#.Development Planing II

Development Planning and Project Analysis II Econ 4132 Module
Arba Minch University

College of Business and Economics
Department of Economics
Development Planning and Project Analysis II

(Econ - 4132)
MODULE
Prepared By: Mulugeta Fekadu (MSc)
December, 2022/23
AMU Department of Economics 2022/23 Page 1

Preface
Dear our learners and readers, we are so happy to carry on with our aspiration of producing
properly educated economists throughout the country. As usual as it is, we have tried, to our best
capacity, to produce classical reading material for our esteemed students and readers. This
module is aimed at serving the needs of students who take the course Development Planning
and Project Analysis II, Econ 4132, offered to upper level undergraduate students of
economics. Development planning and project analysis is seen as an essential ingredient for
rapid development in developing countries like Ethiopia. It is an integral part of the economic
systems. The purpose of the course is to outline and present the general framework and the basic
theories and methodologies for Project preparation, analysis, appraisal, implementation, and
impact evaluations for different interventions.
The module is organized into six major chapters. The first chapter is devoted to the basic
concepts and cycles of a project. Chapter two deal with aspects of project preparation and
analysis. The third chapter focuses on financial analysis and appraisal of projects. The fourth
chapter builds on the economic analysis of the project. Chapters five discuss the concepts of
project implementation, monitoring and evaluation. Chapter six deal with some basics of impact
evaluation. We use the term social benefit cost analysis to refer to appraisal of private or public
project from a public interest view point. Sometimes the scope of the required analysis is broader
than the evaluation of economic benefits and cost: and impact analysis may also be required to
determine the effect of economic benefit and cost.
The person whose background should be sufficient to allow them to benefit from this module is
he/she will find the organizational principle we set out in the module to be innovative and of
considerable practical use. It has been tried to discuss the main principles of project appraisal,
implementation and evaluation and to make the science of project analysis understandable. All
possible efforts have been made to enhance the usefulness of the material. Further, the
explanation of various economic theories has been supported by appropriate tables, figures and
examples. In addition, adequate number of activities and exercises are included for further
learning procedures.
Dear learners and readers! We hope that you will find this material worth reading. And finally
we wish our readers all the best in their academic career.
Mulugeta Fekadu

Table of content Page

Chapter One: Basic Concepts…………………...………………………………………………5
1.1. The Project Concept ……………………………………………………………………...5

1.1.1. Definition: What is a Project? ……………..............................................................5
1.1.2. The Basic Characteristics of a Project …………………………………………...5
1.1.3. Additional Descriptions/Features of Projects ……………………………………7
1.1.4. Classification of Project …………………………………………………………8
1.1.5. Organic Link Between Policy, Development Plan and Projects ……………….10
1.1.6. The Linkage Between Projects and Programs ………………………………….12
1.1.7. Development Planning Versus Project Planning ……………………………….13
1.1.8. The Rationale for Planning ……………………………………………………..16
1.1.9. Significance of Project Planning ……………………………………………….17
1.2.The Project Cycle: Stages of Project Planning........................................................18
1.2.1. Project Identification/Opportunity Study/ Stage ……………………………….19
1.2.2. Project Preparation and Analysis Stage ………………………………………...22
1.2.3. Project Appraisal Stage ………………………………………………………...25
1.2.4. Project Implementation Stage ………………………………………………….32
1.2.5. Evaluation and Supervision …………………………………………………….37
Chapter Two: Aspects of Project Preparation and Analysis ………………………………..40
2.1.Demand and Market Analysis …………………………………………………………...41
2.2.Technical Analysis ………………………………………………………………………46
2.3.Organizational Analysis …………………………………………………………………51
2.4.Financial Analysis ……………………………………………………………………….53
2.5.Economic Analysis ………………………………………………………………………54
2.6.Social Analysis, and ……………………………………………………………………..54
2.7.Environmental /Ecological Analysis …………………………………………………….56
Chapter Three: Financial Analysis and Appraisal of Projects ……………………………...57

3.1.Scope and Rationale ……………………………………………………………………..57
3.1.1. What is Commercial/Financial Analysis?………………………..………………..57
3.1.2. Why and When One Undertakes Financial Analysis?...............................................58
3.1.3. Planning Horizon and Project Life ………………..………………………………59
3.2.Identification of Costs and Benefits ……………………………………………………..60
3.3.Classification of Costs and Benefits ……………………………………………………..61
3.3.1. Tangible costs of a project…………………………………………………………..61
3.3.2. Tangible benefits of a project……………………………………………………….67
3.3.3. Intangible costs and benefits of a project…………………………………………...68
3.4.The Valuation of Financial Costs and Benefits ………………………………………….68
3.5.Investment Profitability Analysis ………………………………………………………..70

3.6.Sensitivity Analysis ………………………………………………………………………71

3.6.1. Non-Discounted Measures of Project Worth……………………………………….72
3.6.2. Discounted Project Appraisal Criteria………………………………………………76
3.7.Sensitivity Analysis: Is Discounting Unfair to Future Generations?..................................91
Chapter Four: Economic Analysis of Projects ……………………………………………….95

4.1.An Overview of Economic Analysis …………………………………………………...96
4.2.Identification Costs and Benefits of Economic Analysis ………………………………99
4.2.1. Sunk Cost ……………………………………………………………………..101
4.2.2. Transfer Payments, Externalities and Others …………………………………107
4.2.3. The Treatment of Taxes, Subsidies and other Transfer Payments…………….108
4.3.Determining Economic Values ………………………………………………………...113
4.3.1. Adjustment for Transfer Payments ……………………………………………114
4.3.2. Shadow Pricing ………………………………………………………………..115
4.4.Social Cost Benefit Analysis ………………………………………………………….117
4.4.1. The UNIDO Approach………………………………………………………..118
4.4.2. Little and Mirrlees Approach………………………………………………….133
4.5.Cost Effectiveness ……………………………………………………………………..137
4.5.1. Cost Effectiveness Measures ………………………………………………….138
4.5.2. Weighted Cost Effectiveness Measures ………………………………………141
4.5.3. Comparing Option with Subjective Outcomes………………………………...142
Chapter Five: Project Implementation, Monitoring and Evaluation ……………………..146

5.1.Monitoring and Evaluation Some Basics ……………………………………………...146
5.2.What is Monitoring and Evaluation …………………………………………………...151
5.3.Why Monitoring and Evaluation………………………………………………………152
5.4.Kinds of Monitoring and Evaluation ………………………………………………….152
5.5.Procedures in Monitoring and Evaluation …………………………………………….155
Chapter Six: Some Basics of Impact Evaluation …………………………………………...161

6.1. What is Impact Evaluation? …………………………………………………..……161
6.2. Why do Impact Evaluation?.......................................................................................161
6.3. Why do Impact Evaluation?.......................................................................................162
6.4. Who to Engage in the Evaluation Process?...............................................................163
6.5. How to Plan and Manage an Impact Evaluation?......................................................163
6.6. What Methods can be used to do Impact Evaluation?...............................................164
6.7. How can the Findings be Reported and Their Use Supported?.................................171
References……………………………………………………………………………173

CHAPTER ONE
AN OVERVIEW OF PROJECT ANALYSIS
Introduction
Dear learner! In this chapter, we would like to familiarize you with some of the basic concepts in
the whole project work. We start with concept definition and broaden our scope on gradual basis
towards the discussion of activities involved in the whole project cycle. We hope you will enjoy
the readings and exercises in this first chapter and in the subsequent chapters as well.
Learning Objectives:
Dear distance learner! After completing this chapter, you will be able to:
 Explain the concept and characteristics of a project;
 Identify the link between policy, development plan, programs and projects;
 Discuss stages of project planning;
 Realize aspects of project analysis;
 Understand the concept of project appraisal and its principles;
1.1. The Project Concept

1.1.1. Definition: What is A Project?
A project is a proposal for an investment to create, expand and/or develop certain facilities in
order to increase the production of goods/services/ during a certain period of time in a
community, region, country, market area and/or certain organization (firm, public organization,
NGO, etc). It is complex set of activities where resources are used in expectation of return and
which lends itself to planning, financing and implementing as a unit. A project can alternatively
be defined as a group of tasks performed in a definable time period in order to meet a specific set
of objectives. A project usually has a specific starting and ending point intending to accomplish
specific objectives. Projects usually have well defined sequence of investment and production
activities and a specific group of benefits that can be identified.
Dear distance learner! Can you describe the concept of a project in your own word with
providing practical examples?
1.1.2. The Basic Characteristics of a Project

In all project types there are basic characteristics of capital expenditure (also referred to as a
capital investment or capital project). Another way of defining a project is to outline these basic
characteristics that a project exhibits, which include the following.
1. A project involves the investment of scarce resources in the expectation of future benefits;

2. There are measurable Objectives of a project. Projects have specific of benefits that can be
identified, quantified and valued, either socially or monetarily/commercially/. Related to the
specificity of objectives, is the fact that projects have specific beneficiaries or clientele
group, which needs to be specifically spelt out during project planning studies.
3. A project is the smallest operational element unit. A project can be planned, financed and
implemented as a unit. Often projects are the subject of special financial arrangements and
have their own management. Despite the fact that a project constitutes many activities and
tasks, it is defined as the smallest operational unit. The major reasons why a project is
defined as the smallest operational unit are the fact that a project is bounded by different
factors. The boundaries of projects make them distinguishable from each other.
 Projects are conceptually bounded. The problem and specific objective or needs that
justify the project involves conceptual delimitations.
 Projects are geographically bounded. Projects exist in space and we say that projects are
geographically/location bounded.
 Projects are organizationally bounded. Projects require the establishment of a special
organization or the crossing of traditional organizational boundaries. i.e. there should be
certain organizational unit responsible for project implementation.
 Projects are time bounded. One factor that makes projects bounded is the time/life cycle/
of a project. Projects have specific lifetime, with a specific start and end time in which
clearly defined set of objectives are expected to be achieved. It is a unique, one-time
investment scheme.
4. Uncertainty and risks is inherent in any project. Achieving project objectives cannot be
predicted in advance with accuracy. The factors that make project risk are:
 Significant and multiple types of scarce resources committed today expecting outcome in
the future; Benefits are expected to be generated in the future, which is less predictable;
 Capital investments are irreversible, i.e. the assumption of perfect exit assumption of the
perfect competition model is refuted.
5. It has a scope that can be categorized into definable tasks. Projects usually have well defined
sequence of investment and production activities.
6. It may require the use of multiple resources. This has an implication on management of
project implementation. The more diverse the types of resources are mobilized the more
complex will the management be. The outcome of project and hence development endeavor
is sensitive to the management of each type of resources. Unmanaged resource can contribute
more to cost than to benefit.

1.1.3. Additional Descriptions/Features of Projects

The following features of a particular project can help us understand more about what a project
should include.
1. Scope: A project should be neither too small nor too large; it has to have an optimal and
reasonable scope. For instance, a plan of action that deals with the agricultural sector can‟t be
called a project. Dear student! You can imagine how big it would be to consider an
economy‟s sector as a project. On the other hand, the decision whether to employ or reject an
extension agent in a given government office can‟t be project or a project concept; such a
single activity can never be considered as a project.
2. Size: Size of a project is a function of capital invested, human labor requirement (skilled or
unskilled), coverage of beneficiaries, total value of inputs used and total value of goods and
services produced by the project.
3. Duration: A project has a limited duration. We can find projects of long and short duration.
Project duration refers to the number of years required to complete the project.
Example: Hydroelectric project, coffee plant, annual crop projects (say bean exporting
agricultural project), or seed distribution projects‐ all these have their own varying project
duration. Economic life of the project (the number of years the project remains economically
productive) is different from the duration of the project. Suppose the duration of project is 10
years, this doesn‟t necessarily mean that the economic life of the project is 10 years.
4. Outcome (output): The outputs of projects may be goods (e.g. machineries and clothing),
services (e.g. education and health), knowledge and information (e.g. research) or
information. Thus, outcome of a project can take various forms.
5. Coverage: A project can be regional, national, international, urban, or rural.
6. Type: As to their type, projects may be agricultural, industrial, transportation, commerce etc.
7. Input use: In relation to input use, projects may be capital intensive, labor intensive, and/or
energy intensive.
8. Budget: A project should have its own budget and should be self-contained i.e. it should
include all the necessary elements to achieve its goal (s).For example; construction of school
building is not a project unless teachers, educational material and students are available.
9. Boundary: It is extremely important to properly establish the boundaries of a project.
Boundary of a project is conceptually simple but in practice it is extremely difficult as it is
not simple where to delineate its boundary. For instance, irrigation project vs. agricultural
research project. How the boundary is drawn will depend upon the point of view (financial,
economic, and social) from which the project is being appraised. As we move down to the
different levels of Cost Benefit Analysis (CBA), which may take financial, economic, or
social form, the project boundary gets wider.
The absence of effective and well defined project preparation is one major problem in
developing countries. Economic planners often give little time to the preparation of suitable
development projects. Public projects, which are not profit oriented, are the main targets of aid‐

flows coming to developing countries (which have their origin in government plans, make
demands on government resources and institutions, even though the private sector may be
involved in the implementation phase.) Good examples may include road construction projects
and power generating projects. Given all the above discussions, one can derive the following
dynamic and comprehensive definitions for a project.
A project is an instrument of change. It is a coordinated series of actions resulting from a

policy decision to change resource combinations so as to contribute to the realization of the
country‟s development objectives. Projects should, according to this definition, be formulated
within the framework of the country‟s development priorities which may include agricultural
production growth, improving income distribution, eradicating poverty and malnutrition,
promoting larger public involvement in producing goods and services.
A project is people‐oriented. It responds to people‟s actions. Projects should forecast the

response of their ultimate beneficiaries. A project within the framework of a national
development changes plan into action at a micro‐level. Hence, a project is undertaken, among
other things, for development reasons (executing national objectives at the micro level) and may
include:
 Promoting exports,
 Employment creation,
 Utilizing non‐utilized and under‐utilized resources, etc....
Dear learners! Would you mention the basic characteristics and features of a project?
1.1.4. Classification of Project

In general every project is unique in the sense that there are factors that distinguish projects from
others. Some of the main factors which bring about differences in the nature of projects and that
determine the breadth and depth of project studies include:
 Size/scale/, small-, medium- and large- scales of projects;

 Markets; projects catering to regional, national or international markets,
 Technologies, heavy, light, mature or newly evolving technology, factor intensity, etc.
 Economic and location context: Rural and urban projects, projects in LDCs and DCs, etc.
 Financial and other resources availability,
 The macro economic situation at which the particular project is being considered,
 The level of competition, high or low competition, local or global competition,
 The type of sector/industry of a project eg. Good or service (education, health, banking,
insurance), public good or private good, industrial or agricultural project, etc.
 Ownership (private and public projects) which has wider implication on the breadth and
depth of coverage.
 Impact/outcome: Projects could be different because of their major impacts. There are
differences in projects in terms of their social and environmental impacts, which may be (and

are gaining importance since the recent past decades) important variables that determine the
level and type of studies required.
It has to be noted that the exercise of identifying the factors that distinguish a project from
another one is not by itself an end in the practical world. Rather the concern is in identifying the
variables that have significant implication on the viability of a project and the need for explicit
consideration of the same in the same study. So apart from discussing the principles and major
procedures that need to be adhered to, one cannot reflect the specific behaviors of different
projects, be agricultural, manufacturing, industrial projects in such level of treatment. It is
therefore the task of the project analyst to decide which characteristic of the project must be
underlined. One can classify projects into:
1. Agricultural project: Agriculture project is focused on five areas: raising productivity;

helping farmers reach markets; reducing risk, vulnerability and inequality; improving
incomes off the farm; and making agriculture more environmentally sustainable. Moreover
the Agricultural Development Project aims to reduce rural poverty by improving and
increasing agricultural production through a community-based approach in designing and
implementing components which directly impact the lives of the poor in the participating
provinces and districts.
2. Industrial Project: Industry is one of the fields of human activity where through processing
of raw materials more valuable goods are manufactured with the purpose of satisfying
society‟s material needs and creating wealth. Industrial Development is the synthesis of
contributions from four major factors, namely, Business, Technology, Government and
Labour and successful industrial projects can be achieved only through a close co-operation
and mutual understanding between these contributors. The concept of integration in industrial
development is based on the creation of integrated organizational structures, including all
main contributors acting as a team, their objective being the successful completion of the
project.
3. Construction project: A construction project, sometimes just referred to as a „project‟, is the

organized process of constructing, renovating, refurbishing, etc
a building, structure or infrastructure. The project process typically starts with an overarching
requirement which is developed through the creation of a brief, feasibility studies, option
studies, design, financing and construction. Construction projects are typically one off's. That
is, a project team, brief and financing are put together to produce a unique design that
delivers a single project. Once the project is complete the team is disbanded and sometimes
will not work together again. This can make it difficult to develop ideas or relationships, and
so lessons learned are often not carried forward to the next project. These projects incur
special risks and problems of organization and communication. They require massive capital
investment and they require rigorous management of progress, finance and quality.

4. Manufacturing project: It is an operation designed to produce large, expensive, specialized

products such as custom homes, defense weapons such as aircraft carriers and submarines,
and aerospace products such as passenger planes, and the space shuttle. Manufacturing
project is highly flexible, because each project is usually significantly different from the one
before it, even if the project‟s size and expense and high degree of customization, project
manufacturing can take an extremely long time to complete. Manufacturing project is an
operation designed to produce unique but similar products. It takes advantage of common
manufacturing requirements (and therefore efficiencies), while allowing for customization
into “unique” combinations. Unique orders may be managed like a project. The more
components of that order that are common to other unique orders the more they may be
manufactured taking advantage of manufacturing methodology. Manufacturing project then
is the melding of Manufacturing and Project Management at a level where the most
advantage may be gleaned from each to the financial advantage of the company.
5. Research projects: Research comprises "creative and systematic work undertaken to

increase the stock of knowledge, including knowledge of humans, culture and society, and
the use of this stock of knowledge to devise new applications." It is used to establish or
confirm facts, reaffirm the results of previous work, solve new or existing problems,
support theorems, or develop new theories. A research project may also be an expansion on
past work in the field. Research projects can be used to develop further knowledge on a topic,
or in the example of a school research project, they can be used to further a student's research
prowess to prepare them for future jobs or reports. To test the validity of instruments,
procedures, or experiments, research may replicate elements of prior projects or the project
as a whole. These projects can involve large sum of money, lasting form many years and yet
the result is less predictable than the other types of projects. The end result could be
surprising, pleasing, disappointing or producing nothing.
1.1.5. The Link Between Policy, Development Plan and Projects

In the context of the preceding introductory remarks, the policy framework defines the context
for periodic development plans (short-, medium- and long-terms plans) which then require
specific instruments for implementation. Projects are the policy and plan instruments, a particular
decision scheme meant to convert policies and plans into reality. So we have this generic
scheme:
Policy ⇒Development Plans ⇒Programs ⇒Projects ⇒Outcomes / impacts /changes

Governments and corporate entities considering their vision into the future, the external
environment and the performance of competitors set up policies which serve as a basis for
strategic /medium- and long-terms/ plans, which in turn serve as a basis for project identification
and its selection. If there is no organic link between policies, plans and projects, then the

effectiveness and efficiency of investment decisions could be compromised. Accordingly, one

has to ensure adequate and proper responses to the following questions.
A. What is the major objective of the project? The actual aims / quotas / milestones to be
reached within a specified time, according to client requirements specified.
B. What is the basis for the demand for the goods/services to be produced by the project?
C. What problem or opportunity is the project addressing?
D. How does the project contribute to the wider goals of the sector/organization/ region? i.e.
whether the project is consistent with the priorities set in policy and development plan
documents of a country, region, zone, woreda or a specific organization.
E. What alternative ways of addressing the problem/opportunity/ have been considered?
F. What Path (Strategy) to be followed and actions to be taken to reach the aims and objectives.
G. Why is the proposed project the most appropriate way of addressing the
problem/opportunity;
H. What is the approximate cost and timescale Schedules of the project? This is a plan showing
when individual / group activities will start and end and at what cost.
I. Who are the major stakeholders and beneficiaries of a project? In what ways are they
expected to participate?
J. Which institution is the most appropriate for implementation? This is about organizing and
Assigning specific people to a specific objective, as well as the specific responsibilities for
each task.
K. Are there additional or special circumstances relevant to the project?
L. Standards and determining quality for each action
The decision making process could include both the public and the private sectors. In the public
sector, there will be a political context in which policies and development plans are set. In the
corporate decision-making, there are corporate strategic plans, which include the vision, major
objectives, strategies and periodic plans. In both types of contexts of decision-making, there is a
need for projects, as the cutting edges for converting ideas, intents, and plans into deeds,
achieving objectives and bringing changes.
Project planning and evaluation 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. But the inclusion of project analysis in development economics did not
necessarily amount to a new analytical discovery, rather to a new approach. Projects are now
assessed from the economy‟s viewpoint instead of only from the firm‟s perspective. The
selection criteria have also included economic criteria on top of financial criteria. Promoting
projects without having development policies and plans will lead to scattered/dispersed and
unorganized development endeavors.

Policies and plans without projects mean non-implementation, paper tiger decision makers,
having policy and plan documents for other purposes. Governments usually have plans and
development plans for publicity and propaganda sake or to respond to external or internal
pressures. Projects are the cutting edges of development plans. Development endeavor without
projects is unperceivable.
In this line developing countries are negotiating, requesting, struggling with bilateral and
multilateral donors and lenders for budget support instead of project financing. This is because
project financing has been less effective to transform economies and bring about expected
results. Multilateral institutions, though are accepting and appreciating the significance of budget
support and limitations of project financing, they argue against budget support on the pretext that
governments abuse donor‟s money. Governments can use donor‟s money for their specific
political ends and abuse or they have weak implementation capacity and hence supervisory and
monitory capacity.
1.1.6. The Linkage Between Projects and Programs

Sometimes people perplex a project with a development program. Unlike a project, a program is
an ongoing development effort or plan. A program may include various projects at various times
as its constituent units. Hence a project is a specific activity (compared to a program), with a
specific starting point and specific ending point intended to accomplish some specific objective.
Most developing countries in general have some sort of national planning. Of course the degree
and complexity of such development plans vary from country to country and even in a particular
country from time to time. For instance in Ethiopia Planning was much centralized in the 1974-
91 periods compared to either before or after this period. Project formulation is an integral part
of a more broadly focused and continuous process of development planning.
Projects can also be understood as an activity for which more will be spent in expectation of
returns and which logically seems to lend itself to planning, financing, and implementing as a
unit. It is the smallest operational element prepared and implemented as a separate entity in a
national plan or program. In general, thus, sound development plans require good and realistic
projects for the latter are the concrete manifestation of the plan as noted above. Projects in such
context are the concrete manifestations of the development plans and programs in a specific
place and time. One can think of projects as subunits and bricks of programs, which constitute a
component of or the entire national plan.
It is necessary to distinguish between projects and programs because there is sometimes a

tendency to use them interchangeably. While a project refers to 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
involving a number of projects. Programs may or may not necessarily be time bounded. Yet
programs cannot live forever, they have limited life cycle, which however, may or may not be
explicitly stated. So in effect in terms of time delimitation, there is only relative difference

between programs and projects. A development plan is a statement of action meant to realize and
implement economic policy.
National development plans are further disaggregated into a set of sectoral plans which involve a
number of programs and projects. A development plan or a program is therefore a wider concept
than a project. It may include one or several projects at various times whose specific objectives
are linked to the achievement of higher level of common objectives. Note that projects can
stand alone without being part of certain program. So, one can visualize the possibility of
policies →development plans → projects. Projects, which are not linked with others to form a
program, are sometimes referred to as “stand alone” projects. Program study that incorporates a
multiple of projects requires three steps:
 The analyst must appraise each project independently.

 The analyst must appraise each possible combination of projects.
 The analyst must appraise the entire program, including all the projects, as a package.
Examples could be a road development program, a health improvement program, a nutritional

improvement program, a rural electrification program, institutional reform program, management
system reform program, etc. 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.
Dear learners! Can you explain the relationship between development plans, programs
and projects applied for different economic development interventions?
1.1.7. Development Planning Versus Project Planning

Development planning is an exercise of consideration in attempt to select the best policies to be
implemented for the development of a nation over a planning period/planning horizon. There are
a number of approaches to development planning, which have been evolved overtime. Until
1980,s developing country governments have implemented fixed period or term (five-year or
short term) plans, which were intended to guide public investment. These plans were often too
ambitious, become quickly outdated, and lacked the flexibility to respond to the changing
economic conditions.
Today, development planning refers to a set of processes, which aim to take the needs of the
poorest section of society into account (Sustainable Development and Poverty Reduction
Program-SDPRP) whilst recognizing that positive changes are complex and multi-faceted. As a
result, fixed term plans have been replaced by rolling plans and attempts have been made to
integrate the planning of investment/capital and recurrent expenditure to that of development
policy of countries. To this end, there are three generally accepted forms of development
planning, which are commonly used, namely,

A. Indirect panning refers to planning where the government controls certain parameters (some
prices, interest rates, taxes, exchange rates, and allocation of public resources) and uses these
parameters to influence the decisions of enterprises/firms in the desired direction. The
introduction of reforms has considerably reduced the range of prices that some governments
try to control.
B. Regulative planning is used to allocate state resources and to coordinate public sector
activities but also to influence the activity of the private sector through incentives and
regulations to cooperate in plan implementation. This type of planning is mostly used in LDC
and to some extent in developed countries, particularly in the area of environment
protection/control and the regulation of natural monopoly.
C. Indicative planning involves forecasting the development of the economy and indicating
expected government and state sector expenditure. This process provides information and
creates an environment that influences the decision of the private sector, although there may
be no attempt to govern those decisions directly. Indicative planning is the main form of
planning in developed capitalist economies. It attempts to tackle directly the problem of
imperfect information that contributes to the failure of markets to give an optimal outcome.
All the three forms of planning outlined above require a certain degree of decentralized decision-
making by sectors if they are to work effectively. Most countries in particular rely on Public
Investment Programs (PIPs) and use a combination of regulative and incentive measures to
channel investments into priority areas. PIPs are usually drawn up on the basis of project
proposals received from a variety of public sector organizations (micro-level).
These proposals are then grouped on a sectoral basis to form a sectoral plan in which specific
priorities are defined. These sectoral plans aim to provide the link between macro-level planning
and project planning. These two ways of interaction (top-down and bottom-up relation) between
development plans and micro projects, which he called the iterative (repetitive) planning process,
are also known as the Reitbergen (1998) development planning process.
As can be understood from the hierarchical networking diagram below the Reitbergen (1998)
development planning process starts with the policies of the government. These policies are
further translated into different (long, medium, and short-term) national goals, macro plans,
sectoral or ministerial (agricultural, industrial, and infrastructure-economic and social) plans,
regional plans, and micro (zonal to district and company or institutional to department/unit level)
projects.
The two ways relationship between plans and projects in the below diagram also indicates that:
i. Development plans require projects and projects require plans (as a reflection of one for
the other).
ii. Projects are considered as catalysts and pillars or building blocks of development, which
constitute national/macro plan.

Fig 1: The Hierarchical Planning Structure
Gov’t policies
Top-down Approach-budgeting
Bottom-up Approach-estimation
Goals
Macro plans
Sectoral plans
Regional Plans
Micro Projects
Usually linking policy, planning, and budgeting system enables investment decisions to be
planned systematically, thus making the most efficient and effective use of available resources.
Historically, in many instances this has not been the case and fragmented decision-making,
unsystematic planning, and budgeting have often led insufficient funds to be allocated
(committed) to the government‟s priority areas. The implementation of government policies in
most LDCs, particularly in Africa, would not have been often failed to match that which is
promised (achieve development objectives and goals) or would be possible if a more strategic
and integrated approach had been taken. Hence, budgeting has to be treated as a strategic and
long-term exercise rather than as an annual attempt to cover costs. In order to overcome this
problem, the World Bank (WB) has recently recommended LDCs for the introduction of a
comprehensive Medium-Term Expenditure Frameworks (MTEFs).
An MTEF is a strategic policy and expenditure framework, which covers all sectors of the
government. It consists a top-down resource envelop (allocation), a bottom-up estimation of the
current and medium-term costs of existing policies and attempts to match these costs with
available resources. It also represents an attempt to move towards a coordinated system that
involves stakeholders in genuine partnership (Tumusiime Mutebile, 2003).According to the WB
(2003) the objectives of MTEF are to:

 Improve the macroeconomic balance by developing a consistent and realistic resource

framework;
 Improve the allocation of resources to strategic priorities between and within sectors;
 Increase commitment to predictability of both policy and funding so that ministries can plan
ahead and programs can be sustained;
 Provide line agencies and ministries with a hard budget constraint and increased autonomy,
thereby increasing incentives for efficient and effective use of funds.
However, the successful creation and utilization of an MTEF requires a certain level of technical
capacity at regional level. If this technical capacity does not exist, as in a country like Ethiopia,
then it would be inadvisable to attempt implementing an MTEF. Hence, due to the absence of
technical capacity Ethiopia demonstrates the ability to adhere to an annual budget before
attempting to formulate an MTEF.
1.1.8. The Rationale for Planning

 Planning is the making of major economic decisions, such as the national income, income
distribution, the saving rate, the investment rate etc.
 Planning is the coordination of economic activities via conscious effort. It is a supplement to
market forces. In most cases price signals are misleading as a result of this there should be a
certain particular apparatus that coordinates economic activities in the economy.
 Planning is a process of cognition and compromise. The very aim of planning is to
compromise the different conflicting interests and to understand the desire of the economy by
singling out social needs.
 Planning is an institutionalized activity by, or on behalf of a certain authority for:
- The preparation of decisions and actions to be taken by the central authority
- The coordination of decisions and actions by lower echelons of the economy and the
central authority for governing the development of the entire economy.
Factors that have led to the adoption of panning profiled in to three broad heads.
A. Institutional requirements: In a number of countries planning has been made use of to meet
the institutional needs of their people. And plan production accordingly.
B. Technological reasons: The rational use of a new technology should be first of all planned
before its operation. The modern technologies are such that their proper use is dependent up
on the adoption of planning. The other important point for planning requirement is that
technologies constantly changing, these give raise two sorts of problems: Modifying,
changing or replacing existing capital goods; and providing for their fast depreciation. To
meet these problems with the least cost to society, planning is needed.
C. Economic considerations: Three kinds of arguments can be put forward.
 The integration of the various segments of a modern economy needs planning.
Example: To the effect of government policies both at the micro-level and the macro- level.
 The second set of arguments relates to the deficiencies of market. There are always ups
and downs in the world market; because of this, nations or economies are obliged to use

planning. Why? Market Mechanism is not in a position to generate fair distribution of

income this resulted in the use of planning.
 The third set of reasons refers to the availability of useful economic knowledge as also
planning techniques for a rational use of resources. These include the application of basic
theoretical ideas to many fields. Generally, due to scarce resource.
1.1.9. Significance of Project Planning

There are different types of projects: public, private, private individual, small, large, agricultural,
industrial, etc. All these decisions involve a capital expenditure decision. Each of them can be
analyzed and apprised reasonably independently. The basic characteristics of capital expenditure
also referred to as capital investment or capital project. Thus, project planning is inevitable so as
to make a correct capital investment decisions. The following points can be taken as the
importance of project planning.
 To eliminate uncertainties
 To increase the effectiveness and efficiency of the operations.
 To identify and work towards a common goal.
 To establish a means of project monitoring and control.
The quest for socio-economic development, inevitably involves the basic economic problem of
scarcity in the face of unlimited needs and hence the need to make choices on the means and
ends of development, which involves the rational use of limited resources to attain the economic
ends. Thus investment decisions are an essential part of the development process. The more
sound the investment decision is the more success will be in the development endeavor.
The need for project planning, preparation and study emanates from:
 The quest for change: dissatisfaction with the present and/or pressure or incentive for
different tomorrow;
 Change involves investment/commitment of resources to realize the objectives. Investment
may be defined as a long-term commitment of economic resources made with the objective
of producing and obtaining net gains in the future. The main aspect of such commitment is
the transformation of liquidity (the investor‟s own and borrowed funds) into productive
assets, and the generation of liquidity again during the use of these assets. Yet once the
resources are committed, there is no way of recovering it apart from conducting profitable
operation. That is exit costs are not zero, as it is assumed in the perfect competition model.
 The scarcity of investible resources and unlimited development/business needs;
 Investment is all about resource commitment into the future, which is less predictable;
 Since investment schemes involve substantial resources commitment and are invested for the
future, there is an inherent high risk involved.
 The costs and benefits are temporally spread and particularly the large part of the costs are
incurred earlier and the benefits are generated later on, 10-20 years for industrial projects and

20-50 years for infrastructural projects. Then the saying goes “ a bird at hand is better than
two birds in the bush”. This raises the question of comparing and equating the future and
present values.
These features of investment decisions constitute the reasons that justify the significance and
relevance of project planning and the major constraints and challenges faced by any project
planner and decision maker in project viability studies. Thus decision makers have to make every
effort to systematically rationalize their decisions by undertaking rigorous viability studies,
which involve conducting studies and appraisal/evaluation of the same. This presupposes that the
major decisions involving substantial resources and that have wider implications on the success
of an operation are not instantaneous as the conventional assumption of rationality imply.
Dear learners! What is the basis for project planning? What benefits countries can
generate from project planning?
1.2. The Project Cycle: Stages of Project Planning
Project cycle means the various stages of information gathering and decision making which take
place between a project‟s inception and completion. A project cycle is a sequence of events,
which a project follows. These events, stages or phases can be divided into several equally valid
ways, depending on the executing agency or parties involved. Some of these stages may overlap.
Capital expenditure decision is a complex decision process, which may be divided into the
following broad phases. The following points are worth mentioning while discussing on the
activities accomplished within a given project.
 The project cycle is not as such a sequential activity. In practice, many of the phases
overlap.
 An understanding of the project cycle would enable the project analyst to grasp the
intricacies of bringing an investment project to the stage where it is ready for submission to
an international financing institution.
 All the stages of project cycle are equally valid, and the process is flexible and making a
mistake at any stage is equally disastrous.
 Project preparation, which involves all the above stages, is a group work involving peoples
from different disciplines project; economists, engineers, livestock specialists, soil
scientists, crop scientists, ecologists, and so on.
Throughout the project cycle, the primary preoccupation of the analyst is to consider alternatives,
evaluate them, and to make decision as to which of them should be advanced to the next stage. If
it is decided to proceed to the next stage, the results (out puts) of a given stage serve as the input
or part of the input of the next sage.
Dear learner! Can you mention the idea of project cycle in your own word?

1.2.1. Project Identification/Opportunity Study/ Stage

A. Project -Concept Definition Phase
This stage is possibly the most crucial in the project cycle, since „project ideas‟ are first
generated at this point. In practice, while this stage may frequently merge invisibly into the
identification stage, it is important conceptually to separate the two stages. The project ‐concept
definition is prerequisite to the decision to proceed to identification. The project‐concept
definition essentially aims at expressing the country‟s development objectives in the form of
projects. Ideally, this stage should be based on a thorough understanding of the country‟s
economic development objectives, its resource base, and an assessment of the options facing the
country.
Here, there is a need for an intensive sector wide survey. These sector‐ wide surveys provide a
more reasonable basis for the assessment of priorities and developing project ideas for the latter
tasks. The survey examines the role of the project against the background of the country‟s
development objectives and the way they are being pursued. Project ideas can emanate from a
variety of sources. Much depends on the experience, and even the imagination, of those entrusted
with the task of initiating project ideas. In general, one can distinguish two levels where project
ideas are born: The macro level and the micro level.
At the macro level, project ideas emerge from:
 National policies, strategies and priorities as may be initiated from time to time;
 National, sectoral, sub-sectoral or regional plans and strategies supplemented by special
studies, sometimes called opportunity studies, conducted with the aim of translating national
and sectoral sub-sectoral and regional programs into specific projects;
 General surveys, resource potential surveys, regional studies, master plans, statistical
publications which indicate directly or indirectly investment opportunities;
 Constraints on the development process due to shortage of essential infrastructure facilities,
problems in the balance of payments, etc.;
 Government decisions to correct social and regional inequalities or to satisfy basic needs of
the people through the developments of projects;
 A possible external threat that necessitates projects aiming at achieving, for example, self-
sufficiency in basic materials, energy, transportation, etc.
 Unusual events such as draughts, floods, earth-quake, hostilities, etc.;
 Government decision to create project-implementing capacity in such areas as construction;
 At the macro-level, Project ideas can also originate from multilateral or bilateral
development agencies and as a result of regional or international agreements on which the
country participates.
In addition individual/entrepreneurial/ inspiration, institutions, workshops, trade fairs,
development experiences of other countries may point to some interesting project ideas.

At the micro-level, the variety of sources is equally broad. Project ideas may emanate from:
 The identification of unsatisfied demand or needs
 The existence of unused or underutilized natural or human resources and the perception of
opportunities for their efficient use
 The need to remove shortages in essential material services, or facilities that constrain
development efforts.
 The initiative of private or public enterprises in response to incentives provided by the
government.
 The necessity to complement or expand investments previously undertaken, and
 The desire of local groups or organizations to enhance their economic status and improve
their welfare
Project proposals could also originate from foreign firms either in response to government
investment incentives or because they consider production within the country a better way to
secure a substantial share of the domestic market for their products.
B. Project Identification / Investigation/ Phase

The next stage in the project cycle is to find potential projects. It is the identification of
investment opportunities. The project identification stage develops the project idea to the point
where a decision can be taken on whether resources should be committed for further action.
Whereas the motive of the project concept is largely the justification of the project in the sectoral
context, that of identification is to delineate the main outlines of the project and to establish the
overall viability of the project proposal. This stage should identify a number of alternatives using
the existing and new data in such away as to limit alternatives under consideration to those few
which are most promising.
Hence, the project evaluation process is the essential way of eliminating relatively less worthy
ones. In theory, the identification of project should be an integral function of the planning
process. In practice, the projects suggested by plans are fairly unspecified‐ there will still be a
number of alternatives to be examined before a final decision is reached. In some cases, projects
will emerge for reasons which have little to do with the plan but which serve the interests of
particular business groups and politicians. In practice, project ideas originate haphazardly, and
are often politically inspired.
Any rural development project not integrating educational, transport, health and agricultural
components, without the coordination between the various competent agencies, is notoriously
bad. If the planning process is sophisticated, projects may emerge at a relatively high degree of
definition with respect to scale, location, type of output, etc. One may hear that there is a lack of
projects available for investment in developing countries. But usually there is no shortage of
proposals for projects that have been identified. Rather there may be a shortage of project
prepared in sufficient detail to permit implementation.

Identification involves listing potential projects. The most common sources of such information
may include well‐informed technical specialists and local leaders. The major steps in the
identification process consist of the following:
1. Evaluation of the current situation (situational analysis): This diagnostic phase has the
objective of establishing the development potential for the area or project proposal and
identifies the constraints to the proposed development. For example, for an agricultural
project it involves identifying the main physical features of the project soils, agronomic and
cropping practices, and water resources, human resources, population and labor, institutional
features (land tenure, credit, marketing, input supplies, research and extension, and the
administrative structure).
2. Identifying relevant policy issues: Examining the current government policies (pricing
policies, subsidies, taxation, irrigation schemes) and assessment of their impact on the
proposed project. Projects do not operate in a vacuum; their performance is subject to a wide
range of government policies covering such matters as taxation, subsidies, land reform and
tenure, level of priority of foreign exchange allocations to various economic sectors, pricing
policy, investment policy, and credit and so on. Hence, the project planner should attempt to
understand and inculcate the effect of all these policy issues on the production, productivity
and prices of project outputs.
3. Establishing the project‟s rationale: This provides the overall justification (absence of
similar projects, demand conditions, production capacity increase, foreign exchange, and
overall potential of the area for intervention) for the country to undertake the project and for
the lending institution to support it. A reasoned analysis from the previous sections would
provide the basis for marshaling the arguments here. Taking a fishery project as an
illustration, the diagnosis should be based on issues such as the country‟s fish imports could
be substituted with increases in the domestic catch; that fishing is or could become an
important economic activity, and that the existing fishery resources are being exploited at
levels far below their sustainable yield potential; but evidence should exist that a few
entrepreneurs with access to credit, are carrying out a profitable operation.
4. Developing the project‟s design and concept: This step consists of setting the project‟s
objectives, measures proposed by the project to achieve these, and identifying the project‟s
main components.
5. Setting the project‟s scale: Identification should establish the rough order of magnitude of
the project, in respect of physical coordinates, such as the size of the irrigation command area
and main project works involved; area to be cleared and planted and families settled in a land
settlement project, number of farmers to be reached and crop rotations to be developed in a
credit project.
6. Preparing preliminary cost and benefit estimates: Identification should establish rough
estimates of the project‟s total costs and benefits, the major project components, and
estimates of the foreign exchange component.

