CHAPTER THREE

PROJECT EVALUATION AND ANALYSIS (PROJECT PREPARATION)

3.1 MEANING OF FEASIBILITY STUDY

A feasibility study is an analytical tool used during a business development process to show how a
business would operate under a set of assumptions. These assumptions often include such factors as the
technology used (the facilities, equipment, production process, etc.), financing, (capital needs, volume,
cost of goods, wages, etc.), marketing (prices, competition, etc.), and so on.
The study is usually the first time in a project development process that many key pieces and information
about the project are assembled into one overall analysis. The study must show how well all of these
pieces fit and perform together. The result will be an overall assessment of whether the proposed business
concept is technically and economically feasible.
Feasibility studies should also provide sensitivity analyses of the business given changes in key
assumptions. One should note that a simulation or projection model, while useful, is not a substitute for a
comprehensive feasibility study. This type of model is sometimes used in a “pre-feasibility” study done
early in the project timeline to provide a first-cut evaluation of the proposed business idea.

A feasibility study must provide all data necessary for an investment decision. The commercial, technical,
financial, economic and environmental prerequisites for an investment project should therefore be defined
and critically examined on the basis of alternative solutions already reviewed in the pre-feasibility study.
 The result of these efforts is then a project whose central objective and possible marketing
strategies, the possible market shares that can be achieved, the corresponding production
capacities, the plant equipment and, if required, its environmental impact have been assessed and
documented.
 The financial part of the study covers the scope of the investment, including the net working
capital, the production and marketing costs, sales revenue and return on capital invested.

3.2 WHY WE PREPARE FEASIBILITY STUDIES?

Developing any new business venture is difficult. Taking a project from the initial idea through the
operational stage is a complex and time-consuming effort. Most ideas, whether a potential cooperative or
an Investor-owned business, do not develop into an operational entity. When ideas do make it to the
operational stage there is a high failure rate (many within the first 6 months). Thus, before potential
members invest in a proposed business project, they must determine if it can be economically viable and
then they must decide if investment advantages outweigh the risks involved—a feasibility study is the
means by which these decisions are made. Without feasibility studies the percentage of startups, that fail
would be higher.
3.3 COMPONENTS OF FEASIBILITY STUDY
Feasibility study (project preparation Phase) of a project may have the following major components:
1. Market and demand analysis
2. Technical analysis
3. Financial analysis
4. Economic and social analysis
5. Environmental analysis
6. Human resource and organization

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 1. MARKET AND DEMAND ANALYSIS
In most cases, the first step in project analysis is to estimate the potential size of the market for the
product proposed to be manufactured (or the service planned to be offered) and get an idea about the
market share that is likely to be captured. Put differently, market and demand analysis is concerned with
two broad issues;
1. What is the likely aggregate demand for the output? and
2. What share of the market will the proposed project enjoy?
For all investment projects market analysis is the key activity for determining the scope of an investment,
the possible production programs, the technology required and often the choice of location. Two important
implications of market study are:
1. Influence the accept / reject decision- if the demand of the project output is very low, the
project may not be accepted. Error in the assessment of market may lead to accepting of a
project that should be rejected or rejecting a project that should be accepted. Or if it is
wrongly projected, it may lead to wrong investment decision.
2. Influence the determination of plant capacity. It may lead to wrong choice of capacity –
- Excess capacity- over investment, idle capacity
- Cost of small capacity – loss of opportunities, loss of the advantage of economy of scale.

Example- The introduction of mobile phone by ETC and the subsequent expansion to meet the demand
seems to be because of error in estimating demand. Initially demand was under estimated (15,000).
Currently the corporation, even after going through many expansion, it couldn’t satisfy the demand..
Demand analysis requires the market analysis a wider varieties of information and appropriate forecasting.
The kinds of information required to answer the above two critical questions include:
- Consumption trends in the past and the present consumption levels
- Past and present supply position
- Production possibilities and constraints
- Import and exports
- Structure of competition
- Cost structure
- Elasticity of demand
- Consumer behavior, intentions, motivations, attitudes, preferences and requirements
- Distribution channels and marketing policies
- Administrative, technical and legal constraints
These are very important questions in project analysis. Because it calls for in-depth study and assessment
of various factors like patterns of consumption, growth, income and price elasticity of demand,
composition of the market, nature of competition, and availability of substitute so on and so forth. Yet, in
many cases project feasibility studies seems to make a short shrift of market and demand analysis. It is not
uncommon to find cursory statement like "the market is attractive" or "the demand is expected to exceed
supply".
Given the importance of market and demand analysis, it should be carried out in an orderly and systematic
manner. The key steps in such analysis are as follows:

- Situational analysis and specification of objectives

- Collection of secondary information
- Conduct market survey
- Characterization of the market
- Demand forecasting and market planning
2. SITUATIONAL ANALYSIS AND SPECIFICATION OF OBJECTIVES
In order to get a 'feel' for the relationship between the product and its market, the project analyst may
informally talk to customer competitors, intermediaries, and others in the industry. Wherever possible, he

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may look at the experiences of the company to learn about the preferences and punishing power of
customers, actions and strategies of competitors.
If such a situational analysis generates enough data to measure the market and enable us to have a clear
picture over projected demand and revenue, a formal study need not be carried out, particularly when time
and cost consideration so suggest. In most cases, of course a formal study of market and demand is
warranted.

To illustrate, suppose that a small but technological competent firm has developed an air cooler based on a
new principle that appears to offer several advantage over the conventional (former) air cooler.
The chief executive of the firm needs information about where and how to market the new air cooler.
The objectives of market and demand analysis in this case may be to answer the following questions:

- Who are the buyers of air cooler?

- What is the total current demand for air cooler?
- How is the demand temporarily distributed (pattern of sales over the year) and geographically?
- What is the break-up of demand for air coolers of different size?
- What prices will the customers be willing to pay for the improved air cooler?
- How can potential customers be convinced about the superiority of the new cooler?
- What price and warranty will ensure its acceptance?
- What channels of distribution are most suited for the air cooler? What trade margin will induce
distributors to carry it?
- What are the prospects of immediate sales?

2. COLLECTION OF SECONDARY INFORMATION

In order to answer the questions listed while delineating the objective of the market study, information
may be obtained from secondary and/or primary sources. Secondary information is information that has
been gathered in some other context and is already available. Primary information, on the other hand,
represents those information which are collected for the first time to meet the specific purpose on hand.
Secondary information provides the base and the starting point for market and demand analysis. It
indicates what is known and often provides leads and cues for gathering primary information required for
further analysis.

The important source of secondary information useful for market and demand analysis in Ethiopia is
mentioned below.

 census of Ethiopia
 national sample survey reports
 statistical abstracts
 annual survey of industries/agriculture and export
 economic survey
 annual report by national bank of Ethiopia
 bulletin on import and export
 other publications

3. CONDUCT OF MARKET SURVEY

For undertaking a market survey there is a need to have a sample, which represents the entire market.
Thus, sampling is the process of drawing a limited number of subjects from a larger population or
universe. Since, the researcher cannot survey the entire universe or population that they are interested,
they usually draw a sample of subjects from the population for investigation.

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Steps in a Sample Survey
Typically, a sample survey consists of the following steps:

1. Define the target population: in defining the target population, the important terms should be
carefully and unambiguously defined. The target population may be divided into various segments
which may have differing characteristics. For example, all television owners may be divided into
three to four income bracket.
2. Select the sampling scheme and sample size: there are several sampling schemes, simple random
sampling, cluster sampling, sequential sampling, stratified sampling, systematic sampling and
non-probability sampling. Each scheme has its advantage and limitations. The sample size, other
things being equal, has a bearing on the reliability of the estimates – the larger the sample the
greater reliability.
3. Develop the questionnaire: the questionnaire is the principal instrument for eliciting information
from the sample of the respondent. The effectiveness of the questionnaire as a device for eliciting
the desired information depends on its length, the type of questions, and the wording of questions.
Developing the questionnaire require a thorough understanding of the product, and its usage,
imagination, insights into human behavior, appreciation of subtle linguistic nuances, and
familiarity with the tools of descriptive and inferential statistics to be used later for analysis.
Since the quality of the questionnaire has an important bearing on the results of market survey, the
questionnaire should be tried out in a pilot survey and modified in the light of problems/
difficulties noted.

4. Recruit and Train the Field Investigators: recruiting and training of field investigators must be
planned well since it can be time consuming. Great care must be taken for recruiting the right kind
of investigators and imparting the proper kind of training to them.
5. Obtain information as per the questionnaire from the sample respondent: respondent may be
interviewed personally, telephonically, or by mail for obtaining information. Personal interview
ensure a high rate of responses. They are, however, expensive and likely to result in biased
responses because of the presence of the presence of the interviewer. Mail survey are economical
and evoke fairly candid responses. The response rate, however, is often law. telephonic interview,
common in western countries have very limited applicability in Ethiopia because telephone tarrifs
are high and low telephone connection.
6. Scrutinize the information gathered: information gathered should be thoroughly scrutinized to
eliminate data which is internally inconsistent and which is of dubious validity. Sometimes data
inconsistencies may revealed only after some analysis.
7. Analyze and Interpret the Information: information gathered in the survey need to be analyzed
and interpreted with care and imagination. After tabulating it as per a plan of analysis, suitable
statistical investigation may be conducted, wherever possible and necessary. For the purpose of
statistical analysis, a variety of methods is available. They may be divided into two broad
categories; parametric and non-parametric methods.
Parametric methods assume that the available or the attribute under study conforms to some
unknown distribution. Non-parametric methods do not presuppose any particular participation.

