Project appraisal for development administration [Reprint 2019 ed.] 9783111345062, 9783110992465

Table of contents :
PREFACE
CONTENTS
INTRODUCTION
1. Projects, Budgets, and Administrative Systems
2. Principles of Appraisal
3. Project Preparation
4. Pricing
5. Technology
6. Location
7. Project Appraisal: A Summing Up
Appendix A.
Appendix B.
BIBLIOGRAPHY

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P R O J E C T APPRAISAL FOR D E V E L O P M E N T A D M I N I S T R A T I O N

PUBLICATIONS OF THE INSTITUTE OF SOCIAL STUDIES

PAPERBACK SERIES XII

INTERNATIONAAL INSTITUUT VOOR SOCIALE S T U D I Ë N - 'S G R A V E N H A G E 1974

PROJECT APPRAISAL FOR DEVELOPMENT ADMINISTRATION

by PHILIP C. P A C K A R D

1974

MOUTON THE HAGUE . PARIS

© Copyright 1974 Institute of Social Studies, The Hague, The Netherlands. No part of this book may be translated or reproduced in any form, by print, photoprint, microfilm or any other means, without written permission from the Institute. The responsibility for works published in the series 'Publications of the Institute of Social Studies' rests with the authors; publication of a work in this series does not commit the Institute of Social Studies to any opinions stated therein.

LIBRARY OF CONGRESS CATALOG CARD NUMBER: 74-75576

PREFACE

Several of these case studies were developed for courses I helped organize during my tenure as Advisor on Parastatal Organizations, Ministry of Economic Affairs and Development Planning, Dar es Salaam. The rest were prepared as a set to be used as a kind of textbook on the subject of project appraisal by various institutions and government agencies within Tanzania. I wish to thank the participants who attended these series of courses for helping to clarify my ideas and the materials to which they were subjected. A number of ideas and modes of thought have been borrowed from John Grindell who collaborated with me in setting up these courses. I am grateful for his intellectual stimulus, even though perhaps wrongly I resisted stubbornly some of his ideas. I wish to express my thanks also to the Ford Foundation in allowing me to devote a part of my assignment in Tanzania to the preparation of these materials. The encouragement to put these materials into published form has come from Professor Jan Koopman of the University of Nairobi, to whom I am especially grateful. Professor Koopman while kindly reading through the manuscript caught several numerical errors and called attention to points of theory which seemed particularly ambiguous. We have not been able to resolve all our differences, but I think it fair to say that we both share the conviction that it is possible to present economic principles in such a way that they are understandable and usable by government officials and planners in underdeveloped countries. I alone remain responsible for the (undoubted) errors that remain. Philip C. Packard via di Monserrato Rome

CONTENTS

Preface Introduction

5 9

1. Projects, Budgets, and Administrative Systems . . . . 2. Principles of Appraisal Appendix: Elaboration of Appraisal Measures . . . . 3. Project Preparation The Sawmill Case Study The Banana Powder Case Study The Bean Processing Case Study 4. Pricing The Lime Concentrates Case Study The Cashew Nut Processing Case Study The Agricultural Bag Production Case Study The Tea Development Case Study 5. Technology The Maize Mill Case Study The Abattoir Case Study The Oil Palm Processing Case Study The Sugar Producing Case Study 6. Location The Poultry Broiler Case Study The Meat Canning Case Study 7. Project Appraisal: A Summing Up

11 16 28 33 33 40 51 64 64 69 72 77 89 89 93 97 107 129 129 134 141

Appendix A Appendix B Bibliography

148 152 156

INTRODUCTION

The material which follows is based on actual experience with the projects described. This experience also extends to my having some years ago organized a course in industrial project analysis at the Institute of Social Studies and contributed to the programme in agricultural project analysis at the Institute Agronomique in Montpellier. Therefore, for several years I have been involved in teaching the subject matter of project analysis and during that time have confronted the problem that everyone who tries to organize such courses must face: what does one do for relevant material for teaching both concepts and practice ? At the same time, my recent experience in working in a planning ministry of government has convinced me that the treatment of the subject matter suffers at the hands of economists from oversophistication and disregard of administrative realities. Perhaps oversophistication is not really the right word to convey the notion that the conceptual apparatus of resource allocation theory in economics is hard to apply. Most administrators-cum-planners neglect it, so planning becomes macroeconomic in content and administrative (lacking microeconomic content) at the project level. As to disregard for administrative realities, the practice of formulating policy without following through to the more detailed levels of decision making that surround the choice of investments and project implementation is widespread. In what follows, I do not presume to offer "the" administrative system or even to suggest how administrators should become better economists so that they can allocate resources effectively. What I have tried to do is to use actual projects (but summarized, inevitably) to convey principles of project choice. The examples are taken from the agricultural and industrial sectors and are in fact

