TOPIC 4: PROJECT APPRAISAL

4.1 Introduction
• In the appraisal stage of the project planning process, the optimal use of scarce
resources by the proposed project is assessed using two approaches:

1. Value for money [or cost-effectiveness] approach

(see https://www.nao.org.uk/successful-commissioning/general-principles/value-for-
money/assessing-value-for-money/)
• The value for money approach assesses whether there was optimal use of public
resources (money) to achieve the intended outcomes
• It uses 3 main criteria or principles:
(a) Economy: minimizing the cost of resources used or required (inputs) – spending
less;
(b) Efficiency: the relationship between the output from goods or services and the
resources to produce them – spending well; and
(c) Effectiveness: the relationship between the intended and actual results of public
spending (outcomes) – spending wisely.

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 Source: https://www.nao.org.uk/successful-commissioning/wp-
content/uploads/sites/4/2013/02/commission_flow_chart_large-1.jpg
• https://www.pwc.com/rw/en/publications/value-for-money.html

2. Time value of money [or cost-benefit] approach

• Why?
o Money has an opportunity cost
▪ Return on investment
o Mainly to determine if the use of scarce resources in the project is justified
from
(i) a value for money perspective (do the project benefits cover the cost of
implementing it?)
(ii) an equity perspective (is there a net welfare gain from the use of scarce
resources in the project?) = distributional effectiveness of scarce resource
•
• CBA represents a framework where all project benefits and costs are identified,
quantified, valued and compared against a range of optimality criteria on an ex ante
(before project) basis [feasibility study]
o or on an ex post (after project) basis.

• CBA determines the economic efficiency of a project

o What is efficiency?
▪ It refers to getting the most from limited resources

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 ▪ It is the primary criterion by which economists evaluate the use of
scarce resources
• Evaluation results are consumed by the decision maker – either
government or private sector or civil societies

NOTE: Efficiency is an important concept in [welfare] economics

because an efficient economy is more productive i.e. it creates larger
national cake (national income =GDP), which can then be applied
toward the achievement of other social goals: ignorance, disease,
poverty, insecurity, etc
HENCE: Efficiency is one of the many criteria by which decisions
about government policies can be made amidst resource
constraints

• CBA provides a framework to analyze project effects measured from different

viewpoints, viz
o Private
o Public
o Economic
o Social
• The CBA also provides the scope for dealing with the various forms of market
distortions (due to (i) market failure & (ii) government policy) and efficiency
considerations

4.2 What is CBA?

• It is a decision-making tool that helps the analyst to compare the stream of costs
of investing in a particular project/intervention against the stream of benefits
expected or realized from the project
• “Streams” imply time element

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4.3 Project Appraisal from 3 viewpoints: financial, economic & social analysis
• Of 3 types of CBA

1. Financial CBA – uses market prices to value the benefits and costs of a project

o Actual or observed market prices [“dirty prices” – distortions due to (i)

government policy [subsidy or taxes], (ii) market failure]
▪ Market failure = inability of the market mechanism [market forces
of supply and demand] to efficiently allocated goods & services to
the society
• Causes
o Lack of competition – monopolistic tendencies
o Existence of public, merit, demerit goods
o Presence of externalities, information asymmetry
o
▪ Market survey of prices of commodities &/or services

• The main focus is the private sector where profit is the main objective/motive
• The CBA here is done through Financial Analysis
• Done using capital budgeting and financial analysis techniques to determine whether
or not the project will be financially profitable, i.e., will contribute to increasing the
net value of the business?
• The net value is the surplus of assets over liabilities as reflected in the balance
sheet. In order to contribute to the net value, it is necessary for the project to be
profitable
o Sales – cost of sales
Gross profit=Gross margin [PQ*Q] – [PX*X]
Less
▪ Depreciation
▪ Taxes
▪ Interest
o Profit = TR- TVC - TFC
• Analysis is therefore done to discount the expected stream of profits and/or losses
to the present in order to determine the effect on the net value

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 Data sources
• Farm output quantities & their market prices
• Farm input quantities & their market prices
• Value of fixed assets – plant & machinery
• Tax regime

2. Economic CBA – uses social prices to value the benefits and costs of a project in order
to reflect the true cost and value of the project to the society

o Social prices are “clean prices” – are devoid of distortions due to (i)
government policy [subsidy or taxes], (ii) market failure
• The main focus is the public sector investments where profit is not the main
objective/motive
• Public investment is usually directed towards public and social services and actions
which will enhance the environment in which business will attempt to make profits,
but which is too expensive or of a long-term nature to attract private investment
o Capital formation
▪ Roads, railways, buildings, etc
• Here, the analysis aims at determining whether the use of the limited resources is
economically efficient
• Hence, it is carried out considering the economic cost to produce economic benefits
to the society at large, which is often called Economic Analysis
• In other words, project benefits and costs are evaluated at prices which reflect the
relative scarcity of inputs and outputs to the society

