Economic and Financial

Appraisal of Projects

MODULE 5
BY Dr. Muhwezi Lawrence
 Introduction
• Development projects impose a series of costs and benefits on
recipient communities or countries. Those costs and benefits
can be social, environmental, or economic in nature, but may
often involve all three.
• Public investment typically occurs through the selection,
design and implementation of specific projects to achieve the
goals of policy.
• Why are some project proposals accepted and others rejected,
and how? What are the considerations in appraisal other than
the economic rate of return?
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 Introduction Cont’d
• It should be the least-cost feasible solution to the problem being solved
and should expect to produce net economic and/or social benefits.
• For example, irrigation projects may facilitate the growing of cash crops
in one locality, but cause water shortages, and hence economic, social
and environmental pressures in another.
• How are questions of environmental impact, welfare distribution and
risk taken into account? In addition to being financially viable, a
development project cannot usually be considered acceptable unless it is
economically, technically and institutionally sound.
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 Project Appraisal
• Appraisal is the analysis of a proposed project to determine its
merit and acceptability in accordance with established criteria;
• It’s the final step before a project is accepted for financing;
• Appraisal justifies spending money on a project;
• Appraisal asks fundamental questions about whether funding is
required and whether a project offers good value for money;
• It can give confidence that public money is being put to good
use, and help identify other funding to support a project.
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Examples of decisions that require appraisal:
• Policy and programme development - decisions on the
level and type of services or other actions to be
provided, or on the extent of regulation;
• New or replacement capital projects - decisions to
undertake a project, its quality, scale, location and
timing, and the degree of private sector involvement;
• Use or disposal of existing assets - decisions to sell
land, or other assets, or relocate facilities or
operations, whether to contract out or market test
services.
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 Examples Cont’d
• Specification of regulations - decisions on the standards for
health & safety, environmental quality, sustainability, or to
balance the costs and benefits of regulatory standards and
how they can be implemented;
• Procurement decisions - decisions to purchase the delivery
of services, works or goods, usually from private suppliers.

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 Project Appraisal Criteria
These include: technical analysis, financial and economic
analysis, impact assessment and risk analysis.
Technical Appraisal:
• Will the project work? Has due attention been paid to
technical factors affecting the project design?
• Required materials, manpower and equipment have been
correctly determined and their sources identified?
• Can the project activities be undertaken and outputs
achieved within the time available and to the required
standards?
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 Technical Cont’d
Technical analysis of a project is aimed at ensuring the
following:
• That the problem or the need to be resolved by the
project has been clearly stated;
• That the source of the project proposal, nature of the
studies – including feasibility studies undertaken and
the nature of decisions taken by all relevant authorities
involved are correct;

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 Technical Cont’d
• That the project has been clearly spelled out
with the correct technical design details
(such as size, location, timing, and
technology);
• That the costs of the project have been
clearly established, expected product prices
projected, and payment modalities and
schedules agreed to.
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 Economic Appraisal of Projects
Economic appraisal is a systematic means of analyzing all
the costs and benefits of various ways in which a project
objective can be met.
In essence, economic appraisal shows:
o Whether the benefits of a project exceed its costs;
o Which among a range of options to achieve an objective
has the highest net benefit; or
o Which option is the most cost effective, where benefits
are equivalent.
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 Economic Appraisal Cont’d
• Social cost - benefit analysis; Will the project benefits
be greater than the project costs over the life of the
investment when account is taken of time (i.e. Net
Present Value of the project positive at the test
discount rate); NPV>0
• Will the nation and society at large be better off as a
result of the project;
• Impact on fulfillment of national goals :-Self
sufficiency(sustaining), Employment and Social order.
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 Ecological Appraisal
• Impact of project on quality of :- Air, Water, Noise,
Vegetation, Human life;
• Major projects such as these, cause environmental
damage:
o Power plants
o Irrigation schemes
o Industries like bulk drugs, chemicals and leather
processing.
• Likely damage & the cost of restoration;
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 Financial Appraisal
• Whether the project is financially viable?
o Sources of funding(internal/external);
o If external-Servicing debt capacity;
o Meeting returns expectations;
• Can the project be financed?
• Will there be sufficient funds to cover the expenditure
requirements during the life of the project?

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 Social and gender:
• What will be the effect of the project on different
groups, at individual, household and community
levels?
• Impact of project on distribution of income in society;
• How will they participate in various stages of the
project cycle? Will the social benefits of the project be
greater than the social costs over the life of the
investment when account is taken of time?
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 • Political: will the project be compatible with
government policy, at both central and
regional levels?
• Sustainability and risk: will the project be
exposed to any undue risks? Will the project
benefits be sustainable beyond the life of the
project?

