CHAPTER FOUR

4. PROJECT FEASIBILITY STUDY/ PREPARATION

4.1 Introduction

Beneficiaries and other stakeholders participate in the detailed specification of the project
idea that is then assessed for its feasibility (whether it is likely to succeed) and sustainability
(whether it is likely to generate long-term benefits). Again, checks need to ensure that cross-
cutting issues and overarching policy objectives are adequately considered in the project
design and objectives. A detailed Logical Framework with Indicators, and Implementation,
Activity and Resource Schedules, should be produced.

On the basis of these assessments, a decision is made on whether or not to draw up a formal
financing proposal and seek funding for the project. The term “ex ante” evaluation is now
frequently used for “Appraisal” or “Feasibility Study”. While Appraisal refers to studies
during the preparatory phases of the project cycle (pre-feasibility or feasibility studies),
“evaluation” as such concerns the assessment of an ongoing or completed project, program
or policy, its design, implementation and results (see chapter 6): “Ex ante evaluation is a
process that supports the preparation of proposals for new or renewed Community actions.
Its purpose is to gather information and carry out analyses that help to define objectives, to
ensure that these objectives can be met, that the instruments used are cost-effective and that
reliable later evaluation will be possible.

4.2 Chapter Objectives

This chapter deals with project feasibility study. Thus, after studying this chapter, make sure
that you are able to:

 understand the concept of project feasibility study, major tasks involved, expected
outcome and quality check in the same, and
 apply the procedures of project feasibility study in designing development projects

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4.3 Project preparation

Project preparation is a very critical activity that determines the success or failure of a
project. When a project analysis fails to anticipate the outcome of a project investment, a
common reason appears to have been simply poor preparation of the analysis. Sound project
requires very realistic imagination, creativity and sensitivity to environmental changes, and a
realistic assessment of what the organization can do. Project preparation and analysis should
be based on relevant information gathered from different perspectives that would directly or
indirectly influence the project and its outcome.

If the project is largely a private venture in a widely market economy context, the initiating
entity will define the concept, expectation and objectives of the project. On the other hand
the project idea can also emanate from government agencies in the context of government
development plans. In the latter case sectoral orientations (i.e. the prioritization of different
sectors as per the needs of the society) matters a lot for acceptance of the project and should
be given a great weight in formulation of the project.

At this point it is worth mentioning that feasibility studies are not always free from vested
interests. That is, it is common to lack objective and neutral expertise (from project
promoter and/or consultants). This in turn will result in unsuccessful projects and rather
wasting of resources. Therefore, one should have a sharp eye on the crucial aspects of a
feasibility study. Moreover, it is not only necessary to have a professional interdisciplinary
team work, but it is also indispensable to link all planning activities even at the identification
and pre – feasibility stage as early as possible with all parties, which may be involved in the
project.

 What are the Expected Outcomes of feasibility study/appraisal?

The expected outcomes of Appraisal are:

o A feasibility study establishing whether the proposed project identified in the pre-
feasibility study is relevant, feasible and likely to be sustainable, and detailing the
technical, economic and financial, institutional and management, environmental and
socio-cultural and operational aspects of the project. The purpose of the feasibility

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 study will be to provide the decision-makers in the Government and the European
Commission with sufficient information to justify acceptance, modification or
rejection of the proposed project for further financing and implementation.
o A decision taken by the donor/grant provider and the partner country or
organization

 to prepare a financing proposal based on the study

 to reject the project

 to further study certain aspects, if not yet clarified in a satisfactory

manner
In terms of Logical Framework, the feasibility study should establish a detailed project
description covering all aspects of the logframe. In addition, an outline of an Activity
Schedule and a Resource Schedule should as well be prepared for the project. Also, the
preparation of a first draft financing proposal forms part of the appraisal.

Figure 1: The Logframe: What should be defined at the End of Feasibility study/Appraisal?

Intervention logic Objectively Verifiable Source of Assumptions

indicators verification
Overall Objectives
Project Purpose
Results
Activities Means costs
preconditions

Outline of Activity and Resource schedule

 Major Tasks
For an individual project Appraisal will usually involve tasks comparable to those of the
Identification phase. The drafting of the TOR for the feasibility study (Standard TOR are
available for most of Donors/grant providers). These usually include;
• The decision made concerning which option to study in-depth,
• The pre-feasibility study report, taking into account the suggestions made there,
• Lessons learnt through evaluation of similar projects.

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Equally, the project design has to be assessed and improved, and a decision to be taken as to
whether or not to proceed with the preparation of a financing proposal. A typical feasibility
study mission will last for several weeks. The key focus for the mission will be:
i. To verify the relevance of the proposed project in addressing the existing problems,
suggested in or in addition to the options studied in the pre-feasibility study. This
means to check the validity of the logframe outline as it was developed during the
identification phase, and running in detail through the steps of the Planning Phase.
ii. To ensure that the project objectives are in line with the objectives in the indicative
program, the overarching policy objectives of the donor and linked to the (sub)
sector or applying institution’s objectives.
iii. To assess in detail the feasibility of the proposed project and to prepare / finalize a
logical framework planning matrix.
iv. To assess in detail the potential sustainability of the project results after project
completion based on consideration of the quality factors.
v. To prepare an Implementation Schedule, an outline for Activity and Resource
Schedules and the institutional structure for implementation stipulating the re-
possibilities of various bodies, project timing/phasing, estimated cost per budget
item.
vi. To draft design specifications, if required.
vii. To prepare a draft Financing Proposal.
viii. To provide recommendations for the next steps and any further actions necessary to
secure project financing and implementation and, possibly, the tender documents for
the selection of consultancy services.
Finally, a planning workshop held towards the end of the mission (and focusing on final
agreement on Overall Objectives, Results, Activities, and Indicators, the outline of Activity
and Resource Schedules and implementation arrangements) is strongly recommended. This
will help improving ownership by the target groups / beneficiaries.