7. Proposing the organization and management structure: proposing the project staff and
organizational structure is a vital one. Government‟s role in the project should also be
explicitly sketched.
8. Spelling out the further work requirement: At identification, the studies and other
requirements for the detailed project‐preparation work should be spelled out, and specific
responsibility assigned for various tasks. For example, detailed terms of reference should be
drawn up, and estimates prepared of the cost of additional studies and the time schedule. The
identification stage is the crucial one at which various alternatives must be explored as
exhaustively as possible. However, no identification can be exhaustive. Even if objectives are
agreed upon, several options may be open, depending on the technical possibilities.
In summary, a good identification should:
 Justify the project in a sectoral context;
 Highlight pertinent issues and propose solutions;
 Demonstrate that the alternative or alternatives proposed and that further resources
should be devoted for preparation; and
 Establish clearly the follow ‐up steps for full preparation.
1.2.2. Project Preparation and Analysis Stage

Once project ideas have been identified and selected for further examination, 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.
Critical element of project preparation is identifying and comparing technical and institutional
alternatives for achieving the project‟s objectives. 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. It involves generally three steps: prefeasibility, feasibility and support study.
A. Pre-Feasibility Study / Preliminary Screening/ Phase
The identification process will give the background information for defining the basic concept
project, which leads to the feasibility study stage. Once a project proposal is identified, it needs
to be examined. Once some project ideas have been put forward, the first step is to select one or
more of them as potentially promising. To begin with, a preliminary project analysis is done. A
prelude to the full blown feasibility study, this exercise is meant to assess:
 Whether the project is prima facie worthwhile to justify a feasibility study and;
 What aspects of the project are critical to its variability and hence warrant an in depth
investigation.

At this stage, the screening criteria are rough and vague, becoming specific and refined as project
planning advances. During preliminary selection, the analyst should eliminate project proposals
that are technically unsound and risky, have no market for their output, have inadequate supply
of inputs, are very costly in relation to benefits, assume over ambitious sales and profitability,
etc. Some kind of preliminary screening is required to eliminate ideas, which prima facie, are not
promising. For this purpose the following aspects may be looked into:
 Compatibility with the promoter
 Consistency with government priorities
 Availability of inputs
 Adequacy of market
 Reasonableness of cost, and
 Acceptability of risk level
When a firm evaluates a large number of project ideas, it may be helpful to stream line the
process of preliminary screening. For this purpose, a preliminary evaluation may be translated
into project rating index. The steps involved in determining the project-rating index are as
follows:
1. Identify factors relevant for project rating
2. Assign weights to these factors (the weights are supposed to reflect their relative
importance)
3. Rate the project proposal on various factors, selecting a suitable rating scale
4. For each factor multiply the factor rating with the factors weight to get the factor score
5. Add all the factor scores to get the overall project-rating index.
Once the project-rating index is determined, it is compared with a pre-determined hurdle value to
judge whether the project is prima facie worthwhile or not. As a result of the preliminary
screening exercise, a project profile, an opportunity study report, or an identification study
report, as appropriate, is prepared showing which project alternatives should be rejected and
which ones may be advanced to the next stage.
B. Feasibility Study Phase
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 analysis of the
marketing, technical, financial, economic, and ecological aspects is undertaken. Feasibility study
provides a comprehensive review of all aspects of the project and lays the foundation for
implementing the project and evaluating it when completed.
The focus of this phase of capital budgeting is on gathering, preparing, and summarizing relevant
information about various project aspects, which are being considered for inclusion in the capital
investment. 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.
A large part of project analysis serves to establish a project‟s technical and institutional
feasibility, whether it is fit with the strategy and the appropriateness of the socio-economic
context for the project. The conventional cost-benefit-analysis-based economic analysis takes for
granted that a project is technically sound and that its institutional arrangements will be effective
during implementation. Appraisal should cover major aspects like technical, institutional,
economic and financial. 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. The
feasibility study would enable the project analyst to select the most likely project out of several
alternative projects. Selection follows, and often overlaps, analysis.
It addresses the question is the project worthwhile? Which of the projects is the best option from
the existing competing once? Given that there are alternative projects, theoretically the owner is
supposed to come up with alternative use of his/her money and hence the need to choose the best
investment opportunity. Project selection involves different factors and forces. It involves
political, social and economic variables. Essentially it is a political process in the sense that
despite economic rationality, political forces could exert significant pressure on the decision
making process on the selection of projects from available alternatives. In this regard, project
appraisal study could be categorized in the selection criterion. After appraisal studies the
decision maker will have to select one or a number of projects on the bases of pre-established
evaluation/selection criteria.
C. Support Studies Phase
Support or functional studies cover specific aspects of an investment project, and are required as
prerequisites for, or in support of, pre-feasibility and feasibility studies of particularly large-scale
investment proposals, the viability of which critically depends upon the quantity and quality of
certain input or aspect of that project. This type of study is justified when a detailed study
required for a specific aspect/input/ is too involved to be undertaken as part of the feasibility
study. Alternatively, the decision towards undertaking a feasibility study could be dependent
upon the outcome of a support study.
Example: Cement processing is tied to the source of major raw materials, which are lime stone
and sandstone. Since the requirement is bulky, one cannot think of a cement factory located at a
distance from the source of these raw materials. So there is little room for outsourcing from
distant locations or imports. Since cement production is critically dependent upon the availability
of adequate quantity and the right quality of these raw materials, a support study is justified
before commissioning a full-fledged feasibility study.
Dear learner! What are the three steps to be applied under project preparation and
analysis stage? Which step is the most crucial for the success of a project?

1.2.3. Project Appraisal Stage

Thus project appraisal can be defined as 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. Appraisal is the comprehensive and systematic assessment
of all aspects of a project study, addressing particularly issues like: Specificity of objectives;
Clarity of problems; appropriateness of data collection techniques and analysis techniques; and
Project specific factors. When a feasibility study is completed the various parties involved in the
project will carry out their own appraisal of the investment project in accordance with their
individual objectives and evaluation of expected risks, costs and gains.
The prime objective of project appraisal should be to identify the weaknesses that have bearing
on decision-making and identify means of strengthening it adequately to ensure final success of
the project. The main objective is then to improve and revamp the project. The appraisal report
concentrates on the health of the company to be financed, the returns obtained by equity holders
and the protection of its creditors. The techniques applied to appraise the project in line with
these criteria center around technical, commercial, market, managerial, organizational, and
financial and possibly also economic aspects. The findings of this type of appraisal enter into the
appraisal report.
Appraisals as a rule deal not only with the project but also with the industries in which it will be
carried out and its implications for the economy as a whole. For large-scale projects, appraisal
report will require field missions to verify the data collected and to review all those factors of a
project that are conditioned by its business environment, location and markets and the
availability of resources. A wide range of appraisal criteria have been developed to judge the
worthwhile of a project. They are divided into two broad categories, viz., non-discounting
criteria and discounting criteria. The principal non-discounting criteria are the payback period
and the accounting rate of return. The key discounting criteria are the net present value, the
internal rate of return, and the benefit cost ratio. To apply the various appraisal criteria suitable
cut off values (hurdle rate, target rate, and cost of capital) have to be specified.
These are influenced by the level of risk pursued. Despite a wide range of tools and techniques
for risk analysis (sensitivity analysis, scenario analysis, Monte carol simulation, decision tree
analysis, portfolio theory, capital asset pricing model, and so on) risk analysis remains the most
intractable part of the project evaluation exercise. This exercise also involves the undertaking of
detailed engineering design, manpower and administration requirement as well as marketing
procedures should be finalized. When the appraisal is completed, the findings and final
recommendations are put together in the form of an appraisal report. The recommendation may
be to approve, re-formulate, postpone, or abandon the project under review.

Comprehensive development plans are ultimately composed of a variety of projects that intends
to address a problem or a need, which may be internal or external to an institution or a company.
Accurate and consistent project appraisal is therefore a crucial factor in the success of
development plans. These include technical, environmental, social, institutional, financial, and
economic analysis. However, since conducting these analyses is costly in terms of both time and
material resources it is important that all appraisal techniques, procedures, and information
required for appraisal purpose are stated in the national project appraisal document (PDA) or
guideline before the appraisal process began. The table below indicates summary of compressive
appraisal techniques.
Table 1: Summary of Appraisal Techniques
No Appraisal Techniques
1 Technical  Problem Analysis
 Demand Analysis
 Logical Framework Analysis
 Technical Feasibility Study
2 Environmental  Environmental Screening
 Preliminary Environmental Assessment
 Environmental Impact Assessment
3 Social  Stakeholders Analysis
 Gender Analysis
 Social Impact Analysis
4 Institutional  Organizational Capacity Assessment
 Work Breakdown Structure (WBS)
 Activity Description Sheet
5 Financial  Cash Flow
 Trading, Profit and Loss Account
 Balance Sheet
 Cost Benefit Analysis
 Cost Effectiveness Analysis
6 Economic  Cost Benefit Analysis
 Cost Effectiveness Analysis
 Economic Analysis
 Identification and removal of Transfer Payments
 Inclusion of linkage effect and externalities
 Use of shadow prices
 Estimation of distributional effect
7 Risk Analysis and Mgt  Risk Identification
 Sensitivity Analysis
 Risk Analysis
 Risk Assessment matrix
 Risk Mgt plan

A. Role of appraisal
For the success of national development plan it is thus vital that project at the micro-level are
found to be suitable i.e. feasible and desirable. Ensuring this is the purpose of project appraisal.
When appraising a project there are a number of issues looked into in terms of posed questions
for ensuring its desirability and feasibility. Their implication and few of the questions are listed
below.
I. Relevant or that which will be of the most benefit in a certain situation. This refers to the
desirability, appropriateness, and significance of a project proposal in relation to the needs of
the target group and to the goal of national development plan. Some of the questions proposed
to ensure this criteria are
 What do the problems consists of? (A thorough analysis of the causes of the problem and
their effects/consequences not the symptoms of the problems on the target groups and other
interested stakeholders/parties should have been made)
 What are the development goals in the sector, which this project should contribute to
achieving in the long term?
 Are the projects goals describes as a future improvement of the situation in relation to the
problem which the target group or society have at present? Does the project greatly reduce if
possible eliminates the problem? Example, infant mortality rate, maternal mortality rate, low
labour productivity, illiteracy, poverty, low level of infrastructure etc.
 What results or services should the project provides for the target group or society? Are they
specific, measurable, and concrete? Example improving access to employment, education,
health etc.
 Do the combined results leads to the attainment of the project goal? Is anything missing?
 Are the activities (including the selection of technology and methods) appropriate and
sufficient to achieve the planned results?
 In what way (s) will target groups participate in the project? What role will the target groups
play during planning and implementation of the project?
 Have alternative ways of achieving the project goals been conducted?
In general appraising project‟s desirability/relevance or that which will be of the most benefit in
a certain situation involves a comparison of the alternative costs and benefits generated or
incurred by different project alternatives. Unlike feasibility, it involves the application of
valuation techniques to decide which option will produce the greatest overall benefits. The issue
of desirability is of particular importance when conducting financial and economic appraisals.
The fundamental basis for assessing project desirability is the supposition that the project will
generate benefits, which would not have been existed if it had not been implemented. It would be

inaccurate to compare the situation before project implementation with the situation after
implementation. This is because the general situation may have changed without the project.
Consider how the desirability a hypothetical project that intends to increase the value of coffee
export should be assessed.
Fig 2: Value of Coffee exports from Zone Y before and after project X
Birr Before After Z

Project X Project X
Start of project operatio
t1 Time
Clearly it would be inaccurate to suggest that project X has been responsible for the total
increase in coffee production since the beginning of operations. As fig 2 illustrates, coffee
exports were already rising before project X began operation at t1. There is therefore every
chance that these exports would have continued to raise without the project. In this scenario
value Z would be a drastic overestimate of the benefits accrued by the project. This whole
scenario illustrates the inaccuracy of assessing the project benefits utilizing a before and after
scenario (as depicted above).Project appraisal is therefore based around the principle of
comparison of the situation „with project‟ with the situation and „without project‟. The value of
the project in the above situation would be the difference between the „with‟ and „without‟
values.
II. Feasible or that which is possible. This implies the project is realistically planned. The
following questions will be considered as checklists.
 What capacity and resources (personnel, financial, material) does the project owner possess
to implement the project? Are there sufficient institutional/technical/administrative expertise
and capacity in the project owner‟s organization (to implement the project, make
procurements etc.)
 Is the division of roles and responsibilities between parties participating in the project clearly
defined?
 In what way have the technical solutions/methods described been adopted to the level of
skills and capacity in the organization?
 Have time schedule been given for activities and is there a plan of phasing out of the project
life?
 How has the financing of the project been planned (project owner‟s contribution, government
contribution, other financing-donors contribution)?

 What is the estimated total budget for the project period? How have the costs been allocated
to the planned activities? Is the budget for each activity of the project realistic and
comprehensive (i.e. the project can be implemented at a reasonable cost be cost effective)?
 Is the realization of the project output, outcome, and impact is practical within the proposed
timeframe using the resources available and proposed (physical, technological, human, and
financial)?
 What negative effect can the project have on the environment? Is there a possibility of
achieving socially and environmentally sustainable development?
 Are key (killing) assumptions on the factors/constraints (both internal and external) that are
likely (can) impede or delay the implementation of the project or in the extreme cases
completely prevent the realization of the project ideas made?
 Are mitigation measures to undertake or strategies to apply when adverse factors occur are
designed (this refers to the risk and uncertainty analysis and management aspect of a project).
When appraising micro project proposals it must be remembered that government budgets are
often limited and so the impact of proposed sectoral projects in terms of both actual (investment)
and recurrent (operating) costs must be carefully assessed/examined. Hence, improving the
application of appraisal techniques and methodology has the following benefits.
 It allows for more efficient and effective utilization of scarce resources.
 It assists the effective implementation of a coherent national development plan/program.
 It increases the likelihood the projects will continue to reap (generate) sustainable
benefits of development.
In the Ethiopian context, the methodology and application of project appraisal techniques has
started when the Planning Commission Office initiated the practice of project appraisal in
Ethiopian public sector in the late 1960‟s. The practice was not applied systematically until 1986
when the Development Project Studies Authority (DPSA) took responsibility for project
appraisal. Repeated institutional restructuring meant that these efforts were largely unsuitable
and inefficient.
Following the 1991 reform and consequent institutional restructuring the Ministry of Planning
and Economic Development (MoPED) was mandated to appraise development projects. This
mandate was then transferred to the Ministry of Economic Development and cooperation
(MEDaC), which became the present day the Ministry of Finance and Economic Development
(MoFED). Increasingly, project appraisal is being decentralized with the result that responsibility
for appraisal decision is being transferred to regional and district levels.
The decentralization has the advantage of enabling a variety of primary stakeholders to be
involved in the appraisal process. Overall technical responsibility for appraisal of public sector
projects, however, lies with MoFED. It has developed standards and guidelines to improve the
technical capacity of both regions and sector ministries and organizations to enable them
coherent project appraisal decisions to be made.

B. Decision/selection criteria (accept, modify/revise, reject)

To enable a fair and accurate comparison of projects across sectors on a national level, it is
necessary for the government to publish the essential elements of their appraisal and selection
criteria. This enables projects to be appraised in a uniform and transparent manner. The appraisal
team should study the published appraisal techniques and selection criteria in advance so that
they have a general comprehension of the standards that should be met. All decisions should then
be based on the suitability of various project components for reaching the standards set out in the
appraisal and selection criteria (feasibility and desirability). Bearing these two forms of
suitability in mind an overview of the selection criteria is given in the table below.
Table 2: Basic selection criteria in terms of feasibility and desirability
No Project Aspect Feasibility Desirability
1 Technical  Technical design criteria are satisfied  Local resources/skills used are
 Technical capacity of the mgt and appropriate
workforce adequate  Suitable technology/method used
 Output targeted can be met  Technical efficiency maximized
2 Environmental  All negative effects are below  All negative effects are minimized
legal/customary limit  All positive effects maximized
3 Social  Project acceptable in relation to  Target groups are involved in project
existing law and social norms design and implementation
4 Institutional  Implementing agencies have autonomy  Preferred form of organization used
and motivation to perform roles  Implementing agency operation are
assumed. suitable
5 Financial  Cash balance is always positive  Financial profitability measures are
(required finance is available and all satisfactory to all parties
financial commitments can be met)  IRR to equity exceeds real interest rate
 All parties have adequate financial  Uncertainty and risk associated with
incentives the project are minimized
6 Economic  EIRR exceeds target rate
 Economic cost effectiveness of
noncommercial projects confirmed
 Distribution of project cost and benefits
contributes to government objectives
 Risk that project failure will damage is
minimized
In summary, the substances to aspects of a project contained in the above table indicate that
when conducting project appraisal it is important the appraiser keeps in mind (give due emphasis
to) the following basic principles in mind.
 Ensure the selection criteria cover all potential aspects of project design and influence/impact.
That is ensuring that objectives are clear and realistic or in short SMART. In other word,

statements of objectives should provide tangible and easy answer for such questions as what is
intended to produce or provide. How much (to what standard/specification)? At what cost?
When and Where? For example the objective of a project could be to build an Olympic
stadium for 80,000 people, to an Olympic standard, to be complete six months before the start
of the Olympic, at a cost of X million Birr in Beijing.
 Ensure the selection criteria are applied consistently and fairly.
 Ensure that stakeholders are involved in the process (in design, implementation, and
monitoring and evaluation of the project) as much as possible. This will increases the
sustainability of the project by enhancing ownership of the project by stakeholders.
C. Relative importance of criteria and trade-offs
In any appraisal process there are liable to be potential trade-offs to be made between desirability
in various project aspects. For instance, increasing the environment desirability of a project may
reduce its financial desirability and vice-versa. The appraiser therefore has a decision to make
the relative importance attached to each assessment criteria. The rule for the appraisal in this
situation is that all project aspects must meet the feasibility criteria outlined in table 2 above.
After this the relative importance of project aspects criteria in terms of desirability is liable to
vary from situation to situation.
Often the relative desirability of these criteria will be decided by political factors, such sectors
objectives and the country‟s development policy or program. This implies that not considering
the development goals of a government or requirements in the case of donors during the
preparation of a project is a futile exercise. For example, the SDPRP sets out the importance of
capacity building and participation in terms of national development. As a result, both the
desirability of institutional and social aspects of a project is likely to highlight.
In principle, the economic IRR should take account of all those aspects of the project decision
that can be measured and valued and so, other things being equal, it should be the main indicator
of the desirability of a project. Nevertheless, there will be many project for which it is difficult to
estimate an EIRR and there may be some cases where important factors that cannot be included
in EIRR to be considered. In such a case, judgment must be made on the desirability based on an
intelligent interpretation of all the available evidences. In most cases the rationale or justification
for the project provides the basis what evidences to refer and interpret the magnitude of the
project‟s desirability to the target groups.
Finally, the result of the entire appraisal process is reduced in a single sheet. Once an appraisal
decision has been made it will be necessary to report the results to all interested parties (project
designer/owner, responsible authorities, sponsor etc), providing feedback when necessary. An
accurate and concise method of disseminating such information is trough an overall project
assessment form indicated below.
What is the ultimate goal of project appraisal? What are the most applicable criteria’s
of project appraisal?

TABLE 3: PROJECT ASSESSMENT FORM

Project name: ________________________ Project code:____________________
Responsible Authority: _________________ Total budget:____________________
Scheduled start date: ___________________ Scheduled completion date:_________
Summary of Appraisal Findings
Aspects of a project V. Good Good Satisfactory/fair Unsatisfactory/poor Comments
Technical Appraisal
Environmental Appraisal
Social Appraisal
Institutional Appraisal
Financial Appraisal
Economic Appraisal
Risk Analysis &Mgt
procedure
TOTAL SCORE
Note: Since government budgets are often limited sometimes weights may be attached to aspects of a project
and cut of point for total score above which to accept, recommend for modification/redesign, and reject a
proposal may be set to allocate financial or physical resource (eg. Land) to government priorities.
The form has room to list any comment or recommendations linked to each aspect of project
appraisal. Once this information has been set out in its totality it will be possible to make final
decision as to whether to accept, reject, or modify/redesign the project.
1.2.4. Project Implementation Stage

A. Pre-Investment Phase
This stage deals with all issues related to the financial package (mobilizing the financial
resources, conditions of disbursement getting ‐paying out, loan negotiations, and mobilizing the
expertise necessary for the successful construction and operation of the project. It is at this stage
that loan negotiations are made. The financing package becomes more difficult to assemble in
projects involving co‐financing. Co‐financing refers to cases where two or more lending
agencies and/or donors join together in a coordinated way to undertake their loan activities and
establish conditions for a particular project.
Broadly speaking, co‐financing takes two forms, namely, joint financing and parallel financing.
In joint financing, the funds of the co‐lenders are blended together and there is no attempt
separately to finance clearly identifiable components of the project. There is a common list of
goods and services, and the financing of all or certain items is shared between the co‐lenders in
agreed proportions. In parallel financing, in contrast, the co‐lenders deliberately would select
certain project components, that is, they would finance development goods and service or parts
of the project. For example, in a multi‐purpose water development project, one agency might
finance the electrical power‐generation aspects; a second agency might finance the downstream

activities of land development and agriculture support services, while a third might finance the
dam and irrigation network.
Disbursement of the loans, recruitment of management and technicians, and supervision during
construction and implementation of auxiliary programs necessary to ensure the supply of inputs
are all the subordinate operational decisions taken during the pre-investment stage. Mobilizing
the necessary financial resources for the project and mobilizing the expertise necessary for
successful construction and operation of the project are all issues of pre‐investment. The end
result of loan negotiation is the drawing up of a set of loan documents, for example, loan
agreement, or credit agreement, guarantee agreement, subsidiary loan agreement and/or joint
project agreement which are legal instruments with covenants binding on both the lender and the
borrower, and the guarantor, where applicable.
B. Investment Phase
If the preparatory work in the pre‐investment is finished and the result of the appraisal is
positive, the implementation or execution phase follows, in which first a detailed design of the
technical components is made. In this stage discrepancies may exist between the costs estimated
and the actual costs to be incurred. If these discrepancies are large, the appraisal may lose its
validity and may need to be redone.
One of the objectives of any effort in project planning and analysis is to have a project that can
be implemented to the benefit of the society. Thus, implementation is perhaps the most important
part of the project cycle. The better and more realistic a project plan is, the more likely it is that
the plan can be carried out and the expected benefit realized. This emphasizes once again the
need for careful attention to each aspect of project planning and analysis.
Project implementation must be flexible. Circumstances will change, and project managers must
be able to respond intelligently to these changes. Technical changes are almost inevitable as the
project proceeds. Price changes may necessitate different techniques of production or
adjustments in inputs. Other changes in the project‟s economic or political environment will alter
the way in which it should be implemented. The greater the uncertainty of various aspects of the
project, or the more innovative and novel the project is, the greater the likelihood that changes
will have to be made. Even as project implementation is under way, project managers will need
to reshape and re‐plan parts of the project, or perhaps the entire project.
Project analysts generally divide the implementation phase into three different time
periods:
 Investment period: the period when Project investments are undertaken. This usually
extends 3‐5 years in agricultural and high scale infrastructure construction projects.

 Development period: As the production builds up, the project is spoken of as being in the
development period (may be 3‐5 years additional). This period ranges from starting
production until full capacity production.
 Full development period: Once the full development is reached, it continues for the
economic life of the project. 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.
Project implementation must be flexible since circumstances change frequently. Technical

changes are almost inevitable as the project progresses; price changes may necessitate
adjustments to input and output prices; political environment may change. Translating an
investment proposal into a concrete operational unit 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.
 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.
 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.
 Develop project management competence: Use of network techniques. For project
planning and control two basic techniques are available - PERT (program evaluation Review
Technique) and CPM (Critical Path Method). These techniques have lately merged and are
being referred to by common terminology that is network techniques. With the help of these
techniques, monitoring becomes easier.
The investment phase can be divided into the following steps:

1. Establish project management office which involve establishing of the legal, financial and
organizational basis for the implementation of the project
2. Technology acquisition and transfer, including basic and detailed engineering
3. Engineering design and Construction work
4. Installation and erection;
5. Pre-production marketing, including securing of supplies and setting up the administration of
the firm
6. Recruitment and training of personnel, and
7. Plant commissioning and start-up.

This implementation basically involves capability in project management. The function of

project management is to foresee or predict as many of the dangers and problems as possible and
to plan, organize and control activities so that the project is completed successfully in spite of the
risks. Project management is the planning, organizing, directing, and controlling of resources for
a specific time period to meet a specific set of one-time-objectives. This process starts before any
resources are committed and must continue until all work is finished.
The aim is for the final result to satisfy the project sponsor or purchaser, within the promised
timescale and without using more money and other resources than those, which were originally
set aside or budgeted for. Since there are different types of projects, the management of these
different types of projects is also different reflecting the peculiarity of the projects. Project
management is a multifaceted process in which many different things get managed
simultaneously. In managing projects we are normally involved in the following types of
management:
 Scope management
 Time management
 Human resource management
 Cost management
 Quality management, and
 Communication management
For each of these activities it is necessary to plan, organize, direct, and control. Successful
project management can then be defined as having achieved the project objectives: within
efficient time & cost.
C. Operational Phase
Project operation involves the running and maintenance of new entity in accordance with set
objectives and planned tasks. The problems of the operational phase need to be considered from
both a short-and long-term viewpoint. The short-term view relates to the initial period after
commencement of production when a number of problems may arise concerning such matters as
the application of production techniques, operation of equipment or inadequate labour
productivity owing to a lack of qualified staff.
Most of these problems have their origin in the implementation phase. The long-term view
relates to chosen strategies and the associated production and marketing costs as well as sales
revenues. These have a direct relationship with the projections made at the pre-investment phase.
If such strategies and projections are proved faulty and remedial measures will not only be
difficult but may prove to be highly expensive. The operational phase involves the following
main functions.

I. Commissioning and starting of commercial production
Project commissioning: is the process of assuring that all systems and components of
a building or industrial plant are designed, installed, tested, operated, and maintained according
to the operational requirements of the owner or final client. A commissioning process may be
applied not only to new projects but also to existing units and systems subject to
expansion, renovation or revamping.
In practice, the commissioning process comprises the integrated application of a set
of engineering techniques and procedures to check, inspect and test every operational component
of the project, from individual functions, such as instruments and equipment, up to complex
amalgamations such as modules, subsystems and systems. Commissioning activities, in the
broader sense, are applicable to all phases of the project, from the basic and
detailed design, procurement, construction and assembly, until the final handover of the unit to
the owner, including sometimes an assisted operation phase.
II. Ex-post project evaluation
The final phase of the project is the evaluation phase. Many usually neglect this stage. The
project analyst looks carefully at the successes and failures in the project experience to learn how
better to plan for the future. In this stage it is important to examine the project plan and what
really happened. Performance review should be done periodically to compare actual performance
with projected performance.
A feedback device, it is useful in several ways: (i) it throws light on how realistic were the
assumptions underlying the project; (ii) it provides a documented log of experience that is highly
valuable in future decision making; (iii) it suggests corrective action to be taken in the light of
actual performance; (iv) it helps in uncovering judgment biases; (v) it induces a desired caution
among project sponsors. Weakness and strengths should carefully be noted so as to serve as
important lessons for future project analysis undertaking. Evaluation is not limited only to
completed projects. Ongoing projects could also be evaluated to rectify problems when the
project is in trouble. The evaluation may be done by the project management, the sponsoring
agency, or other bodies.
III. Replacements/ Rehabilitation
Replacement investment is usually neglected in conventional project studies. However, the

economic life of involved machineries and equipment is different. In fact the economic life of the
envisaged firm/plant is determined on the basis of the economic life of the „core‟ technology. A
number of other technologies, specifically the hard ware technologies do have different
economic life. Normally the Rehabilitation works are usually undertaken as a project, because
not only they involve substantial investment, but also they have to be rationalized as whether to

rehabilitate the existing facilities replace the entire plant or consider alternative ways of
rehabilitation.
IV. Expansion/Innovation/
There are different economic forces that justify expansion and innovation. Given the nature of
the technology is a matured one, without substantial change in the nature of the need and hence
chance of proceeding with the same product, expansion may be a rational venture. On the other
hand the industry could be dynamically changing. In such a state of changing industry, there is a
need for at least keeping up with the truck of change or the firm may venture to be the setter of
the competitive benchmarks of the industry.
1.2.5. Evaluation and Supervision

A. Supervision
The purpose of supervision is to ensure that the project‟s implementation is carried out to
acceptable standards, and that the project‟s targets are being realized. Whereas in the previous
stages of the project cycle, activities were considered to be the joint responsibility of the donor
and the borrower, after the loan resources become effective, the execution of the project becomes
the prime responsibility of the borrower, whereas supervision is that of the financing agency. The
supervision process can be undertaken in terms reviewing the progress reports (required of the
borrower), field visits to the country, and timely audits. Problem areas are identified and reports
of the supervision teams form the basis on which the borrower may be requested to take certain
corrective measures.
B. Evaluation
This is the last phase of the project cycle. Evaluation is a comparative analysis between what the
project was intended to become, in terms of timing and quantity of costs and benefits, and what
actually has happened. This phase is often omitted, and intentionally so, if there occur glaring
discrepancies between what was to happen and what actually has happened. Yet, it is an
important phase, not because it enables an accusing finger to be pointed at the real or seeming
cause of the errors and misfortunes, but because it helps avoid similar mistakes being made in
the future.Ex‐evaluations are means of deriving lessons on a given project‟s undertaking. The
analyst looks systematically at the elements of success and failure indicators in the project
experience to learn how better to plan for the future.
Evaluation is not limited only to completed projects. Evaluation may be undertaken anytime
when the project is in trouble as a first step in a re‐planning effort (projects can be terminated
based on evaluation reports).Evaluation may be undertaken by project management, sponsoring
agency, external evaluators, separate monitoring unit of the project and/or any appropriate
government planning unit. In any case, the project plan should be reviewed to see if it was an
appropriate one in light of the objects set forth. Each objective should be examined to determine

whether it was considered carefully and whether appropriate provision was made. Evaluators
look into the basic questions: Was the technology proposed appropriate? Were the institutional,
organizational, and managerial arrangements suited to the conditions?
Were the financial aspects carefully worked out on the basis of realistic assumptions? Were the
economic implications properly explored? And how did the project in practice compare with
each aspect of the project planning? The evaluation should consider the response of project
management and the sponsoring agencies to changing circumstances. Did management respond
quickly enough to changes? Was its response carefully considered and appropriate? Did the
institutional and organizational structure in the project permit a flexible response? How could a
project‟s structure be altered to make the response to change more flexible and appropriate in the
future? From the evaluation should come carefully considered recommendations about how to
improve the appropriateness of each aspect of the project design so that plans for project
implementation should be revised if the project ongoing.
 Based on the evaluation report, a project has a chance of being rejected, accepted
(implemented as it is), modified, or delayed for some years.
To sum up, preparing a project is anything but a neat, continuous process with well ‐defined
steps, each of which is completed before the next and never retraced. Instead, the whole process
is iterative; i.e., the project analyst must continuously go back and forth, and adjust earlier
decisions in the light of what is learned from later analysis. In general, the process begins with an
idea about the broad nature and objectives of a proposed project that has been supplied by the
political or planning process and ends with deriving lessons for future projects.
Chapter- One: Review Questions

Part I: Read Each Expression and Choose the Most Appropriate Answer.
1. Which one of the following expression is not the characteristic of a project?
A. Projects have specific of benefits that can be identified, quantified and valued monetarily.
B. Projects use a multiple of resources and needs well planned resource management
C. A project is an intermediate operational element unit like public investment programs
D. Projects are organizationally, geographically and time bounded
E. Uncertainty and risks is inherent in any project which forces to change
2. Which one of the project feature is a function of capital investment, human labor
requirement, coverage of beneficiaries, total value of inputs used and goods or service
produced by the project?
A. Boundary of a project D. Size of a project
B. Coverage of a project E. Type of a project
C. Scope of a project
3. Among the following development concerns, which one is not agriculture project focus area?
A. Raising agricultural productivity

B. Reducing risk, vulnerability and inequality

C. Helping farmers reach markets and improving their incomes
D. Making agriculture more environmentally sustainable.
E. Transforming the agriculture sector to industrial sector
4. The following alternative reasons can be taken as the significance of project planning except?
A. To eliminate uncertainties
B. To receive loan or financial support from promoters
C. To increase the effectiveness and efficiency of the operations
D. To identify and work towards a common goal
E. To establish a means of project monitoring and control
5. Good project identification should incorporate the following activities except?
A. Justify the project in a sectoral context;
B. Highlight pertinent issues and propose solutions;
C. Demonstrate the alternative and that further resources should be devoted for preparation;
D. Establish clearly the follow ‐up steps for full preparation. E. None
Part II: Read Each of the Following Expression & Determine Whether it is True or False.
6. Unlike feasibility, project appraisal involves the application of valuation techniques to decide
which option will produce the greatest overall benefits.
7. Throughout the project cycle, the primary preoccupation of the analyst is to consider
alternatives, evaluate them, and to make decision as to which of them should be advanced to
the next stage.
8. In developing countries linking policy, planning, and budgeting system enables investment
decisions to be planned systematically, thus making the most efficient and effective use of
available resources at higher running cost.
9. Project supervision is a comparative analysis between what the project was intended to
become, in terms of timing and quantity of costs and benefits, and what actually has
happened.
10. Translating an investment proposal into a concrete operational unit is a complex, time
consuming and risk fraught task.

CHAPTER TWO
ASPECTS OF PROJECT ANALYSIS
Introduction
Dear learner! In this chapter, we would like to familiarize you with some of the aspects of project
analysis in the project work. Since project studies are a multi-disciplinary exercise, an exposure
towards the different aspects of project studies is expedient. In addition to practical expediency,
financial and economic analysis will essentially depend upon the outcomes from the chapters on
market, technical and human resource aspects of a project. Governments and corporate entities
considering their vision into the future, the external environment and the performance of
competitors set up policies which serve as a basis for strategic /medium- and long-terms/ plans,
which in turn serve as a basis for project identification and its selection.
Learning Objectives
 Realize the significance of demand and market analysis in project preparation
 Understand the implication of technical analysis in project preparation
 Recognize the importance of organizational analysis in project preparation
 Know the merit of financial and economic analysis in project preparation
 Appreciate the value of social and environmental analysis in project preparation
If there is no organic link between policies, plans and projects, then the effectiveness and
efficiency of investment decisions could be compromised. A large part of project analysis serves
to establish a project‟s technical and institutional feasibility, whether it is fit with the strategy and
the appropriateness of the socio-economic context for the project. The conventional cost-benefit-
analysis-based economic analysis takes for granted that a project is technically sound and that its
institutional arrangements will be effective during implementation. With this note the major
questions that any economic analysis should address are:
 What is the objective of the project?

 What will happen if the project proceeds or not?
 Is the project the best alternative?
 Does the project have separable components?
 Winners and losers: who enjoys the music and who pays the piper?
 What is the project‟s fiscal impact?
 Is the project financially sustainable?
 What is the project‟s environmental impact?
 Techniques for assessment: is the project worthwhile?
 Is this a risky project?

The project analyst must consider several aspects when carrying project analysis. The major
aspects of project preparation and analysis are outlined below:
2.1. Demand and Market Analysis

It is the first process of identification of the target beneficiary groups of a public projects. The
primary task is to identify the need and estimate the nominal and effective demand of the
envisaged product or service. This depends upon the nature of the particular product/service/
under consideration. If the product is a public good, or publicly provided private good, the task
may be to undertake social and institutional need assessment. If the product is private good, the
first task is to determine whether there is sufficient market or not. The subsequent discussion of
this section will be on market and demand analysis. The market study needs to ensure the
existence of effective demand at remunerative price. Market analysis is basically concerned with
the following questions:
1. What is the product/service to for which feasibility study is to be undertaken?
 What is the specific need which is the basis for the product/service?
 Are there alternative ways of satisfying the need?
 Have there been noticeable changes in the nature and structure of needs?
 Who should define the need and the corresponding product/service/?
2. What would be the aggregate demand of the proposed product/service in future?
3. What would be the market share of the project under appraisal?
4. What is the ongoing and competitive selling price?
5. Will the realization of the project affect the selling price(s) of the products/services? If yes
what is the likely selling price? What is the implication of this price on the viability of the
project?
6. What are the marketing strategies that enable the firm to enter into a market and capture
adequate market size?
Example: Saying on perspectives on effective demand and market promotion.
A saying goes, “an economist and marketer were sent to make market study for shoes in an
island. Immediately after their arrival, they observed that the people there were all barefoot. Both
had to write independent reports. The economist reported that there is no market because there is
no revealed demand for shoes as the entire population is barefoot. The market reported that there
is big, untapped market, no has not entered into the market and hence he appreciated the
possibility of taking the entire market. But he/she qualified the fact that there is a need for
promotional work.”
To answer the above questions the project analyst requires a wide variety of information and
appropriate forecasting methods. The kinds of information required include the following.
 Consumption trends in the past and the present consumption levels
 Past and present supply positions

 Production possibilities and constraints

 Imports and exports
 Structure and competition
 Cost structure
 Elasticity of demand
 Consumer behaviour, intentions, attitudes, preferences, and requirements
 Distribution channels and marketing policies in use
 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.
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.
5. 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 competitors and
practices of the middlemen/distributors, whole sellers and retailers/. Key steps in market and
demand analysis and their inter-relationships.
Collection of
secondary Demand
data forecasting
Characterization
Situational analysis
And Specification of of the market
objectives
Market
Conduct of planning
Market survey
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.

Example: suppose a given project aims at producing wheat in a given locality. The project
initiator and implementer need information about where and how to market their product. The
objective of the market and demand analysis in this case may be to answer some of the following
questions.
 Who are the buyers of this product? (Consumers)

 What is the total current demand for wheat?
 How is the demand distributed temporally /pattern of sale over the year and
geographically?
 What price will the consumers be willing to pay for the product?
 How can consumers be convinced that wheat could be substituted for other foodstuffs?
 What channels of distributions are most suited for the product?
 What trade margins will induce distributors to carry it out?
 What are the possible immediate sales?
6. Methods of Data Collection

There are two principal sources of assembling market information: Secondary data sources; and
Primary data sources. The secondary sources will include the analysis of regular statistics and the
study of the published results of previous surveys. Demographic, economic, financial and
commercial statistics can collected from the following sources:
 Official sources: customs statistics, various kinds of fiscal and monetary statistics,
statistical abstracts, etc.
 Trade groups: trade union and associations, chambers;
 Enterprises and government organizations who possess statistics for their own use
In general there are several sources of information including census data, national sample survey
reports, plan reports, statistical abstracts, industry specific sources of data etc. Special survey
provides a very effective method of investigating a market. Their purpose will be either to obtain
quantified data or to find out how people feel about a product.
7. Methods of Estimating Future Demand

There are many possible methods for estimating future demand for a product. In some cases a
simple study of import statistics, possibly backed up by a survey among local consumers will
give a fairly clear idea of the size of the future market. In other cases it may be necessary to
pursue the investigation further, possibly using advanced econometric techniques. Between these
two extremes there exists a whole range of methods from which to choose, depending on:
 The nature of the market studies;
 The quality and quantities of the data available;
 The degree of accuracy to be achieved.

The most commonly used methods include:

 Projection of the trend
 Using technical coefficients
 International comparisons
 Possibilities for export or for import substitution
 Econometric models
 Utilization of the result of family budget surveys
 Forecasting without statistical data
It has to be noted that each of the above techniques are not mutually exclusive methods of
projections. Rather if the case at hand and nature of data allows, one will have to adopt more
than one technique. In fact, it is not unusual to find many studies which use simultaneously many
techniques of estimating and forecasting.
Marketing Strategy: Feasibility studies need to incorporate the design of a marketing concept,
which should be based on proper marketing research. Marketing can be characterized by the
following elements:
 Business philosophy: marketing is a business philosophy that doesn‟t focus on products or

production, but puts the problems, needs and desires of existing or potential consumer
groups at the center of the business activities of the firm.
 Marketing Research: well-planned and systematic market and marketing related research
is a precondition for market-oriented decision-making. On the basis of information
obtained about the potential market as well as the human, production and financial
resources available for the project, marketing strategies are to be developed to ensure the
achievement of the project objectives.
 Marketing Instruments: the successful implementation of marketing strategies requires
shaping and influencing the market in a well-planned manner, using the necessary
combination or mix of marketing instruments. The marketing mix includes the analysis of
distribution channels, Analysis of the strength and weakness of competitors, pricing policy,
and the identification of appropriate promotion mix.
8. Methods of Demand Forecasting

The various methods of demand forecasting may be classified into three broad categories as
follows: Some of the most commonly forecasting methods are discussed here under.
A. Qualitative methods
 Jury of executive opinion method:
This method, which is very popular in practice, involves soliciting the opinions of a group of
managers on expected future sales and combining them into a sales estimate. The advantages of
this method are:

 It is an expeditious method for developing a demand forecast

 It permits consideration of a variety of factors like econometric climate, competitive
environment, consumer preferences, technological developments, and so on. To be
included in the subjective estimates provided by the experts.
 It has immense appeal to managers who tend to prefer their judgment to mechanistic
forecasting procedures.
 Delphi method
This method is used for eliciting the opinions of a group of experts with the help of a mail
survey. The steps involved in this method are:
 A group of experts are sent a questionnaire by mail and asked to express their views.
 The responses received from the experts are summarized without disclosing the identity
of the experts, and sent back to the experts, along with a questionnaire meant to probe
further the reasons for extreme views expressed in the first round
 The process may be continued for one or more rounds till a reasonable agreement
emerges in the views of experts
Delphi method appeals to many organizations for the following reasons

 It is intelligible to users
 It has a fancy name
 It seems to be more accurate and less expensive than the traditional face-to-face group
meetings.
B. Time Series Projection Method

 Trend Projection Method
The trend projection method involves determining the trend of consumption by analyzing the
past consumption statistics and projecting future consumption by extrapolating the trend. Various
trend relationships could be identified including the following:
 Linear relationship: Yt = a + bT, Where Y is the variable to be forecasted and T is to be

estimated.
 Exponential (Semi-log) relationship: Yt = aebT Or lnY = lna +bT. This method assumes
that there is a constant growth rate b within each period.
 Polynomial relationship: Yt= a0+ a1t+a2t2
 Cobb Douglas Relationship: Yt = atb
 Exponential Smoothing Method

In exponential smoothing forecast are modified on the light of observed errors. If the forecast
value for year t, St, is less than the actual value for year t, the forecast for the year t+1, F t+1, is set
higher than Ft.

