Wollega University

Faculty of Resource management and Economics

Dep’t of animal science, and AgEc
Agricultural project planning and Analysis(Agec412)

Instructor: Tolesa.T(Msc)
COURSE CONTENT
Chapter 1:Concepts of project
Chapter 2:Aspects of project preparation and analysis
Chapter 3:Project cycle
Chapter 4:Project cost and benefit
Chapter 5:Financial analysis of project
Chapter 6:Economic analysis of project
Chapter 7:Measure of project worthiness
 1. Introduction
1.1. The Project concept
 project planning and analysis has a long history
in financial and business analysis.

 Project planning has always been used as a means

of checking the profitability of a particular
investment by private firms.

 Recent experiences show that project analysis has

attracted the attention of development economists.

 Projects are now assessed from the economy’s

viewpoint instead of only from the firm’s
perspective.

 The selection criteria have also included economic

 Especially from development viewpoint, for most
development activities
 careful preparation in advance of expenditure is, if
not absolutely essential, at least the best available
means to ensure efficient, economic use of capital
funds and to increase the chances of
implementation on schedule.

 Unless projects are carefully prepared in

substantial details, inefficient or even wasteful
expenditure is almost sure to result
 a tragic loss in nations short of capital.
 1.2. Project Definition
 There are many definitions of a project and many
different types of projects.
 The simplest way to understand a project is to identify
the following common characteristics:

it has a specific starting and finishing time,

it has usually geographical and sometimes
organizational boundary,
it has clearly defined set of objectives,
it entails the investment of scarce resources
in the expectation of future benefit, and
it may be planned, financed and
implemented as a unit.
Project…..is …
Gittinger (1982) defines a ‘project’ as an investment
activity upon which resources – costs – are expended
to create capital assets that will produce benefits
over an extended period of time and which logically
lends itself to planning, financing, and implementing
as a Unit.

A specific activity, with specific starting point

and specific ending point, intended to
accomplish a specific objective.

The smallest operational element prepared and

implemented as a separate entity in a national plan
or program.
 Cont…
Or, put more succinctly, ‘The whole complex of activities
for which money will be spent in expectation of returns’
(ibid).
Capital investment decisions often represent the most
important decisions taken by the firm or other decision
maker.
Capital investment decisions have far reaching impact into
the future.
They are also characterized by irreversibility.
Thus, a wrong capital investment decision often cannot be
reversed without incurring substantial loss
 Cont…
 Project, in general, involves the creation of new and additional
fixed production capacity.
Cont…
On the other hand, project appraisal or
analysis is a method of evaluating alternative
investment projects

 in order to maximize the net benefit a society

drives from its scarce resources.

It involves the benefits and costs of project and

reduces them to a common yardstick (present
value).
1.3.Characteristics of Projects

Projects in general need to be SMART.

S – Specific
A project is designed to meet a specific objective as
opposed to a program, which is broad.
 A project has also specific activities.
Projects have well defined sequence of investment
and production activities and a specific group of
benefits.
A project is also designed to benefit a specific group
of people
 Cont…
M - Measurable
Projects are designed in such a way that investment and
production activities and benefits expected should be
identified and if possible be valued (expressed in monetary
terms) in financial, economic and if possible social terms.
Though it is sometimes difficult to value especially
secondary costs and benefits of a project, attempt should be
made to measure them.
Measure costs and benefits must lend themselves for
valuation and general projects are thought to be measurable.
 Cont…

A – Area bounded
As projects have specific and identifiable group of
beneficiaries, so also have to have boundaries.

In designing a project, its area of operation must clearly be

identified and delineated.

Though some secondary costs and benefits may go beyond

the boundary, its major area of operation must be identified.

Hence projects are said to be area bounded.

Cont…
R – Real

Planning of a project and its analysis must be made based on real

information.

Planner must make sure whether the project fits with real social,
economic political, technical, etc situations.

This requires detail analysis of different aspects of a project.

Cont…
T – Time bounded

A project has a clear starting and ending point.

The overall life of the project must be determined.

Moreover, investment and production activities have their own time

sequence.

Every cost and benefit streams must be identified, quantified and

valued and be presented year-by-year.
 Project Planning helps us to:
 think ahead and prepare for the future
clarify goals and develop a vision
 identify issues that will need to be
addressed choose between options
 consider whether a project is possible
make the best use of resources
motivate staff and the community
assign resources and responsibilities
achieve the best results
 1.4.Distinction between programs and projects

Project: is an investment activity where resources are used to

create capital assets, which produce benefits over time and
has a beginning and an end with specific objectives.
A program: is an ongoing development effort or plan which
may not necessarily be time bounded.
E.g. a road development program, a health improvement
program, a nutritional improvement program, a rural
electrification program, etc.
Þ A development plan or a program is therefore a wider
concept than a project.
Þ Projects are the concrete manifestations of the
development plans or programs in a specific place and
time.
Þ It may include one or several projects at various times
whose specific objectives are linked to the achievement
of higher level of common objectives.

Þ For instance, a health program may include a

water project as well as a construction of
health centers both aimed at improving the
health of a given community, which
previously lacked easy access to these
essential facilities.
Projects, which are not linked with others to form a
program, are sometimes referred to as “stand alone”
projects.
One can think of projects as subunits and bricks of
programs, which constitute the national plan (usually the
direction is from plans to projects).
We have to note that projects could be either public or
private.

 It is the smallest operational element prepared and

implemented as a separate entity in a national plan or
program.
 The major difference between a project and a program is not so
much in objectives stated but lies more in scope, the details and
accuracy.

Þ A project is designed with a high degree of precision and details

as regards its objectives, features, calculation of returns and
implementation plan.

Þ A program by contrast is general, lacks details and precision and

aims at a broader goal often related to a sectoral policy of a
country or departmental policy of an organization.
 CHAPTER 2 .Aspects of project preparation and analysis

1.Technical aspect: This aspect may include the

works of engineers, soil scientists and
agronomists in case of, say, agricultural projects.
 The technical analysis is concerned with the
projects inputs (supplies) and outputs of real
goods and services and the technology of
production and processing.
Technical analysis seeks to determine whether the
prerequisites for the successful commissioning of
the project have been considered and reasonably
good choices have been made with respect to
location, size, process, etc.
The other aspects of project analysis can only
proceed in the light of the technical analysis.
In general the technical analysis is primarily
concerned with
 Material inputs and utilities
 Manufacturing process and technology
 Product mix
 Plant capacity(production potential)
 Location and site
 Machines and equipment
 Structure and civil works
 Project charts and layouts
 Work schedule
 2.Commercial (Demand and Market) aspects

This aspect of analysis needs to ensure the existence

of effective demand at remunerative price.
It also assesses possible means in which the market
will absorb the output without affecting the output
price and if its price inevitably be affected, we
would have to assess its magnitude.
Similar arrangements need to be done on the input
side too (including procurement of equipment and
intermediate input supplies).
Market analysis is basically concerned with two
questions:
What would be the aggregate demand of the
proposed product/service in future?
What would be the market share of the project
under appraisal?
To answer the above two questions the project
analyst requires a wide variety of information
and need to use appropriate forecasting
methods.
 The kinds of information required are:
1. Consumption trends in the past and the present consumption level
2. Past and present supply positions
3. Production possibilities and constraints
4. Imports and exports
5. Structure and competition
6. Cost structure
7. Elasticity of demand
8. Consumer behavior, intentions, attitudes, preferences, and requirements
9. Distribution channels and marketing policies in use
10. Administrative, technical, and legal constraints.
• The market analysis is also concerned with the arrangement for

marketing the output to be produced and the arrangement for

the supply of inputs needed to build and operate the project.
• The key steps in such analysis are as follows.

 Situational analysis and specification of objectives

 Collection of secondary information

 Conduct of market survey

 Characterization of the market

 Demand forecasting

 Market planning
 3.institutional-organization-managerial aspects

This aspects are aims at answering the ff questions:

Is the organizational set-up (proposed organization chart to
implement) of the project adequate?
Will the project be provided with competent personnel (adequate
project staff) to manage it?
But, even if the right staff is available, their success will depend
mostly on the institutional set-up i.e., the relationship between
the various organizations involved with the implementing agency.
Appraising organization therefore includes appraisal of the
project related institutions like subsidiary companies, ministries,
headquarters, banks, transport companies and others.
Once the right institutions to facilitate project implementation are
available, the project should be implemented by competent,
responsible and committed managers.
Managerial appointment should be a function of competence and
commitment, not a function of race, tribe, creed or political
opinion.
4. Financial aspect
Financial analysis seeks to ascertain whether the proposed
project will be financially viable in the sense of being able to
meet the burden of servicing debt and whether will satisfy the
return expectations of those who provide the capital.
Need to identify the projects financial efficiency, incentive
impact to the participants in the project, credit worthiness and
liquidity (say, could the firm have enough working capital?).
The financial analysis establishes the magnitude of costs of
(investment, production , overheads )and magnitude of
benefits.
This analysis will be the basis for evaluating the project
profitability. Project profitability depends on a comparison of
costs versus revenues using realistic market prices of
materials, labor and outputs.
 The aspects, which have to be looked into
while conducting financial appraisal, are:
1. Investment outlay and costs of the project
2. Means of financing; source of finance,
credit terms, interest rates, etc
3. Cost of capital
4. Projected profitability
5. Break-even point
6. Cash flows of the project
7. Investment worthiness judged in terms of
various criteria of merit
8. Projected financial position
9. Level of financial risk
 5. Economic aspects

The financial analysis views the project from the

participants (or owners) point of view, while the economic
analysis from the society’s point of views. In such
evaluation the focus is on the social costs and benefits of
a project, which may often be different from its monetary
or financial costs, and benefits.
While financial analysis uses projected market prices to
value inputs and outputs, economic analysis uses
‘economic prices’ or ‘shadow prices’ or ‘efficiency prices’
to better approximate the opportunity costs of an input –
the amount the economy must give up if the resource is
transferred from its present use to the project.
Thus, economic analysis requires adjustment of market
prices, which may not reflect the real value of resources
and outputs, into economic prices.
It also requires determination of economic prices of those
goods that might not have market prices but that involve
6.Social aspect
Project analysts are also expected to examine the broader social
implications of the proposed project.
Although the economic analysis will determine the amount of income
stream generated over and above the costs of labor and other inputs,
it does not specify who actually receive it and hence it does not the
issue of income distribution.