 Project Appraisal Criteria

When assessing the quality of project design at the end of the appraisal phase, it should be
ensured that the project is relevant, feasible and likely to be sustainable. The following
questions and assessment criteria should provide guidance for this check:

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 Table 1: Quality Criteria for Assessment of a Detailed Project Design (or Draft
Financing Proposal)
Question Quality assessment criterion
1. Relevance
1.1 Are the project objectives in The project objectives are compatible with these
line with the overarching policy objectives they fully respect them in the approach
objectives of strengthening and seek to contribute to their achievement. The
good governance, human proposal states clearly which of them are most
rights and the rule of law, and relevant and how they are linked to the project
poverty alleviation? objectives.
1.2 Are the major stakeholders of The most important stakeholders for the project
the project clearly identified identified during identification have been confirmed
and described? and consulted; and the target groups and other
beneficiaries are clearly identified, have confirmed
their interest and expectations, the role they are
willing to play, the resources and capacities they will
provide, also in a gender differentiated way. The
other stakeholders have confirmed their general
support for the objectives of the project. Clear
conclusions are drawn on how the project intends
to deal with the groups.
1.3 Are the beneficiaries (target Their socio-economic roles and positions,
groups and final beneficiaries) geographical location, organizational set-up,
clearly identified? resource endowment, etc. are described in detail.
Educational/skills level, management capacities and
their specific potentials are also described in detail,
especially for the target groups, providing a gender
breakdown where appropriate. The analysis shows
clearly how the project will take advantage of and
support skills, potentials, etc. of the target groups.
No major changes occur compared to the pre-
feasibility study.
1.5 Are the problems of target They are described in detail, including information
groups and final beneficiaries on the specific problems faced by the target groups
sufficiently described? (including sub-groups) and the final beneficiaries.
Problem description of project partners shows their
specific problems and relates them clearly to the
problems of the target groups.
1.6 Is the problem analysis The causes of the problems of target groups / final
sufficiently comprehensive? beneficiaries have been researched, and the problem
analysis gives a clear indication of how these
problems are related (cause – effect).
1.7 Do Overall Objectives explain The proposals clearly indicates
why the project is important • which longer term benefit the final beneficiaries
for sectoral development and find in the project,
society? • how the project fits within the sectoral policies of
the Government and the sectoral objectives stated

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 in the Indicative Program, Country Strategy Paper,
etc., and
• how the project fits within the overarching policy
objectives of the grant
provider[organization/country]

1.8 Does the Project Purpose The Project Purpose describes a direct benefit to be
express a direct benefit for the derived from the project by the target groups at the
target groups? end of the project as a consequence of achieving the
Results.
1.9 Does the EcoFin (Financial The EcoFin Analysis has been performed according
and Economic) Analysis pro- to the EcoFin guide-lines and provides extensive
vide sufficient information on data on the incremental net benefit of the
the questions raised above? beneficiaries as well as on the contribution to the
achievement of national and donor/s policy
priorities
2. Feasibility
2.1 Will the Project Purpose con- Previous experience (in other projects or regions)
tribute to the Overall has shown a strong causal relationship between the
Objectives (if the Assumptions Project Purpose and Overall Objectives.
hold true)?
2.2 Are Results products of the All Results are a consequence of undertaking the
implementation of Activities? related Activities.
2.3 Will the Project Purpose be There is clear evidence that there is a direct and
achieved if all Results are logical link between the Results and the Purpose in
attained? terms of means-ends relationship, i.e. the
achievement of the Results will remove the main
problems underlying the Project Purpose.
2.4 Are the Means sufficiently Indicators for Results and Purpose are ‘specific’ and
justified by quantified are described with measurable quantities, time
objectives? frame, target group, location and quality, if possible.
There is also confirmation of evidence that
Indicators of the Results and Purpose are realistic
given the time frame set for the project.
2.5 Have important external External factors and accompanying measures have
factors been identified? been comprehensively identified at the relevant
levels in the logframe.
2.6 Is the probability of realization For each Assumption, supporting evidence is
of the Assumptions provided that the probability of realization is
acceptable? acceptable.
2.7 Will the project partners and Responsibilities and procedures have been clearly
implementing agencies be able established, the partners have actively participated in
to implement the project? the appraisal phase, and there is clear evidence that
they have relevant implementing experience and
most of the capacity to cope with the tasks of the
project. If not: sufficient capacity building measures
are foreseen to enhance implementation capacity.

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2.8 Does the EcoFin Analysis Efficiency analysis was carried out according to the
provide sufficient information EcoFin guidelines. Relevant alternatives were
on the questions raised above? analyzed in detail. Appropriate sensitivity tests were
carried out.

