Distinctions b/n Fin’l and Econ’c Appra’ls

Issues Financial Appraisal Economic

Appraisal
Net return to individual or the Net return to society
Focus
private group
Determines whether
Measures profitability at Market
Purpose Govt. (public) Inv’t is
prices
economically justifiable
Shadow prices are
Prices received/paid are taken
Prices estimated to remove
from the market
price distortions*
Taxes are production cost;
Transfers Not economic costs
Subsidies are revenue
Interest+
Loan Financial costs Not economic costs
Repayment
Opportunity costs of
Discount Rate Market borrowing rate
investable
Market distortions are caused by monopoly prices, external effects,funds.
unemployed or underemployed resources, under or overvalued currency. etc
Project with non-valued Outputs
(Least Cost/Cost Effectiveness Approach
 When the output of a project is difficult or impossible to quantify, project
appraisal is carried out by comparing the cost structures of projects.
The approach is termed as Least Cost/Cost Effectiveness approach.
 The procedure for arriving at the total cost of project follows by
correcting price distortions and by removing transfer payments.
Illustration -  - hypothetical example of power supply for inhabitants
Assumptions: Project life is 5 years
: Discount rate is 8%
The project is to have three alternative cost structures:-

Alternative 1:Assumes an inv’t of Birr 200,000 & operating cost of Birr 24,000
Alternative 2:Assumes an inv’t of Birr 220,000 & operating cost of Birr 16,000
Alternative 3:Assumes an inv’t of Birr 240,000 & operating cost of Birr 12,000

To find the best alternative we should calculate the present value of all the
projects and choose the least cost.
Least Cost/Cost Effectiveness Approach
Present value of project costs,

Alternative -1 Alternative -2 Alternative -3

Discounting
Yr Factor Present Present Present
Cost Cost Cost
Value Value Value
200,000 200,000 220,000 220,000 240,000 240,000
0 1

1 0.926 24,000 22,224 16,000 14,816 12,000 11,112

2 0.857 24,000 20,568 16,000 13,712 12,000 10,284

3 0.794 24,000 19,056 16,000 12,704 12,000 9,528

4 0.735 24,000 17,640 16,000 11,760 12,000 8,820

    279,488   272,992   279,744

 

 The least costly project, therefore, is project alternative two.

Payback Period

Machine A Machine B
Discounting
Yr Factor/20%/ Cash Present Cash Present
flow Value flow Value
[35000] ? [35000] ?
0 1

1 0.8333 20000 ? 10000 ?

2 0.6944 15000 ? 10000 ?

3 0.5787 10000 ? 15000 ?

4 0.4823 10000 ? 20000 ?

    ?   ?
 

 Payback period for machine A is 2 years ,machine B 3 years

Least Cost/Cost Effectiveness Approach

Illustration -  -
A choice is to be made between a diesels or a petroleum powered
car to be used to service at Office
 which in both cases will perform the same number of kilometers
per year.
 The diesel car will cost Birr 400,000 to buy and Birr 24,000 per
annum in each of the years in which it is operated;
 the petrol car has a lower purchase cost of Birr 200,000 but will
cost Birr 36,000 per annum to operate and require a major
overhaul costing Birr 200,000 six years after purchase.
 In each case, the car is expected to be operated for ten years, and
 to be worthless at the end of the period.
 Which car should be bought to minimize total costs over the ten
year period the resource flow is set out below and
 discounted at 10% discount factor.
Least Cost/Cost Effectiveness Approach-illustration
Present value of costs at 10% DF for diesel and petrol cars

diesel petrol
Yea Discounting Present Present
r Factor Cost Value Cost Value
0 1 400,000 400,000 200,000 200,000
1 0.909 40,000 36,360 60,000 54,540
2 0.826 40,000 33,040 60,000 49,560
3 0.751 40,000 30,040 60,000 45,060
4 0.683 40,000 27,320 60,000 40,980
5 0.621 40,000 24,840 260,000 161,460
6 0.564 40,000 22,560 60,000 33,840
7 0.513 40,000 20,520 60,000 30,780
8 0.467 40,000 18,680 60,000 28,020
9 0.424 40,000 16,960 60,000 25,440
      630,320   669,680

 At 10% discount rate, the diesel car should be chosen as it has the
lower present value costs.