So, the social aspect analysis should address the income distribution
implications of a project. Other closely related aspects as employment
opportunities, gender aspects, stimulating or competing effects with
other sectors, and other desired objectives must be considered.
Such social goals might also include issues of balanced regional
development, the displacement impact of the project (the Amarti –Nashe
hydroelectric power displacement is a good case in point); the gender
implication of the adopted technology; environmental impacts etc.
 7. Environmental aspects
In recent years environmental concerns have assumed a great deal of
significance.
In most developed countries and for projects financed by foreign donors in
developing countries, an environmental impact assessment is a
prerequisite for project financing.
Environmental impact of a project refers to the effect of a project on the
world of animals, plants, water, air, and humans existing in the project area.
Ecological analysis should be done particularly for major projects, which
have significant ecological implications like power plants and irrigation
schemes, and environmental polluting industries.
In such projects environmental impact assessment is important because
economic benefits that may be generated from the project can be counter-
balanced by undesirable environmental effects.
The key questions raised in ecological analysis are:
 What is the likely damage caused by the project to the environment?
 What is the cost of restoration measures required to ensure that the
damage to the environment is contained within acceptable limits?
Chapter 3:THE PROJECT CYCLE

A project cycle the different stages through which a

project passes or is a sequence of events, stages or phases,
which a project follows.

it is the life cycle through which a project advances from

infancy to maturity.
The main features of this cycle are
information gathering,
analysis and
decision- making

Throughout the project the preoccupation of the analysis

is to consider alternatives, evaluate them and decisions
on which of them should be advanced to the next stage.
 There are several approaches to describe project life cycle.
 Some of them are:
The World Bank Project Cycle,
The European Union Project Cycle:
The Asian Development Bank Project Cycle,
The Integrated Planning and Management project cycle,
The UNIDO Project Cycle Etc.

 The first and most well known model is the traditional version of the
World Bank developed in 1970s, with four main stages which further
developed into five in 1978 to close the cycle and known as Baum
cycle.
The European Union Project Cycle:
Cont…
 The two common approaches are

 UNIDO project life cycle.

 World Bank project life cycle

 According to UNIDO, project cycle involves three major phase

pre-investment phase (includes identification, preparation and appraisal)

investment phase (implementation phase)

operation phase (operation and ex-post evaluation)

 A.Project cycle…..(WB approach)
According to World Bank, project cycle involves five stages,
namely,
project
1. Identification
2. Preparation (pre-feasibility and feasibility studies)
3. Appraisal(Selection and project design)
4. Implementation
5. Ex-post evaluation
 1. Identification

Project identification is about generation of projects ideas.

A project may be designed

to solve a problem,
to satisfy a need or
to use available resources.
This phase may take two forms.
If the project is a private venture the initiating entity will define the
concept, expectation and objectives of the project.
 On the other hand the project idea can also immanent form
government agencies in the context of government development
plans.
Cont…
In the latter case sectoral information is an important source
of identification.

In market economy context

 anticipated demand for the projects output is important.

 assessment of appropriate technology,

 scale of the project,

 timing of the project etc. are important.

All types of specialists’ input are required at this stage.

Cont…

In general there are four major sources from which ideas or

suggestions for project may come:

Project ideas from technical specialists

Project ideas from local leaders
Project ideas from entrepreneurs
Project ideas from government policy and plans
Cont…
The identification of project ideas is based on several aspects of development:

Need - a need assessment survey may show the need for

intervention
Market demand - domestic or overseas
Resource availability - opportunity to make available
resources more profitable
Technology - to make use of available technology
Natural calamity - intervention against natural calamity
such as flood or drought
Political considerations
2. Project preparation and analysis

Once project ideas have been identified

the process of project preparation and analysis starts.

Project preparation must cover the full range of

technical,
institutional,
economic, and
financial conditions necessary to achieve the project’s
objective.
Cont…
Different alternatives may be available and therefore,
resource endowment (labor or capital) would have to
be considered in the preparation of projects.
Preparation thus require feasibility studies that identify
and prepare preliminary designs of technical and
institutional alternatives,
compare their costs and benefits,

and investigate in more details the more promising

alternatives until the most satisfactory solution is finally
worked out.
Cont…

It involves generally two steps:

Pre-feasibility studies
Feasibility studies
A) Pre-feasibility Study
Once a project proposal is identified, it needs to be examined.
To begin with, a preliminary project analysis is need to done.
A prelude to the full blown feasibility study, this exercise is
meant to assess
(i) whether the project is prima facie worthwhile to justify a
feasibility study and
(ii) what aspects of the project are critical to its variability and
hence warrant an in -depth investigation.
Cont…
At the pre-feasibility study stage the analyst obtains approximate
valuation of the major components of the projects costs and benefits.
Some of the main components examined during the pre-feasibility
study include:

Availability of adequate market

Project growth potential
Investment costs, operational cost and distribution costs
Demand and supply factors; and
Social and environmental considerations

If the project appear viable form this preliminary assessment

the analysis will be carried to the feasibly stage.
B) Feasibility Study
the major difference between the pre-feasibility and feasibility studies
is the amount of work required in order to determine whether a
project is likely to be viable or not.

If the preliminary screening suggests that the project is prima facie

worthwhile, a detailed an analysis of the marketing, technical,
financial, economic, and ecological aspects is undertaken.

Feasibility study or appraisal provides a comprehensive review of all

aspects of the project and
lays the foundation for implementing the project and evaluating it
when completed.
con’t….

Based on the information developed in this analysis, the

stream of costs and benefits associated with the project can
be defined.

At this stage a team of specialists (Scientists, engineers,

economists, sociologists) will need to work together.

At this stage more accurate data need to be obtained and

if the project is viable it should proceed to the project
design stage.
Cont…
The final product of this stage is a feasibility report
The feasibility report should contain the following elements:
Market analysis
Technical analysis
Organizational analysis
Financial analysis
Economic analysis
Social analysis, and
Environmental analysis
3. Appraisal
After a project has been prepared, it is generally appropriate for a
critical review or an independent appraisal to be conducted.
This provides an opportunity to re-examine every aspect of the project
plan to assess whether the proposal is appropriate and sound before
large sums are committed.
It is a second look at the project report by a team of professionals,
who were not participated in the preparation of the study but qualified
and experienced to evaluate such studies.
It is or should be an independent assessment of the project to identify
the weaknesses and strengths of the study that have a bearing on the
decision to invest and/or to finance the project.
If the appraisal team concludes that the project plan is sound, the
investment may proceed.
But if the appraisal team finds serious flaws, it may be necessary for
the analyst to alter the project plan or to develop a new plan
altogether.
4. Implementation
After the project design is prepared negotiations with the funding
organization starts and once source of finance is secured
implementation follows.

Implementation is the most important part of the project cycle.

The better and more realistic the project plan is the more likely it is
that the plan can be carried out and the expected benefits realized.

At the project implementation phase tenders are let and contracts

signed.
cont…
Project implementation must be flexible since circumstances change
frequently.

Technical changes are almost inevitable as the project progresses

price changes may necessitates adjustments to input and output prices;
political environment may change.
cont…
Project analysts generally divide the implementation phase into
three time periods.

The investment phase, where the major investments are made (3-5years)

The development phase which may also extend from (3-5years)

The project life

 cont…
Every project has: Project design - financing – implementation
It is the translating of an investment proposal in to a concrete project.

Which is complex
 Time consuming
 Risk fraught

Timely implementation is very critical.

Delay of implementation would bring substantial cost over-run.
Translating an investment proposal into a concrete project is a complex, time
consuming and risk fraught task. Delays in implementation, which are common, can
lead to substantial cost overrun. For expeditious implementation at a reasonable cost,
the following are helpful.
1. Adequate formulation of projects. A major reason for the delay is inadequate
formulation of projects. Put differently if necessary homework in terms of
preliminary studies and comprehensive and detailed formulation of projects is not
done, many surprises and shocks are likely to spring on the way. Hence the need for
adequate formulation of the project cannot be overemphasized.
2.Use of the principle of responsibility accounting. Assigning specific responsibilities
to project managers for completing the project within the defined time frame and cost
limits is helpful in expeditious execution and cost control.
3.Use of network techniques. For project planning and control two basic techniques
are available - PERT (program evaluation Review Technique) and CPM (Critical
Path Method).
 5. Ex-post evaluation
It is a final phase of project cycle.
It is an assessment of project impact.

Evaluate the success or failure of project whether it finish its service

or not.
Give Lesson for revising of a project.

Compare actual performance with projected performance.

It examines the project plan and what is really happened.
 cont…

A feedback device, it is useful in several ways

1. It tests the assumptions.

2. It provides document for future decision.
3. It provides corrective actions which can go with real.
4. It shows attainable assumptions.
5. It induces a desired care among sponsors.

The evaluation may be done by the project management, the

sponsoring agency, or other bodies.
 B.Project Life Cycle – UNIDO Approach

According to UNIDO , project cycle involves three

major phases. These are: pre-investment phase,
investment phase (implementation phase), and
operation phase (operation and ex-post evaluation).
Each of the above stages (phases) will be explained in
this section:
1. Pre-investment phase
 The pre-investment phase includes four
major activities; namely project
identification, pre-selection, project
preparation, and appraisal.
`
A. Project Identification/opportunity study: Opportunity study is the main
instrument used to quantify the parameters, information and data required
to develop a project idea in to a proposal.
What aspects of the project should be analyzed in opportunity study? In
opportunity study, the firm is required to analysis the following:
 Availability of resources;
 Future demand for goods,
 increasing population and increasing purchasing power;
 Import and export substitutions;
 Environmental impact; Success of similar projects elsewhere; Possible
inter-linkage with other industries; Expansion through backward linkages
(Backward integration)and forward linkages; (Forward integration);
Industrial policies of the government; General investment climate of the
country; Export potentials; and Availability and cost of production.
 Generally, opportunity studies can be categorized in to area studies,
industry studies, and resource based studies.
B.Pre-selection/Pre-feasibility study: This phase involves the
analysis of the following factors: Examination (investigation) of
all possible project alternatives; Ensure that the detailed analysis of
the project is justified; In-depth investigation of critical areas of the
project; and examine the stability of the environmental situation at
the location site.
C.Preparation (feasibility study): The projects justified by pre-
feasibility study enter this phase for detailed analysis based on
investigated efforts than on guess-estimated. This stage provides all
data, define, and critically examine the commercial, technical,
financial, economic and environmental aspects for each project. In
feasibility study phase, window dressing approach should be
avoided. What should be the major components of feasibility
study?
The components of feasibility studies are:
1. Project Background and history: Name and address of the promoter;
Project background; Project objectives; Outline of the proposed basic
project strategies; Project location; and Economic and industrial policies
supporting the project;
2. Summary of market analysis and marketing concepts
3. Raw materials and supplies
4. Location, site, and environment
5. Engineering and technology
6. Organization and management
7. Implementation planning and budgeting
8. Financial analysis and investment appraisal
D.Project Appraisal: After feasibility studies are completed, the projects
should be presented to the appraising parties. The appraisal of project is
based on the objectives set earlier, the expected risk, cost, and gain. The
quality of feasibility study makes

easier the appraisal work. If the objective of the appraiser is return on
investment, the project is appraised on this base.
Types of decisions to be taken during each pre- investment phases

There are different types of studies done and, then, decisions taken during the pre-
investment phase as summarized in the table here below.
Table 1. Types of decisions in pre- investment phases
Decision Type of Decision goal
study
Opportunity studies -Identify opportunity
Identificatio -Determine critical areas for support studies.
n -Determine area for pre-feasibility or
feasibility study.