If Ft>St is set lower than Ft. In general Ft+1= Ft + aet Where:

Ft= forecast for year t+1
a= Smoothing parameter (which lies between 0 and 1)
et= error in the forecast for year t= St-Ft
C. Casual method
 Consumption Level Method
Consumption Level Method is useful for a product, which is directly consumed.
This method estimates consumption level on the basis of elasticity coefficients, the important
ones being the income elasticity of demand and the price elasticity of demand.
 End-Use Method
This method is suitable for estimating the demand for intermediate products, the end use method,
also referred to as the consumption coefficient method, involves the following steps:
 Identify the possible uses of the product
 Define the consumption coefficient of the product for various uses
 Project the output levels for the consuming industries
 Drive the demand for the product
Dear learner! Would you please explain the significance of demand and market
analysis in the fruitfulness of a project?
2.2. Technical Analysis

Technical study of a project provides the technical basis for all other aspects of a project study,
since a technically unfeasible project cannot be promoted. The main and challenging task in this
technical analysis is to identify the appropriate technology for the objective the project is
intended to meet. Recall that problem identification leads to establish project objectives against
which the appropriateness of a project and specifically the technology is evaluated. In general
this part of project study address issues related to:
i. Project design and processes: to ensure that there is appropriate technology and engineering
work, the study should consider and evaluate alternative technologies and alternative
machines and equipment;
ii. The input-output relationship: 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. Analysis of the technical and engineering aspects of a project
should do continuously when a project is formulated.

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. This is crucial because the rest of the project
analysis cannot be conducted without information from the technical study. In general the
technical analysis is primarily concerned with
 Material inputs and utilities
 Location and site
 Manufacturing process/technology/ and engineering
A. Materials and inputs Aspects

In the materials and inputs study part of the feasibility study, the experts assigned for the task
have to:
 Identify the required types of inputs, their sources and brief assessment of alternative types
of inputs, their relative merits in terms of quality of the product (and hence competitiveness
in the market); and alternative sources of supply;
 Describe general availability of Raw materials, Auxiliary materials, Factory Supplies, and
Utilities
 List annual supply requirements of material inputs;
 Summarize availability of critical inputs and possible strategies of acquiring these inputs;
 Determine the procurement period of each imported input, if any.
 Outline costs related to procurement and storage of inputs (stores, containers of required
type; transport costs required e.g. forklifts etc.), and
 Identify the number of personnel required for this function giving due emphasis for quality
of man power.
B. Location, Site and Environment Aspects

A feasibility study should determine the location and site suitable for an industrial project. The
choice of a location should be made from a fairly wide geographical area, within which several
alternative sites can be considered. The main criteria or key requirements for selecting proper
locations should always be determined at an early stage of the study. The qualitative analysis of
these key requirements would then allow the assessment of a number of potential locations and
the rejection of those not fulfilling the key requirements. To this effect one has to identify the
major variables that need to be taken into account when determining the location of a project
under consideration. This involves the identification and analysis of:
 Access to raw material and the corresponding weight;

 Access to market and the corresponding weight;
 Access to basic infrastructure like power, water, communication, etc. and corresponding
weights;
 The implication on labor supply and issue of residence;
 Cultural considerations, etc.
However it should be noted that the choice of location is not always based on a systematic step-
by-step analysis and assessment of gradually reduced number of possible locations, ending up
with the optimum solution. The promoter of the project may suggest a location at an earlier stage
without undertaking the above analysis. Once the location of the project is decided, alternative
sites have to be analyzed and the final selection made. This will require an evaluation of the
characteristics of each site, and the following requirements and conditions are to be assessed:
 Ecological conditions on site (soil, site hazards, climate etc)

 Environmental impact (restrictions, standards, guidelines)
 Socio-economic conditions (restrictions, incentives, requirements)
 Local infrastructure at site locations
 Strategic aspects (future expansion, supply and marketing policies)
 Cost of land
 Site preparation and development, requirements and costs
This task is followed by description of location and plant site selected, and the statement of
significant costs.
C. Engineering and Technology Aspect

It is the task of the engineering to design the functional as well as the physical layout for the
industrial plant necessary to produce the defined products (outputs), and to determine the
corresponding investment expenditures as well as the costs arising during the operational phase.
The scope of engineering also includes the plant site and all activities required to deliver both
inputs and outputs and to provide the necessary ancillary infrastructure investments.
The initial task and scope of engineering is to define the whole range of project activities and
requirements, including production levels to be achieved under the technical, ecological, social
and economic constraints. This necessitates identifying the principal products or product range,
including by-products, determining the volume of production, and relating production capacity to
the flow of material and performance of services at the selected site.
The range and volume of products to be produced depends primarily on the market requirements
and the proposed marketing strategies. The initial engineering work consists in designing at
preliminary production layout suitable for manufacturing the products defined in accordance
with the marketing concept, and in the qualities and quantities required. After the required sales
program has been determined, the detailed production program should be designed in a
feasibility study. The production program should define the levels of output to be achieved
during specified periods and, from this viewpoint, should be directly related to the specific sales
forecasts.

Once a production program defines the levels of outputs in terms of end products, and possibly
of intermediate products and the interrelation between various production lines and processes,
the specific requirements of materials and labour should be quantified for each stage. For this
purpose, a material-flow diagram should be prepared, showing the material and utilities balance
at various stages of production. The input requirements and costs have to be assessed for basic
material such as raw material and semi-processed and bought-out items; major factory supplies
(auxiliary materials and utilities); other factory supplies; and direct labour requirements. Under
this sub topic the issues addressed include:
I. Plant Capacity
Plant capacity refers to the volume or number of units that can be produced during a given
period. Plant capacity is expressed usually in terms of feasible capacity and nominal capacity.
Feasible capacity refers to the attainable capacity under normal working conditions, taking into
account not only the installed equipment and technical conditions of the plant, such as normal
stoppages, down time, holidays, maintenance, tool changes, desired shift patterns and
indivisibilities of major machines to be combined, but also the management system applied.
Nominal capacity however refers to the technically feasible capacity, which frequently
corresponds to the installed capacities as guaranteed by the supplier of the plant‟s machinery. In
determining the capacity of a plant the following factors are taken into account:
 The marketing concept and the volume of sales, and
 The minimum available economic size of production technology and equipment
II. Technology
An integral part of engineering at the feasibility stage is the selection of an appropriate
technology, as well as planning of the acquisition and absorption of this technology and the
corresponding know-how. Technology is an important factor in determining the production
program and plant capacity. The major issues addressed in the technological analysis include:
 Brief review of the technology development history, focusing on the areas of change and the
implications of these changes on the competitiveness of a business organization in terms of
quality of product, cost leadership and other relevant areas of competitiveness;
 Identification of alternative technologies and alternative scales under use and their relative
merits and demerits in terms of the major areas that determine competitiveness of the product
and the business organization;
 Identification and analysis of the technology selection criteria and description of the selected
one.
III. Engineering
 Plant lay out
After selection of technology, the next task is to prepare the plant layout, drawings, basic design
and engineering. These charts and drawings should adequately reflect the interrelationship

between environmental conditions and constraints, socioeconomic infrastructure, technology

flow, constructions and material flow and inputs. The plant layout and basic engineering are
prepared in accordance with the selected technology and know-how.
 Selection of Machinery and equipment

The selection of machinery and equipment at the feasibility study stage should broadly define the
optimum group of machinery and equipment necessary for a specific production capacity by
using a specific production technique. This selection differs in emphasis with the type of project.
Equipment can be variously categorized. One classification can take the form of the machinery
requirements for each stage of the production processes. In other cases, the machinery can be
listed under plant machinery, mechanical equipment, electrical equipment, instrumentation and
control, transport and conveying equipment, testing and research equipment and other machinery
items.
 Civil engineering
The feasibility study should provide plans and estimates for the civil works related to the project.
This should cover site preparation and development, factory and other buildings, civil
engineering works relating to utilities, transport, emissions and effluent discharge, internal roads,
fencing and security, and other facilities and requirements of the plant. Civil engineering works
are fairly project-specific and have to be related to a particular plant site and the facilities that
may be required. The plans and estimates for the civil engineering works should be detailed for
cost estimates and implementation scheduling. The nature of each construction should be
defined, including modular construction where appropriate, the quality of construction materials
and the quantities and cost of materials required. Detailed civil engineering drawings are usually
not required before the start of project implementation. The estimates for buildings and other
constructions should be based on unit costs such as building costs per square meter in the plant
surroundings.
IV. Maintenance and Replacement Requirements

An important aspect of project engineering is the determination of critical maintenance and
replacement requirements for the project. Satisfactory maintenance of plant, buildings and
various facilities is essential for efficient plant operations. Maintenance requirements should be
assessed in terms of both the maintenance equipment that may be necessary for efficient
maintenance of the plant and facilities, and the maintenance skills and capability that need to be
developed.
V. Estimates of Overall cost

On the basis of the estimates from technology, machinery and equipment and civil engineering
works, the feasibility study should provide an overall estimate of the capital costs of the project.
Such an estimate will undergo modifications in accordance with the bids and offers received

from suppliers and the contractors but will nevertheless provide a fairly realistic estimate of
capital costs.
What are the primary concerns of technical analysis in the project preparation?
2.3. Organizational Analysis

This basically incorporates the socio-cultural patterns and institutions or the population that the
project is believed to serve. Does the project takes into account the cultural setup and customs of
the beneficiaries? Or will it disturb the accepted pattern? If so how should this be included as
part of the project design? To have a chance of being carried out, a project must be related
properly to the institutional structure of the country or region where the project is to be carried.
Examples include the land tenure system, use of local institutions such as Idir or Debbo.
Similarly, managerial issues are critical for successful completion of projects. Thus, the project
analyst must examine the ability of available staff to identify whether they have the capacity to
carry out the managerial needs of the project.
 Organization and Managing

A division of the company into organizational units in line with the marketing, supply,
production and administrative functions is necessary not only from the operational point of view,
but also during the planning phase, to allow the assessment and projection of overhead costs. It is
also essential for the feasibility of a project that a proper organizational structure should be
determined in accordance with the corporate strategies and policies. The organizational set-up
depends to a large extent on the size and type of the industrial enterprise and the strategies,
polices and values of the organization.
 Plant organization and management

Organization is the means by which the operational functions and activities of the enterprise are
structured and assigned to organizational units, represented by managerial staff, supervisors and
workforce, with the objective of coordinating and controlling the performance of the enterprises
and the achievement of its business targets. The organizational structure of an enterprise
indicates the assignment of responsibilities and delegation of authorities to the various functional
units of the company, and is normally shown in a diagram, often referred to as an organigram.
The organizational functions are the building blocks of the company. There may be grouped into
the following organizational units in line with the specific requirements of the individual
company:
 General Management
 Finance, financial control and accounting
 Personnel administration
 Marketing, sales and distribution
 Supplies, transport, storage

 Production:
 Main plant
 Service plants
 Quality assurance
 Maintenance and repair
The organizational structure of the company can also take a number of shapes, the most common
being the pyramid shape, which has the following three organizational levels:
 Top management
 Middle management, and
 Supervisory management
 Human Resources
The successful implementation of any operation of an industrial project needs different
categories of human resources- management, staff and workers-with sufficient skills and
experiences. The feasibility study should identify and describe such requirements and assess the
availability of human resources as well as training needs. On the basis of the qualitative and
quantitative human resources requirement of the project, the availability of personnel and
training needs, the cost estimates of wages, salaries, other personnel-related expenses and
training are prepared for the financial analysis of the project. In case an economic evaluation is
intended, the costs of unskilled labor should be shown separately.
Human resources as required for the implementation and operation of industrial projects need to
be defined by categories, such as management and supervision personnel and skilled and
unskilled workers, and by functions, such as general management, production management and
supervision, administration, production control, machine operation and transport. The numbers,
skills, and experience required depend on the type of industry, the technology used, plant size,
the cultural and socio-economic environment of the project location, as well as the proposed
organization of the enterprise. Since the lack of experienced and skilled personnel can constitute
a significant bottleneck for project implementation and operation, extensive training programs
should be designed and carried out as part of the implementation process of investment projects.
 Overhead Costs
Overhead costs could be categorized into the following:
 Factory overheads: costs that accrue in conjunction with the transformation, fabrication or
extraction of raw materials. Typical cost items include:
 Wages and salaries (including benefits and social security contributions) of manpower and
employees not directly involved in production
 Factory supplies: utilities (water, power, gas, steam), effluent disposal, office supplies,
Maintenance
These cost items should be estimated by the service cost centers where they accrue.

 Administrative Expenses: These are cost elements that should be estimated for administrative
cost centers such as management, bookkeeping and accounting, legal services and patents,
traffic management and public relations, etc. these costs should only be calculated separately
in cases where they are of considerable importance. Otherwise they could be included under
factory overheads. Typical cost items categorized under administrative overhead costs
include:
 Wages and salaries (including benefits and social security contributions)
 Office supplies, communications
 Engineering, rents, insurances (property), taxes (property)
 Marketing overhead Costs: Indirect marketing costs that cannot be easily linked directly with
a product are dually treated as marketing overheads costs. These costs are often included
under administrative overheads. Typical cost items include:
 Wages and salaries (inculcating benefits and social security contributions)
 Office supplies, utilities, communication, indirect marketing costs, advertising, training
etc.
 Depreciation Costs: depreciation is an accounting method used to distribute the initial
investment costs of fixed assets over the lifetime usually the fiscal standard lifetime of the
corresponding investment. Depreciations are frequently included under overhead costs.
Since, however, these costs are treated differently for the discounted cash flow method,
depreciation costs should be shown separately from overhead costs.
 Financial Costs: -Financial costs such as interest on long-term loans, should be shown as a
separate item, because they have to be excluded when computing the discounted cash flows
of the project, but are to be included for financial planning.
The different fields of project study so far considered are essentially relevant for financial/private
project study, which may not be required to incorporate other social and environmental costs and
benefits.
Dear learner! Can you explain the importance of organizational analysis and its
contribution to the final success of a project?
2.4. Financial Analysis

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 the proposed project
will satisfy the return expectations of those who provide the equity capital. Here the project
analyst is concerned with the financial effects of the proposed project on each of its various
participants (firms, framers/workers, government etc.). By examining the financial implications
for these parties the analysts need to identify the projects financial efficiency, incentive impact to
the participants in the project, creditworthiness and liquidity (say, could firms have enough
working capital?). For instance projections of receipts of one particular participant may help to

identify the possibility of/or the demand for credit for that participant. The aspects which have to
be looked into while conducting financial appraisal are:
I. Investment outlay and costs of the project
II. Means of financing
III. Cost of capital
IV. Projected profitability
V. Break-even point
VI. Cash flows of the project
VII. Investment worthwhile ness judged in terms of various criteria of merit
VIII. Projected financial position
IX. Level of financial risk
2.5. Economic Analysis

The economic aspect of project preparation is primarily concerned with the determination of the
likelihood of the proposed project, and hence the committing of scares resources, by justifying
the significance of the project from the whole economy point of view (the society as a whole).
In such evaluation the focus is on the social costs and benefits of a project, which may often be
different from its monetary costs, and benefits. The financial analysis views form the participants
(or owners) point of view, while the economic analysis from the society‟s point of view.
There are three important distinctions between the two types of analyses
A. Treatments of taxes and subsidies: these items are treated as transfers in the economic
analysis while in financial analysis taxes are usually treated as cost and subsidy re a
return/income. The reason for this distinction is basically the point of view (society as
opposed to firm).
B. Use of Prices: in the financial analysis we will use actual market prices. In economic
analysis the market prices are adjusted to accurately reflect social and/or economic values.
The latter prices are termed as „shadow prices‟ or „accounting prices‟ or „economic
accounting prices‟.
C. Treatment of interest on capital: in economic analysis interest on capital is never separated
and deducted from the gross return since it is part of the return from capital which is
available for the society as a whole. Such interest is deducted from benefit stream in
financial analysis whose point of view is the firm and hence interest is a cost to the firm.
2.6. Social Analysis

This aspect is more important to public projects. Project analysts are expected to examine the
broader social implications of the proposed project. Sufficient attention should be given to the
social soundness of a project. This is particularly related to the:
i. The attitude and the likely response of the beneficiary groups;

ii. The existence of potential implementation capacities or organization within communities;

iii. The cultural factors related to the implementation and outcomes of the project;
iv. The political factors;
v. Income distribution implications of the project,
vi. Employment creation: income distribution could be related to employment creation.
vii. Issues of balanced regional development,
viii. The displacement impact of the project (the Wonji-Methara sugar plantations
displacement is a good case in point);
ix. The gender implication of the adopted technology;
x. Environmental impacts etc.
Guidelines for the social analysis of poverty reduction projects

1. Assess the socio-cultural and demographic characteristics of the beneficiary community:
its size, sex distribution, and social structure, including ethnic, tribal and class
composition;
2. Determine the way in which the beneficiary community has organized itself to carry out
productive activities, including the structure of households and families, the availability
of labor, the ownership of the land to be used, and access to and control of resources;
3. The project‟s cultural accessibility; that is, its capacity both for adapting to and fro
bringing about desirable changes in the beneficiary group‟s behavior and in how the
group perceives its needs.
4. The strategy necessary to elicit commitment from the beneficiary population and to
ensure the population‟s sustained participation from design through to successful
implementation, operation and maintenance;
5. The needs and concerns of sensitive beneficiary groups, such as minorities, women, and
so on.
Guidelines for ensuring the project is grounded on an understanding of the culture and the
environment of the intended beneficiaries
 Consult with beneficiaries on the scope and implementation strategy of the proposed
project;
 Ascertain the willingness of each of the affected groups to commit the financial resources
and labor assumed in the project design;
 Assess the likely response to the project of powerful local economic and political groups
and identify ways in which their support, can be obtained or their opposition reduced;
 Assess the potential conflict the project may cause within the community and
surrounding areas, and identify ways in which the conflict could be avoided or reduced;
 Try to understand the “psyche” of the poor and destitute, and seek to understand why
they may be reluctant to participate in a project that appears attractive to an outsider;

 Use social impact assessment techniques to assess how each of the principle socio
economic groups is likely to be affected, place particular emphasis on assessing the
extent to which project benefits will be accessible to the most vulnerable groups.
2.7. Environmental /Ecological Analysis

In recent years environmental concerns have assumed a great deal of significance. Ecological
analysis should be done particularly for major projects, which have significant ecological
implications like power plants and irrigation schemes, and environmental polluting industries.
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- Two: Review Questions

Briefly Explain the Following Questions
1. The project analyst must consider several aspects when carrying project analysis. What are
the major tasks on each aspect the project analyst should make during project preparation
and analysis (feasibility study)?
A. Demand and Market Analysis:
________________________________________________________________________
_______________________________________________________
B. Technical Analysis:
________________________________________________________________________
________________________________________________________
C. Organizational Analysis:
________________________________________________________________________
________________________________________________________
D. Financial Analysis:
________________________________________________________________________
________________________________________________________
E. Economic Analysis:
________________________________________________________________________
__________________________________________________________
F. Social Analysis:
________________________________________________________________________
_______________________________________________________
G. Environmental Analysis:
________________________________________________________________________
________________________________________________________

CHAPTER THREE
FINANCIAL ANALYSIS AND APPRAISAL OF PROJECTS
Introduction
Dear learner! In this chapter, we would like to introduce you with the financial analysis and its
appraisal criteria‟s in the project work. Every project has to be first analyzed in terms of its
timely implementation and financing. Commercial profitability analysis or financial analysis of a
project amounts to reviewing it from the angle of the entity (private or public) that will be
responsible for its execution. The necessity to determine the financial profitability of a project to
the project implementer calls for undertaking financial analysis. It aims at verifying that under
prevailing market conditions the project will become and remain viable.
Learning Objectives
 Understand the scope and rationale of financial analysis in project appraisal
 Know the way of identification of costs and benefits in financial analysis of a project
 Realize the classification of costs and benefits in financial analysis of a project
 Comprehend the valuation of financial costs and benefits in project appraisal
 Recognize the method of investment profitability analysis in project appraisal
 Identify the technique of sensitivity analysis in project appraisal
3.1. Scope & Rationale

3.1.1. What is Commercial/Financial Analysis?
It is concerned with assessing the feasibility of a new project from the point of view of its
financial results. It will be worthwhile to carry out a financial analysis if the output of the project
can be sold in the market or can be valued using market prices. The project‟s direct benefits and
costs are, therefore, calculated in pecuniary terms at the prevailing (expected) market prices. This
analysis is applied to appraise the soundness and acceptability of a single project as well as to
rank projects on the basis of their profitability. In other words, the financial analysis is all about
the assessment, analysis and evaluation of the required project inputs, the outputs to be
produced/generated/ and the future net benefits, (expressed in financial terms) with the aim of
determining the viability of a project to the private investor or the executing entity public body.
 In general Financial Analysis is a process of:

 Analyzing and interpreting financial statements.
 Critically examining the accounting information given in the financial statements.
 Evaluating relationship b/n component parts of financial statements to obtain a better
understanding of firm‟s position and Performance.
The commercial analysis deals with two issues:

1) Investment profitability analysis, with different methods of analysis;

A) Simple methods of analysis of rate of return/static methods/ non-discounted
techniques/. This include: Simple rate of return, Pay-back period, urgency, etc.
B) Discounted-cash-flow methods/dynamic methods. This includes: NPV, IRR, etc.
2) Financial analysis/ ratio analysis/.
A) Liquidity analysis;
B) Capital structure analysis (debt/equity ratio).
The two types of analysis are complementary and not substitutable. In fact in the relevant
literature commercial analysis and financial analysis are used interchangeably. Whatever the
terminology, the investment profitability analysis is the measurement and assessment of the
profitability of the resources put into a project, more directly the return on the capital no matter
what the sources of financing. Thus, investment profitability analysis is an assessment of the
potential earning power of the resources committed to a project without taking into account the
financial transactions occurring during the project‟s life. On the other hand, financial analysis
(ratio analysis) has to take into account the financial features of a project to ensure that the
disposable finances shall permit the smooth implementation and operation of the project.
 Objectives/Importance of Financial Analysis

 To assess the earning capacity and profitability of a project
 To assess the operational efficiency and marginal effectiveness
 To make inter-project comparisons
 To make forecasts about future prospects of a project
 To help in decision making and control of a project
 To identify the reason for change in profitability and financial position
 Steps in Financial Analysis
 Establish objectives of the analysis
 Define extent of analysis
 Re-organization and re-arrangement of financial data
 Relationship among financial statements with help of tools & methods
 Interpretation of information
 Drawing a conclusion for decision making process
3.1.2. Why and When One Undertakes Financial Analysis?
Commercial/financial analysis applies to private and public investments. A private firm will
primarily be interested in undertaking a financial analysis of any project it is considering and
seldom will it undertake an economic analysis. The issue of financial sustainability of a public
project justifies the need for undertaking financial 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.
Even non-commercially oriented government institutions may sometimes wish to choose
between alternative facilities on the basis of essentially financial objectives. In the case of a

hospital service the management of the hospital may be required to provide the cheapest
services. Under such circumstances a cost minimization or cost effectiveness exercise will be
undertaken.
Commercial profitability analysis is the first step in the economic appraisal of a project. A
comprehensive financial analysis provides the basic data needed for the economic evaluation of
the project and is the starting point for such evaluation. In fact economic analysis mainly
involves of adjustments of the information used in financial analysis and of a few additional
ones. The procedure and methodology in financial analysis is basically the same with that of
economic analysis. Yet one has to recognize and realize the differences between the two. It has
to be noted that the financial analyst should be able to communicate and know what to ask from
the different team members to collect relevant information on:
1) Revenue, both forecasted sales and selling price; (from the Demand and Market Study)
2) Initial investment costs distributed over the implementation of the project; (from
Engineering, Site Development as well as Materials and Inputs analysis);
3) Operating costs of the envisaged operational unit/firm/ over its operating life.
The issues and concerns of financial analysis are:
 Identification of required data;

 Analysis of the reliability of data;
 Analysis of the structure and significance of costs and benefits/incomes/;
 Determination and evaluation of the annual and accumulated financial net benefits;
expressed as profitability, efficiency or yield of the investment;
 Consideration of the spread of flows of the costs and benefits over time
 Costs of capital over time;
Dear learner! Can you explain the concept of financial analysis in your own word?
3.1.3. Planning Horizon and Project Life
Planning is understood as a consciously programmed activity having as its focus the objective
consideration of the future. The anticipations and assumptions about the future need to be
explicit and should be analyzed in order to find the optimal development path. The project
planning horizon of a decision maker may be defined as the period of time over which he/she
decides to control and manage his/her project-related business activities, or for which he/she
formulates his/her investment or business development plan.
The planning horizon must consider the life time of a project. The economic life, that is, the
period over which the project would generate net gains, depends basically on the technical or
technological life cycle of the main plant items, on the life cycle of the product and of the
industry involved, and on the flexibility of a firm in adapting its business activities to changes in

the business environment. When determining the economic life span of the project various
factors have to be assessed, some of which are as follows:
Duration of demand (position in the product life cycle);

Duration of raw material deposits and supply;
Rate of technical change;
Life cycle of the industry;
Duration of building and equipment;
Opportunities for alternative investment;
Administrative constraints (urban planning horizon).
It is evident that the economic life of a project can never be longer than its technical life or its
legal life; in other words it must be less than or equal to the shorter of the latter.
3.2. Identification of Relevant Costs and Benefits

In project analysis, the identification of costs and benefits is the first step. This involves the
specification of the costs and benefit variables for which data should be collected, identification
of the sources of information, collection of the same and then assessment of the quality and
reliability of the collected information. The costs and benefits of a project depend on the
objectives the project wants to achieve. So, the objectives of the analysis provide the standard
against which cost and benefits are defined. A cost is anything that reduces an objective, and a
benefit is anything that contributes to an objective. However, each participant in a project has
many and different objectives. Whatever the nature of the project, its implementation will always
reduce the supply of inputs (" consumed" by the project).
Without the project, the supply of these inputs and outputs to the rest of the economy would have
been different. (Examining this difference between the availability of inputs and outputs with and
without the project is the basic method of identifying its costs and benefits.) In many cases the
Situation without the project is not simply a continuation of the status quo, but rather the
Situation that is expected to exist if the project is not under taken, because some increases in
output and costs are often expected to occur any way. Different participants in a project have
many and different objectives.
No formal analytical technique could possibly take in to account all the various objectives of
every participant in a project. Some selection will have to be made. Most often the maximization
of income is taken as the dominant objective of the firm because the single most important
objective of an individual economic agent is to increase income and increased national income is
the most important objective of national economic policy. Anything that reduces national income
is a cost and anything that increases national income is a benefit. Thus anything that directly
reduces the total final goods and services is obviously a cost, and anything that directly increases
them is a benefit. The task of the economic analyst will be to estimate the amount of the increase

in national income available to the society i.e. to determine whether, and by how much, the
benefits exceed the costs in terms of national income.
 Quantification:
Once costs and benefits are enumerated the next step is accurate prediction of the future benefits
and costs which then is quantified in Dollars and cents. Thus, quantification involves the
quantitative assessment of both physical quantities and prices over the life span of the project.
The financial analysis of projects is typically based on accurate prediction of market prices, on
top of quantity prediction. It is worth thinking about the impact of the project itself on the level
of prices; and the independent movement of prices due other factors. The same principle applies
in the Sense of economic analysis the only difference being the price needs to be changed to
reflect net efficiency benefits to the nations at large. One widely accepted" efficiency" measure is
its actual or potential value as an import or export; similarly the opportunity cost of any input is
related to the question of its potential contribution to foreign exchange. In other words, world
prices are considered as efficiency price indicators compared to domestic prices. However, to
take account of the distribution impact of project further adjustment of such price is required.
This lends itself to the social cost-benefit analysis.
Dear learner! Can you define and classify tangible and intangible costs/benefits?
3.3. Classification of Costs and Benefits

There are alternative ways of classifying costs and benefits of a project. One is to categorize both
costs and benefits into:
A) Tangible and
B) Intangible once
Another classification of cost is in terms of:
A) Total investment costs; includes:
i) Initial investment costs; includes:
 Fixed investment costs;
 Pre-Production expenditures;
ii) Investment required during plant operation / rehabilitation and replacement
investment costs/
iii) Net working capital
B) Operational/running costs/costs of goods sold
3.3.1. Tangible costs of a project
In almost all project analyses costs are easier to identify (and value) than benefits. In examining
costs the basic question is whether the item reduces the net benefit of a farm or the net income of
a firm. The prices that the project actually pays for inputs are the appropriate prices to use to
estimate the project‟s financial costs. These prices may include taxes, tariffs; monopoly or
monopsony (seller monopoly) rents, or be net of subsidies. Some of the project costs are tangible
and quantifiable while many more are intangible and non-quantifiable. The costs of a project
depend on the exact project formulation, location, resource availability, or objective of the
project. In general, the cost of a project would be the sum of the total outlays on the following
items:
 Initial Fixed Investment costs
 Pre-production Expenditures
 Plant and Equipment Replacement Costs
 Terminal Values/End-of-Life Costs/Salvage Costs/
 Net Working Capital
 Costs of Goods Sold
 Sunk costs
 Technical know-how and Engineering fees.
 Expenses on Foreign Technicians and Training of local technicians abroad
A) Total Investment Costs
 Initial Fixed Investment costs
The initial fixed investments constitute the major resources required for constructing and
equipping an investment project.
These include the following tangible initial fixed investments.
1) The cost of land and site development
 Land charges
 Payment for lease
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tubes wells
2) The cost of buildings and civil works
 Buildings for the main plant and equipments
 Buildings for auxiliary services (steam supply, workshops, laboratory, water supply,
etc.)
 Warehouses and show rooms
 Non factory buildings like guest house, canteens, residential quarters, staff rooms
 Silos, tanks, wells, basins, sewers, drainages, etc.
 Garages and workshops
 Other civil engineering works
3) Plant and machinery costs
 Cost of imported machinery: is the sum of i) FOB value, shipping, ii) freight and
insurance costs, iii) import duty, and iv) clearing, loading, unloading, and
transportation costs

 Cost of local or indigenous machinery: consists i) FOR cost, ii) sales tax, and other
taxes if any, and iii) railway freight and transport charges to the site
 Cost of stores and spares
 Foundation and installation charges
The cost of plant and machinery is based on the latest available quotation adjusted for possible
escalation. Generally, the provision for escalation is equal to the following product: (latest rate of
annual inflation applicable to the plant and machinery) x (length of the delivery period)
4) Miscellaneous fixed assets: fixed assets and machinery which are not part of the direct
manufacturing process may be referred to as miscellaneous fixed assets.
 Expenses related to fixed assets such as furniture, office machines, tools, equipments,
vehicles, laboratory equipments, workshop equipments
 Pre-production Expenditures
Another component of the initial investment cost which includes both tangible and intangible
costs is the pre-production expenditures. In every project, certain expenditures are incurred prior
to commercial production/ inauguration and commencement of service delivery for public
service rendering projects/.
This includes the following investment cost items.
1) Intangible assets: these assets represent expenditures which yield benefits extending over a
longtime period. These include:
a) Patents, licenses, lump sum payments for technology, engineering fees, copy rights, and
goodwill.
b) Preparatory studies, like feasibility studies, specific functional studies and investigations,
consultant fees for preparing studies, supervision costs, project management services, etc.
2) Preliminary expenses: these costs include preliminary establishment expenses (registration
and formation expenses), legal fees for preparation of memorandum and articles of
associations and similar documents. In addition it includes costs of advertisements, brokerage
for mobilizing resources, shareholders, expenses for loan application and its processing.
3) Other Pre-operation expenses. These include:
 Rents, taxes, and rates
 Trial runs, start-ups and commissioning expenditures( raw materials and other inputs
consumed immediately before commercial operation);
 Salaries, fringe benefits and social security contributions of personnel engaged during the
pre-production period;
 Pre-production marketing costs, promotional expenses, creation of sales network, etc;
 Training costs, including all fees, travel, living expenses etc;
 Traveling expenses interest and commitment charges on borrowings
 Insurance charges
 Mortgage expenses interest on differed payments,
 Miscellaneous expenses
There are two approaches in allocating of pre-production expenditures.
1) All pre-production expenditures may be capitalized and amortized over a period of time
that is usually shorter than the period over which equipment is depreciated, say five
years;
2) A part of the pre-production expenditures may be initially allocated where attributable to
the respective fixed assets and the sum of both amortized/depreciated/ as the fixed asset,
machinery and/or equipment.
 Plant and Equipment Replacement Costs
Every machinery and equipment does not have equal economic life. There are machineries and
equipment that productively be operated for many years, 20 years in the case of industrial
technologies, about 50 years in the case of agricultural and infrastructural works. On the other
hand there are equipments, machinery components and parts which need to be regularly replaced
for smooth operation of the same technology. So sound project planning work should adequately
provide for replacement of components and parts. In fact the first thing to do would be to identify
such items and then estimate the costs for replacement and then the same should be reflected in
the financial and economic analysis.
 Terminal Values/End-of-Life Costs/Salvage Costs/ “Exit is not free and perfect!!”
Though firms may be institutionally organized to live and operate for unlimited period of time
and hence unlimited age, technologies, machineries and equipment do have limited
operational/economic/ life. During the end of the economic life of a good/machinery, equipment,
building, etc) there is some salvaged value and the salvation may involve incurring of costs. The
costs of associated with the decommissioning of fixed assets at the end of the project life, minus
any revenues from the sale of the assets, are end-of-life costs. Major costs are the costs of
dismantling, disposal and land reclamation.
 Net Working Capital
Net working capital is part of the total investment outlays. It is defined to embrace current assets
(the sum of inventories, marketable securities, prepaid items, accounts, receivable and cash)
minus current liabilities (accounts payable). This investment is required for financing the
operation of the plant. Any change in the current assets and/or current liabilities will have an
impact on the net working capital requirements. Any increase in net working capital/NWC/
corresponds to a cash outflow to be financed, and any decrease would set free financial resources
(cash inflow for the project). Working capital is generally categorized into gross working capital
and net working capital (NWC).
The gross working capital consists of all the current assets, including:
a) raw materials;
b) stores and spares;

c) work-in-process;
d) finished goods inventory;
e) Debtors/accounts receivable/;
f) Cash and bank balance.
Net working capital is defined as gross working capital less current liabilities. Current liabilities
consist of credits, provisions, accrued expenses, and short-term borrowings. For the purpose of
financial analysis and even financial management of operational firms, it is net working capital
which is the center of decision makers. Commercial banks and trade creditors provide the
principal support for working capital. However, a certain part of working capital requirement has
to come from long-term sources of finance. Referred to as the "margin money for working
capital”, this is an important element of the project cost.
The margin money for working capital is sometimes utilized for meeting over-runs in capital
cost. This leads to a working capital problem/crisis when the project is commissioned. To
mitigate this problem, financial institutions stipulate that a portion of the loan amount, equal to
the margin money for working capital, be blocked initially so that it can be released when the
project is completed.
B) Costs of Goods Sold/Operational costs
Once the project idea has been accepted and the project is being implemented the cost of
production may be worked out: For instance, for an agricultural project the following may be
necessary:
• Material cost: This comprises the cost of raw materials, chemicals, components, fertilizer and
pesticides for increasing agricultural production, concrete for irrigation canal construction,
material for the construction of homes etc and consumable stores required for production. It is
not the identification that is difficult in this case but the problem of finding out how much is
needed from each.
• Utilities: consisting of power, water, and fuel are also important cost components.
• Labor: this is the cost of all manpower employed in the enterprise. It will not be difficult to
identify and quantify the labor required for the production process. From the highly skilled
manager to the unskilled factory worker the labor input can easily be identified. Problems in the
case of valuing unskilled labor and family labor might arise in the economic analysis of projects.
• Factory Overhead: the expense on repairs and maintenance, rent, taxes, insurance on factory
assets, etc. are collectively referred to as factory overheads.
• Land to be used for the project: can also be easily identified and quantified. It will not be
difficult to know who much land is need and about the location. Yet problems might arise in
valuing land because of the special kind of market conditions that exist when land is transferred
from one owner to another.

