Dev 567 Project and Program Analysis Lecture 1- 2: Introduction and Project Cash Flows

1. Dev 567Project and Program AnalysisLecture 1- 2: Introduction and Project Cash Flows Dr. M. FouzulKabir KhanProfessor of Economics and Finance North South University

2. Course Overview • Requirements and Grading • 2 Midterm examination (30%) • Paper (30%) • Final examination (40%) • Class Materials • “Cost-Benefit Analysis: Concepts and Practice,” 2nd Edition, by Anthony E. Boardman, David H. Greenberg, Aidan R. Vining and David L. Weimer, Prentice Hall, 2001[BGV] • “Capital Budgeting: Financial Appraisal of Investment Projects,” by Don Dayananda, Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland, Cambridge University Press, 2008 [DIH]. • Guidelines for the Economic Analysis of Projects, Asian Development Bank, 1997 [ADB] • সরকারী খাতে উন্নয়ন প্রকল্প প্রনয়ন, প্রক্রিয়াকরন, অনুমোদন ও সংশোধন পদ্ধতি, গণপ্রজাতন্ত্রী বাংলাদেশ সরকার। • Web-page: http://fkk.weebly.com • Office: NAC 751 • Office hours: Saturday, 2pm – 3pm, 6-7pm ; Wednesday, 5pm-6:30 pm

3. Activity Schedule

4. Make-up Policy • There will be only one make-up for all examinations (mid-terms, final etc.) towards the end of the course to accommodate force majeure. All examination dates are pre-announced. Please make necessary arrangements with your office. • Historically, the performance of students taking make-up examinations were always poorer compared to students taking examinations on schedule. • I hope you will appreciate that it is not practical to offer a customized course for any or group of individual student(s).

5. Session 1 • Nature of project appraisal • Overview of cost benefit analysis and capital budgeting • Aspects of capital budgeting • Shareholder wealth maximization and NPV • The capital budgeting process • Essentials in cash flow identification • Calculating project cash flows

6. Preface • Investment decisions are important both for private and public entities. • Goals are different. • Capital budgeting • Concerned with sizeable investment in long-term assets by firms • Various investment criteria • Choice between projects with different life span, • Tax and depreciation issues.

7. Preface • Cost benefit analysis • Measurement of economic benefits and cost • Shadow prices • To correct for distortions in the market prices or put a price on non-marketed goods • Social discount rate • Financial appraisal • Economic appraisal • Environmental appraisal

8. Project Appraisal • Nature of project appraisal Given the limitation of resources, choices must be made among the competing uses, and project appraisalis one method of evaluating alternatives in a convenient and comprehensive fashion • Project appraisal assesses the benefits and cost of a project and reduces them to a common yardstick. If benefits exceed costs, the project is acceptable; if not the project should be rejected • Society’s objective • Growth: to increase total national income • Equity: to improve the distribution of national income • Projects should be assessed in relation to their net contribution to both of these objectives

9. Project and Program Analysis • Project and program sometimes used interchangeably • Project: Bridge project, Pharmaceuticals industry • Program: Literacy program • Analysis by whom? • Private • Investor • Lender • Government agency • Public-private partnership • Donor agency • Tools for analysis will vary • Private investor-capital budgeting • Government/donor agency- cost benefit analysis

10. CBA and Capital Budgeting • Cost-benefit analysis Cost benefit analysis is a program/project assessment method that quantifies in monetary terms the value, net social benefits, of all program /project consequences for all members of the society • Capital budgeting Is the process of evaluating and selecting long-term investments consistent with the firm’s goal of shareholders wealth maximization

11. Major Steps in CBA • Specify the set of alternative projects • Decide whose benefits and costs counts (standing) • Catalogue the impacts and select measurement indicators (units) • Predict the impacts quantitatively over the life of the project • Monetize (attach dollar/taka values to) all impacts • Discount benefits and costs to obtain present values • Compute the NPV of each alternative • Perform sensitivity analysis • Make a recommendation based on the NPV and sensitivity analysis

12. Capital Budgeting Capital budgeting is primarily concerned with sizeable investments in long-term assets. • Tangible: Property, Plant or equipment • Intangible: R&D, Patents or trademarks Different from recurring expenditure in two aspects: • Projects are significantly large • Long-lived projects with their benefits or cash flows spreading over many years.