Results of data based on sample survey will have to be extrapolated to the target population. Here it
should be noted that the results of the market survey can be affected by:

i) non representativeness of sample

ii) imprecision and inadequacies in the questions,
iii) failure of the respondent to comprehend the questions
iv) deliberate distortion in the answer given by the respondent
v) checking on the part of the investigators

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 vi) slip shod scrutiny of data
vii) Incorrect and inappropriate analysis and interpretation of data

4. CHARACTERISTICS OF THE MARKET

Based on the information gathered from secondary sources and through the market survey, the market for
the product may be described in terms of the following:

 Effective demand in the past and present

 Breakdown of demand
 Price
 Methods of distribution and sales promotion
 Consumers
 Supply and competition
 Government policy
I.Effective Demand in Past and Present
To gauge the effective demand in the past and present, the starting point typically is apparent
consumption, which is defined as:

Production + Imports – Exports – Changes in Stock Level

In a competitive market, effective demand and apparent consumption are equal. however, in most of the
developing countries, where competitive markets do not exist for a variety of products due to exchange
restrictions and controls on production and distribution. The figure of apparent consumption may have to
be adjusted for market imperfections.
II. Breakdown of Demand

To get a deeper insight into the nature of demand, the aggregate (total) market demand may be broken
down into demand for different segments of the market. Market segments may be defined by (a) nature of
product, (b) consumer groups and (c) geographical division.

Nature of product: one generic name of subsumes many different products: for example,
commercial vehicles covers trucks and buses of various capacities and so on and so forth
Consumer groups: consumers of product may be divided into industrial consumers and domestic
consumers. Industrial consumers may be sub-divided industry wise. Domestic consumers may be
further divided into different income groups.
Geographical divisions: a geographical breakdown of consumers, particularly for products, which
have a small value to weight relationship, and products which require regular, efficient after
sales services is helpful.
Why is segmental analysis required? Segmental information is helpful because the nature of demand tends
to vary from one segment to another (the demand for consumers in high brackets may not be sensitive to
price variation) and different marketing strategies may be appropriate to different market segments.
III. Price
Price statistics must be gathered along with statistics pertaining to physical quantities. It may be helpful to
distinguish the following types of prices.
i) manufacturer's price quoted as FOB (Free on board) price or CIF (Cost, insurance and freight)
price
ii) landed price for imported goods
iii) average wholesale price, and
iv) average retail price
IV. Method of Distribution and Sales Promotion
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The method of distribution may vary with the nature of product. Capital goods, industrial raw materials or
intermediates, and consumer products tend to have differing distribution channels. Further, for a given
product, distribution methods may vary. Likewise, methods used for sales promotion (advertising,
discount gift schemes etc) may vary from product to product.
The method of distribution and sales promotion employed presently and their rationale must be specified.
Such a study may explain certain patterns of consumption and highlight the difficulties that may be
encountered in marketing the proposed products.
V. Consumers
Consumers may be categorized along two dimensions as follows:

Demographic and Sociological Attitudinal

Age Preference
Sex Intentions
Income Habits
Profession Attitudes
Residence Responses
Social background

VI. Supply and Competition

It is necessary to know the existing source of supply and whether they are foreign or domestic. For
domestic sources of supply, information along the following lines may be gathered location, present
production capacity, planned expansion, capacity utilization level, bottlenecks in production and cost
structure.

Competition from substitute and near substitute should be special because almost any product may be
replaced by some other product may be replace by some other product as a result of relative charges in
price, quality, availability, promotional effort and so on.
VII. Government Policy
The role of government in influencing the demand and market for a product may be significant.
Governmental plans, policies, legislation and fiats which have a bearing on the market and demand of the
product under examination should be spelt out. These are reflected in: production target in national plans,
import and export trade controls, import duties, export incentives, excise duties, sales tax, industrial
licensing, preferential purchase, credit controls, financial regulation and subsidies/penalties of various
kinds.
5. Demand Forecasting and market planning

After gathering information about various aspects of the market and demand from primary and secondary
sources, an attempt may be made to estimate future demand. A wide range of forecasting method is
available to the market analyst. This may be broadly divided into two categories: qualitative and
quantitative methods.

A. Qualitative Methods
These methods rely essentially on the judgment of experts to translate qualitative information into
quantitative estimate. The important qualitative methods are:
 Jury of executive opinion method: very popular in practice, this method calls for the pooling of
views of a group of executive on expected future sales and combining them into sales estimates.

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  Delphi method: this method involves converting the views of a group of experts, who do not
interact face to face into a forecast through an iterative process.

B. Quantitative methods- uses a formal mathematical method to fit cost functions to past data
observations. Examples include Time series analysis, Regression (correlation) analysis, Moving
average, exponential smoothing etc

1. Trend projection method (Time series analysis) Time series analysis forecasts based on an analysis of
how variables of interest have moved historically over the past periods. It does not make a real
attempt to analysis why the variables has changed as they did in the past. The change is only related
to time. It helps to forecast about the future based on what has happened in the past. It is more
suitable when changes have a certain pattern and the same pattern is expected in the future too.

Time series analysis is becoming a very simple task with advancement of computer spreadsheet
technologies. When the trend projection method is used, the most commonly employed relationship is the
linear relationship. Y= a + bx

y= demand for the year (dependent variable)

x= time variable (Independent variable)
a = intercept of the relationship
b= Slope of the relationship
Let us consider the case of Mid-Western Manufacturing Company; that firm's demand for electrical
generators over the period 1981-1987 is shown below:

Electrical Generators
Year Sold
1981 74
1982 79
1983 80
Values of Dependent Variable

1984 90 Dist 5 *
1985 105
1986 142 Dist 3 *
1987 122
Dist 1 * * Dist 6

Time
To develop a linear trend line by a precise statistical method, the least squares method may be applied.
This approaches results in a straight line that minimizes the sum of the squares of the vertical differences
from the line to each of the actual observations.

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A least squares line is described in terms of its y-intercept (the height at which it intercepts the y-axis) and
its slope (the angle of the line). If we can compute the y-intercept and slope, the line can be expressed by
the following equation:

Ŷ= a + bx, where
Ŷ = Computed value of the variable to be predicted (Dependent
variable) a = y - axis intercept
b = slope (the rate of change in y for given changes in
x) x = Independent variable
a = y - bx and b = Σxy - n x y
2 2
Σx - n x
With a series of data overtime, the computations can be reduced if the values of the X- variable (time) are
transformed to simpler numbers that sum to zero.

Time Period Generator Sales

Year (X) (Y) X2 XY

1981 -3 74 9 -222
1982 -2 79 4 -158
1983 -1 80 1 -80
1984 0 90 0 0
1985 1 105 1 105
1986 2 142 4 284
1987 3 122 9 366
ΣX = 0 ΣY = 692 ΣX2 = 28 ΣXY = 295
X= ΣX/n = 0 Y= ΣY/n = 98.86

Then, the computations are as follows:

b = Σxy - n x y
2 2
Σx - n x
b = 295 - 7(0) (98.86)
28 - 7(0)
b = 295
25
b = 10.54
Hence, the least squares equation is:

Ŷ= 98.86 + 10.54X

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To project sales in 1988, we first denote the year 1988 in the new coding system; in this case as X = 4
Ŷ (Sales in 1988) = 98.86 + 10.54(4)
= 141.02 or 141 Generators
Sales for 1989 are estimated by inserting X= 5 in the same equation.
Ŷ= 98.86 + 10.54(5)
= 151.56 or 152 Generators
Therefore, following is the next five years (1988 -1992) projection:

Year Coded Generators (Y)

Time Period (X) [Ŷ = 98.86 + 10.54x]
1988 4 141.02
1989 5 151.56
1990 6 162.10
1991 7 172.64
1992 8 183.18

2. Regression Analysis:
Regression analysis is a causal forecasting model, which usually considers several variables that are
related to the variable being predicted. Once the related variables have been found, a statistical model is
built and used to forecast the variable of interest. Regression analysis uses the least squares approach on
one or more independent variables to develop a forecasting model.
Assume that Wawu Construction Company renovates old homes in Addis Ketema. Overtime, the
company has found that their birr value of renovation work is dependent on the Addis Ketema area
income. The figures for Wawu's revenues and the amount of money earned by income earners in Addis
Ketema for the years 1982-87 are presented below.