10

INTRODUCTION

projects on processing. Apart from the obvious importance of the two sectors and their relation to each other, it seems to me that it is more instructive to limit examples to a certain circumscribed class rather than to cover a wide variety of sectors in a more superficial way. The material can of course be used as a textbook, but it has, I hope, additional uses for the student as a reference guide and for the administrator who wants to know more on the subject in practical as well as conceptual detail. For classroom use and for the on-the-job administrator, the calculations presented in the various case studies (projects) in summary form can be calculated from scratch. This is a device for getting practice in calculating appraisal measures and in understanding the underlying principles. The instructor or student could alter the assumptions, for example, the accounting prices, so that appraisal measures can be recalculated. This is an additional form of practice, but it also conveys the important notion of the relative magnitudes of effects upon any given project. It should be emphasized that the choice of projects is such that the case studies are all parastatal (public corporation) projects. Therefore, the methods for treating items of the cash flow, for example, follow from this concentration on the public sector. I have not alluded to, nor included in the approach, the possible relations between a country's private and public sectors. This can be taken to be an omission which, in theoretical terms, might weaken any practical approach to the projects as presented. I consider, however, that administrative practices which in economic terms are constraints on resource allocation are pervasive enough to raise questions about the relevance of a great deal of microeconomic theory. In my view, this is not inconsistent with trying to use principles consistentlv within, inevitably, an administrative system. This emphasis on consistency is stressed in my earlier work on project preparation and implementation,* which may usefully be read as a companion piece to this work. Philip C. Packard * Critical Path Analysis for Development Administration Studies, Paperback Series, The Hague: Mouton, 1972).

{—Institute of Social

1 PROJECTS, BUDGETS, AND ADMINISTRATIVE SYSTEMS

1.1. NATURE OF AN ADMINISTRATIVE SYSTEM

Investment expenditure, budgeting, government recurrent expenditure, and the expenditures and receipts of parastatal organizations (public corporations) all take place within an administrative system. In economic or financial terms, the agents carrying on these and other activities within the administrative system are said to operate within or to constitute the PUBLIC SECTOR

The distinctive character of a public administrative system is that there are prescribed ways of carrying out activities, such as preparing ministerial budgets. In other words, a public administrative system is based in concept largely on activities of a repetitive, maintenance character. This has important consequences for projects within the public sector. Projects or proposals for expenditures are quite diverse, ranging from simple requests to build a road, an easily organized set of activities, to larger ministerial projects such as health centres, schools and water development, to commercial ventures designed not only to produce goods and services for the public but to generate surpluses for further and future expenditure on public sector projects. Within the administrative system, the tendency is to look at these projects as part of ongoing administrative activity, summarized periodically in government and parastatal budgets and carried out and operated in prescribed ways. If the diversity of projects had a UNIFORM character, if it conformed well to the procedures of the administrative system, no great difficulties could arise. However, the

12

PROJECTS, BUDGETS, A N D ADMINISTRATIVE SYSTEMS

character of many projects tends to lead to conflict with the received administrative system in such a way that many times projects may not be selected properly or implemented effectively. To put it another way, a project need not be perceived in its totality within the administrative system. Administrators tend to think of administrative activity rather than of each project as a whole. In consequence, projects are often divided among public sector agents and administrators, and investment expenditures are not looked at in terms of the lifetime of the project, which in most cases covers more than one budget period. In such cases, no fixed responsibilities for preparing, appraising, and implementing projects uniformly exist. Responsibility for a project is, in general, ADMINISTRATIVE responsibility, not MANAGERIAL responsibility. This error is in some sense an inevitable outcome of any public administrative system. However, there is need to look more closely at expenditures and revenues within the public sector from the project point of view (see below). DEVELOPMENTAL

1.2. NATURE OF A PUBLIC SECTOR

Projects both of government and parastatal organizations fall within the administrative system. However, parastatal organizations are set up based on the recognition that commercial (or corporate) activity is best left to a different type of organization. Therefore, parastatal organizations are within the administrative system in terms of the government policy - the broad objectives laid down and the decisions taken on what is to be the development of the public sector. Parastatal organizations are to carry out policy but retain certain flexibility in decision making and operations. There are, of course, many variations possible in the organization of a public sector, but the principles of delegation by the government to parastatal organizations of certain powers and the control by government over these parastatal organizations (conformity to policy) are general and have wide applicability. Several consequences follow from the relations between the

PROJECTS, BUDGETS, AND ADMINISTRATIVE SYSTEMS

13

government and parastatal organizations within the administrative system extending throughout the public sector. First, a system of delegation with control gives rise to continual problems of meanings and interpretation among levels within the public sector. Thus, for example, government ministries transmit policy to parastatal organizations that in turn transmit policy to their operating units. Since policy involves broad guidelines, specific directives, and combinations of the two, there is a need for clear modes of communication within the public sector. As a second consequence related to the need for clear modes of communication, delegation by government to parastatal organizations may tend to allow for emphasis on what can be termed commercial values. Particularly for those parastatal organizations instructed to produce goods and services and to earn surpluses, parastatal decision making may concentrate on surplus generation to the exclusion (or partial exclusion) of the broad objectives of government. This is sometimes referred to as the problem of establishing CRITERIA for choosing investments and carrying out various expenditures within the public sector. Clear criteria for decision making are necessary and even a part of clear modes of communication. Another major consequence of any system of delegation within a public sector is that parastatal project activities, in particular, cut across administrative divisions of government (the ministries, principally). Thus, sectors of government are reflected in ministerial organization (a ministry for a sector such as agriculture, for example), but a parastatal organization may have a project which is involved directly with more than one sector. The need for clear and consistent criteria for project choice is quite apparent in such a situation.