3. Social CBA

• Focus is on society at large

• The aim is to determine the consequences of a project on the distribution of welfare
benefits on the society
• An appraisal can also be made of the effects of other social factors such as equity
and gender aspects

• We use

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 o Shadow pricing = the practice of assigning a monetary value to something
whose value can only be estimated because it is not something regularly
bought and sold in a marketplace (i.e., nonmarket values/valuation)
o Time periods: present vs future generations

NOTE:
• Economic and social CBA are often carried out together because they focus on the
society at large

Difference between Financial & Economic Perspectives of CBA

Difference Private/Financial Analysis
1. From the point of view Shareholder/Individuals
of [“standing”]
2. Objectives Maximize net value of firm –>
Private Profit
3. Discount rate Market rate or weighted
marginal cost of capital plus
uncertainty and risk premium
i=RF+IP+LP+DRP+MRP+O
4. Value unit Market price
5. Dimensions Limited to aspects of
decision-making that may
affect profits/losses of
individuals
6. Depreciation Included – it apportions the
historical value of fixed
assets to annual costs
7. Income tax Included
Public/Economic Analysis
Community/society/economy
Apply scarce resources
effectively and economic
efficiently
Social time-preference rate
-Usually less than the market
rate
Shadow prices (e.g.,
opportunity cost & WTP)
All aspects necessary for a
rational public decision
Excluded because it does not
effect both the source and
application of funds
• Historical costs are
considered as sunk
costs
Excluded because it does not
directly contribute to a more

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 effective or less effective
application of funds
-Taxes are the sources of
funds for the government
-Exclusion avoids double-
counting
8. Interest payments Included – amortize the loan Excluded because they do not
annually influence the efficiency of
conversion of inputs into
outputs, and can therefore be
considered merely a transfer
payment
9. Externalities – effects Excluded Included
on third parties who
were not envisaged by
current decision to
produce or consume
something, e.g., pollution
10. Social impacts and Excluded – difficulties of Can be examined and
intangibles valuation [non-market values] weighed – if they can be
valued [non-market valuation
techniques]
11. “Advantages” Considers only money income Additional goods, services,
and profit products, income and/or cost
savings included in analysis
12. “Disadvantages” Money payments and Opportunity costs in terms of
depreciation calculated goods and services foregone,
according to accounting which is difficult to determine
principles accurately

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Depreciation methods:
• Focus is on fixed assets – plant & machinery
(a) Straight line method
𝑂𝑟𝑔𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡−𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
Depreciation = 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒

(b) Declining balance

▪ A fixed percentage of depreciation is charged in each accounting period to the net
balance of the fixed asset
▪ The net balance is the value of asset that remains after deducting accumulated
depreciation

(c) Sum-of-the-years' digits

▪ The depreciable amount of an asset is charged to a fraction over different
accounting periods under this method.

▪ This fraction is the ratio between the remaining useful life of an asset in a particular
period and sum of the years’ digits. Thus, this fraction indicates that the capital
blocked or the benefit derived out of the asset is the highest in the first year.

Sum of Years’ Digits Depreciation Formula

• Depreciation Expense = Depreciable Cost x (Remaining useful life of the asset/Sum
of Years’ Digits)

where

Depreciable cost = Cost of asset – Salvage Value

Sum of years’ digits = (n(n +1))/2 (where n = useful life of an asset)

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4.4 Considerations in CBA
1. The counterfactual problem
• What would have happened to beneficiaries’ welfare in absence of the
project/intervention?
o Arises due to failure of the analyst to observe the two states of target
beneficiaries, i.e., “with and without” project, simultaneously
• You need to come up with projections of benefits and costs for the duration of the
project “with” and “without” the project
o With project beneficiaries = “treatment group”
o Without project beneficiaries = “control group”
▪ The control group should be sufficiently far apart from the treatment
group to avoid “spill over” effects = “confounding” effects

Disregarding Time
With project beneficiaries = “treatment group”: T [Treat group]
Without project beneficiaries = “control group: C [Control group]
Net incremental benefit = T-C