Y X
[Wawu's revenue] [Local income]
Year
(100,000's) (100,000,000's)
1982 2.0 1
1983 3.0 3
1984 2.5 4
1985 2.0 2
1986 2.0 1
1987 3.5 7

Now, Wawu wants to establish a mathematical relationship that will help predict sales. Least squares
regression analysis may be used to establish the statistical model. The same basic model applies: Ŷ = a +
bx and the calculations for a and b follow

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 Revenue Income
(Y) (X) X2 XY Y2
2.0 1 1 2.0 4.0
3.0 3 9 9.0 9.0
2.5 4 16 10.0 6.25
2.0 2 4 4.0 4.0
2.0 1 1 2.0 4.0
3.5 7 49 24.5 12.25
ΣY =15.0 ΣX = 18 ΣX2 = 80 ΣXY = 51.5 ΣY2 = 39.5

x = Σx = 18/6 = 3
n
y = Σy = 15/6 = 2.5
n

b = Σxy - n x y
2 2
Σx - n x
b = 51.5 - (6(3)(2.5)) = - 45
51.5 = 6.5 = 0.25
80 - 6(32) 26 26

a = y - bx = 2.5 - 0.25(3) = 1.75

Therefore, the estimated regression equation is:
Ŷ= 1.75 + 0.25X

i.e.,

Lastly, we have to measure how strong the linear relationship is between the two variables, that is the
sales and income using the correlation coefficients for Regression Lines (r):
r = nΣxy - Σx Σy

[n x2  (x)2 ][n y2  ( y)2 ]

Four values of the correlation coefficient:

a) Perfect positive correlation when r = 1
b) Perfect negative correlation when r = -1
c) Positive correlation when 0 < r < 1
d) Negative correlation when -1 < r < 0
e) No correlation when r = 0

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Then the correlation coefficient for Wawu Construction Company is:

r = nΣxy - Σx Σy

[nx2  (x)2 ][n y2  ( y)2 ]

= (51.5) - (15x18)
[6(80)  (18)2 ][6(39.5)  (15)2 ]
= 309 - 270
(408  324) (237  225)
= 39
(156 *12)
= 39
1872
= 39
43.27
= 0.901 , This r-value appears to be a significant correlation and helps
to confirm the closeness of the relationship of the two
variables.

Thus, following is the five years (1988-1992) sales projection:

Income(I), where Revenue (Ŷ), where

I = 0.795 + 0.63t Ŷ = 1.75 + 0.25income
Year (Forecasted using Trend
Analysis) (100,000,000's)
(100,000's)
1988 5 3
1989 6 3.25
1990 7 3.5
1991 7 3.5
1992 8 3.75

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 2. TECHNICAL ANALYSIS
This involves selection of the appropriate technology for the project among the various technologies that
might be available. An integral part of engineering at the feasibility stage is the selection of an
appropriate technology, as well as planning of the acquisition and absorption (incorporation) of this
technology and of the corresponding expertise.

It may include the work of engineers, soil scientists and agronomists in case of, say, agricultural projects.
The technical analysis is concerned with the projects inputs (supplies) and output of real goods and
services and the technology of production and processing. It also involves the identification and
evaluation of alternative technologies in the context of the socio-economic and ecological environment
within which the project will be implemented.

Technology represents technical process and know how (Hardware plus software plus know how). If one
of this is missing, it would be rarely possible to transfer a certain technology to a specific situation.
Analysis of the technical and engineering aspects of a project is to be done continuously when a project is
formulated. Other types of analysis are dependent and closely intertwined with technical analysis.

The scope of an investment project is first defined by the project or corporate objectives and strategies
determined by the potential investors, taking into account the overall business environment, and secondly
by the marketing concept as well as the available project inputs (resources). It is the task of engineering to
design the functional and physical layout for the industrial plant necessary to produce the defined
products (output), and to determine the corresponding investment expenditures as well as the costs arising
during the operational phase. The scope of engineering also includes the plant site and all activities
required to deliver both inputs and outputs and to provide the necessary ancillary infrastructure
investments.
While the choice of technology defines the production processes to be utilized, the effective management
of technology transfer required that the technology and know-how are acquired on suitable terms and
conditions, and that the necessary skills are available or developed.
The required machinery and equipment must be determined in relation to the technology and processes to
be utilized, the local conditions, the state of the art and human capabilities. The skill development needs
to be planned through training programs at various levels.

The analysis must include all technical, managerial and administrative, as well as external, socio-culture
and economic aspects of the required maintenance system. It should also outline the specific requirements
of each individual technology, if selected, and specify the need for technical documentation and
maintenance procedures. In particular, the analysis must include a thorough survey of spare parts and the
format of the necessary lists of spare parts. Technical analysis is concerned with;
Materials inputs and utilities- whether the technology utilizes local raw materials
Manufacturing process/ technology
Product mix
Plant capacity
Location and site
Machineries and equipment
Structures and civil works
Project charts and layouts
Work schedule
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 MATERIAL INPUTS AND UTILITIES

The different materials and inputs required for the operation of the plant are identified in this part of the
feasibility study, and their availability and supply as well as the method of estimating the resulting costs,
are analyzed and described.
There is a closer relationship between the definition of input requirements and other aspects of the project
formulation, such as the definition of plant capacity, location and selection of technology and equipment,
as these inevitably interact with one another. The selection of raw materials and supplies depends
primarily on the technical requirements of the project and the analyses of supply markets.

Issues includes,
 What types of materials are needed? The requirements of raw materials and factory supplies
should be identified.
 Where are the sources of the materials and supplies?
o The sources and the constant availability of basic production materials are crucial to
the determination of the technical and economic viability as well as the size of most
industrial projects. A feasibility study must show how the materials and inputs
required will be provided.
o Supply risks
 What are the costs of each material? Not only the availability but also the unit costs of basic
materials and factory supplies have to be analyzed in detail, as this is a critical factor for
determining project feasibility.
o Relative costs of materials especially when the technology allows the use of different
types of materials
o In the case of domestic materials, current prices have to be viewed in the context of
past trends and future projections of the elasticity of supplies.
o For imported material inputs, CIF (including costs, insurance, and freight) should
considered together with clearing charges (including loading and unloading), port
charges, tariffs, local insurance and taxes, and costs of internal transport to the plant.
 Environmental factors such as resources depletion and pollution concern
Approach in materials and supplies study
1. Classify raw materials and supplies needed into different categories
a. Unprocessed and semi-processed raw materials
b. Processed industrial materials and components
c. Factory supplies, spare parts etc.
2. Prepare specification of requirements (type, quality and quantity of materials) considering
a. Technical factors such as technology and production process, type of machinery and
equipment, production capacity and program.
b. Commercial and financial factors such as market demand regarding products quality,
competition for materials.
c. Socio-economic factors such as skill of work force, environmental policies and
regulations etc
3. Determine the availability and supply and classify into local and imported categories.
a. Local sources (location and area of supplies, concentrated or dispersed, alternative uses,
transportability and transport costs)
b. Imported (sources , foreign exchange restrictions, reliability of supplies)
4. Estimation of the current and projected prices in the context of past trends and future prospective.
This may include CIF (cost, insurance and freight for imported items)

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An important aspect of technical analysis is concerned with defining the materials and utilities required,
specifying their properties in some detail and setting up their supply program. Material inputs and utilities
may be classified into four broad categories: 1. Raw Materials, 2. Processed Industrial Materials and
Components, 3. Auxiliary Materials and Factory Supplies and 4. Utilities

1. Raw Materials
Raw materials (processed and/or semi processed) are those materials which can be taken as an input to
product an output. Raw material could be: agricultural products, mineral products, livestock and forest
products, and marine products.

2. Processed Industrial Materials and Components

Processed industrial materials and components (base metal, semi-processed materials, manufactured
parts, components and sub assemblies) represents important input for a number of industries. In studying
them, the following questions needs to be answered. In the case of industrials materials; what are their
properties? What is the total requirement of the project? What quantity would be available from domestic
sources? What quantity would be procured from foreign sources? How dependable the supplies are? What
has been the past trend in price/ what is the likely future behavior of price?

3. Auxiliary Materials and Factory Supplies

In addition to the basic raw materials and processed industrial materials and components, a manufacturing
project requires various auxiliary materials and factory supplies like chemicals, additives, packaging
materials, paints, varnishes, oil, greasing, cleaning materials, etc. The requirement of such auxiliary
material should be taken into account in the feasibility study.

4. Utilities
A broad assessment of utilities (power, water, steam, fuel, etc) may be made at the time of input study
though a detailed assessment can be made only after formulating the project with respect to location,
technology, and plant capacity.

Manufacturing Process/Technology
It is to be ensured that the manufacturing process to be adopted is modern and at the same time
appropriate to the level of economic development of the country. Where sophisticated or new process is
to be adopted, the advice of a committee of technical experts is also sought before the project is cleared.
Normally the choice of technology is influenced by a variety of consideration:
 Plant capacity: there is a close relationship between plant capacity and production technology.
To meet a given capacity requirement perhaps only a certain production technology may be
viable.
 Principal Inputs: the choice of technology depends on the principal inputs available for the
project. In some cases, the raw materials available influence the technology chosen.
 Investment outlay and production cost: the effect of alternative technologies on investment
outlay and production cost over a period should be carefully assessed.
 Use by other units: the technology adopted must be proven by successful use by other units.
 Latest development: the technology adopted must based on the latest development in order to
ensure that the likelihood of technological obsolescence in the near future, at least, is minimized.
 Ease of absorption: the case with which a particular technology can be absorbed can influence.
The choice of technology, sometimes a high-level technology may be beyond the adoptive
capacity of a developing country, which may train personnel to handle the technology.

Another issues related with technology is acquiring technology, and appropriateness of technology.

