Training on Financial and Economic Project Evaluation (cost benefit analysis)

May 15th 2013

Learning objectives

1. Understand the concept, utility and limits of financial/private and economic/social project evaluation (cost benefit)

2. Know how to interpret the results of financial/economic evaluations (cost benefit)

3. Understand the opportunities of financial/economic evaluation being part of the PCM and its implication for results based project management

4. Identify development projects for which the concept can be applied, and for which kind of projects other methods are more adequate

Group Work

Social Entrepreneur selling a technology like micro irrigation to poor farmers

1. What do you need to know to make this business a success and not a bankruptcy?

Objective of CBA applied to project evaluation

Make better informed decisions on whether to invest or not Relying on the necessary information to quantify variables which are related to • investment, • operational costs and • incomes

Market / feasibility Study

Technical Study

Organisational study Financial Evaluation

Important studies needed for project formulation and evaluation

Economic Evaluation

The different studies provide information for the project evaluation - business approach -

Benefits / Costs Return on investment

Market Study

Objective: Determine the existence of the unmet demand and quantify it

Technical Study

Objective: Verify the technical feasibility

Organisational Study

Objective: define the optimal organisational

structure Analysis of demand Analysis of supply Price or fee Marketing strategy

Production capacity

Technology

Infrastructure

Human resources

Information system

Legal aspects

What is cost-benefit analysis (CBA)?

The aim of the cost benefit analysis is to assess the profitability of investments over time, by comparing the costs of a project with its benefits

COSTS = investment costs running costs or operational costs financial costs support costs

Only real costs are considered in the CBA, i.e. costs that correspond to flows of cash, and the costs are computed at the time when they occur during project life.

BENEFITS: increased production, project sales reduced costs social benefits,  improved  livelihood,  reduced  poverty,…

Quantification is required! CBA requires to quantify all the costs and benefits, which is sometimes rather challenging. Where quantification is not possible, benefits and costs should be included in the discussion and interpretation of the models, or another method should be selected (e.g. Cost effectiveness)

Whose costs should be considered ? Beyond financial evaluation: all costs need to be taken into account • SDC project costs • Other counterpart costs • Costs beneficiaries bear (incl. in-kind contributions)

Note: the CBA compares additional costs and additional benefits for the users / for the enterprise, etc. i.e. the costs and benefits WITH or WITHOUT the project Example of a CBA Note: year 0 is only virtual, so that the project can start in year 1 it is necessary to have the

funds available on the day before the project starts

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 COSTS -100 -12 -13 -11 -13 -12 Investment -100 Operations -10 -10 -10 -10 -10 Other costs -2 -3 -1 -3 -2

BENEFITS 0 12 20 50 50 100 Sales 12 20 50 50 50 Residual value

50

CASH FLOW -100 0 7 39 37 88

DISCOUNTING Principle: 1 dollar today is worth more than 1 dollar tomorrow Question: what is the value today of the money you will earn next year, or in 2, 3 or 10 years from now? Example: on your savings account you have 5’000  CHF   earning 2% per year How much will you have on your account after 5 years? (assuming that you have no transaction costs and that the interest rate remains unchanged) Interest 1st year = 5’000  * 2% = 5’100  CHF Interest 2nd year = 5’100  *  2%  = 5’202  CHF   Etc…  

Compound interest Discounting

capital (P) = today 5'000 capital (P) = today 4’528

interest (r) 2% interest (r) 2%

time (years) (n) 5 time (years) (n) 5

accumulated capital (A) 5’520 accumulated capital (A) 5’000

A = P(1 + r)n P= A(1+r)-n

Net Present Value and Internal Rate of Return Net present value (NPV) = value today of the cash flow of

each year of the analysed period In Excel, use +NPV(10%;year1...year5)+year 0 (here = 15.00)

Internal Rate of Return (IRR) = rate that the project generates over time (this rate can be compared with interest rate of banks or alternative use of the capital

In Excel, use +IRR(year0 ... Year5) (here = 13.81%)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 COSTS -100 -12 -13 -11 -13 -12

BENEFITS 0 12 20 50 50 100 CASH FLOW -100 0 7 39 37 88

Evaluation criteria

Net present value (NPV)

• Expresses the difference between total expenditure and income of the project (cash flow) but discounted to the value of money at project start.

• Shows the surplus after having received the demanded profitability (discount factor) and having retrieved the total investment

• The convention is to accept the project if the NPV is bigger or equal to 0.

Internal rate of return (IRR))

• Shows the maximal profitability that can be expected of the investment.

• The project is accepted if the IRR is bigger or equal to the discount factor.

• IRR only tells us if the project is better than the alternative use of funds (IRR does not allow to compare different project)

Benefit – Cost Relation (BC)

• Compares the present value of the benefits with the present value of the costs including the investment, shown as a ratio

• The project is accepted if the ratio is bigger or equal to zero.

EXTERNALITIES Externalities are “side  effects”  of projects or enterprises

which are not included in the costs and benefits; they can be positive (external benefits) or negative (externals costs). In the case of negative externalities, the costs are usually paid by the society

Examples of external benefits Access to electricity for villagers after a factory was installed in

the neighbourhood After a village installed electricity supply, an enterprise decides

to settle in the neighbourhood ( job creation)

Examples of external costs Pollution, noise, traffic, etc.