1.3. PROJECTS AND THE BUDGET PROCESS

The annual budget is the basis administratively for dealing with expenditures and receipts in the public sector. This budget rests upon estimated CASH FLOWS - the various outflows (investment and recurrent expenditures) and inflows (taxes, parastatal surpluses) - which are presented in budget terms by agents of the

14

PROJECTS, BUDGETS, AND ADMINISTRATIVE SYSTEMS

public sector: ministries and parastatals. In a broad sense, also, the budget is concerned with cash flows of foreign exchange into and out of the public sector. As has been indicated, the budget concept does not conform to that of a project, neither in terms of viewing the project as a unique set of activities under welldefined responsibility nor as a set of activities that last for more than one, and usually for many budget periods in the future. A project is conceived as a set of cash flows now and in the future. Therefore, a set of projects, including established investments and corporate enterprise within the public sector, does make up budget cash flows. However, if government policy is to be effective, these cash flows must be estimated in such a way that their likelihood is increased. This is, of course, the reason for stressing the unit of the project, as opposed to general administrative budgeting which is likely to be less reliable per se for carrying out government policy. Cash flow does not always value activities consistently with government policy. This is another aspect of the problem that can arise in the parastatal sector where emphasis on surplus generation (net cash inflow) can distort government policy. Distortion may manifest itself in overutilization of investment funds in too few projects, or in the overutilization of foreign exchange, with insufficient regard for the relative scarcity of domestic and foreign funds for investment and for such desired policies as creating employment and altering income distribution. By stressing the unit of the project the values of project activities can be assessed in conformity to government policy. The whole question of cash flow and value is taken up at length in the discussion on principles of appraisal and the case studies in subsequent chapters.

1.4. PROJECTS, ADMINISTRATORS, AND THE SECTORS OF AGRICULTURE AND INDUSTRY

It is idle to suppose that administrative systems and the work of administrators can be altered easily. Moreover, there are sound reasons for formulating and carrying out government policies

PROJECTS, BUDGETS, AND ADMINISTRATIVE SYSTEMS

15

within actual received administrative systems. If the project approach were to be stressed to the exclusion of other legitimate administrative activities, coordination of the public sector would suffer. What has been emphasized is that the project approach is the proper focus for deciding upon expenditures and receipts and for carrying out government policy throughout the public sector. There is need in general to introduce more widely into public administration the developmental notion that activities need to have a focus and to be overseen - managed - in order that stated objectives can be realized effectively. As a natural result, increased emphasis on the project approach does call for some reassessment of administrative systems. The materials presented in subsequent chapters are case studies drawn from projects having to do with both the agricultural and industrial sectors. They are actual parastatal projects; the broad development of these two sectors, calling for investment in all kinds of supporting facilities - infrastructure - is not discussed nor analyzed. This is not so serious as a practical matter, since actual work on such projects is, as I have stressed, left in greater or lesser detail by government ministries to parastatal organizations. The case studies illustrate methods of appraisal - of choosing projects - in systematic ways, and they show implicitly that two, and sometimes more, sectors are involved in project preparation and appraisal. In other words, they raise issues that have to be dealt with in the government - within the administrative system in such a way that the investment in resources is emphasized, thereby bringing into focus government policy. The case studies do not, of course, go into the methods or procedures by which administrative decision making will be carried out. These methods and procedures can be expected to vary across administrative systems and within any given administrative system.

2 PRINCIPLES OF APPRAISAL

2.1. NATURE OF A PROJECT

A project is the use of national resources to produce value. Resources include manpower, land in the broad sense of including forests, minerals and the like, and diverse forms of capital. These resources have alternative uses, that is, they can produce goods and services of different values. Appraisal, therefore, is concerned with the allocation of national resources to achieve the best, the maximum, or the most socially effective production of goods and services. Projects can be characterized in a general way as usually having some tangible form: buildings, equipment, and land. These tangible items, or assets, tend to last for long periods of time, in many cases for several years into the future. A project therefore has a length of life or an ECONOMIC LIFETIME directly related to the productive life of the assets which are part of the resources utilized in the project. In addition, a project can be characterized by its location, which can affect the resources allocated to the project and the values of the goods and services produced. The resources utilized in a project and over long periods of time are quite diverse; in order to relate value of resources to the value of goods and services produced, it is necessary to use money as a numéraire. This is accomplished quite easily since most resources are traded in markets: labour receives a (monthly) wage for services rendered; various raw material inputs such as pesticides are purchased for money on a regular basis; and usually resources are paid for in money. Therefore, it is relatively easy to sum up

PRINCIPLES OF APPRAISAL

17

the costs of resources used in any period of time and to assign a money value or cost to these resources. A project can be new in the sense that, for example, buildings and equipment are put up for the first time at a particular location. On the other hand, a project can be the continuation, extension, or even modification of an existing project (an incorporated company, for example). Tangible assets which form part of a project may be separated geographically. Thus, two separate projects of distinct cooperative societies may be combined to form one project. In a similar way, individual geographically separated cold stores can be grouped together to form an integrated cold chain. The scope of a project depends upon a variety of factors. Any meaningful definition of a project, therefore, must take into account the capacity to coordinate or control an array of resources - the capacity to manage a project. 2.2. ROLE OF TIME

Time is continuous. In order to judge the effects of time, however, we divide it into discrete units, or periods. Thus, for example, we can speak of a project lasting for ten years or of an agricultural project in operation for five seasons. As many resources such as manpower are paid on a monthly basis, it may be necessary to estimate costs for this time period. In dealing with projects, time customarily enters into the valuation of goods and services and resources in the following manner. If I am promised 100 shillings to be paid me in the future, the value of this 100 shillings is affected by how distant in the future the payment will be made. If the payment is made one year from the present, this is more desirable, more valuable, than payment two years from the present. In other words, for a fixed sum of money, or value, early payment makes the sum more valuable. Conversely, payments, including expenditures on resources, occurring later in time are less valuable. Of course, the situation is more complicated when different sums or values are involved, but the general rule we assume is that value diminishes as payment occurs farther into the future.