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Acquiring Technology
The company can acquire technology by way of

A. Technology licensing
B. Outright purchases
C. Joint ventures arrangement
A. Technology licensing: this gives the licensee (the one who receive the technology) the right to
use patented technology and get related know how on a mutually agreed bases. The contract for
technology licensing should be carefully scrutinized with respect to
i. Definition of technology to be acquired,
ii. Cost of technology licensing,
iii. Guarantees provided by the licensor,
iv. Duration of technology licensing,
v. Purchase of intermediate products, components etc
B. Outright purchase (purchase of technology): this mode of acquiring technology may be used in
certain kinds of industries. It’s appropriate when
i. there is no possibility of significant improvement in technology in the foreseeable
future and
ii. there is hardly any need for technological support from the seller of technology
C. Joint venture agreement: the supplier of technology may participate technically as well as
financially in the project. Financial participation is typically in the form of equity holding. It’s
argued that financial participation may strengthen the motivation of technology supplier to
transfer improvement promptly.

Appropriateness of Technology
Appropriate technology refers to those methods of production, which are suitable to local economic,
social and cultural conditions. Those who advocate the appropriateness of technology urge that the
technology should be evaluated in terms of the following questions:

 Whether the technology utilizes local raw materials?

 Whether the technology utilizes local manpower?
 Whether the goods and services produced cater to the basic needs?
 Whether the technology protect the ecological balance?
 Whether the technology is harmonious with social and cultural conditions?

PRODUCT MIX

The choice of product mix is guided by market requirements. In the production of most of the items,
variation in size and quality are aimed at satisfying a broad range of customers. For example, a garment
manufacturer may have a wide range of choices in terms of size and quality to cater to different
customers. It may be noted that the variation in quality can enable a company to expand its market and
enjoy higher profitability. Hence, product mix as an element of technical analysis has to be done well in
light of the needs and wants of customers.

PLANT CAPACITY

Plant capacity (also referred to as production capacity) refers to the volume or number of units that can be
manufactured during a given period.

Plant capacity may be defined in two ways: Feasible Normal Capacity and Nominal Maximum Capacity.

15
The Feasible Normal Capacity refers to the capacity attainable under normal working conditions. This
may be established on the basis of the installed capacity, technical condition of the plant, normal
stoppages, down time for maintenance and fool changes, holidays, and shift patterns.

The Nominal Maximum Capacity is the capacity, which is technically attainable, and this often
corresponds to the installed capacity guaranteed by the supplier of the plant.

Our discussion will focus on the feasible normal capacity. Several factors have a bearing on the time
capacity decision.

a. Technological requirements
b. Input constrains
c. Market condition
d. Resource of the firm
e. Governmental policy
f. Investment cost
a. Technological requirements: for many industrial projects, particularly in process type
industries, there is a certain minimum economic size determined by the technological factor. For
example, a cement plant should have be expected to produce a capacity of at least 300 tones per
day, otherwise it may not be cost effective and the like.
b. Input constraints: in a developing country like Ethiopia, there may be constraints on the
availability of certain inputs. Power supply may be limited, basic raw materials may be scarce,
foreign exchange available for import may be inadequate. Constraints of these kinds should be
borne in mind while choosing the plant capacity.
c. Market conditions: the anticipated market for the product has an important bearing on plant
capacity. If the market for the product is likely to be very strong, a plant of higher capacity is
preferable. If the market is likely to be uncertain, it might be advantageous to start with a smaller
capacity. If the market, starting from a small base, is expected to grow rapidly, the initial capacity
may be higher than the initial level of demand further addition to capacity may be effected with
the growth of market.
d. Resource of the firm: the resource, managerial and financial, available to a firm define a limit on
its capacity decision; obviously, a firm cannot choose a scale of operations beyond its financial
resources and managerial capacity.
e. Government policy: the capacity level may be influenced by government policy.

LOCATIONS AND SITE

The choice of location and site follows an assessment of demand, size, and input requirement. Though
often used synonymously, the term ‘location’ and ‘site’ should be distinguished. Location refers to a
fairly broad area like a city, an industrial zone, or a coastal area; while site refers to a specific pieces of
land where the project would be set up.

The choices of location are influenced by a variety of considerations: proximity to raw materials and
market, availability of infrastructure, government policy and other factor.

Proximity to Raw Materials and Markets

An important consideration for location is the proximity to sources of raw material and nearness to the
market for final products. In terms of a basic locational model, the optimal location is one where the total
cost is minimized. This generally implies:

a. a resource based project like cement plant should be located close to the sources of raw material.
b. a project based on imported material may be located near a port,

16
 c. a project manufacturing a perishable product should be close to the center of consumption.
To put in other ways, the location of the project is highly affected by the nature of the project itself.
Projects can be categorized under three forms of locations

1. Rooted Projects: are projects rooted at certain area (proximity to an input) because it is better to
transport end products (outputs) than raw materials for the cost involved in transporting raw
materials is greater than the cost incurred to transport end products. For example, Cement
industry should be located where limestone is located).
2. Tied Projects: are projects that are tied to the market (proximity to the market) because the
transportation of the final product is uneconomical. For example, Beverage industry, Ceramic
projects, etc should be located near to the market.
3. Foot Loose Projects: Projects that can be located anywhere. They are neither tied to the market
nor rooted to the raw materials. For example, Candy industry.
Availability of Infrastructure
Availability of power, transportation, water and communication should be carefully assessed before a
location decision is made. Adequate supply of power is a very important condition for location,
insufficient power can be a major constraints, particularly in the case of an electricity intensive project
like an aluminum plant. In evaluating power supply the following should be taken into consideration:
availability of power, stability of power supply, the structure of power tariff, and the investment required
to install this power from the supplying agency.

For transporting the inputs of the project and distributing the output of the project, adequate transport
connections are required.

Given the plant capacity and the type of technology, the water requirement for the project can be
assessed. Once the required quantity is estimated, the amount to be drawn from the public utility system
and the amount to be provided by the project from surface sources may be identified.

In addition to power, transport and water, the project should have adequate communication facilities like
telephone.

Governmental Policies
Government policies have a bearing on locations. In the case of public sector project, location is directly
decided by the government. It may be based on a wider policy for regional depression of industries.

In the case of private sector projects, location is influenced by certain governmental restrictions and
inducements. The government may prohibit the setting up of industrial projects in certain areas, which
suffer from urban congestion. More specifically the government offers inducements for establishing
industries in backward areas. This inducement consists of subsidies, concessional loan (i.e., loan at a
lower interest rate), tax relief and other benefits.

Other Factors
Several other factors have to be assessed before reaching a location decision: ease of coping with
environmental pollution, labor situation, climatic conditions and general living condition.

Site Selection
Once the broad location is chosen, attentions need to be focused on the selection of a specific site. Two to
three alternative site must be considered and evaluated with respect to cost of land and cost of site
preparation and development.

17
The cost of land tends to differ from one site to another in the same broad location. Sites close to a city
cost more whereas sites away from cities cost less.
The cost of site preparation and development depends on the physical featre of the site, the need to
demolish and relocate existing structures, and the work involved in obtaining utility connections to the
site.

Considerations in choice of site

Ecological conditions of site (soil type, site hazards, seismic history etc)
Environmental impact (restrictions, standards and guide lines) noise, air pollution, effects if it is
close to residential areas
Costs of land – different site may have different costs
Infrastructure – the work involved in obtaining utility connections and the cost associated with
them.
Site preparation and development costs
Strategy of the projects such as future expansion..

MACHINERIES AND EQUIPMENT

The requirements of machineries and equipments are dependent on production technology and plant
capacity. It is also influenced by a type of project. For a process oriented industry, like a petrochemical
unit, machineries and equipment required should be such that the various stages and matched well. The
choice of machineries and equipment for a manufacturing industry is somewhat wider as various
machines can perform the same function with varying degree of accuracy.

The equipment required for the project may include

- Plant (process) equipment - Instruments

- Mechanical equipment - Controls
- Electrical equipment - Internal transportation system
- Others
In addition to the machineries equipment, a list should be prepared of spare parts and tools required. This
may be divided into

a) spare parts and tools to be purchased with the original equipment and
b) Spare parts and tools required for operational wear and tear.
Equipment and machineries service can be acquired in different ways. Each of the following ways of
acquisition has its own advantages and disadvantages. The costs of the project will be affected by the
specific method of acquisition assumed to be taken.
a. Renting
b. Purchasing
c. Leasing
d. Outsourcing
STRUCTURE AND CIVIL WORKS

Structures and civil works may be divided into three categories

- Site development and preparation

- Building and structure
- Outdoor works

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Site Development and Preparation
This cover the following

1. Grading and labeling of the site

2. Demolition and removal of existing structures
3. Relocation of existing pipelines, cables, roads etc
4. Reclamation of swamps and draining and removal of standing water
5. Connections for the following utilities from the site to the public networks; electric power, water
for drinking and other purpose, communication (telephone, telex, fax internet etc
6. Other site preparation and development works

Building and Structure

Building and structure may be divided into

1. Factory or process building

2. Ancillary building required for stores, laboratories, utility supply centers, maintenance service
and others
3. Administrative building
4. Staff welfare building, cafeteria, medical service center etc
5. Residential building

Outdoor Works
Outdoor works covers

1. Supply and distribution of utilities

2. Handling and treatment of emissions, wastages and effluents
3. Transportation and traffic arrangements
4. Outdoor lighting
5. Landscaping
6. Enclosure and supervision (boundary wall, fencing, barriers, gates, doors, security pots etc)

3. FINANCIAL ANALYSIS
INTRODUCTION
Financial analysis is analytical work required to identify the critical variables which are useful for likely
to determine the success or failure of an investment. Its concern is to determine, analyze and interpret all
the financial consequences of an investment that might be relevant to and significant for the investment
and financing decisions. This unit discusses the viability of projects from financial significance to
stakeholders and to the economy in general. For this, purpose different statements such as resource flow
and financial statements, and financial analysis tools (NPV, IRR and payback period) are discussed in
detail.