3. Sustainability
3.1 Will there be adequate Target groups and beneficiaries took the initiative to
ownership of the project by the promote the initial idea, they have been active
target groups / beneficiaries? participants in all phases of the planning process,
and major decisions have been validated by them or
their representatives. They agreed and committed
themselves to achieve the objectives of the project.
3.2 Will the relevant authorities Relevant authorities have demonstrated support to
have a supportive policy during projects of this type through the adaptation of rules,
implementation and after regulations and policies, and the commitment of
project completion? significant resources.
3.3 Is the technology approach Various alternatives have been examined, and in the
appropriate for the local selection the different needs of the target groups
conditions? and beneficiaries (men and women), local conditions
and capacities (technical, financial, etc.) have been
taken into account.
3.4 Will the ecological The appropriate level of Environment Assessment
environment be preserved has been carried out (Environmental Integration
during and after the project? Form), and all necessary recommendations are
integrated in project design. This means that an
environment management plan which specifies the
environmental (mitigating) measures to be
undertaken should be in place, as well as a plan for
monitoring the environmental situation of the
project and for taking further environmental action
should the mitigating measures prove insufficient.
3.5 Will all beneficiaries have Socio-cultural norms and attitudes have been
adequate access to benefits and analyzed for all major sub-groups of beneficiaries,
products during and after the and details are provided how these norms and
project? attitudes will be taken into account in the project to
ensure a more equitable distribution of access and
benefits.
3.6 Will the project contribute to Sufficient measures are built into the project to
gender equality? ensure that it will meet the needs and interests of
both women and men and will lead to sustained and
equitable access by women and men to the services
and infrastructures.
3.7 Will the implementing agencies The implementing agencies have demonstrated a
be able to provide follow-up strong interest in continuing to deliver Results post-
after the project? project, adequate institution-building measures have
been built into the project to enable them to do so,

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 and evidence exists that the required resources
(human and financial) will be available.

3.8 Does the EcoFin Analysis The EcoFin Analysis was carried out according to
provide sufficient information the EcoFin Guidelines. The Financial Analysis of
on the questions raised above? the main stakeholders shows in detail that the
project is sustainable both during and after the
project. The Economic Analysis provides clear
evidence that the project is sustainable
internationally.

4.4 Environment Impact Assessment (EIA)

Environmental impact assessment is a field of growing importance in project analysis.

Failure to incorporate environmental issues in project analysis gives rise to negative
consequences like poor health conditions, social disruption, low productivity and ultimately
the undermining of the development. Recently, the trend is being changed and policy makers
are working towards making development sustainable.

 Environmental Sustainability of the Project

The World Commission on Environment and Development defines sustainable
development as ‘’development that meets the needs of the present without compromising
the ability of future generations to meet their own needs”. This definition strikes a balance
between the preservation of existing environmental assets and the practicabilities of
development aimed at the immediate alleviation of poverty.

Some commentators believe that we are obliged to ensure that future generations are better
or as well off as ourselves rather than preserving natural capital. In this argument, human-
made capital such as infrastructure and building is seen as sustainable for natural capital like,
forests and lakes.

For instance, Ethiopia, adopted its Environmental Policy and Conservation in 1997. During
this period, Environmental Protection Authority was given the legal authority to enforce
compliance with environmental laws and standards. Environmental issues are also given
prominence in Ethiopian Sustainable Development and Poverty Reduction Program.

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When assessing the environmental sustainability of a project, it is necessary to consider these
legal laws’ implications and the weigh the level of potential damage against the potential
project benefits. Conservation does not imply that all resources must remain intact/
integral/ rather it seeks to protect those which are of most value. As a result, it is necessary
to divide natural resources into three categories:

i. Which are of crucial national and international importance and/ or critical ecological
roles,
ii. That are not unique or scarce bur where changes in land use need careful planning
and
iii. Which are in abundance can be substituted by human-made capital.

 Identification of major Environmental Impacts and Assessment of Relative

Importance
Environmental Screening- it is the first stage in the identification and assessment of
environmental impacts. The purpose of this screening process is to assess the type and
complexity of appraisal techniques which are likely to be necessary. The process aims to
assess the project against simple criteria to determine whether more detailed analysis is
required. The criteria used in environmental screening include:
i. Size – larger projects are more likely to require further detailed assessment,
ii. Location– projects which are being implemented in environmentally sensitive
areas are reliable to need further assessment,
iii. Complexity- a project with a number of disparate components is liable to have a
wide range of environmental impacts which need careful consideration and
iv. Type of Project- projects such as mines and dams are liable to cause a great deal
more damage than social projects.
Preliminary Assessment- this involves conducting a process of research and utilizing
expert advice in order to achieve the following three objectives:
a. to identify the key impacts of the project on the environment,
b. to predict and describe the impacts identified above, and
c. to assess the potential importance of these impacts to decision makers.

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  Environmental Management Plan[ EMP]
The environmental management plan set out various mitigation measures and related
monitoring and institutional arrangements to be carried out to reduce the environmental
impacts of a project. An environmental management plan is not required for all projects but
if serious potential impacts were identified during Environmental Identification Assessment,
then the preparation of an EMP is mandatory. The projects’ EMP should consist of the
following components:
A. Mitigation: (1) summarizes each potential negative impact, (2) Provide a detailed
description of mitigation strategies used to avoid, reduce or compensate for each impact,
(3)Encompasses further assessment of the potential environmental impacts of mitigation
strategies, and (4) Likes together the mitigation strategies for each impact to produce a
cohesive whole.

B. Monitoring: the EMP sets out arrangements for monitoring of potential impacts and
mitigation measures throughout the implantation and operational phases of the project cycle.
Continues monitoring will enable mitigation strategies to be adopted to ensure the minimum
possible environmental impact. Monitoring is essential to identify potential impacts which
may have been overlooked or underestimated during the projects’ design and appraisal
stages. Therefore, the EMP
 Provides detailed technical information as to the types monitoring to
be utilized,
 Identifies the relevant monitoring objectives and links these with a
potential environmental impacts identified during EIA,
 Provides details as to who will be responsible for monitoring
environmental impacts,
 Specifies their reporting and feedback procedures outlining who will be
responsible for processing and monitoring information and taking
appropriate actions where necessary.
C. Institutional Arrangements: this relates to the establishment of environmental units
with the specific task of implementing the EMP. Staff may have to be trained to ensure that
the project has the institutional capacity to implement the EMP. This arrangement might
also include such details as procurement arrangements, organizational structure, etc.
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D. Implementation Schedule and Costs: The EMP provides:
a. A project implementation schedule for all aspects of mitigation, monitoring
and institutional arrangements.
a. A detailed breakdown of the costs related to the implementation of
mitigation, monitoring and institutional arrangements. This cost should be
integrated into total project costs.
The EMP should be integrated into the overall implementation plan, budget and project
analysis. It should not be seen as a separate external component but rather as an integral part
of the project as a whole.

