Chapter One

Development Project Concepts

1. Definition of Project

Project is defined as:

• A project is an undertaking to accomplish a specific objective or
goal, which requires resources and effort, and which is unique
(i.e. it is a non repetitive activity

• A project is a well-defined adhoc activity with clear and specific

objective; and has beginning and end dates. It requires
allocation of resources and it should be completed on schedule
and within budget with specified quality standards.
• A project is a planned undertaking of interrelated and
coordinated activities designed to achieve certain specific
objectives within a given budget and period of time
• A set of proposals for investment of resources into a clearly
defined set of actions that are expected to produce future
benefits that exceeds costs.

• An endeavor to accomplish a specific objective through a unique

set of interrelated tasks and the effective utilization of resource.
(Jack Gido).
• A combination of human and non – human resources pooled
together in a temporary organization to achieve a specific
purpose.
2. Characteristics of a Project
Despite differences in project definition, the following few
characteristics are usually common to all projects.

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The key features of a project are as follows:
• A project has a specific objective – an expected result or
product. The objective of a project is usually defined in terms of
scope, schedule and cost
• A project is expected to meet measures of quality and customer
satisfaction
• A project requires various resource such as people,
organizations and materials, equipment and facilities
• A project has a schedule and takes place within predefined time
scales
• A project requires a budget to plan for cost and resource
allocations
• A project is a unique undertaking. It may be unique because it
has never been attempted before (e.g. the channel tunnel) or
because of unique customer satisfactions (e.g. building factory
or developing a new product)
• A project has a customer. This customer provides the funds for
the completion of the project and may be an individual, a group
of people or an organization
• A project will involve some degree of uncertainty. The
combination of unique tasks, various resources and
assumptions about those resources and time scales will,
inevitably cause a degree of uncertainty in how and when the
project objective will be achieved
Some examples of projects
Planning a wedding
Building a house
Designing and implementing a computer system
Hosting a conference
Rebuilding a city after an earth quake

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 Hosting a dinners party
Designing and implementing a saving and credit scheme
Designing and implementing a new loan product
The term project has a wide variety of uses ranging from single
purpose, relatively well defined structures, such as small
infrastructure projects, to complex multi component systems, such as
integrated rural and area development schemes.

Projects may be categorized in various ways according to their

objectives (e.g. social development, economic growth) or by sectors
(e.g. nutrition, transport, agriculture) number of purposes (single vs.
multiple), etc.

Another major classification of projects is based on the type of

relationship a project has with other objectives. Categories under this
classification are as follows:
• Independent projects – those that can be implemented without
precluding the implementation of other projects
• Mutually exclusive projects – those which when implemented
preclude the implementation of other projects (e.g., single unit
vs. apartment building) and
• Complementary projects – those that require implementation of
other projects to attain certain development objectives (e, g.
component projects of an integrated area development package).

3. Factors constraining Project Success

The successful accomplishment of the project objective usually
constrained by four factors: Scope, cost, schedule, and customer
satisfaction.

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a) Scope: The scope of a project – also known as the project scope or
the customer scope-is all the work that must be done in order to
satisfy the customer. In order to achieve the objectives of the project,
it is necessary to accurately estimate the scope of the project- extent
of work to be accomplished.
b) Cost: The cost of project is the amount the customer has agreed to
pay or estimate of costs of resources to be used for acceptable project
deliverables.
c) Schedule: The Schedule for a project is the timetable that specifies
when each activity should start and finish.
The objective of any project is to complete the scope within budget by
a certain time to the customer’s satisfaction. To help assure the
achievement of this objective, it is important to develop a plan before
the start of the project; this plan should include all the work tasks,
associated costs, and estimates of the time necessary to complete them.
The lack of such a plan increases the risk of failing to accomplish the
full project scope within budget and on schedule.

4. The Project Management Process

Succinctly, the project management process means planning the work
and then working the plan, that is, process of first establishing a plan
and then implementing that plan to accomplish the project objective.
1. Clearly define the project objective: The definition must be
agreed upon by the customer and the individual or organization
who will perform the project.
2. Divide and subdivide the project scope into major “pieces,” or
work packages.
3. Define the specific activities that need to be performed for each
work package in order to accomplish the project objective.

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 4. Make a time estimate for how long it will take to complete each
activity. It is also necessary to determine which types of
resources and how many of each resource are needed for each
activity to be completed within the estimated duration.
5. Make a cost estimate for each activity. The cost is based on the
types and quantities of resources required for each activity.
6. Calculate a project schedule and budget to determine whether
the project can be completed within the require time, with the
allotted funds, and with the available resource. If not,
adjustments must be made to the project scope, activity time
estimates, or resource assignments until an achievable, realistic
baseline plan (a roadmap for accomplishing the project scope
on time and within budget) can be established.

Once a baseline plan has been established, it must be implemented.

This involves performing the work according to the plan and
controlling the work so that the project scope is achieved within the
budget and schedule, to the customer’s satisfaction.

5. National Development Planning & Project Analysis

National planning is the mechanism by which governments set up
their proprieties, objectives and demonstrates their intension. Project
analysis and national development planning are closely related;
• The best economic appraisal of projects cannot be made
without referring to such plans and policies of the country
• a sound plan requires a great deal of knowledge about existing
and potential projects. The more elaborate the plans and policies of
the government, the easier becomes the work of the project planner. It
is obvious that the successful formulation and implementation of a

5
national development plan depends on the proper selection of projects
and on the consequent sector programs.

6. Role of Project Managers

A project manager integrates and coordinates all the contributions,
and guides them to successfully complete the project.
a) Responsibilities of the Project Manager
The project manager has primary responsibility for providing
leadership in planning, organizing, and controlling the work effort to
accomplish the project objective. In other words, the project manager
provides the leadership to the project team to accomplish the project
objective.
i) Planning: The project manager clearly defines the project objectives
and reaches agreement with the customer on this objective

ii) Organizing: Organizing involves securing the appropriate resources

such as capital, material and human resources to perform the work.
The project manager also assign responsibility and delegates authority
to specific individuals or subcontractors for the various tasks.
iii) Controlling: Project team members monitor the progress of their
assigned tasks and regularly provide data on progress, schedule, and
costs. If actual progress falls behind planned progress or unexpected
events occur, the project manager takes immediate action

The project manager plays the leadership role in planning, organizing,

and controlling the project but does not try to do it alone. She or he
involves the project team in these functions to gain their commitment to
successful completion of the project.

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b) Skills of the Project Manager
The project manager is a key ingredient in the success of a project. In
addition to providing leadership in planning, organizing, and
controlling the project, the manager should possess a set of skills that
will both inspire the project ream to succeed and win the confidence
of they customer. Effective project managers have strong leadership
ability, the ability to develop people, excellent communication skills,
good interpersonal skills, the ability to handle stress, problem – solving
skills, and time management skills.

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End of chapter activities

1. Define project using your own word.

2. Short list some projects
3. What are the characteristics of a project?
4. What are the factors that affect success of a project? Explain how
these affect its success
5. What is the relationship between national development Planning
and project? Show how the
6. Success/ failure of a project affect national development Planning?

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 Chapter Two
Project Life Cycle
As indicated above projects can be distinguished in many respects
taking into consideration their sector, purpose, relationships, etc.
Projects likewise differ in objectives, scope, target clientele or
beneficiaries, organizational structure etc. Regardless of their
differences, however, all projects are subject to a similar process. All
undergo a salient transition from inception to maturity that is referred
to us “Project Development cycle”.

The various stages through which a project passes from

inception to completion is called the project Cycle.
The major stages and phases of project development, the nature of the
cycle and its management, and the interrelationships governing them
are discussed below.
Project development is a cycle of activity, which runs through the
following principal phases; the process is a cycle because each phase
of analysis develops from preceding ones and in turn leads into
subsequent phases of investigation
Project Cycle Models
There are various models that deal with the project cycle:
United Nations Industrial Development Organization (UNIDO) Model.
BAMU’S project cycle (BAUM’s model, 1978)
Integrated Project Planning and Management cycle (IPPMC) model.
S.choidhury’s model
MDF model
Visitask – Project life cycle model
Global knowledge Apprach.

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 1. UNIDO’S Project cycle Model (UNIDO Model)

1. Pre – investment phases

3. Operation
Phases -Opportunity Study
-Perfectibility Study’
-Feasibility Study
-Appraisal
- Expansion and
Innovation
- Replacement and
Rehabilitation
- Commissioning
and Startup

- Negotiation and
Contracting
- Engineering
Design
- Construction
- Pre Production
marketing
- Recruitment and
training

2. Investment Phases

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UNIDO gives emphasis to industrial projects. It is more practical than
conceptual. It identifies three phases:

The difference between the three stages is the level of resource

commitment. The pre – investment (which includes identification, pre –
selection, preparation, support studies and appraisal) is generally the
study stage, where the project has to pass through different levels of
refinement so as to increase the level of information about the project
feasibility. The investment phase is the stage where the project
initiator/owner gets convinced by the feasibility of the project and
decides to commit some resources in expectation of high return more
than the cost. Under this stage the project would be transformed from
paper work into actual practical implementation activities. The last
stage is the stage at which the project starts to give the
production/service to the beneficiaries
A) Pre – Investment Phases
The pre – investment (which includes identification, pre – selection,
preparation, support studies and appraisal) is generally the study
stage, where the project has to pass through different levels of
refinement so as to increase the level of information about the project
feasibility.

i) Identification or opportunity study: The Identification phase is

one of identifying the problems, which need to be addressed, and
analyzing the ways in which they can be addressed. This would
include, for example:
• Analysis of existing situation
• Problems needs identification
• Prioritization of ideas
• Selection of a project idea

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 • Definition of the project idea
• Consultation with stake holders
• Establishment of overall objectives
Opportunity study involves analysis of the following:
• Natural resources with potential for processing and
manufacture; such as timber for wood based industries, ground
and surface water and uncultivated arable land for agricultural
and rural development projects.
• The existing agricultural pattern that serve as a basis for agro –
based industries.
• Future demand for certain consumer goods that have growth
potential as a result of increased population or purchasing
power of for newly developed goods such as synthetic fabrics or
domestic electrical products.
• Imports, in order to identify areas for import substitution.
• Environmental import
• Manufacturing sector successful in other countries with similar
economic background and level of development, capital, labor
and natural resources.
• Possible inter – linkage with other industries, indigenous or
transactional.
• Possible extension of existing lines of manufacture backward or
forward integration, linking for example, a downstream
petrochemical industry with a refinery; or an electric – are steel
plant with a steel rolling mill or a textile factory encouraging
cotton growers and garment factory.
• The general investment environment
• Availability and cost of production factors
• Export possibilities.

