social rate of
discount. This is the time preference rate for future generation.

Reasons for this substitution (Private Rate to Social Rate)

1. Individuals underestimate the importance of savings and overestimate that of
present consumption. Hence consumer‟s time discount is too high and the
government should correct this by applying a lower rate.
2. People are too greedy and do not care sufficiently about the welfare of those to
come. They therefore do not save more in order to leave future generation with
larger capital stock. Hence the government may use a low rate to offset this.
3. People do care about future generation and will derive pleasure from contributing
to their welfare. But they do not act as a group hence the government should use
a lower rate of discount in order to increase investment.
4. With technical progress raising future productivity the capital stock needed to
sustain the consumption standard may fall, calling for a higher discount rate.
5. The equilibrium rate of return to capital should be equal the growth rate of the
economy which in turn equals the growth rate of the population.

4.7 Conditions which make CBA desirable in LDCs

1. The LDCs experience a lot of inflation, which alters their relative prices and
sometimes governments are forced to intervene in form of price controls which
results in the form of NSB. Hence need arises to estimate this NSB by carrying out
some CBA however crude.

Page 52 of 126
2. A characteristic of LDCs is the overvaluation currency. This often leads to excess
demand for foreign exchange forcing goods to impose import restrictions. Here
market prices of goods may then exceed their world prices and an over estimate of
NSB within the country may ensure hence need for CBA.
3. There are imperfections in the wages and employment in the LDCs labour markets.
There are also different modes of production and often the wages paid to labourers
tend to over estimate their time cost to opportunity cost hence need for a shadow
wage rate to calculate the time cost of labour in the society.
4. Capital markets are imperfect in most cases. Interest rates are artificially low hence
using it in project evaluation may not yield objective figures. Need arises for the
technique of a shadow rate which is one of the CBA methods.
5. Large project to the standard of LDCs are known to have an overwhelming
externality effects i.e. secondary benefits accrue and these need to be estimated if the
true benefit have to be accounted for hence need for CBA.
6. Protection, tariff and quotas are used in LDCs hence market price don‟t reflect NSB
and therefore need to use CBA to estimate NSB.
7. There is a saving deficiency and public is in the LDCs with the government making
an extra unit of savings more valuable than an extra unit of consumption hence use of
taxes to effect savings and discourage consumption. It is desirable to use CBA
exhaustively in order to make such decisions.
8. The distribution of wealth is very uneven in LDCs since CBA takes account of
society‟s benefits in total, it is desirable in LDCs.
9. In elasticity of demand for exports influencing the price, LDCs obtain by restricting
sales. The free market price cannot then correctly measure benefits because like any
monopolist, the country would gain if it exported less at a higher price.
10. External effects: That some industries have important beneficial effects on others in
ways which cannot be reflected in the price obtainable for the output of the industry
or in the price it pays for its inputs. This needs the use of CBA.

4.8 Strengths and Limitations of CBA

4.8.1 Strengths
- Provides a framework for structuring information and considering trade-offs.
- Helps make strategic choices about program priorities.
- Helps weed out the least desirable alternatives
- Can identify areas in which uncertainty is greatest and further research is desirable.
- Can increase explicitness in decisions and thereby elevate the level of public debate
and the usefulness of public participation.
- Enhances consistency among decisions.

Page 53 of 126
- Can help assess the cumulative effects of regulations on groups, industries future
generations, geographical areas, etc.
- Can improve the credibility of government by showing how decisions are made and
that they are rational.

4.8.2 Limitations

a) Difficulties in cost assessment: Cost estimates are made on the basis of the choice of
techniques, locations and prices of factor services used. But market prices,
particularly those of factors of production form an imperfect guide to resource
allocation in under-developed economies, because there exist fundamental
disequilibria which are reflected in the existence of massive underemployment at
present level of wages, the deficiency of funds at prevailing interest rates and the
shortage of foreign exchange at current rates of exchange. Hence use of shadow or
accounting prices has been suggested. These shadow prices reflect intrinsic values of
factors of production.
b) Difficulties in Benefit Assessment, due to the element of uncertainty in a new project
as to the correct estimation of future prices, demand and supply of its products, and
difficulty in assessing external economies.
c) Arbitrary Discount Rate – the assumed social rate of discount for any project is likely
to be arbitrary. This might not make it possible to effectively calculate net present
value of benefits.
d) Neglects joint Benefit and costs arising from a project. It is difficult to evaluate and
calculate such benefits separately.
e) Ignores opportunity costs

f) Adjustment for Risk and Uncertainty problem also arises. This is done in three
ways:-
 At the time of calculating the length of project life
 the discount rate and
 by making due allowance in benefit and costs
g) The problem of externalities. Side effects of a project are difficult to calculate in this
analysis. There may be technological and pecuniary spillovers (externalities) of a
river valley project such as the effects of flood control measures or a storage dam on
the productivity of land at other places in the vicinity. It is difficult to calculate such
external effects.
h) Traditional CBA focuses only on efficiency but other factors e.g. administrability,
distribution of impacts, and promotion of technological innovation, may be of equal
or great importance in decisions.

Page 54 of 126
i) CBA takes technological as given and cannot anticipate technological breakthroughs
that reduce costs.
j) CBA may lead to short sighted and undesirable decisions of agencies, preservation of
the democratic system “irrational” but strongly held views of the public etc are
ignored.
k) Does not consider distribution of costs and benefits hence inequitable decisions are
made.

4.9 Topic Summary

 Cost Benefit analysis (CBA) involves enumeration, comparison and evaluation of

benefits and costs and is useful in describing and quantifying the social advantages
and disadvantages of a project / policy in terms of a common monetary unit
 Objective of CBA in project appraisal is to choose a project which yields Net Social
Benefits (NSB)
 All costs and benefits (direct and indirect) must be considered
 The costs and benefits are measured in terms of market prices paid for inputs required
in executing the project and prices paid for the project‟s output respectively. However
where there exists market imperfections, taxation and unemployed resources shadow
prices are used.
 The cash flows during the project duration are discounted using appropriate discount
rate to translate them into a single figure upon which decisions are made
 A project evaluator (planner) using CBA to make decisions must solve the following
major problems: Identification of benefits and costs; Evaluation of benefits and costs
at prices which will be relevant to the society; Choosing an appropriate rate of
discount for evaluating Bs and Cs and also Consider uncertainty and risk.
Concepts to remember
- Net Social Benefits - Indirect Benefits and costs
- Tangible and intangible - Shadow price
- Discounting - Social rate of discount
- Private rate of discount - Direct benefits and costs

Page 55 of 126
4.10 Work to do

1. Solve the following assuming an interest rate of 5% per annum

 A present debt of how much will Ksh. 1000 at the end of each year for 10 years repay
 A payment of how much now is acceptable in place of a payment of Ksh.3000 ten
years hence.
2. Solve the following using an interest rate of 4% per annum
 $200 at the end of each year for 10 years will repay a present debt of how much
 A payment of how much now is acceptable in place of a payment of $1500 8 years
hence.

4.11 Further reading

Irvin G. 1978. Modern Cost-Benefit Methods. London: Macmillan.

Little, I.M.D. and J.A. Mirrlees (1982) Project Appraisal and Planning for Development
countries. London: Heinemann Educational Books.

Mishan, E. J. 1975. Cost-Benefit Analysis, An informal Introduction (Revision Edition).

London: George Allen & Unwin ltd.

Ray, A. 1984. Cost-Benefit Analysis. Issues and Methodologies. Baltimore: John

Hopkins university press.

Page 56 of 126
 TOPIC FIVE
PROJECT EVALUATION CRITERIA

Introduction

In topic four we looked at Cost Benefit analysis, a method commonly used in

evaluating public projects. While we considered analysis of projects cost and benefits
we did not explore how on the basis of the costs and benefits, decisions are made on
which projects to adopt and which ones to leave out. In this topic we will consider the
various criteria of evaluating projects and the decision criteria for each.

5.1 Topic Objectives

By the end of the topic the student should be able to;

- Describe three non time adjusted investment criteria of project appraisal
- Determine Average (accounting) Rate of Return (ARR) of a project
- Define and compute Net Present Value (NPV) for a project
- Determine Internal rate of return (IRR) of a project
- Interpret NPV and IRR for a project
- Determine Benefit Cost ratio for a project
- State the advantages and disadvantages of each criteria in project appraisal

5.2 Types of appraisal criteria

Various criteria can be employed to determine the desirability of the investment projects
with the aim of implementing one that will maximize value of the firm. In order to
maximize the value of the firm, the evaluation techniques should:
 Consider all relevant cash flows
 Discount cash flows using the firm‟s opportunity cost of capital

Page 57 of 126
  select one project from a set of mutually exclusive projects that maximizes the
value of the firm
 Allow each project to be evaluated independently of all others being considered.

These are suggested to judge the worthwhileness of the investment projects and guide
investment decision making. There are two principle methods of evaluating a project
a. Non – Time Adjusted Investment Criteria
b. Time Adjusted Investment Criteria

5.2.1 Non – Time Adjusted appraisal / Investment Criteria

(a) Urgency
Projects that are deemed to be urgent get priority over projects that are regarded as less
urgent.

Limitation
(i) It is difficult to determine the relative degree of urgency because of lack of an
objective basis.
(ii) The persuasiveness of those who propose projects becomes a very important
factor in investment decisions, and resource allocation may degenerate into a
political battle.

NB: This criterion should not be used for investment decision making except for cases
where genuine urgency exists and the amount of money involved (investment outlay) are
not huge.

(b) Payback period

It is the length of time required to recover the initial cash outlay on the project in terms of
years usually. A project with shorter Payback period is more desirable. The firm needs
to specify the maximum acceptable payback period.
Example:
Year Cash flow of A Cash flow of B
0 (100,000) (100,000)
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 60,000

Page 58 of 126
The payback for project A is 3 years, while that of project B is 4 years. Hence project A
is preferred.

Merits
(i) It is simple both in concept and application i.e. does not involve tedious
calculations and has few hidden assumptions.
(ii) It is a rough and ready method of dealing with risk. If risk tends to increase with
futurity, it may be helpful in weeding out risky projects since it favours projects
which generate substantial cash flows in earlier years. By recognizing the timing
of cash flow. It is therefore valuable for investment decisions for organizations in
high risk markets
(iii) It is a better criterion when a firm is pressed with problems of liquidity or during
periods when financing costs are very high because it emphasizes earlier cash
flows.

Limitations
- Ignores time value of money which violates the principle that cash flows occurring at
different points of time can be added or subtracted only after suitable
compounding/discounting
- Over looks cash flows beyond the payback period, which leads to discrimination
against projects which generate substantial cash flows in later years. In the above
example, the payback criterion prefers project A which has a payback period of 4
years, even though B has very substantial cash flows in years 5 and 6.
- It may divert attention from profitability since it is a measure of a projects capital
recovery, ignoring its profitability.
- It does not indicate the liquidity position of the firm as a whole although it measures a
project‟s liquidity.
- In effect, it assigns zero weight to cash flows beyond the payback period ie fails to
take account of the cash flow earned after the payback period.

Reasons why payback period is commonly employed

Despite its serious shortcomings, the payback period is widely used in appraising
investment due to being a proxy for certain types of information which are useful in
investment decision making. The reasons given are that:
 It may be regarded as the reciprocal for the internal rate of return when the annual
cash flow is constant and the life of the project fairly long.