• Contingency allowances: are usually included as a regular part of the project cost. In general
project costs estimates are assume that there will be no relative changes in domestic or
international prices and no inflation during the investment period or there will not be any
modification in design, no exceptional conditions such as unanticipated environmental
conditions (flood, landslides, or bad weather). It would be unrealistic to base project cost
estimates only on these assumptions of perfect knowledge and complete price stability. 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 cost.
Contingency allowances may be divided into those that provide for physical contingencies and
those for price contingencies. In turn price contingencies comprise two categories, those for
relative cages in price and those for general inflation. Physical contingency allowances and price
contingency allowances for relative changes in price are expected and form part of the cost base
when measures of project worth are calculated. To avoid the problem of inflation on the other
hand it is advisable to work with constant prices instead of current prices. This approach assumes
that all prices will be affected equally by any rise in the general price level. So, contingency
allowances for inflation will not be included among the costs in project accounts other than the
financing plan.
• Taxes: payment of taxes including tariffs and duties is treated as a cost to the project
implementer in financial analysis. But they are considered as transfer payments in economic
analysis.
• Debt service: the same approach applies to debt service - the payment of interest and the
repayment of capital. Both are treated as an outflow in financial analysis. In economic analysis
debt service is treated as a transfer payment within the economy even if the project will actually
be financed by a foreign loan and debt service will be paid abroad.
Sunk costs: Sunk costs are those incurred in the past and upon which the proposed new
investment will be based. Such costs cannot be avoided however, poorly advised they may
have been. When we analyze a proposed investment, we consider only future returns to
future costs; expenditures in the past or sunk costs do not appear in our account.
Technical know-how and Engineering fees.
Often it is necessary to engage technical consultants or collaborators from local or abroad for
advice and help in various technical matters like preparation of project report, choice of
technology, selection of plant and machinery, detailed engineering, and so on. While the amount
payable for obtaining technical know-how and engineering services for setting up the project is a
component of project cost, the royalty payable annually, which is typically a percentage of sales,
is an operating expense taken in to account in the preparation of the projected profitability
statements.
Expenses on Foreign Technicians and Training of local technicians abroad

Services of foreign technicians may be required for Setting up the project and supervising the
trial runs. Expenses on their travel, boarding, and loading along with their Salaries and
allowances must be shown here. Likewise, expenses on local technicians who require training
abroad must also be included here.
 Means of Finance
To meet the cost of project the following means of finance are available:
 Share capital: There are two types of Share capital- equity capital and preference capital.
Equity capital represents the contribution made by the owners of the business, the equity
shareholders, who enjoy the rewards and bear the risks of owner ship. Equity capital being
risk capital carries no fixed rate of dividend. Preference capital represents the contribution
made by preference shareholders and the dividend paid on it is generally fixed.
 Term loans: Provided by financial institutions and commercial banks; term loans represent
secured borrowings, which are a very important source for financing new projects as well
as expansion, modernization, and renovation schemes of existing firms.
 Debenture capital: Debentures are instruments for raising debt capital. There are two
broad types of debentures: non-convertible debentures and convertible debentures. Non-
convertible debentures are straight debt instruments. Typically they carry a fixed rate of
interest and have a maturity period of 5 to 9 years. Convertible debentures, as the name
implies, are debentures, which are convertible, wholly or partly, in to equity shares. The
conversion period and price are announced in advance.
 Deferred credit: Many a time the suppliers of plant and machinery offer a deferred credit
facility under which payment for the purchase of plant and machinery can be made over a
period of time.
 Incentive sources: The government and its agencies may provide financial support as
incentive to certain types of promoters or for setting up investment in certain location.
These incentives may take the form of seed capital assistance, or capital subsidy or tax
exemption.
 Miscellaneous sources: A small portion of project finance may come from miscellaneous
sources like unsecured loans, public deposits, and leasing and hire purchase finance.
3.3.2. Tangible Benefits
Tangible benefits can arise either from increased production or form reduced costs. The specific
forms, in which tangible benefits appear, however, are not always obvious and valuing them
might be difficult. In general the following benefits can be expected:
 Increased production
 Quality improvement
 Changes in time of sale changes in location of sale
 Changes in product form

 Cost reduction through technological advancement

 Reduced transport costs
 Loses avoided
3.3.3. Intangible costs and Benefits
There may be some costs and benefits that are intangible. These may include the creation of new
employment opportunities, better health and reduced infant mortality as a result of more rural
clinics, better nutrition, reduced incidence of waterborne diseases, national integration, or even
national defense. Such intangible benefits, however, do not readily lend them to valuation. Under
such circumstances one may have to resort to the least cost approach instead of the normal
benefit cost analysis. Although the benefits may be intangible most of the costs are tangible.
Construction costs for schools, hospitals, pipes for rural water supply, etc are all quantifiable.
However, cost such as the disruption of family life, the increased pollution as a result of the
project, ecological imbalances as the result of the project, etc, are difficult to capture and
quantify. But effort should be made to identify and quantify wherever possible.
3.4. The Valuation of Financial Costs and Benefits

This is an issue of pricing/valuing/ of the project‟s inputs and outputs. The inputs and outputs of
a project appear in physical form and prices are used to express them in value terms in order to
obtain common denominator. Ideally, for the purpose of the feasibility study prices should reflect
the real economic values of project inputs and outputs for the entire planning horizon of the
decision makers. The financial benefits of a project are just the revenues received and the
financial costs are the expenditures that are actually incurred by the implementing agency as a
result of the project.
If the project is producing some goods and services for sale the revenue that the project
implementer expects to receive every year from these sales will be the benefits of the project.
The costs incurred are the expenditures made to establish and operate the project. These include
capital costs, the cost of purchasing land, equipment, factory buildings vehicles, and office
machines, working capital as well as its ongoing operating costs; for labor, raw material, fuel,
and utilities.
In financial analysis all these receipts and expenditures are valued as they appear in the financial
balance sheet of the project, and are therefore, measured in market prices. Market prices are just
the prices in the local economy, and include all applicable taxes, tariffs, trade mark-ups and
commissions. Since the project implementers will have to pay market prices for the inputs and
will receive market prices for the outputs they produce, the financial costs and benefits of the
project are measured in these market prices.
In a freely perfectly competitive market, without taxes or subsidies the market price of an input
will equal its competitive supply price at each level of production. This is the price at which
producers are just willing to supply that good or service. The supply curve will reflect the
opportunity cost, or the value in their next best alternative use, of the resources used to produce
that input. In equilibrium the supply price of an input will equal to its demand price at the
market-clearing price for that input.
The financial benefit from a project is measured in terms of the market value of the project‟s
output, net of any sales taxes. If the project‟s output is sold in a competitive market with no
rationing or price control for the good concerned, and the project is small and does not change
the good‟s price, its market price will equal its competitive demand price. This is a minimum
measure of what people are willing to pay for a unit of the good or service (produced by the
project, at each level of output demanded. Prices may be defined in various ways, depending on
whether they are:
A) Market/explicit/ or shadow/imputed/ prices;
B) Absolute or relative prices;
C) Current or constant prices.
a) Market Vs Shadow prices
Market or explicit prices are those present in the market, no matter whether they are
determined by supply and demand or by the government. They are the prices at which the firm
will buy the inputs and sell the outputs. In financial analysis market prices are applied. In
economic analysis we raise the question whether market prices reflect real economic value of
project inputs and outputs. In economic analysis, if the market prices are distorted, then shadow
or imputed prices will have to be used for economic analysis.
b) Absolute Vs Relative prices
Absolute prices reflect the value of a single product in an absolute amount of money, while
relative prices express the value of one product in terms of another. For instance, the absolute
price of 1 tone of coal may be 100 monetary units and an equivalent quantity of oil may be 300
monetary units. In this case the relative price of coal in terms of oil would be 0.33, meaning that
the relative price of oil is three times the price of coal. The level of absolute prices may vary over
the lifetime of the project because of inflation or productivity changes. This variation does not
necessarily lead to a change in relative prices, in other words, relative prices may sometimes
remain unchanged despite variations in absolute prices. Both absolute and relative prices can be
used in financial analysis.
c) Constant Vs Current prices
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.
3.5. The Treatment of Transfer Payments in Financial Analysis

Some entries in financial accounts represent shifts in claims to goods and services from one
entity in the society to another and do not reflect changes in national income. So the definition of
costs and benefits might be confusing. These payments are called direct transfer payments. These
direct transfer payments include taxes, subsidies, loans, and debt services.
Taxes: taxes that are treated as a direct transfer payment are those representing a diversion of net
benefit to the society. A tax does not represent real resource flow; it represents only the transfer
of a claim to real resource flows. In financial analysis a tax is clearly a cost. When a firm pays
taxes its net income reduces. But the payment of taxes does not reduce national income. Rather it
transfer income from the firm to the government so that this income can be used for social
purposes presumed to be more important to the society than the increased individual
consumption or investment had the firm retained the amount of the tax. So, in economic analysis
taxes will not be treated as a cost in project account.
No matter what form a tax takes, it is still a transfer payment - whether a direct tax or an indirect
taxes such as sales tax, an excise tax, or tariff or duty on an imported input for production.
Whether a tax should be treated as a transfer payment or as a payment for goods and services
needed to carry out the project or merely a transfer, to be used for general purposes, of some part
of the benefit from the point to the society as a whole.
Subsidies: are simply direct transfer payments that flow in the opposite direction from taxes.
Direct subsidies represent the transfer of a claim to real resources from one enterprise, sector or
individual to another. Subsidies may be open or disguised and are provided on the input or
output side. On the input side subsidies reduce costs to the project, e.g. subsidies to fertilizers. If
the subsidy is granted on the output side i.e., increase the revenue of the project; we should
deduct the amount of the subsidy from the revenue that includes subsidy. If a firm is able to
purchase an input at a subsidized price that will reduce his costs and thereby increase his net
benefit, but the cost of the input in the use of the society‟s real resources remains the same. The
resources needed to produce the input or to import it from abroad reduce the national income
available to the society. Hence, for economic analysis of a project we must enter the full cost of
the input.
Again it makes no difference what form the subsidy takes. One form is that which lowers the
selling price of the input below what otherwise would be their market price. But a subsidy can
also operate to increase the amount the owner receives for that he sells in the market, as in the
case of a direct subsidy paid by the government that is added to what the he receives in the
market. A more common means to achieve the same result does not involve direct subsidy. The
market price may be maintained at a level higher than it otherwise would be by; say levying an
import duty on competing imports or forbidding competing imports altogether. Although it is not
a direct subsidy, the difference between the competing imports that would prevail without such
measure does represent an indirect transfer from the consumer to the producer.
Credit Transactions: these are the other major form of direct transfer payments. A loan
represents the transfer of a claim to real resources from the lender to the borrower. When the
borrower repays loans or pays interest he is transferring the claim to the real resource back to the
lender - but neither the loan nor the repayment represent in itself, use of the resources. From the
standpoint of the producer, receipt of a loan increases the production resources he has available;
payment of interest and repayment of principle reduces them. But from the standpoint of the
national economy loans do not reduce the national income available. It merely transfers the
control over resources from the lender to the borrower. The loan transaction from one enterprise
to another would not reduce the national income; it is rather, a direct transfer payment.
Repayment of a loan is also a direct transfer payment.
3.6. Financial Appraisal Criteria of Projects and Selection of Investments

The three basic steps in determining whether projects is worthwhile or not are:
A) Estimate project cash flows
B) Establish the cost of capital; and
C) Apply a suitable decision or appraisal rule or criterion.
This section deals with the third step.
It is to be reminded that the theme of project planning/study is to determine whether an

investment is feasible or not. This means to show whether the financial return on both the total
capital invested and on the paid-in equity capitals sufficiently high or not. Although sufficient
returns are essential for a project to be implemented, investments must be justified usually within
wider context, which for investors and financiers includes any gains, whether net profits or non-
cash benefits, resulting directly or indirectly from an investment. Thus once, costs and benefits
have been identified, priced and valued, the project analyst should work out to determine on
which project (s) to invest. To this effect, the project analyst should have ways and
means/methods, tools, approaches/ to select more profitable from less profitable or unprofitable
projects.
A wide range of criteria have been suggested for choosing investment proposals, which are
suitable for both financial and economic analysis. These criteria may be classified into two
categories:
1) Non-discounting criteria, including:
 Ranking by inspection
 Urgency;
 Payback period;
 Proceeds per unit of outlay
 Out-put- capital ratio
2) Discounting criteria, including:
 Net present value/NPV/
 Internal rate of return/IRR/
 Net benefit investment ratio /NBIR/
 Domestic resource cost ratio/DRCR/
 Benefit-cost ratio/BCR/
3.6.1. Non-Discounted Measures of Project Worth
Projects, which are powerful means of development, have to be appraised by multiple criteria. In
order to appraise a project idea we need operational criteria applicable in evaluating alternatives.
Technical criteria are used to compare the merits of alternative technical solutions. It should be
noted that there might be no one best technique for estimating project worth although some may
be better than others. We should also note that these are only tools to improve decision-making.
There are other non-quantifiable and non-economic criteria for making project decisions. The
tools are only used to improve the decision making process. Before we discuss the discounted
project appraisal criteria we need to consider some common undiscounted measures.
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.
A) Two investments have identical cash flows each year up to the final year of the short-lived
investment, but one continues to earn cash proceed (financial results or profits) in subsequent
years. The investment with the longer life would be more desirable.
Example: Consider the following hypothetical projects
Net cash proceeds per year

Investment (Project) Initial cost Year I Year II Total Proceeds
A 10,000 10,000 - 10,000
B 10,000 10,000 1,100 11,100
C 10,000 3,762 7,762 11,524
D 10,000 7,762 3,762 11,524
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. More analysis is required to decide between
C & D,

B) Two investments have the same initial out lay (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 4000 more in year 1 than
investment C, which does not make up difference until year 2.
2) Urgency
According to this criterion projects which are considered to be more urgent get priority over
projects which are regarded as less urgent. The problem with this criterion is: how can the degree
of urgency be determined? In certain situations it may not be practically difficult to determine
the urgency of a certain project proposal. For instance the project could be bottleneck alleviation
of an ongoing operation/firm/ etc. Since it is not a systematic decision, this is not something that
can be encouraged. Rather it is a practice that should be discouraged.
3) The Payback Period
The payback period also called the payoff period is one of the simplest and apparently one of the
most frequently used methods of measuring the economic value of an investment. Since it
addresses the prime concern of an investor in terms of reclaiming/recovering the initial outlay, it
is frequently used method of project evaluation. The recovered money can be reinvested in
something else. If the investor recovers its initial outlay, then in a way it is minimizing the risk it
faces in the subsequent operation of the project.
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. It is the period of time that the investor
recovers its initial total outlay. This criterion is most often used in the business enterprises.
However, its use in agricultural projects is limited.
Example-1: 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 be300/100 =
3 years.
Note: if the expected proceeds are not constant from year to year, then the payback period must
be calculated by adding up the proceeds expected in successive years until the total is equal to
the original outlay.
Example-2: consider the previous project C. . Then Then
the payback period is1.80 years. Similarly, for the other projects:

Investment (project) Payback period (in years) Ranking of projects using the payback
period criteria
A 1 1
B 1 1
C 1.8 4
D 1.7 3
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. But a ranking procedure such as the payback period fails to disclose this fact.
Thus it has two important limitations:
 It fails to give any considerations to cash proceeds earned after the payback date. It
simply emphasizes quick financial returns, ignoring the performance of the project over
its economic life.
 It fails to take into account differences in the timing of receipts and earned proceeds prior
to the payback date. For instance, if we have two projects with the same capital cost and
if they have the same payback period then they are equally ranked. Yet we know by the
inspection method the project with earlier benefits should be desirable and should be
preferred since the earlier benefit is received the earlier it can be reinvested or consumed.
4) Proceeds per Unit of Outlay
Under this method, investments are ranked according to their total proceeds divided by the
amount of the corresponding investments. In other words the total net value of incremental
production divided by the total amount of the investment gives us the proceeds per unit of outlay.
Example: consider the following hypothetical example
Investment Total proceeds Investment Proceeds per Ranking

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 4000
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 of 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.
5) Output - Capital Ratio
This is another crude index of investment efficiency. It is defined as the average (undiscounted)
value added produced per unit of capital expenditure. Under this criterion we select the project
with the highest output capital ratio or the lowest capital output ratio (capital coefficient). The
main problem with this approach is that it ignores other factors of production such as labor and
land and concentrates only on the productivity of capital. Accordingly the criterion favors those
projects that use large quantities of labor and land in place of capital. Further it does not consider
the timely spread of costs and proceeds. There are two other undiscounted measures of project
worth.
i) The average annual proceeds per unit of outlay
This is similar to the proceeds per unit of outlay except that the average proceeds per year is
expressed as a ratio of the original investment. The total proceeds are first divided by the number
of years during which they are received, and this figure (the average proceeds per year) is then
expressed as a ratio of the original outlay. In other words;
Average Annual Proceeds

Average Annual Proceeds per unit of outlay
Original Outlay
Total Proceeds
But Average Annual Proceeds
Number of years
This method fails to take properly into considerations the timing of proceeds and exhibits a built
in bias for short-lived investment with high cash proceeds.
Example: consider the following hypothetical example:
We know that project D is superior to C although this method gives them equal ranks.
Investment A and B are also incorrectly ranked by ranking A above B in spite of the fact that the

latter is obviously superior. No weight is given to the time distribution. For instance, a project
that earns 10000 Birr for 10 years would also have an average proceed of 10000 per year and it
would be given the same rank as project A.
ii) Average Income on the Book Value of Investment
This is the ratio of the income to the book value of its assets. The value of assets as recorded in
the operation‟s financial account books.
3.6.2. Discounted Project Appraisal Criteria
The undiscounted measures discussed so far share common Weakness. They fail to take into
account adequately the timing of benefits. Thus, it is an accepted principle 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. The need for such a procedure will be apparent if one considers the
following simple argument. Suppose one is offered the choice between receiving birr 100 today
and receiving the same amount in a year's time. It will be rational to prefer to receive the money
today for several reasons.
1. One may expect inflation to reduce the real value of birr 100 in a year's time
2. If there were no inflationary effect, it would still be preferable to take the money today and
invest it at some rate of interest, r, hence receiving a total of birr 100 (1+r) at the end of the
year.
3. Even if no investment opportunities are available, one might reason that birr 100 today would
still be preferable on the grounds that there is a finite risk to collect the money next year.
4. Even where inflation, investment opportunities and risk are ignored, there is pure time
preference, which would lead one to prefer the immediate offer.
For all these reasons we say there is a positive rate of discount, which leads us to place a lower
present value on a given sum of money the further in the future one expects it to accrue. The
accepted method for this adjustment amounts to bringing them to a common time denominator.
This principle is called discounting.
Discounting is a technique or a process by which one can reduce future benefits and costs to
their present worth or present value. This is the method used to revalue future cost 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.

Hence, discounting is very important for project analysis. The discount rate is usually determined
by the central authorities.
Note that in order to clearly understand the principles of discounting it will be helpful to have a
clear understanding of the principle of compounding. Compounding is the technique of
calculating the future worth (F) of a present amount (P) at the end of some period T at a given
interest rate. On the other hand finding the present worth of a future Stream of value is called
discounting. Hence, if there is an initial amount p at present, then if this investment was
borrowed from the bank at an interest rate of "r" birr then after one period it becomes:
P Pr P r - Since the borrower must also repay the principal
After two periods the amount becomes:
P Pr r p pr
P Pr Pr Pr
P Pr Pr
P r r
P r r P r
In general, the amount accumulated after t periods would be A P r t
Now given that future value accumulated after t periods as above, if we want to know the present
value of this amount we would be taking about discounting. Hence the present value would be:
A amount.. accumulated at some futuredate

P 
(1  r ) t
(1 r ) t
 A (1 r )  t
The term (1+r)t in the denominator or (1+r)-t in the numerator is referred to as discounting
factor, a factor used to estimate the present value of a stream of future values. The „r‟ in this
term is referred to as discounting rate. So the discount factor tells us how much Br 1 at a
future date is worth today at a certain discount rate.
A) The Net Present Value (NPV)
The most widely used and straightforward discounted measure of project worth is the net present
value (NPV). This value is obtained when a stream of cost and benefits accruing over a period of
time are discounted to the present is called the present value of the stream. The NPV is defined
as the difference between the present value of benefits and the present value 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 interstate rate.
The net present value formula is:

B C B C B C B C B C
NPV ∑
r r r r r
Where: are the project benefits in period t.

Is the project cost in period t.
r is the appropriate financial or economic discount rate
n is the number of years for which the project will operate
The discounted rate should be equal either to the actual rate of interest on long term loans in the
capital market or to the interest rate paid by the borrower. However, since capital market does
not usually exist in developing countries, the discount rate should reflect the opportunity cost of
capital i.e. the possible return of capital invested elsewhere. This is the minimum rate of return
below which the planner considers that is does not pay for him to invest.
The discounting period should normally be equal to the life of the project. This period is the
economic life of the project and varies from project to project.
Having set the discount rate, an investment project is deemed acceptable if the discounted net
benefits (benefits minus costs) are positive. The economic criterion of project appraisal is to
accept all projects that show positive NPV at the predetermined discount rate and reject all
projects that show Negative NPV. Thus, the decision is to accept if NPV > 0. We can also
discount benefits and costs separately, and if B>C then NPV >0. Example 1:
Table 1: Consider the following Discounted Cash Flows for a Fertilizer Project in million Birr
1 2 3 4 5 6 7
Net benefits Discounted factors Discounted Net Discounted factor Discounted Net
Year Costs Benefits (Cash flow) = (10 %) = benefits (Net cash (20%) = benefits (Net cash
(2-1) flow) (10%)= (3*4) flow) (20%)=(3*6)
0 0
0 20 0 -20 1/(1+0.10) =1.00 -20.0 1/(1+0.20) =1.00 -20.0
1 1
1 10 14 4 1/(1+0.10) =0.909 3.64 1/(1+0.20) =0.833 3.33
2 10 14 4 1/(1+0.10)2=0.826 3.30 1/(1+0.20)2=0.694 2.78
3 10 14 4 =0.751 3.00 =0.579 2.32
4 10 14 4 =0.683 2.73 =0.482 1.92
5 10 14 4 =0.621 2.48 =0.402 1.61
6 10 14 4 =0.564 2.26 =0.335 1.34
7 10 14 4 =0.513 2.05 =0.279 1.12
8 10 14 4 =0.467 1.87 =0.233 0.93
9 10 14 4 =0.424 1.70 =0.194 0.78
10 10
10 10 14 4 1/(1+0.10) =0.386 1.54 1/(1+0.20) =0.162 0.65
NPV 4.57 -3.21
Note: the values for discount factors for r = 10% and r = 20% can be obtained from any standard
set of discount tables.

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 the cost of capital were to be
raised to 20 percent, the project produces a negative NPV of 3.21 million Birr. In this event the
project would have to be rejected. This shows that the NPV is critically dependent upon the level
of the discounting rate, r.
It is also possible to discount costs and benefits separately (individually) and now the decision
rule becomes that the discounted benefits should exceed the discounted costs, i.e. B > C and
NPV = B - C >0.
Example 2: what would be the present value of 1000 Birr received five years in the future
assuming a 9 percent discount rate?
We consider the discount factor for the 5th period under the 9 percent table. The discount factor
is 0.6499. Then we multiply the amount due by the discount factor.
1000 * 0.6499 = 649.90 Birr
Example 3: what would be present value of a stream of income of 5000 Birr received each year
for nine years assuming a discount rate of say 10 percent?
We use the table that gives the annuity factors to be used to derive the present value of a stream
of uniform values over a number of years. Thus the annuity factor for 9 years at 10 percent
discount rate is 5.759.
Now the annual income to be received is multiplied by the annuity factor.
5000 * 5.759 = 28795 Birr
Thus if the going rate of interest is 10 percent then we could afford to invest Birr 28795 in an
enterprise that would yield us an annual return of Birr 5000 for each of the 9 years.
 Prioritization/Selection/ from a Number of Projects

If there are alternative projects, how do you select from the available alternative projects? The
NPV does not indicate the rate of return, in the sense that it does not directly indicate the
magnitude of investment that generates the NPV.
If one of several project alternatives has to be chosen, the project with the largest NPV should
be selected. But we should know how much investment would be required to generate these
positive NPVs if there are two or more alternatives. The ratio of the NPV and the present value
of investment (PVI) should be considered and we get the net present value ratio (NPVR) when
comparing alternative projects.
NPV
NPV
PV

Given alternative projects, the one with the highest NPVR should be chosen. When comparing
alternative projects, care should be taken to use the same discounting period and rate of discount
rate for all projects.
 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 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.
Both will increase community‟s welfare if they were undertaken and hence both should be
undertaken. If there is resource constraint and the decision maker is forced to make choices, then
one will have to choose the project with the highest NPV.
 Decision Rule for Mutually Exclusive Projects

A mutually exclusive project is defined as a project of that can only be implemented at the
expense of an alternative project as they are in some sense substitutes for each other. The
decision rule for such projects is to accept the project with the highest NPV.
Example: Consider two hypothetical dams, which may be proposed for one prime site in a
locality in a fast flowing river (in million birr). All the benefits and costs are discounted figures.
Alternative Years
Projects
Dam A 1 2 3 4 5 6 7 8 9 10
Cost 5
Benefits 0 0.5 1 1 1 1 1 1 1 1
Net benefits -5 0.5 1 1 1 1 1 1 1 1
NPV=3.50
Dam B 1 2 3 4 5 6 7 8 9 10
Cost 500
Benefits 0 50 50 50 50 100 100 100 100 100
Net benefits -500 50 50 50 50 100 100 100 100 100
NPV=200
Which one of the two dams do you choose? Why?
If the two projects were independent and there was no budget constraint, the country could
therefore construct both, and 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.
 Practical application for the present value method

The practical application of the present value criterion as a means of evaluating investment
proposals for project planning implies the following assumptions.
a) Annual out lays and receipts from each investment are known for the entire life of the
project.
b) That the project life span is known.
c) That there is a rate of discount, which can be applied to every proposal and for every time
period.
However, the information required (the assumptions) made above is not always available for
every project. That means the NPV criterion may be applicable only to a limited number of
project proposals on which relevant data as indicated above could be computed or imputed. In
some projects investment outlays are difficult to estimate.
 Advantages of NPV method

Conceptually sound, the net present value selection criteria have considerable merits:
 It is simple to use and does not rely on complex conventions about where costs and
benefits are netted out.
 It is the only selection criteria that can correctly be used to choose between mutually
exclusive projects, without further manipulation
 It takes in to account the time value of money
 The net present value of various projects, measured as they are in today's birr, can be
added. For example, the net present value of a package consisting of two projects, A and
B, will simply be the sum of the net present value of this project individually:
NPV (A+ B) = NPV (A) + NPV (B)
 Limitations of the Net present value method

 Some projects could be deferred from implementation although they show positive NPV,
due to scarcity of funds. Thus passing the NPV test may be a necessary condition but not
a sufficient condition.
 If some projects were mutually exclusive then the implementation of one would naturally
exclude the execution of the other. This will lead both the central authorities and the
sponsoring agency in to a dilemma which project should be implemented. If funds are
unlimited then both could be implemented, but this is not always the case.
 The selection of an appropriate discount rate is another limitation
 It does not show the exact profitability rate of the project.

 For some projects the required information/data/ for computing the NPV may not be
available, or cheaply accessible.
 It assumes the same class (type and degree) of risk for both the costs and revenue sides of
the cash flow of a project.
 When it is used to select among projects, it implicitly assumes that all projects share
common type and degree of risk.
B) The Internal Rate of Return of a Project (IRR)

This is a second measure of the long- term profitability of an investment. It is also called the
Yield of an Investment Method or simply the Yield Method. The IRR of a project is probably
the most commonly used assessment criterion in project appraisal. This is because the concept of
an IRR is in some way comparable to the long-term profit rate of a project and is therefore
easily conceivable for non-economists. In fact, IRR is defined as the “earning rate of a
project”.
Unlike NPV, it does not rely on the selection of a predetermined discount rate. The method
utilizes present value concept but seek to avoid the arbitrary choice of a discount rate. Hence an
attempt is made to find that discount rate, which just makes the net present value of the cash flow
equal to zero. It is possible to think a level of interest rate that could result in NPV of zero. This
rate of interest 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. Denoting it by R, it is the solution to the
definition of the NPV when the latter is set to zero,
B C
NPV ∑
For financial analysis it would be the maximum interest rate that the project could afford to pay
on its funds and still recover all its investment and operating costs. While calculating the NPV
we have used a pre-determined discount rate and a table. But the calculation of the IRR amounts
to searching for the discount rate that gives a zero NPV. This is achieved through trial and error
using the standard discounting table. This rate, if it is determined, will represent the exact
profitability of the project.
If the IRR is computed for financial appraisal in which all values are measured in market prices,
it is called the financial internal rate of return (FIRR). When economic prices are used instead, it
will be termed as economic internal rate of return (EIRR).

 Calculation of IRR
The calculation procedure begins with the preparation of a cash flow table. Estimated discount
rate is then used to discount the net cash flow to the present value. If the NPV is positive a higher
rate is applied. If it is negative at this higher rate the IRR must be between those two rates.
By iterations it is possible to determine the discount rate that just makes the project‟s NPV equal
to zero. This rate is the IRR of the project. Fortunately spreadsheet programs such as Lotus 123
and excel can calculate the IRR of project‟s net benefit flow once starting value for the iteration
is provided.
Example: To illustrate the calculation of internal rate of return, consider the cash flows of a road
project (million Birr):
Year 0 1 2 3 4
Cash flow -100, 000 30,000 30,000 40,000 45,000
The internal rate of return is the value of r, which satisfies the following equation
 100,000 30,000 30,000 40, 000 45,000

0    
(1 r ) 0 (1 r )1 (1 r ) 2 (1  r ) 3 (1 r ) 4
30,000 30,000 40, 000 45,000

100,000    
(1  r )1 (1  r ) 2 (1  r ) 3 (1  r ) 4
We try different values of r till we find that the right-hand side of the above equation is equal to
100,000. Let us, to begin with, r = 12 percent.
30,000 30,000 40, 000 45,000

    107,773
(1.12)1 (1.12) 2 (1.12)3 (1.12) 4
Since this is more than 100,000, we have to try a higher value of r. (In general, a higher r lowers
the right-hand side value and a lower r increases the right-hand side value.) Let r = 14%
30,000 30,000 40, 000 45,000

    103,046
(1.14)1 (1.14) 2 (1.14)3 (1.14) 4
Since this value is higher than the target value of 100,000, we have to try a still higher value of r.
Let r = 15%
30,000 30,000 40, 000 45,000

    100,802
(1.15)1 (1.15) 2 (1.15) 3 (1.15) 4
This value is a shade higher than our target value, 100,000. So we increase the value of r from
15% to 16%. The right-hand side becomes:

30,000 30,000 40, 000 45,000

    98,641
(1.16)1 (1.16) 2 (1.16) 3 (1.16) 4
Since this value is now less than 100,000, we conclude the at the value of r lies between 15
percent and 16 percent
At 15 percent, the present value is 100,802

At___ Percent, the present value is 100,000
At 16 percent, the present value is 98,641
1 percent difference (between 15 percent and 16 percent) corresponds to difference of 2,161=
(100802-98641). The difference between 100,802 (present value at 15 percent) and 100,000
(target present value) is 802= (100,802-100,000). This difference will correspond to a percentage
802
difference of: x 100  0.37 percent
2161
Adding this number to 15 percent, we get the interpolated value as 15.37 percent.
Note: If the positive and negative NPVs are close to zero, a precise and less time consuming way
to arrive at the IRR is using the following interpolation formula.
Pv
Pv Nv
Where: I1 = the lower discount rate
I2 = the upper discount rate
Pv = NPV (positive) at the lower discount rate of I1
Nv = NPV (negative) at the higher discount rate of I2
Note: I1 and I2 should not differ by more than one or two percent.
802 (16  15) 802
IRR 15   15   15.37%
802 1359 2161
Another approximate solution to IRR is to plot the NPVs corresponding to several discount rates
to give what we call the NPV curve. The present values are plotted on the Y - axis and the
discount rates on the x-axis. A curve is then drawn to connect the various points on the graph.
The point at which the curve cuts the x-axis represents the rate at which the present value of the
investment is equal to zero.
Example: By experimenting with discount rates between 10 and 20 in our hypothetical project,
the IRR for the project is fractionally above 15%. The simplest way of getting this is by plotting
the NPV (y-axis) against different level of discount rates (x-axis); three points are usually
sufficient. The point at which this curve (called the NPV curve) crosses the x - axis provides the
IRR value.

5
4 (4.57)
NPV in million Birr 3 IRR
2
1 Discount rate
0 2 4 6 8 10 12 14 16 1820 22
-1
-2 (3.21)
-3
 Decision rule for independent projects in 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 greater than 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.
Once the IRR is identified, the decision rule is accept the project if the IRR is greater than the
cost of capital, say r. Note also that:
When NPV > 0 then IRR > r

NPV = 0 then IRR = r
NPV < 0 then IRR < r
All projects with an internal rate of return greater than some target rate of return r, should be
accepted. The target rate is usually the same rate used as the financial or social discount rate
employed in the computation of the projects net present value.
 The IRR and mutually Exclusive projects
While the IRR cannot be directly used to choose between mutually exclusive projects it can be
employed for further manipulation. This manipulation entails the subtracting the cash flow of the
smaller project from the cash flow of the larger one and calculating the internal rate of return of
the residual cash flow. It the residual cash flow's internal rate of return exceeds the target
discount rate, which could only occur if the larger project has a higher NPV, then the larger
project should be under taken.
 Comparison of the NPV and IRR
Form the foregoing discussions it is clear that both the NPV and the IRR methods can and do
rank investment projects in more rational manner than the other methods previously considered.
Thus it is advisable to calculate these measures so that easily understandable information is

provided to the authorities. In general it can be said that the NPV method is simpler, easier, and
more direct and more reliable. In some situations both the NPV and the IR criteria give the same
accept- reject decision. However, there are two probable reasons why all acceptable projects
cannot be under taken. One is that inventible funds (capital funds) may be limited. The second
real problem is that the discount rate has not been set correctly.
When the capital requirements of all acceptable projects exceed the available funds, the central
authorities should raise the discount rate up to that level where the projects passing the test are
just enough to exhaust the available funds. But if too few projects are acceptable then the
discount rate should be reduced. Hence as long as capital funds are "unlimited" it is argued that
NPV should be the relevant criterion. But the function of the discount rate is to ration capital in
such a manner, as eventually to pass just sufficient projects as well use up available investment
resources. Hence the argument is not whether NPV or IRR should be preferred as a criterion, but
whether planners have set the discount rate correctly.
The IRR and NPV might suggest different projects for similar level of discount rate.
Example: cash flows for a hypothetical project.
Year Cash flows

Project A Project B Project C
0 -20 -40 -20
1 4 8 14
2 4 8 14
3 4 8 -
4 4 8 -
5 4 8 -
6 4 8 -
7 4 8 -
8 4 8 -
9 4 8 -
10 4 8 -
NPV at 10% 4.57 6.08 4.36
IRR 15.1% 13.7% 25.8%
As it can be observed from the table above the three projects by their NPVs (at 10% discount
rate) results in project B heading the list, while ranking them according to their IRRs would lead
the planners to prefer C. 25.8% is better because a project with 25.8% economic rate of return is
likely to a better investment than with a project with 15% economic rate of return. That is, it
contributes more to the national income relative to the resources used.
There are two possible reasons for not to undertake all the above projects. The first is there may
not be enough capital funds the second problem is related to the fact that two or more projects
could be mutually exclusive. If there are enough budget resources, both NPV and IRR give the

same accept-reject decision. However, ranking the projects using the two methods will lead to
the choice of different projects: project B on NPV basis and project C on the IRR basis.
Note however, that 10% is not an appropriate discount rate because it passes all the three projects
more than can be accommodate by the given capital. Hence we have to set the discount rate
correctly up to the level where the projects passing the test are just enough to exhaust the
available funds as shown below.
Projects
A B C
NPV 15% 0.08 -1.84 2.76
NPV 10% 4.57 6.08 4.36
NPV 20% -3.23 -7.75 1.39
In general if funds are unlimited and the projects are not mutually exclusive, the NPV is the
relevant criteria. All projects with positive NPV should go ahead. But, the function of the
discount rate is to ration capital in such a way that eventually to pass just sufficient projects that
will exhaustively use up available inevitable funds. Thus, the important question is not whether
NPV or IRR is to be preferred, but whether planners have set the discount rate correctly or not.
Example: Assume that the total investment budget is birr 80 million. The projects above are all
projects in the economy. In this case planners can implement all projects. If the budget is birr 40
million however can implement all projects. If the budget is birr 40 million however, the planner
has to make the choice of carrying B alone or A and C together. Since the combine NPV of A
and C is larger B is the least choice at 10% discount rate.
 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 rare.
3) It is a measure that could be understood 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 to matter how high
the discount rate used to discount it, unless the project has at least one negative cash flow
period.

3) Certain cash flows can generate NPV = 0 at two different discount rates. If a project has more
than one IRR, then neither can be reliably used and another decision rule such as the NPV
must be used rather than the IRR.
The following cash flows generates NPV = 0 at both (-50% & 15.2%)
Co C1 C2 C3 C4 C5 C6
-1000 + 800 + 150 + 150 + 150 + 150 - 150
Multiple IRRs
1000
IRR = 15.2%
IRR
IRR = -50%
-500
4) It is relatively complex to compute the IRR-the iterative nature of its computation. But prior
to the advent of business calculators and computers software programs like Lotus and Excel
estimation of the IRR was a tedious process involving interpolations. However this is not
anymore a problem. In fact, we have dedicated project study software‟s, like COMFARE, by
UNIDO.
C) The Net Benefit Investment Ratio (NBIR)
It is the ratio of the present value of the projects benefits, net of operating costs, to the present
value of its investment costs. This is given by,
B OC
∑
r
NB
C
∑
r
Where OCt is operating costs in period t; ICt is investment costs in period t; r the appropriate
discount rate, and B the benefits in period t. The NBIR shows the value of the projects
discounted benefits, net of operating costs, per unit of investment.
The decision rule using NBIR is to accept the project if its value is greater than 1. This criterion
is especially important for ranking investments that shows the benefit per unit of investment.
When we have a single period budget constraint projects with the highest NBIR should be
selected up to the point where the budget exhausted.

The main advantage of the NBIR is its capacity to determine the group of priority projects if
there is a single period budget and investment constraint. Its limitation is however, that it is not
suitable for choosing between mutually exclusive projects, for the same reason that the IRR
cannot be used for this purpose. That is a project with highest NBIR could have the lowest
absolute net present value. The other disadvantage of NBIR is that the convention used for
dividing costs in to operating and investment may vary from institution to institution and may
render problems of comparability.
D) The Domestic Resource Cost Ratio (DRCR)
This ratio is often used in trade oriented projects or trade policy. In its simple form the DRCR
(sometimes referred as Bruno ratio (Bruno, 1967) is a discounted measure of project worth
calculated for a single typical year of project operation.
DRC is a measure of the economic efficiency of production of a commodity or in other words

the national comparative advantage in its production. It is defined as the value of domestic
resources (primary, non-traded factors of production) in domestic currency units required to earn
or save a unit of foreign exchange that is the cost per unit of foreign exchange saved for imported
competing goods and the cost per unit of foreign exchange earned for exports. The DRC
coefficient is a cost benefit ratio and it is essentially a measure of the efficiency of domestic
production relative to the international market.
If the DRC for a commodity is greater than the appropriate accounting price of foreign exchange
(OER or SER) a comparative cost advantage exists in producing the commodity in question and
vice versa. From this:
DRC < 1 implies that the productivity is economically profitable because its production yields
more than enough international value added to compensate for the cost of domestic factors used.
DRC = 1 implies a break-even situation, where it is only just economically worthwhile to
produce the commodity.
DRC > 1 indicates that the cost of domestic resources needed to generate one unit of foreign
exchange exceeds the value of the foreign exchange. This means the country is internally not
competitive in the production of the commodity or the country is better off to import rather than
to produce the commodity.
Undiscounted measures, as we noted, are excessively crude and most invariably inaccurate.
Thus, the discounted version is the most appropriate one. It is given as,
C B
∑ Birr
r
D C
C B
∑ USD
r
Where B are the benefits of the project obtained in local currency

C Are the costs of the project incurred in local currency
B Are the benefits of the project obtained in foreign exchange

C Are the costs of the project incurred in foreign exchange.
 The decision rule for DRCR
When undertaking a financial appraisal of a project should be accepted if it‟s DRCR is less than
or equal to the official exchange rate, OER. This means a project should proceed if it uses less
domestic resources, measured in local prices, to earn 1 unit of foreign exchange than is the norm
for the whole economy (the norm here being represented by the official exchange rate.) The
modified DRCE (Modified because it is discounted which traditionally was not the case) is
sometimes referred as the internal exchange rate approach to emphasize the fact that the
computation of DRCR is independent of any predetermined exchange rate as that of IRR, which
do not immediately, require a discount rate. It produces own internal exchange rate, which is
internal to the project.
Example: Estimation of the domestic resource costs ratio, special economic zone project -
foreign exchange component (denominator) million us dollar.
Year
1 2 3 4 5 6 7 30
Local costs
Investment 40 60 30 10
Production 0 50 75 90 100 100 100 100
Total local costs 40 110 105 100 100 100 100 100
Local Sales 0 0 20 25 25 25 25 25
Net local costs 40 110 85 75 75 75 75 75
PV of net local Birr 711.6
costs
Year
1 2 3 4 5 6 7 30
Foreign exchange earnings
Exported output 0 3 20 30 30 30 30 30
Foreign exchange costs 2
Imported investment goods 20 40 12 8 10 10 10 10
Other imported items 0 5 7
Net foreign exchange earnings -20 -42 1 20 20 20 20 20
(expert-imports)
PV of net foreign exchange Us $ 86.7
earnings
Therefore,

The main advantage of this approach is that non-economists can readily understand its decision
rule. More substantially in economics with serious balance of payment problem the DRCR
clearly show the potential of a project to earn foreign exchange. However, its disadvantages
includes, like that of IRR it cannot be used to rank projects. It cannot also be used to choose
between mutually exclusive projects if both use less domestic resource to earn a unit of foreign
exchange. This is because it does not show which of the two, or more, mutually exclusive
projects will generate the greatest net benefits for the country.
E) The Benefit Cost Ratio (BCR)
The benefit cost ratio is the earliest discounted project assessment criterion to be employed. The
BCR is defined as the ratio of the sum of the project‟s discounted benefits to the sum of its
discounted investment and operating costs. This is given as,
B
∑
r
BC
C
∑
r
 The Decision rule for BCR
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.
The BCR will be less than, equal to, and greater than one when the discount rate used is greater,
equal to, and less than the IRR. One possible advantage of 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.
Example: cost of transporting finished goods (say Br. 25) may be figured as cost in one project
(other costs are Br. 25 + transport cost Br. 25 = Br. 50; if sales price is Br. 100 the BCR will be
2) but price may be given net of transport cost (Br.100- Br.25=Br.75; compare to cost Br. 25 will
give a BCR of3) in the other and the two projects, thus, are incomparable. Clear convention on
such issues will be necessary for comparison purposes.
3.7. Sensitivity Analysis: Is Discounting Unfair to Future Generations?

Some people believe that discounting future values is wrong and even immoral. Yet the
developed countries economic system is predicated on the borrowing and lending of money. A
more modern argument against discounting (and implicitly against charging interest) is that it is
unfair to future generations. The discount rate is determined by the current generation without
any input from future generations. Since the discount rate can be interpreted as an exchange rate
for the value of goods tomorrow versus the value of goods today, then there is a tradeoff between
how we value the well-being of current and future generations that is implicit in the interest rate.

Interest rates are like a price set in a market where one group of traders (the current generation)
gets to set the price and everyone else (all future generations) has to live with that price. Some
people suggest that, while it is necessary to discount, lower interest rates should be used for
investments with particularly desirable “social” benefits. I am not convinced by these arguments.
First, it is not clear that low interest rates are always better for future generations. Not
discounting at all is the same thing as using an interest rate of zero. When someone says they
don‟t believe in discounting, or that they believe that discounting is unfair and should not be
done, they are essentially suggesting that interest rates should be zero.
However, if interest rates were zero, there would be no incentive for anyone to save money. If no
one saved any money, there would be no investment, and that would not be good for future
generations at all. Thus, a discount rate of zero would not necessarily be good for future
generations. So, would positive, but lower interest rates be good for future generations? Low
interest rates do benefit future generations in some ways. For example, with low interest rates
more investment projects that benefit future generations would be able to pay the interest on the
capital used in the project and still show a profit.
Using a lower interest rate for projects which are particularly beneficial to future generations is a
way of biasing the analysis in favor of those projects. However, with low interest rates fewer
people would be willing to invest their money at all, so there will be less money available for
investments in general. In order to raise the capital to fund all the projects that would be
profitable at lower-than-market interest rates, the government would have to subsidize these
investments. This would represent a transfer from the current generation to future generations. A
good argument can be made that current generations are better off than earlier generations and
that future generations are likely to be even better off than we are.
In that case, why should the current generation subsidize future generations? Furthermore, if
these subsidies are funded by deficit spending, as is usually the case for modern governments,
future generations will end up paying for the subsidies anyway. It is best to think of an interest
rate as an equilibrium price where the supply of investment money is just high enough to satisfy
the need for funds from projects that can meet the given interest rate.
One reason suggested for using lower-than-market interest rates for some projects is that there
are benefits associated with those projects that are not accounted for in the cost-benefit analysis.
This may be true; however, we should not arbitrarily bias the financial analyses of such projects
for this reason. A better approach is to use financial analysis as only one of the criteria for
evaluating projects. Benefits that are difficult to quantify in a financial analysis should be
addressed by the other criteria used to evaluate projects. It is probably true that an equilibrium
interest rate that is lower will benefit future generations more than an equilibrium rate that is
higher. But, too low an interest rate may not be fair to current generations.