Support study Determine which of the possible choices is the

most viable.

Pre- Pre- feasibility -Determine provisional viability of the project

selection study -Appraise whether the feasibility study should
be launched.

Support Investigate in detail selected criteria requiring

studies in-depth study

Feasibility -Make the final choices of project

Final study characteristics
analysis -Determine the feasibility of the project and
selected criteria

Project -Make final investment decision

evaluation Evaluation study

Project
appraisal
2. Investment Phase

The investment phase, also called

implementation phase, includes the following
activities:
 Establishing legal, financial and organizational
basis; Technology acquisition and transfer;
Detailed engineering, design, contracting,
tending and negotiations; Acquisition of land,
construction words, and installations; Pre-
production marketing, securing of supplies, and
setting up administration; Recruitment,
training, and placement of workers; and Plant
commissioning and start up.
 Once activities listed under investment phase are
3. Operating phase

completed, the project will go into actual operation.

 The operation involves producing the envisaged goods,
and sale to the target market, or renders the envisaged
service to the target market.
 The project also requires evaluation, which deals with
the review of whether the project is being implemented
as per expectation. The necessary corrective actions
should also be taken if deviation is identified.
 While it is still in the process of change, the procedures
and structures that correspond to each of these
phases, procedures that will be evolving
Over time, the activities, involved actors and outputs
for each of these phases could be summarized as
follows.
 3.2.Gender in project cycle

Gender mainstreaming is a fundamental principle that

guides IFAD’s (International Fund for Agricultural
Development )work and an important criterion used in
project appraisal.
It should be reflected in all project-related practices
(e.g. decision-making, planning and resource
allocation), and promoted throughout the project cycle
as a crosscutting theme.
The IFAD Gender Action Plan 2003-2006 provides a
clear and systematic gender checklist of the main
questions and indicators for the four phases of the
project cycle, i.e. needs assessment,
planning/formulation, implementation and monitoring
and evaluation (M&E).

Taking gender differences into account in project
planning and analysis: To ensure gender-sensitive design
and planning, IFAD includes the following key gender
concerns in the design and formulation of its projects:
Context–specific gender issues and the related gender
strategy to pursue gender equality and women’s
empowerment;
Gender-sensitive targeting, for instance aimed at
woman-headed households; and Operational measures
to ensure gender-equitable participation in and benefit
from project activities, for example:
(i) set proportion of women participants in planned
activities
(ii) Empowerment of women in decision-making through
women’s groups and women's associations; and
(iii) involvement of women and women’s organizations.
The integration of these gender concerns into
projects requires the following preconditions and
support:
Gender analysis of the project area to identify
context-specific key gender issues and an
appropriate gender strategy;
Integration of gender-specific objectives within the
project goals and objectives;
Tools and methodologies to address the identified
gender issues; and
Awareness-raising for partners, management and
field teams on gender and the need for greater
gender sensitivity.
When formulating the project, they must consider both external
and internal constraints and opportunities for gender equality:
External: what opportunities and problems could affect
women’s and men’s equitable participation, access to decision-
making and benefit from the project?
Internal: a dialogue within and between different institutional
stakeholders must assess to what extent project’s implementation
institution and its key partners are willing, able and equipped to
work with gender.
 Intervention: what are the appropriate project components and
activities to address the constraints and opportunities for gender
equality?
 3.4.The Logical Framework Approach

The Logical Framework Approach is an analytical and management

tool which is now used (in one form or another) by most multi-lateral
and bi-lateral aid agencies, international NGOs and by many partner
governments for the management of development projects

The Logical Framework Approach (LFA) is an analytical process

and set of tools used to support objectives-oriented project planning
and management.

It provides a set of interlocking concepts which are used as part of

an iterative process to aid structured and systematic analysis of a
project or programme idea.
 Con’t
•Developed in the late 1960s to assist the US Agency of
International Development to improve its project planning and
evaluation system.
•The Pros and Cons of Logical Framework Approach

Advantages
- It ensures that fundamental questions are asked and weaknesses
are analyzed, in order to provide decision makers with better and
more relevant information.

- It guides systematic and logical analysis of the inter-related key

elements which constitute a well-designed project.

- It improves planning by highlighting linkages between project

elements and external factors.
 con’t

•It provides a better basis for systematic monitoring and analysis of the
effects of projects.

- It facilitates common understanding and better communication between

decision makers, managers and other parties involved in the project.

- Management and administration benefit from standardised procedures

for collecting and assessing information.

- The use of LFA and systematic monitoring ensures continuity of

approach when original project staff is replaced
 Con’t
Limitations
- Rigidity in project administration may arise when objectives and
external factors specified at the outset are over emphasized.

- LFA is a general analytic tool. LFA is therefore only one of several

tools to be used during project preparation, implementation and
evaluation, and it does not replace target-group analysis, cost benefit
analysis, time planning, impact analysis, etc.

- The full benefits of utilizing LFA can be achieved only through

systematic training of all parties involved and methodological follow-
up
 Stages of Logical Framework Approach

The LFA is composed of two stages used

in project identification and formulation:

•Analysis stage and

•Planning stage
 1.ANALYSIS PHASE

The Analysis Stage should be carried out as an

iterative learning process, rather than as a simple set
of linear ‘steps’.
It includes

 Preparatory analysis
 Stakeholder analysis
 Problem analysis - or “Problem Tree”.
 Objective analysis
 Strategy analysis
 The Analysis Stage

A.Preparatory Analysis

•Prior to initiating detailed analytical work with stakeholder

groups (field work), it is important that those involved in the
identification or formulation/preparation of projects are
sufficiently aware of the policy, sector and institutional context
within which they are undertaking their work.

•The scope and depth of this preliminary analysis will be

primarily dependent on how much information is already
available and its quality.
•
 B.Stakeholder Analysis

‘Stakeholders’ can be defined as any individuals, groups of

people, institutions or firms that may have a significant interest in
the success or failure of a project (either as implementers,
facilitators, beneficiaries or adversaries).

There are a variety of key words used to differentiate between

different types of stakeholder.

1. Stakeholders: Individuals or institutions that may – directly or

indirectly, positively or negatively – affect or be affected by a
project or programme.
 Con’t

2. Beneficiaries: Are those who benefit in whatever way from the

implementation of the project. Distinction may be made between:

(a) Target group(s): The group/entity who will be directly positively

affected by the project at the Project Purpose level. This may
include the staff from partner organisations;

(b) Final beneficiaries: Those who benefit from the project in the long
term at the level of the society or sector at large, e.g. “children” due to
increased spending on health and education, “consumers” due to
improved agricultural production and marketing.

C. Project partners: Those who implement the projects in-country

(who are also stakeholders, and may be a ‘target group’)
 How to conduct stakeholder analysis

stakeholder analysis matrix and SWOT analysis are

among the most widely used by donors
I. Stakeholder analysis matrix
the stakeholder analysis matrix describes:

 the basic characteristics of the stakeholders

 problem/potential project
 their capacity and motivation to bring about
change
 the possible action to address their interest
 II.SWOT analysis

SWOT analysis (strengths, weaknesses, opportunities

and threats) is used to analyze the internal strengths and
weaknesses of an organization and the external
opportunities and threats that it faces.

It can be used either as a tool for general analysis, or to

look at how an organization might address a specific
problem or challenge.
• Strengths are the internal resources available to the community that
can be used to move toward vision accomplishment.

• Internal conditions that stand in the way of reaching the community’s

vision may be seen as weaknesses in community conditions.

• Opportunities are the external resources and partnerships that the

community could access in strategies to resolve the problem.

• External factors that negatively impact the community are defined as

threats to the community’s ability to achieve that vision.
• In conducting a SWOT analysis, a facilitator can lead participants through
four brainstorming exercises. For example, for a particular project your
organization may brainstorm to determine:

 What are the strengths of your organization that may help you to address
the challenge(s) at hand?

 What are the weaknesses of your organization that may prevent you from
addressing the challenge or may increase the level of challenge facing you?

 What are the opportunities your organization may have available that may
contribute to addressing the challenge?

 What are the threats facing your organization that could prevent you from
addressing the challenge at hand or threaten the stability of your
organization?
 C.Problem Analysis

•The problem analysis identifies the negative

aspects of an existing situation and establishes the
‘cause and effect’ relationships between the
identified problems.

•The problems identified are arranged in a

‘problem-tree’ by establishing the cause and
effect relationships between the negative aspects of
an existing situation.
•
• Problem tree analysis
• helps to find solutions to an identified problem
by mapping out its causes and effects.

• A problem tree seeks to answer the question of

“why” something is happening in a community,
truly getting to the root cause of a problem and
thereby making it easier to develop solutions.
How to conduct problem analysis by creating problem tree
Step 1: Identify major existing problems, based upon available
information

Step 2: Select an individual starter, a focal problem for analysis.

Step 3: Look for related problems to the starter problem:

identify substantial and direct causes/effects of the focal problem

Step 4: Begin to construct the problem tree by establishing a

hierarchy of cause and effects relationship between the problems
Step 5: All other problems are then sorted in the same way – the
guiding question being ‘What causes that?’ If there are two or more
causes combining to produce an effect, place them at the same level in
the diagram.

Step 6: Connect the problems with cause-effect arrows – clearly

showing key links

Step 7: Review the diagram, verify its validity and completeness and
make necessary adjustment

Step 8: Copy the diagram onto a sheet of paper to keep as a record, and
distribute (as appropriate) for further comment/information
 The example of problem tree
PROBLEM ANALYSIS - RIVER POLUTION
 D.Analysis of Objectives

When the stakeholders have identified the

problems that the project shall contribute to
eliminating, it is time to develop the objectives, to
make an objective tree/analysis

The objective analysis is the positive reverse

image of the problem analysis
How to conduct objective analysis by establishing an objective tree

Step 1: Reformulate all negative situations of the problems analysis into

positive situations that are desirable, realistically achievable

step 2: Check the means-ends relationships to ensure validity and

completeness of the hierarchy (cause-effect relationships are turned into
means-ends linkages)

Step 3: Work from the bottom upwards to ensure that cause-effect

relationships have become means-ends relationships.

Step 4: Draw connecting lines to indicate the means-ends relationships.

OBJECTIVE ANALYSIS - RIVER POLUTION
 E.Analysis of Strategies/Alternatives

The purpose of this analysis is to identify possible alternative options/strategies, to

assess the feasibility of these and agree upon one project strategy.