Page 59 of 126
  It is acts like a break-even point and serves as a useful shortcut in the process of
information generation and evaluation.
 It conveys information about the rate at which the uncertainty associated with the
project is resolved. The shorter the payback period, the faster the uncertainty
associated with the project is resolved. Early resolution of uncertainty enables the
decision maker to take prompt corrective action, adjust her/his consumption
patterns, and modify/change other investment decisions.

(c ) Returns on investment (ROI) criteria

Also referred to as Accounting Rate of Return or Average Rate of Return

It is a measure of profitability which relates income to investment, both measured in

accounting terms.

This is found by dividing the average income after depreciation by the initial investment.
n

 Cash Flows
0
Average profits after depreciati on n
ROI  
Initial investment I0
Where:
n = life of the project
Io = initial outlay

Example 1
The Ministry of Health is planning to acquire a new machine for an income-generation
project. It has two alternatives
Machine X Machine Y
Cost Ksh.20,000 Ksh. 20,000
Estimated lifespan 5 years 5 years
Estimated residual value Nil Nil
Estimated net returns before depreciation Year
1 10,000 12,000
2 8,000 10,000
3 7,000 8,000
4 5,000 5,000
5 5,000 5,000

Page 60 of 126
Required:
Based on the return on investment criterion, which machine should be purchased?

Solution
Machine X Machine Y
Total Profits before depreciation Ksh35,000 Ksh40,000
Total Profits after depreciation Ksh15,000 Ksh20,000
Average profit after depreciation Ksh3,000 Ksh4,000
Average return on investment (%) 15% 20%

- To get total profits before depreciation, add all estimated net returns
Thus for X = 35000 and for Y = 40 000
- To get total profits after depreciation divide the initial cost (20000) with number of
years of lifespan, then multiply by the lifespan years and subtract from the total
profits before depreciation.

Therefore;

For Machine X: For Machine Y

20000 20000
 5  20000  5  20000
5 5
then then
35000  20000  15000 40000  20000  20000

Average profits after depreciation

For X: For Y

15000 20000
 3000  4000
5 5

Average ROI (%)

3000 4000
For X =  100  15% For Y=  100  20%
20000 20000

Page 61 of 126
*Decision
Realize machine Y because it has a higher return on investment.

Various Measures of ARR

The definition, of ARR/ROI as the ratio of average profits after depreciation to capital
investment is only a basic definition. Various other definitions exist. For example;
- Profits may be considered before or after tax
- Capital may or may not include working capital
- Capital invested may mean the initial capital investment or the average of the capital
invested over the life of the project

An alternative term also used is Return on Capital Employed (ROCE)

Example 2
Year Investment Depreciation Income before Interest Income Tax Income
(Book value) interest & before after tax
taxes tax

1 1.00 0.20 0.30 0.10 0.20 0.100 0.100

2 0.80 0.20 0.35 0.10 0.25 0.125 0.125
3 0.60 0.20 0.40 0.10 0.30 0.150 0.150
4 0.40 0.20 0.40 0.10 0.30 0.150 0.150
5 0.20 0.20 0.35 0.10 0.25 0.125 0.125
Sum 3.00 1.00 1.80 0.50 1.30 0.650 0.650
Average 0.60 0.20 0.36 0.10 0.26 0.130 0.130

(i) ARR = Average income after tax = 0.13 = 13%

Initial investment 1.00

(ii) ARR = Average income after tax = 0.13 = 21.7%

Average investment 0.60

(iii) ARR = Average Income after tax but before interest = 0.13 + 0.10 = 23%
Initial investment 1.00

(iv) ARR = Average Income after tax but before interest = 0.13 + 0.10 = 38.3%
Average investment 0.60

Page 62 of 126
 (v) ARR = Average Income before interest and taxes = 0.36 = 36%
Initial investment 1.0

(vi) ARR = Average income before interest & taxes = 0.36 = 60%
Average investment 0.60

(vii) ARR = Total income after tax but before depreciation – Initial investment
Initial investment
 years
2
0.65  1.0  1.0 1.65  1.0 0.65
= =   26%
1.00 2.5 2.5
x5
2

Decision criteria
(i) The higher the accounting rate of return (ARR) is, the better the project.
(ii) Projects that have ARR equal or greater than a pre-specified cut off rate of return
(usually between 15 per cent and 30 per cent) are accepted.

Advantages of ROI
(i) Simple to understand and use: Readily calculated using accounting data.
(ii) Uses entire stream of incomes in calculating the ROI.

Disadvantages
(i) Ignores the time value for money.
(ii) Does not allow for the fact that profits can be re-invested.
(iii) Does not consider the length of the projects life e.g. 20% ROI for 10 years is
better than 20% for 20 years.

5.2.2 Time Adjusted Appraisal / Investment Criteria

In these criteria project cash flows are discounted to take into account the time value of
money.

(a) Net Present Value Criteria

NPV is equal to the sum of the present value of all the cash flows associated with a
project.
t
CFo CF1 CFt CFt
NPV =
(1  r ) 0

(1  r ) 1
 ........... 
(1  r ) t
= 
t  0 (1  r )
t

Page 63 of 126
Where;
NPV = Net Present Value
CFt = Cash flow occurring in period / year t (t = 0, i --- n)
t = Life of the project
r = Opportunity Cost of capital

Features of the NPV method

(i) Based on the assumption that intermediate cash flows of the project are re-
invested at a rate of return equal to the cost of capital.
(ii) The NPV of a simple project steadily decreases as the discount rate increases

Example I
Suppose the following information represent cash flows in different time periods from a
project, in which the cost of capital (r) is 10%, calculate the NPV

Year Cash flow

0 (1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 550,000

NPV = -1,000,000 + 200,000 + 200,000 + 300,000 + 300,000 + 550,000

(1 + 0.1)0 (1 + 0.1)1 (1 + 0.1)2 (1 + 0.1)3 (1 + 0.1)4 (1 + 0.1)5
= 118,750

Example 2
Consider the previous example on deciding between Machine X and Y

Page 64 of 126
Cash flow
Year Machine X Machine Y Discount factor P.V for P.V for
1 Machine X Machine Y
(15%);
(1  r) t (20,000) (20,000)

0 (20,000) (20,000) 1.00 (20,000) (20,000)

1 10,000 12,000 .870 8,700 10,440
2 8,000 10,000 .756 6,048 7,560
3 7,000 8,000 .658 4,606 5,264
4 5,000 5,000 .572 2,860 2,860
5 5,000 5,000 .491 2,455 2,4 55
NPV 4,669 8,579
Machine Y is chosen because it has the highest net present value.
Generally NPV is computed using the formula;

B0  C 0 B1  C1 B  Ct
NPV    t
(1  r ) 0
(1  r ) 1
(1  r ) t

t n
Bt  Ct

t 0 (1  r ) t

*Decision Rule/criteria
 NPV > 0 (+ ve) – the project is viable – accept. A positive NPV implies that the
project earns an excess return
 NPV < 0 (- ve) – the project is not viable – reject
 NPV = 0 Indifferent; Thus consider other factors such as social and political factors.
NPV of zero signifies that the benefits of the project are just enough to:-
- Recoup the capital invested and
- Earn the required return on the capital invested

Context within which NPV criteria may be used

(i) Accept – Reject
Faced with a single project, the NPV rule dictates that it should be accepted if the NPV
exceeds zero and rejected if it is less than zero. If NPV = 0, the decision maker would be
indifferent between undertaking the project or not.

Page 65 of 126
(ii) Ranking
Where the decision maker has a series of investments all with positive NPVs and yet the
budget is fixed, she needs to rank projects in order of desirability and work down the list
until the budget is exhausted.

(iii) Mutual Exclusion

Where the choice is between projects, the general rule is to select the project offering the
highest NPV.

Observations
- Strict exclusivity – implies that either project may be undertaken or neither.
However, where there is variable degree of exclusivity such that a total commitment
to the other project and some combination is possible, it is essential to consider any
such combinations and compute their NPVs. The combined projects should then be
treated as if they were extra projects. Exclusively still applies i.e. one may be able to
undertake one project or the other or some combinations being guided by the rule of
the highest NPVs.
- In the presence of capital rationing, it is necessary to normalize projects so that they
are comparable.

Advantages of NPV Criteria

(i) It recognizes time value of money.
(ii) Considers all cash flows over the entire life of the project.
(iii) Ease to compare/rank projects.
(iv) The NPV of various projects can be added. This ensures that a poor project (with
a negative NPV) will not be accepted just because it is combined with a good
project (with positive NPV) since NPV (A + B) = NPV (A) + NPV (B)

Disadvantages of the NPV Criteria

(i) NPV depends on the rate of discount chosen and tends to favour large projects,
which are capital intensive.
(ii) Given a discount rate, it favours projects whose returns (benefits) accrue in the
early life.
(iii) It may not give satisfactory results when the project compared involve different
amounts of investment.
(iv) Ranking of projects on NPV is influenced by the discount rate.
(v) NPV is an absolute measure and does not appeal to businessmen who think in
terms of rate of return.

Page 66 of 126
(b) Internal Rate of Return (IRR) Criteria

Internal Rate of Return (IRR) is the rate of discount, which equates the present value of
cash inflows with the present value of cash outflows of investments. Therefore it is the
rate of discount where NPV = 0.
t n
NPV  
1
Bt  Ct   0
t 1 (1  r )
t

Where;
r = internal rate of return (IRR)
Bt = cash inflows for year t.
Ct = cash outflows for year t.
t = time period in years
Hence;
t n
 1  t n  1 
 Ct     Bt  
 (1  r )  (1  r )
t t
t 0  t 0 

NB: The value of r*that makes the statement hold is the IRR

Alternative names for IRR

- DCF yield
- MEC
- Actuarial rate of Return

Methods of Estimating IRR

(i) Trial and error method.
(ii) Direct calculation (if the cash flows are for one year)
(iii) Linear Interpolation.

Calculated by setting the discounted value of net benefits to the initial capital outlay and
solve the resulting equation for rate of discount
T
Bt  Ct
t 1 (1  r )
t
 C0

**Solve for r

Example
For a simple project, cash flows can extend for only two periods as follows
Year 0 Year 1

Page 67 of 126
 2000 3000
2000  3000
(1  r ) 0 (1  r )1
2000(1+r)1 = 3000
2000 + 2000r = 1000
2000r = 1000
1000 1
r    0.5 or 50%
2000 2
* Pr oof
3000 3000
2000    2000
(1  0.5) 1
1.5

For a more complex project e.g. one with cash flows at three points of time, the IRR can
be found through solution to a quadratic equation

Thus if ax 2  bx  c  0 then
 b  b 2  4ac
x1, 2 
2a

Example
Year 0 1 2
1000 2000 1000
1000 2000 1000
 
(1  r ) 0
(1  r ) 1
(1  r ) 2
Thus
1000(1  r ) 2  2000(1  r )  1000
 1000(1  r ) 2  2000(1  r )  1000  0

Let (1+r) = x

So that
 1000 x 2  2000 x  1000  0
OR
x 2  2x  1  0

Therefore;

Page 68 of 126
  (2)  (2) 2  (4  1  1) 2  4  4 8
x1, 2    1
2 1 2 2

2.8284
 1  1  1.4142  1  1.41
2
x1, 2  1  1.41  2.41 or  0.41
But x  1  r
Thus
1  r  2.41  r  1.41  141%
OR
1  r  0.41  r  1.41  141% : the negative value is discarded

The negative value is discarded as it is meaningless

(iii) By Linear Interpolation

IRR  Lower discount rate  Difference between the rates

 PV of cash flow at lower discount rate 
  
 Sum of the PVs at the two discount rates irrespecti ve of negatives 

That is
(r 2  r 1 )
IRR  r 1  PV1
PV1  PV 2

Suppose: r1 = 10%, PV1 = 10,000, r2 = 20% and PV2 = -5,000, then;

 10,000 
IRR  10%  10   10  10(0.67)  10  6.7  16.7%
 15000 

Page 69 of 126
NB: One of the discount rates chosen should yield a negative NPV so that the PV
profiles cuts the zero axis

NPV

10,000

10 20 Discount rates

-5000

NPV line

Interpretation of IRR
 Represents the rate of return on the unrecovered investment balance in the project
 Is the rate of return earned on the initial investment made in the project.