Considering Time
• Focuses on “before” & “after” as well as “with” & “without” situations
• The “before” situation is measured during the project’s baseline study
• Hence
(a) At the baseline, time =0
With project beneficiaries = “treatment group”: T0 [Treat group]
Without project beneficiaries = “control group: C0 [Control group]
Net incremental benefit = T0-C0

(b) At the project is implemented, time =1

With project beneficiaries = “treatment group”: T1 [Treat group]
Without project beneficiaries = “control group: C1 [Control group]
Net incremental benefit = T1-C1
• The final incremental net benefit is called a difference-in-difference (D-in-D)
computed as:
𝐷 = (𝑇1 − 𝐶1 ) − (𝑇0 − 𝐶0 )

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 • Graphically:

2. The Pareto Optimality Principle

• CBA is a technique used in an attempt to bring about a more effective allocation and
distribution of scarce resources

• We therefore use Pareto optimality principle [=Pareto efficiency criterion] to gauge

how resources are allocated among the target beneficiaries:

o It states that an allocation of goods/resources is Pareto efficient if it is not

possible, through further reallocations, to make one person better off without
making someone else worse off

• A necessary prerequisite here is that the social benefits of the proposed project should
exceed the social cost. The central role that the Pareto principle plays is to ensure
that CBA is aimed at distributional effectiveness. It should also be ensured that a
given objective/goal is achieved with the application of the fewest resources possible
by carrying out cost-effectiveness studies

o Once we determine who gains from the project, we also need to determine the
gainers can potentially compensate the losers and still remain better off

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 ▪ This is what is called potential Pareto compensation criterion

▪ A positive net present value [NPV] guarantees the potential Pareto

compensation criterion [see later]

3. Time value of money

• Value contributed to assets by time
o Time increases value, e.g., crop/animal enterprise, land
o Time reduces value, e.g., capital [money, plant & machinery]
▪ Money – inflation
▪ Plant & machinery – wear & tear + obsolescence
• Because of these factors, we need to account for the effect of time on money
• Deals with compounding and discounting
• “A bird in hand is worth two in the bush”
• A shilling in hand today is worth more than a shilling to be received in the future
because if you had it now, you could invest it, earn interest, & end up with more than a
shilling in the future
• Capital projects – fixed assets – plant & machinery lock in capital, e.g., SGR, so that that
capital is not available for alternative uses

Discounting
• Q: How much is a future sum of money worth today?
• Recall: FVn = PV (1 + i) n
FVn
• Hence PV =
(1 + i ) n
where
FV = Future value
PV = Present value
i= interest rate
n = time period

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Example:
Suppose you have some $500 in a fixed deposit which will mature in four years' time. What
is the present value of that money if the interest rate is 9%?

SOLN:
1 500
Using the discounting formula, PV = FVn , PV = = $ 354.21
(1 + i) n
(1 + 0.09) 4

• Graphically, PV diminishes as the years to receipt & the interest rate increase:
 discounting is a decay process

Present i=0%
value of $1

i=5%

i=10%

i=15%

Time period

4.5 CBA process and its applications

STEPS OF UNDERTAKING A CBA
1a. List all the costs of the project
• Direct costs – are obtained from the project implementers/documents
(i) personnel
(ii) vehicles
(iii) equipment
(iv) consumables
(v) other incidentals

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 • Indirect costs = negative spillovers/externalities
(i) social costs
(ii) health costs
(iii) environmental costs
(v) etc
o Indirect costs are difficult to measure and value than direct costs
▪ Most constitute what we call “non-market goods”
▪ Non-market good valuation methods
(i) Contingent valuation – (a) willingness-to-pay, (b) willingness-to-
accept compensation, etc
(ii) Conjoint analysis
(iii) Disability-adjusted life years (DALYs) – health costs (morbidity)
(iv) Value of economic life – mortality
▪ Application of the non-market good valuation methods requires
advanced skills, e.g., Master’s degree
▪ However, try to include as many indirect costs as possible in your
calculations

1b. List all the benefits attributable to the project

• Direct benefits – directly attributable to the project
• Indirect benefits – indirectly attributable to the project = positive spillovers
o Use non-market methods to establish the value of both direct & indirect
benefits

2. Value the costs and benefits

(a) Financial CBA
• Use market prices to value benefits
• Use historical prices as costs
o For fixed assets (plant & machinery) you depreciate them
(i) straight-line method
(ii) reducing balance method
(iii) integer method
(b) Economic CBA
• Benefits in terms of willingness-to-pay (WTP)

