WEL COME TO:

CHAPTER-6
SOCIAL COST BENEFIT ANALYSIS (SCBA)
 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.
• SCBA is a technique of economic analysis allowing
the evaluation and determination of
economic costs and benefit, both direct and
indirect, of the particular public initiative or
private projects.
 …

• It measures the project's effect on the efficiency

of the whole economy.
• 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 & Investment, and Concern for
redistribution of benefits and Merit wants.
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.
 …

• Merit goods are the production of which the

Government will want to encourage. E.g. education and
healthcare generates positive externalities and are not
relevant from private point of view but social.
• Demerit goods or services, in contrast, are those known
to cause clear harm when produced and consumed. E.g.
tobacco, alcoholic beverages, recreational drugs,
gambling, junk food and prostitution.
• In economic analysis shadow prices (set of prices that is
believed better reflect the opportunity cost) are used.
• Hence, Economic analysis is concerned with public
"profitability" which is based on economic resource
flows.
 …

• Economic resource flows relates to:

a. Social opportunity costs (shadow prices) adjust
market prices by taking into account differences
based on tax and subsidies, external costs and
benefits, monopolistic pricing, price control and
rationing, quantitative trade restrictions, over-
valued (or under valued) exchange rate and labor
opportunity costs.
b. Divergence between real rate of interest and
nominal (financial) rate of interest, and difference
between private and social/public rate of discount.
 Economic analysis consists mainly of adjustments to information used in financial analysis and of a few
additional ones.

 The methodology and the criteria used to evaluate a

project using financial and economic information are the
same. However, the main difference lies in the value that
the NPV and IRR take.
 This difference occurs because of the difference of:
o the items considered as inputs and outputs of the project
o the prices used in the valuation of the project inputs and
outputs
o the treatment of taxes, subsidies and other transfer
payments.
 The following table and the discussion that follows best explains the difference between
economic and financial analysis.

Factors Financial Analysis Economic Analysis

Pricing of inputs Domestic market price Shadow prices

Treatment of transfer All included Excluded

payments, tax, subsidy, etc

Externalities Excluded Included

Discount rates Takes into account the The economic discount

current lending rate rate
 1. External costs and Benefits (Externalities)
• Externalities in short are costs or benefits to the
economy as a whole that are attributed to the project
but not taken into account in estimating quantities
and values for the project inputs and outputs.
• Examples of externalities include access to roads,
energy lines, sewerage services, flood control dams
etc.
• The benefits and costs and benefits attributed to the
project do not appear among its inputs and outputs
when it is analyzed from the company's viewpoint
and they do not enter in the calculation of NPV and
IRR.
 …

• The reason is they are considered as "external" to

the organization. But they are internal from
economy's angle and included in the calculation
of IRR and NPV.
• Because, somebody pays for such externals and
somebody receives the benefits of such externals
even if it is not the enterprise.
• Therefore, to the extent they can be measured
and evaluated they are included in the economic
analysis.
 2. Prices of Inputs
• As it is shown in the table above, another difference
between financial analysis and economic analysis is
that even inputs and outputs are "internal" to both
the single firm and the economy, they are valued
differently.
• In financial analysis the need is to value input over
output at actual market prices while in economic
analysis shadow prices are employed.
• Consequently, using different prices will give
different economic and financial NPV and IRR, even
if the inputs and outputs are identical in physical
terms.
 …

 Domestic/market price is a price we can get in the

market and be used in financial analysis. It is set
by cost plus certain percentage of margin.
• Whereas, shadow price is estimated price and are
not observed prices.
• One cannot find them in the market. They are
estimated by the macro planners and are taken as
given by the project analysts in all types of
projects.
 3. Transfer Payments
 The third reason why financial and economic NPV
and IRR might differ emanates from the treatment
of taxes, subsidies and other transfer payment.
 Transfer payments are payments that are made
between different persons or organizations but are
not related to any particular resource cost. This
payments affect the distribution of income but do
not affect the volume of resources available to the
country’s economy.
 Taxes and custom duties from which the enterprise
is not exempted are taken as costs in financial
analysis.
 …

• But they are excluded from economic analysis

because they do not reflect the commitment of
real resources.
• Similarly, subsidies paid to the enterprise from
the government are viewed as transfer payments
and are omitted in economic analysis, but they
are treated like any other revenue of the
enterprise in the financial analysis that is, IRR and
NPV calculations.
 4. Discount Rate

• In financial analysis, the discount rate used is simply the

rate the sponsors expect they will have to pay for
borrowed funds or the rate they wish to receive on
capital invested.
• However, in economic analysis accounting or shadow
prices are used, which are believed to be more
competitive, to receive signals that will guide the
allocation of resources and the structure of domestic
production.
• For economic analysis purpose, all the inputs and
outputs of the project are valued at world price which
are formed independent of whatever distortions prevail
in the domestic market.
 …

• These world prices are known as accounting or

shadow prices estimated as border prices in the
form of Cost Insurance and Freight (CIF) for the
imported and FOB (Free On Board) for the
exported commodities.
 Social Cost Benefit Analysis/Economic analysis is done because of the following reasons.