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Note the following:
1. Opportunity studies are rather sketchy in nature and rely more on
aggregate estimates than detail analysis. Cost data are usually taken
from comparable existing projects and not from quotations of sources
such as equipment suppliers (for industrial projects) and cost of
production of commercial farms (for agricultural projects
2. Project ideas may be:
Resource based: Stem from the opportunity to make profitable use of
available resource
Market based: Arise from an identified demand in home or overseas
market.
Need based: To make available to all people in an area where minimal
amounts of certain basic material requirements and services exist
ii) Pre-feasibility study (preliminary project selection and
definition)
The project idea must be elaborated in a more detailed study.
However, formulation of a feasibility study that enables a definite
decision to be made on the project is costly and time – consuming
task. Therefore, before assigning larger funds for such a study,
further assessment of the project might be made in a pre – feasibility
study.
A pre-feasibility should be viewed as an intermediate stage between a
project opportunity study and a detailed feasibility study, the difference
being in the degree of detail ness of the information obtained and the
intensity with which project alternatives are discussed. The structure
of a pre – feasibility study should be the same as that a detailed
feasibility studies.

iii)Project Preparation (Project formulation).

Project preparation is the stage at which over all feasibility of an
identified project is established thereby making it (if found feasible)

13
ready for appraisal and financing. It is thus interchangeably used
with the term “feasibility study”. Basically it involves the investigation
of the market, technical, financial, economic and operational viability
of the project.
• Specifically the feasibility study looks in to the alternative
technical schemes of attaining the project objectives including possible
size, location, production process, and physical resource requirements.
The study also determines whether the project would generate
sufficient benefits to offset estimated investment and operating costs.
• Similarly, it ascertains which, if any, of the alternative would
yield the largest positive returns to the economy that would justify the
allocation of resources to it.
• Finally, project preparation seeks the most suitable legal,
administrative and organization arrangements to ensure that
implementation would proceed as planned and that completed
facilities would be properly maintained and operated

iv) Appraisal and Decision

The appraisal/audit phase involves a systematic review of all aspects

of the project in order that a decision can be made as to whether to
proceed. The following questions are often the subject of an appraisal
report on the basis of which a series of decisions may be made. These
could involve discarding the project or alternation of some of the
plans.
Technical: Is the project design appropriate and will the project work
as expected?
Financial: Has proper provision been made to cover the financial
requirements and obligations of the project? Is the financing planned
adequate? Are the financial aspects of the project beneficial to the

14
different actors and beneficiaries involved with the project? If the
project is commercial how will the necessary inputs be obtained and
(where relevant) how will the output be sold?
Economic: Is the project advantageous from the point of view of the
economy as a whole?
Social: Is the project both advantageous and acceptable to the people
affected by it?
Institutional: Are there suitable organizations in place to implement
and manage the project? Is the legal framework appropriate?
Environmental: Have the environmental impacts of the project been
properly considered?
Sustainable: Will the project be sustainable in the long term both
financially and institutionally?
B. Investment Phases
The investment phase is the stage where the project initiator/owner
gets convinced by the feasibility of the project and decides to commit
some resources in expectation of high return more than the cost.
Under this stage the project would be transformed from paper work
into actual practical implementation activities. It includes:
Project and engineering design:
Design of buildings and other facilities that include time
scheduling, site prospecting and probing, preparation of blue prints,
detailed plant engineering and a final selection of technology and
equipment.
Negotiation and Contracting:
Defines the legal obligations in respect to project financing,
acquisition of technology, construction of building and services, and
supply of machinery and equipment for the operation phase. It also
requires negotiation with equipment and machinery suppliers and
collaborators and contracting with architects and contractors.
Construction:

15
It includes actual construction of building, installation of machinery
and manpower. It involves site preparation, construction of building
and other civil workers together with the erection and installation of
equipment in accordance with proper programming and scheduling.
Recruitment and Training of Workers:
It includes local and abroad recruitment and training of workers for
the smooth running of operation. It should proceed simultaneously
with the construction stage and it may prove relevant to the rapid
growth of productivity and efficiency.
Commissioning and Start up:
It requires handover of the building to project sponsor or promoter.
Start up (delivery stage) is brief but technically critical span in project
development. Its success indicates the effectiveness of the planning
and execution of the project.

C. Operation or Implementation Phases

A project reaches its operational stage after the investments have been
made, i.e. after the physical structure has been constructed or the plan has
been installed in the case of the infrastructure projects, and or the
development services have been completed; in other words when the
expected project benefits start being generated . The problems of the
operational phase need to be considered both from long and short –
term viewpoint. This is the phase where actual commissioning and
start – up activities are started. The Implementation phase is one of actually
performing the project and ensuring that the objectives are met and the out puts
made. This include:
Mobilization of resources for each task and objectives
Project marketing
Ongoing monitoring and reporting arrangement
Identifying problems
Addressing failures
Modification of the planned results and project objectives as appropriate

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17
End of Chapter Activities
1. What does Project life cycle mean?
2. Explain each Phase of the cycle
2. By taking construction of your residential house,
a) short list the series of activities from its idea generation up
to implementation
b) Classify the activities as Identification, preparation,
appraisal, implementation, and evaluation,

3. What is the difference between identification and Pre-feasibility

study?

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 Chapter three
Project Identifications

Introduction
The first phase of the project life cycle involves the identification of a
need, problem or opportunity and can result in customer’s
requesting proposals from individuals, project team or organizations
(contractors) to address the identified needs or solve the problem.

Example: A couple who need a new house may spend time identifying
requirements for the house size, style, number of rooms, location,
maximum amount they want to spend, and date by which they would
like to move – in (Jack P.8)

Need may be identified formally or informally during a meeting or

discussion among a group of individuals (Jack).

Phases of Project Identification

There are four key phases of project identification. These are:

Actual Project Identification: The generation of project ideas by formal

and informal institutions and individuals.

Description of Project Idea: An actual written description of the project

idea or concept, summarizing the main elements of the proposed project
to use in the screening raking and prioritization of project ideas.

Screening: An initial review of project ideas and concepts to see if they

should be advanced or abandoned at an early stage.

Prioritization: The tanking and selection of projects against a set of

criteria to identify the “best projects to move actively into the designed
stage and development.

19
At identification stage an initial screening of project idea will take
place, with some projects ideas being abandoned as impractical or of
a low propriety. A prelude to the full blown feasibility study, these
exercise is meant to assess:

• Whether the project is prima facie worthwhile to justify a

feasibility study, and
• What aspects of the project are critical to its viability and hence
warrant an in – depth investigation.
I. Identification of Public Projects
How to come up with a project before grasping to project preparation?
Usually there are two major levels where project ideas are originate:
the macro and micro level.
1. Macro level, Project ideas emanate from, among others:
• National, sector or regional plans,
• Unusual events such as droughts, floods, earthquakes, etc
• Multilateral or bilateral development agencies,
• Regional or international agreements in which a country
participates, etc
2. Micro level project ideas can emerge from;
• Existence of unused or under utilized natural and human
resources and the perception of opportunities for their efficient
use.
• Identification of unsatisfied demand or needs
• Need to remove shortage in essential materials, services, or
facilities that constrain the development effort etc
During identification the analyst should eliminate project
proposals that:
• Are technically unsound and risky
• Have no market for the output

20
 • Have inadequate supply of inputs
• Are very costly in relation to benefits
• Assume over ambitious sales and profitability, etc.

As a result, some of the project alternatives will be rejected and those

the are promising will be advanced to the next stage called project
preparation.
3. Project Concepts and Profiles
Once a project idea has been conceived, the next stage is to describe
the idea so that it can be prioritized and move on to the next stage in
the process. This may involve the preparation of a project
identification report or project concept or profile. Whenever it is
developed it is essential to have a clear idea of what the proposed
project is supported to be and what are hopes to achieve. It should
include answers to the questions given in the following box.

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Questions and Project Profile or Concept
Justification and Purpose
• What goal is the project contributing to?
• What is the purpose of the project, what does it intend to
achieve?
• What problem is the project addressing?
• What is the justification of the project?
• What demands, needs or opportunities is the project
addressing?
Beneficiaries and Stakeholders Best regards,
• What will benefit from the project?
• Who has a share or s take in the project?
• How have project beneficiaries and other stakeholders
participated in the identification of the project?
• Which institutions are the targets of the project?
Resource and Institutions
• What potential resources may be available for implementing the
project?
• Which organizations are to be involved in project planning and
implementations?
Policies and Plans
• How does the project proposal fit into any sector or regional
plans?
• Does the project fit into current policies?
Impacts
• What are the likely major positive and negative social impacts of
the project?
• What are the likely positive and negative environmental impacts
of the project?

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Support
• What is the level of political and administrative support for the
project?
• Does the project have the support of beneficiaries and/or local
communities?
Risks
• What are the chances of the project achieving its objective?
• What are the main risks associated with the project?
• What assumptions have been made, e.g., what support is
needed for others?

4. Prioritization & Ranking

The limited resources available mean that effective project
identification and selection at various levels will be essential. There
will be more ideas for potential projects than resources available.
Potential criteria for ranking projects are given in the box below.

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Examples of Criteria for Ranking Project
Extent
• Number of people and Geographic area affected by the project-
More people affected means the project will be given more
weight
Economic and Financial
• Potential financial and economic benefits to the country or
region and individuals.
Environmental; Impact of the project on
• Conservation of natural resources and more sustainable land
use
• Protection of natural resources (e.g., forests)
Social;
• Contribution of the project to Poverty alleviation and Assistance
to disadvantage groups
Policy Is the project in line with national policies
Resources;
Availability of human resources to implement project
• Likely availability of funding from government, etc
Success or Failures;
• What are the chance of the project successfully meeting its
objectives?, What degrees of the risks are associated with the
project that may affect its implementation?
Support
• Political support for project
• Community support and demand for project.

During selection process, each project can be assessed against each of

the criteria to give a rating. At this stage of the project cycle this more

24
likely to be qualitative than quantitative. Certain criteria can be given
greater weighting to reflect the importance of the criteria in
determining the overall rank of the project.
II. Identification of Commercial Project Ideas
The following are undertaken when ideas are identified for commercial
or industrial projects
1. Generation of Ideas
2. Monitoring the Environment
3. Corporate Appraisal
4. Scouting for Project Ideas
5. Preliminary Screening
6. Project Rating Index

1. Generation of Ideas
SWOT Analysis: This represents a conscious, deliberate, and
systematic effort by an organization to identify opportunities, that can
be profitability exploited by it. Periodic SWOT analysis facilitates the
generation of ideas.
Clear Articulation of objective: A clear articulation and prioritization
of objectives helps in channeling the effort of employees and prods
them to think more imaginatively.
Fostering a conducive climate: To tape the creativity of people and
harness their entrepreneurial urges, a conducive organizational
climate has to be fostered.

2. Monitoring the Environment

Basically a promising investment idea enables a firm (or entrepreneur)
to exploit opportunities in the environment by drawing on its
competitive strengths. Hence, the firm must systematically monitor of
environment and assesses its competitive abilities. The important

25
aspects studied in monitoring the key sectors of the environment are
as follows:
Economic Sector : State of the economy, Overall rate of growth,
cyclical fluctuations, Inflation rate, linkage with the world economy,
Trade surplus/deficits, balance of payment situation
Governmental Sector: Industrial policy, government programmes
and projects tax framework, subsidies, incentives, and concessions,
import and export policies, Financing norms, lending conditions of
financial institutions and commercial banks
Technological Sector: Emergences of new technology, access to
technical know-how, receptiveness on the part of industry
Socio-Demographic Sector; Population trends, age shifts in
population, Income distribution, educational profile, attitude toward
consumption and investment
Competition Sector: Number of firms in the industry and the market
share of the top few (four or five); entry barriers; comparison with
substitutes in terms of quality, price, appeal, and functional
performance; marketing policies and practices
Supplier Sector; Availability and cost of raw materials and sub –
assemblies; availability and cost of energy; etc

3. Corporate Appraisal (analysis of internal situation of the firm)

A realistic appraisal of corporate strengths and weaknesses is
essential for identifying investment opportunities which can be
profitably exploited. The broad areas of corporate appraisal and the
important aspects to be considered under them are as follows:
4. Scouting for Project Ideas
Good project ideas – the key to success are elusive so a wide variety of
sources should tapped to identify them. Here are some suggestions in
this regard.