Economic analysis SHADOW PRICES / economic prices

(also called opportunity costs) Market prices do not always reflect the real value of products. This

is the case for instance when subsidies or taxes are paid / charged. Example:

fertiliser  price  on  the  market  =  100’000  VND subsidy from the Government = 25% real  value  of  fertiliser  =  100’000  VND  +  25%  =  125’000  VND In this case, farmers get fertilisers cheaper than the real value, the

financial value is lower than the economic value

FINANCIAL VS ECONOMIC ANALYSIS

Financial Economic

CBA shows the interests of ...

Private enterprise: is the project profitable for the investor?

Society: is the project beneficial to the society (whole economy)

Prices considered

Costs and benefits at market prices

Shadow prices (opportunity prices), i.e. prices are corrected from subsidies, taxes, etc.

Externalities Not considered Considered

Excel data

Reserve Slide: Structure of the flow of funds statement

+ Income (tax relevant) - Expenditure (tax relevant) - Expenditure not implying cash flows, but tax relevant (depreciation and amortization) = Profit before taxes - Taxes = Profit after taxes + Adjustment for expenditures not implying cash flows (depreciation and amortization) - Expenditure not relevant for taxes (investments) + Benefits not relevant for taxes (residual value) = Cash Flow

Consideration concerning the cash flow

Time horizon of the evaluation

• Is highly dependent on the characteristics of each project.

• If the project life time can be foreseen, and is not long term, the most convenient is to construct the flow of funds for this number of years.

• If the enterprise (or structure) the project wants to create will stay in the market (no exit strategy), the general convention is to project the flow of funds for 10 years.

• The expected benefits beyond the 10th year are then reflected in the residual value.

Risk within projects When preparing and evaluating projects one has to rely on assumptions, e.g. with respect to – population growth, – demand, – supply, – technologies, – availability of inputs, – estimation of costs, – estimation of benefits, – etc., etc., etc.

…  where  there  are  assumption  there  are  risks

Mainly serves for : a. Determine critical variables and their ranges of

variation.

b. Study and determine the effects of the critical variables on the results of the project.

c. Evaluate the project with different external conditions.

Sensitivity analysis

Methods for sensitivity analysis

Select the critical variables :

Consider the variables that are difficult to predict Select the variable with the biggest impact on the NPV

… or those with the highest uncertainty. Move one variable at a time (Ceteris Paribus) Construct different scenarios for a group of the above

variables and re-calculate the project criteria.

Possible Alternative: Cost Effectiveness Analysis • Applied when benefits cannot be quantified (with

reasonable effort)

• Instrument for comparing different approaches to reach a certain benefit

• Choose the approach that creates the biggest and lasting benefit for the beneficiaries

• Used to justify an approach for funding (as compared to alternatives)

Cost Effectiveness Analysis

Impacts that the project is supposed to reach Distinguish major impact and side impacts (or secondary impacts)

Starting point = project design

COSTS = Direct costs Investment costs, Support costs (coaching, backstopping, etc.) Maintenance costs Costs for SDC and costs for partner organisations Indirect costs may also be considered

BENEFITS: are the benefits really the same, how sustainable are the benefits, etc.

Important to remember

1. You need solid numbers

a) to construct financial and economic evaluations, evaluate results before, after, during

b) to formulate your project: market studies etc.

2. Financial (private) evaluation shows whether private sector part is viable or what the project needs to do to make it viable

Important to remember

3. Financial and economic evaluation are key

tools to improve result management:

Identify benefits Quantify benefits Establish causality … even if no precise NPV can be calculated.

Important to remember

4. Economic/social evaluation provides valuable, additional decision criteria (not the only ones!)

a) to approve or reject projects

b) to identify more objectively and quantified

what works and can be scaled up

1. Reserve Slide: Domains of application of CBA in development cooperation

• CBA can be applied in a wide range of projects, key condition is the quantification of costs and benefits

• CBA can be applied to entire projects or to selected project components

Difficulty to apply Low Medium High

Project dealing with

Income generation, livelihood, economic development

Health, education, nature conservation, biodiversity, etc.

Governance, policy dialogue, institutional development

Examples of CBAs (done or in preparation)

Vietnam, Mongolia, South Africa, Latin America

Macedonia, Moldavia

Balkan region

2. Reserve Slide: Basic steps to conduct meaningful CBAs

• First step: define the boundaries of the project or component that is to be analysed

What exactly is to be analysed? What is the purpose of the analysis? (includes geographic, institutional, topical boundaries, etc.)

• Second step: what are the outcome / impact hypotheses? How do costs relate to benefits, what are the expected outcome/impact

chains?

• Third step: list all the costs related to the selected project / component (including local contributions, investment costs, operational costs and management costs) and the benefits (in three categories: i) easy to quantify, ii) difficult to quantify, iii) non quantifiable)

• Fourth step: assess data availability; plan and implement data collection

• Fifth step: set up CBA model and interpret it