PURPOSE OF FINANCIAL ANALYSIS IN PROJECT PLANNING

An Investor transfers the liquid financial resources (his/her own personal selling or borrowed money) into
production assets with the objective of producing and obtaining future benefits. This process is known as
investment, a long-term commitment of scarce resources.

The long-term commitment by the investor needs the transformation of liquid financial resources (own or
borrowed) into productive assets for financing an investment project. Project financing includes the

19
design of proper financial structure, considering the adequacy of the financial plan, and the optimization
of project financing from the different actors or beneficiaries point of view. Therefore, the scope and
objective of financial analysis are to determine, analyze and interpret all the financial consequences of an
investment that might be relevant for and significant for the investment and financing decisions.

Financial analysis is essentially undertaken for the following purposes:

1. It provides an adequate financing plan for the proposed investment

2. It determines the profitability of a project
3. It assists in planning the operation and control of the project by providing management
information to both internal and external users
4. It advises on methods of improving the financial viability of a project entity
5. It illustrates the financial structure of the project and its existing and potential financial viability.

Therefore, the purpose of financial analysis is not just to document the expected impact of the project,
liquidity, credit worthiness, financial efficiency, etc, of the various agents involved; it should also be part
of the process of project design itself.
METHODS OF FINANCIAL ANALYSIS

To assess financial viability of a project a range of tools and methods can be used and various types of
financial statements can be prepared. This includes:

1. Resource flow statements

2. Profit and loss statements
3. Cash flow statements and
4. Balance Sheet
These statements are explained in detail below.

1. Resource Flow Statements

The starting point of the financial analysis of a project is drawing up of a statement of project cost and
benefits. The benefit and cost items included in the statement should include only those items, which are
incremental. The resource flow statement shows: (1) the list of resources used in the project and (2) the
resources generated by the investment on the project.

The major elements of resource flow statements are:

1. Investment costs: investment costs cover capital expenditure items such as land, buildings,
equipment and furniture etc. It includes three group of costs:
(a) Initial fixed investment costs. This includes investment made for the acquisition of land,
development of land for construction purpose, civil works (laying the foundation),
equipment and machinery costs, installation of the machines or the plant, vehicle,
furniture, building etc. All these above costs are subject to depreciation except land,
which is depleted over time.
(b) Pre-production capital expenditure. The pre-production capital expenditure includes:
- Research and development
- Pre-feasibility or feasibility study cost
- Training costs incurred before the commencement of the operation
- Recruitment of personnel costs
- Arrangement for marketing of the product such as early advertisement to inform
the public in advance before the actual distribution of the product to the market
- Arrangements for supplies etc.

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 (c) Working capital. Working capital is simply a revolving fund. It is the difference between
current asset and current liability. This is known as a circulating fund because at the end
of the project's life it can be put as a benefit of the project. Defining the working capital
requirement appropriately is important because many projects fail while they are in
operation due to shortage of cash or working capital. The amount of the total working
capital required depends upon the operating costs for the project.
There are three basic components of physical working and capital inventories needed for
production to be continuous. These are:
- Initial stock and materials
- Work-in-process and
- Stock of outputs
When these three components of working capital have been estimated, they can be
summed to give the total working capital requirements in any year. The working capital
resources that need to be included in a project statement are the incremental amount
(additional commitment of resources) as the inventories build up or vary from year to
year.

Table 1: Project Investment Costs ('000 Birr)

Item Project
Year
1 2 3 4 5 N

Land preparation X X X X X

Building X X X X X

Equipment X X X X X

Vehicles/machineries X X X X X

Working Capital X X X X X

Other costs X X X X X

Total XX XX XX XX XX XX

Generally speaking, the amount of funds required for operating needs varies from time to time in every
business. But a certain amount of assets in the form of working capital are always required; if the business
has to carry out its functions efficiently and without a break. The two types of requirements are
permanent (fixed) and variable.
The permanent working capital in that part of capital, which is permanently locked up in the circulation of
current assets and in keeping it moving. On the other hand, variable working capital changes with the
volume of the output of the project.

2. Operating Costs/Product Costs: operating costs can be divided into two: Fixed and Variable
components. Variable cost includes items such as materials, power, labor inputs required for manufacture
which will vary directly with the volume of production while fixed costs will include maintenance,
administration and managerial charges, etc. which will be relatively fixed with respect to the volume of
production.

21
The total operating costs will then be the sum of the fixed and variable costs and will increase over the
operating years until full utilization of the investment asset is reached.
Table 2 Project Operating Costs Schedule

Years
No Items 1 2 3 4 5 N
Capacity Utilization Rate (%) 50% 75% 80% 85% 90% 100%
1 Raw material
2 Labor
3 Factory Overhead
X
Production Costs (1-3) (a) XX XX XX XX X
4 Administrative costs
5 Sales costs
6 Distribution cost

Administrative and marketing Costs XX XX XX XX XX

(4-6) (b)
7 Interest expenses (7) XX XX XX XX XX
Total operating/ product
Cost (a + b + c ) XX XX XX XX XX

Note: n represents the number of periods covered in the project appraisal.

As it is shown in the above schedule, operating costs includes cost of production, administrative
expenses, selling expenses, depreciation on fixed assets, and interest expenses.
a) Cost of Production
The cost of production includes
1. Direct Material cost
2. Direct labor cost
3. Factory over heads. These items include expenses for the factory as:
- rent, for factory, if any
- insurance premium for factory assets and factory workers
- postage, telephone, fax, e-mail, etc, in the factory
- traveling expenses
- depreciation of plant and machinery and other factory equipment;
- Proportionate management expenses, which may be charged to factory based on time spent
by management on the project operation.
b) Administrative Expenses
This represents all indirect expenses incurred in the organization including estimates for
- salaries of all indirect staff
- postage, telephone, fax, e-mail etc
- traveling expenses
- insurance other than for the factory assets

22
 - rent, rates, taxes, electricity etc and
- depreciations of all fixed assets other than factory assets o
c) Selling Expenses
This represents estimated expenses in sales divisions as per projected organizations and include the items:
- salaries and personnel cost for sales staff and managers as planned
- publicity, advertisement, exhibitions, etc.
- subsidies, commissions, discounts to dealers, etc.
- administrative expenses of sales office including rent.
d) Other operating expenses such as tax expenses
3. Benefits
Benefits of a project can be several. For example, a range of different farm products in an agricultural
project, or cost savings as well as production benefit from a transport infrastructure project. The different
benefits will all be variable with respect to their associated costs, and hence, total benefits will also be
variable.
Benefits can be direct (production output) which may include items like:
- main product
- by product
- residual and other income
Benefits can also be indirect or external. For example, in a road projects reducing transportation costs,
reducing operating costs for maintenance of vehicles and saving time of the society are indirect benefits
of the project.
Benefits are associated with the capacity utilization factor to which operating costs were also related.
When the value and timing of investment costs of and operating costs have been determined the net
benefits of the project can be calculated. The net benefit is computed by simply subtracting the
investment, operating and working capital costs from benefits.
The following table depicts the complete project resource statement, which brings together the investment
costs, operating costs, working capital and project benefits.

23
Table 3 Project Resource Statements
Project Period
No Items 1 2 3 4 5 6
1 Land preparation
2 Buildings
3 Equipment
4 Vehicles
5 Total investment
cost (1 + 2 + 3 + 4)
6 Factory /production costs
7 Administrative costs
8 Selling expenses
9 Interest expense
10 Total operating
costs (6 + 7 + 8 + 9)
11 Incremental working capital
12 Benefits
13 Net Benefits( 12-(5+10)

The net benefits are negative in the first year while investment is taking place, and become positive when
the utilization of the new assets is building up.
2. Project Financial Statements
Financial analysis also involves formulation of various financial statements, which enable project owners
and other interested stakeholders to know whether the projects worthy or not. Most commonly prepared
financial statements are balance sheet, loss and profit statement, and cash flow statements.
a) Profit and Loss Statements
The main purpose of profit and loss or trading profit and loss account in short income statement is to
calculate the profit or loss of enterprise or project. It is the measure of the profitability of the project.
Firms are required by law to prepare an income statement at the end of each year to report to stakeholders
on the performance and profitability of the project and at the same time, it is used to calculate the tax
liability to the government. Borrowers also use this income statement as the base to grant loans. An
example of typical income statement is given below.