18

PRINCIPLES OF APPRAISAL

One other characteristic of future time is that we can never be sure of it until it arrives. Therefore, the payment of 100 shillings in the future is assumed, or estimated. It is quite clear ttiat all future events, such as payment of the 100 shillings or expenditures on resources, may not take place or may be altered as time goes on. An estimate, an educated guess about the future, is subject to some amount of risk and uncertainty. It is necessary, therefore, to distinguish between value as it is affected by time and by risk and uncertainty. 2.3. DISCOUNTING

Let us suppose that we have 100 shillings that we wish to lend out to be repaid in the future. In addition, the price for lending this sum will be 10 percent of the 100 shillings for every year the sum is outstanding. Therefore, we in effect charge 10 percent of 100 shillings for every period of time (in this case a year) the sum is outstanding. We have the following: Years -

0

1

2

3

(amounts in shillings) 4

5

100.0

110.0

121.0

133.1

146.4

161.0

Year "O" is the time period which corresponds to now or the present. The negative sign indicates that it is paid out (or lent in this case). The year "O" illustrates that the division of time into discrete periods is such that each period is assumed to be a unique point in time - an event. This is a necessary convenience to overcome the difficulties of continuous time. If repayment is made in year "1", we receive the initial sum of 100 shs. plus the additional 10 percent (10 shillings), or a total sum of 110 shillings. If repayment is not made until year five, the total repayment of 161 shillings is made, of which 100 shillings is the original sum lent and 61 shillings the charge for the use of the 100 shillings for five years. Alternatively, we could have the following: Year -

0

(amounts in shillings) 3

100.0

140.0

PRINCIPLES OF APPRAISAL

19

If we invest 100 shillings in a project, after three years 140 shillings is returned. This is to be compared with the above example where, if repayment is made in the third year, 133.1 shillings is returned. Investment in the project is preferable to lending a sum of money at the fixed charge of 10 percent per annum. Let us suppose that, for the sum of 100 shillings lent, repayment is made in the fifth year. As the project pays off in the third year, it is not possible to judge directly tne value of 140 shillings in the third year as compared to 161 shillings in the sixth year. If, however, the sum of 140 shillings is lent out, we have the following: 0 -

100.0 -

Year 3

4

(amounts in shillings) 5

140.0 140.0

154.0

169.4

It is clear that the sum of 169.4 shillings, for the project and for lending from the third year onwards, is greater than the sum of 161 shillings obtained lending the sum of 100 shillings for five years. The value of 161 shillings can also be expressed in the following way: 100.0 (1.10) = 110.0 = 100.0 (1.10)1 110.0 121.0 133.1 146.4

(1.10) (1.10) (1.10) (1.10)

= = = =

121.0 133.1 146.4 161.0

= = = =

100.0 100.0 100.0 100.0

(1.10) 2 (1.10) 3 (1.10) 4 (1.10) s

By a rearrangement, we have 100.0 = The figure 161 can now be referred to as the nominal value occurring in period five, and the figure 100 as the present value of that nominal value. The present value occurs, of course, in the year "0", which is now. If we substitute the nominal value of 169.4 shillings - the sum payable in the fifth year from the project plus investment from the third year onwards - we get: 105.2 =

169.4 (1.10)5

20

PRINCIPLES OF APPRAISAL

The present value of 105.2 shillings is greater than 100 shillings; therefore, the investment in the project plus lending of the sum 140 shillings yields greater value as compared to lending the sum of 100 shillings at 10 percent for live years. Present value can be illustrated also by looking at the third year for the project and for the repayment of the sum of 100 shillings lent. For the latter, the nominal value is 133.1 shillings, giving a present value of 100 shillings: 100.0 =

(1.10)3

For the former, we have 105.1 =

which illustrates that the (1.10)d present value of payment of 140 shillings is greater than the present value of 133.1 shillings. Present value enables us to compare nominal values occurring at different points in time, at different periods in the future. As projects have different economic lifetimes and payments occur in varying amounts, present value reduces the time dimension of projects to one point in time - time "0", or now. This applies equally to payments to the project and expenditures on resources incurred by the project. We can therefore develop a general way , nominal value, . of dealing with payments in future: present value = — ^ ^ where r is equivalent to the price charged for lending a sum of money. It is given the general designation RATE OF DISCOUNT. The n refers to the time period in which the nominal value occurs. It is clear that the higher the rate of piscount and the higher the n, the lower the present value for a given nominal value, and conversely. The tables of present value (given in the Appendices) are based N.V. on the formula P.V. = -—-——. For example, for the rate of (1 + r)n discount of 10 percent and for the period 3, a DISCOUNT FACTOR of 0.751 occurs in the table. If we substitute 10 percent for r and 3 for «, and give the value 1 to nominal value we obtain the following: (N.V.). ^ = (0.751). (N.V.)