26
a. Analyze the Performance of existing Industries: A study of
existing industries in terms of their profitability and capacity
utilization is helpful. This may indicate promising investment
opportunities – opportunities which are profitable and risk – free.
b. Examine Inputs and Output of Various Industries: Investment
opportunities exist when:
Materials, purchased parts, or supplies are presently being procured
from distance sources with attendant time lag and transaction cost,

Several firms produce internally some components/parts which can

be supplied at a lower cost by a single manufacturer who can enjoy
economies of scale.
c. Review Imports and Exports: An examination of export statistics
is useful in learning about export possibilities of various products.
d. Study plan outlays and Governmental Guidelines: Government’s
proposed outlays in different sectors provide useful pointers toward
investment opportunities. They indicate potential demand for goods
and services required by different sectors.
e. Investigate availability of Local materials & Resources: A search
for project ideas may begin with an investigation into local resources
and skills.
f. Analyze Economic and Social Trends: A study of economic and
social trends is helpful in projecting demand for various goods and
services. Changing economic conditions and consumer preferences
provide new business opportunities.
g. Study New Technological Development: New product or new
process and technologies for existing products developed by research
laboratories may be examined for profitable commercialization.

27
5. Preliminary Screening
By using the suggestions made in previous sections, it is possible to
develop a long list of project ideas. Some kind of preliminary
screening is required to eliminate ideas which prima facie are not
promising. For this purpose, the following aspects may be looked
into:
Compatibility with the promoter: The ideas must be compatible with
the interest, personality, and resources of entrepreneur.
Consistency with government Proprieties: The project idea must be
feasible given the national goals and governmental regulatory
framework.
Availability of Inputs: The resources and inputs required for the
project must be reasonably assured.
Adequacy of the Market: The size of the present market must offer
the prospect of adequate sales volume. Further, there should be a
potential for growth and reasonable return on investment. To judge
the adequacy of the market the following factors have to be examined.
 Total present domestic market
 Competitors and their market share
 Export market
 Qualify – price profile of the product vis-à-vis competitive
products.
 Sales and distribution system
 Projected increase in consumption
 Barriers to the entry of new units
Reasonableness of Costs: The cost structure of proposed project
must enable it to realize an acceptable profit with a competitive price.
The following should be examined in this regard:

Cost of material inputs

Labor cost

28

Factory overheads

General administration expense

Selling and distribution costs

Services costs

Economics of sale
Acceptability of Risk Level: The desirability of a project is critically
dependent on the risk characterizing it. In the assessment of risk – a
difficult task, indeed – the following factors should be considered:
Vulnerability of business cycle
Technological changes
Competition from substitutes
Competition from imports
Governmental control over price and distribution.
6. Project Rating Index
When a firm evaluates a large number of project ideas regularly, it
may be helpful streamline the process of preliminary screening. For
this purpose, a preliminary evaluation may be translated into a
project rating index. The steps involved in determining the project
rating index are as follows:
1. Identify factors relevant for project rating
2. Assign weights to these factors (the weights are supposed to
reflect their relative importance).
3. Rate the project proposal on various factors, using a suitable
rating scale (Typically a 5 – point scale or a 7 – point scale is
used for this purpose.)
4. For each factor multiply the factor rating with the factor weight
to get the factor score.
5. Add all the factor scores to get the overall project rating index.
The following table illustrates the determination of the project rating
index. Once the project rating index is determined, it is compared

29
with a pre – determined hurdle value to judge whether the project is
prima facie worthwhile or not.

Construction of a Rating Index

Factors Factor Rating (Step 3 &4) Factor
(Step 1 Weight VG G A P NP Score
(Step) 5 4 3 2 1 (Step 5)
Input availability 0.25 ♦ 0.75
Technical Know-how 0.10 ♦ 0.40
Reasonableness of cost 0.05 ♦ 0.20
Adequacy of market 0.15 ♦ 0.75
Complementary relationship
With other products 0.15 ♦ 0.20
Stability 0.10 ♦ 0.40
Dependence on firm’s
Strength 0.20 ♦ 1.00
Consistency with
Governmental priorities 0.10 ♦ 0.30
1.00 Rating Index 4.00

30
End of Chapter Activities
1. By studying your working environment, generate and identify
one development project one from each both demand and
supply side by providing brief justification,.
2. What is the difference between public and Commercial projects?
3. Who identify public projects?
4. Identify any five public or development projects relevant for
your kebele.
5. Once a project is conceived, the next stage is to describe the
idea so that it can move to the next stage in the process. What
questions should be answered in order to prioritize project idea?
6. Why ranking of projects is important?
7. What criteria do you use to rank projects?
8. What is the concept of project ranking index?
9. What are the steps of project Ranking Index?
10 Generate three development project ideas that are catering to
your environment’s social problems with brief justification.
Accordingly:
a. Set a factor/criteria that enables you to select one best
project idea
b. Assign factor weights our of 100%
c. Set your minimum cut-off/hurdle rate for accepting or
rejecting the project
d. Using the preliminary rating index, rate the alternative
project ideas
e. Rank the projects and decide/ select one best idea with
brief explanation.
10. How do you scout commercial project?

31
 Chapter Four
Project Preparation (Formulation)

4.1. General Introduction

If project is believed to be viable during identification and pre –
feasibility studies, it enters into feasibility study stage. The feasibility
study should provide you all data necessary for an investment
decision. Market, technical and institutional, commercial
profitability, social cost benefit analysis and etc are prerequisite for an
investment project. Therefore, these should be defined and critically
examined on the basis of alternative solutions already reviewed in the
pre – feasibility study.
In this chapter the multifaceted project feasibility study: technical,
institutional, financial, economic, social etc studies will be discussed,
after a brief introduction of pre – feasibility study.
4Feasibility Study (analysis)
What is Feasibility Analysis?
As the name implies, a feasibility study is an analysis of the viability
of an idea. A feasible business venture is one where the business will
generate adequate cash-flow and profits, withstand the risks it will
encounter, remain viable in the long-term and meet the goals of the
founders
Feasibility Study Outline
A Feasibility Study Outline is provided to give you guidance on how to
proceed with the study and what to include.
The content/outline of feasibility study includes:
• Technical feasibility
• Economic Feasibility

32
 • Financial Feasibility
• Cultural Feasibility
• Social Feasibility
• Safety Feasibility
• Political Feasibility
• Environmental Feasibility
• Market Feasibility
• Institutional Feasibility
1. Technical Feasibility
Technical feasibility refers to the ability of the process to take
advantage of the current state of the technology in pursuing further
improvement. The technical capability of the personnel as well as the
capability of the available technology should be considered. Technology
transfer between geographical areas and cultures needs to be
analyzed to understand productivity loss (or gain) due to differences
(see cultural feasibility)
Analysis of the technical and engineering aspects of a project needs to
be done continually when a project is formulated. Technical analysis
seeks to determine whether the prerequisites for the successful
commissioning of the project have been considered and reasonably
good choices have been made with respect to local, size, process, etc.
Summary of technical Analysis is discussed below
1. Determine facility needs.
Plant capacity (also referred to as production capacity) refers to the
volume or number of units that can be manufactured during a given
period. Several factors have a bearing on the capacity decision.
• Technological requirement
• Input constraints
• Investment cost
• Market conditions

33
 • Resources of the firm
• Government policy
a. Technological requirement
For many industrial projects, particularly in process type industries,
there is a certain minimum economic size determined by the
technological factor. For example, a cement plant should have a
capacity of at least 300 tones per day in order to use the rotary kiln
method; otherwise, it has to employ the vertical shaft method which is
suitable for lower capacity.
b. Input constraints
In a developing country like Ethiopia, there may be constraints on the
availability of certain inputs. Power supply may be limited; basic raw
materials may be scarce; foreign exchange available for imports may
be inadequate. Constraints of these kinds should be borne in mind
while choosing the plant capacity.
c. Investment cost
When serious input constraints do not obtain, the relationship
between capacity and investment cost is an important consideration.
Typically, the investment cost per unit of capacity decreases as the
plant capacity increases. This relationship may be expressed as
follows:
C1= C2 (Q1/Q2)α
Where
C1 = derived cost for Q1 units of capacity
C2 = known cost for Q2 units of capacity
α = a factor reflecting capacity-cost relationship.
This is usually between 0.2 and 0.9.
Example Suppose the known investment cost for 5,000 units of
capacity for the manufacture of a certain item is Br. 1,000,000. What

34
will be the investment cost for 10,000 units of capacity if the capacity-
cost factor is 0.6?
The derived investment cost for 10,000 units of capacity may be
obtained as follows:
C1= 1,000,000 (10,000/5,000)0.6
d. Market Conditions
• If the market for the product is likely to be very strong, a plant
of higher capacity is preferable.
• If the market is likely to be uncertain, it might be advantageous
to start with a smaller capacity.
• If the market, starting from a small base, is expected to grow
rapidly, the initial capacity may be higher than the initial level
of demand-further additions to capacity may be effected with
the growth of market.
e. Resources of the firm
The resources, managerial and financial, available to a firm define a
limit on its capacity decision. Obviously, a firm cannot choose a scale
of operations beyond its financial resources and managerial
capability.
f. Government policy:
The capacity level may be influenced by the policy of the government.
Traditionally, the policy of the government was to distribute the
additional capacity to be created in a certain industry among several
firms, regardless of economies of scale. This policy has been
substantially modified in recent years and the concept of ‘minimum
economic capacity’ has been adopted in several industries.