How to conduct analysis of strategies/alternative options

1. Identify differing “means-ends” ladders, as possible alternative options or project

components.

2. Eliminate objectives which are obviously not desirable or achievable.

3. Eliminate objectives which are pursued by other projects in the area.

4. Discuss the implications for affected groups.

5. Make an assessment of the feasibility of the different alternatives.

6. Select one of the alternatives as the project strategy.

7. If agreement cannot be directly reached, then: Introduce additional criteria,

 2.PLANNING PHASE

In the Planning Stage the results of the analysis are transcribed into a practical,
operational plan ready to be implemented. It is the stage where the project is
technically designed.

•to review and revise the scope of project activities and expected results once the
resource implications and budget become clearer.

•Developing Logical Framework matrix – defining project structure, testing its

internal logic & risks, formulating measurable indicators of success.

•Activity scheduling – determining the sequence and dependency of activities;

estimating their duration, and assigning responsibility

•Resource scheduling – or “Budgeting”. from the activity schedule, developing

input schedules and a budget
 CHAPTER 4

COSTS AND BENEFITS

PROJECTS
4.1. Identifying Costs and benefits

In identifying costs and benefits of a project, objectives play

important role.
The objectives of the project provide the standard against which
costs and benefits are defined.
cost is anything that reduces an objective, and
benefit is anything that contributes to an objective.
 Cont…
A farmer may have the following objectives at certain period
of time:
Increase household income/ Net incremental benefit;
Educating children;
 Reducing work hours (consuming more leisure);
 Paying debt; Reducing risk; Meet social obligations; etc

However, since it is difficult to incorporate all objectives, we will

judge the effect of a project on the incremental income & thus, on
the new income generated by the project.
 Cont…
A private business firm can have objectives such as:

 Maximizing net income (profit);

 increasing market share;

 improving customer satisfaction;

 reducing risk, etc.

 Cont…
A society or a nation as a whole may want to achieve the
following objectives as:

Increasing national income (growth objective);

Ensuring equitable distribution between persons, regions,
generations, etc. (distributional objective);
Improving balance of payments ;
Improving regional integrity;
Reducing inflation and unemployment; and
Maintaining environment, etc.
 Cont…
Thus, we will take maximization of net incremental
income (profit) for a private firm and maximization of
national income for a nation as the fundamental
objectives in the analysis of a project.

In financial analysis, which is conducted from the

viewpoints of the private project-operator, we will evaluate
the project in terms of its contribution to the net income
(profit) of the private owner (which is usually considered to
be the fundamental objective of the private business firm)
 Cont…
 In contrast to this, in economics analysis, which is conducted from the
standpoint of the society as a whole, we will evaluate a project in its
contribution to the national income - the value of all final goods and
services produced during a particular period, usually a year.

 Thus, project that contributes the highest to the national income

and also that makes a significant contribution to other social objectives
will be selected.

 In the economics analysis we will assume that all financing for a

project comes from domestic sources and that all returns from the
project go to domestic residents, thus we identify cost and benefits in
terms of GDP instead of GNP.
Costs and Benefits: In Financial and Economic Analysis
 The projected financial revenues and cost are often a good starting
point for identifying economic benefits and costs but two types of
adjustments are necessary.

 First it is necessary to include (or exclude) some costs and

benefits.
 Second it is necessary to revalue inputs and outputs at their
opportunity cost.

 In financial analysis we are interested in the items that entail monetary

outlays.

 In economic analysis, we are interested in the opportunity costs for the

country.
 Cont…
 Even if the project entity does not pay for the use of resources, this
does not mean that the resource is free good.

 If a project diverts resources from other activities that produce goods

or services, the value of what is given up represents an opportunity
cost of the project to society.

 The important difference between financial and economic analysis is

in the price that the project entity uses to value the inputs and outputs.
 Financial analysis is simply based on the actual prices that the
project entity pays for inputs and receives for outputs.

 The prices used for economic analysis, however, are based on the
opportunity costs to the country.
 Cont…
 The economic values of both inputs and outputs usually
differ from their financial value (market prices) because:

There are different market imperfections;

There are government interventions of various kinds (taxes,

subsidies, tariff, price control, etc, and;

Some goods are public goods by their nature (may not totally have
market or the price consumers are willing to pay are less).
 Cont…
Financial analysis:
 We view project from owner or implementing agency
prospective and thus we are interested in the items that require
monetary outlays.
 Anything that reduces the profit of the owner is a cost
 Anything that increases the profit of the owner is a benefit.

Economic analysis:
 Look projects from perspective of the entire economy or
society, thus we are interested in the opportunity cost for the
country.
Cont…
Accordingly:


 Economic costs are anything that reduce the national income

 Economic benefits are anything that increases the national income

In economic analysis all finance of project comes from GDP.

Categories of Costs and Benefits
1. Direct Transfer Payments
 Some entries in financial accounts really represents shifts in
claims to goods and services from one entity in the society to
another and do not reflect changes in national income.
These are the so-called direct transfer payments,

 Common transfer payments in projects are:

 taxes,
 subsidies,
 loans and debt services
 Depreciation allowances.
 A. Taxes
 Payment of taxes is clearly cost in financial analysis.
 When a firm pays a tax, its net benefit is reduced.
 But the firm’s payment of tax doesn’t reduce the national
income.

 Rather it transfers income from the firm to the

government so that this income can be used for social
purposes

 Thus, in economic analysis we would not treat the

payment of taxes as a cost in project accounts.
 Cont…
 Of course, no matter what form a tax takes, it is still a transfer
payment - whether a direct tax on income or an indirect tax such a
sales tax, an excise tax, or a tariff or duty on an imported input for
production.

Benefit from the project to the society as a whole.

Monetary out lay as financial cost for the project.

Nothing to do with NI.

Project owner’s net benefit reduced when tax is paid.

Tax is transfer of income from firm to government

Tax does not treat as a cost in economic analysis
 B.Subsidies

Subsidies are simply transfer payments and will not be

included as a benefit in economic analysis.

Simply, direct transfer of payment as opposed to tax.

Monetary benefit to project owner.
It is not benefit in economic analysis.
 C. Credit transactions
Credit transactions are the major form of direct transfer payment
in projects.
From the standpoint of the project owner, receipt of a loan increases
the production resources he has;

payment of interest and repayment of principal reduce them.

But from the standpoint of the economy, these are merely transfers of
control over resources from the lender to the borrower.

The financial cost of the loan occurs when the loan is repaid,
`but the economic cost occurs when the loan is spent.
Cont…
Financial analysis of projects is based on cash flow analysis.
The financial analyst estimates the cash likely generated by the
project and subtracts the cash likely to be needed to sustain the
project.

The net cash flows result in financial profile of the project.

Because the financial evaluation of a project is based on cash
flows, omits some important items that appear in profit-and-loss
statements.
Cont…
In economic analysis, debt service is treated as a transfer
within the economy even if the project will actually be
financed by a foreign loan & debt service will be paid
abroad.

This is because of the convention of assuming that all

financing for a project will come from domestic sources and
returns from the project will go to domestic residents.

Thus convention separates the decision of how good a

project is from the decision of how to finance it.
Cont…

NB.Credit transactions are

Major form of direct transfer payments in project.

Receipt of loan increases production resources.

Repayment of principal and Payment of interest are costs to

the owner.
In economic analysis it is cost only when the loan is spent.
 D.Depreciation allowances
The economic cost of using an asset is fully reflected in the
initial investment cost less its discounted terminal value.
Depreciation is the amount in decreasing of the total (initial)
value of a material due to its service value.
It is cost in financial analysis.
It is not considered as a cost in economic analysis.
Suppose the cost of machinery with initial cost 10,000 birr and
life time of machinery is 10 years.
Annual depreciation cost is 1,000 birr using straight line method.
 1,000 is saved amount of a machine, then we can replace the
machinery after 10 years because we gain and save 1000 birr
every year.
 2. Costs of Inputs
A. Physical goods: construction materials, raw materials, etc.
 Need to adjust market price in to economic price by removing
the effects of market distortion.
Eg. The price of shoe = 90 (producing value), there is 10 birr
tax by government = 100birr.
Economic cost is 90 birr.
Financial cost is 100 birr.
If government subsidizes 30 birr to project:
Financial cost = 70 birr.
Economic cost = 90 birr.
B.Labor

skilled and unskilled.

Here the problem of valuation may arise when the project
uses family labor.
In economic analysis always we have to find economic price
of labor.
Suppose a project use labor that was previously employed in
agricultural sector.
The project is paying a wage rate of 15 birr per day per
worker.
Let the project employed 100 workers.
The economic cost of the project is 1500 birr per day.
 C.Land
 it is not difficult to identify.
 The problem is with valuation of land because of the very special
kind of market conditions that exist when land is transferred from
one owner to another.

 In financial analysis take market price for inputs, and if no

market prices, then we say it has no cost.
 But in economic analysis we take opportunity cost or economic
prices of that input.
 3. Contingency Allowance
 Sound project planning requires that provision be made in
advance for possible adverse changes in physical conditions
or prices that would add to the baseline costs.
 Contingency allowance may be divided into those that
provide for physical contingencies and those for price
contingencies.
 price contingency allowances comprise two categories, those
for relative changes in price and those for general inflation.
 Good plan have to consider the provision be made in
advance for possible adverse changes in physical conditions
or prices that would add to the baseline costs.
 Cont…
Relative changes in price
A rise in the relative cost of an item implies that its productivity
elsewhere in the society has increased, that is, its potential
contribution to national income has risen.
Thus, costs that may be incurred due to possible relative changes in
prices will be considered as a cost in both financial and economic
analysis.
Price of inputs may increase or price of outputs
may decline.
Costs may be incurred due to possible relative
changes in prices and will be considered as a cost in
both financial and economic analysis because it is a
real change.
Relative change in price of inputs affects the relative
 Cont…
General change price (inflation)

General change price (inflation) however, does not affect

national income in real terms & in project common means is to
work in constant prices, on the assumption that all prices will be
affected equally by any rise in the general price level.

All prices are affected equally.

 4. Sunk Costs
Sunk costs are those costs incurred in the past upon which a
proposed new investment will be based.
When we analyze a proposed investment, we consider only
future returns to future costs; expenditure in the past, or sunk
costs, do not appear in both financial and economic accounts.
Money spent in the past is already gone; we do not have as one
of our alternatives not to implement a competed project.
In project analysis always we have to look in to future earning or
benefit and future cost by forgetting the past cost and benefits.
 Tangible and Intangible Benefits&Costs of Projects

Tangible Benefits of Projects are

Increased production
Quality improvement
Change in time of sale
Change in location of sale
Change in product form (grading & processing)
Cost reduction (through mechanization)
Losses avoided
 Since all these benefits are real increase in value of
commodities or reduction in costs, they will be considered in
both analyses.
 Externalities (Secondary costs and benefits)
 Projects can lead to benefits created or costs incurred outside the
project itself.
 we have to adjust the market prices into ‘economic’ prices there
by in effect converting them to direct costs and benefits.
 Price effects caused by a project are also part of externalities.
Examples of such costs and benefits are:

 Technological spill-over or technological externalities

 Negative or positive ecological effects
 Multiplier effects of projects
 Intangible Costs and Benefits
Almost all projects have costs and benefits that are
intangible.

creation of job opportunities,

better health and reduced infant mortality,
better nutrition,
reduced incidence of disease, national integration,
national security, etc.