• Inflation: is a general price increase of commodities (Inputs

and outputs). When high degree of inflation prevail in any
economy, the project's inputs and outputs do not reflect their
real value.
• Therefore, the price of these inputs and outputs should be
adjusted using the world price by conducting economic
analysis.
• Currency over valuation: when the foreign currency is over
valued (eg., dollar), most developing countries are exercising
devaluation of their currency in order to reflect the world price.
• For example, our birr is depreciated from time to time
whenever the value of dollar is appreciating. ($1 = Br. 40.00, $1
= Br. 45 etc.)
 …

• Existence of under employment: in developing

countries like Ethiopia, the domestic prices are
distorted and do not reflect the real value of
inputs and outputs. In other words, the market
prices and economic prices are not the same.
• One of the highly distorted market is the labor
market. Unskilled and semi-skilled labor market is
highly affected because workers are paid less and
the payment for employees is not the same for all
doing the same job.
• Therefore, for economic analysis purpose, this
distortion should be adjusted.
 …
• Existence of income/wealth inequality: due to this
inequality price may not reflect the social equalities.
As a result project analysts shift to apply social pricing
techniques (i.e., shadow pricing techniques).
• Externalities: are costs and benefits to the economy as
a whole and that are attributed to the project but are
not taken in to account in estimating quantities and
values for the project inputs and outputs.
• Since they are not paid for by a particular firm,
financial analysts ignore them. But someone has
covered their cost (government), thus their value
should be included in the economic pricing technique.
 …

• Existence of tariffs, customs and duties:

existence of these restrictions and impositions by
the government may increase the price of
commodities.
• This cost needs to be excluded in the economic
analysis because it does not reflect the
commitment of real resources.
 6.2. 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.
 Each stage of appraisal measures the desirability of the project
from a different angles.
 6.2.1 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 that you thought in Financial
Management under Capital budgeting as well you
do as assignment.
 6.2.2 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.
 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.
 i. 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?
 …
 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? To private or public?
 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”.
 ii) 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.
 iii) 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 or increase imports, or
(iv) increase 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.
 iv) Taxes:
 When shadow prices are being calculated, taxes
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.
 v) 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.
 SHADOW PRICES
• Shadow prices for economic analysis are based
on the opportunity costs.
• Opportunity cost is defined as the next best
alternative foregone in undertaking a course of
action.
 Opportunity Cost of Land
• In economic analysis, land is not usually treated as a
capital value. The opportunity cost of land is defined by
its next best alternative use. Urban land can be used for
houses, offices, shops and factories. Rural land is
normally used for crops, pasture, forestry or sometimes
conservation.
• The opportunity cost of rural land is likely to be very
important in the assessment of any agricultural or agro
industrial project. When agricultural land is being used,
the opportunity cost is the value of the alternative crop
produced less the other costs involved in producing the
crop. For urban land the opportunity cost is usually
defined by rental values.
  
Opportunity Cost of Labor

• Opportunity cost of labor is the value of the worker's

output in the next best alternative. It usually varies
significantly between occupational groups and often
between regions. In determining the opportunity
cost of labor it is important to identify the potential
source of labor (urban or rural). Project appraisal
also distinguish between skilled and unskilled labor.
• The most common assumption is that skilled labor is
in scarce supply and has an opportunity cost equal or
greater than its market price, while unskilled labor is
in excess supply and has an opportunity cost below
its market price.
 …

• Skilled labor was assumed to be relatively scarce

and so the opportunity cost of skilled manpower
was assumed to be the same as the market price.
The opportunity cost is assumed to consist of
outputs of the various sectors in proportion to
the estimated employment of skilled labor in
each sector.
WEL COME TO:
CHAPTER-7
PROJECT FINANCING
 7.1. Sources of Project Finance
• Project finance is the funding (financing) of long-
term infrastructure, industrial projects, and public
services using a non-recourse or limited recourse
financial structure.
• Project finance may come from a variety of sources.
• The main sources include equity, debt and
government grants.
• Financing from these alternative sources have
important implications on project's overall cost,
cash flow, ultimate liability and claims to project
incomes and assets.
 i. Equity
• Equity refers to capital invested by sponsor(s) of
the project.
• Equity is provided by project sponsors,
government, third party private investors, and
internally generated cash.
• Equity providers require a rate of return target,
higher than the interest rate of debt financing to
compensate the higher risks taken by equity
investors as they have junior claim to income and
assets of the project.
 Loan financing