2. Determine Suitability of production technology.

Appropriate technology refers to those methods of production which

are suitable to local economic, social, and cultural conditions. The

35
advocates of appropriate technology urge that the technology should
be evaluated in terms of the following questions:
• Whether the technology utilizes local raw materials?
• Whether the technology utilizes local manpower?
• Whether the goods and services produced cater to the basic
needs?
• Whether the technology protects ecological balance?
• Whether the technology is harmonious with social and cultural
conditions?
3. Determine Location and Site
The choice of location and site follows an assessment of demand, size,
and input requirement. Though often used synonymously, the terms
‘location’ and ‘site’ should be distinguished. Location refers to a fairly
broad area like a city, an industrial zone, or a coastal area; site refers
to a specific piece of land where the project would be set up.
The choice of location is influenced by a variety of considerations:
• Proximity to raw materials and markets,
• availability of infrastructure,
• governmental policies, and
• Other factors.
i) Proximity to Raw materials and Markets
An important consideration for location is the proximity to sources of
raw materials and nearness to the market for final products. In terms
of a basic locational model, the optimal location is one where the total
cost (raw material transportation cost plus production cost plus
distribution cost for the final product) is minimized. This generally
implies that: (i) a resource-based project like a cement plant or a steel
mill should be located close to the source of basic material (for
example, limestone in the case of cement plant and iron-ore in the
case of a steel plant); (ii) a project based on imported material may be

36
located near a port; and (iii) a project manufacturing a perishable
product should be close to the center of consumption.
ii) Availability of infrastructure
Availability of power, transportation, water, and communications
should be carefully assessed before a location decision is made.
• Adequate supply of power is a very important condition for
location – insufficient power can be a major constraint,
particularly in the case of an electricity-intensive project like an
aluminum plant. In evaluating power supply the following
should be looked into the quantum of power available, the
stability of power supply, the structure of power tariff, and the
investment required by the project for a tie-up in the network of
the power supplying agency.
• For transporting the inputs of the project and distributing the
outputs of the project, adequate transport connections-whether
by rail, road, sea, inland water, or air-are required. The
availability, reliability, and cost of transportation for various
alternative locations should be assessed.
• Given the plant capacity and the type of technology, the water
requirement for the project can be assessed. Once the required
quantity is estimated, the amount to be drawn from the public
utility system and the amount to be provided by the project
from surface or sub-surface sources may be determined. For
doing this the following factors may be examined: relative costs,
relative depend abilities, and relative qualities.
• In addition to power, transport, and water, the project should
have adequate communication facilities like telephone and
telex.

37
iii) Governmental policies
Governmental policies have a bearing on location. In the case of public
sector projects, location is directly decided by the government. It may be
based on a wider policy for regional dispersion of industries.
In the case of private sector projects, location is influenced by certain
governmental restrictions and inducement. The government may
prohibit the setting up of industrial projects in certain areas which
suffer from urban congestion. More positively, the government offers
inducements for establishing industries in backward areas. These
inducements consist of subsidies, concessional finance, tax relief, and
other benefits.
iv) Other factors
Several other factors have to be assessed before reaching a location
decision: a) ease in coping with environmental pollution, b)labor
situation, c)climatic conditions, and d) general living conditions.
a) Pollution analysis
A project may cause environmental pollution in various ways:
• it may throw gaseous emissions;
• it may produce liquid and solid discharges;
• it may cause noise, heat, and vibrations.
The location study should analyze the costs of mitigating
environmental pollution to tolerable levels at alternative locations.

b)Labor situation
The labor situation at alternative locations may be assessed in terms
of
• the availability of labor, skilled, semi-skilled, and unskilled;
• the past trends in labor rates, the prevailing labor rates, and
the projected labor rates; and

38
 • the state of industrial relations judged in terms of the frequency
and severity of strikes and lockouts and the attitudes of labor
and management.
c) Climate condition
The climatic conditions (like temperature, humidity, wind, sunshine,
rainfall, snowfall, dust, flooding, and earthquakes) have an important
influence on location. They have a bearing on cost as they determine
the extent of air-conditioning, de-humidification, refrigeration, special
drainage, etc., required for the project.

d) General living condition

General living condition, judged in terms of cost of living, housing
situation, and facilities for education, recreation, transport, and
medical cared, need to be assessed at alternative locations.
iv) Site selection
Once the broad location is chosen, attention needs to be focused on
the selection of a specific site. Two to three alternative sites must be
considered and evaluated with respect to cost of land and cost of site
preparation and development.
The cost of land tends to differ from one site to another in the same
broad location. Sites close to a city cost more whereas sites away from
the city cost less. Sites in an industrial are developed by a
governmental agency maybe available at a confessional rate.
The cost of site preparation and development depends on the physical
features of the site, the need to demolish and relocate existing
structures, and the work involved in obtaining utility connections to
the site. The last element, viz., the work involved in obtaining utility
connections and the cost associated with it should be carefully looked
into. It may be noted in this context that the cost of the following may
vary significantly from site to site: power transmission lines from the
main grid, railway siding from the nearest railroad, feeder road

39
connecting with the main road, transport of water, and disposal of
effluents.
2. Market Feasibility
In most cases, the first step in project analysis is to estimate the
potential size of the market for the product proposed to be
manufactured (or service planned to be offered) and get an idea about
the market share that is likely to be captured. Put differently, market
and demand analysis is concerned with two broad issues:
• What is the likely aggregate demand for the product/service?
• What share of the market will the proposed project enjoy?
Market analysis is concerned primarily with two questions :

What would be the aggregate demand of the proposed
product/service in future?

What would be the market share of the projects under
appraisal?
Given the importance of market and demand analysis, it should be
carried out in an orderly and systematic manner. The key steps in
such analysis are as follows:
• Situational analysis and specification of objectives
• Collection of secondary information
• Conduct of market survey
• Characterization of the market
• Demand forecasting
• Market planning some of the main points of these steps are
discussed below
1. Conducting Market survey
The market survey may be a census survey or a sample survey. In a
census survey the entire population is covered. The information
sought in a market survey may relate to one or more of the following:
• Total demand and rate of growth of demand

40
 • Demand in different segments of the market
• Income and price elasticity of demand
• Motives for buying
• Purchasing plans and intentions
• Satisfaction with existing products
• Unsatisfied needs
• Attitudes toward various products
• Distributive trade practices and preferences
• Socio-economic characteristics of buyers
2. Characterization of the Market
Based on the information gathered from secondary sources and
through the market survey, the market for the product/service may
be described in terms of the following:
• Effective demand in the past and present
• Breakdown of demand
• Price
• Methods of distribution and sales promotion
• Consumers
• Supply and competition
B1. Effective demand in the past and present
In a competitive market, effective demand and apparent consumption
are equal. However, in most of the developing countries, where
competitive markets do not exist for a variety of products due to
exchange restrictions and controls on production and distribution,
the figure of apparent consumption may have to be adjusted for
market imperfections. Admittedly, this is often a difficult task.
B2. Breakdown of Demand
To get a deeper insight into the nature of demand, the aggregate (total)
market demand may be broken down into demand for different

41
segments of the market. Market segments may be defined by (i) nature
of product, (ii) consumer group, and (iii) geographical division.
B3. Price
Price statistics must be gathered along with statistics pertaining to
physical quantities. It may be helpful to distinguish the following
types of prices: (i) manufacturer’s price quoted a FOB (Free on board)
price or CIF (cost, insurance, and freight) price, (ii) landed price for
imported goods, (iii) average wholesale price, and (iv) average retail
price.
B4. Methods of distribution and sales promotion
The method of distribution may vary with the nature of product.
Capital goods, industrial raw materials or intermediates, and
consumer products tend to have differing distribution channels.
Further, for a given product, distribution methods may vary. Likewise,
methods used for sales promotion (advertising, discounts, gift
schemes, etc.) may vary from product to product.
The methods of distribution and sales promotion employed presently
and their rationale must be specified. Such a study may explain
certain patterns of consumption and highlight the difficulties that
may be encountered in marketing the proposed products.
B5. Consumers
Consumer may be characterized along two dimensions as follows:

Demographic and Sociological Attitudinal

Age Preferences
Sex Intentions
Income Habits
Profession Attitudes
Residence Responses
Social background

42
B6 Supply and Competition
It is necessary to know the existing sources of supply and whether
they are foreign or domestic. For domestic sources of supply,
information along the following lines may be gathered: location,
present production capacity, planned expansion, capacity utilization
level, bottlenecks in production, and cost structure.
Competition from substitutes and near-substitutes should be
specified because almost any product may be replaced by some other
product as a result of relative changes in price, quality, availability,
promotional effort, and so on.

3. Demand Forecasting
After gathering information about various aspects of the market and
demand from primary and secondary sources, an attempt may be
made to estimate future demand. A wide range of forecasting methods
is available to the market analyst. These may be divided into three
categories:
• Qualitative methods,
• Time series projection methods, and
• Causal methods.
A brief description of these methods follows.
A. Qualitative Methods Demand forecasting
These methods rely essentially on the judgment of experts to translate
qualitative information into quantitative estimates. The important
qualitative methods are as follows.
• Jury of executive opinion method Very popular in practice, this
method calls for the pooling of views of a group of executives on
expected future sales and combining them into a sales estimate.

43
• Delphi method This method involves converting the views of a
group of experts, who do not interact face-to-face, into a forecast
through an iterative process.
B. Time series projection methods of demand
These methods generate forecasts on the basis of an analysis of the
historical time series. The important time series projection methods
are as follows:
• Trend projection method Very popular in practice, the trend
projection method involves extrapolating the past trend onto the
future.
• Exponential smoothing method In exponential smoothing,
forecasts are modified in the light of observed errors.
• Moving average method According to this method, the forecast
for the next period represents a simple arithmetic average or a
weighted average of the last few observations.
C. Casual Methods of Demand frecastig
More analytical than the preceding methods, casual methods seek to
develop forecasts on the basis of cause-effect relationships specified in
an explicit, quantitative manner. The important methods under this
category are as follows:
• Chain ration method A simple analytical approach, this
method calls for applying a series of factors for developing a
demand forecast.
• Consumption level method Useful for a product that is directly
consumed, this method estimates consumption level on the
basis of elasticity coefficients, the important ones being the
income elasticity of demand and the price elasticity of demand.
• End use method Suitable for intermediate products, the end
use method develops demand forecasts on the basis of the
consumption coefficient of the product for various uses.

44
 • Leading indicator method According to this method, observed
changes in leading indicators are used to predict the changes in
lagging variables.
• Econometric method Perhaps the most sophisticated
forecasting tool, the econometric method involves estimating
quantitative relationship derived from economic theory.

3. Managerial Feasibility:
Managerial feasibility involves the capability of the infrastructure of a
process to achieve and sustain process improvement. Management
support, employee involvement, and commitment are key elements
required to ascertain managerial feasibility.
Managerial feasibility include assessment of availability of:

 Sound internal organizational structure of the project,(line of

authority and decision making)
 Competent management and supervisory personnel,
 Adequate technical and skilled personnel,
 Provision of any necessary training facilities,
 Effective channels of communication and good relationships with
contributory agencies, e.g., national research organizations;

4. Economic Feasibility

This involves the feasibility of the proposed project to generate

economic benefits. A benefit – cost analysis and a breakeven
analysis are important aspect of evaluating the economic feasibility of
new industrial projects. The tangible and intangible aspects of a
project should be translated into economic to facilitate a consistent
basis for evaluation.

45
Economic analysis, also referred to as social cost benefit analysis, is
concerned with judging a project from the large social point of view.
The questions sought to be answered in social cost benefit analysis
are:

• What are the direct economic benefits and costs of the project
measured in terms of shadow (efficiency) prices and not in
terms of market prices?

• What would be the impact of the project on the distribution of

income in the society? What is impact on digital divide of the
investment project?

• What would be the contribution of the project towards the

fulfillment of certain merit wants Self – sufficiency, employment,
and social order?
Economic feasibility looks at the net benefits from projects from the
point of view of the nation as a whole in terms of the efficient use of
scarce resources. All resources are relatively scarce, some scarcer
than others, and almost all resources can be used in alternative ways.
So the question is, done this project make the most efficient use
of the resource to be employed?
Under economic analysis, resources are valued in terms of their
opportunity costs. These opportunity costs are valued in terms of a
common unit of account, or yardstick or mummeries; called variously
as shadow prices, economic efficiency prices, economic accounting
price or simply accounting prices. Economic Analysis is presented in
chapter six of this module in detail.