4.5 Social Cost Benefit Analysis (SCBA)

Social Cost Benefit Analysis (SCBA), also called economic analysis is a methodology
developed for evaluating investment projects from the view point of the society (or
economy) as a whole. Being primarily used for evaluating public investments (though it can
be applied to both private and public investments), SCBA has received a lot of emphasis in
the decades of 1960s and 1970s in view of the growing importance of public investments in
many countries, particularly in developing countries, where governments are playing a
significant role in the economic development. SCBA is also relevant to a certain extent to
private investments as these have now to be approved by various governmental and quasi-
governmental agencies which bring to bear larger national consideration in their decisions.

In the context of planned economies, SCBA aids in evaluating individual projects within the
planning framework, which spells out national economic objectives and broad allocation of
resources to various sectors. In other words, SCBA is concerned with tactical decisions
making within the framework of broad strategic choices defined by planning at the macro-
level. The perspectives and parameters provided by the macro level plans serve as the basis
for SCBA which is a tool for analyzing and appraising individual projects.

4.5.1 Rationale for Social Cost Benefit Analysis (SCBA)

SCBA or Economic analysis of projects is similar in form to financial analysis in that both
assess the profit of an investment. However, the concept of financial profit is not the same
as the social profit of economic analysis. The financial analysis of a project identifies the

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money profit accruing to the project operating entity or owners, whereas social profit
measures the effect of a project on the fundamental objectives of the whole economy. These
different concepts of project are reflected in the different items considered to be costs and
benefits and in their valuation. For instance, a money payment made by the project operating
entity for instance wages is by definition a financial cost. But, it will be an economic cost
only to the extent that the use of labor in this project implies some sacrifice elsewhere in the
economy with respect to output and other objectives of the country. Conversely, if the
project has an economic cost that does not involve money outflows from the project entity
it will not be considered as financial cost.

Similar comments apply to economic and financial benefits. It is important, therefore, to

remember that some costs and benefits that may appear in the financial accounts may not
appear in the economic accounts and vice versa. Similarly, some costs and benefits may be
lower (higher) in financial but higher (lower) in economic analysis even though that the cost
or the benefit appear in both economic and financial accounts. The extent to which
economic costs and benefits diverge from their counterpart financial costs and benefits rests
on the presence and extent of factors such as market imperfections, government
interventions of various forms and the fundamental policy objectives

4.5.2. Approaches to social-cost benefit analysis: UNIDO Vs Little-

Mirrlees approach

A project will be profitable to society if the economic/ social/ benefits of the project exceed
the economic/ social/ costs; or to put in another way, if the net present value of the project
to society is greater than zero. The question is how should a projects economic/ social/
benefits and costs be measured, and what common unit of account should the benefits and
cots be expressed in given a societies objectives and the fact that it has trading opportunities
with the rest of the world so that it can sell and buy outputs and inputs abroad (so that
domestic and foreign goods will be made comparable).

There is also conceptual difference between social costs - benefits and economic cost -
benefit analysis. The results of social cost-benefit analysis may diverge from the results of
economic cost-benefit analysis. Economic costs and benefits when they are adjusted to

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consider other objectives of society as distributional consequences and other objectives, they
become social costs and benefits of a project.
This depends on the method used in the analysis. If the market prices are adjusted only for
market distortions of various kinds; direct transfer payments and externalities, it is simply
economic cost-benefit analysis. If on the other hand, this adjustment process systematically
considers other objectives as distributional aspects it will become social cost-benefit analysis.
Hence, economic costs benefit analysis limits itself only to the analysis of effects of a project
on real national income of the country. Some analysts simply adjust financial cost and
benefits into efficiency prices and leave other social aspects for subjective judgments.

Some others recommend evaluating proposed projects first by using essentially the same
efficiency prices then by further adjusting these prices to weight them for income
distribution effects and for potential effects on further investment of the benefits generated.
Still some others, Little and Mirrlees (1974) and UNIDO Guidelines for project evaluation
(1972a), propose evaluating the project first by establishing its economic accounts in
efficiency prices then by adjusting these accounts to weight them for income distribution
and saving effects.

Making allowance for the effect of a project on income distribution and saving, however,
involves somewhat more complex adjustments than those necessary to estimate ‘efficiency’
prices and it also unavoidably incorporates some element of subjective judgment. In any
case, broadly there are two popular approaches of measuring social cost and benefit of a
project (SCBA): UNIDO approach and Little-Mirrlees approach.

⇒ UNIDO Approach
The UNIDO approach provides a comprehensive framework for SCBA in developing
countries. The rigor and length of this work created a demand for a concise and operational
guideline for project evaluation in practice. The UNIDO method of project appraisal
involves five stages, each of which measures the desirability of the project from different
angles.
 Calculation of the financial profitability of the project measured at market
prices.

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  Obtaining the net benefit of the project measured in terms of economic
(efficiency) price
 Adjustment for the impact of the project on saving and investment
 Adjustment for the impact of the project on income distribution
 Adjustment for the impact of the project on merit goods and demerit goods
whose social values differ from their economic values

 Net Benefits in terms of Economic (Efficiency) Prices

Stage two of the UNIDO approach is concerned with the determination of the net benefit
of the project in terms of Economic Efficiency Prices, also referred to as Shadow Prices.
Shadow prices are defined as the value of the contribution to the country’s basic socio
economic objectives made by any marginal change in the availability of commodities or
factors of production.