Chapter- Two: Review Questions

1. Which one of the following is not the immediate objective of Financial Analysis?
A. To assess the earning capacity and profitability of a project
B. To assess the operational efficiency and marginal effectiveness
C. To make inter-project comparisons
D. To investigate the contribution of a project for national income
E. To help in decision making and control of a project
2. The initial fixed investments constitute the major resources required for constructing and
equipping an investment project which include these costs items except?
A. The cost of land and site development D. Miscellaneous fixed asset costs
B. The cost of buildings and civil works E. None
C. Plant and machinery costs
3. Another component of the initial investment cost is the pre-production expenditures which
includes the following investment cost items except?
A. Patents, licenses, lump sum payments for technology, engineering fees, copy rights
B. Preparatory studies, specific functional studies, consultant fees for preparing studies
C. Expenses related to furniture, office machines, tools, equipments, vehicles
D. Registration expenses, legal fees and costs of advertisements
E. Rents, taxes, and rates, Trial runs, start-ups and commissioning expenditures
4. Once the project idea has been accepted and the project is being implemented the cost of
production may be worked out which include cost items except?
A. Material, utilities and labor costs D. Contingency allowances
B. Plant and equipment replacement costs E. Taxes & Debt service
C. Factory overhead costs
5. To meet the cost of project which of the following means of finance are available and should
be principally exploited?
A. Share capital C. Deferred credit E. All
B. Term loans D. Incentive sources
Part II: Workout Questions

1. Consider the following hypothetical cash flows for sugar production projects in million Birr.
Net cash proceeds

Investment Initial cost per year Total Payback Proceeds per
(Project) Year I Year II Proceeds Period Unit of Outlay
A 9,000 5,500 6,000 11,500
B 10,000 6,000 6,500 12,500
C 8,500 6,000 5,000 11,000
D 9,500 6,500 5,500 12,000

A. Given the above information, estimate the payback period of each project and determine
which project is superior to other projects as per the decision rule.
________________________________________________________________________
_________________________________________________________________
B. Given the above information, estimate proceeds per unit of outlay of each project and
determine which project is superior to other projects as per the decision rule.
________________________________________________________________________
__________________________________________________________________
2. Consider the following discounted cash flows for a fertilizer project in million Birr. The
discounted rate equal either to the actual rate of interest on long term loans in the capital
market or to the interest rate paid by the borrower which is equal to 11%.
Year Costs Benefits Net benefits Discounted factors Discounted Net benefits
0 20 0
1 10 15
2 10 15
3 10 15
4 10 15
5 10 15
6 10 15
NPV=
A. Given the above information, estimate net present value (NPV) of the project and
determine whether it is financially feasible or not as per the decision rule.
________________________________________________________________________
__________________________________________________________
B. Given the above information, estimate the internal rate of return (IRR) of the project and
determine whether it is financially feasible or not as per the decision rule.
________________________________________________________________________
___________________________________________________________

CHAPTER FOUR
ECONOMIC ANALYSIS OF PROJECTS
Introduction
Dear learner! In this chapter, we would like to introduce you with the economic analysis and its
appraisal criteria‟s in the project work. The main objective of conducting a project economic
analysis is to help not only assess the sustainability of investment projects but also to inform the
design and select projects that can contribute to a sustainable improvement in the welfare of
project beneficiaries, and the country as a whole. Economic analysis is a means to help bring
about a better allocation of resources that can lead to enhanced incomes for investment or
consumption purposes. Therefore, it is best undertaken at the early stages of the project cycle to
enable decision makers to make an informed decision on whether to undertake a particular
investment given various alternatives and their corresponding costs.
Learning Objectives
 Familiarize with the concept Economic Analysis
 Realize identification Costs and Benefits of Economic Analysis
 Know the method of determining Economic Values
 Understand the principles of Social Cost Benefit Analysis and Cost Effectiveness
Social Cost Benefit Analysis (SCBA), also known as economic analysis, is a methodology
developed for evaluating investment projects from the point of view of the society (or economy)
as a whole. In the economic analysis of projects, we are interested in the total return or
productivity or profitability to the whole society or economy of all the resources committed to
the project. Project economic analysis aims to ensure that scarce resources are allocated
efficiently, and investment brings benefits to a country and raises the welfare of its citizens.
All resource inputs used by a project have an opportunity cost because, without the project, they
could create value elsewhere in the economy. An economically viable project requires that, first,
it represents the least-cost or most efficient option to achieve the intended project outcomes;
second, it generates an economic surplus above its opportunity cost; and third, it will have
sufficient funds and the necessary institutional structure for successful operation and
maintenance.
In the context of planned economies, SCBA aids in evaluating individual projects within the
planning framework which spells out national economic objectives and broad allocation of
resources to various sectors. In other words, SCBA is concerned with tactical decision making
within the framework of broad strategic choices defined by planning at the macro level. The
perspectives and parameters provided by the macro level plans serve as the basis of SCBA which
is a tool for analyzing and appraising individual projects.

4.1. Major Questions that Economic Analysis Should Answer

A large part of project analysis serves to establish a project's technical and institutional
feasibility, its fit with the government's strategy for the country and the sector, and the
appropriateness of the economic context for the project. Economic analysis takes for granted that
the project is technically sound and that its institutional arrangements will be effective during
implementation. It is, therefore, only one part of the overall analysis of the project, but a very
important part, as its main objective is to ascertain that the value of project benefits will exceed
project costs. Good economic analysis should leave no doubts about the project's contribution to
the country's welfare. This section provides a general overview of the questions that good
economic analysis should answer and can serve as a checklist and a map for finding tools that
could help answer those questions.
1) What Is the Objective of the Project?

The first step in the economic analysis of a project is to define clearly its objective(s). A clear
definition is essential for reducing the number of alternatives to consider and for selecting the
tools of analysis and the performance indicators. If the project tries to achieve a narrow
objective, such as improving the delivery of vaccines to a target population, then the analyst will
only look at alternative ways of delivering vaccinations to a target population and will judge the
success of the project terms of the vaccination coverage obtained. If the project tries to achieve a
broader objective, such as improving health status, then analysts will look not only at alternative
ways of delivering vaccinations, but at alternative ways of reducing morbidity and prolonging
the lives of the target population.
The success of the project then will be judged in terms of its impact on health status. The
appropriate tool of analysis also depends on the breadth of the objective. For example, if the
objective is to reduce the cost of vaccination, cost-benefit ratios might be adequate ways to
compare and select among interventions. If the objective is to improve health status, then the
interventions need to be compared in terms of their impact on health status. If the objective is
even broader say, to increase a country's welfare; then the comparisons need to be done in terms
of a common unit of measurement, usually a monetary measure.
2) What Will Happen if the Project Proceeds or Not?

One of the most fundamental questions concerns a counterfactual: What would the world look
like without the project? What would it look like with the project? What will be the impact of the
project on various groups in society? In particular, what will be the impact of the project on the
provision of goods and services in the private sector? Will the project add to the provision of
goods and services, or will it substitute for or displace goods and services that would have been
provided anyway? These differences between the situation with and without the project are the
basis for assessing the incremental costs and benefits of the project. Both the financial and

economic analysis of the project are predicated on the incremental net gains of the project, not on
the before and after gains.
3) Is the Project the Best Alternative?

Another important question concerns the examination of alternatives. Are there any plausible or
mutually exclusive alternatives to the project? Alternatives could involve, for example, different
technical specifications, policy or institutional reforms, location, beneficiaries, financial
arrangements, or differences in the scale or timing of the project. How would the costs and
benefits of alternatives compare with those of the project? Comparison of alternatives helps
planners choose the best way to accomplish their objectives.
4) Does the Project Have Separable Components?

Is the project one integrated package, or does it have separable components that could be under
taken and justified by themselves? If the project contains separable components, then each and
every separable component must be justified as if it were an independent project. Omitting a
component that cannot be justified always increases the project's net benefits. Separable,
unsatisfactory components should always be deleted from the project.
5) Winners and Losers: Who Enjoys the Music and Who Pays the Piper?
A good project contributes to the country's economic output; hence, it has the potential to make
everyone better-off. Nevertheless, usually not everyone benefits from a project, and some may
lose. Moreover, groups that benefit from a project are not necessarily those who incur the costs
of the project. Identifying those who will gain, those who will pay, and those who will lose gives
the analyst insight into the incentives that various stakeholders have to implement the project as
designed, and to support it or oppose it. Identifying the benefits accruing to and the costs borne
by the poor or very poor is especially important.
6) What Is the Project's Fiscal Impact?

Given the importance of fiscal policy for overall macroeconomic stability, the fiscal impact of
the project should always be analyzed. How and to what extent will the costs of the project be
recovered from its beneficiaries? What changes in public expenditures and revenues will be
attributable to the project? What will be the net effect for the central government and for local
governments? Will the cost recovery arrangements affect the quantities demanded of the services
provided by the project? Are these effects being properly taken into account in designing the
project? What will be the effect of cost recovery on the distribution of benefits? Will the cost
recovery arrangements contribute to the efficient use of the output from the project and of
resources? Is the non-recovered portion factored into the analysis of fiscal impact?

7) Is the Project Financially Sustainable?

The financing of a project is often critical for its sustainability. Even projects with high benefit
sunder go lean periods when external funds must sustain them. The cash flow profile is often as
important as the overall benefits. For these reasons, knowing how the project will be financed,
and who will provide the funds and on what terms, is important. Is adequate financing available
for the project? How will the financing arrangements affect the distribution of the project's
benefits and costs? Is concessional foreign financing available only for the project and not
otherwise?
8) What Is the Project's Environmental Impact?

An important difference between society's point of view and the private point of view concerns
costs or benefits attributable to the project that are not reflected in its cash flows. When these
costs and benefits can be measured in monetary terms, they should be integrated into the
economic analysis. In particular, the effects of the project on the environment, both negative
(costs) and positive (benefits), should be taken into account and, if possible, quantified and
valued in monetary terms. The impact of these external costs and benefits on specific groups
within society especially the poor should be borne in mind.
9) Techniques for Assessment: Is the Project Worthwhile?

After taking into account all the costs and benefits of the project, the analyst must decide
whether the project is worth undertaking. Costs and benefits should be quantified whenever
reasonable estimates can be made, but given the present state of the art, quantifying all the
benefits and costs is not always possible. Various proxies or intermediate output may have to
suffice. The net present value is the appropriate yardstick for judging the acceptability of projects
whose benefits are measured in monetary terms. To be acceptable on economic grounds, a
project must meet two conditions:
 The expected net present value of the project must not be negative.
 The expected net present value of the project must be higher than or equal to the expected
net present value of mutually acceptable project alternatives.
For other projects, physical indicators of achievement in relation to costs, or cost-effectiveness,

are appropriate. In some other cases, a qualitative account of the expected net development
impact might have to suffice. In all cases, however, the economic analysis should give a
persuasive rationale for why the benefits of the project are expected to outweigh its costs, that is,
economic analysis should give the reasons for expecting the net development impact of the
project to be positive. When analysts carry out quantitative analysis, they should apply economic
prices, not market prices.

10) Is This a Risky Project?

Economic analysis of projects is necessarily based on uncertain future events and involves
implicit or explicit probability judgments. The basic elements in the costs and benefits streams
are seldom represented by a single value. More often they are represented by a range of values
with different likelihood of occurring. Therefore, analysts should take into consideration the
range of possible variations in the values of the basic elements and reflect clearly the extent of
the uncertainties attached to the outcomes. At the very least, economic and risk analysis should
identify the factors that could create the greatest risks for the project. To the extent possible, the
analysis should also identify and reflect the likelihood that these variables may deviate
significantly from their expected value and show the major factors affecting these deviations.
The analysts should be explicit about actions taken to reduce these risks.
4.2. Scope of Economic Analysis

The purpose of the economic analysis of projects is to bring about a better allocation of
resources, leading to enhanced incomes for investment or consumption. For a directly productive
project, where the output is sold in a relatively competitive environment, choices are made
within the economy to ensure that projects selected for investment meet a minimum standard for
resource generation and to weed out those projects that do not. For an indirectly productive
project, where the output is not sold in a competitive environment, choices are made within the
project between different means of achieving the same objectives. Economic analysis is used to
choose the means using the least resources for a given output. All resource inputs and outputs
have an opportunity cost through which the extent and value of project items are estimated.
Projects should be chosen where the resources will be used most effectively.
Economic viability depends upon the sustainability of project effects. Projects are sustainable if
their net benefits or positive effects endure as expected throughout the life of the project.
Sustainability is enhanced if environmental effects are internalized, and if financial returns
provide an adequate incentive for project related producers and consumers. Sustainable
development is concerned also with distributional issues. When looking at the distribution of
project effects and judging project social acceptability, it is important to determine who benefits
and who pays the costs. An assessment of the capacity of the project to cope with an uncertain
future is another measure. Sensitivity analysis is applied when testing projects for both
productive and allocative efficiency. The scope of economic analysis seeks to address several
issues in the economic analysis of Bank project loans (see Figure 1). Previous practice focused
on forecasting demand, choosing least‐cost options, and, where possible, calculating the
economic internal rate of return.
The demand forecasts themselves depend upon project charges and affordability, which also
affect financial incentives for different participants. At the same time, environmental effects can
now be incorporated into the analysis, and policy dialogue requires a statement of the
distribution of project effects. This broadening of the scope of economic analysis must be

tailored to the particular project and the issues it generates. In some cases, project preparation
does not end with the decision to accept a project. In process projects, design and appraisal are
continual and go along with project implementation. This allows for greater participation by
project beneficiaries in the design and testing of different options. Economic analysis can be
applied at the outset of such projects to test the underlying rationale. The principles of economic
analysis can be applied at key decision points in the process. The procedure for undertaking
economic analysis follows a sequence of interrelated steps:
 Defining project objectives and economic rationale;
 Forecasting effective demand for project outputs;
 Choosing the most cost effective way of attaining the project objectives;
 Determining whether economic benefits exceed economic costs;
 Assessing whether the projects net benefits will be sustainable throughout the life of the
project;
 Testing for risks associated with the project;
 Identifying the distributional effects of the project, particularly on the poor; and
 Enumerating the non quantifiable effects of the project that may influence project design
and the investment decision.
For indirectly productive projects, economic analysis would comprise all of the above steps,
except determining whether economic benefits exceed costs.
Basically, the procedures followed and the criteria used (NPV, IRR, BCR) are the same in
economic and financial analysis of projects. But the values, which the NPV, IRR and BCR

assume, are different in economic analysis and financial analysis. The main factors, which
explain this difference, are:
 The items considered as inputs and outputs of the project

 The prices used in the valuation of inputs and output
 The treatment of taxes, subsidies and other transfer payments
Dear learner! Would you please explain the concept and significance of economic
analysis of a project?
4.2.1. Items Considered as Inputs and Outputs

Often, some real costs and benefits attributed to projects do not appear among its inputs and
outputs when it is analyzed from the enterprises viewpoint and, therefore, they do not enter the
calculations of financial NPV, IRR, and benefit cost ratio. The main reason for excluding certain
cost and benefits is that they are considered “external” to the enterprise. But costs or benefits
viewed as “external” to the enterprise are “internal” when they are considered from the
economy‟s angle; somebody pays for these “external” costs and somebody receives these
“external” benefits, even if it is not the enterprise. Consequently, to the extent that they can be
measured and valued they are included in the calculations of the economic NPV, IRR, and BCR.
4.2.1.1. Meaning, Sources and Implications of Market Failure

In a perfectly competitive market, the opportunity cost of an item would be its price, and this
price would also be equal to the marginal value product of the item. If a non‐traded item is
bought and sold in a relatively competitive market, the market price is the measure of the
willingness to pay and is generally the best estimate of an opportunity cost. In a perfectly
competitive market, the opportunity cost of an item would be its price which in turn will equal
the marginal value product of the item. Most agricultural projects are expected to meet a growing
demand for food or fiber and are small relative to the total agricultural production of the nation.
If that is the case, in general we can accept the market price directly as our estimate of the
economic value of a non‐traded item. Also, if we are valuing a domestically produced project
input that is produced by a supply industry operating near full capacity, we can generally accept
the market price of the input as its economic value.
In a neo‐classical world, domestic price is presumed to reflect marginal utility of consumption on

the one hand, and marginal production cost on the other. The legitimacy of such an assumption is
conditional upon certain well‐known conditions being satisfied; i.e. homogeneous goods (in
quality), perfect knowledge of all economic agents, large number of competitors, absence of
externalities, acceptance of the ruling pattern of income distribution, ability of consumers to be
the best judges of their welfare and so on. That some, or all, of these conditions may not hold is
widely recognized, particularly in the case of LDCs where income disparities are likely to be
very wide, markets poorly articulated, and choice information at a premium. Nevertheless, it has
usually been convenient to justify valuation decisions „as if‟ such conditions did hold.

Economic analysis will state the cost and benefit to the society of the proposed project
investment either in opportunity cost or in values determined by the willingness to pay. The costs
or values will be determined in part by both the resource constraints and the policy constraints
faced by the project. Basically, one major argument in favor of economic pricing (against
financial analysis of projects) is that of market failure. What do we mean by market failure and
why does the market fail? Divergence between market and economic price is simply what we
mean by market failure. It occurs whenever the market fails to function effectively or when the
government intervenes. The market fails when it can‟t value appropriately project costs and
benefits! Market failure manifests itself in different forms:
A. Failures of Competition: The existence of various types of monopoly power in the
economy, for example the existence of localized trading monopolies on the supply of
consumer goods to rural areas or in the purchase of crops from farmers brings absence of
competition.
B. Failures of Provision / Incomplete Markets / Missing Markets: The existence of a class of
goods and services that private operators are not prepared to supply because once they are
made available it is impossible to exclude individuals from making free use of them (public
goods) such as street lighting, police force, road in LDCs, national defense, and so on. Where
markets fail to produce commodities or services for which there is a private demand at prices
above production costs, due to transaction cost and moral hazard, and adverse selection
problems is another source of market failure. The credit market and the insurance business
with high risks of default and high cost of enforcing the agreement in the transaction are
possible cases in point.
C. Open Access Resources: Resources of communal access (e.g. forestry for firewood, wild
life, fishery, where the private cost of using more of resource is lower than the social cost
incurred by the community as a whole, resulting in over ‐ exploitation (over‐fishing, over‐
grazing, and over‐hunting and possible permanent damage to the resource) which is the result
of absence of well defined property rights is another source of market failure.
D. Failures of Information: A tendency to under‐produce (due to private interest) the type of
information to which everyone should have access if markets are to work well (e.g.
information on prices and technologies) is another source of market failure problem.
E. Macro-economic Problems: Problems that can only be handled by a central authority, like
money supply inflation, exchange rate, taxation, balance of payment problems and soon are
problems which are never the concerns of private investors from whose point of view
financial CBA is normally done
F. Poverty and Inequality: The market outcome may result in a degree of inequality or an
incidence of poverty that is regarded as unacceptable by the majority of people in society.
G. Environmental Problems, Futures Generation and Sustainability: These are very
difficult, controversial and debatable issues of recent origin in the economics literature. They
are hardly dealt by the interplay of demand and supply. Therefore, the market fails due
mainly to the absence of coincidence of national and private objectives.

4.2.1.2. Government Intervention

As there is market failure, there is also government failure which needs to be taken care of.
Government intervention takes different forms ‐ protective trade policies (import taxes,
subsidies, quotas, and import licensing); unrealistic rates of fixed exchange rates ‐ overvalued
currencies; government controls of interest rates ‐ subsidized interest rate; controls on prices,
production, and sales; private monopolist controls of production prices; government or trade
union pressure (wage rates exceeding real cost of labor ‐ minimum wage legislation); and so on.
In financial analysis, the project analyst is concerned with the profitability of the project from an
individual (firm's profitability) point of view. 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. Given the prevailing market
prices the financial analysis will tell the project analyst whether a project will be financial
profitable. Thus, governments and other individuals can pursue only limited objectives when
they choose projects on the basis of financial appraisal. However, 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 or not. In financial analysis prices could be
distorted because of:
 Failure of markets
 The absence of perfect knowledge and the existence of externalities, consumer and producer
surplus, government and public goods, etc.
So that governments must choose projects on the basis of an economic analysis if they wish to
promote the community's welfare. It is useful to have a full understanding of the areas where
government intervention and market failure result in serious distortion in market prices. The
major conditions under which it is impossible to use market prices to assess the economic worth
of projects can be grouped under the following headings:
1) Government intervention in and/or failures of goods market; including the markets for
internationally traded goods.
2) Government intervention in and/or failure of factor markets including the market for labor,
capital, and foreign exchange.
3) The existence of externalities, public goods, and consumer and producers surplus.
1) Government Interventions and /or Failure of Goods Market.

a) Failure of Domestic Goods Market
The true economic value of a good produced by a project, which can be called its marginal social
benefit, or how much it will add to community welfare, is in general measured by what people
are willing to pay for that good. Traditionally this is reflected by the market prices of the

commodity. But the market price of that commodity will not measure what people are willing to
pay for it unless the following conditions are met:
1) If there is no price controls in the market for the good. That is the quantity of the good that is
demanded by consumers must equal the quantity supplied by producers, and the price of the
good must be its competitive demand price.
2) If there is no consumer's surplus from the consumption of the good. If people are willing to
pay more than they actually have to pay for a project output, then these market prices do not
reflect the true value of the good produced by the project.
3) If there is no monopsony buyer who is large enough to force the project to sell its output
below the price that the monopsonist is really willing to pay.
Unless these conditions are met the good's market price will not reflect people's true willingness
to pay for the good and will not be a good measure of the income in welfare that people will
obtain from consuming the project's output. If any of these market imperfections exist, it will be
necessary to use corrective measures (shadow prices).
Figure 2: Goods market distortions, price fixing

Price In the figure the price of controlled
P Qs commodity is set at Pmf, below the market-
clearing price (equilibrium price) Pe.
Pe This results in excess demand for the
commodity (Qd - Qs), so the existence of
Pmf controlled price will result in rationing of
Qd the commodity.
𝑃𝑑 𝑃𝑠 𝑃𝑒
𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑃𝑟𝑖𝑐𝑒 Q
b) Trade protection and Intervention in the Markets for internationally traded goods
Governments frequently intervene in import markets by imposing quotas & tariffs to protect
infant industries that are internationally competitive. Tariffs and quotas will causeFixed price
a divergence
between local market prices and the world prices of internationally traded goods.
Fig 3: Traded goods market distortions - Import quota. Ds
P Qs An import quota will push theQuantity

domestic
good
Qs market cost Qd
of the input to Pmd, well above
Pmd
the foreign exchange cost to the economy
Excess demand
of importing the input, which is the world
Pw
price Pw. So, such import quota over value
Qd the social cost of the traded input used by
Q the project.
DS
World supply curve
Qs
𝑃𝑚𝑑
Import Quota
2) Failures of /or Interventions in Factor Market

The true economic cost to an economy of a project's input, its marginal social cost, will be
measured by its economic opportunity cost to suppliers. The market price of an input will equal
to its opportunity cost of production if the following conditions are met:
 There are no rationing, price controls or taxes in factor markets
 There is no producer's surplus in the market price of the input
 There is no monopsony buyer who is in a position to force the factor's market price below
their marginal revenue product and hence the price they would be willing to pay for it.
a. Intervention in the Labor Market:
Labor markets are frequently regulated with fixed minimum wage rates or centrally fixed
wage rates for formal sector jobs. If these wages rates are set above the Market clear levels,
there is likely do open unemployment or disguised unemployment. This is particularly true for
unskilled labour. In the case of skilled labour, fixed wage rates may actually be set below
market clearing levels causing an artificial shortage of skilled labour.
Figure 4: Labour market distortions - fixed wage rates
W The government fixed wage Wm
D SL
fixed above the market equilibrium
Ls wage We. This will result in
Wm unemployment of labour
Gov’t fixed wage
(unskilled) with the number of such
workers offering themselves for the
formal sector jobs, Workers S
Ld exceeding demand, Workers D.
Q
The existence of open unemployment or underemployment L will indicate to the project analyst
S
that market wage for the categories of labour concerned is greater than its marginal social cost.
Qs Workers S
The project analyst willWorkers DL
need toDadjust these wage rates downwards until they reflect the true
social cost of labour in the country, the shadow wage rate.
b. Intervention in / or Failure of Capital Market:

Another important factor market in which governments often intervene by fixing prices is the
S I - Investment
capital market. In Iorder to encourage investment interest rates are often kept low. Fixed interest
The rate
interest
Supply Quantity Labour
rate paid for investible funds is held down to Imf well below the equilibrium interest rate. As
savings
more people wish to borrow than to save at this low interest rate there will be an excess demand
for capital funds. It will then be necessary to ration the available credit to preferred borrowers. In
addition government routinely tax both borrowers and lenders introducing further distortions into
the capital market. For these reasons market interest rates should not be used to discount future
income streams in an economic analysis. The government will have to estimate the social
discount rate that better reflects the opportunity cost of using investible funds in a project.

c. Intervention in Foreign Exchange Markets:

Many countries often peg or manage their foreign exchange rate. Often the exchange rate is set
significantly above its free market level in terms of say a US dollar per unit of local currency.
Exchange rate
Overvaluation of local currency is a common practice in developing countries. Currency
overvaluation creates an apparent shortage of foreign exchange. This happens because at the
overvalued exchange rate imports appear cheap relative to locally produced goods unless tariffs
are imposed, demand for imports will rise. On the other hand currency over valuation makes
exporting as compared with supplying the local market, financially unattractive to producers.
The price that exporters receive in local currency for a given dollar value of exports is reduced if
the exchange rate is overvalued.
The official exchange rate is fixed at OER. This will result in excess demand for foreign
exchange Qfed-Qfes. In these circumstances the official exchange rate will understate the true
value of foreign exchange to the country concerned. This is given by the shadow exchange rate,
SER, the amount residents are willing to pay for the fixed quantity of foreign exchange available
Qfes. Use of the OER in project appraisal will have the effect of undervaluing projects that
produce exportable outputs and overvaluing those that use imported inputs. The overvaluation of
the exchange rate must be corrected in an economic analysis. One method of doing this is to
employ a shadow exchange rate to convert foreign prices into local currency.
3) Externalities And Public Goods

Another reason why the perfect world of neoclassical theory fails to represent the real world is
the existence of public goods and externalities. A financial analysis of a project that uses or
produces public goods and externalities, therefore, will fail to capture the full impact of a project
on the community‟s welfare.
a) The Existence of Externalities

Externalities are created in the process of producing, distributing and consuming many goods
and services. There are positive or negative attributes or effects of a good or service, or its
production, that are not directly felt by the people who buy it and hence may not be reflected in
the price they are willing to pay for it. Some costs and benefits do not appear among its inputs
and outputs when it is analyzed from the enterprises or individual‟s viewpoint and thus do not
enter into the financial NPV and IRR. These items are considered as external to the enterprise
but are internal when they are considered from the economy‟s angle. Somebody pays for the
external costs and someone receives these external benefits even if this is not the enterprise.
Example:
 The costs incurred in providing the project area with infrastructure inputs, e.g. access roads,
energy lines, sewerage services, etc. Although these inputs are required by the project their
cost is often met by the government rather than the enterprise, because often they serve other
purposes too.
 Flood control measures (benefits) resulting from a hydroelectric dam are real benefits to
downstream farmers and the economy but external to the power authority.

 Pollution created in the production of a commodity is a cost to the society but external to the
project.
b) The Existence of Public Goods

Public goods are usually provided free by governments and in financial analysis would therefore,
be priced at zero. However, they do have a beneficial impact on the welfare of those receiving
them, most of whom will be willing to pay for such goods through taxation. But it costs the
society significant sum of money to produce many of the public goods. This is a case where the
market price of a good or service will not reflect its true cost or benefit to the society. If the
project uses public goods as inputs or produces them as out puts it would be wrong to value them
at their market price of zero in many economic analysis of the project. They will have to be
valued at the amount that it is estimated people will be willing to pay for them. In short, public
goods and services can be described as: Goods and services whose use by one person does not
reduce their availability to others.
4.2.2. The prices used in the valuation of inputs and output

Another difference between financial and economic analysis is that even inputs and outputs
“internal” to both the enterprise and the economy are valued differently. In financial analysis the
rule is to value inputs and outputs at actual market prices, at the same time in economic analysis
shadow or Efficiency or Accounting prices are employed. Consequently, using different prices
will give different economic and financial NPV, IRR, and BCR even if the inputs and outputs are
identical in physical terms. For example, the enterprise will have to pay workers the market
wages in real Birrs (not in 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 it is believed that the foreign currency is undervalued.
Again, in financial analysis it is the actual expenditure and revenue, which matter, not shadow
ones. Market prices, which form the basis for computing the monetary costs and benefits from
the point of view of project sponsor reflect social values only under conditions of perfect
competition, which are once in a blue moon, if ever, realized by developing countries. When
imperfections are obtained, market prices do not reflect social values. The common market
imperfections found in developing countries are: Rationing, Prescription of minimum wage rates,
and Foreign exchange regulation.
 Rationing of a commodity means control over its price and distribution. The price paid by a
consumer under rationing is often significantly less than the price that would prevail in a
competitive market.
 When minimum wage rates are prescribed, the wages paid to labour are usually more than
what the wages would be in a competitive labour market free from such wage legislations.

 The official rate of foreign exchange in most of the developing countries, which exercise
close regulation over foreign exchange, is typically less than the rate that would prevail in the
absence of foreign regulation. This is why foreign exchange usually commands premium in
unofficial transactions.
4.2.3. The Treatment of Taxes, Subsidies and other Transfer Payments

Some payments that appear in the cost streams of financial analysis do not represent economic
costs, but merely a transfer of the control over resources from one group in society to another.
Transfer payments 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. Thus transfer payments are payments made among different persons/economic
agents/ but they are not related to any particular resources cost. So they do not reflect changes in
the national economy. The term direct transfer payment notifies payments that show up directly
in the project accounts but do not affect National income. Direct transfer payments redistribute
national income and generally affect the government treasury, positively or negatively. When
looking at the project from the project entity's point of view, taxes and subsidies affect the
benefits and costs of the project.
When looking at the project from society's viewpoint, however, a tax for the project entity is an
income for the government, and a subsidy for the entity is a cost to the government; the flows net
out. Hence transfer payments have to be excluded from all estimates of economic costs and
benefits during the economic analysis of a project. It is to be noted that transfer payments affect
the distribution of income though they don‟t affect the overall level of resources available to the
economy/society/. Taxes and subsidies should not be disregarded altogether.
Transfer payments affect the distribution of project costs and benefits and, hence, are important
to assess gainers and losers. If taxes and subsidies render a project unfeasible from the project
entity's viewpoint, they are important in assessing project sustainability. A complete profile of
the project should identify not only the amounts involved in taxes and subsidies but also the
groups that enjoy the benefits and bear the costs. Usually, the government collects the taxes and
pays the subsidies. In these cases, the difference between the financial and economic analysis
accounts for a major portion of the fiscal impact of the project.
The other reason why financial and economic NPV and IRR might differ emanates from the
treatment of taxes, subsidies and other transfer payments. This issue relates to the valuation of
inputs and outputs discussed above, but it is treated separately because of its importance in
practice. Taxes and customs duties from which the enterprise is not exempted are taken as cost in
financial analysis although they do not reflect commitment of real resources; for this reason they
are excluded from the calculations of the economic NPV and IRR. Similarly, subsidies paid to
the enterprises by the government are viewed as transfer payments and are excluded from
consideration in economic analysis, but they are treated like any other revenue of the enterprise

in computing the financial NPV or IRR or BCR. In addition to the factors discussed above, the
impact of the project on savings, its effect on redistribution, and the consideration for merit
goods are also seen as the other factors that entail differences between financial and economic
analysis of projects:
i. Concern for Savings: Unconcerned about how its benefits are divided between
consumption and savings, a private firm does not put differential valuation on savings
and consumption.
From a social point of view, however, the division of benefits between consumption and
savings (which leads to investment) is relevant, particularly in capital‐scarce developing
countries. One Birr of benefits saved is deemed more valuable than a birr of benefits
consumed. The concern of society for savings and investment is properly reflected in
SCBA wherein a higher valuation is placed on savings and a lower valuation is put on
consumption.
ii. Concern for Redistribution: A private firm does not bother how its benefits are
distributed across various groups in the society. The society, however; is concerned about
the distribution of benefits across different groups. One Birr of benefit going to a poor
section is considered more valuable than a Birr of benefit going to an affluent section.
iii. Merit Wants: Goals and preferences not expressed in the market place, but believed by
policy makers to be in the larger interest, may be referred to as merit wants. For example,
the government may prefer to promote an adult education program or a balanced nutrition
program for school‐going children even though; these are not sought by consumers in the
market place. While merit wants are not relevant from the private point of view, but
relevant from social point of view.
For the reasons discussed above the financial and economic analysis of a project will show a
different picture, particularly as regards the NPV, IRR, and BCR. In analyzing public projects in
particular both the financial analysis and the economic analysis should be conducted. This is
especially user‐to view a project from various angles and to obtain different perspectives.
Decision makers need both profiles in order to evaluate a project and to design the necessary
fiscal and monetary measures to meet its financial requirements. In deciding on the acceptance or
rejection of such projects, the economic criterion is superior to the financial one, and when a
project passes the economic test it is an acceptable project for the country. It should be
implemented provided that the government will take the necessary financial and other measures
to ensure its smooth operation. `
A project, for example, that shows very low, or even negative financial returns as a result of the
fact that the major benefits it generates are “external” to and cannot be captured by the
enterprise, could show acceptable economic returns when these benefits are considered as
“internal” to the economy and are valued accordingly. In this case the solution is to subsidize the
enterprise sufficiently so that it will stay in operation and generate these benefits. However,
although this is the economically rational approach, one should be careful with projects that pass
the economic test but fail the financial test. The project analyst explaining the pass/fail situation

with projects that pass/fail the financial and economic test should present convincing data and
justification in such a way that one can feel more comfortable.
I. Taxes versus User Charges

Some care must be exercised in identifying taxes. Not all charges levied by governments are
transfer payments. Some are user charges levied in exchange for goods sold or services rendered.
Water charges paid to a government agency, for example, are a payment by farmers to the
irrigation authority in exchange for the use of water. Whether a government levy is a payment
for goods and services or a tax depends on whether the levy is directly associated with the
purchase of a good or a service. Also, it must accurately reflect the real resource flows associated
with its use. For example, irrigation charges frequently do not cover the true cost of supplying
the service. While they indicate a real resource flow as opposed to a pure transfer payment, the
real economic cost would be better measured by estimating the long-run marginal cost of
supplying the water and showing the difference as a subsidy to water users.
II. Subsidies
Subsidies are taxes in reverse. They shift control over resources from the giver to the recipient
and do not constitute a cost to society. As with taxes, analysts must keep track of the recipient's
benefit and the giver's cost to present a complete picture of project flows. Because the flows net
out, they are not a cost to society. Nevertheless, because subsidies often flow from the
government to the project entity, they are part of the project's fiscal impact, and analysts must
take care to show them explicitly.
III. Donations and Contributions in Kind

In some cases, the project entity receives goods and services free of charge. For example,
hospitals may receive costly medical equipment as gifts from the private sector or
nongovernmental organizations. When evaluating projects from society's viewpoint, it is
important to include these items. It is customary to impute a value to the goods and services so
rendered by valuing them at their market price as a first approximation to their economic cost.
The next chapter will deal with the valuation problems in more detail.
IV. Interest Payments and Repayment of Principal

Financial costs are an important component of a firm's income statement. Debt service-the
payment of interest and the payment of principal entails cash out lays, but is never the less
omitted from economic and financial analysis. In both cases assessing the quality of the project
independently of its financing mode is what matters most. Another reason for excluding debt
service from economic analysis is that debt service does not entail a use of resources, but only a
transfer of resources from the payer to the payee.
Gittinger (1982) states the rationale clearly: From the standpoint of the farmer [who receives a
loan], receipt of a loan increases the production resources he has available; payment of interest
and repayment of principal reduce them. But from the standpoint of the economy, things look

different. Does the loan reduce the national income available? No, it merely transfers the control
over resources from the lender to the borrower. A loan represents the transfer of a claim to real
resources from the lender to the borrower. When the borrower pays interest or repays the
principal, he is transferring the claim to the real resources back to the lender but neither the loan
nor the repayment represents in itself, use of the resources (Gittinger, 1982).
V. Consumer Surplus
In some cases, a project may not only increase output of a good or service but also reduce its
price to consumers. When a project lowers the price of its output, more consumers have access to
the same product, and the old consumers pay a lower price for the same product. Valuing the
benefits at the new, lower price understates the project's contribution to society's welfare. If the
benefits of the project are equated with the new quantity valued at the new price, the estimate of
benefits ignores consumer surplus-the difference between the maximum amount consumers
would be willing to pay for a product and what they actually pay. In principle, this increase in
consumer surplus should be treated as part of the benefits of the project. There may also be a
gain in consumer surplus without any decline in price. If supply is rationed at a price below what
consumers would be willing to pay, an increase in supply at the same controlled price involves a
gain in consumer surplus over and above what consumers actually pay for the increase. This may
be particularly significant for public utility projects.
VI. Externalities and Linkage Effects
[A] Externalities
Externality is an economic problem that arises as a result of relationships among economic
agents whereby agent „A‟ is benefited or not benefited by other economic agent (s) without being
charged or paid for the benefit derived or the cost incurred. Externalities may be positive or
negative. Positive externalities may be production or consumption. Externalities, created by
another agent, which have positive production effect to an economic agent without his / her
intention, are called positive production externalities while externalities of opposite nature are
called negative production externalities. Externalities, created by another agent, which have
positive utility effect to an economic agent without his/her intention, are called positive
consumption externalities while externalities of opposite nature are called negative consumption
externalities. These „good- positive externalities‟ or „bad ‐ negative externalities‟ do not have a
market price.
Costs that are not incurred by the private operator but represent negative benefits to other
members of the community, such as the impact on downstream river users of pollution by a
private industrial plant (negative externality), or benefits that do not accrue to the private
operator but represent gains to society, such as the beneficial impact of higher education on the
level of skills in the country and workers‟ on the job training (positive externality) are some of
the practical externality problems. Smoke coming from a cigarette smoker in your dormitory is a
negative consumption externality. Waste disposal by a factory to fisherman‟s river is negative

production externality. The mutual beneficial relationship between the bee keeper and
horticulture farmer is a positive production externality to both economic agents. A garden freely
made available to someone by his / her neighbor is positive consumption externality. In addition
to the above mentioned ones, externalities may take different forms:
 Price effects, one form of externality whereby higher price may be the result of undertaking
the project for inputs that it requires and lower price for outputs that it produces.
 For projects that produce an export product or that use an import input, there may be a price
externality with an international dimension - effect of the project on world price.
 Increased competition as a result of the project may be another externality effect
Unfortunately, externalities are mostly difficult to identify and nearly always difficult to
measure. However, whether or not externalities can be quantified, they should at least be
discussed somewhere in the project document in qualitative terms. The general principle in
considering externalities in economic analysis is that the effects should be measured and, where
possible, valued so that they can be included in the costs and benefits of the project. This is what
is sometimes called „internalizing the externalities‟. Externalities may be considered as a special
class of non‐traded goods that may be either positive or negative.
[B] Linkage Effects

Linkage effects occur when the activities of one project cause an increase (or a decrease) in
economic activity elsewhere in the economy. To some extent this happens with all projects.
Forward linkage effects may occur is industries that use or process a project‟s output, and
backward linkages in industries that supply its inputs. Such industries may be encouraged or
stimulated by increased demand and higher prices for their output or lower prices for their inputs.
For economic analysis, what is important is whether the linkage effect is a necessary
consequence of the project. For instance, production and processing of the perishable primary
products is the case in point. In Ethiopia, this applies particularly to the sugar and tea industries.
Sugarcane has little or no economic value outside the immediate production system in which it is
produced unless it is processed in a sugar mill. One can find forward (input supplying) and
backward (output purchasing) linkage effects. A project which affects sugarcane production,
therefore, necessarily has some consequences for the sugar industry (a forward linkage).
The economic analysis of a sugarcane production project would, therefore, have to extend the
boundaries of the project to include the impact of the project on the sugar industry. The linkage
from the sugarcane farm to the sugar mill could be looked at in another way (backward linkage
effect) if a new sugar mill were to be established in an area that was previously too inaccessible
for sugarcane production to take place. The new sugar mill would not make any sense without a
supply of sugarcane and so it would be necessary to include the backward linkage to the
sugarcane farmers in the economic analysis of the project.
The sugarcane example above can be contrasted with the situation in the meat sector. The
livestock sector has an export market in the form of live animals. A livestock production project

might cause more animals to be sold to meat processing industries but it is not a necessary
consequence of the production of the livestock. The decision whether or not to slaughter the
animals locally can be regarded as a separate economic decision that depends on whether the
meat industry can pay at least as much as the exporters for animals. Since the linkage effect is
not a necessary one it would not be included in the economic analysis of the livestock project.
Similarly, the decision to establish a meat processing project can be separated from the decision
to produce more livestock. If Ethiopia is regarded as a net exporter of livestock, establishment of
additional meat processing capacity might have the effect of reducing net livestock exports rather
than increasing livestock production. In practice, it is usually only backward linkages that can be
picked up.
4.3. Identification of Costs & Benefits of Economic Analysis