21

PRINCIPLES OF APPRAISAL

Therefore, in calculating present value, we look up in the table of present values the year in which the nominal value occurs, select the appropriate rate of discount, and with the resulting discount factor, multiply it with the nominal value to obtain the present value. In the case of nominal values occurring in the period "0", the nominal value is equal to the present value because ^ = 1, irrespective of any zero or positive value for r. One other use of present value has to do with what is termed ANNUAL EQUIVALENTS. If 1 have a series of payments occurring each year for five years, 1

2

Year 3

4

(amounts in shillings) 5

10.0

100.0

200.0

250.0

300.0

the present value for the sum of these payments is 599 shillings (tor a discount rate of 10 percent). If, now, I wish to have an annual equivalent, a figure which is the same for each year but which when discounted at 10 percent gives me 599 shillings, I can use the table in the Appendix for annual equivalents. For five years at the rate of discount of 10 percent the factor to be divided into 599 is 3.791. Therefore, the annual equivalent of 158 (599 4- 3.791) which occurs as follows: ( amounts in shillings) 5

1

2

Year 3

4

158.0

158.0

158.0

158.0

158.0

when discounted for each year at 10 percent rate of discount, yields a total present value of 598.8 shillings (rounded off to the first decimal place) which is equivalent to the original present value of 599 shillings: Present Year

at

1

2

143.6

130.5

10 percent rate of discount (amount in shillings) 3 4 5 118.7

107.9

98.1

Total 598.8

22

PRINCIPLES OF APPRAISAL

The annual equivalent is useful for determining a figure for annual value for output produced (such as annual sales for a project) or for the value of annual costs.

2.4. APPRAISAL MEASURES

A project can be looked on in the following way:

Year

Amounts in shillings Costs

Investment

0 1 2 3 4 5

- 1,000.0

Total

- 1,000.0

-

—

•— — — —

Sales

200.0 300.0 400.0 500.0 500.0

100.0 300.0 500.0 1,000.0 2,000.0

- 1,900.0

3,900.0

The negative signs indicate that expenditures occur: payments are made which constitute an OUTFLOW of money. Conversely, the positive numbers in the sales column represent INFLOWS of monev. This concept of inflow and outflow can be used as the basis for appraisal of a project. If we take the rate of discount to be 10 percent for each of the five years, we have the following for present value: Shillings Year

Investment

0 1 2 3 4 5

- 1,000.0

Total

- 1,000.0

— — — — —

at 10 percent Costs

rate of discount Net Sales

Present Value

181.8 247.8 300.4 341.5 310.5

90.9 247.8 375.5 683.0 1,242.0

- 1,000.0 90.0 0.0 75.1 341.5 931.5

- 1,382.0

2,639.2

258.2

-

PRINCIPLES OF APPRAISAL

23

One appraisal measure is NET PRESENT VALUE, calculated by taking the difference between inflow and outflow for each period and summing these differences for the lifetime of the project. For the project above, net present value is equal to 258.2 shillings. Alternatively, we can have a measure of appraisal by dividing 2,639.2 . the sum of costs and investment into sales: - = 1,UUUU ~r 1,382.0 1.11. The ratio 1.11 is termed the BENEFIT-COST RATIO and measures the discounted return of sales (inflow) to discounted costs and investment (outflow). In other words, the benefit-cost ratio shows the return on the use of resources for a particular project. Each of these measures of appraisal is to be compared with the alternative of lending 1,000 shillings at the rate of discount of 10 percent per annum. If 1,000 shillings is lent in period "0", and repaid in period five (year "5"), the sum of 1,610 shillings will have accumulated The present value of this inflow is 1,000 shillings: 1,000.0 = Therefore, the net present value is equal to 1,000 less 1,000 or 0; the benefit-cost ratio is

= 1.

For net present value, the investment is an outflow of 1,000 shillings, which is exactly offset by the inflow (over the five years) of 1,000 shillings (the present value of 1,610 shillings). In a similar way, for the benefit-cost ratio, 1,000 shillings is the inflow, and 1,000 shillings is also the outflow, resulting in a ratio equal to 1. When a project is compared with the alternative of lending a sum of money equivalent to the original investment in period "0", if the net present value is greater than zero, or alternatively, if the benefit-cost ratio is greater than 1, the project is more desirable - earns more - than lending out the investment sum at the same rate of discount. A project is therefore minimally acceptable if its net present value is greater than zero and its benefit-cost ratio is greater than 1. In addition to comparing it with sums lent at a fixed rate of discount, a project can be compared with other projects. For example, we can have the following as a second project:

24

PRINCIPLES OF APPRAISAL Amounts in Shillings Costs

Investment

Year 0 1 2 3 4 5

-

Total

-

Sales

1,000.0 -

300.0 400.0 500.0 1,000.0 2,000.0

300.0 1,000.0 2,000.0 2,000.0 2,000.0

-

4,200.0

7,300.0

— — — —

—

1,000.0

To compare this project with the first one presented above, it is necessary to calculate the present value of the nominal values of investment, costs, and sales, occurring in the periods "0" through "5". Using the same rate of discount of 10 percent we get the following:

Year

Amounts in Shillings Investment

0 1 2 3 4 5

-

Total

-

Costs

at 10 percent rate of discount Sales Net Present Value

1,000.0

-

272.7 330.4 375.5 683.0 1,242.0

272.7 826.0 1,502.0 1,366.0 1,242.0

-

1,000.0 0.0 495.6 1,126.5 683.0 0.0

-

2,903.6

5,208.7

1,305.1

-

— — — —

—

1,000.0

For this project, the net present value is 1,305.1 shillings and the 5 208 7 benefit-cost ratio is , , , which is 1.33. Therefore, ljUUU.l) + 2,yU3.o the first project is in fact minimally acceptable, since its net present value is greater than zero and its benefit-cost ratio is greater than 1. The second project, however, is to be preferred to the first because its net present value is 1,305.1 shillings as compared to 257.2 shillings, and its benefit-cost ratio is 1.33, as compared to 1.11. Choices between projects can occur in a general way as funds for development expenditure are limited at any given time or for any period in the future, such as a fiscal year. Projects having

PRINCIPLES OF APPRAISAL

25

the highest net present value and benefit-cost ratios can be selected. Projects can also be selected in this fashion on the basis of a sector such as agriculture or industry. Alternatives of a particular project can also be compared. A project is judged in two ways: in comparison with sums lent at a fixed rate of discount, such that the project is judged to be at least minimally acceptable, and in relation to other projects which may be variants or alternatives of the project under consideration.