Decision rule
Accept the investment project if r* > r where r* is the IRR and r is the predetermined
discount rate.
Reject if r* < r (IRR < r)

Advantages
- It considers time value of money.
- It considers the cash flows over the entire life of the project.
- Calculation of the cost is not a pre-condition for the use of the method.

Page 70 of 126
Disadvantages
- It is possible to obtain more than one solution rate hence no clear cut criterion for
acceptance or rejection.
- It may overstate the desirability of a short life project if project with different
economic lives are being compared.
- It gives high ranking to projects, which bunch the benefits into the early part of their
economic lives relative to other projects.
- It discriminates against project, which have large capital outlay if the projects in
consideration are mutually exclusive.

(c) Benefit Cost Ratio (BCR)

There are two ways of looking at BCR;

(i) Benefit cost ratio (BCR) = Present value of Benefits

Initial Investment

(ii) Net Benefit Cost Ratio (NBCR) = Net Present Value of Benefits
Initial Investment

= Present value of Benefits – initial investment

Initial investment

= BCR - 1

Example
If cash flows for a project are as follows

Year 0 1 2 3 4
Benefits 100000 25000 40000 40000 50000

(i) BCR = 25,000 + 40,000 + 40,000 + 50,000

(1.12)1 (1.12)2 (1.12)3 (1.12)4

= 1.145

Page 71 of 126
(ii) NBCR = BCR – 1 = 1.145 - 1 = 0.145

Decision Rules
BCR > 1 Accept NBCR > 0 Accept
BCR = 1 Indifferent NBCR = 0 Indifferent
BCR < 1 Reject NBCR < 0 Reject

Merit
Since the criterion measures NPV per shilling of outlay, it can discriminate better
between large and small investments hence preferred to NPV criterion.

Short comings
- Under unconstrained conditions, it will accept and reject the same projects as the
NPV
- When the capital budget is limited in the current period, it may rank projects correctly
in the order of decreasingly efficient use of capital. However, its use is not
recommended because it provides no means for aggregating, several smaller projects
into a package that can be compared with a large project.
- When cash outflows occur beyond the current period, the BCR criterion is unsuitable
as a selection criterion.

(d) Discounted Payback Period

Cash flows are converted into their present values and then added to ascertain the period
of time required to recover the initial outlay on the project. This is done to take into
account the time value of money.

Page 72 of 126
5.3 Topic Summary

 There are two principle methods of evaluating a project; Non – Time Adjusted
investment Criteria and Time Adjusted Investment Criteria
 The non-time adjusted investment criteria considers the benefits and costs as they are
in each period while in the time adjusted criteria, costs and benefits are discounted
and decisions are based on their present values
 Non time adjusted investment criteria include urgency, payback period and Returns
on investment or Accounting rate of return (ARR). Projects that are deemed to be
urgent get priority over projects that are regarded as less urgent. A project with
shorter Payback period is more desirable. The higher the accounting rate of return is,
the better the project. Projects that have ARR equal or greater than a pre-specified cut
off rate of return (usually between 15 per cent and 30 per cent) are accepted.
 Time adjusted criteria include The Net Present Value (NPV) criteria, the Internal Rate
of Return (IRR) and Benefits - Cost ratio. If NPV > 0, the project is viable hence
accept. If NPV < 0, the project is not viable hence reject. If NPV = 0 it implies PV of
benefits =PV of costs, thus the investor is indifferent; In this case other factors such
as social and political factors need to be considered. In using IRR, it is compared to a
predetermined discount rate (r). The project is accepted if IRR is at least greater than
r. on the basis of benefits- cost ratio, the project is acceptable only if BCR>1 or
NBCR > 0
Important Concepts
Non time Adjusted Investment Criteria Payback Period Net Present Value
Benefit Cost Ratio Time Adjusted Investment Criteria
Returns on investment Internal Rate of Return

Page 73 of 126
5.4 Work to do

1. You have been given the following information about various projects

Project Year
0 1 2 3 4
A (1000) 1200 0 0 0
B (1361.1) 500 500 500 500
C (1000) 1200 1500 0 0
D (2000) 1000 0 0 0

Required: Using the NPV and IRR criteria, evaluate the above projects.

2. A firm is considering three projects each with an initial investment of $1000 and a
life of 5 years. The profits generated by the projects are estimated to be as follows:

After Tax and Depreciation Profits

Year Project I Project II Project III
1 200 350 150
2 200 200 150
3 200 150 150
4 200 150 200
5 200 150 200
Total 1000 1000 1000

Calculate the ARR on

a. Initial capital
b. Average capital

Page 74 of 126
5.5 Further reading

Gittinger J. P. 1987. Economic Analysis of Agricultural Projects. John Hopkins

University press.

Terry Lucey . 2000. Quantitaive Techniques. 6th edition South Western

Mishan, E. J. 1975. Cost-Benefit Analysis, An informal Introduction (Revision Edition).

London: George Allen & Unwin ltd.

Squire, L. and H.G. Vander TAK.1975. Economic Analysis of projects. Baltimore: John
Hopkins

Page 75 of 126
 TOPIC SIX
RISK AND UNCERTAINTY

Introduction

In the previous topic we considered the criteria for evaluating desirability of projects. We
have assumed that the costs and benefits are known with certainty. In practice this will
not be true due to risk and uncertainty. In this topic we will look at how to incorporate
situations of risk and uncertainty in project evaluation and how these would affect our
decisions.

6.1 Topic Objectives

By the end of the topic the student should be able to;

- Differentiate between a risk situation and an uncertainty situation for projects
- Explain the various ways of incorporating risk in project evaluation
- Describe the main decision rules for projects in situations of uncertainty

6.2 Definitions

Uncertainty situation
Is a context in which we do not know the probabilities attached to the sizes of the costs or
benefits, but we do know the values that the costs and benefits could take. In many cases,
we simply will not know the probabilities and hence were require some rules on how to
proceed in such contexts.

Risk Situation
This is a situation in which we know the probability that the benefit or cost will take
some particular values. That is, the probability distribution is known. Therefore, risk is

Page 76 of 126
some quantifiable form of uncertainty because probabilities of occurrence for risk can be
estimated.

Consider the information on the probabilities associated with benefits of a project given
as in the table

Benefit Probability

100 0.2
200 0.5
500 0.2
1000 0.1

The information in the table means that there is a 20 per cent chance of the benefit being
100, a 50 percent chance of it being 200, etc. There is need to compress the information
into a single indicator which we can put into CBA formula. In the situation of ex-ante
evaluation we use expected NPV because there is risk and uncertainty. Under ex-post
evaluation we do not use expected NPV since the project has already started.

6.3 Decision Rules on Projects under Uncertainty

Whichever rule is selected very much depend upon the outlook of the decision maker.
This outlook should consider the views of the society. If society appears optimistic,
optimistic rules can be adopted. If social attitudes appear cautious then certain cautious
rules should be adopted.

Example:
Economic growth
Policy 1% 2% 3% 4%
1 0 3 7 16
2 4 4 4 5
3 0 0 3 3
4 6 10 5 3

The main body of the matrix shows the resulting net benefit figures from a policy over
which the government has control. They vary according to the policy chosen (1 to 4)

Page 77 of 126
(i) The maximax criterion
Go for the policy that maximizes the net benefits i.e. maximize the maximum.

Policy Maximum Net Benefits

1 16
2 5
3 3
4 10

Policy 1 is taken since it has the potential of yielding the highest net benefits of 16 units
provided economic growth occurs at 4 per annum.

Problem
This is a very dangerous criterion because 1 per cent economic growth could occur and
the benefits will be zero. Only a gambler can use this criterion.

(ii) The Maximin Criterion (Wald Criterion)

Look for the minimum benefits for each policy and choose the maximum of them i.e.
maximize the minimum.

Policy Minimum
1 0
2 4
3 0
4 3

Policy 2 would be taken since it gives the maximum of the minimum i.e. 4.
It is a cautious policy and misses a chance to go for the larger benefits under policies 1
and 4.

(iii) Index of Pessimism (Hurwicz Criterion)

Take the best and the worst benefits for each policy and apply an index of pessimism to
the worst outcomes and (1 – the index) to the best outcomes.

Page 78 of 126
 Policy Minimum Maximum
1 0 16
2 4 5
3 0 3
4 3 10
Suppose the index of pessimism is 0.9, the index of optimism at 0.1 we get
Policy
1 0.9  0  0.116  1.6
2 0.9  4  0.1 5  4.1
3 0.9  0  0.1 3  0.3
4 0.9  3  0.110  3.7

Policy 2 would be chosen since it has the highest pay off. If the index is set to equal to
unit, the criterion collapses to maximum criterion.

(iv) Laplace Criterion

Used where we do not know the probabilities of any of the growth rates occurring. An
assumption is made that each one of them is equally likely to occur. (This is what the
principle of insufficient reason suggests; if we know nothing then everything is equally
probable). We therefore assign equal probability i.e. 1/4 = 0.25 to each of the four growth
rates. We then calculate the weighted expected value of the net benefits for each policy.

Policy Weighted Net Benefits

1 0 + 0.75 + 1.754 + 4 = 6.50
2 1 + 1 + 1 + 1.25 = 4.25
3 0 + 0 + 0.75 + 0.75 = 1.50
4 1.5 + 2.5+ 1.25 + 0.75 = 6.00

Policy 1 would be selected since it has the highest weighted pay off of 6.50.

Problem
The method is misplaced since if we do not know, we simply cannot deduce from a state
of ignorance. Assigning equal probabilities is making an assertion (statement) about the
world on the basis of no information of any kind. The method is thus a dangerous rule to
use.

(v) Minimax (minimum Regret) criterion

We minimize the maximum regret. We compute the cost of making a wrong choice.

