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Project Appraisal Simplified

Article  in  SSRN Electronic Journal · December 2009

DOI: 10.2139/ssrn.1524212

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 DUKE UNIVERSITY
Duke Center for International Development (DCID)
Sanford School of Public Policy

Spring 2010

Assessing public expenditures:

Applied Project Appraisal and Risk
Management for Economic Development

Project Appraisal Simplified

Abstract: A short summary of the basic principles of project appraisal

JEL codes: D61, H50, H43, G31

Project appraisal
Project appraisal is an objective, systematic framework for assessing whether an
investment project is good or bad.

Good investment versus bad investment

From society’s point of view, if the investment project is good, it means that the
investment creates wealth; whereas if the investment project is bad, it means that the
investment destroys wealth.

Role of the government

Effective project appraisal means that government agencies and institutions select
projects that create wealth and reject projects that destroy wealth, taking into account
relevant equity concerns and distributional impacts.

Current demand for the investment project

Generally speaking, an investment project is likely to be good if there is current
demand for the output of the project. The demand for the output does not necessarily
mean that the project is good. However, if there is no current demand for the output, then
it is most likely that the project is bad.

Scarcity and opportunity cost

Resources in society are scarce. By using the resources in one project, we give up
the “opportunity” to use the same resources in another project. In other words, if we use
resources for one project, then we cannot use the same resources in another project.
Resources are human, physical and financial.

Selection criterion
Since resources are scarce, the project analyst should select and implement the
best projects that create wealth for the country.

Electronic copy available at: http://ssrn.com/abstract=1524212

 ProjectAppraisalSimplified_Dec2009.doc

Using the principles of project appraisal, the project analyst should select good
projects and reject bad projects

Key perspectives (or points of view)

There are two key perspectives:
9 Financial perspective
9 Economic perspective

Market distortions
Due to distortions in the economy, such as taxes, subsidies, public goods, merit
goods, externalities and other market failures, there are discrepancies between the
financial values and the corresponding economic values. For example, the negative
impacts (or externalities) of a project are not listed in the financial NCF. However, the
negative externalities affect the welfare of members of society, and we include the
negative externalities as a cost item in the economic NCF.
From society’s point of view, the economic values measure the true values of the
benefits and costs of the investment project.

Four scenarios
1. Financial NPV of the NCF (Net Cash Flow) is positive and the economic NPV of
the NCF (Net Cash Flow) is positive
2. Financial NPV is negative and the economic NPV is negative
3. Financial NPV is positive and the economic NPV is negative
4. Financial NPV is negative and the economic NPV is positive

Best case scenario

In the best case scenario, an investment project is good from both the financial
perspective and the economic perspective. This government agency should approve and
implement the project.

Worst case scenario

In the worst case scenario, an investment project is bad from both the financial
perspective and the economic perspective. The government agency should reject the
project.

Good project from the financial perspective and bad project from the economic
perspective
A project that is good from the financial perspective means that an investor
benefits. Since the project is bad from the economic perspective, the project destroys
wealth for the society. The government agency should reject the project. However, since
an investor benefits, there may be outside pressures to approve the project.

Electronic copy available at: http://ssrn.com/abstract=1524212

 ProjectAppraisalSimplified_Dec2009.doc

Bad project from the financial perspective and good project from the economic
perspective
A project that is bad from the financial perspective means that a private investor
would not implement the project. However, since the project is good from the economic
perspective, the project creates wealth for the society. Many public sector projects, such
as roads, water supply and health, are of this type. The government agencies should
approve projects that create wealth from the economic perspective.
A suitable financing arrangement, such as a cost recovery scheme or public-
private partnership (PPP), may enable the implementation of the investment project.

Example 1: Road project

In a road project without toll charges, there are no financial inflows for the
project. The financial Net Cash Flow (NCF) consists of investment costs and
maintenance costs, and the (present) value of the financial NCF is negative.
However, the road project creates benefits for the users of the road by reducing
the travel time and reducing the vehicle operating costs (VOC). Thus, the road project
creates wealth for society, if the (present) value of the economic NCF, taking into
account the benefits to the users, is positive.

Example 2: Basic education project

Typically, in a basic education project, there are no school fees. Thus, the
financial NCF consists of the costs of the school facilities, teacher salaries and other
operating costs, and the (present) value of the financial NCF is negative.
From society’s point of view, the most important economic benefits of the basic
education project are the higher salaries that educated persons earn, compared to persons
without education. In addition, there are other positive benefits that should be included in
the economic benefits of an education project. We should approve an education project if
the (present) value of the economic benefits outweighs the (present) value of the
economic costs.

Example 3: Water supply project

In a water supply project, the water enterprise may charge for the water.
Typically, the water charges do not cover the investment and operating costs of the
project. Thus, generally the (present) value of the financial NCF is negative.
We measure the benefits of the water by estimating the people’s willingness to
pay for the water. The water project creates wealth for society if the (present) value of the
economic NCF, which takes into account the people’s value of the water, is positive.