Identifying costs and benefits is the first and most important step in economic analysis. Often
project costs and benefits are difficult to identify and measure, especially if the project generates
side effects that are not reflected in the financial analysis, such as air or water pollution. A
second important step is to quantify them. The final step is to value them in monetary terms. The
major steps in economic analysis can be summarized as:
1) Identification of cost and benefit items that need to be incorporated in economic analysis; this
involves the inclusion of some variables and exclusion of others from the economic
accounts.
2) Quantify both the cost and benefit items;
3) Revalue the cost and benefit items; i.e. what prices to use?
The projected financial revenues and costs are often a good starting point for identifying
economic benefits and costs, but two types of adjustments are necessary. First, we need to
include or exclude some costs and benefits. Second, we need to revalue inputs and outputs at
their economic opportunity costs. Financial analysis looks at the project from the perspective of
the implementing agency. It identifies the project's net money flows to the implementing entity
and assesses the entity's ability to meet its financial obligations and to finance future
investments. Economic analysis, by contrast, looks at a project from the perspective of the entire
country, or society, and measures the effects of the project on the economy as a whole. These
different points of view require that analysts take different items into consideration when looking
at the costs of a project, use different valuations for the items considered, and in some cases,
even use different rates to discount the streams of costs and benefits.
Financial analysis assesses items that entail monetary outlays. Economic analysis assesses the
opportunity costs for the country. Just because the project entity does not pay for the use of a
resource, does not mean that the resource is a 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. Many projects involve economic costs that do not necessarily
involve a corresponding money flow from the project's financial account. For example, an

adverse environmental effect not reflected in the project accounts may represent major economic
costs. Likewise, a money payment made by the project entity--say the payment of a tax--is a
financial but not an economic cost. It does not involve the use of resources, only a transfer from
the project entity to the government. Finally, some inputs say the services of volunteer workers--
may be donated, entailing no money flows from the project entity. Analysts must also consider
such inputs in estimating the economic cost of projects.
Another important difference between financial and economic analysis concerns the prices the
project entity uses to value the inputs and outputs. Financial analysis is based on the actual prices
that the project entity pays for inputs and receives for outputs. The prices used for economic
analysis are based on the opportunity costs to the country. The economic values of both inputs
and outputs differ from their financial values because of market distortions created either by the
government or by the private sector. Tariffs, export taxes, and subsidies; excise and sales taxes;
production subsidies; and quantitative restrictions are common distortions created by
governments. Monopolies are a market phenomenon that can either be created by government or
the private sector. Some market distortions are created by the public nature of the good or
service. The values to society of common public services, such as clean water, transportation,
road services, and electricity, are often significantly greater than the financial prices people are
required to pay for them. Such factors create divergence between the financial and the economic
prices of a project.
Economic and financial costs are always closely intertwined, but they rarely coincide. The
divergence between financial and economic prices and flows shows the extent to which someone
in society, other than the project entity, enjoys a benefit or pays a cost of the project. Sometimes
such payments are in the form of explicit taxes and subsidies, as in a sales tax; sometimes they
are implicit, as in price controls. The magnitudes and incidence of transfers are important pieces
of information that shed light on the project's fiscal impact, on the distribution of its costs and
benefits, and, hence, on its likely opponents and supporters. By identifying the groups benefiting
from the project and the groups paying for its costs, the analyst can extract valuable information
about incentives for these groups to implement the project as designed, or to support it or oppose
it.
A thorough evaluation should summarize all the relevant information about the project. To look
at the project from society's and the implementing agency's viewpoint, to identify gainers and
losers, and ultimately to decide whether the project can be implemented and sustained, it is
necessary to integrate the financial, fiscal, and economic analyses and identify the sources of the
differences.
4.3.1. Sunk Costs

For both financial and economic analysis, the past is the past. What matters are, future costs and
future benefits. Costs incurred in the past are sunk costs that cannot be avoided. When analyzing
a proposed project, sunk costs are ignored. Economic and financial analyses consider only future

returns to future costs. Ignoring sunk costs sometimes leads to seemingly paradoxical, but
correct, results. If a considerable amount has already been spent on a project, the future returns to
the costs of completing the project may be extremely high, even if the project should never have
been undertaken.
As a ridiculous extreme, consider a bridge that needs only one dollar to be completed in order to
realize any benefits. The returns to the last dollar may be extremely high, and the bridge should
be completed even if the expected traffic is too low to justify the investment and the bridge
should never have been built in the first place. However, arguing that a project must be
completed just because much has already been spent on it is not valid. To save resources, it is
preferable to stop a project midway whenever the expected future costs exceed the expected
future benefits.
On the other hand, although stopping a partially completed project may be more economical than
finishing it, closing a project is often costly. For example, one may have to cancel partially
completed contracts, and lenders may levy a penalty. Such costs have to be taken into account in
deciding whether or not to close the project. Similarly, the cash flow of a project should show
some liquidation value at the end of the project. This liquidation value should be counted as a
benefit. Sometimes, to focus attention on the years for which the information is more reliable, we
use the estimated liquidation value of a project as of a certain year.
4.3.2. Determining Economic Values

Valuation of the Impact of a Project: Pareto Optimality Vs. the Hicks Kaldor
Compensation Principle
This section is meant to lay the theoretical basis for evaluating the worth of a project. Different
economists are concerned with the valuation of alternative economic situations (state,
configurations) from the point of society‟s well-being. To evaluate alternative economic
situations, we need to have criteria for evaluating social well-being or welfare (social welfare
function). Measurement of welfare requires some ethical standard and interpersonal
comparisons, both of which involve subjective value judgments. Welfare economics is
concerned with the evaluation of alternative economic situations from the point of the society‟s
well-being. Welfare analysis is a systematic method of evaluating economic implications of
alternative allocations. Welfare analysis gives answers to the following questions:
 Is a given resource allocation efficient?
 Who gains and who loses under various resource allocations? By how much?
Related to the above two questions, the two major tasks of welfare economics (WE) are:
1) To show/measure present day welfare (W) and show whether or not the present welfare is
less than the optimal welfare (W*), i.e. W<W*
2) Suggest ways to rise W to W*.
Welfare economics is a methodological approach to assess resource allocations and establish
criteria for government intervention. Once a project‟s financial cost and benefits have been

identified, valued in market prices and entered in the cash flow, the remaining task is to use this
information to determine whether or not the project will be profitable and should be selected for
implementation. The basic selection criterion, which is applicable in both financial and economic
analyses, is that a project should not be undertaken unless its benefits outweigh its costs. The
theoretical justification for this rule is the Hicks - Kaldor selection criterion.
The standard measure employed in welfare economics to determine whether a change in resource
allocation will result in people being better off is the Pareto welfare improvement criterion. A
Pareto improvement in welfare is said to occur if at least one person is made better off and no
one is made worse off by a given change in economic conditions. When using this criterion it is
unnecessary to make any comparison between the utility (welfare) enjoyed by different people as
a result of any change in their income, since everyone must either be unaffected or made better
off by the change for it to be considered a Pareto welfare improvement. However, if projects
could only be implemented when they were expected to result in an actual Pareto welfare
improvement, it is obvious that very few, if any, would be approved. This is because there will
always be someone who is made worse off by the improvement of project, such as a tax payer
who does not receive any benefit.
To overcome the restrictive nature of Pareto unanimity rule, the concept of a potential Pareto
improvement or the compensation principle, was developed by Hicks (1939) and Kaldor (1939).
This criterion states that a given change in the allocation of resources will potentially improve
welfare if those who gain could compensate those who lose, and still be better off themselves.
The Hicks-Kaldor compensation principle is central to the theoretical justification for cost
benefit analysis in welfare economics. This criterion provides the rationale for choosing projects
whose benefits outweigh their costs, even if the people who gain from a project are not the same
as those who pay for it. The excess of benefits over costs is called the project‟s net benefit. A
crucial element of this criterion is that it is not necessary for the gainers from a project to actually
compensate the losers, only for them to be able to do so if they wished and still remain better off
than if the project had not been implemented.
Hence a project that meets the Hicks - Kaldor hypothetical compensation criterion will not
necessarily result in an actual Pareto welfare improvement, only a potential improvement. The
Hicks - Kaldor criterion can be criticized because of its failure to address the distributional
impacts of projects. Total welfare will not necessarily be increased even if a project meets the
Hicks - Kaldor criterion, unless those who gain receive the same increase in their utility from an
extra unit of income as those who lose from the project. However, it is a basic tenet of welfare
economics that the poor can be expected to receive a greater increase in their utility or welfare
from 1 extra unit of income than the rich.
That is, the poor are expected to have higher marginal utility of income than the rich. Put simply
a project that costs the poor 1 unit of income and increases the income of the rich by 1.5 units
will pass the Hicks - Kaldor criterion and be selected, but will not increase total community

welfare if the poor value their unit of lost income twice as highly as the rich value each
additional unit of income they gain. Nevertheless, in economic analysis these problems are
largely ignored and it is implicitly assumed that everyone has the same marginal utility of
income. However, the rationale for the social analysis of projects is largely based on this failure
of the Hicks - Kaldor compensation criterion to deal with the distributional issues that will arise
if actual compensation does not take place.
4.4. Social Cost-Benefit Analysis

In essence, project analysis assesses the benefits and costs of a project and reduces them to a
common denominator. If benefits exceed costs both expressed in terms of this common
denominator-the project is acceptable: if not, the project should be rejected. Economic analysis
of projects is similar inform to financial analysis in that both assess the profit of an investment.
The concept of financial profit, however, is not the same as the social profit of economic
analysis.
 The Purpose of Social Cost-Benefit Analysis
When under taking financial and economic project appraisal it is implicitly assumed that income
distribution issues are beyond the concern of the project analyst or that the distribution of income
in the country is considered appropriate. A financial objective is narrow one for a public agency
to pursue and for public decisions. But in most countries governments are not only interested in
increasing efficiency but also in promoting greater equity. When one project is chosen rather
than another the choice has consequences for employment, output, consumption, savings, foreign
exchange earnings, income distribution and other things of relevance to national objectives. The
purpose of social cost-benefit analysis is to see whether these consequences taken together are
desirable in the light of the objectives of national planning.
Therefore, a social appraisal of projects goes beyond economic and financial appraisal to
determine which project will increase welfare once distributional impact is considered. The
project analysts will not be only concerned to determine the level of project's benefits and costs
but also receives the benefits and pays the costs. In a situation where a project is only marginal
from the point of view of an economic analysis but has strong positive distributional benefits, the
analyst may consider a social analysis in addition to the traditional economic analysis.
In an economic analysis of a project it is implicitly assumed that a dollar received by any

individual will increase the community's welfare by the same amount as a dollar received by any
other individual. But an extra dollar given to a very poor person will usually increase the person's
welfare by much more than would a dollar given to a rich person. A rationale in welfare
economic for the social analysis of projects is therefore, quite strong, the marginal utility of
income of a person who receives a low income is expected to be greater than the marginal utility
of income of the same person if he or she receives a high income. An economic analysis of

projects A & B would not capture those differences and would merely indicate that both had the
same positive impact on community welfare.
 Difference between Financial Calculation and Social Cost-Benefit Analysis:

Financial profitability is measured in terms of the difference between the value of earnings and
costs in a certain period. Social cost-benefit analysis must go deeper and ask what the meaning
of profit is.
1) The price offered in the market is not a good guide to Social welfare for it includes the
influence of income distribution on the prices offered. One of the simpler means of income
redistribution may in fact be project Selection. The choice may be between project A to be
located in a poor region or project B to be located in a rich area or between project X which
uses a large amount of poor, unskilled labor which might be un employed and project Y
which uses factors of production supplied by rich people.
2) A project may have influences that work outside the market rather than through it. These
effects are called "externalities” externalities are relevant for social choice and provide a
sufficient argument for rejecting commercial profitability as a guide to public policy.
Externalities may arise in the process of production, in the process of consumption, and in
the process of Sales and distributions.
3) Even in the absence of externalities and consideration of income distribution commercial
profitability may be misleading because of consumer's surplus.
 Two Approaches to Social Cost-Benefit Analysis (SCBA)

Two principal approaches to SCBA have emerged in the late 1960s and early 1970s: the UNIDO
approach and the Little and Mirrlees approach. The UNIDO approach was first articulated in the
Guidelines for Project Evaluation (1972) which provides a comprehensive framework for SCBA
in developing countries. The rigor and length of this work created a demand for a concise and
operational guide for project evaluation in practice. To fulfill this need, UNIDO came out with
another publication, Guide to Practical Project Appraisal in 1978. UNIDO is the specialized
agency of the United Nations that promotes industrial development for poverty reduction,
inclusive globalization and environmental sustainability. The Little and Mirrlees approach (also
known as the OECD approach) was developed by I.M.D. Little and J.A. Mirrlees in their work
Manual of Industrial Project Analysis for Developing Countries, Volume II, Social Cost‐Benefit
Analysis (1968) and Project Appraisal and Planning for Developing Countries (1974). We shall
investigate the two approaches briefly in the following part.
4.4.1. The UNIDO (United Nations Industrial Development Organization) Approach

The UNIDO approach to SCBA involves five stages, each stage of which measures the
desirability of the project from a different angle:
 Calculation of financial profitability of the project measured at market prices.

 Obtaining the net benefit of project measured in terms of shadow or economic (efficiency)
prices.
 Adjustment for the impact of the project on savings and investment.
 Adjustment for the impact of the project on income distribution.
 Adjustment for the impact of project on merit goods and demerit goods whose social values
differ from their economic values.
The measurement of financial profitability of the project in the first stage is similar to the
financial analysis.
Stage two of the UNIDO approach is concerned with the determination of the net benefit of the
project in terms of economic (efficiency) prices, also referred to as shadow prices. Market prices
represent shadow prices only under conditions of perfect markets, which are almost invariably
not fulfilled in developing countries. Hence, there is a need for developing shadow prices and
measuring net economic benefit in terms of these prices.
4.4.1.1.Shadow Pricing: Basic Issues

Before we deal with shadow pricing of specific resources, certain basic concepts and issues must
be discussed: choice of numeraire, concept of tradability, source of shadow prices, treatment of
taxes, and consumer willingness to pay.
1. Choice of Numeraire: Just as it is a great convenience to express market prices in terms of
money, so it will be appropriate to measure shadow prices all in terms of a unit of account,
which is called the numeraire. In economic analysis the value of inputs and outputs is
expressed using this numeraire, or unit of account. In the UNIDO approach „aggregate
consumption expressed in domestic prices‟ is used as the unit of account; i.e., inputs and
outputs are measured in terms of domestic a price that is used as a numeraire. In the Little
and Mirrlees approach, „uncommitted social income measured in border prices‟ is the unit of
account; i.e., values are expressed in terms of border prices that is used as the numeraire.
2. Concept of Tradability: A key issue in shadow pricing is whether a good is tradable or not.
For a good that is tradable, the international price is a measure of its opportunity cost to the
country. Why? For a tradable good, it is possible to substitute import for domestic production
and vice versa; similarly it is possible to substitute export for domestic consumption and vice
versa. Hence the international price, also referred to as the border price, represents the 'real'
value of the good in terms of economic efficiency.
3. Sources of Shadow Prices: The UNIDO approach suggests three sources of shadow pricing,
depending on the impact of the project on national economy. A project, as it uses and
produces resources, might for any given input or output:
 Increase or decrease the total consumption in the economy,
 Decrease or increase production in the economy,
 Decrease imports or increase imports,
 Increase exports or decrease exports.
If the impact of the project is on consumption in the economy the basis of shadow pricing is
consumer willingness to pay. If the impact of the project is on production in the economy, the

basis of shadow pricing is the cost of production. If the impact of the project is on international
trade ‐ increase in exports, decrease in imports, increase in imports, or decrease in exports, and
the basis of shadow pricing is the foreign exchange value.
4. Taxes when shadow prices are being calculated, usually pose difficulties. The general
guidelines in the UNIDO approach with respect to taxes are as follows:
 When a project results in diversion of non-traded inputs which are in fixed supply from
other producers or addition to non-traded consumer goods, taxes should be included.
 When a project augments domestic production by other producers, taxes should be
excluded.
 For fully traded goods, taxes should be ignored.
4.4.1.2. Shadow Pricing of Specific Resources

Tradable Inputs and Outputs: A good is fully traded when an increase in its consumption
results in a corresponding increase in import or decrease in export or when an increase in its
production results in a corresponding increase in export or decrease in import. For fully traded
goods, the shadow price is the border price, translated in domestic currency at the market
exchange rate. The above definition of a fully traded good implies that domestic changes in
demand or supply affect just the level of imports or exports. This means for an imported good,
the following conditions should be met:
 If there is an import quota, it is not restrictive.
 The import supply is perfectly elastic over the relevant range of import volume.
 There is no surplus capacity in the domestic industry; all additional supply must be
imported. If there is surplus domestic capacity it cannot be utilized for want of necessary
inputs.
 If extra demand exists inland, the imported goods, after taking into account the cost of
transport from the port of entry to the point of inland demand, cost less than the marginal
cost of local production;
 The imported input costs less than the domestic marginal cost of purchase.
When the above conditions are satisfied, additional demand will be met fully by external trade.
Hence the input is considered fully traded. Similar conditions must be satisfied for importable
outputs, exportable inputs, and exportable outputs, if they are to be considered fully traded. In
practice, it is reasonable to regard tradable inputs and outputs as fully traded, if the above‐
mentioned conditions are not fully satisfied.
Non-tradable Inputs and Outputs: A good is not traded if it is tradable but conditions (i)
through (iv) above are not fulfilled. For non‐traded goods the border price does not reflect its
economic value. What then is the value of non‐traded goods? The value of a non‐traded good
should be measured in terms of what domestic consumers are willing to pay, if the output of the
project adds to its domestic supplies or if the requirement of the project causes reductions of its
consumption by others. The value of a non‐traded good should be measured in terms of its

marginal cost of the project causes reduction of production by other units. A good is non‐
tradable when the following conditions are satisfied:
I. Its import price (CIF price) is greater than its domestic cost of production
II. Its export price (FOB price) is less than its domestic cost of production.
CIF - Cost Insurance and Freight (named port of destination): Seller must pay the cost and
freight includes insurance to bring the goods to the port of destination. However, risk is
transferred to the buyer once the goods are loaded on the ship.
FOB - Free on Board (Freight on Board): This basically means that the cost of delivering the
goods to the nearest port is included but you the buyers, are responsible for the shipping from
there and all other fees associated with getting the goods to your country/address.
The valuation of non‐tradable is done as per the principles of shadow pricing discussed earlier.
On the output side, if the impact of the project is to increase the consumption of the product in
the economy, the measure of value is the marginal consumers' willingness to pay; if the impact
of the project is to substitute other production of the same non‐tradable in the economy, the
measure of value is the saving in cost of production. On the input side, if the impact of the
project is to reduce the availability of the input to other users, their willingness to pay for that
input represents social value; if the project's input requirement is met by additional production of
it, the production cost of it is the measure of social value.
Labour Inputs: The principles of shadow pricing for goods may be applied to labour as well,
though labour is considered to be service. When a project hires labour, it could have three
possible impacts on the rest of the economy: it may take labour away from other employments; it
may induce the production of new workers; and it may involve import of workers. When a
project takes labour away from other employments, the shadow price of labour is equal to what
other users of labour are willing to pay for this labour. In a relatively free market this will be
equal to the marginal product of such labour. The social cost associated with inducing 'additional'
production of workers consists of the following:
 The marginal product of the worker in the previous employment - if the worker is previously
unemployed, this would naturally be zero;
 The value assigned by the worker on the leisure that he may have to forego as a result of
employment in the project -the value of this leisure is reflected in his reservation wage;
 The additional consumption of food when a worker is fully employed as opposed to when he
is idle or only partly employed;
 The cost of transport and rehabilitation when a worker is moved from one location to
another;
 The increased consumption by the worker and its negative impact on savings and investment
in the society when the worker is paid market wage rate by the project; and
 The cost of training a worker to improve his skills. The social cost associated with import of
foreign workers is the wage they command. In this case, however, a premium should be
added on account of foreign exchange remitted abroad by these workers from their savings.

Capital Inputs: When a capital investment is made in project two things happen:
i. Financial resources are converted into physical assets.
ii. Financial resources are withdrawn from the national pool of savings and hence alternative
projects are foregone.
Thus, shadow pricing of capital investment involves two questions:
 What is the value of physical assets?
 What is the opportunity cost of capital (which reflects the benefit foregone by sacrificing
alternative project/s)?
The value (shadow price) of physical assets is calculated as the value of other resources is
calculated. If it is a fully traded good, its shadow price equal to its border price. If it is a non‐
traded good its price is measured in terms of cost of production (if the project induces additional
domestic production of the asset) or consumer willingness to pay (if the project takes the asset
from other users). The opportunity cost of capital depends on how the capital required for the
project is generated. To the extent that it comes from additional savings, its opportunity cost is
measured by the consumption rate of interest (which reflects the price the saver must be paid to
sacrifice present consumption); to the extent that it comes from the denial of capital to alternative
projects, its opportunity cost is the rate of return that would be earned from those alternative
projects. This is also called the investment rate of interest. In practice, the consumption rate of
interest may be used as the discount rate because in stage three of UNIDO) analysis an inputs
and outputs are converted into their consumption equivalents.
There are, however, problems in determining the consumption rate of interest empirically. So the
UNIDO approach recommends a 'bottom up' procedure. As per this procedure, the project
analyst calculates the internal rate of return of a project and presents the project to the planners
(or politicians) who are the decision makers. If the project is accepted, the analyst may assume
that the planners judge the consumption rate of interest to be more than the internal rate of return.
On the basis of a repetitive application of this process, the range for estimated consumption rate
of interest can be sufficiently narrowed for practical use, provided, of course, the planners on the
top are consistent.
Foreign Exchange: The UNIDO method uses domestic currency as the numeraire. So the
foreign exchange input of the project must be identified and adjusted by an appropriate premium
(as discussed below). This means that valuation of inputs and outputs that were measured in
border prices has to be adjusted upward to reflect the shadow price of foreign exchange.
The premium on foreign exchange and the Shadow Exchange Rate: The official exchange
rate, OER, will be equal to the true economic value placed on foreign exchange if it is able to
move freely without intervention or control by the government and if there is no rationing of
foreign exchange, no tariffs or non‐ tariff barriers on imports and no taxes or subsidies on
exports. In countries where these conditions hold the market price of foreign exchange, the OER,
should be a good measure of people's willingness to pay for the foreign exchange needed to buy

imported inputs and the economic benefit the local economy receives from any foreign exchange
earnings made by a project.
In many developing and developed countries, there are many distortions in the market for foreign
exchange and traded goods. The market for foreign exchange may be strictly controlled and it
may only be possible to purchase foreign exchange for permitted purposes. These controls will
often be imposed because the fixed official exchange rate is overvalued, which results in the
demand for foreign exchange greatly exceeding supply. A currency is overvalued if the official
exchange rate understates the amount of domestic currency that residents of the country would
be willing to pay for a unit of foreign currency, such as one dollar US, if they could freely spend
it on duty-free goods - goods sold at their border prices. Obviously, in most countries, people
would pay more for foreign currency if they could spend it freely on duty‐free goods without
having to travel internationally to do so.
Most currencies in the world are therefore overvalued in this sense, with the exception of those
of duty‐free economies like Hong Kong and Singapore. Trade distortions such as import tariffs
and quotas therefore result in a country's currency being overvalued. If the official exchange rate,
OER, expressed in terms of units of local currency needed to buy one unit of foreign exchange is
fixed below the appropriate level it is said to be overvalued. This means that an unrealistically
high value is placed on the local currency in terms of how much foreign exchange can be bought
with a unit of currency.
Countries that have an overvalued exchange rate are said to place a premium on foreign
exchange, or to have a foreign exchange premium. A foreign exchange premium, FEP, measures
the extent to which the OER understates the true amount of local currency that residents would
be willing to pay for a unit of foreign exchange, or its true opportunity cost to an economy. The
FEP can be measured crudely by the ratio of the value of total trade, imports plus exports, valued
in domestic prices and therefore including the effect of tariffs and other distortions, to the value
of trade in border prices, minus one, as given in the equation below:
t d s
FEP {[ ] }
Where:
 t are the tariffs, or tariff equivalents of non-tariff barriers, imposed on imports
 d are the export tax equivalents of any restraints and taxes imposed on exports
 s are the export subsidy equivalents of any support given to encourage exports
 M is the value of imports in border prices, (CIF)
 X is the value of exports in border prices, (FOB).
The numerator of this ratio measures the total amount in local currency that residents are actually
paying to consume imports, including tariffs and taxes, plus the amount they are actually
accepting for exports, excluding export taxes and including export subsidies. It therefore
measures the true value put on traded goods consumed and produced by the country. The
denominator of the ratio in the above equation shows the actual foreign exchange value of these
traded goods when they are measured at their border prices, converted into local currency at the
OER. The ratio of the domestic value to the border price value of trade therefore shows the true
value placed on traded goods, relative to apparent economic value at the official exchange rate.
The FEP is usually expressed as a percentage, so the ratio of value of trade in domestic prices to
its value in border prices, minus one, is multiplied by 100. The FEP therefore shows the extra
percentage local residents would be willing to pay for foreign exchange, above the official
exchange rate, if they were able to buy currency freely and spend it on duty‐ free goods.
When estimating the economic prices of tradable in countries that have an overvalued exchange
rate, it will not be correct to merely value traded goods (which may normally be subject to a
tariff) at their border prices and then convert these values to local currency at an artificially low
official exchange rate. Such a process would make them appear unrealistically cheap compared
with locally produced non‐ traded goods. This is because the local price of non‐traded goods
will, over time, have adjusted upwards to equal the tariff inclusive price of traded goods, which
consumers find equally attractive. Given a choice between a US dollar's worth of imported
goods, valued at their tariff‐free border price and converted to local currency at the official
exchange rate, and a US dollar's worth of locally produced non‐traded goods, valued at their
domestic market price, the average consumer would prefer a dollar's worth of duty‐free imported
goods. The foreign exchange required to purchase these imported goods will therefore have a
higher value to the local consumer than is indicated by the official exchange rate, OER.
In this situation, the project analyst must correct for these distortions in the market for foreign
exchange and traded goods that result in a premium being placed on foreign exchange. Almost
all projects include a mixture of traded and non‐traded inputs and outputs. If no correction is
made for this premium on foreign exchange in economic appraisals, projects that produce traded
good outputs will yield an NPV that is undervalued, compared with those producing non‐traded
goods. This occurs because the traded good outputs would be valued at their FOB (or CIF)
border prices, converted into local currency at the artificially low official exchange rate, in terms
of local currency per $US. On the other hand, projects that use imported inputs will appear to
have low costs when the border prices of these inputs are converted at the OER and will
therefore have a NPV that is overvalued compared with projects using non‐traded good inputs.
If a foreign exchange premium exists, it is therefore necessary to take account of it in all projects
where both traded and non‐traded goods and services are included among project inputs and
outputs, or when comparing projects producing or using traded and non‐traded goods and
services. If both traded and non‐traded commodities are used or produced in a project, they need
to be valued in comparable prices before they can be added together in the net cash flow of the
project. The reason for this can be seen from the following simple example.
Assume that in a particular economy there are only two homogeneous consumer products
produced and consumed. One is a non-traded good, housing, and the other is a traded good,

automobiles. The average equilibrium price for both houses and automobiles in the domestic
market is Br. 100 000. At this price, consumers are just as indifferent to purchasing more
automobiles as to more housing, since both are equally valuable to them. However, automobiles
are subject to a 100 percent tariff and are sold on the international market for only $US 10 000,
or Br.50000 (converted at the OER of Br. 5 to $US l). Since automobiles are the only goods
traded (imported) by this economy, from the equation above, the foreign exchange premium will
be:
FEP {[ ] }
In this country, two alternative projects are being considered: one a housing construction
program and the other an automobile factory. When an economic appraisal is made of the auto
factory, if no account is taken of the foreign exchange premium, automobiles, which are traded
goods, would be valued at their border price, Br. 50000 per automobile. On the other hand, an
economic analysis of the housing construction program would value housing, a non‐traded good,
at its local free market equilibrium price, Br. 100 000 per house. If the two projects had the same
level of input costs per unit of output and the same project life, the housing construction program
would appear to have the higher net present value. It would therefore be selected in preference to
the automobile project if only one of two projects could be undertaken.
Figure 5: Demand and Supply of Foreign Exchange with no trade distortions
D
Price
(Br./$) DD
S
SER(10)
5
Dnt
Dt
0 Q0 Q1 Quantity
However, if the tariffs were removed from automobiles and local residents could buy them for
Br.50 000 each, domestic demand for cars would increase strongly. As there is only one traded
good in this economy, at every exchange rate the demand for foreign exchange would rise, as can
be seen from the figure above. The demand curve for foreign exchange, DDt would move out to
DDnt, the tariff‐free demand curve for foreign exchange and demand for foreign exchange would
expand from Q0 to Q1. As a result, if the OER were allowed to float freely it would devalue
increasing the units of local currency received for each US dollar of foreign exchange earned.

This would encourage producers to export more and earn more foreign exchange, to the point
where demand for and supply of foreign exchange would again be equal. In the figure above this
occur at an exchange rate of Br. 10 / $US1. At this new distortion‐free equilibrium exchange
rate, the border price of automobiles would rise to Br. 100,000 and their economic price would in
fact equal the price of the non traded housing.
Alternatively, if the project were designed to export automobiles, these could be sold for $US 10
000 of foreign exchange per automobile. If we continue the assumption that there is only one
traded good in the economy, the foreign exchange would be used to import more automobiles for
which people would be willing to pay Br. 100000. On the other hand, the project might produce
automobiles that could be sold locally in competition with imported automobiles, also for Br.100
000 per automobile. The $US 10 000 of foreign exchange earned for each exported automobile
from the project would actually have a value of Br.100 000 to the economy at local market
prices. Thus, in this one‐traded‐good economy, the true value of each $US1 of foreign exchange
earned would be Br. 10, not Br. 5. The results of this simple example can be used to show how
the SER of the economy is calculated.
The shadow exchange rate, SER, is the foreign exchange rate that reflects the true economic
value placed on foreign exchange in an economy. In an economy with no trade or foreign
exchange market distortions the SER would be the equilibrium exchange rate. However, if
distortions remain in the market for foreign exchange, the shadow exchange rate will be
different. One way of correcting for an overvalued exchange rate in project appraisal is to use a
shadow exchange rate, rather than the official exchange rate to value all foreign exchange earned
and used by the project.
A simple definition of a country's SER involves addition of the percentage FEP to the OER, or
more precisely, multiplication of the OER by one plus the FEP divided by 100:
FEP
SE OE ( )
In our example of the two‐good economy, with a FEP of 100 per cent, the shadow exchange rate
can be estimated by:
Br Br
SE ( )
The shadow exchange rate would therefore be
So foreign exchange in fact has twice the value indicated by the official exchange rate. From the
definition of the foreign exchange premium, the SER can also be defined as:
Value of trade in domestic price

SE OE ( )
Value of trade in border prices

t d s
SE OE [ ]
Where:
 t are the tariffs, or tariff equivalents of non-tariff barriers, imposed on imports
 d are the export tax equivalents of any restraints and taxes imposed on exports
 s are the export subsidy equivalents of any support given to encourage exports
 M is the value of imports in border prices, (CIF)
 X is the value of exports in border prices, (FOB).
If the country imports 100 cars and its tariff on cars is 100 per cent, its SER will equal:
Br Br
SE [ ]
In this simple formula for measuring the SER, the OER is inflated by the ratio of the full amount
people are actually willing to pay for traded goods in domestic market prices, to the value of
these goods in border prices converted at the OER. The SER will always be higher than the
OER, in terms of the local currency unit people will pay for a unit of foreign exchange, if the
value of traded goods in domestic prices, including taxes and tariffs is higher than their value in
border prices (if export taxes do not outweigh import tariffs).
The traditional method employed in cost benefit analysis to take account of the foreign exchange
premium that was used in the 'UNIDO Guidelines' is to value all traded and non‐traded goods
and services in terms of domestic price equivalents. Domestic prices are used as the numeraire or
common unit of account, in terms of which all project inputs and outputs are valued. For this
reason, the UNIDO approach is sometimes known as the domestic price approach. The project's
traded good inputs and outputs are firstly valued in their FOB and CIF border prices. They are
then converted from foreign currency to local currency using a shadow exchange rate, SER,
rather than the official exchange rate, OER.
This is done to better reflect the true economic value of foreign exchange to the economy. In a
situation where the local currency is overvalued and the foreign exchange premium is positive,
the ratio of the shadow exchange rate to the official exchange rate will be greater than one (when
both are expressed in terms of units of local currency per dollar of foreign exchange). Use of a
shadow exchange rate to convert the border prices of traded goods into local prices will have the
effect of inflating these border prices until they equal the amount that people are willing to pay,
or receive, for traded goods.
These inflated traded goods prices will then reflect the true value placed on traded goods vis‐à‐
vis non‐traded goods. As these traded goods will now be valued in domestic price equivalents
they will be directly comparable with the project's non‐traded inputs and outputs valued in
domestic prices. When using the domestic price approach, a project's non‐traded inputs and
outputs are simply valued in their domestic prices. As indicated earlier, adjustments should first

be made to the prices of non‐traded goods to ensure that they reflect the true marginal social
costs and benefits of consuming and producing these goods. This will be done by including
consumers' surplus, but excluding producer surplus, and deducting transfers where appropriate.
No additional adjustment is made to non traded goods prices to reflect their overvaluation in
relation to traded goods, the foreign exchange premium, as this would involve double counting.
Both traded and non‐traded goods will then be valued in comparable, domestic price equivalents
and it will therefore be possible to add them together in the project's cash flow. The domestic
price approach therefore corrects for the FEP by inflating the border price values of traded
goods, using the economy's estimated SER, until these values correctly reflect the goods' relative
worth compared with the domestic prices of non‐traded goods.
In summary, the domestic price approach values:
Traded Goods Non Traded Goods
@ Border price x SER @ Domestic prices
Domestic price equivalent Numeraire: domestic prices
Examples using the UNIDO approach

[I] Imported input
Table 1 below illustrates how the economic value of a project's imported textile inputs will be
measured using the UNIDO approach. It has been estimated that the country has a foreign
exchange premium of 30 per cent and the shadow exchange rate is therefore (1 +0.3) x OER. All
tariffs and taxes are deducted from the domestic retail price of textiles and their tradable (foreign
exchange) component is inflated by the shadow exchange rate to obtain the domestic price
equivalent of the CIF import price. The economic cost of domestic transport and handling is then
added.
Table1: Valuation of imported textile inputs using the UNIDO approach (Millions of Birr)
Financial Cost Economic Cost
CIF import price (@ OER) 250
(@ SER = 1.3 x OER) 325
Import Tariff (40 Per Cent) 100 0
Internal Transport 50 50
Total 450 395
Handling and Distribution* 50 20
*60 per cent of these 'costs' represent rents earned from privileged access to foreign exchange,
and are therefore not included in the economic cost of handling and distribution
Ratio of Economic Value to Financial Value=

[II] Exported output

Table 2 below gives an example of the economic valuation of a project's exported garment
output, using the UNIDO approach. The country again has a foreign exchange premium of 30
per cent. The foreign exchange earnings are inflated by the shadow exchange rate and all export
subsidies are deducted from the fob export price to obtain the domestic price equivalent of the
border price.
Table 2: Valuation of exported garment output using the UNIDO approach ($‟000)
FOB output value (@ OER) 1200 ‐
(@ SER = 1.3 x OER) ‐ 1560
Export Tax (10 Per Cent) ‐120 0
Transport to port* (including 50% fuel tax) ‐40 ‐30
Total 1040 1530
*The market price of transport includes a 50 per cent fuel tax. Since fuel equals half of total
transport costs its economic value = 40 - (40 x 0.5 x 0.5) = 30
Ratio of Economic Value to Financial Value =
[III] Non-traded input

The domestic price approach to the valuation of a non‐traded input such as electricity is shown in
Table 3 below. The financia1 cost of the electricity is its domestic sales price, Br.2 million, plus
Br. 300,000 sales tax. If the non‐traded input's supply can be increased, its economic value will
be measured by its domestic market supply price, after any adjustments have been made for
market imperfections such as taxes, price fixing, subsidies or monopoly pricing. If the project
uses electricity that must be bid away from existing consumers, then the electricity should be
valued at the price that people are willing to pay for it, its demand price. In the example above,
electricity is a private monopoly and monopoly rents are found to represent Br. 500,000 of the
total Br. 2 Million supply price of electricity. If the project uses electricity that must be bid away
from existing consumers, then the monopoly rents should be included when measuring its
economic value, as people are willing to pay this total amount, including these rents for this
electricity.
Monopoly rents are only treated as a transfer and excluded if the supply of electricity can be
expanded to meet the project's needs. In this case only the cost to the economy of producing
additional electricity is the relevant economic cost. Of the project's total electricity input
requirements, 40 per cent will be met by displacing existing consumers and 60 per cent will be
met by expanding supply. The economic cost of this displaced consumption is the total amount
that people were willing to pay for this electricity, including monopoly rents and sales tax.
Approximately Br.200, 000 (40 percent of Br. 500,000) of the monopoly rents should therefore
be included in the economic value of the input, but the remaining Br. 300,000 should not be

included. Similarly, approximately 40 percent of the sales tax (Br.120, 000) should be included
in the economic value of the input, the part that is met by displacing existing consumers, but the
remaining Br. 180,000 of sales tax should not be included in the project's economic costs.
Table 3: Valuation of 1 Giga watt of electricity input using the UNIDO approach (Br. „000)
Domestic Sales price (before tax) 2000 ‐
Cost of new production 1200 900*
Cost of displaced consumption: 800 800
Of which monopoly rents are: (500) (200)
Sales Tax 300 120
Total 2300 1820
*The economic cost of newly produced electricity; is obtained as (2000 x 0.6) - (500 x 0.6) =
1200 - 300 = 900, since that part of monopoly rents that is earned on newly produced electricity
is only a transfer.
Ratio of Economic Value to Financial Value=
[IV] Non-traded output

If instead the project is producing electricity a non‐traded output, the UNIDO approach to
valuing this electricity is as shown in the Table 4 below. If the entire project's output meets new
demand its economic value is simply its domestic market demand‐price, as long as there is no
price fixing or rationing. In this case all new output represents an increment in supply.
Consequently, all monopoly rents and sales taxes imposed should be included in measuring the
economic benefits of the project, as this is the amount people are willing to pay for the
electricity. The electricity authority does not receive the sales tax paid on electricity, so it is not a
financial benefit to it.
Table 4: Valuation of 1 Giga watt of electricity output using the UNIDO approach (Br.
„000)
Domestic Sales price: 2000 2000
Sales Tax* 0 300
Total 2000 2300
*Sales tax is included as an economic benefit because the country‟s government will receive the
tax revenue even though the electricity authority will not
4.4.1.3.Impact on Income Distribution

Many governments regard redistribution of income in favor of economically weaker sections or
economically backward regions as a socially desirable objective. Due to practical difficulties in

pursuing the objective of redistribution entirely through the tax, subsidy, and transfer measures
of the government, investment projects are also considered as investments for income
redistribution and their contribution toward this goal is considered in their evaluation. This calls
for suitably weighing the net gain or loss by each group, measured earlier, to reflect the relative
value of income for different groups & summing them. Stages three and four of the UNIDO
method are concerned with measuring the value of a project in terms of its contribution to
savings and income redistribution.
To facilitate such assessments, we must first measure the income gained or lost by individual
groups within the society. Groups: For income distribution analysis, the society may be divided
into various groups. The UNIDO approach seeks to identify income gains and losses by the
following: Project, Other private business, Government, Workers, Consumers, and External
Sector. There can, however be, other equally valid groupings. Measure of Gain or Loss: The gain
or loss to an individual group within the society as a result of the project is equal to the
difference between the shadow price and the market price of each input or output in the case of
physical resources or the difference between the price paid and the value received in the case of
financial transaction.
Example1: Farmers in a certain area use 1 million units of electricity generated by a hydro-
electric project. The benefit derived by them, measured in terms of the willingness to pay is
equal to Br. 0.4 million. The tariff paid by them to the electricity board is Br. 0.25 million. So the
impact of the project on the farmers gain of Br. 0.15 million. (0.4-0.25million)
Example2: A mining project requires 1000 laborers. These laborers are prepared to offer
themselves for work at a daily wage rate of Br. 8.00. (This represents their supply price.) The
wage rate paid to the laborers, however, is Br. 10 per day. So the redistribution benefit enjoyed
by the group of 1000 laborers is Br. 2000 (1000 x (10 – 8) per day.
4.4.1.4.Savings impact and its value

Most of the developing countries face scarcity of capital. Hence, the governments of these
countries are concerned about the impact of a project on savings and its value thereof. Stage
three of the UNIOO method, concerned with this and seeks to answer the following questions:
Given the income distribution impact of the project what would be its effects on savings? What
is the valu e of such savings to the society? Impact on Savings: The savings impact of a project is
equal to: ∑ i PSi
Where: Yi = Change in income of group i as a result of the project.
MPSi = Marginal propensity to save of group I
Example: As a result of a project the change in income gained/lost by four groups is:
Group 1=10000; Group 2=50000; Group 3 =–20000; and Group 4=-40000.
The marginal propensity to save of 4 groups is : MPS1=0.05; MPS2=0.10; MPS3=0.20; and
MPS4 = 0.40.
The impact on savings of the project=

10000x0.05 + 50000x0.10 - 20000x0.20 – 40000x0.40 =- 1 4500.
4.4.1.5.Adjustment for Merit and Demerit Goods

In some cases, the analysis has to be extended beyond stage four to reflect the difference
between the economic value and social value of resources. This difference exists in the case of
merit goods and demerit goods. A merit good is one for which the social value exceeds the
economic value. For example, a country may place a higher social value than economic value on
production of all because it reduces dependence on foreign supplies. The concept of merit goods
can be extended to include a socially desirable outcome like creation of employment. In the
absence of the project, the government perhaps would be willing to pay unemployment
compensation or provide more make‐work jobs.
In the case of a demerit good, the social value of the good is less than its economic value. For
example, a country may regard alcoholic products as having social value less than economic
value. The procedure for adjusting for the difference between social value and economic value is
as follows:
 Estimate the economic value.
 Calculate the adjustment factor as the difference between the ratio of social value to
economic value and unity.
 Multiply the economic value by the adjustment factor to obtain the adjustment
 Add the adjustment to the net present value of the project.
To illustrate, consider a project for which the following information is available:

 The present economic value of the output of the project is Br. 25 million.
 The output of the project has social value, which exceeds its economic value by 20 per cent.
Given this information, the adjustment factor would be 0.2 (120 per cent/100 per cent ‐ 1).
Multiplying the present economic value by 0.2, we get an adjustment of Br. 5 million. This, then,
is added to the present economic value of Br. 25 million. Where the socially valuable output of
the project does not appear as an output in the economic analysis ‐ as is the case where the
project generates employment ‐ the procedure is somewhat different. In such a case the output is
treated like an externality and its valuation in social terms is the adjustment.
While the adjustment for the difference between the social value and economic value is
seemingly a step in the fight direction, it is amenable to abuse. Once, the analyst begins to make
adjustment for social reasons, projects which are undesirable economically maybe made to
appear attractive after such adjustments. Since the dividing line between 'political' and 'social' is
rather nebulous, it becomes somewhat easy to push politically expedient projects, irrespective of
their economic merit by investing them with social desirability. While there is no way to prevent
such a manipulation, the stage‐by‐stage UNIDO approach mitigates its occurrence by throwing it
in sharp relief.