Page 79 of 126
We therefore compute the regrets associated with each policy given the different possible
states, to obtain a regret matrix is given as

Economic growth
Policy 1% 2% 3% 4%
1 6 7 0 0
2 2 6 3 11
3 6 10 4 13
4 0 0 2 13

Thus
Policy Maximum Regrets
1 7
2 11
3 13
4 13
The minimum of the maximum regrets (making the best of a bad job) is 7 hence chose
policy 1

Advantage
It has equity appeal in that it enables us to avoid disaster, particularly if the investments
in question impose costs on future generations

Disadvantages
(i) The minimax criterion is rather cautious. This is detrimental to the long run
growth prospects if applied consistently in CBA programs.
(ii) it appears to be inconsistent with the requirements that such decision rules be
independent

6.4 Decision making under risk

The criteria are separated into three groups

- Time based- Cost of Risk bearing, payback period and finite horizon
- Probability based – Expected value criteria
- Measures of central tendency and variability
- Sensitivity analysis

Page 80 of 126
6.4.1 Time Based Criteria

(a) Incorporating the cost of risk bearing (CRB) to adjust the NPV (NSB)

Under situations of risk, we adjust our decision rule in such a way that the cost of risk
bearing (CRB) is deducted from the expected value of the Net Social Benefit (NSB) or
NPV of the project. That is, where before the decision rule for the initial acceptance of
T
B  Ct T
Bt  Ct
the project was NPV   t , it now becomes NPV *    CRB.
t  0 (1  r ) t  0 (1  r )
t t

The above expression does not allow for time consideration in relation to CRB. If time
was to be incorporated, then there would be need to rewrite the CRB as a discounted sum
accruing each year with a present value of
T
Kt
PV (CRB )   : Where K t = Cost of risk bearing in year t
t  0 (1  r )
t

Further, since the context is of risk, benefits Bt  and costs Ct  are in expected
values Bt and Ct . Thus the equation for NPV* becomes:
T
Bt  Ct  K t
NPV *   .
t 0 (1  r ) t

This equation provides one way of modifying the basic CBA equation to allow for risk.

Another method for capturing the cost of risk in project appraisal is to use a risk premium
to adjust the discount factor so as to get a smaller net present value (NPV). The new
formula for NPV becomes:
T
F
NPV   ;
t  0 (1  R*)
t

Where;
F = Forecast of Cash flows
R* = Risk adjusted discount rate R  i   
i = Risk free rate of interest
 = Risk parameters rate

Page 81 of 126
Example 1.

Suppose a project costs Ksh. 50,000

Inflows are 25,000 20,000 10,000 1000

Then
 50000  25000 20000 10000 1000
NPV      Ksh.3585
(1  0.1) 1
(1  0.1) 2
(1  0.1) 3
(1  0.1) 4

If we introduce risk premium of 5%, then NPV = Ksh. (- 850)

Therefore this is not a viable project. By using the risk premium of 5%, the project turns
out not viable.

Example 2
Suppose a project has an initial cost of Ksh. 10,000. The cost of capital is 10%. The
project is considered to be risky so a risk premium of 5% is to be added to the basic rate.
The projected cash flows in the next five years are, Kshs. 2000, 3000, 2500, 3000, and
3500 respectively. Suppose the risk premium was not considered, then

2000 3000 2500 3000 3500

NPV  10000     
1.11 1.12 1.13 1.14 1.15
 10000  1818.18  2479.34  1878.29  2049.04  2173.22  Ksh.  398.07

The positive NPV implies that the project is viable

However, with the risk premium the NPV becomes

2000 3000 2500 3000 3500

NPV  10000     
1.15 1.15 2 1.153 1.15 4 1.155
 1000  1739.13  2268.43  1643.79  1715.26  1740.12  893.27

The result is a negative NPV, which implies that the project is not viable.

The advantage of using the risk premium is that it is simple to use.

The disadvantages are:
1. It makes an implicit assumption that the risk is a function of time. This is because
the discounting progressively increases over time

Page 82 of 126
 2. It does not consider variability of project cash flows
3. It creates the problem of deciding on the suitable risk premium. That is, whether it
should vary for different projects or it should be the same.

The Relevance of the cost of Risk-Bearing in Project appraisal - the Arrow-Lind

Theorem
According to the Arrow-Lind theorem, allowing for risk is not relevant in government
decision making. Since governments are organizations with massive expenditures on
capital investments, it can be argued that the risk attached to any single project is so small
that it is not worth worrying about. This arises from two aspects of investments
i. Those with risk of losses to be at least balanced by those with a risk of securing higher
net benefits than expected. This is known as risk pooling. The requirements for this
argument to hold are;
 That the government‟s portfolio of capital projects should not be dominated by one or
larger projects such that the risks on those projects dominate the general risk structure
of the portfolio
 that there should be no interdependence among projects or if there is, it should be
such that this interdependence reduces the overall risk attached to the portfolio
ii. In LDCs large projects such as irrigation, water supply or electrification may
dominate. In these countries factors offsetting risks in such projects are;
 such investments tend not to benefit risks investments, the return reasonably being
certain
 the risk is in any event frequently shared by donors of capital aid

The Arrow-Lind theorem is more concerned with the risk-reducing phenomenon of

spreading of risks across people. The intuitive meaning of the argument is that the larger
the number of tax payers in a given country, the less is the risk per tax payer from any
given project. By spreading the risk across more individuals the project risk is reduced.
This is the essence of the Arrow-Lind theorem which demonstrates that in the limit, if the
number of individuals tends to infinity, the project risk tends to zero.

Fisher (1974) asserts that the theoretical validity of the Arrow-Lind theorem holds only
for private goods; those goods which when consumed by any one individual, cannot be
consumed by some other individual and where the principle of exclusion applies. In many
public investments however, the goods being provided are not private but are public
goods- i.e. those goods that have at least an element of non exclusion and non rivalry e.g.

Page 83 of 126
defense expenditures and many environmental improvement expenditures. In such cases
the number of persons does not affect the risk of the project. That is, risk is invariant with
how many people there are.

The point therefore is that the arrow-Lind theorem does not hold if the goods in question
are public goods or if the risks in question take on the form of public bads (public bad
elements in such projects).

(b) Payback Period

Apart from its use as accept/reject criterion, payback can also be used as a measure of
risk, often in conjunction with a discounted cash flow (DCF) measure such as NPV or
IRR. If two projects, A and B had the same NPV and A had a shorter payback period,
then A would be preferred. The method is easy to use because of simplicity of
calculations involved and is easy to understand, but has the following draw backs
- it assumes that uncertainty relates only to the time elapsed
- assumes that cash flows within the calculated payback period are certain
- fails to consider variability of the cash flows for the particular project being appraised

(c) Finite Horizon

This is the simplest of all the methods to apply. Projects beyond a certain time period,
e.g. 10 years are ignored. Therefore, all the projects are appraised over the same time
period.

The limitations are:

- The establishment of any fixed time horizon is arbitrary. Projects do vary in length
and this fact should be considered in appraisal
- The project cash flows within the time horizon are considered certain which may not
be the case
- Variability in the cash flows are not considered

(d) Certainty Equivalent Criteria

Certainty equivalent (CE) is the certain outcome held to be equivalent to an investment
with an uncertain outcome. If we are sure (certain) that NPV = Ksh. 12000, then it
becomes our certain cash flow. Suppose the risk cash flow is Ksh.15000, then we give
ourselves a conservative value of the cash flows of Ksh. 3000. The NPV is given by

T
 t Ft
NPV   ; i = risk free rate of interest, F = forecast cash flow
t 0 (1  i ) t

Page 84 of 126
We introduce  t which is the risk adjusted factor (certainty equivalent);  t Varies
inversely with the risk and its value ranges from 0 to 1. A higher rate of risk mean the
coefficient is low and vise versa.

F Certain cashflow
t  
F* Risk cashflow

In the above case

12000 4
t    0.8
15000 5

If F = F* then  t =1 and NPV is the same meaning there is no risk. But if  t <1, we have
a change in NPV, thus reducing NPV. If  t = 0, then NPV = 0

Example

Suppose for a project: Cost: Ksh. 5000 and r = 10%

Inflows 3000 2000 2000 3000
 0  1, 1  0.9,  2  0.7,  3  0.5,  4  0.4
1.0(5000) 0.9(3000) 0.7(2000) 0.5(2000) 0.4(3000)
NPV       Ksh.6640
(1  0.1) 0 (1  0.1)1 (1  0.1) 2 (1  0.1) 3 (1  0.1) 4

6.4.2 Probability based procedures

The main objective of the probability based methods is to demonstrate the likely
variations in the cash flows so that the effects of uncertainty are more clearly shown and
a more informed decision may be taken. The three methods that use subjective
probabilities are: Expected value, discrete probabilistic analysis and continuous
probabilistic analysis

(a) Expected Values (Returns) criterion

n
At   A jt Pit
j

Where;
At = Expected cash inflow

Page 85 of 126
A jt = Cash flow of investment in period t
Pit = probability of the cash flow and it = ith event in period t

Example 1
Consider projects X and Y where;
Project X Project Y
Year Cash Probability Expected cash Probability Expected
flow value flow value
1 4000 0.1 400 12000 0.1 1200
2 5000 0.2 1000 10000 0.15 1500
3 6000 0.4 2400 8000 0.5 4000
4 7000 0.2 1400 6000 0.15 900
5 8000 0.1 800 4000 0.1 400
1.0 At  6000 1.0 At  8000
On the basis of expected values we prefer Y to X
The total figure for At is put into CBA

Probability Distribution and their characteristics

Probability based methods rest on the assumption that realistic estimates of the subjective
probabilities associated with various cash flows can be established. For example, the
project analyst might ask a manager to make three estimates of the cash flow of a period
(Optimistic, most likely, pessimistic) instead of just a single estimate, and in addition ask
the manager to assess the likelihood of each of the three estimates. The estimates so
obtained form a probability distribution of the cash flows. It follows that if the individual
cash flows are expected to vary then overall return to the project will also vary.

Example
Suppose the manufacturers said the operating costs are likely to be Kshs. 3,500 at the
worst or below Kshs. 500 at the best and gave their own best estimate of Kshs. 2,000.

Required
Calculate X and standard deviation using
(i)Triangular distribution (3 point statistics)
(ii) Beta distribution
This is a typical situation where only the high (H), the low (L) and the best (B) guess can
be made. Here triangular and/or „Beta‟ best estimates are used.

Page 86 of 126
(i) Triangular Distribution (3 point statistics)
X  H  2B  L
4
 3500  2 x 2000  500
4
 4000  4000  8000
4 4
 Kshs.2000
Where;
H – Highest
B - Best
L – Lower
X - Mean
Standard deviation (s)
s  H  L  3500  500
4 4
= Kshs.750

(i) Beta Distribution

In the case of „Beta‟ distribution, more weight is given to the central value in relation to
the extreme point values.
H  4 B  L 3500  4  2000  500 12000
X     Ksh.2000
6 6 6
H  L 3500  500
s   Kshs.500
6 6

Aggregating Probability

Example
You are asked to evaluate a 5 years agricultural project where the yield is sensitive to
rainfall and operating cost and depend on the performance of the new agricultural
harvesting machine.
Additional information
(i) Project involves an outlay of $2000.
(ii) Price of output is fixed for the next 5 years at $10 per ton.

Page 87 of 126
(iii) Expected annual rainfall is described by the following probability distribution.

Rainfall (cm) Pr Expected Annual yield (ton)

5 0% 25
15 15% 75
30 20% 90
50 35% 100
70 15% 80
85 10% 50
100 5% 10___________________

The expected annual yields from different levels of annual rainfall (cm) are given
above (column 3).
(iv) Annual operating costs are expected to be $300 per annum but the machine
suppliers has indicated that depending on the machine‟s performance, this might
be as low as $200 p.a. (optimistic) or as high as $350 p.a. (pessimistic).

Required
Assuming no salvage value after 5 years and rate of 4% per annum, show how you would
evaluate this project and reach a decision.