2.5. PRICES A N D VALUES

The actual prices at which goods and services are traded and the prices charged and paid for resources constitute the bases for calculating the inflows and outflows for a project over its economic lifetime. Certain questions do arise with respect to these prices. For example, goods and services are imported into and exported from the country continuously over many periods of time. The sum of all the payments for imports and the sum of all the receipts from exports in a given period of time may well result in a net outflow of funds, i.e. more payments abroad than receipts from abroad. If this should continue for long periods, the nation as a whole would not have the funds to maintain its overall imports per period, and it would have to curtail its imports in relation to its capacity to export. Of course, any net outflow in a period of time can be made up through resort to national balances of foreign currency (the nation's foreign exchange reserves) and through borrowing from other nations and international financial institutions. However, over many periods of time resort to foreign exchange reserves and foreign borrowing will be dependent upon capacity to export, which is the basis of the nation's capacity to repay its loans incurred from abroad. Therefore, actual prices for imported goods and services and actual prices for exports may not truly reflect the value of these goods and services from the national point of view. To avoid serious loss of foreign exchange reserves and avoid increased dependency on foreign loans, for example, the national value of the currency will be altered in such a way

26

PRINCIPLES OF APPRAISAL

as to make imported goods and services more expensive. The national value of exports will be raised in a similar fashion. By alteration of the national value of the currency is meant that, for purposes of calculation of net present value and the benefit-cost ratio, a higher national value is assumed. The effect of such an assumption is to lower the net present value and benefit-cost ratio for projects absorbing imports in the form of investments and costs per period; conversely, the net present value and benefitcost ratio for a project will be increased to the extent that goods and services are exported. A project can obviously be affected both by imports and exports; final appraisal reflects the relative importance of imports and exports on the project's costs and investments, and sales, respectively. Assumed prices for foreign exchange are referred to as SHADOW or ACCOUNTING prices. These accounting prices are not actual prices, but values assumed for analytical purposes to enable one to choose projects which enhance the national interest. In the case of foreign exchange, the nation with a lack of export capacity is interested in the preservation of foreign exchange reserves and avoidance of dependence upon foreign loans to support imports. In a similar way, the value of labour may not be correctly reflected in the wage rate paid. Workers in any given situation may be paid more (per month, per annum) than is consistent with the full employment of everyone willing and able to work. From the national point of view, differences between wages paid and the value of labour are reflected in levels of income for certain groups within the nation in comparison to the levels of employment. By assuming a value for labour below wages paid (in certain lines of employment), similar to the assumption of the value of foreign exchange for the country, employment is encouraged in those projects which are labour absorptive. Other discrepancies between prices and values can be noted. Where goods and services are traded in markets (the usual case), it is generally assumed that prices paid reflect consumers' valuation of these goods and services. In other words, consumers pay in money what the commodity is worth to them. Particular situations may arise where the assumption that prices paid for commodities

PRINCIPLES OF APPRAISAL

27

correctly reflect their values is questionable. The rate of discount used for determining net present value and the benefit-cost ratio is usually based on the price for lending and borrowing funds. This price is set by commercial banking institutions, the central bank, or government directly. Funds available for projects can be greater or less than the amounts which would be forthcoming for investment in projects at the correct national rate of discount. In other words, the value of funds for lending may be greater, for example, than is reflected in the fixed rate of discount. The effect of such a situation will be that more minimally acceptable projects than funds are available at the given rate of discount. By assuming a higher value for the rate of discount, the existing number of projects will be discounted at this higher figure, and some of these projects will become less than minimally acceptable. The correct national value for the rate of discount is that figure which makes the investment funds for the minimally acceptable projects equal to the funds available for investment. Accounting or shadow prices are in reality dependent upon national policy. Control of foreign exchange, employment policy, and concern for production of commodities which consumers desire at particular prices depend upon government Moreover, objectives of national policy overlap. By raising the value of the rate of discount above its current price, we may in effect be dealing with the related problem of foreign exchange. In other words, by discounting projects at higher discount values, we may discourage for investment projects which are heavily dependent upon imports. In a similar way, any attempts to conserve on scarce funds whether local or foreign exchange - may be similar or even equivalent to promotion of employment through a shadow price for labour which is below the actual wage rate paid. Shadow prices should in principle be consistent with each other in order to implement government policies effectively.