 These benefits do not, however, lend themselves to valuation.

 These are not accounted in financial analysis but have to be
accounted in economic analysis at least in qualitative terms.
 Cont…
Likewise in the cost side,
a project may displace workers,
it may increase disease incidences,
it may increase regional income inequality,
it may destroy or reduce the scenic beauty of an area, etc

All these are intangible costs of the project, which are not captured by
or not reflected in the market prices.
All these intangible benefits and costs must be carefully identified and
where possible, be quantified although valuation is impossible
 CHAPTER 5

Financial aspects of
project analysis
FA project profitability in financial terms
FA is focused on the contribution to the project owner
It use market price to value goods and services

TWO MAJOR SECTIONS

The first section is pricing costs and benefits of project

The second section is about financial ratios
5.1.Objectives of Financial Analysis

Assessment of financial impact

The most important objective of financial analysis

is to assess the financial effects the project will have on participants
(farmer, firms, government, etc).

This assessment is based on the comparison of each participant’s

current and future financial status with the project against the
projection of his future financial performance as the project is
implemented.
Cont…
Assessment of Incentives
 The financial analysis is of critical importance in assessing the
incentives for different participants of the project.

 Will participants have an incremental income large enough to

compensate them for the additional effort and risk they will incur?

 Will private sector firms earn a sufficient return on their equity

investment & borrowed resources to justify making the investment the
project requires?

 For semipublic enterprises, will the return be sufficient for the

enterprises to maintain a self-financing capability and to meet the
financial objectives set out by the society?
Cont…
Provision of sound financial plan

The financial plan provides a basis for determining

 the amount and timing of investment,
 debt repayment capacity,
 and also helps to coordinate financial contributions.

financial analysis will enable the analyst to judge the complexity of

the financial management and

what changes in organization and management may be necessary.

How to Undertake Financial Analysis?
A financial analysis must be undertaken if it is necessary to
determine the financial profitability.

Carried out if the output of the project can be sold in the market or can
be valued using market prices.
This applies to private and public investments.
A private firm will primarily undertaking a financial analysis of any
project it is considering and seldom will it undertake an economic
analysis.
But commercially oriented government authorities that are selling
output such as railway, electricity, telecommunications, etc., will
usually undertake a financial and an economic analysis of any project
it is undertaking.
 Market Analysis

concerned with the arrangement for marketing the output to be produced

and the arrangement for the supply of inputs needed to build and operate the project.

Given the importance of market and demand analysis in project analysis it should be
carried out in an orderly and systematic manner.

The key steps in such analysis are as follows.

 Situational analysis and specification of objectives

 Collection of secondary information

 Conduct of market survey

 Characterization of the market

 Demand forecasting

 Market planning
 Situational analysis and
specification of objectives
 In order to get a feel for the relationship between the product and its market,
the project analyst may talk to consumers, competitors, middlemen, and other in the
industry.

 He/she may also look at the preferences and purchasing power of consumer’s,
actions and strategies of competition and practices of the middlemen.
 If such a situational analysis generates enough data to measure the market and
get a reliable projection of the demand and revenues a formal study may not
need to be undertaken.

 In order to carry out such a study it is necessary to spell out its objective clearly and
comprehensively.

 A helpful way of spelling out the objectives would be to structure the objective in the
form of questions.
 Collection of secondary information
In order to answer the questions listed while delineating the objectives
of the market study information may be obtained from` secondary or
primary sources.

Secondary information is information that has been gathered in some

other context and is already available.
Secondary information provides the base and the starting point for
market and demand analysis.

It includes what is known and often provides clues for gathering

primary information required for further analysis.
Several sources of information’s include; census data, national
sample survey reports, plan reports, statistical abstracts, industry
specific sources of data etc.
 Conduct Market study
Secondary information though useful, often does not provide a
comprehensive basis for market and demand analysis.

It needs to be supplemented with primary information gathered

through a market survey, specific to the project being appraised.

The market survey may be a census or a sample survey.

The information sought in market survey may relate to one or

more of the following.
Cont…
Total demand and rate of growth of demand
Demand in different segments of the market
Income and price elasticity of demand
Motives for buying
Purchasing plans and interventions
Satisfaction with existing products
Attitudes towards various products
Socio-economic characterization of buyers
 Based on the secondary sources and through the market surveys the
Characterization of the market

market for the product /service may be described in terms of the

following
• Effective demand in the past and present
• Breakdown of demand
• Prices
• Methods of distribution and sales promotion
• Consumers
• Supply and competition
• Government policy
Demand Forecasting

After gathering information about various aspects of the market and

demand from primary and secondary sources, an attempt may be made
to estimate future demand.

A wide variety of forecasting methods is available to the market

analyst.

The methods may be divided into qualitative methods, time series

projection methods and causal methods.
Market Planning

To enable the product to reach a desired level of market

penetration, a suitable plan should be developed.

Broadly it should cover pricing, distribution, promotion and

services.
 5.2.Pricing project costs and benefits
Once costs and benefits have been identified, if they are to be
compared they must be valued.
Since the only practical way to compare differing goods and
services directly is to give each a money value, we must find
the proper prices for the costs and benefits in our analysis.
1.Finding market prices
Project analysis characteristically are built first by identifying
the technical inputs and output for a proposed investment,
then by valuing the inputs and outputs at market prices to
construct the financial accounts, and finally by adjusting the
financial prices so they better reflect economic values.
Thus, the first step in valuing costs and benefits is finding the
market prices for the inputs and outputs.
The project will have to consult many sources such as
merchants, consumers, experts, published statistical bulletins,
etc.
 Point of first sale and farm-gate price

 In project analysis, a good rule for determining a market price for agricultural

commodities produced in the project is to seek the price at the “point of first sale”.
 The increased value added of the product as it goes to higher markets in the

channel arises as a payment for marketing services.

 Thus, if the project includes such marketing services in its design, we can take

these higher prices.

 Even in this case, the analyst must make the project as small as possible and try to

analyse the marketing service component independently of the production

component.

 If the product is sold only in central markets, no local market, then the analyst

must find out the value of marketing service to arrive at price at project site.
 Prices for some products like agricultural products generally are

subjected to substantial seasonal fluctuation.

 If this is the case as it may often is some decision must be made

about the price in the seasonal cycle at which to choose the price

to be used for the analysis.

 A good starting point is the farm-gate price at the peak of the

harvest season.
 This is probably close to the lowest price in the cycle. The

reasoning is that the rise in price is due to marketing services.

Predicting future prices
 Since project analysis is about judging future returns from future

investment, we have to judge what the future prices of inputs and

outputs may be.
 The best starting point is to see the trend of these prices over the past

few years. Having this data, the project analyst can forecast the price
with certain degree of precision.
 However, even then judgment is important to arrive at what price we

have to use to value inputs and outputs of the project.

 Moreover, we have to keep in mind that, as projects involve distant

future, the prediction power of the model will decline as we go far

from the present.
 Change in prices
Change in prices could be general change in price or change in relative prices of goods.
 Change in relative price
If relative price of inputs or outputs are variable over time, i.e.
PXO PX1 P
  X2     
PYO PY1 PY2

Changes in relative prices have a real effect on

the project objective and must be reflected in
project accounts in the years when such
changes are expected.
This can be judged from past trend. For
instance, the price of agricultural products to
price of inputs (manufactured) may rise over
time. This would have a real effect on the net
 Inflation: an increase in general prices of goods

 Inflation is common for every country although the magnitude may

vary between countries.

 Current and constant prices differ over time due to inflation, which is

understood as a general rise of a price levels in an economy.

 If inflation can have a significant impact on project inputs and output
prices, such an impact must be dealt with in the financial analysis.
 Wherever relative input and output prices remain stable, it is

sufficiently accurate to compute the profitability or yield of an

investment at constant prices.
 Only when relative prices change and project input prices

grow faster (or slower) than output prices, or vice versa,

then the corresponding impacts on net cash flows and
profits must be included in the financial analysis.
 If inflation impacts are negligible, the problem of choosing

between current and constant prices does not exist, since

they are equal and the planner may use either.
 2.Financial export and import parity price
As indicated earlier, financial analysis will be
made base on market price.
The project may use imported inputs and export
its output, to foreign markets.
If there are domestic markets for these inputs
and outputs, and if the firm is free to sell or buy
at the domestic or world market, we take the
domestic price with appropriate adjustment to
reflect the price at the project site.
 If, on the other hand, commodities of the
project are produced only for foreign market or if
the domestic demand cannot absorb the firm’s
output, we will take export-parity and import
parity prices ever in financial analysis.
In financial analysis, we use export and import
parity prices if the project will export its output to
and import inputs from foreign markets.
A project for several reasons may use imported
inputs or export outputs even though there are
domestic markets.

In both cases what we need to determine is the

amount of income the project receives from its
exports or the amount the project pays for imports
at the project location.
Suppose a project exports coffee to Canada, we
start with c.i.f. (Cost, Insurance, and Freight )price
at Canada port.
 c.i.f. :Rule used in international trade, where the seller
covers the costs of transporting goods to the buyer's
destination, including freight and insurance. The seller
is responsible for arranging and paying for the cost of
transporting the goods to the buyer's designated port of
destination, including the cost of freight and insurance.
 CIF primarily applies to goods transported by sea or
inland waterway.
 The seller is responsible for arranging and paying for the
cost of freight and insurance. The risk of loss or damage
to the goods passes to the buyer once the goods are
loaded on board the vessel at the port of shipment.
 Once the goods have reached the buyer's port of
destination, the buyer assumes costs and liabilities for
unloading and delivering the shipment to the final
destination.
FOB: means the seller is responsible for
delivering the goods to the port of shipment,
loading them onto the vessel, and covering all
costs up to that point. FOB is used primarily for
sea and inland waterway transport. Once the
goods are on board the ship at the named port,
the risk and responsibility for the goods,
including any damage or loss, transfer from the
seller to the buyer.
Buyer's responsibility: After the goods are on
board, the buyer is responsible for all further
costs, including freight, insurance, and
unloading at the destination port.
Examples: FOB Shanghai, FOB New York
 Export parity price

 C.i.f. at point of import (say, Canada port) Deduct-

unloading at point of import
 Deduct- freight to point of import (in this case ship freight) Deduct

– insurance
 Equals – f.o.b. at point of export (Djibuti port)

 Convert foreign currency to domestic currency at official exchange rate

(OER) Deduct –tariff (export duties)
 Add - subsidy
 Deduct - local port charges 1

Deduct - local transport & marketing costs (if not part of project)

Equals export parity price at project boundary

Deduct - local storage, transport & marketing costs (if not part of project

cost)
Equal export parity price at project location (farm gate)
A parallel computation leads to the import parity price.
Here the issue can be finding the price of project's output
that is intended to substitute previous imports.