13. Capital Budgeting • Capital budgeting is one of the most significant financial activity of the firm. • Capital budgeting determines the core activities of the firm over a long term future. • Capital budgeting decisions must be made carefully and rationally.

14. Capital Budgeting Within the Firm

15. Aspects of Capital Budgeting Capital budgeting involves: • Committing significant resources. • Planning for the long term: 5 to 50 years. • Decision making by senior management. • Forecasting long term cash flows. • Estimating long term discount rates. • Analyzing risk. • Emphasizes the firm’s goal of wealth maximization, which is expressed as maximizing an investment’s Net Present Value • Requires calculation of a project’s relevant cash flows

16. Aspects of Capital Budgeting Capital budgeting uses • Sophisticated forecasting techniques:- • Time series analysis by the application of simple and multiple regression, and moving averages • Qualitative forecasting by the application of various techniques, such as the Delphi method Capital budgeting requires: • Application of time value of money formulae. • Application of NPV analysis to forecasted cash flows. • Risk analysis – Risk Adjusted Discount Rate(RADR) and certainty equivalent • Application of sensitivity and break even analyses to analyze risk.

17. Aspects of Capital Budgeting • Application of: • simulation and Monte Carlo Analysis as extra risk analysis. • long term forecasting and risk analysis to projects with very long lives. • optimization techniques to projects which have constrained resources. • application of generic and specific financial models • cash flow forecasting, and NPV analysis to all aspects of property investment projects. • NPV analysis under the additional risks associated with international investments

18. Conceptual Foundations of CBA • The goal of allocative, or Pareto efficiency provides the conceptual basis for economic analysis/appraisal of projects • Recall that, allocation of goods is Pareto efficient if no alternative allocation can make at least one person better off without making anyone else worse off • Net benefits and Pareto efficiency: If a policy or a project has positive net benefits, then it is possible to find a set of transfers, or side payments, that makes at least one person better off without making anyone else worse off

19. Hicks/Kaldor and Scitovsky Criteria As long as analysts value all benefits in terms of willingness to pay and all costs in terms of opportunity costs, then the positive net benefits indicate the potential for compensation to make the policy Pareto efficient • The Kaldor criterion A Kaldor improvement is a change from a given output mix distributed in a given way to another output-mix which would enable the gainers to compensate the losers while continuing to gain themselves. Since compensation need only be hypothetical, a Kaldor improvement offers only a potential Pareto improvement • Critique of the Kaldor criterion • Scitovsky criterion Actual compensation is not necessary!

20. What is Economic Analysis? • The economic analysis of projects is similar to financial analysis: • Both appraise the profit of an investment • Financial analysis is about profit for project entity • Economic analysis is for the national government or the economy • The economic analysis looks at any investment decision from the perspective of improving welfare of its citizens • For a project to be economically viable, it must be financially sustainable, because if project is not financially sustainable, economic benefits will not be realized. • Financial analysis and economic analysis are therefore two sides of the same coin and complementary

21. Economic Analysis Basics • Economic analysis needs to be undertaken prior to financing of projects, but should also be carried out for all stages of project cycle- • Design and financing, ex-ante • Implementation- in medias res • Evaluation-ex-post • Comparison of ex-ante and ex-post, or ex-ante and in medias res

22. Major Issues: Aggregation • Over people, is Tk 1000 cost to a wealthy person to be considered equally Tk. 1000 cost to a poor person? How to compare benefits to criminals and children? How do we compare benefits to people alive and the unborn • Over goods, costs (concrete for a dam) in one form with benefits in another (electricity)? • It is easier when there are markets for the goods, harder when there aren’t • Over time, How to compare costs now with benefits in the future? Discount rate • Aggregation over the sates of the world: How to deal with uncertainty and risk?