 Shadow Pricing: Basic Issues

i. Choice of Numeraire
One of the important aspects of shadow pricing is the determination of the numeraire, the
unit of account in which the values of inputs or outputs are expressed. To define the
numeraire, the following questions have to be answered:
a) What unit of currency (domestic or foreign) should be used to express benefits
and costs?
b) Should costs and benefits be measured in current values or constant values?
c) With reference to which point (present or future) should costs and benefits be
evaluated?
d) What use (consumption or investment) will be made of the income of the
project?
e) With reference to which group should the income of the project be measured?

The specification of the UNIDO numeraire in terms of the above questions is “net present
consumption in the private sector in terms of constant price in domestic accounting birr.”

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 ii. Concept of Tradability
A key issue in shadow pricing is whether a good is tradable or not. For a tradable good, the
international price is a measure of its opportunity cost to the country because it is possible to
substitute import for domestic production and vice-versa. Hence, the International Price,
also referred to as the Border Price, represents the “real” value of the goods in terms of
economic efficiency.
iii. Sources of Shadow Price

The UNIDO approach suggests three sources of shadow pricing, depending on the impact
of the project on national economy. A project may:
1. Increase or decrease the total consumption in the economy,
2. Increase or decrease production, and
3. Increase or decrease imports and exports

If the impact of the project is on consumption in the economy, the basis of shadow pricing
is consumer willingness to pay. If the impact is on production in the economy, the basis is
the cost of production. If the impact is on import and export, the basis is the foreign
exchange value.
iv. Taxes

When shadow prices are being calculated, taxes usually pose difficulties. The general
guidelines in the UNIDO approach with respect to taxes are as follows:
a) For fully traded goods, taxes should be ignored
b) When the project adds to non-traded consumer goods, taxes should be included.

v. Consumer Willingness to Pay

If the impact of the project is on consumption in the economy, the basis of shadow pricing
is consumer willingness to pay. How is this measured?

Prince
D S/

E
P

S
D/
82
0 Q Quantity
In the graph, DD’ represents the demand schedule, SS’ represents the supply schedule and E
represents equilibrium. The consumer who buys the first unit is willing to pay OD and the
consumer who buys the last unit is willing to pay OP for that unit.
The consumer willingness to pay for various units is indicated by the schedule DE. So the
total willingness to pay by consumers who buy the product is measured by the area ODEQ.
The price paid by them, however, is only OPEQ. The difference between ODEQ and
QPEQ, namely DEP, is referred to as the consumer surplus.

 Shadow Pricing of Specific Resources

o Tradable inputs and outputs
A good is fully traded when an increase in its consumption results in a corresponding
increase in import or decrease in export or when an increase in its production results in a
corresponding increase in export or decrease in import. For fully traded goods, the shadow
price is the Border Price, translated in Domestic Currency at the market exchange rate.

o None -Tradable Inputs and Outputs

A good is none-tradable when the following conditions are met:
i. Its import price (CIF) is greater than its domestic cost of production, and
ii. Its export price (FOB) is less than its domestic cost of production.

On the output side, if the impact of the project is to increase the consumption, the measure
of value is the marginal consumers’ willingness to pay. If the impact of the project is to
substitute other production of the same none-tradable in the economy, the measure of value
is the saving in cost of production.

On the input side if the impact of the project is to reduce the availability of the inputs to
other users, their willingness to pay for that input represents social value. If the project input
requirement is met by additional production of it, the production cost of it is the measure of
social value.
o Externalities
An externality, also referred to as an external effect, is a special class of good which has the
following characteristics:

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 a) It is not deliberately created by the project sponsor but is an incidental outcome of
legitimate economic activity.
b) It is beyond the control of the persons who are affected by it.
c) It is not traded in the market place.
An external effect may be beneficial or harmful. Since SCBA seeks to consider all costs and
benefits, external effects need to be taken into account. The valuation of external effect is
rather difficult because they are often intangible in nature and there is no market price which
can be used as a starting point. Their value is estimated by indirect means:

For example,
a) The cost of noise may be inferred from the differences in rent in noise-affected area
and non-affected area,
b) The cost of pollution may be estimated in terms of the loss of earnings a result of
damage to health,
c) The value of better transport provided by the approach roads may be estimated in
terms of increased activities and benefits derived from them.

o Labour Inputs
When a project hires labour, it can have three possible impacts on the rest of the economy:
(1) It may take labour away from other employments,
(2) It may induce the production of new workers, and
(3) it may involve import of workers.

When a project takes labour away from other employments, the shadow price of labour is
equal to what other users of labour are willing to pay for this labour.

The social cost associated with inducing additional production of workers consists of:
(1) the marginal product of the worker in the previous employment,
(2) the value assigned by the worker on the leisure that he may have to forego,
(3) the additional consumption of good when a worker is fully employed as opposed
when he is idle or partly employed,
(4) the cost of training to improve skills, and

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 (5) the cost of transport and rehabilitation when a worker is moved from one
location to another.
The social cost associated with import of foreign workers is the wage they command. In this
case, a premium should be added on account of foreign exchange remitted abroad.