XYZ Project

24
 Profit and Loss Statements
Project Period
No Items 1 2 3 4 5 6 n
1 Total sales
2 Variable and fixed cost of goods
3 Gross margin (1-2)
4 Variable and fixed selling and
5 marketing costs
Corporate tax
6 Net profit after tax (3 – (4 + 5)
7 Dividend
8 Retained profit or earning (6-7)

b) Balance Sheet
Balance sheet is a statement of the assets and liabilities of the enterprise and gives "the net worth" an
enterprise at a point of time. It is prepared to present a picture of the firm on one day in the year. The
information represents the account balances recorded and does not indicate exact economic values.
The balance sheet shows the way in which a project is financed, whether by sponsors, lenders or creditors
and how these funds have be employed. The sources of funds, even where they represent the capital
invested by shareholders are regarded, as the liabilities of the company and the use to which funds have
been put are the assets.
The Balance Sheet is the key to understanding the financial position of a project or enterprise unlike the
profit and loss account, which shows how well a project has performed over a period; the balance sheet is
a measure of what the project is worth at a particular point in time. This is done by comparing assets
(what the project owns) and liabilities (what the project owes). Balance sheet is usually prepared annually
for project analysis and it is considered by commercial bankers to be one of the most important statements
when deciding whether to invest in an existing project.
Balance sheets are presented in a number of different formats. An example of a typical vertical format is
shown below.

XYZ Project

25
 Balance Sheet
On Sene 30, 200x
Years
No Items 1 2 3 4 5 N
1 Current Assets:
2 Cash
3 Inventories and supplies
4 Accounts receivables
5 Total current assets (2+3+4)
6 Fixed assets:
7 Building
8 Machinery and equipment
9 Other assets
10 Total fixed assets(7 + 8 + 9)

11 Accumulated depreciation
12 Net book value of fixed assets
(10 – 11)
13 Total assets( 5+12)
13 Current liabilities:
14 Short term loan
15 Salary payable
16 Tax payable
17 Total current
liability (14 + 15 +
16)
18 Long term liability

19 Total
liability (17
+ 18)
21 contributed capital
22 Retained earnings
23 Total owner’s equity(21+22)
24 Total liability and owner’s
equity (19+ 23)

c) Cash flow statement

Finance is considered by many as the lifeblood of an organization or any project. A well-designed project
may fail due to insufficient cash for its day-to-day operation. Therefore, a project planner has to develop
some techniques of forecasting cash inflows and out flows. Cash flow statement is a basis for showing the
cash flows associated with operating resources, funding and investment.
Cash flow statements are prepared for two reasons:
First, it is prepared for financial planning purpose: in this case, the purpose is to know the liquidity
position of the project. It helps project planners to identify potential periods of cash shortages and

26
enables them to plan appropriate responses designed to remove such shortages or how to utilize excess
amount of fund during the life of the project.
Secondly, cash flow statement may be prepared for the purpose of Net Present Value (NPV) and Internal
Rate of Return (IRR) calculation. The purpose here is to measure the overall profitability of the project.
In general, cash flow statement is the main tool of financial planning and is sometimes referred to as the
"Source and application of funds statement". An example of a typical cash flow statement is given below:
XYZ Project
Cash Flow Statement for Financial Planning ('000)
Years
No Items 1 2 3 4 5 6 N
1 Cash inflows;
2 operating
3 Investing
4 Financing
5 Total in flow (2 + 3 + 4 )
6 Cash out flows:
7 operating excluding non cash outlay
8 Investing
9 Financing
10 Total outflow(7+8+9)
11 Surplus or deficit (Net cash flow) (5-10)

d) Supporting statements/schedules
To prepare the three main financial statements the following supporting schedules and additional
information are required:

1. Depreciation schedule: it calculates the total amount of depreciation for all project assets. This
balance is deducted from the net profit figures in the income statement. Therefore, in order to be
able to complete the income statement the annual total depreciation charges need to be calculated.
Depreciation is a means of charging the cost calculated. Depreciation is a means of charging the
cost of an asset against profit over a number of years. In other words, it is a way of spreading costs
over the entire life of the assets used to produce the goods/services.

There are several methods employed to calculate depreciation and the choice depends on the
preferences of the project analyst and the requirements of the taxation department of the government.

2. Taxation: the income statement is used to calculate the project's tax liability to the government.
The analyst should check for the rate (which is governed by the government), tax holidays
(number of years the project may be free from paying tax) and whether or not losses from previous
years can be carried forward.
3. Loan repayment schedule: In this schedule, the loan disbursement and loan repayment conditions
should be stated and understood very well. Because, the terms of the loan will affect the benefits
received by the lender and by the borrower

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 4. ECONOMIC ANALYSIS or SOCIAL COST BENEFT
ANALYSIS(SCBA)
4.1 INTRODUCTION
Economic analysis is one-step forward in the project planning effort. Because as compared to financial
analysis, which should assess the impact of a project on the income of its owners, economic analysis is a
form of more general tool of social cost benefit analysis. The use of the word "economic" implies the
analysis is undertaken from the point of view of the nation or the economy as a whole. It can be seen as a
cost benefit analysis from the social and national perspective. It ascertains the overall country impact of a
project. In other words, it is the measure of the costs and benefits of a project to the society. The exercise
of project appraisal is not accomplished until the proposed project is also viewed from the economic
viewpoint. Therefore, this section focuses on economic analysis and items included in it.
4.2 Distinction between Financial and Economic Analysis
The reason for conducting both financial and economic analysis is to view the project from various angles
and to obtain different perspectives. Decision makers need both profiles in order to evaluate the project
and to design the necessary fiscal and monetary measures to meet its financial requirements. Even though
the tools of analysis are the same, financial analysis is concerned with private profitability and is based on
financial flows which relate to:
- market prices for products and inputs
- the terms of credit and borrowing in general
- tax and subsidy policy
- financial depreciation and other financial conventions
The financial analysis focuses on money profits accruing to the project entity. Various financial indicators
are used to evaluate the entity's ability to meet its financial obligation and to finance future investment.
Economic analysis, on the other hand, is concerned with public "profitability" which is based on
economic resource flows. It measures the project's effect on the efficiency of the whole economy. In
economic analysis, shadow prices (set of prices that is believed had better reflect the opportunity cost) are
used.
Economic resource flows relates to:
a) Social opportunity costs (shadow prices) which adjust market prices to take into account
differences based on tax and subsidies, external costs and benefits, monopolistic pricing, price
control and rationing, quantitative trade restrictions, over-valued (or undervalued) exchange rate
and labor opportunity costs.
b) Divergence between real rate of interest and nominal (financial) rate of interest, and difference
between private and social/public rate of discount
Economic analysis consists mainly of adjustments to information used in financial analysis and of a few
additional ones.
The methodology and the criteria used to evaluate a project using financial and economic information
are the same. However, the main difference lies in the value that the NPV and IRR take. This difference
occurs because of the difference of:
- the items considered as inputs and outputs of the project
- the prices used in the valuation of the project inputs and outputs
- the treatment of taxes, subsidies and other transfer payments

28
 The following table and the discussion that follows best explain the difference between economic and
financial analysis.
Factors Financial Analysis Economic Analysis
Pricing of inputs Domestic market price Shadow prices
Treatment of transfer payments, All included Excluded
tax, subsidy, etc
Externalities Excluded Included
Discount rates Takes into account the The economic discount rate
current lending rate

1. External costs and Benefits (Externalities)

Some real costs and benefits attributed to the project do not appear among its inputs and outputs when it
is analyzed from the company's viewpoint and they do not enter in the calculation of NPV and IRR. The
reason is they are considered as "external" to the organization. However, they are internal from
economy's angle and included in the calculation of IRR and NPV. Because, somebody pays for such
externals and somebody receives the benefits of such externals even if it is not the enterprise. Therefore,
to the extent they can be measured and evaluated they are included in the economic analysis. Examples
of externalities include access to roads, energy lines, sewerage services, flood control dams etc.
Externalities in short are costs or benefits to the economy as a whole that are attributed to the project but
not taken into account in estimating quantities and values for the project inputs and outputs.
2. Prices of Inputs
As it is shown in the table above, another difference between financial analysis and economic analysis is
that even inputs and outputs are "internal" to both the single firm and the economy, they are valued
differently. In financial analysis, the need is to value input over output at actual market prices while in
economic analysis shadow prices are employed. Consequently, using different prices will give different
economic and financial NPV and IRR, even if the inputs and outputs are identical in physical terms.
Domestic/market price is a price we can get in the market. It is set by cost plus certain percentage of
margin; whereas, shadow price is estimated price. They are not observed prices. One cannot find them in
the market. They are estimated by the macro planners and are taken as given by the project analysts in all
types of projects.
3. Transfer Payments
The third reason why financial and economic NPV and IRR might differ emanates from the treatment of
taxes, subsidies and other transfer payment. Transfer payments are payments that are made between
different persons or organizations but are not related to any particular resource cost. These payments
affect the distribution of income but do not affect the volume of resources available to the country’s
economy.
Taxes and custom duties from which the enterprise is not exempted are taken as costs in financial
analysis. Nevertheless, they are excluded from economic analysis because they do not reflect the
commitment of real resources. Similarly, subsidies paid to the enterprise from the government are viewed
as transfer payments and are omitted in economic analysis, but they are treated like any other revenue of
the enterprise in the financial analysis that is, IRR and NPV calculations.
4. Discount Rate
In financial analysis, the discount rate used is simply the rate the sponsors expect they will have to pay for
borrowed funds or the rate they wish to receive on capital invested. However, in economic analysis
accounting or shadow prices are used, which are believed to be more competitive, to receive signals that
will guide the allocation of resources and the structure of domestic production.
For economic analysis purpose, all the inputs and outputs of the project are valued at world price, which
are formed independent of whatever distortions prevail in the domestic market. These world prices are

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known as accounting or shadow prices estimated as border prices in the form of Cost Insurance and
Freight (CIF) for the imported and FOB (Free On Board) for the exported commodities.