46
5. Financial Feasibility:
Financial feasibility should be distinguished from economic feasibility.
Financial feasibility involves the capability of the project organization
to raise the appropriate funds needed to implement the proposed
project. Loan availability, credit worthiness, equity, and loan
schedule are important aspects of financial feasibility analysis.
Financial analysis seeks to ascertain whether the proposed project
will be financially viable in the sense of being able to meet the burden
of servicing debt and whether the proposed project will satisfy the
return expectations of those the shareholders (owners of the firms).
The aspects which have to looked into while conducting financial
appraisal in ICT projects are:


Investment outlay and cost of project

Means of financing

Cost of capital

Project profitability

Break – even point

Cash flows of the project

Investment worth wholeness judged in terms of various
criteria of merit.

Projected financial position.

Level pf risk
6. Cultural Feasibility
Cultural feasibility deals with the compatibility of the proposed project
with the cultural setup of the project environment. In labor –
intensive projects, planned functions must b e integrated with the
local cultural practices and beliefs. For example, religious beliefs may
influence what an individual is willing to do or not do.

47
7. Social Feasibility
Social feasibility addresses the influences that a proposed project may
have on the social system in the project environment. The ambient
social structure may be such that certain categories of workers may
be in short supply or nonexistent. The effect of the project on the
social status of the project participants must be assessed to ensure
compatibility. It should be recognized that workers in certain
industries may have certain status symbols within the society.
8. Safety Feasibility
Safety feasibility is another important aspect that should be
considered in project planning. Safety feasibility refers to an analysis
of whether the project is capable of being implemented and operated
safely with minimum adverse effects on the environment.
9. Political Feasibility
A political feasible project may be referred to as a “politically correct
project”. Political considerations often dictate direction for a proposed
project. This is particularly true for large projects with national
visibility that may have significant government inputs and political
implications. For example, political necessity may be a source of
support for a project regardless of the project’s merits. On the other
hand, worthy projects may face insurmountable opposition simply
because of political factors. Political feasibility analysis requires an
evaluation of the compatibility of project goals with the prevailing
goals of the political system.
10. Environmental Feasibility
Often a killer of projects through long, drawn-out approval processes
and outright active opposition by those claiming environmental
concerns. This is an aspect worthy of real attention in the very early
stages of a project. Concern must be shown and action must be
taken to address any and all environmental concerns raised or
anticipated.

48
 Generation of Idea

Initial Screening

Is the idea prima facie

promising

No
Yes
Terminate
Plan feasibility
Analysis

Conduct Market Conduct Technical

Analysis Analysis

Conduct Financial
Analysis

Conduct economic
and ecological
analysis

Is the Project
worthwhile

Yes Terminate

Prepare Funding
Proposal

Feasibility Study: A schematic Diagram

49
End of Chapter Activities
1. What do we mean by Project formulation?
2. Briefly explain the following and their content ( explain
what activities are going to be under taken)
• Identification
• Pre-feasibility study
• Feasibility study
3. Define and explain the concept of technical feasibility
4. What are the elements of Technical feasibility? List them
5. What does plant capacity mean? What are the factors that
have a bearing on capacity decision?
6. what does appropriate technology mean? How do you
evaluate the appropriateness of technology?
7. What factors influence location of a project? Explain how
each factor affects its success.
8. Explain what market feasibility means.
9. What primary questions should be considered to evaluate
the market feasibility?
10. what factors or conditions indicate good existence
of demand for products of a project
11. Expalin the concepts of the following
a. Managerial feasibility
b. Social feasibility
c. Ecological feasibility

50
 Chapter Five
Financial Feasibility
What is financial Appraisal?
Financial appraisal is a method used to evaluate the viability of a
proposed project by assessing the value of net cash flows that result
from its implementation. Financial feasibility involves the capability of
the project organization to raise the appropriate funds needed to
implement the proposed project
How does financial Appraisal Differ From Economic Appraisal?
The economic analysis of a project is similar in form to financial
analysis:
• Both appraise the profits of an investment. The concept of
financial profits is not the same as economic profits. The financial
analysis of a project estimates the profits accruing to the project-
operating entity or to the project participants, whereas economic
analysis measures the effect of the project on the national economy.
For a project to be economically viable, it must be financially
sustainable, as well as economically efficient. If a project is not
financially sustainable, economic benefits will not be realized.
Financial analysis and economic analysis are, therefore, two sides of
the same coin and complementary.
• Both types of analysis are conducted in monetary term, the
major difference lying in the definition of costs and benefits
Financial appraisals differ from economic appraisals in the scope
of their investigation, the range of impact analyzed and the
methodology used.
• A financial appraisal essentially views investment decisions
from the perspective of the organization undertaking the
investment. It, therefore, measures only the direct effects on the
cash flow of the organization of an investment decision.

51
 • By contrast, an economic appraisal considers not only the
impact of a project on the organization sponsoring the project,
but also considers the external benefits and costs of the project
for other Government agencies, private sector enterprises and
individuals-regardless of whether or not such impacts are
matched by money payments.

• Financial appraisal also differs from Economic appraisal in that:

• Market prices and valuations are used in assessing benefits and
costs, instead of measuring such as willingness to pay and
opportunity costs
• the discount rate used to represent the weighted average cost of
debt and equity capital, rather than the estimated social
opportunity cost of capital; and
• the discount rate and the cash flows to which it is applied are
usually specified on a nominal basis, as the cost of debt and
cost of equity observed only in nominal terms.
Content of financial Appraisal
To judge a project from the financial angle, we need information about
the following:
1. Cost of project
2. Means of financing
3. Estimates of sales and production
4. Cost of production
5. Working capital requirement and its financing
6. Breakeven point
7. Projected cash flow statements
8. Projected balance sheet.

52
 This chapter discusses the manner in which the above information,
essential for proper financial, evaluation is gathered, prepared,
summarized and presented.
1. Cost of Project
Conceptually, the cost of project represents the total of all items of
outlay associated with a project. It is the sum of the following
outlays:
1.1. Cost of land and site development
This is the sum of all costs necessary to bring the land for its intended
use (construction of building)

Basic cost of land xxx

Cost of leveling and development xxx
Cost of laying approach roads and internal xxx
roads
Cost of gates xxx
Cost of tube wells xxx
Total cost of land xxx

1.2. Cost of Building and Civil work

Cost of building and civil works cover the following:
Building for the main plant & equipment xxx
Building for auxiliary services like workshops, laboratory, water supply xxx
Godowns, warehouses and open yard facilities xxx
Non – factory building like canten, guest house, etc xxx
Quarters for essential staff xxx
Garages xxx
Sewers, drainage etc xxx
Other civil engineering works xxx
Total cost of building & civil works xxx

53
The cost of buildings and civil works depends on the kind of structure
required which in turn, are dictated, largely by the requirement of the
manufacturing process.
1.3. Cost of Plant and Machinery
The cost of plant and machinery, typically the most significant
component of project cost, consists of the following:


Cost of Imported machinery: this is the sum of (i) FOB
(Free on Board) value, (ii) shipping, freight, and insurances, cost (iii)
import duty and (iv) clearing, loading, unloading and transportation
charges as well as installation costs

Cost of indigenous machinery: This consists of 9i) FOR
(Free on rail), (ii) sales tax, and other tax, if any (iii) transport
changes, (iv) loading, unloading (v)Cost of storage and spare (vi) cost
of foundation and installation
The cost of plant and machinery is based on the latest available
quotation adjusted for possible escalation. Generally, the provision
for escalation is equal to the following product:
1.4. Technical know – how and Engineering Fees
Often it is necessary to engage technical local or foreign consultants
or collaborators for advice and help in various technical matters like
preparation of project report, choice of technology, selection of plant
and machinery, detailed engineering and so on. This may also
include expenses on foreign technicians and training of technicians.
1.5. Miscellaneous Fixed Assets
Fixed assets and machinery which are not part of the direct
manufacturing process may be referred to as miscellaneous fixed
assets. They include items like furniture, office machinery and
equipments, tools, vehicles, laboratory equipment, workshop
equipment, etc.
1.6. Preliminary and Capital issue expenses (costs)

54
Costs incurred for identifying the project, conducting the market
survey, preparing the feasibility report, drafting the memorandum and
articles of association, and incorporating the company are referred as
preliminary expenses.

Expenses born in connection with the raising of capital from the

public are referred to as capital expenses. The major components of
capital issue expenses are:

Underwriting commission xxx

Brokerage fees xxx
Fees to managers and registrars xxx
Printing and postage expenses xxx
Advertising and publicity expenses xxx
Listing fees and stamp duty xxx
Total cost of land xxx
1.7. Pre – operative expenses (Costs)
Expenses of the following types incurred till the commencement of
commercial production are referred to as pre – operative expenses:

Establishment expenses xxx

Rent, rates, and taxes xxx
Traveling expenses xxx
Interest and commitment charges on borrowing Xxx
Insurance charges xxx
Interest on deferred payments xxx
Start – up expenses xxx
Total cost of land xxx

Pre – operative costs incurred up to the point of time the plant and
machinery are set up may be capitalized by apportioning them to fixed

55
assets on some acceptable basis. Pre – operative expenses incurred
from the point of time the plant and machinery are set up are treated
as revenue expenditure.

1.8. Provision for Contingencies

A provision for contingencies is made to provide for certain unforeseen
costs and price increase over and above the normal inflation rate
which is already incorporated in cost estimates.
1.9 Initial Cash Losses
Most of the projects incur cash losses in the initial years. Yet,
promoters, typically do not disclose the initial cash losses because
they want the project to appear attractive to the financial institutions
and investing public. Hence, prudence calls for making a provision,
overt or covert, for estimated initial cash losses to be capitalized.
2. Meaning of Financing
To meet the cost of project the following means of finance are
available:

1. Share capital (common or equity capital and preference capital.

2. Term loan secured borrowings for financing new projects as
well as expansion, modernization, and renovation schemes of
existing firms.
3. Bond capital
4. Deferred credit: This a credit offered by suppliers of plant and
machinery under which payment for the purchase of the plant
and machinery can be made over a period for time.
5. Incentive sources: The government and its agencies may
provide financial support as incentive to certain types of
promoters or for setting up industrial unit in certain locations.
This may be in the form of seed capital assistance at normal rate
of interest, or capital subsidiary, or tax deferment or exemption.