If this import substitute would have to compete with

foreign products when it is sold in the domestic markets.

In this case we need to determine the import parity price

of the project's output.

Similarly if a project uses an imported input in bulk, we

may want to know the import parity price. In either case,
the import parity price can be derived as follows.
  Import parity price: at the project location (Farm/project gate
price)
 F.o.b. price at point of export

 Add-freight charges to point of import Add-insurance

charges
 Add- unloading from ship to pier at port
 C.i.f. Price at the harbor of importing countries

 Convert foreign currency to domestic one (multiply by OER)

Add-tariffs (import duties)
 Deduct-subsidies
 Add-local port charges

Add-transport & marketing costs to relevant wholesale market Equal

price at wholesale market

 Add-local storage & other marketing costs (if not part of project cost) -this is the
marketing margin between central market and the project site. 2
 Equals import parity price at project location (Farm/project gate price).
 5.3.Financial Ratios
o Financial ratios used to measure
o project growth.
o project profitability.
o project efficiency.

o Based on the result of each ratio the status of the

o about a company’s current financial health as well as its
potential.
o
o Financial Ratios allow analyst to form a judgment
about
o efficiency of the enterprise,
o its return on key aggregates and
o its credit worthiness.
 A. Efficiency Ratios

 Efficiency ratios use to measure the efficiency of project’s

operations

• Inventory turnover
• Operating ratio
 ……..

1. Inventory turnover:- measure the number of times

that an enterprise turns over its stock in each year
and indicates the amount of inventory required to
support a given level of sales. It can be computed as

 It measures the efficiency of the project in managing

inventories and expenses

 Inventories; are unsold goods or what is left over from

past year and may be found in store
 …….
 Example 1

• Beginning inventory = 200

Total production = 1000
• Cost of goods sold = 800

 ITOR = 800/200 = 4

 ITOR –rate at which business inventory is sold and

replaced

 High ratio is preferred because it shows us inventory

management
 ………..
2. Operating ratio:- shows us the amount of
expenditure per 1birr revenue

 OR = is the profit (revenue)


Lower ratio is good, why????
Extremely low OR value tell us that the project is
not using the optimum size
 B. Income ratios

 It tells us income generating power of the project

Return on sales
Return on equity
Return on assets
 ………….
1. Return on sales
 This shows how large an operating margin the project
has on its sales

 The amount of net income for each one sales

revenue

 The higher this ratio the higher the income generating

power of the project
 ………….
2. Return on equity

 It is an amount received by the owner of the equity

 it is one of the main criteria by which owners are guided in their

investment decisions.

 It is very important for owners, because equity is the

investment for owners.

 The ratio must be higher than the market interest rate

 ………….

3. Return on assets

 The earning power of the assets of an project

 The ratio must be greater than the bank interest rate

 C. Creditworthiness Ratios
 Solvency ratios measure the

 stability of a project and its ability to repay debt

 is to enable a judgment about the degree of financial risk

 It also helps to estimate the amount and terms finance needed.

 It is especially important for lending institutions

Current ratio
Debt-equity ratio
Debt-service-coverage ratio
 ……….
 1. Current ratio

 2. Debt-equity ratio
 ………
 It tells us, of the total capital, how much proportion is equity
and how much is debt
 low ratio of long-term liability to equity is a necessary

Example
Equity = 8,000 birr
LT liability = 12,000 birr

Equity + Liability = 20,000 birr

 ER = 8,000 / 20,000 = 0.4 , 40% is equity of total capital

DR = 12,000 / 20,000 = 0.6 , 60% is liability of the total capital

 D-E Ratio = 0.6 / 0.4 = 1.5

 ………

3. Debt service coverage ratio:-the most comprehensive ratio

of creditworthiness is the debt service coverage ratio

 It tells us how a project can absorb any shocks without

impairing the firm's ability of meeting obligations.


 In contrary to this it can also tell us how the firm chose an

appropriate credit term.
 Chapter 6. The Economic Analysis of Projects

 In financial analysis, the analyst is concerned with the profitability of the

project from an individual point of view (firm’s profitability).
 The main objective here is to maximize the income of the firm or to
analyze the budgetary impacts.
 In financial analysis the analysis is done by applying market prices.
 From the standpoint of the economy as a whole, however, the objective is
to maximize national income no matter who receives it. But financial
analysis will rarely measure a project’s contribution to the community’s
welfare.
 The starting point for the economic analysis would be the financial prices.
 They are adjusted as needed to reflect the value to the society as a whole
of both the inputs and outputs of the project.
 6.1. The Rationale for Economic Analysis
 The objective of any legitimate government should be the promotion of
community welfare.
 They will be more concerned with their public work programs to promote
community welfare than they merely maximize financial profits at distorted
local prices.
 The basic question here is whether it is possible to use market prices to
assess the economic worth of projects.
 The answer is obviously no. Prices could be distorted because of failures of
markets, the absence of perfect knowledge, and the existence of externalities,
consumer and producers surplus, government and public goods, etc.
 So governments must choose projects on the basis of an economic analysis if
they wish to promote the community’s welfare.
The major conditions under which it is impossible to use market prices
to assess the economic worth of projects can be grouped under three or
four major headings:
1.Intervention in and failures of goods markets including the markets for
internationally traded goods.
2.Intervention in and failure of factor markets including the market for
labour, capital, and foreign exchange.
3.The existence of externalities, public goods and consumer and
producers surplus.
4.Imperfect knowledge, that consumers and producers have full
knowledge of about all aspects of the economy relevant to their choice of
operations. This is unrealistic because of poor transport and
communication and low education levels.
 6.2. The Essential Elements of an Economic Analysis

The economic analysis of a project has many features in

common with a financial analysis.
1.Both involve the estimation of a project’s cost and benefits
over the life of the project for inclusion in the project’s cash
flow.
2.In both the cash flow is discounted to determine the project’s
net present value, or other measures of project worth
3.Both may also use sensitivity or probability analysis to assess
the impact of uncertainty on the project’s NPV.
• But an economic analysis goes beyond a financial analysis appraisal,
as it will also involve all or some of the following adjustments.
a) The elimination (deduction) of transfer payments within the
economy from the project’s cash flow. Transfer payments are
payments that transfer the command over the use of resources but do
not, themselves use resources.
• Examples:
 Taxes-Personal and company income taxes, VAT, indirect taxes.
 Subsidies ---- Including those given via price support schemes.
 Tariffs on imports and exports subsidies and taxes .
 Credit transactions - loans received and repayment of Interest and
principal
b) The estimation of economic or shadow prices for project outputs and
produced inputs (included internationally traded and non-traded goods)
to correct for any distortions in their market prices.
 In financial analysis inputs and outputs are valued at actual market prices
while in economic analysis accounting (shadow) prices are employed.

 Example: enterprises will pay workers the market wages and in real Birr
(not shadow ones) irrespective of what is believed to be their opportunity
cost from the economy’s viewpoint.
 Similarly, the enterprise will collect for its exports the equivalent of local
currency calculated at the official exchange rate, even when the foreign
currency is undervalued.
c) The estimation of economic prices for non produced
project inputs (including labor, natural resources and
land) to correct for any distortions in their market
prices.
d)The valuation and inclusion of any externalities
created by the project in economic analysis
e)The valuation and inclusion of any un-priced outputs
or inputs such as public goods or social services.
 6.3.DETERMINING ECONOMIC VALUES
 As indicated earlier according to (financial analysis) inputs and outputs of a project are
valued at prices prevailing in the domestic market

 The rationale for using market prices lies in the assumption that these prices reflect
both marginal utilities of consumption and marginal production costs.

 But this assumption may only hold true under the ideal condition of perfect
competition and therefore, the optimality of resource allocation depend on whether
such conditions actually prevail in the market.

 It now generally accepted that market prices are very far from this ideal.
 For social, political, historical, and economic reasons the markets are distorted and
consequently the signals they give in the form of prevailing prices are also distorted
and do not reflect marginal product ivies and marginal utilities.
• All sections of the domestic market are distorted due to a variety of
reasons.

• Divergence between economic and market prices could be due to

market failure, government interventions, externalities, public goods
and distributional considerations.

• Hence serious distortions exist in the market for labor, capital, and
foreign exchange and efforts are necessary to replace the signals from
these markets by more appropriate measures.
 The key to understanding of economic analysis is the concept of
opportunity cost.
 When a commodity or service is used for one purpose we must give up the
benefit we could have received had we used the good or service for the
next best good or service.
 The opportunity cost is equal to the marginal value product (the
contribution of an additional unit of a commodity to output) and the market
price of the item in a relatively competitive market.
 In financial analysis the price is the opportunity cost because we give up
what we could have done with the money we paid for an item if we had
used it for some other purpose.
Economic pricing involves making adjustments to market
prices to correct for distortions and to retake account of
consumer and producers surplus.

The adjusted price should then reflect the true opportunity

cost of an input or people’s willingness to pay for it.

When the market price of any good or service is changed

to make it more closely represent the opportunity cost to
the society the new value assigned becomes the Shadow
Price also called the accounting price.
The shadow price is what we call the economic price.
1. Adjustment for Transfer Payments
 It is important when undertaking a project appraisal to identify the
major distortions that will create the mot serious divergence between
market (financial) and economic prices in the market for a project’s
outputs and inputs.
Transfer payments are defined as payments that are made without
receiving any good or service.
They involve the transfer of claims over real resources from one person
or entity in society to another, rather than payments made for the use of
or received from the sale of any good or service. So they do not reflect
changes in the national economy.
 Some examples of items that are considered as transfer payments are:
a)Taxes –
 Personal and company income taxes, value added taxes and other
indirect taxes, excise taxes, stamp duties, etc.
 In financial analysis a tax is clearly a cost. When an individual pays
taxes his net benefit is reduced.
 But this payment does not reduce national income. Rather it is transfer
from the individual to the government so that the income can be used
for social purposes that are important to the society.
 Thus payments of taxes does not reduce national income, it is not a
cost from the standpoint of the society as a whole.
 Thus economic analysis, which assesses the impact of a project on
national income, we would not treat the payment of taxes as a cost in
project accounts.
C) Production Subsidies
 are simply direct transfer payments that flow in the opposite direction from taxes.
 Different from of subsidies may exist ranging from lowering the selling price of inputs
below what otherwise would be the market price to the raising or increasing of the price
received by the producer.
 Subsidies do not increase or decrease national income.
 Of course the subsidy increases the individual’s income, so it is revenue for the receiver.
D) Credit Transactions
 are also transfer payments because the lender transfers control over resources to the
borrower.
 Loans received and payment of interest and capital when these transactions occur
between domestic borrower and lenders are examples of such credit transactions.
 The payment of interest and repayment of capital (debt service) is treated as an outflow
in financial analysis but treated as transfer payments and are omitted from economic
accounts.