4.3 Objectives/Reasons for Economic Analysis

In project planning there are two main objectives to economic analysis. These are:
1. to provide information for making decisions on the acceptability of projects from the national
point of view, and
2. to provide information of value for project design and planning, macroeconomic planning and
economic research
Economic analysis broadens the analysis from confining attention to the project itself to investigating the
impact of the project on the national economy.
Economic analysis is the core of project analysis and evaluation. It is made to ascertain the overall
country impact of a project. It is a measure of the costs and benefits of a project to the society. The
exercise of project appraisal is not accomplished until the proposed project is also viewed from the
economy viewpoint.
Economic analysis substitutes shadow price (economic prices) for market prices because market prices do
not reflect their true or scarcity prices. Regardless of their difference, financial analysis is the base for
economic analysis. It provides the necessary information to be used for economic analysis.
Social Cost Benefit Analysis/Economic analysis is done because of the following reasons.
1. Inflation: is a general price increase of commodities (Inputs and outputs). When high degree of
inflation prevails in any economy, the project's inputs and outputs do not reflect their real value.
Therefore, the price of these inputs and outputs should be adjusted using the world price by
conducting economic analysis.
2. Currency over valuation: when the foreign currency is overvalued (e.g., dollar), most developing
countries are exercising devaluation of their currency in order to reflect the world price. For
example, our birr is depreciated from time to time whenever the value of dollar is appreciating.
($1 = Br. 17.00, $1 = Br. 17.65 etc.)
3. Existence of under employment: in developing countries like Ethiopia, the domestic prices are
distorted and do not reflect the real value of inputs and outputs. In other words, the market prices
and economic prices are not the same. One of the highly distorted markets is the labor market.
Unskilled and semi-skilled labor market is highly affected because workers are paid less and the
payment of employees is not the same for all doing the same job. Therefore, for economic
analysis purpose this distortion should be adjusted.
4. Existence of income/wealth inequality: Due to this inequality, price may not reflect the social
equalities. As a result, project analysts shift to apply social pricing techniques (that is shadow-
pricing techniques).
5. Externalities: are costs and benefits to the economy as a whole and that are attributed to the
project but are not taken in to account in estimating quantities and values for the project inputs
and outputs. Since they are not paid for by a particular firm, financial analysts ignore them.
Nevertheless, someone has covered their cost (government), thus their value should be included in
the economic pricing technique.
6. Existence of tariffs, customs and duties: existence of these restrictions and impositions by the
government may increase the price of commodities. This cost needs to be excluded in the
economic analysis because it does not reflect the commitment of real resources.

The existence of the above-mentioned factors demands economic analysis so that the value of inputs and
outputs of a project can reflect its real value. Markets like commodity market, labor market, foreign
exchange and capital markets are highly distorted in developing countries. Therefore, adjustment of price
to reflect the real cost of resources should be made using shadow prices, which is a set of prices that had

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better reflect the opportunity costs of goods and services in their best use. The objective of economic
analysis is utilization or best use of the scarce resources of a nation.
Economic analysis, to achieve its intended purposes, should follow the following steps. These are:
Step 1: Identify and eliminate transfer payments. As it is explained above, transfer payments like
duties, taxes etc should be eliminated.
Step 2: Identify linkages and externalities
Step 3: Identify the effect on the use or creation of traded goods
Step 4: Identify the effect of the project on the employment of labor.

A frequent cause of confusion is that project analysis can be applied in different ways, from different
perspectives. This may give the impression that there are conflicting measures of project worth. The
following table attempts to clarify the techniques used to analyze projects, their objectives and
indicators that can be calculated at each analysis level.

Levels of Project Analysis

Perspective What is measured? Indicator
FNPV,
Financial Owners or lenders Change in private income for FIRR
analysis owners or lenders
ENPV,
Economic National economy Change in national income EIRR
analysis
Distributional All groups affected by the Distribution of change in national Proportion of ENPV
analysis project. income going to target group
e.g., government, lenders, or cost of income
workers, owners, etc change for target group

Note: FNPV, FIRR stands for financial NPV and IRR respectively
ENPV, EIRR stands for economic NPV and IRR respectively.

More recently, there has been a renewal of interest in the distributional impact of projects associated
with attempts to determine the fiscal impact of projects (effect on government income). Although it
is not always straightforward in principle, it should always be possible to show how the income of
different groups is affected by project. The easiest way to do this is to show how projects economic
net present value ENPV (discounted value of the change in national income), is allocated between
different groups. Normally, the ENPV may composed of positive income steams for some groups
and negative ones for others. In other words, in reality there are losers and gainers of the income of
the project. Identifying these groups is known as distributional analysis.
4.4 SHADOW PRICES
Shadow prices are a set of prices that are believed to better reflect the opportunity cost of resources
in their best use. They are employed instead of domestic market prices in guiding the allocation of
resources since the later is distorted and using them would lead to resource misallocation.
Shadow prices for economic analysis are based on the opportunity costs. If costs can be broken down into
basic resource categories on an opportunity cost basis, all that remains to be done is to value the basic
categories according to their opportunity cost.
4.4.1 Opportunity Cost
Before we proceed to the discussion of shadow price and its calculation, let us first outline the opportunity
costs of resources because opportunity cost is the most important concept underlying economic analysis.
It is defined as the next best alternative foregone in undertaking a course of action. Whenever, there is an

31
opportunity cost, there is an argument for using shadow prices. Opportunity cost can best be explained by
reference to examples commonly used in the economic analysis of projects: land, labor and capital.
a) Opportunity Cost of Land
In economic analysis land is not usually treated as a capital value. The opportunity cost of land is defined
by its next best alternative use. Urban land can be used for houses, offices, shops and factories. Rural land
is normally used for crops, pasture, forestry or sometimes conservation.
The opportunity cost of rural land is likely to be very important in the assessment of any agricultural or
agro industrial project. When agricultural land is being used, the opportunity cost is the value of the
alternative crop produced less the other costs involved in producing the crop. For urban land the
opportunity cost is usually defined by rental values.
b) Opportunity Cost of Labor
Opportunity cost of labor is the value of the worker's output in the next best alternative. It usually varies
significantly between occupational groups and often between regions. In determining the opportunity cost
of labor it is important to identify the potential source of labor (urban or rural). Project appraisal also
distinguishes between skilled and unskilled labor. The most common assumption is that skilled labor is in
scarce supply and has an opportunity cost equal or greater than its market price, while unskilled labor is in
excess supply and has an opportunity cost below its market price.

The first assumption implies that skilled workers are able to obtain the same salary whether they work on
the project in question or on another project. This assumption is reasonable for most countries including
Ethiopia. For our country, on the other hand, the labor category assumed to be in excess supply are formal
sectoral rural and urban unskilled labor. The largest potential source of unskilled labor is the agricultural
sector.

Skilled labor was assumed to be relatively scarce and so the opportunity cost of skilled manpower was
assumed to be the same as the market price. The opportunity cost is assumed to consist of outputs of the
various sectors in proportion to the estimated employment of skilled labor in each sector.

c) Opportunity Cost of Capital

In principle the opportunity cost of capital (investment funds) for an individual, a company or an
economy is the rate of return available on the next best alternative project. For an individual or company
the bank interest rate may give a reasonable guide. Because the alternative to investing in a project is to
lend to a bank that pays a periodic interest. However, it is not easy to directly estimate the opportunity
cost of capital for an economy at large because economic analysis using shadow prices is not applied
consistently to all projects.
d) Opportunity Cost and Traded Goods
Traded goods are those items, which can be imported or exported. The opportunity cost of traded goods to
an economy is defined by their border prices (CIF for imports and FOB for exports). This can be
understood using the following example.
Assume that the country produces sugar to satisfy the local market. The alternative to production of the
sugar is to import the sugar. The value of the sugar produced is then the CIF (Cost Insurance and Freight)
price, which has been saved. Similarly, if a textile factory use locally produced cotton as a raw materials
the alternative is to export the raw material (cotton). The opportunity cost of using the cotton for the
textile project is the export price (FOB) foregone.

There are four main types of traded goods. The basic for their valuation can be summarized as: Imported
input (opportunity cost: foreign exchange foregone i.e., the input price plus the cost of transport and
handling to the project)

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Locally produced import substitute (opportunity cost: foreign exchange saved (the import price) plus
transport and handling costs from boarder to the point of sale minus transport from the project to the point
of sale.
Exported output (value foreign exchange earned (the export price) minus transport and handling from
the project to the boarder.
Diverted export as an input.

e) Opportunity Cost and Non-Traded Goods

Most projects, in addition to imported inputs and exported outputs, use inputs and produce outputs that are
not traded internationally. Goods and services produced and sold in a country only are defined as non-
traded. They do not enter world trade either because of their nature, e.g. Electricity, unskilled labor, inland
transport etc or due to trade barriers and other special reasons such as high transport cost, government
policy etc.

The value of non-traded items is estimated by decomposing them in to traded and non traded elements.
The former is valued at boarder price directly and the later at specially estimated shadow prices or at
domestic prices multiplied by conversion factor. (Conversion factors are covered in the following section
of this material).