o Capital Goods
The shadow pricing capital investment involves the value of physical assets and the
opportunity cost of capital. The shadow price of physical assets is equal to its border price if
it is a fully-traded good. If it is a none-traded good, its price is measured in terms of cost of
production or consumer willingness to pay.
The opportunity cost of capital is measured by the consumption rate of interest which
reflects the price the saver must be paid to, sacrifice present consumption.
o Foreign Exchange
The UNIDO method uses domestic currency as the numeraire. So the foreign exchange
input must be identified and adjusted by an appropriate premium. This means that the
valuation of inputs and outputs that were measured in border price has to be adjusted to
reflect the shadow price of foreign exchange. The foreign exchange requirement of a project
is met from the sacrifice of others. The use of foreign exchange may also induce the
production of foreign exchange through additional exports. In such a case, the shadow price
of foreign exchange would be based on the cost of producing foreign exchange. However,
consumer willingness to pay for foreign exchange is generally used as the basis for
calculating the shadow price of foreign exchange.

o Measurement of the Impact on Income Re-distribution

Stages three and four of the UNIDO approach are concerned with the measuring the value
of a project in terms of its contribution to savings and income redistribution. For income
distribution analysis, the society may be divided in to various groups. To facilitate such
assessments, we must first measure the income gained or lost by different groups within the
society, such as the project itself, other private business, government, workers, consumers,
and external sector.

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 o Measure of Gain or Loss
The gain or loss to an individual group within the society as a result of the project is equal to
the difference between the shadow price and the market price of each input or output. For
example, a project requires 100 labourers. These labourers are prepared to offer themselves
for work at a daily wage rate of Birr 4. The wage rate paid to the labourers is Birr 7 per day.
So, the redistribution benefit enjoyed by the group of 100 labourers is 300 (100 x 3) per day.

o Savings Impact and Its Value

Most of the developing countries face scarcity of capital. Hence, the governments of these
countries are concerned about the impact of a project on savings and its value. Stage three
of the UNIDO method, concerned with this, seeks to answer the following questions:
1. Given the income distribution impact of the project, what would be its effects on
savings?
2. What is the value of such savings to the society?

The savings impact of the project = Yi MPSi

Where: Yi = Change in income of group ‘i’ as result of the project
MPSi = Marginal propensity to save of group ‘i’.
For example, as a result of a project, the income gained by group ‘i’ is 20,000.
The marginal propensity to save of this group is 10%.
The impact on savings of the project is 2,000.

o Value of Savings
The value of a Birr of savings is the present value of the additional consumption stream
produced when that Birr is invested. The additional stream of consumption generated by a
Birr of investment depends on the marginal productivity of capital and the rate of
reinvestment from additional income.
o Income Distribution Impact
Many governments regard redistribution of income in favor of economically weaker sections
or economically backward regions as a socially desirable objective.

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Due to practical difficulties in pursuing the objectives or redistribution entirely through the
tax, subsidy, etc, investment projects are also considered as investments for income
redistribution and their contribution towards this goal is considered in their evaluation.

This calls for a net to suitably weighing the net gain or loss by each group, measured earlier,
to reflect the relative value of income for different groups and summing them. In order to
decide the relative weights, the best single factor, the elasticity of marginal utility of income,
is used. The marginal utility of income is the value derived from one more unit of income.

o Adjustment for Merit and Demerit Goods

In some cases, the analysis has to extend to reflect the difference between the economic
value and social value of resources. This difference exists in case of merit goods and demerit
goods. A merit good is one for which the social value exceeds the economic value. For
example, a country may place a higher social value than economic value of creation of
employment. In the case of a demerit good, the social value of the good is less than its
economic value. For example, a country may regard cigarettes as having social value less
than the economic value.
The procedure for adjusting for the difference between social value and economic value is as
follows:
a. Estimate the economic value
b. Calculate the adjustment factor as the difference between the ratio of social value to
economic value.
c. Multiply the economic value by the adjustment factor to obtain the adjustment
d. Add the adjustment to the net present value of the project.

 Example:
The present economic value of the output of the project is 25 million.
The social value of the project is 20% greater than the economic value.
The adjustment factor would be, 0.2(or 120/100 – 1).

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Multiplying the present economic value by 0.2, we get an adjustment of 5 million. This,
then, is added to the present economic value of 25 million. Where the socially valuable
output of the project doesn’t appear as an output in the economic analysis (example:
employment generated by the project), the output is treated like an externality and its
valuation in social terms is the adjustment.
⇒ Little-Mirrlees Approach
In this approach benefits and costs may be measured at world price to reflect the true
opportunity cost of project inputs and outputs using public saving measured in foreign
exchange as the numéraire (that is, converting everything into its foreign exchange
equivalent). The fact that foreign exchange is taken as a nureraire does not mean that project
accounts are necessarily expressed in foreign currency. The unit of account can remain the
domestic currency, but the values recorded are the foreign exchange equivalent that is how
much net foreign exchange is earned.
The stimulus to valuing output (and inputs) at world prices (as a measure of true economic
benefit) originally came in the context of import substitution policies pursued by many
developing countries in the 1950s and 1960. It is during these times that it becomes clear
that large number of commercially profitable industries were producing goods at a much
higher price than the alternatives available on the international market. It was thought that if
a project was analyzed at world prices, this would give an indication first of whether it could
survive in the long term in the face of international competition, and secondly of whether its
output could be obtained more cheaply from international sources.

If world prices are used, the economic price at which to value a project’s output is its export
price if it adds to exports or its import price if domestic production leads to a saving in
imports. Similarly, on the cost side, the price at which to value a project input is its import
price if it has to be imported, or export price if greater use leads to a reduction in exports.
The above adjustment applies for traded goods (imported or exported goods). But if the
goods (inputs and outputs) in question are non-traded ones, the analyst needs to use
conversion factor to translate domestic prices into their border price equivalent. A
conversation factor (CF) is the ratio of the economic (shadow) price to the market price, that
is:

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 Economic price
CF=
Market price

Many analysts use conversion factors (the ratio of an item's economic price to its financial
price) to conduct economic appraisals of projects. However, whether the analyst uses
conversion factors or economic prices does not alter the conclusion of the analysis. In many
cases, however, conversion factors are more convenient than economic prices. First,
conversion factors can be applied directly to the financial data. Second, as long as the
underlying tax and subsidy distortions remain unchanged in percentage terms relative to the
price of the good, inflation does not affect conversion factors. Finally, as long as the
underlying distortions remained unchanged, conversion factors calculated for one project
can be applied to other project in the same country. The calculation of conversion factor is
straightforward if we know the economic and financial prices.