4.4.2. Little and Mirrlees Approach

The Little and Mirrlees approach (sometimes known as the border price approach), also values
traded goods at their border prices, in the same way as the UNIDO (domestic price) approach.
However, these border prices are then converted into local currency at the official exchange rate
rather than at a shadow exchange rate. The project's traded good inputs and outputs are
effectively kept in their border prices. However, if there is a foreign exchange premium in the
country concerned the prices of non‐traded goods will have risen to match the tariff inclusive
prices of tradable. The price of non‐tradable will therefore overstate the goods' true value to
consumers, relative to the border prices of traded goods. The border price approach therefore
revalues these non‐traded goods in border price equivalents using commodity specific
Conversion Factors.
These conversion factors are the ratio of the border price equivalent of each non‐traded good to
its domestic price. Multiplying the domestic price value of a non‐traded good by its conversion
factor has the effect of converting the good's domestic price into its border price equivalent. Both
traded and non‐traded goods are then valued in the same numeraire, i.e., border prices, so it will
be possible to include them together in the project's cash flow. This is the reason why this
method can also be called the border price approach. The Little‐Mirrlees approach makes traded
and non‐traded goods prices comparable by precisely the inverse method to that used by the
UNIDO approach, which values both traded and non‐traded goods in comparable, domestic
prices. In summary this approach values:
Traded Goods Non Traded goods
@ Border price x OER @ Domestic price i x Cfi
Numeraire: border prices Border price equivalent
( )
Practical Examples of the Little - Mirrless Approach

[I] Imported input
For purposes of comparison, we shall use similar examples to the ones used under the UNIDO
approach. If the analyst decides to use the border price approach to incorporating the foreign
exchange premium, a project's imported textile inputs would be valued as shown in Table 5
below. All tariffs and taxes are deducted from the domestic retail price but the foreign exchange
component of the input is valued at the official exchange rate, so that it is expressed in border
prices. Non‐traded components such as transport and internal handling and distribution, on the
other hand, are valued in border price equivalents using individual conversion factors.

Table5: Valuation of imported textile inputs using the L-M approach (Br.‟000)
CIF import price (@ OER) 250 250
Import Tariff (40 Per Cent) 100 0
Internal Transport* 50 40
Handling and Distribution** 50 14
Total 450 304
*The conversion factor for transport, CFt which puts the domestic price of transport into its
border price, = 0.8, hence the transport's economic value = 50 x 0.8 =40
*60 per cent of this item represents rents earned from privileged access to foreign exchange. In
addition, the conversion factor for handling, CFh, = 0.7.
Hence economic value = (financial value x 0.4) x CFh = 20 x 0.7 = 14
[II] Exported output

As shown in Table 6 below, to value the exported garment output of a project using the border
price approach the foreign exchange component is converted into local currency using the
official exchange rate and any export taxes and subsidies are treated as transfers and are
deducted. Once again, non‐traded components will be valued in their border price equivalents
using their own conversion factors.
Table 6: Valuation of exported garment outputs using the L-M approach (Br.‟000)
FOB output price (@ OER) 1200 1200
Export Tax (10 Per Cent) ‐120 0
Transport to Port* ‐40 ‐24
Total 1040 1176
*The 50 per cent fuel tax is deducted (fuel = half transport costs), and CFt = 0.8, hence the
transport's economic value = [40 - (40 x 0.5 x 0.5)] x 0.8 = 24
[III] Non-traded input

The valuation of non‐traded electricity inputs using the L‐M approach is shown in Table 7
below. As in the example in Table3, 60 per cent of the project's electricity requirements will be
met by new production and 40 per cent by displacing existing consumers. The electricity is
valued at its border price equivalent by multiplying its corrected domestic prices, as calculated in
Table 3, by its commodity specific demand and supply price conversion factors, CFdpi and
CFspi. These conversion factors are the ratio of the economic price (border price equivalent) to
the financial (market price) of electricity.

Table 7: Valuation of 1 giga watt of electricity input using the L-M approach (Br.‟000)
Financial Cost Economic
Cost
Domestic Market Price: 2000
Of which monopoly rents are: (500)
Sales Tax 300 0
Cost of new production* 1200 630
Supply Price Conversion Factor for Electricity, CFsp 0.7
Sales Tax (0.6 x 300) 180 0
Cost of Displaced Consumption** (pretax) 800
640
Demand Price Conversion Factor for electricity, CFdp 0.8
Sales Tax (0.4 x 300) 120 48
Total 2300 1318
*Economic cost of new production in border prices = economic cost in domestic prices x CFsp =
900 x 0.7 = 630, see notes at the bottom of Table.2 for an explanation of the derivation of the
economic cost of new production and displaced consumption in domestic prices
**Economic cost of displaced consumption in border prices = economic cost in domestic prices
(including sales taxes) x CFdp = 800 x 0.8 = 640
[IV] Non-traded output

The method of valuing non‐traded electricity output using the border price approach is shown in
Table 8. If all of the project's electricity output meets new demand, its economic value is its
domestic market demand price, including any monopoly rents and sales taxes, multiplied by the
demand price conversion factor relevant to electricity output. This CFdp for electricity has
already been assumed to be 0.8.
Table 8: Valuation of 1 giga watt of electricity output using the L-M approach (Br.‟000)
Financial Cost Economic
Cost
Domestic Market Price (pretax): 2000
Of which monopoly rents are: (500)
Sales Tax 300
Value of new consumption (pretax) 2000 1600
Demand Price Conversion Factor for Electricity, CFdp 0.8
Sales Tax (0.8 x 300) 0 240
Total* 2000 1840

*Economic value of new electricity consumption in border prices = economic value in domestic
prices (including sales taxes) x CFdp = 2300 x 0.8 = 1840
4.4.3. Usage, Advantages and Disadvantages of the Two Approaches

The L‐M approach is probably the more widely used of the two approaches, according to recent
surveys of the practice of social cost benefit analysis. This is probably because it has been
adopted by major international lending institutions like the World Bank and several of the
regional development banks like the Asian Development Bank and Inter‐American Development
Bank. The border price approach is easier to use when analyzing projects that use mainly traded
good inputs and produce traded good outputs, such as export‐oriented industries. Tradable goods
and services can be readily valued in border prices and converted to local currency at the official
exchange rate. The main claim to superiority of the border price approach is that it may enable
more precise estimates to be made of the economic value of the project by making use of
individual conversion factors for non‐traded goods.
These show the precise impact of the project on welfare, in border prices. Because the L‐M
approach uses many individual conversion factors and the data requirements for estimating each
conversion factor are less, the chance and consequences of making a major error may be
reasonably low. On the other hand, for projects that mainly uses non‐traded inputs and produce
non traded outputs, such as local infrastructure and social service projects, the UNIDO approach
may be more appropriate and simpler to use. In this case these non tradable can be simply left in
their domestic price values once corrections have been made for domestic distortions. It could be
claimed that the UNIDO approach gives a less precise measure of the project's impact on
economic welfare as a result of its use and production of traded goods. This is because the
method uses only one parameter, the SER, to revalue traded goods in domestic price values.
The SER is an average measure of the value placed on foreign exchange and consequently there
are sound theoretical reasons for using it to revalue traded goods in domestic prices. However,
there are empirical problems in accurately estimating a country‟s SER. As this parameter is so
central to the UNIDO (domestic price) approach, there is scope for making substantial errors in a
project appraisal if the analyst has made a mistake in the estimation of the SER. However, if a
reliable estimate for the SER is available, this method may be simpler to implement, particularly
if the project has many non traded inputs & outputs.
In summary, because of the difficulty of obtaining accurate data on the ratio of domestic to
border prices for all traded goods in an economy, empirical estimates of shadow exchange rates
can be subject to considerable uncertainty and may not be very satisfactory. In addition, the use
of a shadow exchange rate in project appraisals may be politically unacceptable to a country as it
can be seen as an admission of sub‐optimal trade and foreign exchange regulation policies. For
these reasons, among others, the World Bank and many other international institutions prefer to

use the Little and Mirrless approach to correct for the foreign exchange premium in an economic
analysis. Nevertheless, both techniques are in common use and the analyst may vary the
approach used depending on the nature of the project being appraised.
4.5. Cost Effectiveness

Thus far we have focused on cost‐benefit analysis. This technique is appropriate for projects with
benefits and costs that are measurable in monetary terms. A vast class of projects generates
benefits that are not easily measurable in monetary terms. If the project measures its benefits in
some non‐monetary unit, the NPV criterion for deciding whether to implement it cannot be used.
In such cases, economic analysis can still be a great help in project design and selection. We use
it to help select among programs that try to achieve a given result, such as choosing among
several methods to improve mathematical skills. Economic analysis is also useful to select
among methods that have multiple outcomes. For example, three methods might be available for
raising reading speed, comprehension, and word knowledge. Each method may have a different
impact on each of the three dimensions and on cost. Economic analysis enables us to compare
the costs of various options with their expected benefits as a basis for making choices.
Two main techniques exist for comparing projects with benefits that are not readily measurable
in monetary terms: Cost effectiveness and Weighted Cost effectiveness. In all cases we measure
costs as shown in the previous sections. The main difference between the approaches is in the
measurement of benefits. If the benefits are measured in some single non‐monetary units, such as
number of vaccines delivered, the analysis is called cost‐effectiveness. If the benefits consist of
improvements in several dimensions, for example, morbidity and mortality, then the several
dimensions of the benefits need to be weighted and reduced to a single measure. This analysis is
known as weighted cost‐effectiveness. The choice of technique depends on the nature of the task,
the time constraints, and the information available. We would use cost‐effectiveness for projects
with a single goal not measurable in monetary terms, for example, to provide education to a
given number of children.
When the projects or interventions aim to achieve multiple goals not measurable in monetary
terms, we use weighted cost‐effectiveness; for example, several interventions may exist that
simultaneously increase reading speed, comprehension, and vocabulary, but that are not equally
effective in achieving each of the goals. A comparison of methods to achieve these aims requires
reducing the three goals to a single measure, for which we need some weighting scheme. All
evaluation techniques share some common steps. The analyst must identify the problem,
consider the alternatives, select the appropriate type of analysis, and decide on the most
appropriate course of action. This topic provides the tools for identifying the costs and benefits
and assessing whether the benefits are worth the costs.

4.5.1. Cost Effectiveness Analysis

Cost effectiveness analysis is a technique closely related to cost benefit analysis .it differs in that
it asks a different question, namely given a particular objective, which is the least cost way of
achieving it? It aids choice between options but cannot answer the question whether or not any of
the options are worth doing. It is utilized when there are difficulties in associating monetary
values with the outcomes of projects but where the outcomes can be quantified along some non‐
monetary dimension. In cost‐effectiveness analysis, we measure the benefits in non‐monetary
units, such as test scores, number of students enrolled, or number of children immunized.
Cost effectiveness in education: As an example, suppose we want to evaluate the cost
effectiveness of four options to raise mathematics skills:
 Small remedial groups with a special instructor
 A self-instructional program supported with specially designed materials
 Computer-assisted instruction
 A program involving peer tutoring
We first estimate the effect of each intervention on mathematics skills as measured by, say, test
scores, while controlling for initial levels of learning and personal characteristics. Suppose we
find that students taught in small groups attain scores of 20 points, those undergoing the self‐
instructional program score 4 points, those with computer‐assisted instruction score 15 points,
and those in the peer‐tutored group score 10 points (table 9). These results show that small group
instruction is the most effective intervention. Now consider cost‐effectiveness. Suppose that the
cost per student is US$300 for small group instruction, US$100 for the self‐instructional
program, US$150 for computer‐assisted instruction, and US$50 for peer tutoring. The most cost‐
effective intervention turns out to be peer tutoring; it attains one‐half the gain of small group
instruction at only one‐sixth the cost for a cost‐effectiveness ration of only 5 (see table 9). Cost‐
effectiveness analysis can be used to compare the efficiency of investment in different school
inputs.
Table 9: Hypothetical cost-effectiveness ratios for interventions to improve mathematics

skills
Intervention Size of effect on test scores Cost per student (US$) Cost
effectiveness ratio
Small group instruction 20 300 15
Self-instructional materials 4 100 25
Computer-assisted instruction 15 150 10
Peer tutoring 10 50 5
Cost‐effectiveness ratios must always be used with caution. In the above example, peer tutoring
is the most cost‐effective intervention. If we have several cost effectiveness (CE) ratios and
either the numerator or the denominator has exactly the same value in all cases, CE ratio can be
used safely for decision‐making. CE ratios would be safe to use if the benefits had differed, but

the cost per student had been the same for each intervention. If, however, both the measure of
benefits – test scores in this case – and the costs per student vary among interventions, the
analyst should use CE ratios with caution.
In the example above computer assisted instruction produces a gain of five points over peer
tutoring at an additional cost of US$100, or US$20 per point. To choose peer tutoring over
computer‐assisted instruction solely on the basis of CE ratios would be tantamount to saying that
the marginal gain in test scores is not worth the marginal expense. When using CE ratios, we
advise analysts to ask the following three questions:
 Can I increase the intensity of an intervention and improve the results?
 Can I combine interventions and improve the results?
 Is the intervention‟s marginal gain worth the extra cost?
 Cost Effectiveness in Health

We can use cost‐effectiveness in evaluating interventions that aim to improve the health of a
population. Suppose that we want to design a program of immunization that would provide the
maximum improvement in health for allocated program funds. The package could include only
DPT (a combination of diphtheria, pertussis, and tetanus vaccines) for the child and T (tetanus
toxoid) for the mother, or it could also include BCG (Bacille Calmette Guerin, used to prevent
tuberculosis) for the child. We would want to examine the economic advisability of adopting a
DPTT program, a BCG program, or a combined DPTT plus BCG program rather than continuing
with the existing low level of immunization and treatment of morbidity for diphtheria, petrtussis,
and tetanus.
Having mounted; a DPTT program, suppose we want to examine the advisability of adding a
BCG program and vice versa. Table 10 summarizes the incremental costs and benefits of adding
an expanded program of immunization to the existing program of health services. We measure
the benefits of the project in terms of the deaths prevented, as calculated from a simple
epidemiological model. We base this model on the number of immunizations, the efficacy of the
vaccines, and the incidence and case fatality rates of the diseases involved. The most effective
alternative is a complete immunization program. ADPT only immunization program, however, is
just as cost effective.
If the budget constraint were US$115 million, the most cost‐effective feasible alternative would
be a program of DPT immunization. This example starkly illustrates the limitations of CE ratios.
In line 1, DPT only is just as effective as line 3, a total immunization program. The cost per life
saved for either program is about US$480. Adding BCG to an existing program of DPTT,
however, saves an additional 29,500 lives at a cost of US$14 million, or US$475 dollars per life.
Forgoing adding the BCG program to DPT on the grounds of CE ratios alone would be
tantamount to saying that each additional life saved is not worth US$475.
Table 10: Cost-benefit comparison of immunization alternatives

Alternative Benefits (Death prevented) Costs (US$ millions) Cost-benefit ratio

DPTT only 231,900 111 478.7
BCG only 29,500 61 2,067.8
DPTT+BCG 261,400 125 478.1
Existing BCG,DPTT added 231,900 64 276.0
Existing DPTT,BCG added 29,500 14 474.6
Assessing Unit Costs

We use unit costs for comparing the intervention‟s efficacy within and across countries. In
education, for example, analysts often wish to know the average cost per student of a particular
intervention. Calculating the unit costs of a mature intervention that has reached a steady state is
the simplest of problems, as all the capital costs have already been incurred. The recurrent costs
and the number of students enrolled are fairly stable. Assessing unit costs for a new intervention
is more difficult. Capital costs are typically higher in the initial years, and enrollment and
graduates are typically higher once the project is working at full capacity. Thus, comparing costs
and benefits that occur at different points in time is necessary. The tools of economic analysis are
helpful in these instances as well. Given the cost and benefit profile of the project, the analysis
can discount the benefit and costs flows and compare them at a single point in time.
Consider Higher and Technical Education Project. One of the purposes of this project was to
increase the number of graduates coming out of the University of the Country and the three
polytechnic schools. The investment costs, which would be distributed over five years, amounted
to Birr 343 million (present value discounted at 12 percent). The recurrent costs would be
proportional to the number of students and would rise from about Birr 4 million in the initial year
to about birr 21 million once full capacity had been reached. The discounted value of the
recurrent costs over the life of the project was assessed at Birr 143 million. Enrollment, on the
other hand, would rise slowly from 161 students in the initial years, to about 3700 at full
capacity. To assess the cost per student, the number of students enrolled throughout the life of
the project was discounted at 12 percent.
The discounted number of students was calculated at 13,575 students and the cost per enrolled
student at US$2048 at the then prevailing market exchange rate. Similar calculations show the
cost per graduate at about US$8700. Analysts could use the same methodology to assess the unit
costs of interventions in health or in any project where the output is not easily measured in
monetary terms. For the moment, suffice it to say that by using this procedure, analysts are
discounting the project‟s benefits. The number of students enrolled is a proxy for these benefits.
In this sense, the procedure is, in principle, the same as for projects with benefits measurable in
monetary terms.
4.5.2. Weighted Cost-Effectiveness

Sometimes project evaluation requires joint consideration of multiple outcomes, for example,
test scores in two subjects, and perhaps also their distribution across population groups. In such
situations, the analyst must first assess the importance of each outcome with respect to single
goal, usually a subjective judgment derived from one or many sources, including expert opinion,
policymakers‟ preferences, and community views. These subjective judgments are then
translated into weights. Once the weights are estimated, the next step is to multiply each of the
outcomes by the weights to obtain a single composite measure. The final step is to divide the
composite measure by the cost of the options being considered. The results are called weighted
cost-effectiveness ratios.
 Application in Education
Suppose that employing better‐qualified teacher raises mathematics scores more than language
scores. To evaluate the two options for improving student learning, the analyst must compare the
effect of each option on mathematics and language performance. The analyst could apply equal
weights to the gains in test scores, but if mathematics is judged to be more important than
language, policy makers may prefer to weight scores differently to reflect the relative importance
of the two subjects. Owing to the many dimensions of learning, the need for weighting may arise
even when only one subject is involved.
Consider the data in table 11 which show the effects of two improvement strategies for three
dimensions of reading skills, as well as the weights assigned by experts to these skills on a scale
of 0‐10 points. Assigning the weights is the trickiest part of the exercise; the rest of the
calculation is mechanical. Dividing the weighted scores by the cost of the corresponding
intervention gives the weighted cost‐effectiveness ratio for comparing the interventions. At a
cost of US$95 per pupil for intervention A and US$105 per pupil for intervention B, the option
with the more favorable ratio is the latter.
Table 11: Weighting the outcomes of two interventions to improve reading skills
Category Weights assigned by expert opinion Intervention Aa Intervention Bb
Reading speed 7 75 60
Reading comprehension 9 40 65
Word knowledge 6 55 65
Weighted test score b n.a 1215 1395
Cost per pupil n.a 95 105
Weighted cost-effectiveness ratio n.a 12.8 13.3
n.a. Not applicable
a. the scores on each dimension of outcome are measured as percentile ranking
b. The weighted score is calculated by multiplying the score for reading speed, reading
comprehension, and word knowledge by the corresponding weight and summing up the result.
The weighted score of 1215 for intervention A equals (7x75+9x40+6x55).

Note that this procedure becomes meaningful only when the analyst scores outcomes on a
comparable scale. We could not compare, say, reading speed in words per minute with reading
comprehension in percentage of material understood. The reason is that the composite score
would then depend on the scale used to measure the individual scores. The metric used must be
the same for all dimensions being compared. One procedure is to express all the scores in terms
of percentile rank, as in the earlier example. Applying the appropriate weights to the scores then
provides the desired composite score.
 Application in Health
Weighted cost‐effectiveness is also useful for assessing health projects. Going back to the
immunization example considered before, the immunization interventions reduce morbidity as
well as mortality. A given intervention might have different impacts on the reduction of these
two indicators. To choose among several interventions would require weighting morbidity and
mortality to produce a single measure of benefits. It has become increasingly common to
measure and aggregate reduction in morbidity and premature mortality in terms of years of life
gained.
Table 12 Benefits from interventions: years of life gained from immunization program
Category Mortality Morbidity Total Gain from Gain from
DPT only BCG only
Benefits (years) 56,000 16,992,000 17,048,000 15,127,000 1,921,000
Costs (US$ millions) n.a n.a 125 111 61
Cost-effectiveness ratios n.a n.a 7.3 7.3 31.8
n.a Not applicable
Table 12 shows the costs and benefits of three interventions with the benefits calculated in terms
of health years of life gained, which are calculated as the sum of the difference between the
expected duration of life with and without the intervention plus the expected number of years of
morbidity avoided as a result of the intervention. The analyst calculates the years of life gained
from reductions in mortality and morbidity by using the same epidemiological model applied to
calculate deaths prevented by adding the computation of cases, information on the average
duration of morbidity, & years of life lost based on a life table.
4.5.3. Comparing Option with Subjective Outcomes

Sometimes no quantitative data exist that relate interventions to outcomes. Suppose that we want
to assess two options to improve performance in mathematical and reading, but have no data on
test scores. The evaluator could first ask experts to assess the probability that test scores in the
two subjects will rise by a given amount, say by one grade level, under the interventions being
considered, and then weighting these probabilities according to the benefit of improving test
scores in the two subjects. To elaborate, suppose informed experts judge the probability of
raising mathematics scores to be 0.5 with strategy A and 0.3 with strategy B. Experts also judge
the probability of raising reading scores to be 0.5 with strategy A and 0.8 with strategy B. The

information is insufficient to choose between the strategies, however, because neither dominates
for both subjects. The weighted cost‐effectiveness approach overcomes this difficulty by asking
policymakers or other relevant audiences to assign weights to the gain in test scores.
 Some important caveats
When quantitative data on the relationship between project interventions and their outcomes are
available, and when only a single dimension of outcomes matters, cost‐effectiveness analysis
offers a systematic tool for comparison. The method does not incorporate subjective judgments.
When such judgments enter into measuring project outcomes, the method is called weighted cost
effectiveness analysis. The main advantage of weighted cost‐effectiveness analysis is that we use
it to compare a wide range of project alternatives without requiring actual data. The reliance on
subjective data gives rise to important shortcomings in weighted cost‐effectiveness analysis.
These shortcomings related to two questions: Who should rank the benefits of the options being
considered? How should the ranking of each person or group be combined to obtain an overall
ranking? Choosing the right respondents is critical.
An obvious group to consult comprises people who will be affected by the interventions.
However, other relevant groups include experts with specific knowledge about the interventions
and government officials responsible for implementing the options and managing the public
resources involved. Given that the choice of respondents is itself a subjective decision, different
evaluators working on the same problem almost invariably arrive at different conclusion using
weighted cost‐effectiveness analysis. The method also does not produce consistent comparisons
from project to project. Analysts must be careful when consolidating individual rankings.
Preference scales indicate ordinal, rather than cardinal, interpretations.
One outcome may assign a score of eight as superior to one assigned a score of four, but this
does not necessarily mean that the first outcome is twice as preferable. Another problem is that
the same score may not mean the same thing to different individuals. Finally, there is the
problem of combining the individual scores. Simple summation may be appealing, but as pointed
out in a seminal paper on social choice, the procedure would not be appropriate if there were
interactions among the individuals so that their scores should really be combined in some other
way. Because of the problems associated with interpreting subjective weights in project
evaluation, weighted cost effectiveness analysis should be used with extreme caution, and the
weights be made explicit.

Chapter Review Questions

1. Which one of the following expression cannot represent the purpose of conducting economic
analysis of a project?
A. To evaluate the profitability, sustainability and viability of investments from the project
point of view
B. To assess a sustainable improvement in the welfare of project beneficiaries
C. To ascertain that the value of project benefits will exceed project costs
D. To ensure that scarce resources are allocated efficiently and raises the welfare of its
citizens
E. To assess the productivity of all the resources committed to the project in the economy
2. An economically viable project requires that?
A. It represents the least-cost or most efficient option to achieve the intended project
outcomes
B. It generates an economic surplus above its opportunity cost
C. It will have sufficient funds and well planned resources mobilization
D. It will have the necessary institutional structure for successful operation and maintenance
E. All of the above
3. Among the following expressions which one is the wrong about economic analysis of a
project?
A. Comparison of alternatives helps planners choose the best way to accomplish their
objectives
B. Groups that benefit from a project are not necessarily those who incur the costs of the
project
C. Economic analysis of projects is necessarily based on certain future events
D. The cash flow profile of a project is often as important as the overall benefits
E. Costs and benefits should be quantified whenever reasonable estimates can be made
4. The main factors, which explain the difference in the values of the NPV, IRR and BCR
assumed different in economic analysis and financial analysis except?
A. The items considered as inputs and outputs of the project
B. The prices used in the valuation of inputs and output
C. The procedure for undertaking economic analysis differ that of financial analysis
D. The treatment of taxes, subsidies and other transfer payments
E. None of the above
5. In a neo‐classical world, domestic price is presumed to reflect marginal utility of
consumption on the one hand, and marginal production cost on the other. The legitimacy of
such an assumption is conditional upon certain well‐known conditions being satisfied
except?
A. Homogeneous goods (in quality)

B. Perfect knowledge of all economic agents and large number of competitors

C. Absence of externalities, acceptance of the ruling pattern of income distribution,
D. Ability of consumers to be the best judges of their welfare
E. None
Part II: Short Answer Questions.

1. What are the major questions that good economic analysis should answer and can serve as a
checklist and a map for finding tools that could help answer those questions.
__________________________________________________________________________
_______________________________________________________________
2. The UNIDO approach to SCBA involves five stages, each stage of which measures the
desirability of the project from a different angle. Explain the five stages of UNIDO
approach.
__________________________________________________________________________
______________________________________________________________

CHAPTER FIVE
PROJECT IMPLEMENTATION, MONITORING AND EVALUATION
Introduction
Dear learner! In this chapter, we would like to introduce you with the some ideas of project
implementation and evaluation in the project work. It will be recalled that a project is an
assemblage of people, financial resources and material facilities mobilized and organized for the
purpose of attaining a well defined objective. The implementation of a project requires from the
person in charge the display of managerial capacities in the widest sense of the term, in order to
forecast, organize, direct and control the various operations. More specifically, an efficient
planning system is an indispensable tool for the management of the project.
Learning Objectives
 Understand some basics of monitoring and evaluation
 Realize the significance of monitoring and evaluation
 Know kinds of monitoring and evaluation
 Familiarize with procedures in monitoring and evaluation
Project management/implementation is the project cycle, specifically evolved to coordinate and

control the numerous activities of a project having complex interrelationships. The execution of a
modern project, most of the times, is a race against time. The efficient utilization of resources
and meeting the target dates had become highly complicated and involved and has necessitated
the application of scientific techniques of planning, scheduling and control.
Once a project is selected, the focus shifts to its implementation. This involves the completion of
numerous activities (project components) by employing various resources-men, materials,
machine, money, and time-so that a project on paper is translated into concrete reality. The
activities of a project have inter-relationships arising from physical, technical, and other
considerations. For proper planning, scheduling, and control of the activities of a project, given
their inter-relationships and constraints on the availability of resources, network techniques have
been found quite useful.
Dear learner! Can you explain the concept of project implementation, monitoring and
evaluation in the project work?
5.1. PROJECT IMPLEMENTATION

A. PRE-INVESTMENT PHASE
This stage deals with all issues related to the financial package (mobilizing the financial
resources, conditions of disbursement getting ‐paying out, loan negotiations, and mobilizing the
expertise necessary for the successful construction and operation of the project. It is at this stage

that loan negotiations are made. The financing package becomes more difficult to assemble in
projects involving co‐financing. Co‐financing refers to cases where two or more lending
agencies and/or donors join together in a coordinated way to undertake their loan activities and
establish conditions for a particular project. Broadly speaking, co‐financing takes two forms,
namely, joint financing and parallel financing. In joint financing, the funds of the co‐lenders are
blended together and there is no attempt separately to finance clearly identifiable components of
the project.
There is a common list of goods and services, and the financing of all or certain items is shared
between the co‐lenders in agreed proportions. In parallel financing, in contrast, the co‐lenders
deliberately would select certain project components, that is, they would finance development
goods and service or parts of the project. For example, in a multi‐purpose water development
project, one agency might finance the electrical power‐generation aspects; a second agency
might finance the downstream activities of land development and agriculture support services,
while a third might finance the dam and irrigation network.
Disbursement of the loans, recruitment of management and technicians, and supervision during
construction and implementation of auxiliary programs necessary to ensure the supply of inputs
are all the subordinate operational decisions taken during the pre-investment stage. Mobilizing
the necessary financial resources for the project and mobilizing the expertise necessary for
successful construction and operation of the project are all issues of pre‐investment. The end
result of loan negotiation is the drawing up of a set of loan documents, for example, loan
agreement, or credit agreement, guarantee agreement, subsidiary loan agreement and/or joint
project agreement which are legal instruments with covenants binding on both the lender and the
borrower, and the guarantor, where applicable.
B. INVESTMENT PHASE
If the preparatory work in the pre‐investment is finished and the result of the appraisal is
positive, the implementation or execution phase follows, in which first a detailed design of the
technical components is made. In this stage discrepancies may exist between the costs estimated
and the actual costs to be incurred. If these discrepancies are large, the appraisal may lose its
validity and may need to be redone. One of the objectives of any effort in project planning and
analysis is to have a project that can be implemented to the benefit of the society. Thus,
implementation is perhaps the most important part of the project cycle. The better and more
realistic a project plan is, the more likely it is that the plan can be carried out and the expected
benefit realized. This emphasizes once again the need for careful attention to each aspect of
project planning and analysis.
Project implementation must be flexible. Circumstances will change, and project managers must
be able to respond intelligently to these changes. Technical changes are almost inevitable as the
project proceeds. Price changes may necessitate different techniques of production or
adjustments in inputs. Other changes in the project‟s economic or political environment will alter
the way in which it should be implemented. The greater the uncertainty of various aspects of the
project, or the more innovative and novel the project is, the greater the likelihood that changes
will have to be made. Even as project implementation is under way, project managers will need
to reshape and re‐plan parts of the project, or perhaps the entire project.
Project analysts generally divide the implementation phase into three different time periods:
 Investment period: the period when Project investments are undertaken. This usually extends
3‐5 years in agricultural and high scale infrastructure construction projects.
 Development period: As the production builds up, the project is spoken of as being in the
development period (may be 3‐5 years additional). This period ranges from starting
production until full capacity production.
 Full development period: Once the full development is reached, it continues for the economic
life of the project. 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.
Project implementation must be flexible since circumstances change frequently. Technical
changes are almost inevitable as the project progresses; price changes may necessitate
adjustments to input and output prices; political environment may change. Translating an
investment proposal into a concrete operational unit 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.
 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.
 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.
 Develop project management competence: Use of network techniques. For project planning
and control two basic techniques are available - PERT (program evaluation Review
Technique) and CPM (Critical Path Method). These techniques have lately merged and are
being referred to by common terminology that is network techniques. With the help of these
techniques, monitoring becomes easier.
The investment phase can be divided into the following steps:
i. Establish project management office which involve establishing of the legal, financial
and organizational basis for the implementation of the project

ii. Technology acquisition and transfer, including basic and detailed engineering
iii. Engineering design and Construction work
iv. Installation and erection;
v. Pre-production marketing, including securing of supplies and setting up the
administration of the firm
vi. Recruitment and training of personnel, and
vii. Plant commissioning and start-up.
This implementation basically involves capability in project management. The function of
project management is to foresee or predict as many of the dangers and problems as possible and
to plan, organize and control activities so that the project is completed successfully in spite of the
risks. Project management is the planning, organizing, directing, and controlling of resources for
a specific time period to meet a specific set of one-time-objectives. This process starts before any
resources are committed and must continue until all work is finished. The aim is for the final
result to satisfy the project sponsor or purchaser, within the promised timescale and without
using more money and other resources than those, which were originally set aside or budgeted
for. Since there are different types of projects, the management of these different types of
projects is also different reflecting the peculiarity of the projects. Project management is a
multifaceted process in which many different things get managed simultaneously. In managing
projects we are normally involved in the following types of management:
 Scope management
 Time management
 Human resource management
 Cost management
 Quality management, and
 Communication management
For each of these activities it is necessary to plan, organize, direct, and control. Successful
project management can then be defined as having achieved the project objectives: within
efficient time & cost.
C. OPERATIONAL PHASE
Project operation involves the running and maintenance of new entity in accordance with set
objectives and planned tasks. The problems of the operational phase need to be considered from
both a short-and long-term viewpoint. The short-term view relates to the initial period after
commencement of production when a number of problems may arise concerning such matters as
the application of production techniques, operation of equipment or inadequate labour
productivity owing to a lack of qualified staff. Most of these problems have their origin in the
implementation phase. The long-term view relates to chosen strategies and the associated
production and marketing costs as well as sales revenues. These have a direct relationship with
the projections made at the pre-investment phase. If such strategies and projections are proved
faulty and remedial measures will not only be difficult but may prove to be highly expensive.

The operational phase involves the following main functions.
I. Commissioning and starting of commercial production

Project commissioning is the process of assuring that all systems and components of
a building or industrial plant are designed, installed, tested, operated, and maintained according
to the operational requirements of the owner or final client. A commissioning process may be
applied not only to new projects but also to existing units and systems subject to
expansion, renovation or revamping. In practice, the commissioning process comprises the
integrated application of a set of engineering techniques and procedures to check, inspect and
test every operational component of the project, from individual functions, such
as instruments and equipment, up to complex amalgamations such
as modules, subsystems and systems. Commissioning activities, in the broader sense, are
applicable to all phases of the project, from the basic and
detailed design, procurement, construction and assembly, until the final handover of the unit to
the owner, including sometimes an assisted operation phase.
II. Ex-post project evaluation
The final phase of the project is the evaluation phase. Many usually neglect this stage. The
project analyst looks carefully at the successes and failures in the project experience to learn how
better to plan for the future. In this stage it is important to examine the project plan and what
really happened. Performance review should be done periodically to compare actual performance
with projected performance. A feedback device, it is useful in several ways: (i) it throws light on
how realistic were the assumptions underlying the project; (ii) it provides a documented log of
experience that is highly valuable in future decision making; (iii) it suggests corrective action to
be taken in the light of actual performance; (iv) it helps in uncovering judgment biases; (v) it
induces a desired caution among project sponsors. Weakness and strengths should carefully be
noted so as to serve as important lessons for future project analysis undertaking. Evaluation is
not limited only to completed projects. Ongoing projects could also be evaluated to rectify
problems when the project is in trouble. The evaluation may be done by the project management,
the sponsoring agency, or other bodies.
III. Replacements/ Rehabilitation
Replacement investment is usually neglected in conventional project studies. However, the

economic life of involved machineries and equipment is different. In fact the economic life of the
envisaged firm/plant is determined on the basis of the economic life of the „core‟ technology. A
number of other technologies, specifically the hard ware technologies do have different
economic life. Normally the Rehabilitation works are usually undertaken as a project, because
not only they involve substantial investment, but also they have to be rationalized as whether to
rehabilitate the existing facilities replace the entire plant or consider alternative ways of
rehabilitation.

IV. Expansion/Innovation/
There are different economic forces that justify expansion and innovation. Given the nature of
the technology is a matured one, without substantial change in the nature of the need and hence
chance of proceeding with the same product, expansion may be a rational venture. On the other
hand the industry could be dynamically changing. In such a state of changing industry, there is a
need for at least keeping up with the truck of change or the firm may venture to be the setter of
the competitive benchmarks of the industry.
Dear learner! Can you mention the three phases of project implementation?
5.2. Monitoring and Evaluation: What is Monitoring and Evaluation?
Throughout life we are monitored and evaluated: in school we receive grades, at work we are
given performance appraisals, and we evaluate relationships and monitor our health. Before we
use the formal definitions of monitoring and evaluation, let‟s use commonsense definitions:
Evaluation asks the question “Are we doing the right thing” or “Do we have the right plan?” and
Monitoring checks to see if we are following our plan. Monitoring and Evaluation is the
systematic collection and analysis of information to enable managers and key stakeholders to
make informed decisions, maintain existing practices, policies and principles and improve the
performance of their projects.
Monitoring is the regular gathering analyzing and reporting of information that is needed for
evaluation and/or effective project management. Monitoring is either ongoing or periodic
observation of a project‟s implementation to ensure that inputs, activities, outputs, and external
factors are proceeding according to plan. It focuses on regular collection of information to track
the project. Monitoring provides information to alert the stakeholders as to whether or not results
are being achieved. It also identifies challenges and successes and helps in identifying the source
of an implementation problem.
Evaluation is a selective and periodic exercise that attempts to objectively assess the overall
progress and worth of a project. It uses the information gathered through monitoring and other
research activities and is carried out at particular points during the lifetime of a project.
Evaluation is different from monitoring. Monitoring checks whether the project is on track;
evaluation questions whether the project is on the right track. Monitoring is concerned with the
short-term performances of the project, and evaluation looks more at long-term effects of project
goals. Frequently, evaluation is perceived as an activity, carried out by an expert or a group of
experts, designed to assess the results of a particular project. This is a common misconception. It
is vital that evaluation is carried out with the participation of all project stakeholders, including
beneficiaries. The results of a periodic evaluation are fed into the project planning process as
quickly as possible to enhance the project‟s effectiveness.
Monitoring is useful because it tends to highlight little problems before they become big ones.
An evaluation is a systematic examination of a project to determine its efficiency, effectiveness,

impact, sustainability, and the relevance of its objectives. The dictionary defines evaluation as a
systematic investigation of the worth or merit of an activity. Traditionally, evaluation has been
the last step in the project life cycle and in the project development process. However, it does not
make sense to wait until the project is finished to ask the question “Did we do the right thing?”
Indeed, you could evaluate the effectiveness at each stage of the project life cycle.
In a project the monitoring and evaluation group decides what to monitor. By collecting data
regularly on activity inputs and outputs, processes, and results, the community can monitor the
progress toward the group‟s goals and objectives (e.g., income generated by the sale of a
cookbook, how many people sold how many books over what period of time). In managing a
project indicators are indispensable management tools. They define the data needed to compare
the actual verses the planned results. M&E can be seen as a practical management tool for
reviewing performance. M&E enables learning from experience, which can be used to improve
the design and functioning of projects. Accountability and quality assurance are integral
components of M&E, which help to ensure that project objectives are met, and key outputs and
impacts are achieved.
5.3. Why Monitor and Evaluate?