4.4.2 Conversion and Adjustment Factors

Shadow prices are often applied using either conversion factors (CF's) or adjustment factors (AF's).
Ideally, all project inputs and outputs should be valued directly at accounting price/shadow price or
boarder prices. However, this is not always possible because some of the goods and services are not
traded and for them you know only the domestic price. This price most of the times is distorted due to
several reasons. Therefore, it should be translated into shadow prices using conversion factors.
Conversion factor (CF) is the factor by which we multiply the actual price(s) in the domestic market of an
input or output to arrive at its economic price, when the later cannot be observed or estimated directly.

How and How Many CF's should be estimated?

A CF is estimated by taking the ratio of border prices to domestic price/s of the goods. We can estimate
commodity specific, service specific or sector specific conversion factors, depending on the degree of
aggregation desired.

Most literatures show that at least three conversion factors need to be estimated. These are:
1. Standard Conversion Factor (SCF): SCF is an all-inclusive conversion factor used in place of
commodity specific CF's or sectoral specific CFs. It is a summary and approximation of the
distortions in the domestic market. It is estimated as the ratios of the values of imports and exports of
the country at boarder prices (CIF and FOB) to their value at domestic prices. Algebraically,
CF = World Price /Shadow Price
Domestic Market Price

2. Shadow Wage Rate (SWR): it is the opportunity cost of labor or marginal productivity of labor. In
principle shadow, wage rate is determined by the opportunity cost of labor, which may be adjusted for
any difference between the shadow price and market price of the commodities produced by workers
in their alternative occupations.

The conventional approach to estimating the shadow wage rate is to adopt the following procedure:
a) determine the opportunity cost of labor (OC) by finding out the next best alternative
occupation for labor of the category under consideration and the number of days worked
(N)
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 b) estimate the additional costs (AC) associated with transfer to work with the project from
the alternative occupation
c) Estimate a conversion factor for the output of the worker in the alternative occupation
without the project (CFW)
Where: OC = opportunity cost
The shadow wage rate is then given by:
SWR = OC.N. CFW + Ac N = Number of days
CFW = Conversion
factor

For example: - if the average daily wage rate of a worker is Birr 5 and workers are able to work for 250
days per year, and if it is estimated that the conversion factor for the alternative output of the workers is
0.95. The extra cost of transferring the worker to the new occupation (to the project) is Birr 150,000 per
year, what is the SWR for the unskilled workers?
Solution:
OC = 5 Birr
N = 250 days
CFW = 0.95
A = 150,000 Birr
SWR = 5 x 250 x 0.95+ 150,000
Birr. 151,187.5 per year

In economic analysis, the concern of project analysts is to know the economic price of labor (EPL),
which is calculated as: Market Wage Rate (MWR) times shadow wage rate. (EPL = MWR x SWR). If
there is no distortion in the market wage rate, there could be equality of MWR and EPL.

When you estimate the EPL you have to know the original place or source of labor and the foregone
output. For example, assume if some member of the family migrates from rural area to the project site (to
work) there is a foregone output that is the output that he/she can produce in the families plot of land. In
the project, he/she is paid the MWR, which may be higher than the previous work. Therefore, there is
some distortion, which needs some adjustment using conversion factors.

The conversion factor can be calculated as follows:

Daily Wage
CF = foregone output = Rate
Market wage rate MWR

Example
If a person comes from the rural area where he can produce from one hectar of land 10 quintal of Teff
and one house hold has 5 members. The price of one quintal of teff is Br. 800. What is the opportunity
cost/foregone output? CF? EPL?

The yearly output of the family in their original place (rural area) is Br. 8000 (800 x 10). The average
yearly price of labor in the family is Br. 1600 (8000/5).

Therefore, the foregone output of the person is Br. 1600/250 = Br. 6.7 per days assuming that the person
can work for 250 days per year. Therefore, the opportunity cost or foregone output from his region is Br.
6.7 per day. However, if he is paid Br. 10/day or more in the project, this shows that there is some

34
distortion in the market wage rate. In order to adjust this distortion you have to calculate the conversion
factor.

CF =Foregone output
MWR
CF =6.7
10

CF = 0.67

If the cost of labor in the financial analysis shows Br. 100,000, the economic cost would be Br. 67,000
(0.67 x 100,000). If the CF>1, it shows that labor is overprice whereas if CF<1, it shows that labor is
under priced in the project.

3. Foreign Exchange: this is also another national economic parameter. In most developing countries,
the capital market is distorted. When there is a shortage of foreign exchange, the official exchange
rate understates the value of foreign exchange. Therefore, shadow exchange rate (SER) should be
used in project analysis. Use of a SER should encourage those projects, which either save or earn
foreign exchange and discourage those projects, which use foreign exchange.

Shadow exchange rate (SERS) are usually expressed as conversion factors to be applied to the official
exchange rate rather than as a rate of Birr to the dollar or pound. The reason is that we are concerned
with the value of foreign exchange as a whole rather than the value of particular currencies.

The following formula can be used for calculating SER:

Formula 1 Where:
SER M + + X – +
= T MT X S X

M+T M is the total value of imports

TM is the total value of import duties

X is the total value of export

TX is the total value of export taxes

SX is the total value of export subsidies

This formula assumes that additional foreign exchange expenditure affects the level of imports and
exports in proportion to their value in total trade.

Formula 2
SER = M + TM
M
This formula assumed that additional foreign exchange expenditure only affects the level of imports.

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To conclude, these are the major national economic parameters used to make economic analysis. All
parameters (shadow prices) reflect opportunity cost. They are very important for project planners because
they show the alternative side of the project, what it will contribute to the economy and to the society.

5. ENVIRONMENTAL IMPACT ASSESSMENT (EIA)

It is an assessment, which aims at ensuring that development projects are environmentally sounds
(friendly). This issue is becoming very sensitive these days; especially, when project feasibility is
developed for applying for international funding. Therefore, the feasibility study should include a through
and realistic analysis of the environmental impact of industrial investment projects.
The site and environmental impact analysis will cover the impact of the project and its alternatives (in
terms of size, technology etc.) on the surrounding area, including its population, flora and fauna. This
analysis should be integrated and interdisciplinary, assessing the overall impact while taking into account
the synergetic effects of interlinked systems.
Environmental impact assessment is designed to develop an understanding of the environmental
consequences of a newly planned or existing project and of any project-related activities. These
consequences and the beneficial or adverse effects of such human activities on the environmental are
assessed and evaluated from a technical, financial and socio-economic point of view, to the extent that are
significant for the project implementation decision.
Environmental impact assessment is part of the planning process. Environmental benefits or costs of a
project are usually externalities or side effects that affect the society in whole or in part.
EIA must be designed to develop an understanding of the environmental consequences of the project. The
consequence should be assessed from technical, financial, and socio-economic points of view
(qualitatively and quantitatively). EIA is required by law in some countries and could be critical if
international financing is sought for the project. It is also a requirement to include an EIA in a project
feasibility study to get permit.

Specific objectives of EIA

 Prompting a comprehensive, interdisciplinary investigation of the environmental consequences of
the project and its alternatives. Interdisciplinary persons are required because the environmental
impact may have various forms.
 Developing an understanding of the scope and magnitude of environmental impacts of the project
under alternative designs. Different design may have different impact and costs.
 Incorporating any existing regulatory requirements in the project design. Standards,
environmental audit…
 Identifying measures for reducing adverse environmental impacts and enhancing beneficial
impacts.
 Identifying critical environmental problems which require further investigation.
 To assess environmental impacts qualitatively and quantitatively, as required, for the purpose of
determining the overall environmental merit of each alternative.

N.B. Not all the environmental impact of a project may be known immediately; some of the impacts may
be known after a long time.
6. ORGANIZATION AND HUMAN RESOURCES
Part of the feasibility study concerned on defining the organization setting and the human resource
organization of the project. Focuses on answering questions such as:
 How will the project be organized?
 How the project is managed?
 What types of skill and number of employees are required (human resource requirement)?
 What will be the costs of getting the required human resources?
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The manner in which the project will be organized and managed will have implications on the resource
requirements of the project. For example, resources requirements (particularly human resources) will be
different if the project has a wholly independent structure than a matrix type of organization.
Manpower Requirements
The determination of the manpower requirements of the project should come after:
 The production capacity of the project has been determined.
 The technological processes to be used have been selected.
 The organizational setup of the project has been identified.

Organizational
structure

Human resource Costs

Technology
requirement

Production capacity

The process should start from the smallest unit/departments. The manpower requirement of each unit
should be defined in terms of functions and categories:
Functions Categories
Workers Supervisors, skilled, semi-skilled, unskilled
Staff Managerial, administrative, sales,
The departmental manpower requirements should be aggregated to arrive at the total manpower
requirements of the whole project. The aggregate manpower requirement becomes the basis for
establishing the labor costs by taking into account:

 The supply and demand for labor (unskilled, semi-skilled) in the project area
 The supply and demand for skilled and managerial personnel at the national level
Distribution must be made between the manpower requirement of the project during the pre-
production phase and the operational phase. The former should be capitalized. The aggregated
manpower requirement also provides the framework for conducting recruitment and training. If
potential shortage for certain skills is anticipated, training programs should be planned and the costs
should be estimated and included.
Training may be conducted:
 Within the project itself
 Through local training institutes
 Through foreign training institutions or as part of technology supply agreement

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