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 Benefits of Economic Appraisal
The principles of appraisal are applicable to all decisions, even
those concerned with small expenditures. However, the scope of
appraisal can also be very wide.
• Good economic appraisal leads to better decisions and value for
money(VFM);
• It facilitates good project management and project evaluation;
• Appraisal is an essential part of good financial management,
and it is vital in decision-making and accountability.

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 Benefits Cont’d
• Systematic process for examining alternative uses of resources,
focusing on assessment of needs, objectives, options, costs,
benefits, risks, funding, affordability and other factors relevant
to decisions;
• Methodology designed to assist in defining problems and
finding solutions that offer the best value for money (VFM);
• Important in relation to public expenditure and is often used as
a vehicle for planning and approval of public investment
relating to policies, programmes and projects.
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 Economic Vs. Financial Appraisals
• Economic appraisal is a more comprehensive method of analysing
project costs and benefits than financial appraisal. For example,
economic appraisal considers a wider range of costs and benefits of
a project.
• Economic appraisal uses either cost-benefit analysis or cost-
effectiveness analysis to assist decision makers to choose between:
o Alternative project options designed to achieve the same objective;
o A range of projects directed at a variety of objectives which cannot
all proceed due to resource constraints.
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 Economic Appraisals cont………
In addition, economic appraisals also:
Take into account costs and benefits which may not be reflected in
monetary transactions (for example the value to the public of travel
time savings from a new road),
The purpose and objectives of financial and economic appraisals
are quite different so it will not always be the case that a project that
is financially viable will be economically viable or a project that is
economically viable will be financially viable. 

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 Financial appraisal
• Financial appraisal views investment decisions from the perspective of
the organization. It assesses the viability of a project based on the direct
effects on the cash flow of the organization;
• It considers whether the projected revenues will be sufficient to cover
expenditures and whether the financial return is sufficient to make the
investment commercially viable (profitable); 
• Financial appraisal concentrates on effects on the agency sponsoring the
project, whereas economic appraisal also considers external benefits and
costs for other government agencies, private sector enterprises and
individuals.
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Content of an Economic Appraisal
There are two main types of economic appraisals:
i. Cost Benefit Analysis (CBA) and
ii. Cost Effectiveness Analysis (CEA).
The guiding principle is that wherever feasible,
CBA is preferable to CEA.
• CBA is the more comprehensive of these two
techniques.
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 Cost-Benefit Analysis
• It quantifies in monetary terms all the major costs and benefits
of project options. Thus the outcomes for a range of options are
translated into comparable terms to facilitate evaluation and
decision making;
• By presenting social benefits and costs in a monetary
format, CBA not only facilitates choices between alternative
investment options but also gives an idea of the project
worth.
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 Cost-Benefit Analysis
• In cost-benefit analysis method, a project is considered to be
desirable, when the net benefit (total benefits less disbenefits-
losses) associated with it exceeds its cost. Thus it becomes
imperative to list out separately the costs, benefits and
disbenefits associated with a public project.
• Costs are the expenditures namely initial capital investment,
annual operating cost, annual maintenance cost etc. to be
incurred by the owner of the project and salvage value if any is
subtracted from the costs.
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 Cost-Benefit Analysis Cont’d
• Benefits are the gains or advantages whereas disbenefits are the losses,
both of which are experienced by the owner in the project.
• In case of public projects which are funded by the government
organizations, owner is the government. However, this fund is
generally taxpayers’ money i.e. tax collected by government from
general public, thereby the actual owners of public projects are the
general public;
• Thus in case of public projects, the cost is incurred by the government
whereas the benefits and disbenefits are mostly experienced by the
general public.
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 Example: Thermal Power Plant
• The costs to be incurred by the public sector organization are cost
of purchasing the land required for the thermal power plant, cost of
construction of various facilities, cost of purchase and installation
of various equipment, annual operating and maintenance cost, and
other recurring costs etc.
• The benefits associated with the project are generation of electric
power that will cater for the need of the public, generation of
revenue by supplying the electricity to the customers, job
opportunity for local residents, development other infrastructure in
the nearby areas etc.
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 Disbenefits
• The disbenefits associated with project are loss of land of the local
residents on which the thermal power plant will come up.
• If it is agricultural land, then the farmers will lose their valuable
land along with the annual revenue generated from farming, even
though they get money for their land from the public sector
organization at the beginning.
• The other disbenefits to the local residents are greater likelihood of
air pollution in the region because of the thermal power plant,
chances of contamination of water in the nearby water-bodies etc. 
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 Examples of Project Benefits
• Increased output;
• Enhanced services;
• Create/increase employment;
• Large govt revenue;
• Higher earnings;
• Higher standards of living;
• Increased national income;
• Improved income distribution.
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 Benefit-Cost Ratio
• Also known as Profitability Index(PI)
• The benefit-cost ratio of a project is calculated by taking the
ratio of the equivalent worth of benefits to that of the costs
associated with that project.
• Either of present worth, annual worth or future worth
methods can be used to find out the equivalent worth of costs
and benefits associated with the project.
• For project acceptability, B/C ≥1
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 Benefit-Cost Ratio Cont’d
The benefit-cost ratio of projects is determined in different forms
namely: conventional benefit-cost ratio and modified benefit-cost
ratio. The benefit-cost ratio is generally designated as B/C ratio.
Conventional B/C ratio
• The conventional benefit-cost ratio of a project is calculated as
follows;