Ideally, the shadow price of a non-traded item is defined in terms of marginal social cost and
marginal social benefit. In practice, the calculation of marginal social cost and marginal social
benefit is often a difficult task. As a practical expedient, L-M suggests that the monetary cost
of a non-traded item be broken down into tradable, labor and residual components. The
tradable and residual components may be converted into social cost by applying suitable
social conversion factors; the labor component's social cost can be obtained by using social
wage rate. The shadow wage rate is an important but difficult-to-determine element in social
cost benefit analysis. L-M suggests the following formula for calculating the shadow wage
rate:
SWR = c' - 1/s(c-m)

Where:

SWR = shadow wage rate

c’ = additional resources devoted to consumption
1/s = value of a unit of committed resources
c = Consumption of the wage earner.

m = marginal product of the wage earner

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In any case, there are considerable similarities between the UNIDO approach and the L-M
approach. Both approaches call for:
 Computation of accounting (shadow) prices particularly for foreign exchange
savings and unskilled labor.
 Consider the factor of equity
 Use of the discounted cash flow analysis (DCF) analysis.

Despite considerable similarities, there are certain differences between the two approaches.

 The UNIDO approach measures costs and benefits in terms of domestic

prices, whereas, the L-M approach measures costs and benefits in terms of
international prices, also referred to as border prices;

 The UNIDO approach measures costs and benefits in terms of consumption

whereas the L-M approach measures costs and benefits in terms of
uncommitted social income; and

 The stage-by-stage analysis recommended by the UNIDO approach focuses on

efficiency, savings and redistribution considerations in different stages. The L-
M approach, however, tends to view these consideration together.
Activity

 Explain the similarities and differences between the following approaches of social-
cost benefit (SCBA) analysis of a project.
i. The UNIDO approach
ii. Little-Mirrlees Approach
4.6 Prioritizing projects
The prioritization of investment projects is a key task for all Candidate Countries. It is clearly
not possible to implement all projects simultaneously, and a rational, systematic approach to
prioritization will help to ensure not only that the requirements of the acquits are met as
early as practicable but also that the available resources (including project finance) are used
as effectively as possible.

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Prioritization needs to be carried out at many different levels, both geographically and
technically. In practice, any organization responsible for managing a pipeline of projects will
need to prioritize within that pipeline. Thus prioritization will often need to be carried out at
a national, regional and local level within government, and also by funding organizations
both within the country and outside. Equally, prioritization may involve a single directive
(e.g. Urban Waste Water), a specific sector (e.g. waste) or a range of sectors/directives.
Important to answer at this point is what criteria are there to prioritize projects?

There are many different criteria that might in principle be used for project prioritization.
The criteria(though not comprehensive) is grouped under seven separate headings, which
may themselves help to prompt the inclusion of other criteria that may be important in
specific circumstances. It is important to recognize that in any one prioritization exercise
only a small number of the most relevant criteria may be used. However, it is clear that
different criteria will be relevant in different circumstances.
The headings are:
 Accession Criteria, linked the role of the directive, sector or region in question to
the wider accession planning and negotiation process;
 Environmental Criteria, including all the relevant environmental costs and benefits
of a proposed project;
 Financial Criteria, covering the income and expenditure associated with the project
and the sources of finance;
 Economic Criteria, covering the wider economic framework (costs, benefits and
affordability);
 Technical Criteria, relating directly to the nature of the project and how and when
it can be implemented;
 Social & Political Criteria, particularly in relation to support for or opposition to a
proposed project;
 Commercial & Institutional Criteria that may impact on the timing or success of
a proposed project.

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4.7 Financing development Projects

The allocation of financial resources to a project constitutes an obvious and basic

prerequisite for investment decisions, for project formulation and pre-investment analysis,
and for determining the cost of capital and make through project appraisal and hence
selection.

4.7.1. Sources of Development Project Finance

There are different sources to finance development projects. The following figure indicates
some of the possible sources to finance development projects. Subsequently, the brief details
of each source are detailed.

 The International Monetary Fund (IMF)

 Set up in 1944 at the Bretton Woods Conference, New Hampshire
 Set up to help put in place an economic structure that would help prevent the
problems experienced by many countries in the 1930s

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 Aims to stabilise the international monetary system and help when monetary flow
from trade causes problems
 Provides help and advice as well as funds to countries experiencing balance of
payments problems

 IMF
 IMF gets its funds from its 184 member states – called ‘quotas’
 Current funds in excess of $310 billion
 Quotas determined by the economic size of the member state

 The world Bank

o An agency of the United Nations
o A group of five organisations which focus on providing funds for projects aimed at
alleviating poverty, inequality and promoting development
o Currently has 184 members
o The 5 institutions:
o The International Bank for Reconstruction and Development (IBRD) – provides
loans and advice to poor countries to assist development
o The International Development Association (IDA) – interest free credits and grants
to countries who are not able to borrow through normal market channels
o International Finance Corporation (IFC) – providing finance through the private
sector for development
o The Multilateral Investment Guarantee Agency (MIGA) – providing investors with
protection against risk
to promote investment in developing countries
o The International Centre for the Settlement of Investment Disputes (ICSID) –
arbitration service
in the event of investment disputes