Additional perspectives
In addition to these two key perspectives, there are other relevant perspectives:
Budget perspective
Debt holder’s point of view
Private investor’s point of view (equity holder’s point of view)
Beneficiaries’ point of view

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Other stakeholders’ point of view

1. Financial perspective
In the financial perspective, there are two points of view:
a. Total investment point of view
In the total investment point of view, we list the expected cash
inflows and expected cash outflows that the project generates,
including the opportunity costs of existing assets. The (present)
value of the NCF from the total investment point of view measures
whether the project creates or destroys wealth, from the financial
perspective.
b. Equity point of view
We obtain the equity point of view by adding the debt financing to
the total investment point of view.
2. Economic perspective
In the economic perspective, we use the demand curve to measure the true
values of the benefits, and the supply curve to measure the true values of
the resources that the project requires.

Components of project appraisal

Project appraisal consists of 3 key components:
¾ Financial analysis (including sensitivity and risk analysis)
¾ Economic analysis
¾ Distributive analysis

Efficiency versus equity

In the financial and economic analyses, we analyze the investment project from
an efficiency point of view. In the distributive analysis, we take into account the equity
aspects of the investment project.

Financial analysis
In the financial analysis, we list the expected cash inflows, cash outflows
and opportunity costs. All of the cash flow items are in nominal terms.
9 Sensitivity analysis
Since there is always variability in the cash inflows and cash outflows, we
use sensitivity analysis to examine the impacts of changes in the key
project parameters on the outcomes of the project. In a one-way table, we
examine the impact of changes in the values of one variable on the
outcomes of the project.
9 Scenario analysis
In scenario analysis, we define a number of scenarios, based on the values
for sets of important project parameters. For each scenario, we examine

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how changes in the values of a set of key parameters affect the project
outcomes.
9 Risk analysis
In risk analysis, we identify the key risk variables for a project. In Monte
Carlo Simulation, which is a part of risk analysis, we improve on the
sensitivity analysis by assigning appropriate probabilities to the key
project parameters, and obtain probability distributions for the project
outcomes.

Risk management
Based on the risk analysis, which identifies the key risk variables, we design a
risk management strategy for the project. We examine mechanisms for reducing and
reallocating the risks of the project.

Economic analysis
In the economic analysis, we list the true economic values for the benefits and the
true economic costs of the resources. In addition, we include positive and negative
externalities that do not appear in the financial analysis.

Distributive analysis
The distributive analysis examines the winners and losers of the project. Who are
obtaining the benefits from the projects? Who are incurring the costs? From the
government’s point of view, what are the increases or decreases in tax revenues and
subsidy expenditures?

Basic needs
A project may generate increases in the quantities of basic needs or merit goods.
Based on the increase in the quantities of the specific basic needs or merit goods, we
assign a positive premium to the project.

Time value of money and the discount rate

An investment project generates cash inflows at different points in time, and also
incurs costs at different points in time. We cannot simply “add” up the net cash flows into
a summary statistic because the cash flows at different points in time have different
values.

Nominal discount rate, real discount rate and the expected inflation rate
The expression for the relationship between the nominal discount rate dn, the real
discount rate dr, and the expected inflation rate g is as follows:

dn = dr×(1 + g) + g

Investment criterion

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The best investment criterion is the Net Present Value. Using the appropriate
discount rate (or cost of capital), we obtain the NPV by discounting the net cash flow to a
common reference point and adding them up.

Financial NPV
We obtain the financial NPV by discounting the financial NCF with the financial
discount rate.

Economic NPV
We obtain the economic NPV by discounting the economic NCF with the
economic discount rate (or cost of capital). See definition of economic cost of capital
below.

Nominal NCF versus the real NCF

For consistency, we use the nominal cost of capital to discount the nominal net
cash flow, and we use the real cost of capital to discount the real net cash flow.
The NPV of the nominal NCF, discounted by the nominal discount rate, must
equal the NPV of the real NCF, discounted by the real discount rate.

Nontraded goods
For nontraded goods, the economic price equals a weighted average of the supply
and demand prices, where the weights are the corresponding supply and demand
responses to a change in price.

Traded goods
For traded goods, the economic price equals the world price of the item. In
addition, we adjust the tradable proportion of the financial value with the foreign
exchange premium.

Conversion factor
The conversion factor equals the ratio of the economic value to the financial
value.

Conversion factor = Economic value/Financial value

Converting financial values to economic values

We convert the financial cash flows into the corresponding economic cash flows
by multiplying the line items in the financial cash flows with the appropriate conversion
factors.

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National Economic parameters

There are two key national economic parameters: the economic opportunity cost
of foreign exchange and the economic opportunity cost of capital.

Economic opportunity cost of foreign exchange

The economic opportunity cost of foreign exchange measures the economic value
of the foreign exchange that the project generates or requires. The value of the economic
opportunity cost of foreign exchange depends on the distortions in the supply and
demand for foreign exchange. Exports generate the supply of foreign exchange and
imports create the demand for foreign exchange.

Economic opportunity cost of capital

The economic opportunity cost of capital measures the economic value of the
financial resources that a project requires. The value of the economic opportunity cost of
capital depends on the distortions in the capital market. Investors are the demanders of
capital, and savers are the suppliers of capital. We use the economic opportunity cost of
capital to discount the economic NCF.

Conclusion
In project appraisal, government agencies assess the merits of investment projects
in the public sector. The government agencies should select projects that create wealth for
society and reject projects that destroy wealth.
If the economic NPV of the project is positive, it means that the project creates
wealth for society. If the economic NPV of the project is negative, it means that the
project destroys wealth for society.

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