Economic Analysis Concepts

1. Economic Analysis Concepts

2. Questions & Decisions (1) • Is the project justified ?- Are benefits greater than costs? • Which is the best investment if we have a set of mutually exclusive alternatives? • If funds are limited, how should different schemes be ranked? • When should the road be built or upgraded? 2

3. Questions & Decisions (2) • What standard of construction should be used? • What standard and frequency of road maintenance is optimal? • Should staged construction be used? • Are complementary investments required? 3

4. Appraisal Framework • All appraisals need a framework or model for: a) Forecasting changes b) Evaluating those changes 4

5. Components of Economic Analysis (1) • Costs and benefits are measured in money terms • Road construction and maintenance costs are compared with estimates of the direct primary benefits going to road users and road agency • Secondary benefits are usually ignored • Economic prices are used in constant terms 5

6. Components of Economic Analysis (2) • Costs and Benefits are forecast over the planning time horizon (usually between 10 and 20 years) • Future Benefits are valued less as time progresses using the planning discount rate • Costs and Benefits are compared using decision criteria such as NPV, IRR, etc. 6

7. Economic and Financial Prices The cost to the economy of road rehabilitation and maintenance may differ from the financial cost because of : • taxes and duties • shortage of foreign exchange • under-employment The Government will usually be concerned with ECONOMIC costs. Contractors will usually be concerned with FINANCIAL costs. 7

8. Use of Economic Prices In an Economic Appraisal we use ECONOMIC (or SHADOW) prices NOT FINANCIAL prices • Adjust financial prices as follows: • Exclude all taxes and duties and subsidies • Use the planning discount rate not financial market rate • If overvalued exchange rate then value imports and • exports more highly • Use the opportunity cost of labor • Standard Conversion Factors are now widely used for • road construction costs 8

9. Benefits from Road Investment Changes in transport costs occur because of : • Lower road roughness • Shorter trip distance • Faster speeds • Reduced chance of impassability • Reduced traffickability problems • Change in mode 9

10. Project Costs • Management (including design and supervision) • Labor • Equipment • Materials • Land, Resettlement, Environment 10

11. Primary Effects (1) • Reduced vehicle operating costs (VOC) • fuel and lubricants • vehicle maintenance • depreciation and interest • Tire wear • Crew time • overheads • Reduced journey time • drivers, passengers and goods 11

12. Primary Effects (2) • Changes in road maintenance costs • Changes in accident rates • Increased travel • Environmental effects • Change in value of goods moved 12

13. Secondary Effects • Changes in agricultural output • Changes in services • Changes in industrial output • Changes in consumers behavior • Changes in land values • Changes in income 13

14. Consumers’ Surplus Approach • Captures primary benefits • Advantages: Simple, cost based, traffic approach dependent on predicting changes in traffic • Disadvantages: May not address critical factors promoting either rural development or social access 14

15. Total Benefits Normal and Generated Traffic Benefits Transport cost savings to Normal traffic and growth = Cost + Additional benefits to Generated traffic C1 C2 Demand Curve (Price Elasticity of Demand) T1 T2 Traffic Normal Generated 15

16. Generated Traffic Benefits Traffic induced by the road investment are traditionally valued at: Half the difference in transport costs Hence total generated transport cost benefits = Generated Traffic Volume x Change in Transport Costs per km x Distance x 1/2 16

17. Producers’ Surplus Approach • Captures secondary benefits • Advantages: Draws attention to changes in agricultural output (key economic activity in rural areas) • Disadvantages: No reliable way of predicting response - impact studies give widely different answers - it could be based on agricultural supply price elasticities but this is almost never done; it requires very careful examination to use. • For most projects benefits are just invented ! 17

18. Producers’ Surplus Price & Costs per Unit of Output IncreasedFarmgate Price P2 P1 Lower Input Costs Output O1 O2 18

19. Coverage and Double Counting • Any economic analysis should be designed to give maximum coverage of benefits • But we must avoid double counting. Do not add primary and secondary benefits (e.g. changes in land values added to changes in transport costs) • In a competitive economy the consumers’ surplus approach (used in HDM) should be adequate 19

20. Economic Comparisons • Economic analysis involves a comparison of “With” and “Without” project cases • Forecasts are made of traffic, road condition, VOC and road maintenance effects for BOTH scenarios • An unrealistic “Without” case (i.e. with little maintenance) can give a false result • A range of “With investment” cases should be analyzed to find the best solution 20

21. Traffic Categories • Normal traffic: Existing traffic and growth that would occur on road, with and without the investment • Diverted traffic: Traffic diverted from another road with same origin and destination to as the project road as a result of the investment • Generated traffic: Traffic associated with existing users of the road driving more frequently or driving further than before • Induced traffic: Traffic attracted to the project road due to increased economic activity in the road’s zone of influence brought about by the project 21

22. Benefits from Road Investment Transport cost savings for existing (or normal) traffic = Normal Traffic Volume x Change in Transport Costs per km x Distance Main changes in cost from: a) change in transport MODE b) reduced journey TIME c) reduced VOCs 22

23. Benefits of Upgrading to a Motorable Track Headloading C1 Track Costs Improved road C2 C3 T1 T2 T3 Traffic 23

24. Cost Effectiveness Against Standard of Road 24

25. Development Benefits • Development benefits arise from a combination of increased traffic and reduced transport costs. • Benefits may also include : • Increased agricultural production • Increased service provision • Increased industrial activity 25