M&E can help an organization to extract, from past and ongoing activities, relevant information
that can be used as the basis for future planning. Without M&E how would it be possible to
judge if a project was going in the right direction, whether progress and success was being
achieved, and how future efforts might be improved? A structured M&E approach makes
information available to support the implementation of projects and activities and will enhance
the sustainability. Used effectively M&E can help to strengthen project implementation and
encourage useful partnerships with key stakeholders. The main objectives of M&E are thus to:
 Ensure informed decision-making;
 Enhance organizational and development learning;
 Assist in policy development and improvement;
 Provide mechanisms for accountability;
 Promote partnerships with, and knowledge transfer to, key Stakeholders;
 Build capacity in M&E tools and techniques.
 M&E is about feedback from implementation.
 The ultimate purpose of M&E is change for the better.
5.4. Different Kinds of Monitoring & Evaluation

M&E can deal with many issues. It can be M&E of projects, policy implementation, the
performance of a unit in an organization, staff performance or, for example, deliveries from a
subcontractor. This (course) module deals with M&E related to a project. The concepts, tools,
and procedures for project M&E, as presented in this module, also helps to understand other

kinds of M&E.
 Internal and External Project Monitoring & Evaluation
Internal Project M&E is built into the design of a project and is undertaken by the team that is
responsible for management and implementation of the project. This is done to ensure that the
project meets deadlines, stays within the budget and achieves its objectives, activities, outputs
and impacts!. A project that does not monitor its implementation is not a well-managed project.
Findings, recommendations etc of internal monitoring is usually captured in progress reports
submitted by project management. External Project M&E is carried out by an outside team,
which is not directly responsible for the management or implementation of the project. External
M&E should assess the effectiveness of the internal M&E put in place by the project
management team. External monitoring can take place once the project has been completed,
and/or during implementation of the project.
External M&E is often required by donor agencies or government organizations if, for example,
they need to know how their funds are being spent or if their policies are being adhered to. All
projects can benefit from external M&E. Findings and recommendations of external monitoring
are often documented in a review or evaluation report.
Figure 5.1: Differences Between Internal and External Monitoring & Evaluation
Monitoring and Evaluation
Internal M&E External M&E

1. Integrated part of project design 1. Prescribed outside of project
and management. design and management.
2. Undertaken by the project 2. Conducted by a team external
management team. to the project often carried out
3. Findings, lessons learnt and Assessing & by consultants.
recommendations documented improving
3. Findings, lessons learnt and
in regular project progress/ performance
recommendations documented
activity reports. in an evaluation/review report.
Dear learner! Can you explain the difference between project monitoring and evaluation?

 Monitoring Levels
Traditionally, M&E focused on assessing the inputs and activities of a project. Today the focus is
increasingly on measuring the outputs and impacts of a project to achieve a broader development
objective or goal. Project inputs, activities and assumptions/risks are also important, however, as they all
affect outputs. For example, if the budget (an input) is cut by 50%, this will obviously affect the outputs
of the project and will need to be taken into account when conducting the M&E. The various monitoring
levels in a project are:
Input Monitoring
Input monitoring is the monitoring of the resources that are put into the project - these include budget,
staff, skills, etc. Information on this type of monitoring comes mainly from management reports, progress
reports and accounting. For example, ways of measuring this can be the number of days consultants are is
employed, or the amount of funds spent on training and equipment.
Activity Monitoring
Activity monitoring monitors what happens during the implementation of the project and whether those
activities which were planned, were carried out. This information is often taken from the progress report.
Output Monitoring
Output monitoring is a level between activity and impact monitoring. This type of monitoring assesses the
result or output from project inputs and activities. The measurements used for output monitoring will be
those which show the immediate physical outputs and services from the project.
Impact Monitoring
Impact monitoring relates to the objectives of the project. The aim of impact monitoring is to analyze
whether the broader development objectives of the project have been met. Such monitoring should
demonstrate changes that are fundamental and sustainable without continued project support.
 Monitoring & Evaluation and Stakeholder Participation
The participatory approach to project management seeks to enable local communities living adjacent to
projects and other local stakeholders to take part in decision-making and share the benefits of project
activities. This participatory approach should also be applied to M&E. Participatory M&E can play an
important role in ensuring that the participatory principles are put into practice by:
 Improving the effectiveness of project management and decision-making, as the parties who have
been involved in M&E will be informed and aware of the results of the M&E procedure;
 Ensuring that accurate and reliable information is communicated to communities and
stakeholders from the M&E process;
 Ensuring that stakeholders understand the reasons for failure in achieving project outputs and
objectives and how and what to improve in the future;
 Providing mechanisms for transparency and accountability to stakeholders;
 Building community capacity in M&E tools and techniques.
Recommendations from M&E are more likely to be accepted and taken forward by stakeholders, if they
have had an active role in shaping them.

5.5. The Monitoring and Evaluation Procedure
The M&E procedure below sets out the steps in planning and implementing external M&E. The M&E
procedure must be customized to the specific needs of each project, taking into account the project
objectives, inputs, outputs, activities, stakeholders and beneficiaries. The M&E steps will vary from
situation to situation. Seven key steps are listed in Figure 5.2 and further explained in the rest of this
chapter.
Figure 5.2: The M&E Procedure
Step 1
Establish the Purpose and Scope of M&E
Step 2
Identify Performance Questions and Indicators
Step 3
Establish M&E Functions and Assign
Responsibilities and Financial Resources
Step 4
Gather and Organize Data
Step 5
Analyze Data and Prepare an Evaluation Report
Step 6
Disseminate Findings and Recommendations
Step 7
Learn from the M&E

Step 1: Establish the Purpose and Scope of M&E

Specifying the purpose and scope of the M&E helps to clarify what can be expected of the M&E
procedure, how comprehensive it should be and what resources and time will be needed to
implement it.
When formulating the purpose of M&E, relevant stakeholders including the project management
team, should be consulted or at least made aware of and understand the purpose of the M&E.
Example of an External M&E Purpose

To verify that the development objective and outputs of the project have been achieved within
the allocated budget. The scope of the M&E may be determined by asking some of the following
questions:
 What is the purpose of M&E?
 How much money is available for your M&E?
 What type of information is required by project management,
donor agents or other stakeholders?
 What is the level of M&E expertise available?
 To what extent should local communities and other stakeholders, participate in the M&E
procedure?
Step 2: Identify Performance Questions and Indicators
I. Performance Questions
A performance question is used to focus on whether a project is performing as planned and if
not, why not. Performance questions will be guided by the broader development objective, the
project objectives, the project outputs, as well as the M&E purpose. Once performance questions
have been identified, it will be easier to decide what information is needed to evaluate the
project. Table 1 gives examples of performance questions for the M&E of a particular project.
II. Indicators
Indicators should be guided by performance questions and linked to the purpose of the M&E.
Indicators are basically measurements that can be used to assess the performance of the project.
While performance questions help to decide what should be monitored and evaluated, indicators
provide the actual measurements for M&E and determine what data needs to be gathered. The
project itself may have indicators by which it monitors it's own progress - these may be used for
external M&E, if relevant. Also the funding organization and other stakeholders can provide
broader indicators that may be relevant to the external M&E of the project.
Indicators, and therefore the data needed to verify them, can be qualitative or quantitative.
Quantitative data is factual while qualitative information is based on opinions and perceptions

and thus may be subject to further interpretation. During M&E, one should aim to have both
qualitative and quantitative indicators. Table 3 provides examples of quantitative and qualitative
indicators.
Table 3: Examples of Quantitative and Qualitative Indicators
INDICATOR
EXAMPLES
TYPES
Quantitative . Fifty bundles of poles are harvested each month.
Indicators . Five training courses were run during the project.
Qualitative The pole harvesters regard the harvesting system as being sustainable
Those who attended the training courses perceived the courses to be
Indicators
meeting the demands for skills in the area.
 Relevant - The indicators should be directly linked to the project 0bjectives/ outputs.
 Technically feasible - The indicators should be capable of being verified or measured and
analyzed.
 Reliable - The indicators should be objective: i.e. conclusions based on them should be
the same if different people assess them at different times.
 Usable - People carrying out the M&E should be able to understand and use the
information provided by the indicators to evaluate the project.
 Participatory - Relevant stakeholders should be involved in the collection of information
generated by the indicators, the analysis of the information and possible use of the
information in the future.
Step 3: Establish M&E Functions and Assign Responsibilities and Financial Resources
Establishing M&E functions and responsibilities at the beginning of the procedure can help to
avoid major communication issues, conflicts of interest, duplication of tasks and wasted efforts.
Organizing responsibilities means deciding which stakeholders will be involved and clarifying
and assigning roles to these stakeholders as well as to funding organization officials, project
management and any partner organizations. Stakeholders may need to be trained in different
aspects of the M&E procedure
M&E will require financial resources in accordance with the type of project(s) that is being
evaluated as well as the M&E purpose, performance questions and indicators. Among the items
that should be included in M&E costs are:
 Staff salaries;

 Fees and expenses for consultants;

 M&E training;
 Organizing M&E meetings and other participatory exercises.
Consultants can play an important role in enabling projects to fulfill its M&E responsibilities by
providing specialist knowledge and expertise that may not be readily available in the
organization.
Step 4: Gather and Organize Data

Data is the oxygen that gives life to M&E. However, selecting methods of data collection can be
confusing, unless it is approached in a systematic fashion. Rarely is anyone method entirely
suitable for a given situation. Instead, using multiple methods helps to validate M&E findings
and provides a more balanced and holistic view of project progress and achievements. The
performance questions and indicators will provide guidance in deciding what data/information to
gather and the methods to be used. Data can either be primary or secondary.
A. Data Sources and Data Collection Methods

Potential data sources and data collection methods are listed below:
 Document Review: Documents and reports provide a rich source of information for M&E.
 .Interviews : Interviews can provide a rich source of data, particularly in regard to
qualitative and sensitive information that may not be readily available in official documents.
 Surveys and Questionnaires: Surveys and questionnaires provide a way of obtaining
information from a large number of people. Questions should be relevant and simple to
answer.
 Field Visits and Transect Walks Visits to the site of a project can provide valuable
information about the environment in which the project is taking place, its impact on
beneficiaries and the working methods that are being used. Transect walks are an effective
participatory method to gather this information.
 Expert Opinion Obtaining the views of experts who are knowledgeable about particular
aspects of the project's activities can in some instances provide valuable insights that may
not be revealed by other methods of data collection.
B. Organizing and Storing Data

Data needs to be captured, organized and stored so that it can be readily used for the M&E
purposes.. Proper capturing, organizing and storage is particularly important when information
has been collected from different sources with different methods.
Step 5: Analyze Data and Prepare an Evaluation Report

The captured and organized data needs to be analyzed, and findings and recommendations
summarized and compiled into a report. In this regard, the performance questions and indicators
can provide important assessment tools for the analysis. A final comparison with the outputs and
impacts of the project should then be made. In this way performance, progress and achievements

of the project can be assessed.
Reporting
Feedback and reporting are key to both internal and external M&E as, in this way, information
can be meaningfully combined, explained, compared and presented. All reporting should thus be
as accurate and relevant as possible. As mentioned earlier, external M&E will frequently use the
internal project progress reports and other relevant information as part of the information
gathered to externally monitor and evaluate the project. For external M&E the report is usually
called an evaluation or review report.
Step 6: Disseminate Findings and Recommendations

The evaluation reports, or summaries of these reports, should be widely distributed and presented
to decision-makers and key stakeholders including those who were consulted in the M&E
process.
Step 7: Learn from the M&E

Knowledge gained through M&E lies at the core of DW AF's organizational learning process.
M&E provides information and facts that, when analyzed, understood and accepted, become
knowledge that can be used to improve Project management. Besides learning about the
progress/achievements of the project outputs, etc, it is essential to learn from what works
regarding partnership strategies, project design and implementation, and to feed this knowledge
back into ongoing and future projects and policies. This information also provides a means to
regulate the sustainable management of state projects by other agencies. Project evaluations can
help to bring development partners together, and when this occurs the learning from M&E goes
beyond project to stakeholders involved in other development and natural resource management
activities.
Chapter Review Questions
1. Delays in implementation, which are common, can lead to substantial cost overrun and; to
reduce such discrepancies and expeditious implementation at a reasonable cost we should
give due attention for?
A. Adequate formulation of projects
B. Use of the principle of responsibility accounting
C. Developing a network for functions
D. Develop project management competence E. All
2. In managing projects we are normally involved in the following types of management
except?
A. Scope management D. Cost management
B. Time management E. None
C. Human resource management
3. Which one of the following expression is wrong about project monitoring and its purpose?

A. Monitoring is the regular gathering, analyzing and reporting of information that is needed
for effective project management.
B. Monitoring is either ongoing or periodic observation of a project‟s implementation to
ensure that inputs, activities, outputs, and external factors are proceeding according to
plan
C. Monitoring is a selective and periodic exercise that attempts to objectively assess the
overall progress and worth of a project.
D. Monitoring provides information to alert the stakeholders as to whether or not results are
being achieved.
E. Monitoring also identifies challenges and successes and helps in identifying the source of
an implementation problem.
4. The various monitoring levels in a project includes all except?
A. Input monitoring D. Impact monitoring
B. Output monitoring E. None
C. Activity monitoring
Part II: Short Answer Questions.

3. Briefly explain the three important phases of project implementation and their relative
functions.
__________________________________________________________________________
__________________________________________________________________________
________________________________________________________
4. Describe the main objectives of project monitoring and evaluation.
__________________________________________________________________________
__________________________________________________________________________
_________________________________________________________

CHAPTER SIX
SOME BASICS OF IMPACT EVALUATION
Introduction
Dear learner! In this chapter, we would like to introduce you with the some ideas of project
impact evaluation in the development intervention. An impact evaluation provides information
about the impacts produced by an intervention - positive and negative, intended and unintended,
direct and indirect. This means that an impact evaluation must establish what has been the cause
of observed changes (in this case impact referred to as causal attribution (also referred to as
causal inference). If an impact evaluation fails to systematically undertake causal attribution,
there is a greater risk that the evaluation will produce incorrect findings and lead to incorrect
decisions. For example, deciding to scale up when the program is actually ineffective or effective
only in certain limited situations, or deciding to exit when a program could be made to work if
limiting factors were addressed.
Learning Objective
 Familiarize with the idea of project impact assessment
 Realize the methodologies used in impact evaluation
6.1. What is Impact Evaluation?

An impact evaluation provides information about the impacts produced by an intervention.
The intervention might be a small project, a large programme, a collection of activities, or a
policy. Many development agencies use the definition of impacts provided by the Organisation
for Economic Co-operation and Development – Development Assistance Committee: “positive
and negative, primary and secondary long-term effects produced by a development intervention,
directly or indirectly, intended or unintended.” (OECD-DAC 2010).
This definition implies that impact evaluation:

 Goes beyond describing or measuring impacts that have occurred to seeking to
understand the role of the intervention in producing these (causal attribution);
 Can encompass a broad range of methods for causal attribution; and,
 Includes examining unintended impacts.
Dear learner! Can you explain the idea of impact evaluation on your own word?
6.2. Why do Impact Evaluation?

An impact evaluation can be undertaken to improve or reorient an intervention (i.e., for
formative purposes) or to inform decisions about whether to continue, discontinue, replicate or
scale up an intervention (i.e., for summative purposes). While many formative evaluations focus
on processes, impact evaluations can also be used formatively if an intervention is ongoing. For

example, the findings of an impact evaluation can be used to improve implementation of a

programme for the next intake of participants by identifying critical elements to monitor and
tightly manage. Most often, impact evaluation is used for summative purposes. Ideally, a
summative impact evaluation does not only produce findings about „what works‟ but also
provides information about what is needed to make the intervention work for different groups in
different settings.
6.3. When to do Impact Evaluation?

An impact evaluation should only be undertaken when its intended use can be clearly identified
and when it is likely to be able to produce useful findings, taking into account the availability of
resources and the timing of decisions about the intervention under investigation. An evaluability
assessment might need to be done first to assess these aspects. Prioritizing interventions for
impact evaluation should consider: the relevance of the evaluation to the organizational or
development strategy; its potential usefulness; the commitment from senior managers or policy
makers to using its findings; and/or its potential use for advocacy or accountability requirements.
It is also important to consider the timing of an impact evaluation. When conducted belatedly,
the findings come too late to inform decisions. When done too early, it will provide an inaccurate
picture of the impacts (i.e., impacts will be understated when they had insufficient time to
develop or overstated when they decline over time).
Issue Impact evaluation might be appropriate Impact evaluation might NOT be appropriate
when... when…
Intended uses and There is scope to use the findings to There are no clear intended uses or intended
timing inform decisions about future interventions. users – for example, decisions have already
been made on the basis of existing credible
evidence, or need to be made before it will be
possible to undertake a credible impact
evaluation.
Focus There is a need to understand the impacts The priority at this stage is to understand and
that have been produced. improve the quality of implementation.
Resources There are adequate resources to Existing data are inadequate and there are
undertake a sufficiently comprehensive insufficient resources to fill gaps.
and rigorous impact evaluation, including
the availability of existing, good quality
data and additional time and money to
collect more.
Relevance It is clearly linked to the strategies and It is peripheral to the strategies and priorities of
priorities of an organisation, partnership an organisation, partnership and/or government.
and/or government.

6.4. Who to Engage in the Evaluation Process?

Regardless of the type of evaluation, it is important to think through who should be involved,
why and how in each step of the evaluation process to develop an appropriate and context-
specific participatory approach. Participation can occur at any stage of the impact evaluation
process: in deciding to do an evaluation, in its design, in data collection, in analysis, in reporting
and, also, in managing it. Being clear about the purpose of participatory approaches in an impact
evaluation is an essential first step towards managing expectations and guiding implementation.
Is the purpose to ensure that the voices of those whose lives should have been improved by the
programme or policy are central to the findings? Is it to ensure a relevant evaluation focus? Is it
to hear people‟s own versions of change rather than obtain an external evaluator‟s set of
indicators? Is it to build ownership of a donor-funded programme? These, and other
considerations, would lead to different forms of participation by different combinations of
stakeholders in the impact evaluation.
The underlying rationale for choosing a participatory approach to impact evaluation can be either
pragmatic or ethical, or a combination of the two. Pragmatic because better evaluations are
achieved (i.e., better data, better understanding of the data, more appropriate recommendations,
better uptake of findings); ethical because it is the right thing to do (i.e., people have a right to be
involved in informing decisions that will directly or indirectly affect them, as stipulated by the
UN human rights-based approach to programming).
Participatory approaches can be used in any impact evaluation design. In other words, they are
not exclusive to specific evaluation methods or restricted to quantitative or qualitative data
collection and analysis. The starting point for any impact evaluation intending to use
participatory approaches lies in clarifying what value this will add to the evaluation itself as well
as to the people who would be closely involved (but also including potential risks of their
participation). Three questions need to be answered in each situation:
(1) What purpose will stakeholder participation serve in this impact evaluation?;
(2) Whose participation matters, when and why?; and,
(3) When is participation feasible?
Only after addressing these, can the issue of how to make impact evaluation more participatory
be addressed.
6.5. How to Plan and Manage an Impact Evaluation?

Like any other evaluation, an impact evaluation should be planned formally and managed as a
discrete project, with decision-making processes and management arrangements clearly
described from the beginning of the process.
Planning and managing include:

 Describing what needs to be evaluated and developing the evaluation brief

 Identifying and mobilizing resources

 Deciding who will conduct the evaluation and engaging the evaluator(s)
 Deciding and managing the process for developing the evaluation methodology
 Managing development of the evaluation work plan
 Managing implementation of the work plan including development of reports
 Disseminating the report(s) and supporting use
Determining causal attribution is a requirement for calling an evaluation an impact evaluation.
The design options (whether experimental, quasi-experimental, or non-experimental) all need
significant investment in preparation and early data collection, and cannot be done if an impact
evaluation is limited to a short exercise conducted towards the end of intervention
implementation. Hence, it is particularly important that impact evaluation is addressed as part of
an integrated monitoring, evaluation and research plan and system that generates and makes
available a range of evidence to inform decisions. This will also ensure that data from other
M&E activities such as performance monitoring and process evaluation can be used, as needed.
6.6. What Methods can be used to do Impact Evaluation?

Framing the boundaries of the impact evaluation
The evaluation purpose refers to the rationale for conducting an impact evaluation. Evaluations
that are being undertaken to support learning should be clear about who is intended to learn from
it, how they will be engaged in the evaluation process to ensure it is seen as relevant and
credible, and whether there are specific decision points around where this learning is expected to
be applied. Evaluations that are being undertaken to support accountability should be clear about
who is being held accountable, to whom and for what. Evaluation relies on a combination of
facts and values (i.e., principles, attributes or qualities held to be intrinsically good, desirable,
important and of general worth such as „being fair to all‟) to judge the merit of an intervention
(Stufflebeam 2001). Evaluative criteria specify the values that will be used in an evaluation and,
as such, help to set boundaries. Many impact evaluations use the standard OECD-DAC criteria
(OECD-DAC accessed 2015):
 Relevance: The extent to which the objectives of an intervention are consistent with
recipients‟ requirements, country needs, global priorities and partners‟ policies.
 Effectiveness: The extent to which the intervention‟s objectives were achieved, or are
expected to be achieved, taking into account their relative importance.
 Efficiency: A measure of how economically resources/inputs (funds, expertise, time,
equipment, etc.) are converted into results.
 Impact: Positive and negative primary and secondary long-term effects produced by the
intervention, whether directly or indirectly, intended or unintended.
 Sustainability: The continuation of benefits from the intervention after major development
assistance has ceased. Interventions must be both environmentally and financially
sustainable. Where the emphasis is not on external assistance, sustainability can be defined as

the ability of key stakeholders to sustain intervention benefits – after the cessation of donor
funding – with efforts that use locally available resources.
The OECD-DAC criteria reflect the core principles for evaluating development assistance
(OECD-DAC 1991) and have been adopted by most development agencies as standards of good
practice in evaluation. Other, commonly used evaluative criteria are about equity, gender
equality, and human rights. And, some are used for particular types of development
interventions such humanitarian assistance such as: coverage, coordination, protection,
coherence. In other words, not all of these evaluative criteria are used in every evaluation,
depending on the type of intervention and/or the type of evaluation (e.g., the criterion of impact
is irrelevant to a process evaluation).
Evaluative criteria should be thought of as „concepts‟ that must be addressed in the evaluation.
They are insufficiently defined to be applied systematically and in a transparent manner to make
evaluative judgements about the intervention. Under each of the „generic‟ criteria, more specific
criteria such as benchmarks and/or standards* – appropriate to the type and context of the
intervention – should be defined and agreed with key stakeholders. The evaluative criteria should
be clearly reflected in the evaluation questions the evaluation is intended to address.
*A benchmark or index is a set of related indicators that provides for meaningful, accurate and
systematic comparisons regarding performance; a standard or rubric is a set of related
benchmarks/indices or indicators that provides socially meaningful information regarding
performance. Defining the key evaluation questions (KEQs) the impact evaluation should
address. Impact evaluations should be focused around answering a small number of high-level
key evaluation questions (KEQs) that will be answered through a combination of evidence.
These questions should be clearly linked to the evaluative criteria. For example:
KEQ1. What was the quality of the intervention design/content? [assessing relevance, equity, gender equality,
human rights]
KEQ2. How well was the intervention implemented and adapted as needed? [assessing effectiveness, efficiency]
KEQ3. Did the intervention produce the intended results in the short, medium and long term? If so, for whom, to
what extent and in what circumstances? [assessing effectiveness, impact, equity, gender equality]
KEQ4. What unintended results – positive and negative – did the intervention produce? How did these occur?
[assessing effectiveness, impact, equity, gender equality, human rights]
KEQ5. What were the barriers and enablers that made the difference between successful and disappointing
intervention implementation and results? [assessing relevance, equity, gender equality, human rights]

KEQ6. How valuable were the results to service providers, clients, the community and/or organizations involved?
[assessing relevance, equity, gender equality, human rights]
KEQ7. To what extent did the intervention represent the best possible use of available resources to achieve
results of the greatest possible value to participants and the community? [assessing efficiency]
KEQ8. Are any positive results likely to be sustained? In what circumstances? [assessing sustainability, equity,
gender equality, human rights]
A range of more detailed (mid-level and lower-level) evaluation questions should then be
articulated to address each evaluative criterion in detail. All evaluation questions should be
linked explicitly to the evaluative criteria to ensure that the criteria are covered in full.
The KEQs also need to reflect the intended uses of the impact evaluation. For example, if an
evaluation is intended to inform the scaling up of a pilot programme, then it is not enough to ask
„Did it work?‟ or „What were the impacts?‟. A good understanding is needed of how these
impacts were achieved in terms of activities and supportive contextual factors to replicate the
achievements of a successful pilot. Equity concerns require that impact evaluations go beyond
simple average impact to identify for whom and in what ways the programmes have been
successful.
Within the KEQs, it is also useful to identify the different types of questions involved –
descriptive, causal and evaluative.
 Descriptive questions ask about how things are and what has happened, including describing the
initial situation and how it has changed, the activities of the intervention and other related
programmes or policies, the context in terms of participant characteristics, and the
implementation environment.
 Causal questions ask whether or not, and to what extent, observed changes are due to the
intervention being evaluated rather than to other factors, including other programmes and/or
policies.
 Evaluative questions ask about the overall conclusion as to whether a programme or policy can
be considered a success, an improvement or the best option.
Impact evaluations must have credible answers to all of these questions.

Defining impacts
Impacts are usually understood to occur later than, and as a result of, intermediate outcomes. For
example, achieving the intermediate outcomes of improved access to land and increased levels
of participation in community decision-making might occur before, and contribute to, the
intended final impact of improved health and well-being for women. The distinction between

outcomes and impacts can be relative, and depends on the stated objectives of an intervention. It
should also be noted that some impacts may be emergent, and thus, cannot be predicted.
Defining success to make evaluative judgments

Evaluation, by definition, answers evaluative questions, that is, questions about quality and
value. This is what makes evaluation so much more useful and relevant than the mere
measurement of indicators or summaries of observations and stories. In any impact evaluation, it
is important to define first what is meant by „success‟ (quality, value). One way of doing so is to
use a specific rubric that defines different levels of performance (or standards) for each
evaluative criterion, deciding what evidence will be gathered and how it will be synthesized to
reach defensible conclusions about the worth of the intervention.
At the very least, it should be clear what trade-offs would be appropriate in balancing multiple
impacts or distributional effects. Since development interventions often have multiple impacts,
which are distributed unevenly, this is an essential element of an impact evaluation. For example,
should an economic development programme be considered a success if it produces increases in
household income but also produces hazardous environment impacts? Should it be considered a
success if the average household income increases but the income of the poorest households is
reduced?
To answer evaluative questions, what is meant by „quality‟ and „value‟ must first be defined and
then relevant evidence gathered. Quality refers to how good something is; value refers to how
good it is in terms of the specific situation, in particular taking into account the resources used to
produce it and the needs it was supposed to address. Evaluative reasoning is required to
synthesize these elements to formulate defensible (i.e., well-reasoned and well evidenced)
answers to the evaluative questions. Evaluative reasoning is a requirement of all evaluations,
irrespective of the methods or evaluation approach used.
An evaluation should have a limited set of high-level questions which are about performance
overall. Each of these KEQs should be further unpacked by asking more detailed questions about
performance on specific dimensions of merit and sometimes even lower-level questions.
Evaluative reasoning is the process of synthesizing the answers to lower- and mid-level
questions into defensible judgements that directly answer the high-level questions.
Using a theory of change

Evaluations produce stronger and more useful findings if they not only investigate the links
between activities and impacts but also investigate links along the causal chain between
activities, outputs, intermediate outcomes and impacts. A „theory of change‟ that explains how
activities are understood to produce a series of results that contribute to achieving the ultimate
intended impacts, is helpful in guiding causal attribution in an impact evaluation. A theory of

change should be used in some form in every impact evaluation. It can be used with any research
design that aims to infer causality, it can use a range of qualitative and quantitative data, and
provide support for triangulating the data arising from a mixed methods impact evaluation.
When planning an impact evaluation and developing the terms of reference, any existing theory
of change for the programme or policy should be reviewed for appropriateness,
comprehensiveness and accuracy, and revised as necessary. It should continue to be revised over
the course of the evaluation should either the intervention itself or the understanding of how it
works – or is intended to work – change.
Some interventions cannot be fully planned in advance, however – for example, programmes in
settings where implementation has to respond to emerging barriers and opportunities such as to
support the development of legislation in a volatile political environment. In such cases, different
strategies will be needed to develop and use a theory of change for impact evaluation (Funnell
and Rogers 2012). For some interventions, it may be possible to document the emerging theory
of change as different strategies are trialled and adapted or replaced. In other cases, there may be
a high-level theory of how change will come about (e.g., through the provision of incentives) and
also an emerging theory about what has to be done in a particular setting to bring this about.
Elsewhere, its fundamental basis may revolve around adaptive learning, in which case the theory
of change should focus on articulating how the various actors gather and use information
together to make ongoing improvements and adaptations.
A theory of change can support an impact evaluation in several ways. It can identify:
 Specific evaluation questions, especially in relation to those elements of the theory of change
for which there is no substantive evidence yet
 Relevant variables that should be included in data collection
 Intermediate outcomes that can be used as markers of success in situations where the impacts
of interest will not occur during the time frame of the evaluation
 Aspects of implementation that should be examined
 Potentially relevant contextual factors that should be addressed in data collection and in
analysis, to look for patterns.
The evaluation may confirm the theory of change or it may suggest refinements based on the
analysis of evidence. An impact evaluation can check for success along the causal chain and, if
necessary, examine alternative causal paths. For example, failure to achieve intermediate results
might indicate implementation failure; failure to achieve the final intended impacts might be due
to theory failure rather than implementation failure. This has important implications for the
recommendations that come out of an evaluation. In cases of implementation failure, it is
reasonable to recommend actions to improve the quality of implementation; in cases of theory
failure, it is necessary to rethink the whole strategy for achieving impacts.

Deciding the evaluation methodology

The evaluation methodology sets out how the key evaluation questions (KEQs) will be answered.
It specifies designs for causal attribution, including whether and how comparison groups will be
constructed, and methods for data collection and analysis.
 Strategies and designs for determining causal attribution

Causal attribution is defined by OECD-DAC as: “Ascription of a causal link between observed
(or expected to be observed) changes and a specific intervention.” (OECD_DAC 2010).
This definition does not require that changes are produced solely or wholly by the programme or
policy under investigation (UNEG 2013). In other words, it takes into consideration that other
causes may also have been involved, for example, other programmes/policies in the area of
interest or certain contextual factors (often referred to as „external factors‟).
There are three broad strategies for causal attribution in impact evaluations:
 Estimating the counterfactual (i.e., what would have happened in the absence of the
intervention, compared to the observed situation)
 Checking the consistency of evidence for the causal relationships made explicit in the theory
of change
 Ruling out alternative explanations, through a logical, evidence-based process.
Using a combination of these strategies can usually help to increase the strength of the
conclusions that are drawn.
There are three design options that address causal attribution:

 Experimental designs – which construct a control group through random assignment.
 Quasi-experimental designs – which construct a comparison group through matching,
regression discontinuity, propensity scores or another means.
 Non-experimental designs – which look systematically at whether the evidence is consistent
with what would be expected if the intervention was producing the impacts, and also
whether other factors could provide an alternative explanation.
Some individuals and organisations use a narrower definition of impact evaluation, and only
include evaluations containing a counterfactual of some kind. These different definitions are
important when deciding what methods or research designs will be considered credible by the
intended user of the evaluation or by partners or funders.
 Data collection, management and analysis approach

Well-chosen and well-implemented methods for data collection and analysis are essential for all
types of evaluations. Impact evaluations need to go beyond assessing the size of the effects (i.e.,

the average impact) to identify for whom and in what ways a programme or policy has been
successful. What constitutes „success‟ and how the data will be analysed and synthesized to
answer the specific key evaluation questions (KEQs) must be considered up front as data
collection should be geared towards the mix of evidence needed to make appropriate judgements
about the programme or policy.
In other words, the analytical framework – the methodology for analysing the „meaning‟ of the
data by looking for patterns in a systematic and transparent manner – should be specified during
the evaluation planning stage. The framework includes how data analysis will address
assumptions made in the programme theory of change about how the programme was thought to
produce the intended results. In a true mixed methods evaluation, this includes using appropriate
numerical and textual analysis methods and triangulating multiple data sources and perspectives
in order to maximize the credibility of the evaluation findings.
Start the data collection planning by reviewing to what extent existing data can be used. After
reviewing currently available information, it is helpful to create an evaluation matrix (see below)
showing which data collection and analysis methods will be used to answer each KEQ and then
identify and prioritize data gaps that need to be addressed by collecting new data. This will help
to confirm that the planned data collection (and collation of existing data) will cover all of the
KEQs, determine if there is sufficient triangulation between different data sources and help with
the design of data collection tools (such as questionnaires, interview questions, data extraction
tools for document review and observation tools) to ensure that they gather the necessary
information.
Evaluation matrix: Matching data collection to key evaluation questions

Programme Key Observation of
participant informant Project programme
Examples of key evaluation questions (KEQs) survey interviews records implementation
✔ ✔ ✔
KEQ 1 What was the quality of implementation?
KEQ 2 To what extent were the programme ✔ ✔ ✔

objectives met?
KEQ 3 What other impacts did the programme ✔ ✔

have?
✔ ✔
KEQ 4 How could the programme be improved?

There are many different methods for collecting data. Although many impact evaluations use a
variety of methods, what distinguishes a ‟mixed methods evaluation‟ is the systematic
integration of quantitative and qualitative methodologies and methods at all stages of an
evaluation (Bamberger 2012). A key reason for mixing methods is that it helps to overcome the
weaknesses inherent in each method when used alone. It also increases the credibility of
evaluation findings when information from different data sources converges (i.e., they are
consistent about the direction of the findings) and can deepen the understanding of the
programme/policy, its effects and context (Bamberger 2012).
Good data management includes developing effective processes for: consistently collecting and
recording data, storing data securely, cleaning data, transferring data (e.g., between different
types of software used for analysis), effectively presenting data and making data accessible for
verification and use by others. The particular analytic framework and the choice of specific data
analysis methods will depend on the purpose of the impact evaluation and the type of KEQs that
are intrinsically linked to this.
For answering descriptive KEQs, a range of analysis options is available, which can largely be
grouped into two key categories: options for quantitative data (numbers) and options for
qualitative data (e.g., text).
For answering causal KEQs, there are essentially three broad approaches to causal attribution
analysis: (1) counterfactual approaches; (2) consistency of evidence with causal relationship; and
(3) ruling out alternatives (see above). Ideally, a combination of these approaches is used to
establish causality.
For answering evaluative KEQs, specific evaluative rubrics linked to the evaluative criteria
employed (such as the OECD-DAC criteria) should be applied in order to synthesize the
evidence and make judgements about the worth of the intervention (see above).
6.7. How can the Findings be Reported and Their Use Supported?
The evaluation report should be structured in a manner that reflects the purpose and KEQs of the
evaluation. In the first instance, evidence to answer the detailed questions linked to the OECD-
DAC criteria of relevance, effectiveness, efficiency, impact and sustainability, and
considerations of equity, gender equality and human rights should be presented succinctly but
with sufficient detail to substantiate the conclusions and recommendations.
The specific evaluative rubrics should be used to „interpret‟ the evidence and determine which
considerations are critically important or urgent. Evidence on multiple dimensions should
subsequently be synthesized to generate answers to the high-level evaluative questions. The

structure of an evaluation report can do a great deal to encourage the succinct reporting of direct
answers to evaluative questions, backed up by enough detail about the evaluative reasoning and
methodology to allow the reader to follow the logic and clearly see the evidence base.
The following recommendations will help to set clear expectations for evaluation reports that are
strong on evaluative reasoning:
1. The executive summary must contain direct and explicitly evaluative answers to the KEQs
used to guide the whole evaluation.
2. Explicitly evaluative language must be used when presenting findings (rather than value-
neutral language that merely describes findings). Examples should be provided.
3. Use of clear and simple data visualization to present easy-to-understand „snapshots‟ of how
the intervention has performed on the various dimensions of merit.
4. Structuring of the findings section using KEQs as subheadings (rather than types and sources
of evidence, as is frequently done).
5. There must be clarity and transparency about the evaluative reasoning used, with the
explanations clearly understandable to both non-evaluators and readers without deep content
expertise in the subject matter. These explanations should be broad and brief in the main
body of the report, with more detail available in annexes.
6. If evaluative rubrics are relatively small in size, these should be included in the main body of
the report. If they are large, a brief summary of at least one or two should be included in the
main body of the report, with all rubrics included in full in an annex.
Chapter Review Question

Part I: Short Answer Questions.
1. What is Impact Evaluation? Why do Impact Evaluation? When to do Impact Evaluation?
__________________________________________________________________________
__________________________________________________________________________
______________________________________________________________
2. What Methods can be used to do Impact Evaluation?
__________________________________________________________________________
__________________________________________________________________________
_______________________________________________________________
3. How can the Findings be Reported and Their Use?
__________________________________________________________________________
__________________________________________________________________________
_________________________________________________________________

REFERENCES
1. Chandra, Prassana, 1995. Projects: Planning, Selection, Implementation and Review.
2. Jhingan, M.L.1997. The Economics of Development and planning, 37th ed. Vrinda
Publications Ltd, Delhi.
3. Little I.M. and Mirrlees J. A., 1974. Project Appraisal and Planning for Developing
Countries.
4. Austin, E. James. (1981). Agro-Industrial Project Analysis. The Johns Hopkins
University Press. London.
5. Boardman Anthony E David H. Greenberg Aidan R. Vining and David L. Weimer, (1996)
Cost Benefit Analysis: Concepts and Practice.
6. Curry, Steve and John Weiss, (1993) Project Analysis in Developing Countries, Mc
Millan,
7. Gittenger, Price, J. (1982). Economic Analysis of Agricultural Projects. The Johns
Hopkins University Press. London.
8. Tsegabirhan W.Giorgis, (2007/08). Development planning and project analysis II,
Lecture note; Addis Ababa University.

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Development Planning and Project Analysis II Econ 4132 Module

Arba Minch University

Development Planning and Project Analysis II

Prepared By: Mulugeta Fekadu (MSc)

AMU Department of Economics 2022/23 Page 1

AMU Department of Economics 2022/23 Page 2

Table of content Page

1.1. The Project Concept ……………………………………………………………………...5

Chapter Three: Financial Analysis and Appraisal of Projects ……………………………...57

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3.6.Sensitivity Analysis ………………………………………………………………………71

Chapter Four: Economic Analysis of Projects ……………………………………………….95

Chapter Five: Project Implementation, Monitoring and Evaluation ……………………..146

Chapter Six: Some Basics of Impact Evaluation …………………………………………...161

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1.1. The Project Concept

1.1.2. The Basic Characteristics of a Project

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1.1.3. Additional Descriptions/Features of Projects

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A project is an instrument of change. It is a coordinated series of actions resulting from a

A project is people‐oriented. It responds to people‟s actions. Projects should forecast the

1.1.4. Classification of Project

 Size/scale/, small-, medium- and large- scales of projects;

AMU Department of Economics 2022/23 Page 8

1. Agricultural project: Agriculture project is focused on five areas: raising productivity;

3. Construction project: A construction project, sometimes just referred to as a „project‟, is the

AMU Department of Economics 2022/23 Page 9

4. Manufacturing project: It is an operation designed to produce large, expensive, specialized

5. Research projects: Research comprises "creative and systematic work undertaken to

1.1.5. The Link Between Policy, Development Plan and Projects

Policy ⇒Development Plans ⇒Programs ⇒Projects ⇒Outcomes / impacts /changes

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effectiveness and efficiency of investment decisions could be compromised. Accordingly, one

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1.1.6. The Linkage Between Projects and Programs

It is necessary to distinguish between projects and programs because there is sometimes a

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 The analyst must appraise each project independently.

Examples could be a road development program, a health improvement program, a nutritional

1.1.7. Development Planning Versus Project Planning

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Fig 1: The Hierarchical Planning Structure

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 Improve the macroeconomic balance by developing a consistent and realistic resource

1.1.8. The Rationale for Planning

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planning. Why? Market Mechanism is not in a position to generate fair distribution of

1.1.9. Significance of Project Planning

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1.2.1. Project Identification/Opportunity Study/ Stage

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B. Project Identification / Investigation/ Phase

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1.2.2. Project Preparation and Analysis Stage