56
 6. Miscellaneous sources: A small portion of project finance may
come from miscellaneous sources like unsecured loan, leasing
and hire purchase finance.
Planning the Means of Finance
We described the various means of financing that can be tapped for a
project. The guidelines and consideration that should be born in
mind for this purpose are as follows:
1. Norms of Regulatory Bodies and Finance Institution: In
many countries the proposed means of financing for a project must be
either approved by a regulatory agency or conform to certain norms
laid down by government or financial institutions in this regard. For
example, in Ethiopia issues different regulations that must govern the
operations of financial institutions.
2. Key Business consideration: The key business considerations
which are relevant for the project financing decision are: cost, risk,
control and flexibility.
a. Cost: In general the cost of debt capital is lower than the cost of
equity capital because the interest payable on debt is tax deductible
expense whereas the dividend payable on equity capital is not.
b. Risk: The two main sources of risk for a firm (a project) are:
business risk and financial risk. Business risk refers to the
variability of earnings before interest and tax and arises mainly from
fluctuation in demand and variability of prices and costs. Financial
risk refers to the risk arising from financial leverage – inability to
serve the source of capital. It must be emphasized that while debt
capital is cheap it is also risky because of the fixed & legal financial
burden associated with it.
c. Control: Promoters of the project would ordinarily prefer a scheme
of financing which enable them to maximize their control over the
affairs of the firm, given their commitment of funds to the project.

57
d. Flexibly: This refers to the ability of a firm (or project to raise
further capital from any source it wishes to tap to met the future
financing needs.
Thus, when we determine (choose) the financing mix we must
consider: the financial regulations and norms of the country; key
business considerations which include: risk associated with the firm,
cost of involved in different sources of finance, source of finance the
provide the firm with good degree of control, and flexibility in raising
future fund
3. Estimates of Sales and Production
Typically, the starting point for profitability projection is the forecast
for sales revenues. In estimating sales revenue, the following
considerations should be born in mind:

1. It is not advisable to assume a high capacity utilization level in the

first years of operation. Even if the technology is simple and the
company may not face technical problems in achieving high rate of
capacity utilization in the first year itself, there are likely to be other
constraints like raw material shortage, limited power, marketing
problems. It is sensible to assume that capacity utilization would be
somewhat low in the first year and risk therefore gradually to reach
the maximum level in the third or fourth year of operation. A
reasonable assumption with respect to capacity utilization is as
follows: 40 –50 percent of the installed capacity in the first year, 50 –
80 percent in the second year, and 80 – 90 percent from the third year
onward.
2. It is not necessary to make adjustments for stocks of finished
goods. For practical purpose, it may be assumed that production
would be equal to sales
3. The selling price considered should be the price realizable by the
company.

58
4. The selling price used may be the present selling price – it is
generally assumed that changes in selling price will matched by
proportionate changes in cost of production.
4. Cost of Production
Given the estimated production, the cost of production may be worked
– out. The major component of cost of production is:
• Material cost (raw materials, chemicals, components, and
consumables required for production).
• Labor cost (Direct & indirect labor)
• Utilities Cost) Power, water, and fuel)
• Factory overhead cost (repairs and maintenance, rent, taxes,
insurance on factory assets, etc)
5. Working Capital Requirements and Its Financing
Working capital is commonly defined in financial analysis as net
current assets. Current assets consists of inventories, including goods
in process; net receivables; marketable securities; bank balances; and
cash in hand. A certain amount of working capital is normally require
to run project facilities created by investment in fixed assets. The
principal sources of working capital finance are (i) working capital
advances provided by commercial banks, (ii) trade credit (iii) accruals
provisions; and (iv) long – term sources of financing.
6. Profitability Projects
Given the estimates of sales revenue and cost of production, the next
step is to prepare the profitability projections. The estimates of
profitability may be prepared along the following lines:

59
A) Expected Sales……………………………………………………….….xxxx
B) Cost of production (Dire M + Direct Labor+ MOH……………..(xxxx)
C) Gross profit (A-B)……………………………………… …….…….. xxxx
D) Total admin and Selling expenses……….………………………..(xxx)
E) Operating profit (C-D) ……………………… ………..............…. xxxx
F) Other Income such as Interest and rent income …………..…..xxxx
G) Other Expense such as interest expense………………..……...(xxxx)
H) Profit/loss before taxation (E+F – G )……………..… …..…...…xxxx
I) Prevision for taxation (I x tax rate) ………………….……….…….xxxx
J) Profit after tax ( H-I) or I+H if there is loss …….…….……..…...xxxx
K) Retained profit (earnings) ( K-Dividends) …………………….... xxxx
L) Net cash inflow (K+ Depr and other none cash exp) ……..…..xxxx

7. Breakeven Points
In addition to knowing what the projected profit would be at certain
levels of capacity utilization, it is also helpful to know what the level of
operation should be to avoid losses. For this purpose, the break –
even point, which refers to the level of operations at which the project
neither makes profit nor incurs loss is calculated. Breakeven point is
calculated as follows:
Breakeven Point = Fixed Costs
Unit selling price – Unit variable cost

8. Projected Cash Flow Statements

The cash flow statement shows the movement of cash into and out of
the firm and its net impact on the cash balance with the firm. The
cash flow statement is really a cash flow budget.
The three basic steps in determining whether a project is worthwhile
or not is:

60
 • Estimate project cash flows,
• Establish the cost of capital (Or hurdle rate), and
• Apply a suitable decision or appraisal criterion
Note the following:
Cash outflows, not expenses in accounting terms, are the relevant
measure of financial costs; likewise, cash inflows, not revenues as
determined by accounting conventions, reflect financial benefits.

The discussion on developing project cash flows of this chapter is

divided into:
• Basic principles for measuring project cash flows
• Components of cash flow stream
• Cash flow illustration

1. Basic Principles for Measuring Project Cash Flows

For developing the stream of financial costs and benefits, the following
principles must be kept in mind:
• Incremental principle
• Long – term of financing costs principle
• Post – tax principle
a. Incremental Principle
To ascertain a project’s incremental cash flows, one has to look at
what happens to the cash flows of the firm with the project and
without the project. The Difference between the two reflects the
incremental cash flows attributable to the project.
In estimating the incremental cash flows of the project, the following
guidelines must be borne in mind:
1. Consider all incidental effects In addition to the direct cash
flows of the project, all its incidental effects on the rest of the firm
must be considered. The project may enhance the profitability of

61
some of the existing activities of the firm because it has a
complementary relationship with them; or, it may detract from the
profitability of some of the existing activities of the firm because it has
a competitive relationship with them – all these effects must be taken
into account.
2. Ignore Sunk Costs A sunk cost refers to an outlay incurred in
the past or already committed irrevocably. So it is no affected by the
acceptance or rejection of the project under consideration. Remember
that bygones are bygones and are not relevant for decision
making.
3. Include Opportunity Cost If a project requires the use of some
response already available with the firm, the opportunity cost of these
resources should be charged to the project.
4. Question the Allocation of overhead Costs When a new
project is proposed, a portion of the overhead costs of the firm is
usually allocated to it. For purposes of investment appraisal what
matters is the incremental overhead costs (along with other
incremental costs) attributable to the project and the allocated
overhead costs.
b. Long – term Funds Principle
It is generally recommended that project may be evaluated from the
point of long term funds. For determining the costs and benefits of an
investment project we will raise the questions: What is the sacrifice
made by the suppliers of long – term funds? What benefits accrue to
the suppliers of long – term funds?
c. Exclusion of Financing Costs Principle
When cash inflows relating to long – term funds are being defined,
financing costs of long – term fund (interest on long – term debt and
equity dividend) should be excluded from the analysis. Why? The
weighted average cost of capital used for evaluating the cash flows
takes into account the cost of long – term funds. Put differently the

62
interest and dividend payments are reflected in the weighted average
cost of capital.
d. Post – tax Principle
Cash flows must be defined in post – tax terms. ( It may be noted that
the cost of capital employed for evaluating the cash flow stream is also
measured in post – tax terms)

2. Components of the Cash Flow Stream

The cash flow stream associated with a project may be divided into
three basic components:
(i) initial investment, (ii) operating cash inflows, and (iii) a terminal cash
flows.
The initial investment represents the relevant cash outflow when the
project is set up. The operating cash inflows are the cash inflows that
arise from the operation of the project during its economic life. The
terminal cash flow is the relevant cash flow occurring at the end of the
project life on account of liquidation of the project.

2b. Operating Cash Inflow

Operating cash inflow is calculated as follows:
A. Operating cash flow of new project = Profit after tax+ Depreciation
+ other non cash expenses+ [interest on long-term loan x (1-tax
rate)]
B. Operating cash inflow of replacement project= Change in profit
after tax + change in depreciation + [change in other non-cash
expenses + change in interest (1-tax rate)]
2c. Terminal Cash Flow
The cash flow resulting from the terminal or liquidation of a project at
the end of its economic life is called its terminal cash flows. It is
defined as follows

63
New project Replacement project
Post – tax proceeds* from the sales of Post – tax proceeds from the sale of
capital assets replacement capital assets
+ -
Net recovery of working capital Post – tax proceeds from the sale of
margin present capital assets
+
Net recovery of working capital margin
* Post – tax proceeds are also referred to as the net salvage value.

A word about the two components of the terminal cash flow is order.
Net salvage value of capital assets Usually, the sale price of a
capital asset exceeds its book value. Therefore, the net salvage value
is equal to:

Sale value – Tax, if any, on sale

If, however, a loss is incurred on sale, the net salvage value is equal
to:
Sale value – tax shield, if any, on sale
Net recovery of Working Capital Margin Working capital is
normally expected to be liquidated at its face value. Hence no profit
or gain is expected from its liquidation Therefore the net recovery of
working capital margin is equated with the working capital margin
provided at the outset.

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Illustration I
Empire General Business is considering a new investment project
about which the following information is available.
1. The total outlay on the project will be Birr 10 million. This
consists of Birr 6 million on plant and equipment and Birr 4 million
on gross working capital. The entire outlay will be incurred at the
beginning of the project.
2. The project will be financed with Birr4 million of equity capital,
Birr 3, million of long term debt (in the form of debentures), Birr2
million of short – term bank borrowings, and Birr 1 million of trade
credit. This means that Birr 7 million of long – term funds (equity +
long term debt) will be applied towards plant and equipment (Birr 6
million) and working capital margin (Birr 1 million) – working capital
margin is defined as the contribution of long – term funds toward
working capital. The interest rate on debentures will be 15 percent
and the interest rate on short – term borrowings will be 18 percent.
3. The life of the project is expected to be 5 years and the plant
and equipment would fetch a salvage value of Birr 2 million. The
liquidation of value of working capital will be equal to Birr4 million,
the book value.
4. The project will increase the revenues of the firm by birr 8
million per year. The increase in operating expenses on account of
the project will be Birr 3.5 million per year. (This includes all items of
expenses other than depreciation, interest, and taxes.) The effective
tax rate will be 50 percent.
5. Plant and equipment will be depreciated at the rate of 33.33
percent per year as per the written down value method. So the
depreciation charges will be:

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 (birr in million)
First year 2.00
Second year 1.33
Third year 0.89
Fourth year 0.59
Fifth year 0.40

Given the above details the post – tax, incremental cash flows relating
to long – term funds are worked out below.
• The initial investment, occurring at the end of year 0, is Birr 7
million. This represents the commitment of long – term funds to the
project. (Note that the total outlay on the project is birr 10 million.
However, our focus is on flows relating to long – term funds.) The
operating cash inflows, relating to long term funds, at the end of year
1 is Birr 3.07 million. This is defined as follows:

Profit after tax + Depreciation + Interest on (1 – tax rate)

Debenture
Birr 0.845 million + birr2 million + Birr 0.45 million (1-0.50)
The operating cash inflows for the subsequent years have been
calculated similarly. The terminal cash flow relating to long – term
funds is equal to:

Net salvage value of – Net recovery of

Plant and equipment working capital margin
It may be noted that when the project is terminated, its liquidation
value will be equal to:
Net salvage value of – Net recovery of
Plant and equipment working capital margin

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 The first component belongs to the suppliers of long – term funds.
The second component is applied to repay the current liabilities and
recover the working capital margin.