26. Estimating Benefits Normal traffic benefits: tripsN * d1 * (VOC1- VOC2) Diverted traffic benefits: tripsD * ((d1 * VOC1)-(d2*VOC2)) Generated and Induced traffic benefits: tripsG * d2 * (VOC1- VOC2)/2 d1 = existing road length d2 new road length VOC1 = vehicle operating costs per km “without” investment VOC2 = vehicle operating costs per km “with” investment VOC data relates to each road section and its condition at the time 26

27. Net Present Value NPV = (B1- C1)/(1 + r) + (B2- C2)/ (1 + r)2 + …+ (Bn- Cn)/(1 + r )n Internal Rate of Return To calculate IRR, solve for r, such that NPV = 0 B1, B2…Bn = Benefits in years 1, 2 … n C1, C2…Cn = Costs in years 1, 2 …. n r = Planning discount rate n = Planning time horizon Economic Decision Criteria (1) 27

28. Economic Decision Criteria (2) • Net Present Value/ Investment Cost NPV/ C = NPV/Ci • First Year Rate of Return FYRR = (B1- C1) / Ci B1 , C1 = Benefits and Costs in year 1 after construction Ci = Road investment costs • Payback Period 28

29. Economic Decision Criteria (3) • NPV IRR3 NPV/C FYRR • Project economic validity V.Good V.Good V.Good Poor • Mutually exclusive projects V.Good Poor Good Poor • Project timing Fair Poor Poor Good • Project screening 1Poor V.Good Good Poor • Under budget constraint 2Fair Poor V.Good Poor • Notes: • 1. check for robustness to changes in key variables (sensitivity analysis) • . with incremental analysis • . IRR may be indeterminate with NONE or MANY solutions. 29

30. Present Value Calculation Period Flow A0 PV(A0) = A0 0 1 2 3 4 A5 PV(A5) = A5 / (1 + i ) ^ 5 5 6 7 PV(Aj) = Aj / (1+ i ) ^ j PV(Aj) = Present Value of Aj Aj = Amount at year j i = Discount rate j = Year 30

31. Present Value at 12.0% Discount Rate 1.00 Year 1 in Year 1 1.00 in = 0.89 Year 2 0.80 Year 3 0.71 Year 4 in Year 1 0.64 1.00 in = Year 5 0.57 Year 6 0.51 Year 7 0.45 Year 8 0.40 Year 9 0.36 Year 1 0 in Year 1 1.00 in = in Year 1 1.00 in = 0.20 Year 15 0.12 Year 20 in Year 1 1.00 in = 31

32. Discount Rate • The discount rate is opportunity cost of capital in the public sector, ie the rate of return on marginal public sector investments • The discount rate to be used will be given by the planning authority responsible for the project • The World Bank traditionally has not calculated a discount rate for each project but has used 10 to 15 percent as a notional opportunity cost of capital in developing countries 32

33. Discount Rate Versus Interest Rate US discount rate around 4% 33

34. NPV and IRR • The Net Present Value (NPV) of a project alternative relative to the without project alternative is the sum of the discounted annual net benefits. • The Internal Rate of Return (IRR) is the discount rate at which the NPV is zero. 34

35. NPV Decision Rule 1. If the NPV is positive, for the chosen discount rate, then the alternative is acceptable. 2. If the NPV is negative, for the chosen discount rate, then the alternative is unacceptable. 3. If the NPV is zero, for the chosen discount rate, then the alternative is indifferent to the without project alternative. 35

36. NPV and IRR Calculation (1) 36

37. NPV and IRR Calculation (2) 37

38. NPV Versus IRR - The IRR and NPV will not necessarily rank the alternatives by the same order- Always use NPV to compare project alternatives 38

39. Multiples Rates of Return 39

40. No Rate of Return 40

41. Same Rate of Return 41

42. Incremental Rate of Return 42

43. IRR Reinvestment Assumption 43

44. Modified Internal Rate of Return 44

45. Benefits X Cost 45

46. Net Benefits X Costs (Efficiency Frontier) 46

47. Comparison of Alternatives • When comparing project-alternatives, the Net Present Value (NPV) is used to select the optimal project-alternative (alternative with highest NPV) • The Internal Rate of Return (IRR) or the B/C ratio are not recommended to compare alternatives of a given project Alternatives NPV0.03.76.75.5 Project Optimal Alternative:Highest NPV 47

48. Ranking Projects • When comparing the economic priority of different projects, a recommended economic indicator is the NPV per Investment ratio SelectedAlternative OverlayReseal Overlay NPV/Investment 8.45.2 2.1 PRIORITY Projects 48

49. Budget Constraints Simple Methodology Selected Alternative OverlayReseal Overlay Reseal Overlay NPV16.815.6 20.0 3.0 5.0 Investment 2.03.0 5.0 2.0 10.0 NPV perInvestment 8.45.2 4.0 1.5 0.5 Projects PRIORITY Available Budget Budget Constraint Cut Off 49

50. Budget Constraints Optimization NPV0.03.76.75.50.02.01.03.50.05.42.13.2 Projects Alternatives Evaluates all possible combinations of project-alternatives to find the combination that maximizes the NPV of the overall network for the given budget constraint. P = Number of projects A = Number of alternatives C = Number of possible combinations C = A ^ P Available Budget 50