Solution
1. Expected Annual Yield (tons)
E ( X i )   pi X i
 0(25)  0.15(75)  0.2(90)  0.35(100)  0.15(80)  0.1(50)  0.05(10)
 81.75 tons
2. Expected annual returns
= Annual yield X price
= 81.75 tons X $10
= $817.50
 Expected annual cost

(i) Three point statistic (triangular) method

Page 88 of 126
 X  H  2B  L
4
 350  2 X 300  200
4
 550  600
4
 1150  $287.50
4
(ii) Beta method

X  H  4B  L
6
 350  4 X 300  200
6
 550  1200  1750
6 6
 291.67

3. Expected Net Revenue = Expected Returns – Expected costs.

(i) Triangular method
= $817.50 - 287.50
= $530
(ii) Beta method
= $ 817.50 - $291.67
= $525.80

4. Expected NPV (at 4%)

(i) Triangular Method
ENPV = -2000+525.80 (4.452)
= -2000+2359.60
= $359.60
**Implement the project

(ii) „Beta‟ method

ENPV = -2000 + 525.80 (4.452)

Page 89 of 126
 = -2000 + 2340.86
= $340.86
**Implement the project.

6.4.3 Use of Measures of central tendency and Variability

Variance is divergence from mean of particular values. If we look at variance project, and
project X has a smaller variance than Y , we reject project Y whose variance about the
mean is larger. Thus we need to select projects whose variance is so close to the mean.

It can be observed that although the mean is the same, variability is different implying
risks are high.

Measures of central tendency

(ii) The arithmetic mean is the sum of the values in the data given divided by the
number of observations


 X for the population X   x for sample
N n
(iii) Median is the value of the middle item when all the values are arranged in ascending
or descending order
(iv) The mode is the value which occurs most frequently in a set of values. We can talk
of a distribution being unimodal (one mode), Bimodal (two) or Multimodal (if more
than two)

For a situation of normal distribution, the mean, median and mode take the same value as
in (i) below. If the distribution is not normal, then the three measures will be different as
in (ii) and (iii).

Page 90 of 126
   median  mod e Median
Median

Mode  
 Mode

(ii) Positively skewed (iii) Negatively skewed

(i) Normal

Measures of Variability
(a) The range
This is the difference between the highest and lowest value of values not arranged in
frequency distribution. That is, R = H – L
(b) Variance

 2

 ( X  ) 2

: Population s 2

 (x  X ) 2

: sample
N n 1
(c) Standard deviation
( X  )2 (x  X )2
 : population s
N n 1

Standard deviation helps to establish some variations around the mean. It is the most
important measure of dispersion used in statistical inference

Page 91 of 126
Numerical Example
A firm is considering whether or not to purchase a second hand machine from a sample
of 12. The estimates of annual operating costs in hundreds of Kshs. are given as below

No. Cost (X) XX ( X  X )2

(00) ( X  20)
1 21 1 1
2 10 -10 100
3 16 -4 16
4 23 3 9
5 21 1 1
6 14 -6 36
7 30 10 100
8 18 -2 4
9 27 7 49
10 20 0 0
11 7 -13 169
12 33 13 169
  240 (X  X ) 0 (X  X ) 2
 654

240
X   20
12

s 2

(X  X ) 2


654
 59.5
n 1 11

s  s 2  59.5  7.7

Therefore: X  2000; s  770

x XX
z 
 s

28000  2000
Where X = 2800, then z   1.04
770

Page 92 of 126
  0 z =1.04

The assumption made is that the distribution of costs is normal and that we have a
standard deviation of 1.04 from the mean. Since the highest observation is 2770 then it is
inside the area (< 2800) the decision is to accept the purchase of the machine, it is
economical.

Statistically:     68%   2  95%

68%

95%

The Central Limit Theorem

As sample size increases (>30), the sampling distribution of the mean approaches the
normal distribution irrespective of the distribution of the population. The sample means
vary from sample to sample. For any given sample size, n, taken from a population with
mean, μ, the values of the sample mean will vary from sample to sample. This variability
serves as a basis for sampling distribution. The sampling distribution of the mean is
determined by the expected value of the mean

E( X )  

x 
n
The standard deviation from the mean indicates the accuracy of the sample mean as a
point estimator. It is referred to as the standard error of the mean

Page 93 of 126
 
n

X
E (X )  
Confidence Interval
A confidence interval for the mean is an estimate interval constructed from the mean by
which the probability that the interval includes the value of the population mean can be
specified. The degree of confidence indicates the percentage that such intervals would
include the parameters being estimated.

Confidence interval for the sample mean: X  Z X

Z(Number of deviation units Proportion of area in the Percentage

from the mean) interval   Z X
1.65 0.90 90%
1.96 0.95 95%
2.58 0.99 99%

If the mean becomes higher while the variability decreases, the project can be considered
for selection purposes. However, as the mean decreases and variability increases, this is a
situation of risk and uncertainty
A (preferred due to B (less risky)
less variability)
A (more risky
than B)
B

A' B A

Page 94 of 126
When we introduce risk premium, project A becomes more acceptable for planning
purposes (mean of A will move from A to A ' ). Greater variability makes a project more
risky.

6.4.4. Sensitivity Analysis (SA)

(a) Definition
This is the process of changing values of selected valuables in the Cost Benefit Analysis
in order to determine the effects of Net Present Value or internal rate of return. It
therefore involves considering of the effect on IRR, NPV of plausible variations in some
of the assumptions made.

The purposes of SA are;

 Improving understanding of the nature and workings of the project
 Increasing expected NPV by improving the design of the project
 Reducing risk by suggesting precautions to be taken
 Indicating areas needing more investigation to improve knowledge.

Sensitivity Analysis shows how the value of the criterion (normally NPV and IRR)
changes with changes in the value of any variable in the Discount cash flow analysis
(DCF). It may be expressed either as the absolute change in NPV (or the IRR) divided by
a given percentage or a given absolute change in the variable which seems more
appropriate.
dNPV
Sensitivity may be expressed as X where X is the chosen value of the variable.
dX

For instance, the variable might be price of the output and sensitivity analysis will then
record that a 10% change in the assumed price would make a difference of, say, 1 million
shillings to the NPV. OR if the IRR is being used as a criterion, it would record that a
10% change in assumed price would make a difference of say, 1 percentage point to the
IRR.

The most useful way is to record what absolute or percentage change is required in any
figure or sets of figures, to make NPV zero. This we may say, it will take a halving of
the price to make the NPV zero.

The value of a variable which makes the NPV zero is known as a switching value or
cross-over value. As the assumed value of the variable passes through this absolute
value, the decision (if it depends solely on the chosen criterion) is switched from YES to

Page 95 of 126
NO or vise versa. It follows from this definition that the IRR is the switching value of the
ARI (Average return on investment).

Switching value tests are often helpful in providing a better understanding of the critical
elements on which the outcome of the project depends. They may:-

 Focus attention on the variables for which further effort should be made to form
up the estimates and narrow down the range of uncertainty.

 Also aid the management of the project by indicating critical areas that require
close supervision to ensure the expected favourable return to the economy.

(b) The Uses of Sensitivity Analysis

1. Shows how marginal a project is
If a very small percentage change in the quantity or price of an input or output
wipes out the positive NPV then the project is clearly marginal. It is useful to
indicate the marginality of the project even if it is risk-free.
2. Illustrating risk and the need for further work
It can be used to illustrate the risk ness of a project. If NPV is sensitive the
project is clearly risky. Sensitivity analysis may be useful in suggesting how care
should be devoted to making estimates.
3. In dealing with unqualified values.
The device of a switching value is essentially an attempt to get the decision maker
to put a value on something in the context of a project, which he is not willing to
value in a void.
4. The IRR as a function of the shadow wage.
One can give the IRRs corresponding to levels of shadow wages within some
sensible range. The combination of a low shadow wage and a conventional rate
of return will rule out relatively few projects.

(c) Limitations of SA
1. Sensitivity Analysis does not show the combined net effect of changes in all
variables or
2. The likelihood of various changes occurring together.

Risk analysis or probability analysis can throw light on the above limitations by:-
- Specifying probabilities for the several values that may be attained by each variable
in project analysis as well as how changes in one variable are correlated with changes

Page 96 of 126
 in the others. The resulting probability distribution of NPV (or IRR) gives the
decision maker a better picture of the degree of risk involved in the project than the
one given by a single value calculation. Risk analysis however, does nothing to
diminish the risks themselves.

6.5 Topic Summary

- Risk situation is one in which we know the probability that the benefit or cost will
take on particular values i.e. probability distribution is known. In such a situation we
use expected values for in CBA
- The Cost of Risk Bearing (a risk premium) is introduced to adjust the NPV.
- In cases where we cannot measure risk by attaching probabilities measures of central
tendency and variability are used to guide decision making.
- Certainty equivalent (CE) is the certain outcome held to be equivalent to an
investment with an uncertain outcome.
- Option value is the price people are willing to pay for an assurance (an option) that
the good in question will be available (at a predetermined price) if they want it. It
exists as long as individuals are risk-averse. The assurance is equivalent to the
removal of the risk of the commodity not being available.
- Uncertainty situation is a context in which we know the values that the costs and
benefits could take but we do not know the probabilities attached to the sizes of these
costs or benefits
- The analyst under uncertainty can make decisions based on various criteria; Maximax
criterion, Maximin criterion, Index of Pessimism criterion, Laplace Criterion and
Minimax Regret criterion. Each of these criteria has its own strengths and
weaknesses.
- Sensitivity analysis considers the effect on IRR and NPV of plausible variations in
some of the assumptions made. It involves changing values of selected valuables in
the Cost Benefit Analysis

Concepts to remember
- Risk
- Certainty equivalent
- Beta distribution
- Maximax criterion
- Criterion
- Uncertainty
- Expected Values
- The Arrow-Lind Theorem
- Maximin criterion
- Minimax Regret criterion
- Cost of Risk Bearing
- Triangular distribution
- Option value
- Index of Pessimism
- Sensitivity Analysis

Page 97 of 126
 6.6 Work to Do

1. Use the following pay off matrix to explain the decision making criteria appropriate to uncertainty
as listed below the matrix

N 1 2 3 4
S
1 2 2 0 0
2 1 1 1 1
3 0 4 0 0
4 0 3 0 0
(i) The wald criterion
(ii) The minimax regret criterion
(iii) The index of pessimism criterion

2. Assume that you are a planning officer with a local NGO. You are asked to evaluate a five year
agricultural project where the yield is sensitive to rainfall and operating costs depend on the
performance of a new agricultural harvesting machine. You are supplied with the following
information;
 The initial cost of the project is Ksh.30000
 The price of the output is fixed for the next five years at ksh.100 per ton
 The expected annual rainfall and yields are described by the following

Rainfall (mm) Probability (%) Yield (tons)

50 5 300
150 10 700
300 25 800
500 30 1200
700 15 900
850 10 400
1000 5 200

Annual operating costs are expected to be Ksh. 5000 but the machine supplier has indicated that
depending on the machines performance; these might be as low as Ksh. 2000 per annum or as high as
Ksh. 8000. Assuming no salvage value after five years and a discount rate of 5 per cent per annum
show how you would evaluate this project and reach a decision

Page 98 of 126
6.7 Further Reading

Ray, A. 1984. Cost-Benefit Analysis. Issues and Methodologies. Baltimore: John Hopkins
university press.