 6.4. Efficiency or Economic shadow Prices

Once it is decided that market prices are inappropriate in project selection, the
question arises how the necessary accounting prices should be estimated. Thus the
economic analysis of projects requires that inputs and outputs be valued at their
contribute.
 Definition of shadow (accounting) prices
 Accounting or shadow prices are simply a set of prices that are believed to better

reflect the opportunity cost, i.e. the cost in their best use, of goods and services.
 It represents all non market prices. It is the value used in economic analysis for a

cost or a benefit in a project when the market price is left to be a poor estimate of
economic value.
 Efficiency shadow prices are border prices determined by international trade.
 An accounting or shadow prices reflect the increase in welfare resulting from one

more unit of an output or input being available.

Shadow pricing and the numeraire
 The implicit objective of project analysis when project items are valued at
opportunity cost is to maximize the net resources available to the economy. For
many project items the opportunity cost will be given directly by its border
prices. A numeraire is a unit of account.
 Shadow prices can be expressed in two ways:
a) Either they can all be expressed directly in foreign exchange units - valuing
all project effects at world prices termed as the world price numeraire. If a world
price numeraire is adopted then the domestic market price of the import
substitute needs to be adjusted downward to its world price.
b) They can be expressed in domestic price units termed using a domestic
price numeraire. Conversely if a domestic price numeraire is adopted the border
price of export products need to be adjusted upwards by a certain factor
(conversion factor).
•Shadow price estimates can be made at two levels:
• · Economic analysis
• · Social analysis
•
•Distinction stems from the objectives pursued in project appraisal.
•In economic analysis resource efficiency also is considered.
•In social analysis growth and income distribution objectives are pursued.
•In practice estimates of the parameters needed for a social analysis are
relatively rare.
 Traded and Non Traded Goods

The valuation of goods and services depends on whether the good can be traded in international
market or whether it is consumed locally such as in a closed economy.

Goods and services produced by the project or that serves as project inputs can be classified as:
· Non-traded goods
· Traded goods or
Non-Traded Goods
• The non-traded goods are goods that do not enter into the international trade because of their
nature or physical characteristics.
• So the non-traded inputs and outputs of a project cannot be valued directly at border or world
prices directly. Some also consider goods which do not enter into trade because of protection
is presently instituted (trade barriers).
Example: Electricity is only rarely transmitted across frontiers. Unskilled labor is also another
example of non-traded commodity. Inland transportation and cement or cement is usually
considered as non-traded goods.
In both cases the non-traded inputs and outputs of the project
cannot be valued directly at border or world prices. So the
valuation of non traded goods at world prices consists of a
number of steps.

a) net out taxes from the domestic market price of the commodity.
b) The net of taxes price is decomposed into its traded and non-
traded cost elements. For the traded components a border price is
available by definition and they are valued at this price.
 Traded Goods

 Traded goods are defined as goods and services whose use or production
causes a change in the country’s net import or export position.
 Examples:
all kinds of manufacturing
Agricultural goods
Intermediate goods
Raw materials
Some services such as tourism and consultancy services
 Traded goods are either exportable or importable goods (or services).
Exportable goods are those whose domestic cost of production is below
the FOB export price that local producers can earn for the good on the
international market.
 Conversion Factors
 A conversion factor is defined as the factor by which we multiply the actual
price in the domestic market of an input or output to arrive at its accounting
price when the latter cannot be observed or estimated directly. The more the
inputs and outputs are traded the less will be the need to use conversion
factors.
 The conversion factor is simply the ratio of the shadow price of the item
to its market price.
 A conversion factor is estimated simply by taking the ratio of border
prices (world prices) to domestic market prices of the good.
 As it has been indicated earlier the market distortions vary from commodity
to commodity, therefore, the conversion needed varies from case to case.
 It is therefore possible to estimate commodity specific, service specific, or
sector specific like electricity, transportation, construction etc., or for a basket
of goods e.g. consumption goods for a particular income group conversion
factors depending on the degree of aggregation desired.
But at least we need one conversion factor to multiply all the domestic
market prices of all no traded components of the input and output of a
project. This parameter is called the standard conversion factor.
The Standard Conversion Factor
 This is an all-inclusive conversion factor used in place of commodity - or
sector specific conversion factors, either because they cannot be
estimated accurately, or because we believe that they cannot be
estimated accurately or because they do not differ substantially from the
standard conversion factor. It is a summary measure to calculate
accounting prices for non traded commodities.
 In the case of Ethiopia the standard conversion factor is interpreted as a
summary and approximate quantification of the distorted markets
(domestic) as compared to the international market. It is therefore
estimated as the ratio of the value of imports and exports of a country at
border prices (CIF and FOB) to their value at domestic prices.
 The formula for computing the standard conversion factor is give as:

M X
SCF 
( M  Tm  S m )  ( X  S x  Tx )

Where M and X are total imports and exports respectively at world prices converted at the official
exchange rate.

 Tm and Tx are the total trade taxes on imports and exports respectively
 Sm and Sx are total trade subsidies on imports and exports respectively
Broadly, there are two methods of measuring

economic costs and benefits of a project:

UNIDO approach and

Little-Mirrlees approach.
Two approaches of measuring economic costs & benefits of a project

UNIDO Approach: In this method economic benefits & costs

may be measured at domestic prices using consumption as
the numiraire, with adjustment made for divergence
between market prices and economic values, and making
domestic and foreign resources comparable using shadow
exchange rate (SER).

 In this method, if commodities are traded, first all these

traded goods will be adjusted for any distortions in the
domestic markets.

 After this adjustment is made the adjusted domestic

price will be multiplied by SER to make domestic
resources be comparable with foreign resources.
……..
Suppose we have a project producing export item that
uses both foreign & domestic inputs.
The net benefit would be estimated as:
Net benefit = SER (X-M)-D
Where
X - border price of exports in FC
M - border price of imported goods in FC
D - adjusted (economic) values of domestic goods in DC
SER - is the shadow exchange rate
Shadow Exchange Rate: Premium
SER =Pd/Pw
Where Pd - domestic price
Pw - world price in foreign currency
Little-Mirrlees Approach

The other method of adjusting market prices into

economic prices is the Little-Mirrlees approach.
In this approach benefits and costs measured at world
price to reflect the true opportunity cost of outputs and
inputs

The fact that foreign exchange is taken as a nureraire

does not mean that project accounts are necessarily
expressed in foreign currency.

The unit of account can remain the domestic currency,

but the values recorded are the foreign exchange
equivalent that is, how much net foreign exchange is
earned.
 ……..
But if the goods or inputs in question are non-traded
goods, the analyst needs to use conversion factor to
translate domestic prices into their border price
equivalent.

CF = economic price /market price

So the economic price for a non-traded good is its

market price multiplied by the conversion factor.
How are conversion factors derived?
 ……..
A project that produces export goods can be assessed as
follows.

Net Present Value (NPV) = OER (X-M) - SCF.D

Where -OER- official exchange rate

X- exported goods in foreign currency
M- imported goods in foreign currency
SCF- standard conversation factor
D- price of non-traded goods in domestic currency

To summarize, as long as SCF is the ratio of OER to SER, the

two approaches - UNIDO and Little-Mirrless - differ only to
the extent that SER is different from the actual exchange
rate.
 CHAPTER- 7
Measure of project
worthiness
 When costs and benefits have been identified,
quantified and priced (valued),
 the analyst is trying to determine which among various
projects to accept, which to reject.
 There are two methods for measuring the
worthiness of projects:
undiscounted and discounted
methods
 these financial and economic measures of
investment worth are only tools of decision-
making, i.e., they are necessary conditions &
are not sufficient condition for final decision.
 •Fail to take into account
Undiscoun
ted adequately the timing of
measure benefits.
Discounte •Time dimension should
d
measure
be included
 I. Non-Discounted Measures of Project Worth

• 1. Ranking by Inspection
• It is possible, in certain cases, to determine by mere inspection which of
two or more investment projects is more desirable. There are two cases
under which this might be true.
(i) two investments have identical cash flows each year up to the final
year of the short-lived investment, but one continues to earn cash
proceeds (financial results or profits) in subsequent years. The
investment with the longer life would be more desirable. Accordingly
project B is better than investment A, since all things are equal except
that B continues to earn proceeds after A has been retired.
(ii) Two investments have the same initial outlay (the total net value
of incremental production may be the same), the same earning life
and earn the same total proceeds (profits), but one project has more
of the flow earlier in the time sequence, we choose the one for
which the total proceeds is greater than the total proceeds for the
other investment earlier. Thus investment D is more profitable than
investment C, since D earns 2000 more in year 1 than investment C,
which does not make up the difference until year 2.
Investment (project) Initial cost Net cash proceeds per year

Year I Year II

A 10,000 10,000 ---

B 10,000 10,000 1,100

C 10,000 3,762 7,762

D 10,000 5,762 5,762

2. The Payback Period
• The payback period is defined as the length of time required for the stream of cash
proceeds produced by the investment (project) to be equal to the original cash outlay
required by the investment (capital investment).
•It is defined as the number of years it is expected to take from the beginning of the project
until the sum of its net earnings (receipts minus operating costs) equals the cost of the
projects initial capital investment.
• Example: if a project requires an original outlay of Birr 300 and is expected to produce a
stream of cash proceeds of Birr 100 per year for 5 years, the payback period would be
• 300/100 = 3 years.
Example: consider project C. 10000 - 3762 = 6238. then 6238/7762 = 0.8 so 1.80 years.
Investment A and B are both ranked as 1, since they both have shorter payback periods than any of the other investments, namely
1 year. But investment B which has the same rank as A will not only earn 10,000 Birr in the first year but also 1,100 Birr a year
later. Thus investment B is superior to A.

Investment Payback period Ranking

A 1 1
B 1 1
C 1.8 4
D 1.7 3

But a ranking procedure such as the payback period fails to disclose this fact. Thus it has two important limitations:

(i) it fails to give any considerations to cash proceeds earned after the payback date. It simply emphasizes quick financial
returns.
(ii) It fails to take into account differences in the timing of receipts and earned proceeds prior to the payback date.
3. Proceeds per Unit of Outlay

Under this method, investment are ranked according to their total proceeds divided by the amount of the corresponding
investments.
Example: consider the following hypothetical example

Investment Total Investment Proceeds per Ranking

proceeds outlay unit of outlay

A 10,000 10,000 1.00 4

B 11,100 10,000 1.11 3
C 11,524 10,000 1.15 1
D 11,524 10,000 1.15 1
Accordingly project C and D must be implemented. However, both projects are given the
same rank.
Although we know by inspection that project D is superior because D generates Birr
2000 of proceeds in year 1.