Cash Flows for the net Project

(Birr in million
Year

0 1 2 3 4 5
A. Plant and equipment (6.00)
B. Working capital margin (1.00)
C. Revenues 8.00 8.00 8.00 8.00 8.00
D. Operating costs 3.50 3.50 3.50 3.50 3.50
E. Depreciation 2.00 1.333 0.889 0.593 0.395
F. Interest on short – term bank 0.36 0.36 0.36 0.36 0.36
borrowing
G. Interest on debentures 0.45 0.45 0.45 0.45 0.45
H. Profit before tax 1.690 2.357 2.801 3.097 3.295
I. Tax 0.845 1.179 1.401 1.549 1.648
J, Profit after tax 0.845 1.179 1.401 1.549 1.648
K. Net salvage value of plant and 2.00
equipment
L. Net recovery working capital margin 1.00
M. Initial investment (A + B) (7.00)
N. Operating cash inflows
(J + E + F (I – T)) 3.070 2.736 2.514 2.366 2.267
O. Terminal Cash flow (K + L) 3.000
P. Net cash flow (7.00) 3.070 2.736 2.514 2.366 5.267
(M + N + O)

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End of Chapter activities
1. What does financial feasibility mean?
2. What is the difference between financial analysis and Economic
analysis?
3. List down the contents of financial analysis
4. Write the components of
a. cost of a project
b. cost of land
c. Building
d. Cost of imported and indigenous machinery
5. What is the alternative source of finance?
6. What conditions should you consider in planning financial source?
7. Explain the basic principles for measuring project cash flow.
8. How do you determine the following? Put the formula
a. initial cost of project
b. operating cash flow
c. terminal cash flow.
9. Refer to the above illustration on cash flows and determine the
following
a. Pay back period
b. Net present Value assuming cost of capital of 10%
c. Profitability index
d. IRR

68
 Chapter six
Economic Analysis

1. Introduction
Social cost benefit analysis (SCBA) also called economic analysis is a
methodology developed for evaluating investment project from the
point of view of the society (or economy) as a whole. Used primarily for
evaluating public investments (though it can be applied to both
private and public investments), economic analysis has received
increasing emphasis in recent years in view of the growing importance
of public investments in many countries, particularly in developing
countries, where governments are playing a significant role in
economic development. Economic analysis is also relevant, to a
certain extent, to private investment as these have now to be approved
by various governmental and quasi-covenantal agencies which bring
to bear larger national consideration in their decisions.
In the context of planned economies, SCBA aids in evaluating
individual project within the planning framework which spells out
national economic objectives and broad allocation of resources to
various sectors. In other words, SCBA is concerned with tactical
decision making within the framework of broad strategic choices
defined by planning at the macro level. The perspectives and
parameters provided by the macro level plans serve as the basis of
SCBA which is a tool for analyzing and appraising individual projects.
This chapter, concerned with SCBA, discusses the following:
• Rationale for SCBA
• UNIDO approach to SCBA

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2. Rationale for SCBA
In SCBA the focus is on the social costs and benefits of the project.
These often tend to differ from the monetary costs and benefits of the
project. The principal sources of discrepancy are:
• Market imperfections
• Externalities
• Taxes
• Concern for saving
• Concern for redistribution
• Merit wants
Market imperfections
Market prices, which form the basis for computing the monetary costs
and benefits from the point of view of project sponsor, reflect social
values only under conditions of perfect competition, which are rarely,
if ever, realized by developing countries. When imperfections are
obtained, market prices do not reflect social values.
The common market imperfections found in developing counties are:
i. rationing,
ii. Prescription of minimum wage rates, and
iii. Foreign exchange regulation.
Rationing of a commodity means control over its price and
distribution. The price paid by a consumer under rationing is often
significantly less than the price that would prevail in a competitive
market. When minimum wage rates are prescribed, the wages paid to
labor are usually more than what the wages would be in a competitive
labor market free from such wage legislations. The official rate of
foreign exchange in most of the developing countries, which exercise
close regulation over foreign exchange, is typically less than the rate
that would prevail in the absence of foreign regulation this is why

70
foreign exchange usually commands premium in unofficial
transactions.
Externalities
A project may have beneficial external effects. For example, it may
create certain infrastructural facilities like roads which benefit the
neighboring areas. Such benefits are considered in SCBA, though they
are ignored in assessing the monetary benefits to the project sponsors
because they don’t receive any monetary compensation from those
who enjoy this external benefit created by the project. Likewise, a
project may have a harmful external effect like environmental
pollution. In SCBA, the cost of such environmental pollution is
relevant, though the project sponsors may not incur any monetary
costs. It may be emphasized that 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.
Taxes and Subsides
From the private point of view, taxes are definite monetary costs and
subsidies are definite monetary gains. From the social point of view,
however, taxes and subsidies are generally regarded as transfer
payments and hence considered irrelevant.
Concern for Savings
Unconcerned about how its benefits are divided between consumption
and savings, a private firm does not put differential valuation on
savings and consumption. From a social point of view, however, the
division of benefits between consumption and savings (which leads to
investment) is relevant, particularity in capital-scarce developing
countries. A Birr of benefits saved is deemed more valuable than a
Birr of benefits consumed. The concern of society for savings and
investment is duly reflected in SCBA wherein a higher valuation is
placed on savings and a lower valuation is put on consumption.

71
Concern for redistribution
A private firm does not bother how its benefits are distributed across
various groups in the society. The society, however, is concerned
about the distribution of benefits across different groups. A Birr of
benefits going to a poor section is considered more valuable than a
Birr of benefit going to an affluent (rich) section.
Merit wants
Goals and preferences not expressed in the market place, but believed
by policy makers to be in the larger interest, may be referred to as
merit wants. For example, the government may prefer to promote an
adult education program or a balanced nutrition program for school-
going children even though these are not sought by consumers in the
market place. While merit wants are not relevant from the private
point of view, they are important from the social point of view.

3. UNIDO Approach
The guide by UNIDO provides a comprehensive framework for SCBA
in developing countries.
The UNIDO method of project appraisal involves five stages:
• Calculation of financial profitability of the project measured at
market prices.
• Obtaining the net benefit of project measured in terms of
economic (efficiency) prices.
• Adjustment for the impact of the project on savings and
investments.
• Adjustments for the impact of the project on income
distributions.
• Adjustment of the impact of project on merit goods and demerit
goods whose social values differ from their economic values.

72
Each stage of appraisal measures the desirability of the project from a
different angle.
3.1 Financial profitability of the project measured at market
prices
The measurement of financial profitability of the project in the first
stage is similar to the financial evaluation discussed in the previous
chapter. So the first stage will not be discussed here.
3.2 Net benefit in terms of economic (efficiency) prices
Stage two of the UNIDO approach is concerned with the determination
of the net benefit of the project in terms of economic (efficiency)
prices, also referred to as shadow prices.
Market prices represent shadow prices only under conditions of
perfect markets which are almost invariably not fulfilled in developing
countries. Hence, there is a need for developing shadow prices and
measuring net economic benefit in terms of these prices.
a. Shadow pricing: Basic issues
Before we deal with shadow pricing of specific resources, certain basic
concepts and issues must be discussed: choice of nume’raire, concept
of tradability, source of shadow prices, treatment of taxes, and
consumer willingness to pay.
Choice of Nume’raire One of the important aspect of shadow pricing
is the determination of the nume’raire, the unit of account in which
the value of inputs or outputs is expressed.
To define the nume’raire, the following questions have to be answered:

What unit of currency, domestic or foreign, should be used to
express benefits and costs?

Should benefits and costs be measured in current values or
constant values?

With reference to which point, present or future, should benefits
and costs be evaluated?

73

What use, consumption or investment, will be made of the income
from a project? Should the income of the project be measured in
terms of consumption or investment?

With reference to which group should the income of the project be
measured?
The specification of the UNIDO nume’raire in terms of the above
question is: “net present consumption in the hands of people at the
base level of consumption in the private sector in terms of constant
price in domestic accounting Birr”.
i) Concept of tradability A key issue in shadow pricing is whether a
good is tradeable or not. For a good that is tradeable, the international
price is a measure of its opportunity cost to the country. Why? For a
tradeable good, 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, represents the ‘real’ value of
the good in terms of economic efficiency.
ii) Sources of Shadow prices The UNIDO approach suggests 4
sources of shadow pricing, depending on the impact of the project on
national economy. A project, as it uses and produces resources, may
for any given input or output (i) increase or decrease the total
consumption in the economy, (ii) decrease or increase production in
the economy, (iii) decrease imports or increase imports, or (iv) increase
exports or decrease exports.
If the impact of the project is on consumption in the economy the
basis of shadow pricing is consumer willingness to pay. If the impact
of the project is on production in the economy, the basis of shadow
pricing is the cost of production. If the impact of project is on
international trade-increase in exports, decrease in imports, increase
in imports, or decrease in exports- the basis of shadow pricing is the
foreign exchange value.

74
iii) Taxes When shadow prices are being calculated, taxed usually
pose difficulties. The general guidelines in the UNIDO approach with
respect to taxes are as follows: (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.
iii) Consumer Willingness to pay As noted above, if the impact of the
project is on consumption in the economy, the basis of shadow
pricing is consumer willingness to pay.