Squire, L. and H.G. Vander TAK.1975.Economic Analysis of projects. Baltimore: John

Hopkins

Terry Lucey .(2002) Quantitative Techniques. 6th edition South Western

Page 99 of 126
 TOPIC SEVEN

SOCIAL COST BENEFIT ANALYSIS

Introduction

In topic seven we studied the financial appraisal of investment projects. As we noted this
is capable of only assessing achievement of private objectives, therefore can only be
used to appraise private projects. To evaluate public projects social costs and benefits
are relevant. The costs and benefits must therefore be converted to their economic values
and the impact of the project on savings, income distribution, and merit wants are also
assessed. The concern in this topic is to study the two major approaches in Social Cost
Benefit analysis; UNIDO and LM approaches. The departure between the two in terms
of shadow pricing is analyzed.

7.1 Topic objectives

By the end of the topic the student should be able to;

- Explain the rational for SCBA
- State the similarities and differences between the UNIDO and LM approaches of
SCBA
- Describe the differences in shadow pricing for different resources under UNIDO
and LM approaches
- Use SCBA to appraise a project

7.2. Definition and rationale for SCBA

Social Cost Benefit Analysis is referred to as economic analysis of projects and is used
mostly to evaluate public investments. Here we use shadow prices. It focuses on social

Page 100 of 126

costs and benefits of the project which often differ from monetary costs and benefits.
The principle sources of the discrepancy are:
 Market imperfections
 Externalities
 Taxes
 Concern for redistribution
 Merit wants

(a) Market imperfections

Where there are imperfections, market prices do not reflect social values. The market
imperfections found in developing countries are:
 Rationing involving control over prices and distribution of a good
 Prescription of minimum wage rates
 Foreign exchange regulation

(b) Externalities
A project may have:
 Beneficial external effects, for example, it may create infrastructural facilities like
roads which benefit the neighbouring areas.
 Harmful external effects like environmental pollution.
In SCBA, such benefits and harmful effects are considered, although they are ignored in
assessing the monetary benefits and costs of the project because they do not receive any
monetary compensation from those who enjoy or incur it or are affected by these external
benefits and costs.

Externalities are relevant in SCBA because in such analysis all costs and benefits,
irrespective to whom they accrue and whether they are paid for or not, are relevant.

(c) Taxes and subsidies (transfers)

Taxes are monetary costs and subsidies are monetary gains. From the social point of
view, taxes and subsidies are regarded as transfer payments and hence considered
irrelevant.

(d) Concern for savings

The division between consumption and savings is relevant from the social point of view
due to scarcity of capital. A shilling of benefits saved is deemed more valuable than a
shilling of benefits consumed. The concern of the society for savings and investment is
reflected in SCBA where a higher valuation is placed on savings and a lower valuation is
put on consumption.

Page 101 of 126

(e) Concern for redistribution
The society is concerned about the distribution of benefits across different groups. A
shilling going to the poor section is considered more valuable than a shilling of benefit
going to the affluent section.

(f) Merit wants

These are goods and preferences that are not expressed in the market place, but believed
to be in the larger interest of the society. For example, the government may prefer to
promote adult education program or a balanced nutrition program for school-going
children even though these are not sought by consumers in the market place.

(g) Sunk costs

Before carrying out a project, some streams of costs have to be incurred. For example,
costs incurred for experimentation and on infrastructure, hence there is series of sunk
costs which don‟t appear in financial analysis but do in economic analysis

7.3. UNIDO Approach to SCBA

The approach involves five stages:-
(i) Calculation of financial profitability of the project measured at market prices
(already done)
(ii) Obtaining the net benefits of project measured in terms of economic (efficiency)
prices
(iii) Adjustment for the impact of the project on savings and investment
(iv) Adjustment for the impact of the project on income distribution
(v) Adjustment for the impact of project on merits goods and demerits goods whose
social values differ from their economic values.

Stage 2: Net Benefit of a project in terms of economic (Efficiency) prices

Economic/Efficiency prices are also referred to as shadow prices. Market prices
represent shadow prices only under conditions of perfect markets. Where there are
imperfect markets, there is a need to develop shadow prices and measure net benefits in
terms of these shadow prices. The assumption is that these prices replace market prices
since they are theoretical prices which reflect the scarcity of resources in the economy.

Basic issues on shadow pricing

(a) Choice of numeraire – This is the unit of account in which the value of inputs or
outputs is expressed. The UNIDO numeraire is the present consumption in hands

Page 102 of 126

 of people at the base level consumption in the private sector in terms of constant
price in domestic accounting shillings.

(b) Concept of tradability - For a tradable good, the international price is a measure
of its opportunity cost to the country. This is because it is possible to substitute
import for domestic production and vice versa. Similarly it is possible to
substitute export for domestic consumption and vice versa. Hence the
international price also referred to as the border price or world price represents the
real value of the good in terms of economic efficiency.

(c) Sources of shadow prices - This depends on the impact of the project on national
economy.
These sources include:-
(i) Increase or decrease in total consumption in the economy. If the impact of the
project is on consumption, the basis of shadow pricing is consumers‟
willingness to pay.
(ii) Decrease or increase in production. If the impact of the project is on production,
the basis of shadow pricing is the cost of production.
(iii) Decrease or increase in imports. In this case the basis of shadow pricing is the
foreign exchange value
(iv) Decrease or increase in exports. The basis of shadow pricing is the foreign
exchange value.

(d) Taxes
(i) When a project results in diversion of non-traded inputs which are in fixed supply
from other producers or addition to non-traded consumer goods, taxes should be
included.
(ii) When a project augments domestic production by other producers, taxes should
be excluded
(iii) For fully traded goods, taxes should be ignored

Page 103 of 126

(e) Consumer willingness to pay
Price
S
A

P* E

0
Q* Quantity

The consumer who buys the first unit is willing to pay OA for that unit, and the consumer
who buys the last unit is willing to pay OP* for that unit. The willingness to pay is
indicated by AE. Hence the total willingness to pay by consumers who buy the product
is measured by the area OAEQ*. The price paid by them is however OP*EQ*. Hence the
difference AEP* is the consumer surplus.

UNIDO Shadow pricing of specific Resources

1. Tradable inputs and outputs

A good is fully traded when an increase in its consumption results in a corresponding

increase in import or decrease in export or when an increase in its production results in a
corresponding increase in export or decrease in import. The shadow price is the border
price, translated in domestic currency at the market exchange rate.

For imported goods the conditions to be fulfilled are:

(i) If there is an import quota, it is not restrictive
(ii) The import supply is perfectly elastic over the relevant range of import volume.
(iii) There is no surplus capacity in the domestic industry, all additional supply must be
imported

Page 104 of 126

(iv) If the additional demand exists inland, the imported goods, even after taking into
account the cost of transport from the point of entry to the point of inland demand,
costs less than the marginal cost of local production.
(v) The imported input costs less than the domestic marginal cost of purchase

2. Non-tradable inputs and outputs

A good is non-tradable when the following conditions are satisfied;
(i) Its import price CCIF (price) is greater than its domestic cost of production
(ii) Its export price (FOB) is less than its domestic cost of production.

Valuation of non-tradable – Output side

- If the impact of the project is to increase the consumption of the product in the
economy, the measure of value is the marginal consumer‟s willingness to pay.
- If the impact of the project is to substitute other production of the same non-tradable,
the measure of value is the saving in cost of production.

Valuation of non-tradable – input side

- If the impact of the project is to reduce availability of the input to other users, their
willingness to pay for that input represents social value
- If the projects input requirement is met by additional production of it, the production
cost of it is the measure of social value.

3. Externalities
This is a good with the following characteristics
(i) It is not deliberately created by the project but is an incidental outcome of
legitimate economic activity.
(ii) It is beyond the control of the persons who are affected by it, for better or for
worse
(iii) It is not traded in the market place

Example
 Building an approach road may improve the transport system in the area.
 Location of an airport may raise noise level considerably

They must be taken into account whenever it is possible to do so. Even if these effects
cannot be measured in monetary terms, some qualitative evaluation must be attempted.

The value of external effects is difficult to determine because they are often intangible in
nature and there is no market price which can be used as a starting point. Their value is

Page 105 of 126

estimated therefore by indirect means. For example, the value of better transport
provided by the approach road may be estimated in terms of increased activities and
benefit derived thereby.

4. Labour Inputs
1. When a project takes labour away from other employments, the shadow price of
Labour is equal to what other users of labour are willing to pay this labour, i.e. the
shadow price is equal to marginal product of labour.

2. When a project induces the production of new workers, the social cost associated
with it consists of the following:-
(i) The marginal product of the worker in the previous employment. This would
be zero if the worker was previously unemployed.
(ii) The value assigned by the worker on the leisure that he may have to forgo as a
result of employment in the project – the value of this leisure is reflected in
the reservation wage.
(iii) The additional consumption of food when a worker is fully employed as
opposed to when he is idle or only partly employed.
(iv) The cost of transport and rehabilitation when a worker is moved from the
location to another
(v) The increased consumption by the workers and its negative impact on savings
and investment in the society when the worker is paid market wage rate by the
project
(vi) The cost of training a worker to improve his skills.

3. When the project imports foreign workers, labour is valued at the wage they
command. A premium is added on account of foreign exchange remitted abroad by
these workers from their savings

5. Capital Inputs
Two things happen when a capital investment is made
a. Financial resources are converted into physical assets
b. Financial resources are withdrawn from the national pool of savings and hence
alternative projects are foregone.
- For physical asset which is fully traded, its shadow price is equal to its border price. If
it is non-traded good, its price is measured in terms of cost of production (if it induces
additional domestic production) or consumer willingness to pay if the project takes
the asset from other users

Page 106 of 126

- If capital is generated through additional savings, its opportunity cost is measured by
the consumption rate of interest which reflects the price the saver must be paid to
sacrifice present consumption
- If capital is generated from due denial of capital to alternative projects, its opportunity
cost is the rate of return that would be earned from those alternative projects. The
consumption rate of interest is proxied through the internal rate of return of a project

6. Foreign Exchange
Identify the foreign exchange impact of the project and adjust by an appropriate premium
to domestic currency. Valuation of inputs and outputs that were measured in border
shillings has to be adjusted upward to reflect the shadow price of foreign exchange.

The shadow price of foreign exchange is determined 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. This is equal to;
n

FQ P
i 1
i i i

Where Fi = fraction of foreign exchange at the margin, spent on importing

Commodity i
Qi = quantity of commodity i that can be bought with one unit of foreign
exchange (i.e 1 divided by the CIF value of the good).
Pi = domestic market clearing price of commodity i

Example

Commodities 1, 2, 3 and 4 are imported at the margin. The proportion of foreign

exchange spent on them, the quantities that can be bought per unit of foreign exchange,
and the domestic clearing price are as follows:-
F1  0.3 F2  0.4 F3  0.2 F4  0.1
Q1  0.6 Q2  1.5 Q3  0.25 Q4  3.0
P1  16 P2  8 P3  40 P4  5

The value of a unit of foreign exchange is

= (0.3) (0.6) (16) + (0.4) (1.5) (8) + (0.2) (0.25) (40) + (0.1) (3.0) (5)

= Ksh. 13.180

Page 107 of 126

Programming approach and domestic resource cost method can be used to determine the
value of foreign exchange. According to the programming approach, the shadow price of
foreign exchange is obtained by solving the dual problem of an economy – wide
optimizing mathematical programming model. In the primal model, one of the
constraints represents limited foreign exchange availability. Hence the shadow price
represents the contribution that a unit of foreign exchange at the margin would make to
the objective function.