This method is again deficient because it still fails to consider the timing of proceeds. In
other words, the method considers that 1 Birr or proceeds received in year 2 is equal to 1
Birr received in year 1. This is inconsistent with the generally accepted economic
principle that 1 Birr today is more valuable than 1 Birr at some future date.
II.Discounting Future Income Flows in Project Analysis
Time value of money: Present values are better than the same values in the
future and earlier returns are better than later.
This shows that money has time value.
Thus, to include the time dimension in our project evaluation, we have to use
discounting methods.
The undiscounted measures fail to take into account adequately the timing
of benefits.
In economics that inter-temporal variations of costs and benefits influence
their values and a time adjustment is necessary before aggregation.
Therefore a time dimension should be included in our evaluation.
That means we need to express costs and benefits in terms of value by
discounting all items in the cash flows back to year 0.
• Discounting is a technique or a process by which one can reduce future
benefits and costs to their present worth or present value.
• Costs and benefits are discounted by a factor that reflects the rate at which
today’s value of a monetary unit decreases with the passage of every time
unit.
• Any costs and benefits of a project that are received in future periods are
discounted, or deflated by some factor, r, to reflect their lower value to the
individual (society) than currently available income.
• The factor used to discount future costs and benefits is called the discount
rate and is usually expressed as a percentage.
• The discount rate is usually determined by the central authorities (national
Bank).
 cont…

Suppose a bank lends 1567.05 Birr for a project at 5%

interest rate. The project owner is supposed to repay the
principal & interest rate after 5 years.
How much the owner will have to pay at the end
of 5 years.
At=p (1+r) t
 cont…

Suppose again a project is expected to obtain 2000 B after 5 years.

Value of this money today can be calculated as:

The difference between this and the previous is only the viewpoint.

interest rate a viewpoint from now to the future,

discounting looks back ward form the future to the present.

 Discounted Project Assessment Criteria

1. The Net Present Value (NPV)

 The most widely used and straightforward discounted measure of project worth is the net present worth or the net
present value (NPV).
 The NPV is defined as the difference between the present value of benefits and the present values of costs.
 The NPV can be obtained by discounting separately for each year, the difference of all cash outflows and inflows
accruing throughout the life of project at a fixed, pre determined interest rate.

Where Bt are the project benefits in period t

Ct are the project costs in period t
r is the appropriate financial or economic discount rate
n is the number of years for which the project will operate
n
( Bt  Ct )
NPV   t
t 0 (1  r )
 Having set the discount rate, an investment project is deemed
acceptable if the discounted net benefits (benefits minus costs)
is positive.
 Accept all projects that show positive NPV at the predetermined
discount rate and reject all projects that show negative NPV.
 Thus, the decisions is to accept if NPV > 0.
 We can also discount benefits and costs separately, and if B > C
then NPV = B - C > 0
 Example: Consider the following Discounted Cash Flow for the ABC Project in m. Birr)

Year Cash flow Discount factors for 10 Discounted cash flow (10%)
percent
0 -20 1.00 -20.0
1 4 0.909 3.64
2 4 0.826 3.30
3 4 0.751 3.00
4 4 0.683 2.73
5 4 0.621 2.48
6 4 0.564 2.26
7 4 0.513 2.05
8 4 0.467 1.87
9 4 0.424 1.70
10 4 0.386 1.54
NPV 4.57

Since discounting the cash flow at 10 percent produces a positive NPV of 4.57 million Birr we conclude that the
project should be undertaken. Suppose now that cost of capital were to be raised to 20 percent, the project produces a
negative NPV of 3.21million Birr. In this event the project would have to be rejected.
NPV and Decision Rule for Independent Projects

Independent projects are projects that are not in any way substitutes for each other. In such
cases the decision rule is to accept the project if the NPV is greater than or equal to 0(approve
any project for which NPV>=0). If two projects have positive NPV and there is no budget
constraint both should be accepted and you do not need to choose the one with higher NPV.
For example, if two independent projects road and fisheries development projects in different
locations are being considered and both have a positive NPV, then both should be undertaken.

Decision Rule for Mutually Exclusive Projects

A mutually exclusive project is defined as a project that can only be implemented at the
expense of an alternative project as they are in some sense substitutes for each other.
Example of the mutually exclusive projects includes two versions of the same project, say
with different technology, scale or time. The decision rule for such projects is to accept the
project with the highest NPV. Dam A and Dam B
Which one of the two dams do you choose? Why?

• Dam A is small but has a higher net present value

ratio/NPVR/ =0.700, indicating that it is relatively
more efficient than Dam B.
• However, the total benefits it produces and hence
its NPV are quite small only Birr 3.5 million. The
alternative dam B is much larger and has much
larger benefits as well as higher costs, with
NPV=Birr 200 million.
• Although NPV is large its NPVR(=0.400) is lower
than project A’s, indicating that project/Dam/ B is
relatively inefficient. In such a case, the decision
rule is the NPV not the NPVR.
If the two projects were independent and the country could
therefore construct both, then it should do so as they both
have positive NPVs.
However, since the projects are mutually exclusive the dam
with the higher NPV should be selected, that is dam B.
 If dam A were constructed a gain of only 3.5 million Birr
would be realized, and the community would be prevented
for ever from gaining the much greater net benefits of 200
million Birr, which dam B is expected to produce.
• The opportunity of gaining the other Birr
196.5 million (200-3.5) of benefits from this
unique dam site would be lost forever.
• Consequently in choosing between mutually
exclusive projects the one with the highest
NPV should always be selected.
Advantages of NPV Approach
The major advantage of the NPV selection criteria is that it is simple to use and does not
rely on complex conventions about where costs and benefits are netted out, as do some
ratio measures. In addition it is the only selection criteria that can correctly be used to
choose between mutually exclusive projects, without further manipulation.
Limitations of the Net Present Value Test
1.Some projects could be deferred from implementation although they show positive
NPVs, due to scarcity of funds. Thus passing the NPV test may be a necessary condition
but not a sufficient condition.
2.If some projects are mutually exclusive then the implementation of one would naturally
exclude the execution of the other.
3.The selection of an appropriate discount rate is another limitation.
4.It does not show the exact profitability rate of the project.
 2.The Internal Rate of Return of a Project (IRR)

It is also called the yield of an investment method or

simply the yield method.
It is possible to think a level of interest rate that could
result in NPV of zero. This rate of interest rate is termed
as the Internal Rate of Return (IRR).
The IRR is the rate of discount, which makes the
present value of the benefits exactly equal to the
present value of the costs.
Thus, it is the discount rate at which it is worthwhile
doing the project. This is the interest rate that a project
could pay for the resources used if the project is to
recover its investment and operating cost and still can
be at the break-even point.
Decision rule Using IRR
According to the IRR version of economic criterion we implement all projects that show an IRR greater
than the predetermined discount rate (opportunity cost of capital), i.e., accept all independent projects
having an IRR >= the opportunity cost of capital (cut off rate).
The reference discount rate which is also called the target rate, is predetermined by the Central Bank(r).
All projects with an internal rate of return greater than some target rate of return, r*, should be accepted

Once the IRR is identified, the decision rule is ‘accept the project if the IRR is greater that the cost of
capital, say r. Note also that:

When NPV > 0 then R > r

NPV = 0 then R = r
NPV < 0 then R < r
cont…
 cont…

“r”can be found through trial & error method.

When r = 23.068 percent

the value in the above equation in the RHS will be equal

to about 1000.00 which is equal to the value in the LHS.

The problem with this method is that the value of

r (IRR) can only be found by trial and error
 cont…

The procedure can be described as follows:

1. Select an arbitrary value of r;
2. Calculate the value of the RHS equation with this value of r.

3. If the RHS < LHS reduce the value of r.

If the RHS >LHS, increase r; continue this until RHS is very close
to the LHS.
When the RHS is more or less equal to LHS, it is that value
of r, which is the IRR.
 Advantages of the IRR
1. The IRR is used in many projects
2. It is the only measure of project worth that
takes account of the time profile of a project but
can be calculated without reference to a
predetermined discount rate.
3. It is a measure that could be understood
easily by non-economists since it is closely related
to the concept of the return on investment.
4. It is a pure number and hence allows projects
of different size to be directly compared.
Problems with the IRR

1.The IRR is inappropriate to use for mutually exclusive projects and

independent projects when there is a single period budget constraint.
2.A project must have at least one negative cash flow period before it
is possible to calculate its internal rate of return. This is because the
NPV will always be positive no matter how high the discount rate
used to discount it, unless the project has at least one negative cash
flow period.
3.Another problem with the IRR is that in some cases it my be
possible to compute more than one IRR for a project. For instance,
the net benefit stream of an oil-drilling project become negative half
way though the project’s life because it is necessary to replace rigs
after a number of years. If a project has more than one IRR, then
neither an be reliably used and another decision rule such as the NPV
must be used rather than the IRR.
 3. Benefit-Cost Ratio
A third discounted measure of project worth is the benefit-cost ratio.

This is the ratio obtained when the resent worth of the benefit stream is
divided by the present worth of the cost stream.

The mathematical formula is given below.

 Decision

The formal selection criterion for the benefit-cost ratio measure of project worth is

to accept all independent projects with a benefit-cost ratio of

A project should be accepted if its BCR is greater than or equal to 1 (i.e. if its
discounted benefits exceed its discounted costs). But if BCR is less than 1 , the
project should be rejected.
Advantage and disadvantage

• One possible advantage o the BCR, on top of being

easy to show to non-economists is that it is easy to
show the impact of a percentage change in cost or
benefits on the projects viability.

• Its major disadvantage is the need to specify and

adhere to conventions regarding the designation of
expenditures as costs and benefits.
 4. Net Benefit - investment Ratio

This criterion is suitable and convenient for ranking projects

especially when sufficient budget is not available to
implement all projects that satisfy other criteria.

That is, two or more projects may all have a positive NPV, IRR that
exceeds the discount rate and a benefit-cost ratio of greater than
one.

In this case, ranking could be made using net Benefit - investment

ratio.
It is simply the present value of net benefits divided by the net
present worth of the investment.

selection criterion
accept all projects with a ratio of one or greater

• Very important for ranking project than the remaining 3

measures because it shows profit per project.
 It is simply the present value of net benefits divided by the net
present worth of the investment.

selection criterion

 accept all projects with a ratio of one or greater

 Very important for ranking project than the remaining 3

measures because it shows profit per project.
 Thank
you !!!!!!

Galaatoomaa!