23. Major issues: Standing • Who has standing in relation to the project? • Whose benefits and costs should be counted? • Geographical jurisdiction, foreigners • Legal, security system for Baridhara • Future generation • Flora and fauna, mosquito eradication • Only willingness-to-pay of humans count • A person who does not have standing will not have their costs and benefit recognized in the analysis • Transfers A transfer from a person with standing to another person with standing is neither a cost nor a benefit • Taxes, except in case of negative externality

24. Shareholder Wealth Maximization and NPV • The shareholder wealth maximization goal requires that management should endeavor to maximize net present value (NPV) of expected future cash flows to the shareholders of the firm. • NPV represents discounted sum of the expected net cash flows. • Cash outflows: capital outlays • Cash inflows: proceeds from sales • Net cash flows are determined by subtracting a given period’s cash outflows from that period’s cash inflows.

25. Shareholder Wealth Maximization and NPV • The discount rate takes into account the timing and riskof the futurecashflowsresulting from the investment. • The longer it takes to receive a cash flow, the lower the present value to the investor. • The greater the risk associated with receiving a future cash flow, the lower the value investors place on that cash flow. • Shareholder wealth depends on magnitude, timing and risk associated with the cash flows expected to be received in future by the shareholders

26. Exercise • Project Alpha requires an initial capital outlay of Tk. 45,000 and will have net cash inflows of Tk. 15,000, Tk. 20,000 and Tk. 30,000 at the end of years 1,2, and 3 respectively. The discount rate is 8% per annum. • How much project Alpha will add to the firm’s value?

27. Classification of Investment Projects • An independent project is one the acceptance or rejection of which does not directly eliminate other projects from consideration or affect likelihood of their selection • Mutually exclusive projects- cannot be pursued simultaneously-the acceptance of one prevents the acceptance of the alternative proposal • A contingent project is one the acceptance or rejection of which is dependent on the decision to accept or reject one or more other projects • Complementary projects, pharmacy and doctor’s clinic • Substitute projects, Thai or Fast-food restaurant

28. 10 Key Questions • Project rationale • What is the rationale for public sector involvement? • What is the rationale of the project: what market or government failure does it address? • What is the main alternative to the project?

29. 10 Key Questions • Macroeconomic and sectoral context • How does the project relate to the overall development strategy? • What is the policy environment for the project: taxes and subsidies, trade controls, exchange rate and interest rate policy? • How does the project relate to sectoral strategy? • What is the sectoral policy context in terms of market structure and regulation? • Is the project a priority public investment?

30. 10 Key Questions • Project alternatives • Have project alternatives been considered in terms of location, scale, timing? • How has the best alternative been chosen? • Has the least cost alternative been identified for the project or major subprojects? • Real options • Options to defer • Option to scale up and down • Option to abandon • Is it possible to import services?

31. 10 Key Questions • Demand analysis • What is the basis for projecting the demand for project output? • How will demand be affected by income growth? • What other sources of supply are there for meeting the demand? • How will demand be affected by an increase in price or user charge?

32. 10 Key Questions • Identification of costs and benefits • Have the without and with project situations both been described? • Have all project costs, comparing the with and without project situations, been identified? • Have all project benefits, comparing the with and without project situations, been identified?

33. 10 Key Questions • Use of shadow prices • Which numeraire has been used in the application of shadow prices? Has it been used consistently? • Have project outputs been identified as nonincremental*? • Have benefits and especially costs been broken down into traded and non-traded items? • What value of the SERF/SCF has been used: has it been correctly applied? • Have more specific conversion factors been used for some items: how were they derived? • What discount rate has been used: to choose between alternatives, and to assess economic viability?

34. Class Exercise • A project would supply additional 50MW of power. • Graphically show incremental and non-incremental output of the project.