APPENDIX

ELABORATION OF APPRAISAL MEASURES The basis for appraisal of projects is the maximization of net present value. Projects are ranked in relation to sums lent at a fixed rate of discount and in relation to each other. The alternative measure of the benefit-cost ratio does give a ranking of projects similar to that of net present value. However, the benefit-cost ratio is in reality an average measure of present value over the economic lifetime of the project, as is illustrated by Figure 1. At the scale of production of X, the benefit-cost ratio is highest. This means in effect that the highest return is achieved through the investment of a given amount of resources in the form of discounted costs plus investment. In other words, the return is highest at X per unit of discounted costs plus investment employed. On the other hand, at Y the net present value is the highest. This is the result of expanding production (and investment). The benefit-cost ratio at Y is less than at X, but higher than at Z. At Z, the benefit-cost ratio is equal to 1, and the net present value is zero. Between X and Y, resources are added (expenditure increased), but at the same time the value of output rises. Between X and Y, therefore, for every addition of a discounted unit of resources, the value of output increases more than this discounted unit of resources. The marginal increase in discounted costs including investment is more than compensated for by an increase in the discounted value of output. Therefore, between X and Y, total net present value increases as production and investment move from X towards Y. Any expansion of production and investment beyond Y towards

APPENDIX

29

Z results in a diminution of net present value, so that at Z it has declined to zero. Therefore the scale of production and investment should be chosen at Y. When two or more projects are compared, the point Z will be determined by the next best benefit-cost ratio higher than 1, which may even prevent the expansion of production and investment to Y. The point is that, given the next best benefit-cost ratio, adjustment of the scale of a project may well yield a higher net present value. Alternative scales of a project depend upon such factors as technology - the possibilities to combine recourses in different combinations - and the availability of resources. 100 90 80 70

60 SO 40 30 20 10

6:1 5:1 4:1 3:1 2:1 1:1

COSTS IN DOLLARS SCALE OF PROJECT

Figure 1.

30

APPENDIX

The two projects previously compared can be presented in the following way: Project A

Project B

Amounts in Shillings Year 0 1 2 3 4 5

Net Returns -

Net Returns

1,000.0 100.0 0.0 100.0 500.0 1,500.0

-

1,000.0

Total

1,000.0 0.0 600.0 1,500.0 1,000.0 0.0 2,100.0

One alternative method for appraisal is to discount the net returns (as given above) to zero. In other words, a rate of discount is selected which makes the net return for a project equal to zero. For project 'A' (the first project) we have the following: Amount in shillings of Net Returns Year 0 1 2 3 4 5 Total

at 14% -

1,000.0 87.7 0.0 67.5 296.0 778.5 54.3

at 15% -

1,000.0 87.0 0.0 65.8 286.0 745.5 10.3

at 16% -

—

1,000.0 86.2 0.0 64.1 276.0 714.0 32.1

The rate of discount which reduces the net returns the closest to zero is 15 percent, and is termed the INTERNAL RATE OF RETURN of the project. It is the highest possible rate of discount consistent with a net present value of the project equal to zero. Therefore, if the external rate of discount, determined by the country's financial institutions, or the accounting rate of discount, given by national policy, are less than this internal rate of return, the projact is minimally acceptable.

31

APPENDIX

The internal rate of return for project 'B' (the second project) is as follows: Year 0 1 2 3 4 5 Total

Amount in shillings of Net Returns at 40% at 45% -

1,000.0 0.0 306.0 546.0 260.0 0.0 112.0

-

1,000.0 0.0 285.6 492.0 226.0 0.0 3.6

The internal rate of return for project "B" is therefore 45 percent. Project B is preferred to project A by three criteria of appraisal : Amount in shillings for Net Present Value Project A Project B Net present value Benefit-cost ratio Internal rate of return

258.2 1.11 15.0 %

1,305.1 1.33 45.0 %

These three appraisal criteria will rank projects in the same way if no constraints exist in the funding of projects or in carrying out projects in accordance with project design. One kind of constraint can be budgeting, in that public sector funds budgeted are first divided across sectors, e.g. agriculture and industry, and then funds are allocated to particular projects within each sector. Such a budgetary procedure will alter present values of projects and thereby alter project rankings. Another set of constraints may be present in actual project implementation, where, for example, the project may not be able to receive necessary inputs or sell the commodities produced in accordance with project estimates. These constraints may be physical, e.g. inability to produce as estimated, or administrative and managerial. Constraints therefore may cause projects to be ranked differently by the three criteria. This is illustrated in Figure 2 where two projects (alternatives of one project which are mutually exclusive) may be ranked differ-

32

APPENDIX

ently depending on the external rate of discount. Therefore, project A is preferred to B at 5 percent rate of external discount, whilst B is preferred to A at 12 percent rate of external discount. It is therefore necessary to be consistent in the use of project appraisal criteria. In the subsequent chapters, the appraisal measures of the net present value and benefit-cost are used. (At most rates of external discount the two measures rank projects similarly.) These two criteria are also chosen for ease of calculation when shadow pricing and indirect effects are introduced into project appraisal.

Figure 2.

3

PROJECT PREPARATION

3.1. PRESENTATION OF PROJECTS

Each of the three projects presented in this chapter sets forth information on project items and data peculiar to that project and necessary for appraisal of the project. The information and data are summarized in the cash flow table for each project. It is the cash flow table which is basic to the discounting process, to the use of accounting prices, and for a wide variety of other purposes within government. The use of the cash flow table therefore enables appraisal of different projects to be carried out and projects to be judged against general rates of lending and in comparison with one another.