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 Benefit-Cost Ratio Cont’d
• As already stated the equivalent worth may be calculated either by Present
Worth method, Annual Worth method or Future Worth method. Thus the
expression for conventional benefit-cost ratio (B/C ratio) is expressed as follows;

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 Modified Benefit-Cost ratio method
• In the modified benefit-cost ratio method, the operating and
maintenance cost is subtracted from the benefits in the numerator of
the ratio. In other words, operating and maintenance cost is considered
similar to the disbenefits. The expression for modified benefit-cost ratio
using PW, AW or FW is given as follows;

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 Benefit-Cost Ratio Cont’d
• The disbenefits associated with the project are subtracted
from the benefits in the numerator of the ratio to obtain the
net benefit associated with the project.
• Similarly the equivalent worth of salvage value of the initial
investment is subtracted from equivalent worth of cost in
the denominator of the ratio. The total cost mainly consists
of initial cost (initial capital investment) plus the operating
and maintenance cost.
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 Key steps in Investment appraisal
Choices between investment options may be based on a
comparison of:
• Net Present Values at the test discount rate,
• Internal Rate of Return (IRR),
• Payback periods, and;
• Benefit/cost ratios.

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 Key steps in Investment Appraisal
• Identify project benefits and costs (distinguishing between capital and
recurrent costs);
• Calculate the net cash flow by comparing benefits with costs over the life of
the investment;
• Discount the net cash flow by expressing all future benefits and costs in
present values in order to take account of people’s preference for time; 4.
Discount rates
• Often governments and donors set test discount rates that vary according to the
type of project. At present, discount rates for public sector investments stand at
12%; for projects with a strong poverty or environmental focus, rates may be
as low as 3%. For private sector investments, discount rates usually reflect
commercial rates of interest.
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 Investment Appraisal Cont’d
• Sum the discounted net cash flow to calculate the Net Present
Value (NPV);
• Calculate the Internal Rate of Return (IRR), the discount rate
at which the NPV equals zero (representing the maximum
interest rate a project could pay and still break even);
• Conduct a sensitivity analysis to determine how sensitive the
results are to changes in key variables.

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 Internal Rate of Return (IRR)
• The IRR of a project is defined as that rate of discounting the
future that equates the initial cost and the sum of the future
discounted net benefits.
• It is the discounted rate that makes the NPV of a project equal
to zero OR its BCR = 1
• The decision criterion: A project with an IRR exceeding some
predetermined level (Social discount rate) is deemed
acceptable.
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• It is calculated by using the following equation:
=… ; OR
IRR: Σ discounted benefits – Σ discounted costs = 0
• The internal rate of return is a very popular method of project appraisal
because it takes into account the time value of money.
• IRR tells shows the rate of return one will receive by putting money
into a project.
• It describes by how much the cash inflows exceed the cash outflows on
an annual percentage basis, taking account of the timing of those cash
flows. IRR is also referred to as the ‘yield’ of a project.
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 What can a Project Appraisal deliver?

• Being consistent and objective in choosing projects

• Make sure their program benefits all sections of the community
• Provide documentation to meet financial and audit
requirements
• Appraisal justifies spending money on a project.
• Appraisal is an important decision making tool.
• Appraisal lays the foundations for delivery.
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