Example – Bridge Project

The government is considering construction of a bridge over the river. It is estimated that
after the bridge is constructed, 250,000 persons will cross the river on the bridge. The
bridge is expected to cost Ksh. 3 million initially and its annual maintenance cost would
be Ksh. 10,000. It has an indefinitely long life. Once the bridge is constructed, the ferry
operator is expected to close down the ferry service and sell the ferry boats for Ksh.
100,000. The ferry operator charges Ksh. 3 per person. It costs him Ksh. 2 per person.
50,000 persons use the ferry service.

Required: - Define the social cost and benefits of constructing the bridge assuming that
the monetary figures given in the problem are economic values.
Costs
1. Construction cost - Ksh. 3,000,000
2. Maintenance cost - Ksh. 10,000 (annually)

Benefits
1. Value of ferries released – Ksh. 100,000
2. Savings in the cost of ferry operation – Ksh. 100,000
3. Increase in consumer satisfaction. This is equal to willingness to pay of 200,000
additional persons who are expected to use the bridge.

Since the first additional person is willing to pay Ksh. 3 and the last person is willing to
pay nothing (no toll for using the bridge), The average willingness to pay of additional
users, assuming that the demand schedule is linear is Ksh. 1.50, so the willingness to pay
of 200,000 additional persons is 200,000 x 1.50 = Ksh. 300,000.

Page 108 of 126

 Kshs.

0
50 150 250 000’s of Users

Consumer willingness to pay = ½ bh

= ½ x 200,000 x 3

= Ksh. 300,000

7. UNIDO Measurement of the Impact on distribution

The UNIDO approach seeks to identify income gains and losses by the project, other
private business, government workers, consumers and external sector. The gain or loss to
an individual group is equal to the difference between the shadow price and the market
price of each input or output in the case of physical resources or the difference between
the price paid and the value received in the case of financial transaction.

Example
A mining project requires 1,000 labourers. These labourers are prepared to offer
themselves for work at a daily wage rate of Ksh. 4. The wage rate paid to the labourers
however is Ksh. 10 per day. The redistribution benefit enjoyed by the group of 1,000
labourers is Ksh. 1000 x (10-4) = 6,000 per day.

Page 109 of 126

Stage 3: Impact of project on saving and investment

The savings impact of a project is given as  Y MPS

i i

Where Yi  change in income of group i as a result of the project

MPS i  Marginal propensity to save of group i

Example
As a result of a project, the income gained/lost by four groups is as follows;
Group 1 = Kshs. 100,000 Group 3 = Kshs. -200,000
Group 2 = Kshs. 500,000 Group 4 = Kshs. -400,000
MPS1 = 0.05 MPS3 = 0.20
MPS2 = 0.10 MPS4 = 0.40

The impact of the project on savings is:

100,000 x 0.05 + 500,000 x 0.10 - 200,000 x 0.20 - 400,000 x 0.40

= Ksh. 145,000

7.1 Value of Savings

The value of a shilling of savings is the present value of the additional consumption
stream produced when that shilling of savings is invested at the margin. The additional
stream of consumption generated by a shilling of investment depends on the marginal
productivity of capital and the rate of reinvestment from additional income.

If the marginal productivity of capital is (r) and the rate of reinvestment from additional
income (a), the additional stream of consumption generated by a shilling of investment
can be worked out as:-

Year 0 1 2 3 ------ n______

Investment 1 1 + ar (1 + ar)2 - (1 + ar)n
Cumulative
Income 0 r r(1 + ar) r(1 + ar)2 r(1 + ar)n-1
Additional
Investment - ar ar(1 + ar) ar(1 + ar)2 ar(1 + ar)n-1

Consumption - r(1 - a) r(1 – a)(1 + ar) r(1-a)(1 + ar)2 r(1-a)(1+ar)n-1

Page 110 of 126

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 ί is:-

r (1  a)
n 1
r (1  a) r (1  a)(1  ar ) r (1  a)(1  ar ) (1  i ) r (1  r )
I    
(1  i ) (1  i ) 2
(1  i ) n (1  ar ) i  ar
1
(1  i)
I = Social value of a shilling of savings (investment)
r = Marginal productivity of capital
a = Reinvestment rate on additional income rising from investment
ί = Social discount rate

The social value of saving also called the shadow price of investment, for certain values
of r, a and i are given below:

Shadow Price of Investment

ί = 0.08 ί = 0.10 ί= 0.12

r = 0.10 a = 0.20 1.33 1.00 0.80

a = 0.30 1.40 1.00 0.77
a = 0.40 1.50 1.00 0.75
a = 0.50 1.67 1.00 0.71

r = 0.12 a = 0.20 1.72 1.26 1.00

a = 0.30 1.91 1.31 1.00
a = 0.40 2.25 1.38 1.00
a = 0.50 3.00 1.50 1.00

r = 0.15 a = 0.20 2.40 1.71 1.33

a = 0.30 3.00 1.91 1.40
a = 0.40 4.50 2.25 1.50
a = 0.50 15.00 3.00 1.67

The formula for the social value of savings is valid when the following conditions are
satisfied.
- The marginal productivity of capital and the reinvestment rate on additional
income (marginal propensity to save) are constant over time.
- Savings rate in the society will not become optima in the foreseeable future.

Page 111 of 126

Stage 4: Income Distribution Impact
Redistribution of income in favour of the poor is a socially desirable objective. Apart
from redistributing income through tax, subsidy and government transfer measures,
investment projects are also used for this purpose. This calls for weighing the net gain or
loss by each group to reflect the relative value of income for different groups and
summing them.

The UNIDO guidelines suggest that weights may be determined by an iterative process
involving interaction between the analyst and the planners.

7.2 Illustration
In the shadow price of investment, let NPV of the project be Ksh. 2million and income
gain to low income group as a result of the project be Ksh. 5 million. If this project is
accepted by the planners, it implies that the planners place a premium of at least 40 per
cent on income going to the poor.

This procedure works well if only two groups are involved (poor and others). Where
more than two groups are involved, a single factor known as the elasticity of marginal
utility of income is used. This is defined as the rate at which the marginal utility of
income falls with increase in the level of income.

For example, if the marginal utility of income declines by 5 per cent with a 5 per cent
increase in income, the elasticity of marginal utility of income is

5 per cent
 1
5 per cent

This implies that a 1 per cent increase in the income of a person earning Ksh. 1000 a year
is socially as valuable as a 1 per cent increase in the income of a person earning Ksh.
10,000 a year. Therefore, from a social point of view the following gains are equally
valuable.
- A gain of Ksh. 10 to a person earning Ksh. 1000 a year
- A gain of Ksh. 100 to a person earning Ksh. 10,000 a year
- A gain of Ksh. 1000 to a person earning Ksh. 100,000 a year

This implies that if the weight at Ksh. 1000 is put at 1, the weight at Ksh. 10,000 is 1/10
and the weight at Ksh. 100,000 is 1/100. In general the weight attached to an income is
given as

Page 112 of 126

 n
b 
wi    Where: wi = Weight attached to income at c i level
 ci 
b = base level of income that has a weight of 1
n = elasticity of the marginal utility of income

7.3 Illustration
Relative weights for different levels of income for values of n varying between 0 and 1

______________________Value of n_______________
Level of income 0.2 0.4 0.6 0.8 1.0__
500 1.15 1.32 1.52 1.74 2.00
1,000 1.00 1.00 1.00 1.00 1.00
5,000 0.72 0.53 0.38 0.28 0.20

Stage 5: Adjustments for Merits Goods

A merit good is one for which the social value exceeds the economic value. For example,
a country may place a higher social value than economic value on production of oil
because it reduces dependency on foreign supplies. This concept can be extended to
include a socially desirable outcome like creation of employment. In the absence of the
project, the government would pay unemployment compensation or provide mere make-
work jobs. In case of demerit goods, the social value of the good is less than its economic
value. For example, alcoholic products have less social value than economic value.

The procedure for adjusting the difference between the social and economic value is:-
(i) Estimate the economic value
(ii) Calculate the adjustment factor as the difference between the ratio of social value
to economic value and unity
(iii) Multiply the economic value by the adjustment factor to obtain the adjustment
(iv) Add the adjustment to the net present value of the projected

Example

Consider a project for which the following information is available.

(i) The present economic value of the output of the project is Ksh. 25 million
(ii) The output of the project has social value which exceeds its economic value by 20
per cent

Page 113 of 126

 120%
The adjustment factor =  1  0.2 0
100%

Multiply the present economic value by 0.2, an adjustment of 5 million is got (0.2 x 25).
This 5 million is added to the present economic value of Ksh. 25 million to give Ksh. 30
million.

Limitations
(i) Once the analyst begins to make adjustments for social reasons, projects which
are undesirable economically may be made to appear attractive after such
adjustments.
(ii) Easy to push through projects on political grounds rather than economic or social
grounds.

7.4 Little - Mirrlees (LM) Approach

7.4.1 Similarities between LM and UNIDO

(i) Calculating accounting (shadow) prices particularly for foreign exchange savings
and unskilled labour
(ii) Considering the factor of equity and
(iii) Use of discounted cash flow analysis (DCF)

7.4.2 Differences between LM and UNIDO

a. The UNIDO approach measures costs and benefits in terms of domestic shilling
whereas the LM approach measures costs and benefits in terms of international prices
i.e. border price.
b. The UNIDO approach measures costs and benefits in terms of consumption whereas
LM approach measures costs and benefits in terms of uncommitted social income.
c. The stage-by-stage analysis recommended by the UNIDO approach focuses on
efficiency, savings and redistribution considerations in different stages. LM
approach, however, tends to view these considerations together.

Page 114 of 126

7.4.3 Shadow Prices

(a) Shadow price of traded good is simply its border price.

Exports
If a good is exported its shadow price is its FOB price. If foreign demand is not perfectly
elastic the marginal export revenue is substituted for the FOB price.
Imports
If a good is imported its shadow price is CIF price. If foreign supply is not perfectly
elastic, the marginal import cost is substituted for the CIF price.

The logic for using border prices for traded goods is that border prices represent the
correct social opportunity costs or benefits of using or producing a traded good.

(b) Accounting/shadow price of non-traded goods

 These are goods and services that are not amenable to foreign trade. Hence there
is no border price observable for them. They include land, building,
transportation and electricity. The accounting prices are defined in terms of
marginal social cost and marginal social benefits.
 Marginal social cost of a good is the value in terms of shadow prices of the
resources required to produce an extra unit of the good. For example, the
marginal social cost of a bus trip is equal to the cost of material inputs (fuel, oil,
wear and tear of the bus, etc), evaluated at border prices plus the social wage of
the driver and the conductor.
 The marginal social benefit is the value of an extra unit of the good from the
social point of view. When a good is not taxed and consumed by only one
income group, its marginal social benefit is equal to its market price multiplied by
a factor which represents the value assigned to an increase in the income of that
group vis-a -vis an equal increase in uncommitted social income.

To determine the shadow price of a non-traded input, one should estimate the proportion
in which the demand for that input will be met from increased production and decreased
consumption elsewhere in the economy. If the proportion of increase in production to
decrease in consumption is say 2:1, the accounting price of the non-traded input will be;
2 1
M arg inal social Cost  M arg inal social benefit
3 3

Page 115 of 126

7.4.4 Use of conversation Factors
LM suggests that the monetary cost of a non- traded item be broken down into tradable,
labour, and residual components. The tradable and residual components may be
converted into social cost by applying suitable social conversation factors (SCF) since the
calculation of marginal social cost and marginal social benefit is difficult. The labour
components social cost can be obtained by using social wage rate.