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 o Includes notion of demand
• Costs in terms of opportunity cost → value of the next best alternative foregone
o Family labor → wage rate of similar labor “quality” in the neighbor
o Manure
o Fodder – banana stems
o Land - the opportunity cost of the land is the discounted net output from the
that land
• In economic CBA, prices are referred to as “shadow prices” as they reflect the
relative scarcity of inputs and outputs
• Alternatively, adjust financial prices to economic values by (see Part 3 of Gittinger
(1982, pp. 243 to 284):

(i) Adjusting for direct transfer payments

(ii) Adjusting for price distortions in traded items
(iii) Adjusting for price distortions in nontraded items

3. Compare costs and benefits using the following investment appraisal criteria:
(i) Benefit-cost ratio (BCR)
n n
Bt Ct
BCR =   (1 + s)
t =0 (1 + s) t t =0
t

(ii) Net present value (NPV)

n n n
Bt Ct NBt
NPV =  −  = 
t =0 (1 + s) t
t = 0 (1 + s )
t
t =0 (1 + s )
t

(iii) Internal rate of return (IRR)

n n n
Bt Ct NBt
IRR=s s.t. NPV = 
t =0 (1 + s )
t
− 
t = 0 (1 + s )
t
= 
t =0 (1 + s )
t
=0

where s is the social discount rate e.g. the shadow price of capital

Decision rule:
(i) Accept all projects with
• BCR>1 ➔ Benefits cover the cost of the project ➔ project is value for money
• Positive NPV ➔ use of resources in the project is socially beneficial/Pareto
efficient

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 • IRR> project’s cost of capital ➔ investing in this project will give a higher rate of
return on investment relative to investing the same money in a different/alternative
project/use
(ii) In case of multiple mutually exclusive projects, accept the one with the highest BCR,
highest positive NPV or highest IRR because they are value for money

• In case of any conflict: Accept only projects with a positive NPV as they are Pareto
efficient
o Now, if a project has positive net benefits [or NPV], then it is possible to
find a set of transfers that makes at least one person better off without
making anyone else worse off; i.e., it meets the potential Pareto
efficiency criterion = Kaldor-Hicks compensation criterion

(iv) Payback period

(a) Regular payback period
Is the expected number of years required to recover the original investment
Example: Consider 2 projects, S & L with the following cash flows:

Expected net cash flows (CFt)

Year (t) Project S Project L
0 (investment) ($1,000) ($1,000)
1 500 100
2 400 300
3 300 400
4 100 600

• Payback period of Project S is given by:

-$1000 + 500= -$500 + 400 = $-100 + 300 =$200 which just covers the initial cash
outflow. Hence the payback period is 3 years
• To get the exact payback period we use the formula:

Unrecovered cost at start of year

PaybackS = Year before full recovery +
Cashflow during the year

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 100
= 2+ = 2.33years
300
• QUESTION: WHAT IS THE PAYBACK PERIOD FOR PROJECT L?
200
• ANSWER: 3.33 years, i.e., 3 +
600
• DECISION RULE:
o For mutually exclusive projects [i.e., projects for which if one is accepted the
other is rejected], accept projects with a shorter payback period – in this
case accept S instead of L.
o Same for independent projects [i.e., projects whose cashflows are not
affected by the acceptance or nonacceptance of other projects]

(b) Discounted payback period

• Similar to the regular payback period except that cashflows are discounted by the
project’s cost of capital [or discount rate]
• Discounted PBP is defined as the number of years required to recover the
investment from discounted net cash flows

Example:
Assuming a 10% discount rate, what is the discounted payback period for project S?
SOLN:
• Discount factor = (1+k)-t where t= the year in which the cash flow occurs & k = cost
of capital or discount rate

Year
Project S 0 1 2 3 4
Net cash flow ($) -1000 500 400 300 100
Discounted NCF (at -1000 455 331 225 68
10%)
Cumulative discounted -1000 -545 -214 11 79
NCF

• Exact discounted payback period is given by:

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 Unrecovered discounted cost at start of year
Discounted PaybackS = Year before full recovery +
Discounted cashflow during the year
214
= 2+ = 2.95years
225

QUESTION: WHAT IS THE DISCOUNTED PAYBACK PERIOD FOR PROJECT L?

4. Sensitivity analysis (SA)

• Used to assess the effect of varying parameter values of inputs/variables suspected
to have the greatest degree of uncertainty, or with the greatest influence on the CBA
results
• You can vary those input/variables by some margin, e.g.,
(i) ±10% of operations and maintenance [O & M] costs
(ii) ±20% of benefits
(iii) ±1% of project cost of capital (interest rate)
• SA gives you a set of possible options for management to consider when making
the decision whether or not to invest in the project

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