• Lenders of debt capital have senior claim on income and

assets of the project.
• Generally, debt finance makes up the major share of
investment needs (usually about 70 to 90 per cent) in
some projects. The common forms of debt are:
• Commercial loan
• Bridge finance
• Bonds and other debt instruments (borrowing from the
capital market)
• Subordinate loans
 Commercial loans are funds lent by commercial banks
and other financial institutions and are usually the main
source of project financing.
 …
 Bridge financing is a short-term financing arrangement
(e.g., for the construction period or for an initial
period) which is generally used until a long-term
financing arrangement can be implemented.
 Bonds are long-term interest bearing debt instruments
purchased either through the capital markets or
through private placement (which means direct sale to
the purchaser, generally an institutional investor).
 Subordinate loans are similar to commercial loans but
they are secondary or subordinate to commercial
loans in their claim on income and assets of the
project.
 …

• Government grants can be made available to

make projects commercially viable, to reduce the
financial risks of private investors, and to achieve
socially desirable objectives such as to induce
economic growth in lagging or disadvantaged
areas.
• Many governments have established formal
mechanisms for the award of grants to projects.
• Where grants are available, depending on
government policy they may cover 10 to 40 per
cent of the total project investment. 
 Leasing
 Leasing and hire purchase are financial facilities
which allow a business to use an asset over a
fixed period, in return for regular payments.
 Leasing provides an easy access to the much
needed assets for productive business.
 Leasing is simply a legal agreement or contractual
relationship between two parties, lessor and
lessee, whereby the lessor owns the capital or
capital asset and allows the lessee to use or hire
it up on the condition that the lessee pays a form
of rental for a specified period of time.
 7.2. Cost of Capital

• The cost of capital is often used as the discount

rate, the rate at which projected cash flow is
discounted to find the present value or net
present value of a project.
• The cost of capital for a project is a weighted sum
of the cost of debt and the cost of equity.
• The rate of return required by the investor should
definitely be provide by some other party.
• The party which should provide the investor its
required rate of return is the issuing party.
 …
• For example, if the required rate of return by an investor
on a given bond is 10%, the issuing company should
provide this 10% to the investor.
• This required rate of return that should be met by the
issuing company becomes its cost.
• This is a minimum cost on the capital the issuing
company wants to raise.
• Therefore, cost of capital is the minimum rate of return
that a firm must earn in order to satisfy the overall rate of
return required by its investors.
• It is also the minimum rate of return a firm must earn on
its invested capital to maintain the value of the firm
unchanged.
 The cost of debt

• This is the minimum rate of return required by suppliers of debt.

• Generally, debt is the cheapest source of finance to a firm. There
are two basic explanations for this.
• First, debt suppliers, generally, assume the lowest risk among all
suppliers of capital. They receive interest payments before
preferred and common dividends are paid. Since they assume
the smallest risk, their return is the lowest. Their lowest return
would be the lowest cost of capital to the firm.
• Second, raising capital through debt sources entails interest
expense. The interest expense in turn reduces the firm’s income
which ultimately would cause tax payment to be reduced. So
raising money in the form of debt results in the smallest tax
burden, and finally, the firm’s cost of debt would be the lowest.
 The cost of preferred stock

• The cost of preferred stock is the minimum rate of

return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock
investors.
• It is also the minimum rate of return a firm’s
preferred stock investors require if they are to
purchase the firm’s preferred stock. 
• When a firm raises capital by issuing new preferred
stock, it is expected to pay fixed amount of dividends
to the preferred stockholders.
• So it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.
 The cost of common stock

• The cost of common stock is the minimum rate of

return that a firm must earn for its common
stockholders in order to maintain the value of the firm.
A firm does not make explicit commitment to pay
dividends to common stockholders. However, when
common stockholders invest their money in a
corporation, they expect returns in the form of
dividends. Therefore, common stocks implicitly involve
a return in terms of the dividends expected by
investors and hence, they carry cost.
• Generally, common stock dividends are paid after
interest and preferred dividends are paid. As a result,
common stock investors assume the maximum risk.
 The cost of Retained Earnings

• Retained earnings represent profits available for common

stockholders that the corporation chooses to reinvest in itself
rather than payout as dividends. Retained earnings are not
securities like stocks and bonds and hence do not have
market price that can be used to compute costs of capital.
• The cost of retained earnings is the rate of return a
corporation’s common stockholders expect the corporation
to earn on their reinvested earnings, at least equal to the
rate earned on the outstanding common stock.
• Therefore, the cost of capital of retained earnings is equated
with the cost of common stock.
• However, flotation costs are not involved in the case of
retained earnings.
 Reading contents in Chapter-7

7.3. Public Policy and Regulations on Financing

7.4. Financing Institutions
7.5. International Financial Institutions (World Bank,
IMF, Asian Development Bank, African Development
Bank)
 WEL COME TO:
CHAPTER-8
Why PROJECTS FAIL?

Will be left to you as future researchable title

to be done.
 End of the course !!
Thank you for your patience !!