Shadow wage rate is a function of:

(i) The marginal productivity of labour
(ii) The cost associated with urbanization (cost of transport, urban overheads etc.) and
(iii) The cost of having an additional amount committed to consumption when the
consumption of worker increases as a result of the higher income he enjoys in
urban employment.
1
Thus SWR  C ' (C  m)
S
Where; SWR = Shadow wage rate
C ' = additional resources devoted to consumption
1
= Value of a unit of committed resource
S
C = Consumption of the wage earner
m = Marginal product of the wage earner

This can be rewritten as:-

 1
SWR  m  (C 'C )  1  (C  m)
 S

The first term m, is the marginal product of labour.

(C1 – C) = the cost of urbanization i.e. cost associated with providing the
consumption level of C
 1
1  (C  m) = the cost of having an additional amount (C – M) committed
 S
to consumption
1= the value of a unit of uncommitted resource
1
= the value of a unit of committed resource
S

Page 116 of 126

7.4.5 Criticisms of LM Approach
1. Use of world prices is best only when the economy is open e.g. if a good has a
restricted access to world market it would be improper to use the border prices.
Also excess capacity may mean that arise in demand is unlikely to influence the
trade balance. To solve this, the approach assumes full capacity
2. Determination of world prices is cumbersome but LM advocates for the use of the
marginal export revenue and marginal import costs to estimate world prices.
3. Does not consider linkages and externalities. Assume that public projects would
affect trade only and not domestic activities.
4. Assume that the government will always follow optimal and sensible economic
policies
5. Don‟t highlight the problems of inequalities in income distribution
6. Evaluation of non traded BS in terms of world prices causes both
conceptualization and practical difficulties

Page 117 of 126

7.5 Topic Summary

 Social Cost Benefit Analysis (SCBA) is referred to as economic analysis of projects.

It is mostly used to evaluate public investments. Contrary to financial appraisal that
uses market prices to measure costs and benefits, SCBA uses shadow prices.
 It focuses on social costs and benefits of the project which often differ from monetary
costs and benefits because of existence of; market imperfections, externalities, taxes,
concerns for redistribution and merit wants.
 SCBA involves five stages; (i) Calculation of financial profitability of the project
measured at market prices (ii) Obtaining the net benefits of project measured in terms
of economic (efficiency) prices (iii) Adjustment for the impact of the project on
savings and investment (iv) Adjustment for the impact of the project on income
distribution (v) Adjustment for the impact of project on merits goods and demerits
goods whose social values differ from their economic values.
 The two approaches of conducting SCBA are the UNIDO approach and the Little-
Mirrlees (LM) approaches.
 The basic difference between the two approaches lies in shadow pricing and
measurement of costs and benefits.
 The UNIDO approach measures costs and benefits in terms of consumption whereas
LM approach measures costs and benefits in terms of uncommitted social income.
 The UNIDO approach measures costs and benefits in terms of domestic shilling
whereas the LM approach measures costs and benefits in terms of international prices
i.e. border price.
 We have also noted that the UNIDO approach proceeds stage-by-stage with analysis
focusing on efficiency, savings and redistribution considerations in different stages.
However, the LM approach tends to view these considerations together.
 Economic appraisal of industrial projects considers three aspects; Economic Rate of
Return, Effective Rate of Protection and Domestic Resource Cost

Important Concepts
- Shadow costs - merit wants - Willingness to pay
- Tradability - externality - Border price

Page 118 of 126

7.6 Work to do

You work for an international NGO and you have the following information at your disposal

Good Units Domestic price Accounting

Imported/Exported per unit ration
Tea (export) 2000 200 1.00
Coffee (export) 500 250 1.00
Machinery (Import) 750 400 0.75
Perfumes (Import) 300 200 0.50
Pagers (Import) 250 100 0.80

The official exchange rate (OER) is $1 = Ksh.100

Required
(a) calculate the border price of foreign exchange equivalent for each good expressed in
domestic currency
(b) The total value of exports minus imports at border prices expressed in
 foreign currency
 Domestic currency
(c) The shadow exchange rate (SER) for the economy
(d) The total value of export minus imports using domestic consumption as a numeraire
(e) The summary conversion factor and interpret it.

Page 119 of 126

7.7 Further reading

Little, I.M.D. and J.A. Mirrlees (1982) Project Appraisal and Planning for Development
countries. London: Heinemann Educational Books.

U.N.I.D.O. 1972. Guidelines for Project Evaluation. New York: United Nations.

Irvin G. 1978. Modern Cost-Benefit Methods. London: Macmillan.

Mishan, E. J. 1975. Cost-Benefit Analysis, An informal Introduction (Revision Edition).

London: George Allen & Unwin ltd.

Page 120 of 126

 TOPIC EIGHT
QUALITATIVE APPRAISAL OF PROJECTS

Introduction

In the previous section we have assumed that project appraisal is based on its
quantitative (Measurable) components. However, there is a host of qualitative
considerations that are made in order to accept or reject a project. In this topic we are
going to look at some of the important qualitative aspects that are considered in project
choice for an organization.

8.1 Topic Objective

By the end of the topic the student should be able to;

- Explain the qualitative factors, strategic aspects and organizational
considerations that may affect project choice

8.2 Qualitative Factors

These are the non measurable factors that are important in project decision making. They
include the following;

(a) Intuition
This refers to good judgement and is the subconscious integration of all the experiences
conditioning, and knowledge of a lifetime, including the emotional and cultural biases of
that life time to make a decision.

Page 121 of 126

(b) Vision
The vision of the leaders serves as a super ordinate goal and influences the investment
decisions directly and indirectly. E.g. IBM = Value Added Leadership position

(c) Superstition
Many businessmen all over the world consult astrologers or depend on some other
superstitions counsel. Astrologers and psychologists have argued that magical rites and
superstitions behaviour make the world look more deterministic and instill confidence in
our ability to manage it. This helps in:-
(i) Relieving anxiety
(ii) Imparting a sense of control
(iii) Encouraging necessary activity

The more unpredictable or uncertain the future appears to be, the greater may be the
psychological urge to rely on superstitions.

(d) Politics
Mutual loyalties among people belonging to the same faction may lead to acceptance of
otherwise marginal or even sub-marginal projects. On the other hand, negative feeling
among people belonging to different faction may lead to rejection of otherwise promising
projects. Therefore, internal political game can mar the quality of decision making and
investment proposals may not be viewed in an unbiased and objective manner.

(e) Sponsorship
Facts and projections about a project may be secondary in importance if the questions
asked by the top management are:
- Who is the sponsor?
- What is his/her commitment to the project?
- What is his/her track record?
- Will he/she be able to surmount obstacles on the way and deliver the goods?

(f) Intangible Benefits

They can not be translated into monetary terms and yet they are relevant and cannot be
ignored in investment decision making. These benefits include:-
(i) Increasing flexibility available to the organization
(ii) Improving the attractiveness of the product
(iii) Giving organization a sense of pride
(iv) Making work environment more pleasing
(v) Strengthening the technological capacity of the firm

Page 122 of 126

 (vi) Enhancing the morale of the firm

8.3 Strategic Aspects

There is need to strengthen the links between corporate strategy and investment project
process. In this case the following ought to be done:-
(i) Long range planning should precede capital budgeting
(ii) Long-range plans should be formalized and communicated to all persons involved
in the process of capital budgeting.
(iii) During the capital budgeting exercise, investment proposals should be viewed in
the contest of the critical premise of long range plans.

To determine whether a project is worthwhile or not, strategic factors, financial pay off
and intangible benefits may be combined as shown below:-

An approach to decision making

No
Consistency
with strategy

Yes

Yes
Accept Positive NPV Reject

No

Yes Significant No
intangibles

The key guidelines underlying this approach are:

(i) In a decision involving measurement as well as judgement, separate the
quantifiable and intangible factors
(ii) Don‟t rely exclusively on measurable factors and spurious over-quantification.

Page 123 of 126

Mistakes committed in Financial Analysis
(i) Mechanical projection of cash flows – projection for incorporating the effects of
factors like competition, technical change, inflation which is a difficult task.
(ii) Optimistic Bias in cash flows – profitability is overstated because the initial
investment is understated and operating cash flows exaggerated. The reasons for
optimistic bias are:-
- International overstatement
- Lack of experience
- Capital rationing
- Myopic euphoria
(iii) Emphasis on IRR – IRR is biased against long lived capital – intensive projects
which may be of greater strategic significance to the firm
(iv) Inconsistent Treatment of Inflation in DCF analysis discriminates against long
lived projects which may have substantially positive NPVs.
(v) Unreasonably high discount rates due to:-
- lack of familiarity by the management with what the normal returns in the capital
market are
- premiums asked for risk that can be easily diversified away
- required returns are raised to compensate for the optimism of project sponsors

8.4 Organizational Considerations

Capital budgeting must satisfy the following conditions

(a) Compatibility
It must be compatible with the resource of the firm i.e. financial capacity and managerial
capability
(i) Financial capacity = operating cash flow – fixed funding requirement + potential
funding sources
(ii) Operating cash flow = profit after tax + depreciation + other non-cash charges –
increase in working capital (or + decrease in WC)
(iii) Fixed Funding Requirement = Debt Repayment Obligation + preference capital
repayment obligation + preference dividend + normal equity dividend
(iv) Potential Funding sources = excess cash balance -saleable fixed assets + reserve
borrowing capacity + new equity issue.
(v) Managerial capability = Management must be competent

(b) Controllability
It must be controllable – since the business environment is continually changing and
evolving. Sound controls must be instituted and these are:

Page 124 of 126

 (i) the base level spending and expansion investments should be segregated
(ii) sound profitability criteria should be applied to expansion investments
(iii) projects included in the capital budget should be thoroughly reviewed prior to
actual implementation
(iv) major projects should be divided into sub-phases for purposes of controlling
expenditures
(v) actual costs must be periodically compared against planned costs

(c) Endorsement
It must be endorsed by the executive management at all stages: long-range planning;
funds planning, planning to strengthen managerial capabilities and rectify organizational
imbalances and development of budgetary controls. Endorsement means:
(i) Conviction in long range strategy of the firm
(ii) Strong desire to implement the approved project
(iii) Willingness to be subjected to the discipline of capital budgeting.

8.5 Topic Summary

 Qualitative factors such are intuition, Vision, superstition, politics, sponsorship and
intangible benefits are not directly measurable in monetary terms but have great
influence in project decision making
 Strategic aspects of an organization which are defined in the long term plans often
prepared before capital budgeting form a basis of assessing projects. During the
capital budgeting exercise, investment proposals should be viewed in the contest of
the critical premise of long range plans.
 Organizational considerations such as compatibility of the projects budget with the
resource of the firm i.e. financial capacity and managerial capability are also
considered.
 The capital budget must be controllable and must be endorsed by the executive
management at all stages

Page 125 of 126

8.6 Work to do

Consider a development organization of your own choice. Conduct an analysis of the

qualitative aspects that guide project decisions

8.7 Further Reading

Chandra, P .2005. Projects planning, analysis, financing, implementation and review.

New Delhi: Tata McGraw-Hill publishing company limited

Haynes, M. E, 1996. Project management, a practical guide for success, revised

edition. California, Crisp publication, Inc.

Page 126 of 126