3.2. THE SAWMILL CASE STUDY : THE SAWMILL PROJECT

3.2.1. Background to Project

This project is based on the availability of African hardwoods which have a ready market in Europe where specialty woods are in great demand. A suitable site for a mill exists alongside docking facilities where the sawn planks can be directly loaded for shipment. Logs can be supplied by cooperatives to the mill, with the mill purchasing logs at a stated delivered price. Financing will come from government in the form of equity and from the Investment Bank in the form of a loan. The sawmill project is therefore a public sector project in the form of an enterprise which will be a subsidiary

34

PROJECT PREPARATION

of the Industrial Development Corporation. The IDC is directly responsible to the Ministry of Commerce and Industry. 3.2.2. Technical Data The following data are the bases of the financial estimates (in paragraph 3.2.3.): Rated capacity Actual production rate Plant utilization Raw material Labour requirements

25 logs per 8 hour shift 20 logs per 8 hour shift/250 days per annum one 8 hour shift Mninga logs delivered to mill 8 indirect labour 27 direct labour Equipment one 20 H.P. horizontal band saw, three 5 H.P. circular saws, 1 pickup van Production per annum 50,000 cu.ft. of finished planks Production based on 25 (average) cu.ft. per log and 40 percent yield in finished planks from logs (40 percent of 125,000 cu. ft. of logs per annum yielding 50,000 cu. ft. of finished planks) Markets Europe Location of mill alongside dock

3.2.3. Financial Cost and Sales Estimates (given in U.S. Dollars) 3.2.3.1. Buildings Main sawmill building including construction of timber yard, log yard and office, approximately 90' x 50' = 4,500 sq.ft. @ 3.00 per sq.ft. 13,500 3.2.3.2. Machinery and Equipment One 20 H.P. band saw with accessories Three 5 H.P. circular saws One pickup van Furniture and fixtures Spare parts, tools, and fire extinguishers Installation expenses Contingencies (5 percent)

15,500 1,140 4,300 1,400 1,740 1,400 1,300

PROJECT PREPARATION

3.2.3.3. Access Road Fixed investment Buildings Machinery and equipment Access road

35

400 13,500 26,780 400 40,680

3.2.3.4. Labour Number Indirect Labour: Manager/technician Accountant Clerks Driver Messenger Watchmen Total Direct Labour: Machine operators Helpers Mechanic Foreman Logyard workers Timberyard workers Total

Per Month

Per Year

1 1 2 1 1 2 8

300.00 115.00 43.00 43.00 25.70 25.70

3,600.00 1,380.00 1,032.00 516.00 308.40 616.80 7,453.20

4 11 1 1 4 6

57.00 25.70 70.00 57.00 25.70 25.70

2,736.00 3,392.40 840.00 684.00 1,233.60 1,850.40 10,736.40

27

3.2.3.5. Raw Material 125,000 cu.ft. of logs per annum (for 250 days production @ 0.93 per cu.ft. delivered to mill) 116,250.00 3.2.3.6. Depreciation Buildings: 4 percent per annum Horizontal band saw: 12.5 percent per annum Circular saws: 50 percent per annum Pickup van: 25 percent per annum Furniture and fixtures: 20 percent per annum Spare parts, tools, and fire extinguishers: 50 percent per annum Total Annual Depreciation

540.00 1,937.50 570.00 1,075.00 280.00 870.00 5,272.50

36

PROJECT PREPARATION

3.2.3.7. Overhead Costs Depreciation Indirect labour Electricity, water, fuel oil, and petrol Insurance and legal fees Maintenance and repairs P.T. andT. Other administrative expenses Total Annual Overhead Costs

5,272.50 7,453.20 3,000.00 1,140.00 1,400.00 1,000.00 400.00 19,665.70

3.2.3.8. Working Capital Raw material in stock (4 months' supply) Goods in process (1 month) Finished goods in stock (3 months' production) Accounts' receivable (1 month) Cash Total Working Capital Capital Required Fixed investment Working capital Total Capital Capitalization Equity Loan Total

100,000.00 65,000.00 165,000.00

3.2.3.9. Production Costs Raw material Direct labour Overhead costs Total Annual Production Costs

116,250.00 10,736.40 19,665.70 146,652.10

3.2.3.10. Other Expenses Operating Costs Production costs Other expenses Total

38,750.00 9,687.50 46,556.90 15,519.00 14,000.00 124,513.40 40,680.00 124,513.40 165,193.40

10,532.50 146,652.10 10,532.50 157,184.60

PROJECT PREPARATION 3.2.3.11.

37

Sales

Grade I finished planks (60 percent o f total annual production

of

50,000 cu.ft. F.O.B.

@

3.75 per 112,500.00

cu.ft.) Grade

II

finished

planks

(40 percent

of

total

annual production F.O.B. @ 3.60 per cu.ft.) Waste w o o d 1,000 (metric) tons @ 1.50 per t o n

3.2.3.12. Loan Repayment

1 2 3 4 5 6 7 8

1,500.00 186,000.00

Total A n n u a l Sales

Year

72,000.00

Schedule

Principal Outstanding 65,000 65,000 65,000 52,000 39,000 26,000 13,000

3.2.3.13. Foreign Exchange

Loan Repayment

—

13,000 13,000 13,000 13,000 13,000

—

—

5,850 5,850 5,850 4,680 3,510 2,340 1,170 —

Estimates Foreign Exchange

Local Currency

Buildings Machinery Pickup van Furniture & fixtures Spares, tools, extinguishers Installation Contingencies Access road

2,700.00 16,640.00 4,300.00 420.00 1,740.00 420.00 870.00

10,800.00

Total Working capital

27,090.00

Fixed investments

Interest

—

—

Total

980.00 430.00 400.00

13,500.00 16,640.00 4,300.00 1,400.00 1,740.00 1,400.00 1,300.00 400.00

13,590.00 124,513.40

40,680.00 124,513.40

— —

980.00 —

Recurrent expenditure (production costs plus other expenditures plus interest charges): estimated 10 percent foreign exchange per annum.

38

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