35. Incremental outputs & inputs - • Incremental output is additional output produced by a project over and above what would be available and demanded in the without project situation. • Incremental inputs are inputs that are supplied from an increase in production of the input over and above what would be produced and supplied in the without project situation Incremental Non-incremental Source: Guidelines for the Economic Analysis of Projects, ADB

36. 10 Key Questions • Financial and fiscal sustainability • Has the FIRR for the project been calculated? • Have the financial returns to different project participants been calculated? • What is the level of charges for goods and services? Is the economic analysis related to the charge level? • What is the difference between the FIRR and EIRR, and what accounts for the difference? • Have the average incremental financial and economic costs been calculated?

37. 10 Key Questions • Financial and fiscal sustainability (continued) • What is the level of cost recovery? • Is there any explicit or implicit subsidy to the project? What is the justification for the subsidy? • Has the fiscal impact on the capital and recurrent budget been calculated? • What will be the source of funds to meet net fiscal requirements: extra taxation, extra borrowing, or a reallocation of expenditure?

38. 10 Key Questions • Environmental sustainability • Have the environmental effects of the project been identified: costs and benefits? • How have they been quantified and valued? • Are they expressed in the same numeraire as the basic economic analysis? • Have they been integrated into the economic analysis: for choosing between project alternatives; for assessing economic viability? • Have required mitigatory and monitoring expenditures been identified and included in economic costs?

39. 10 Key Questions • Benefit monitoring and evaluation • What are the key variables necessary to identify project impact during implementation & operation? • Does this include key performance variables, physical or financial, for the implementing agency? • Is a system in place to collect data on all the key variables?

40. 10 Key Questions • Distribution analysis • Has a distribution analysis been undertaken for the project? • Has the effect of different levels of charges for goods and services been assessed for operators, customers and government? • Has the distribution of costs, especially on the poor, been identified? • Has the distribution of benefits, especially to the poor, been identified?

41. 10 Key Questions • Distribution analysis (continued) • What proportion of net benefits will go to poor people? • Is the distribution of costs and benefits analyzed by gender? • Is there a substantial foreign involvement in investment and operation? • Has the proportion of incomes and revenues going to foreign investors, lenders and workers been identified?

42. Overall assessment • Have the major conclusions of the economic analysis been clearly spelt out? • Does the project incorporate the best alternative? • Is the project economically viable? • Are any policy changes necessary to complement project implementation? • Are any capacity building measures necessary: to provide incentives or training to the executing agency and other participants?

43. Sensitivity analysis • What type of sensitivity analysis has been applied? • Does it relate to underlying benefit and cost variables? • Have the key variables been identified? • Have switching values been calculated? • What measures are proposed to monitor the key variables?

44. Risk analysis • Is there a quantitative risk analysis? • Have probabilities been attached to any of the key sensitivity variables? • Have institutional risks been assessed? • Are there sufficient incentives for government participants in the project? • What measures have been proposed for reducing project risks?

45. Class Exercise II • Identification and measurement of consumers surplus • Assume a linear demand curve and a price without the project Pwo and a lower price with Pw with the project. • Identify and measure consumers surplus from incremental and non-incremental output • Graphically show gross benefits of the project

47. Economic Analysis Usually Involves • Defining project objectives and economic rationale; • Forecasting effective demand for project outputs; • Choosing the least-cost design for meeting demand or the most cost-effective way of attaining the project objectives; • Determining whether economic benefits exceed economic costs;

48. Economic Analysis Usually Involves (continued) • Assessing whether the project's 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 on each participating country; • Enumerating the non-quantifiable effects of the project that may influence project design and the investment decision.

49. Bias and Errors in Analysis of Projects • Bureaucratic and political lenses • Guardians, revenue-expenditure analysis, ignores non-financial social benefits • Spenders, favor large, irreversible, capital intensive projects, treats expenditure as benefits, use low discount rates • Disingenuous or strategic errors resulting from self interest, overestimation of benefits and underestimate costs • Omission errors • Forecasting errors • Measurement errors, • Valuation errors, shadow prices

50. Why Cash Flows? Cash flows, and not accounting estimates, are used in project analysis because: • They measure actual economic wealth. • They occur at identifiable time points. • They have identifiable directional flow: inflow and outflow. • They are free of accounting definitional problems.