3.3 Shadow pricing of specific resources

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.
For fully traded goods, the shadow price is the border price,
translated in domestic currency at the market exchange rate.
The above definition of a fully traded good implies that domestic
changes in demand or supply affect just the level of imports or
exports.
For non-traded goods, the border price does not reflect its economic
values. The value of a non-traded good should be measure in terms of
what domestic consumers are willing to pay, if the output of the
project adds to its domestic supplies or if the requirement of the
project causes reductions of its consumption by others. The value of a
non-traded good should be measured in terms of its marginal cost of
production if the requirement of the project induces additional

75
production or if the output of the project causes reduction of
production by other units.
Non-traded inputs and outputs A good is non-tradable when the
following conditions are satisfied: (i) its import price (CIF price) is
greater than its domestic cost of production and (ii) its export price
(FOB price) is less than its domestic cost of production.
The valuation of non-tradable is done as per the principles of shadow
pricing discussed earlier. On the 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 a marginal consumers’ willingness to pay;
if the impact of the project is to substitute other production of the
same non-tradable in the economy, the measure of value is the saving
in cost of production. On the input side, if the impact of the project is
to reduce the availability of the inputs o other users, their willingness
to pay for that input represents social value; if the project’s input
requirement is met by additional production of it, the production cost
of it is the measure of social value.
Externalities An externality, also referred to as an external effect, is
a special class of good which has the following characteristics: (i) It is
not deliberately created by the project sponsor 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.
External effects must be taken in to account wherever it is possible to
do so. Even if these effects cannot be measured in monetary terms,
some qualitative evaluation must be attempted.
Labor inputs The principles of shadow pricing for goods may be
applied to labor as well, though labor is considered to be service.
When a project hires labor, it could have three possible impacts on
the rest the economy: it may take labor away from other

76
employments; it may induce the production of new workers; and it
may involve import of workers.
Capital inputs When a capital investment is made in a project two
things happen: (i) Financial resources are converted into physical
assets. (ii) Financial resources are withdrawn from the national pool
of savings and hence alternative projects are foregone. Thus, shadow
pricing of capital investment involves two questions:
• What is the value of physical assets?
• What is the opportunity cost of capital (which reflects the
benefit foregone by sacrificing alternative project/s)?
The value (shadow prices) of physical assets is calculated the way the
value of other resource is calculated. If it is a fully traded good, 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 the project induces
additional domestic production of the asset) or consumer willingness
to pay (if the project takes the asset from other users).
The opportunity cost of capital depends on how the capital required
for the project is generated. To the extent that is comes from
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); to the extent that it comes
from the denial of capital to alternative projects, its opportunity cost
is the rate of return that would be earned from those alternative
projects. This is also called the investment rate of interest. In practice,
the consumption rate of interest may be sued as the discount rate
because in stage three of UNIDO analysis all inputs and outputs are
converted into their consumption equivalents.
Foreign exchange The UNIDO method uses domestic currency as the
nume’raire. So the foreign exchange input of the project must be
identified and adjusted by an appropriate premium. This means that

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valuation of inputs and outputs that were measured in border Birr
has to be adjusted upward to reflect the shadow price of foreign
exchange.
The calculation of the shadow price of foreign exchange in terms of
consumer willingness to pay is based on the assumption that the
foreign exchange requirement of a project is met from the sacrifice of
others. The use of foreign exchange by a project, however, may also
induce the production of foreign exchange through additional exports
or import substitution. In such a case, the shadow price of foreign
exchange would be based on the cost of producing foreign exchange,
not consumer willingness to pay for foreign exchange.

Economic Analysis (Taken from UNIDO manual)

All countries, and particularly the developing ones, face the basic
economic problem of allocating limited resources such as labor, land
and other natural resource, foreign exchange, etc. to their best use.
Best use is defined as the use where these resources make the
maximum contribution in achieving fundamental objectives specified
in the development strategy of the country.
Market prices and market distortions
Under the traditional approach to cost-benefit analysis, all inputs and
outputs of a project are valued at prices prevailing in the domestic
market, with occasional adjustments for transfer payments such as
subsidies and evident taxes. The rationale of using domestic market
prices lies in the crucial, but questionable, assumption that these
prices reflect both marginal utilities of consumption and marginal
production costs. Consequently, the structure of consumption is
expected to determine optimally the structure of production and the
allocation of resources.
This assumption holds true only under the ideal conditions of perfect
competition and, therefore, the optimality of resource allocation

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depends on whether such conditions actually prevail in the market. It
is generally accepted that the markets of most countries and
particularly those of the developing countries are very far from this
ideal. For social, political, historical and economic reasons, the
markets of these countries are distorted and consequently the signals
they give in the form of prevailing prices are also distorted and do not
reflect marginal productivities and marginal utilities. As a result,
these prices cannot be used in allocating limited resources optimally
and this has created the need for a new set of prices to serve this
purpose.
It is believed that in many countries all sections of the domestic
market are distorted, though to varying degrees, since distortions
emanating from one section of the market have a tendency to
penetrate the others. It was recognized early that serious distortion
exist in the markets for labor, capital, and foreign exchange and
efforts were made to replace the signals from these market by more
appropriate ones. To this end, the traditional cost-benefit analysis
employed what has been known as shadow wage rates, opportunity
cost of capital, and shadow foreign exchange rate respectively. For
other inputs and outputs domestic market prices were used with
some corrections for taxes and subsidies. Nevertheless, even with
these corrections and the use of shadow prices for the inputs
mentioned, the pattern of domestic consumption remained the basic
determinant of production structure and allocation of resources. In
other words, the demand for goods and services for domestic
consumption determined what should be produced.
The current cost-benefit analysis considers international market as
the main determinant of resource allocation and productive efficiency.
Even if the degree of competitiveness of the world market is
questioned, the fact remains that trade is always possible and a

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country can import or export at international prices; consequently
these prices can be taken as opportunity costs for the economy.
The new approach resorts to the international market, believed to be
more competitive, to receive signals that will guide the allocation of
resources and the structure of domestic production. Even if the
degree of competitiveness of the world market is questioned, the fact
remains that trade is always possible and a country can import or
export at international prices; consequently, these prices can be taken
as opportunity costs of the economy.
In this approach, all project inputs and outputs are valued at world
prices which are formed independent of whatever distortions prevail in
the domestic market. These world prices are accounting or shadow
prices estimated as border prices in the form of c.i.f. for imported and
f.o.b. for the exported commodities. Under this approach international
trade replaces domestic consumption structure in providing
information for determining the allocation of resources. The rationale
of using international prices as the benchmark of productive efficiency
is found in the theory of comparative advantage.
Since in this approach international efficiency, as reflected in world
trade, is the main determinant of domestic efficiency, the accounting
prices of all inputs and output should be world prices read at the
borders of the country, i.e. border prices. However, not all project
inputs and outputs are traded goods and services and world prices
might not be available for those that are non-traded. If the goods are
not traded, the conversion factor can be used (as short cuts).
Shadow prices are simply set of prices that are believed to better
reflect the opportunity cost, i.e. the cost in their best use, of different
goods and services. They are employed instead of domestic market
prices in guiding the allocation of resources since the latter are
distorted and using them would lead to resource misallocation. Often
these prices are not observed but estimated; hence the term shadow

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prices. Equally often, however, they are observed, as for example in
the case of world price, and therefore the adjective “shadow” could be
misleading. A more accurate term is “accounting prices” since these
prices, estimated or observed, are used in the calculations, in the
account of he project.
With a very broad interpretation of the term accounting prices we
might say that all values relating to price and even quantities in
project analysis are shadow values. Some of these values are
observed, some are estimated or assumed and others are forecasts or
even hopes. It is only when implementation has been completed and
the project is operational for some time that the real prices and
quantities will be known. Strictly speaking, project planning is an
exercise in forecasting.
Limits in the role of shadow prices
If accounting prices are considerably different from the prevailing
market prices, it is almost certain that in the implementation and
operation stage we will face input and output prices substantially
different from the shadow prices used in calculating costs and
benefits at the planning stage. Therefore, since workers and owners
of other inputs don’t accept “shadow Birrs”, it is necessary to include
in project planning what is called financial analysis, where market
prices are used.
It should be clear that shadow/accounting prices do not replace
market prices in all project considerations. Their role is to guide the
allocation of resource and it ends there. Actual and not shadow
capital requirements, revenue, operating expenditures and similar
matters will be determined by prevailing market prices as will be the
monetary deficit or surplus that the project will generate. Comparing
project analysis under market prices (financial analysis) with the one
under accounting prices (economic analysis), will provide valuable

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information on subsidies and other government measures that might
be necessary to ensure that timely implementation and smooth
operation of the project. Although the need for possible subsidies is
revealed by financial analysis itself, it is the comparison with
economic analysis that shows the difference in returns under
desirable and prevailing market conditions and provides the
justification for subsidies and other measures.
Efficiency or economic shadow prices
Qn? The market prices are inappropriate in project selection, and
therefore, how to estimate the necessary shadow prices?
Ans. Look for them in international trade. What has to be emphasized
here is that, the formula used in estimating accounting prices is
determined by what we try to achieve by employing such prices. In
other words, although all non-market prices are called shadow prices
their value might differ. To avoid confusion, we should make this term
more specific to indicate clearly what we aim at in using such prices,
e.g. efficiency shadow prices and social accounting prices.
The objective in employing shadow prices is derived from the aim of
the project and, therefore, how shadow prices will be estimated
depends on what we try to achieve through project selection. We have
already stated that projects are just a policy instruments and not a
panacea (cure) for development. Some development objectives can be
reached more efficiently through other means such as fiscal,
monetary and trade polices. However, since a project commits scare
resources we should, as a minimum, aim at achieving through project
evaluation the efficient allocation of such resources. Consequently,
accounting prices should be estimated with at least this objective in
mind. When the analysis is limited to the efficiency objective, the
accounting or shadow prices employed are called efficiency or
economic shadow prices; they are distinguished from social shadow

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prices. It has been said that efficiency shadow prices are boarder
prices determined by international trade.
Social shadow prices
The scope of social pricing
When efficiency prices are used in project analysis it is implicitly
assumed that our primary concern is the efficient allocation of scarce
resources, leaving to other policy measure the task of achieving other
development objectives. Specifically, it is assumed that we are
interested in maximizing project net benefits and we are not
concerned with the question as to who receives these benefits and to
what use they are put. In other words, we are not interested whether
the benefits go to a poor or a rich person and whether they are
consumed or saved. Stated differently, under efficiency pricing the
project analysis is, in his work, indifferent to the question of
intratemporal distribution of income (rich vs. poor) and to the
intertemporal allocation of benefits (present consumption and future
consumption through savings). Under efficiency pricing a Birr is a
Birr irrespective of whom it goes to and how it used.
Traded, non-traded and potentially traded goods
Imported inputs.
Some project inputs are directly imported or, though supplied locally,
they indirectly lead to imports since local production is not sufficient
to satisfy domestic demand. Inputs that fall in this category are
valued at the c.i.f. price which represents the direct foreign exchange
cost of the inputs up to the port or other borders.
Exported output.
The project output that is directly exported or, although sold on the
domestic market, leads to additional exports because the domestic
demand is already satisfied for existing capacity, should be valued at
the border price which in this case is the f.o.b. price. The border price

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should be adjusted to expenses incurred in bringing the exported
commodity to the port or the borders.
Import and export substitutes
Imported inputs and exported outputs are broadly interpreted and the
valuation procedure described earlier applies also to import and
export substitutes.
Non-traded goods
Goods and services produced in a country are defined as non-traded
when they don’t enter world trade; either because of their nature, due
to trade barriers and other special reasons. In this case, the non-
traded goods will be valued at the domestic price multiplied by a
conversion factor. Conversion factor is the factor by which we multiply
the actual price in the domestic market of an input or output to arrive
at its shadow price, when the later cannot be observed or estimated
directly. The conversion factors are estimated by central planners.
Potentially traded goods.
This category falls between the traded and non-traded groups. It
includes commodities that are not traded at present but could be
traded if the country had followed optimal trade policies.

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End of Chapter Activities
1. What does social cost benefit analysis mean? Explain its concept.
2. Why economic analysis is important in addition to financial
analysis?’
3. What is the concept of shadow prices?
4. What is the nume’raire in shadow pricing?
5. Explain what the following mean:
a. Tradable goods (explain their concept, characteristics, and
give at least 3 examples)
b. Non tradable goods ((explain their concept, characteristics,
and give at least 3 examples)
6. How do you determine the cost of:
a. Tradable goods
b. Non-tradable goods

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