 Special Drawing Rights (SDRs)-potential claim on IMF currencies

o Originally set up in 1969 to support fixed exchange rates
o Value based on a basket of international currencies – currently 1.24 SDRs to the £
o Now used as a potential claim on currencies of IMF members – currencies can be
bought in exchange for SDRs held by members

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  International Finance Facility (IFF)
o Aiming to bridge the gap between the funds currently pledged and those needed to
meet the Millennium Development Goals (MDGs)
o Aims to raise an extra $50 billion per year between now and 2015
o Uses the long term commitments of donor countries as security for raising further
funds on international capital markets
o There is concern from some about the technical feasibility of the scheme and
whether the funds will be used in the correct way
to achieve the MDGs

 Foreign Direct Investment (FDI)-Multinational Corporations

 Policies to attract investment
 Such investment often associated with multinational corporations (MNCs)
 Policies need to focus on having the right conditions in place –
o Infrastructure
o Security
o Peace
o Local laws and regulation
o Government corruption
o Freedom of the market
o Local labour supply
o Legal issues – protection for the investor, property rights, etc.
o Tax regime
 Has been criticised as being a means by which MNCs can exploit poorer countries

 Aid[official aid from Governments, or aid from charities]

o Bilateral – from one country to another
o Multilateral – aid distributed by an agency who co-ordinate donations
o Benefits:
o Help to kick-start economic development
o Used to help develop vital infrastructure needed to encourage other
investment

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 o Costs/disadvantages
o Not always used for appropriate purposes
o Can be linked to various ‘strings’ that may not be in the recipient countries’
interests
o Crowding out of domestic investment
o Creates a dependency culture
o Distorts the working of the market
Tax Measures
Includes;

 Tobin Tax(foreign exchange Transaction Levy)

 Reducing tax Evasion

 Taxing arms export

o Tobin Tax – a tax imposed on currency trading
o Aims to reduce short term speculative trades and stabilise currency flows
o Funds raised used to finance development projects
o Political will to implement such a tax?
o International aid to help developing countries improve tax systems to generate tax
revenue more efficiently
o International taxes on pollution, air transport, arms, rent on deep sea mineral
extraction – funds raised used to help fund development
o Issues of how far such taxes could raise sufficient funds and whether they would
distort markets too much

4.7.2. Cost of Capital

The cost of capital is a central concept in financial management. It is used for evaluating
investment projects, for determining the capital structure, for assessing leasing proposals, for
setting the rates that regulated organizations like electric utilities can change to their
customers, so on and so forth. An organizations cost of capital is the weighted average cost
of various sources ( WACC) of finance used by it, viz., equity(for business organization
only), preference, long-term and short term debt. The rationale for using the WACC as the
hurdle rate in capital budgeting is fairly straight forward, If an organization rate of return on
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its investment exceeds its cost of capital, decision could be made as to whether the project
should be taken or not[for business organizations only). For non-business organization this
solely helps to know the cost on outsourced funds for the project under consideration.

4.7.3 Financing institutions

In financial economics, a financial institution is an institution that provides financial

services for its clients or members. Probably the most important financial service provided
by financial institutions is acting as financial intermediaries. Most financial institutions are
regulated by the government. Broadly speaking, there are three major types of financial
institution;
i. Depositary Institutions : Deposit-taking institutions that accept and manage deposits
and make loans, including banks, building societies, credit unions, trust companies,
and mortgage loan companies
ii. Contractual Institutions : Insurance companies and pension funds; and
iii. Investment Institutions : Investment Banks, underwriters, brokerage firms.
Note:
It is relatively easy for a sound project to obtain loans, the process of project financing may
well start by identifying the extent to which loan capital can be secured, together with the
interest rate applicable. Such loan capital need to be separately defined as: short and medium
term borrowings from financial institutions(locally) for working capital or suppliers’ credit;
and long-term borrowings from national or international development finance
institutions(see section 4.8.1).

4.8 Project Appraisal and Selection

Project Appraisal is perhaps the best-known phase of project work ( in part, because it is
the culmination of preparatory work, provides a comprehensive review of all aspects of the
project and lays the foundation for implementing the project and evaluating it when
completed. It involves a further analysis of the proposed project. The systematic and
comprehensive review is usually undertaken by an independent team of experts in
consultation with the stakeholders of the project.

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The project is appraised in terms of relevancy, effectiveness, efficiency, feasibility,
sustainability and replicablity issues. This provides an opportunity to re-examine every aspect
of the project plan to assess whether the proposal is justified before large sums of resources
are being committed. Usually, project appraisal covers major issues such as technical,
institutional, economic and financial aspects.

Technical Appraisal- in this case appraisal is made to ensure whether projects are soundly
designed, appropriately engineered, and follow accepted standards. The appraisal mission
looks into technical alternatives considered, solutions proposed, and expected results.

More concretely, technical appraisal is concerned with questions of physical scale, layout,
and location of facilities; what technology is to be used, including types of equipment or
processes and their appropriateness to local conditions; what approach will be followed for
the provision of services; how realistic implementations schedules are; and what the
likelihood is of achieving expected levels of output.

A critical part of technical appraisal is a review of the cost estimates and the engineering or
other data on which they are based to determine whether they are accurate within an
acceptable margin and whether allowances of physical contingencies and expected prices
increased during implementation are adequate. In addition, technical appraisal is concerned
with estimating the costs of operating project facilities and services and with the availability
of necessary raw materials or other inputs. The potential impact of the project on human
and physical environment is examined to make sure that any adverse effect will be controlled
or minimized.

For instance, an appraisal of an education projects, with whether the proposed curriculum
and the number of layout of classrooms, laboratories, and other facilities are suited to the
country’s educational needs.

Institutional Appraisal-in current terminology, “institutional building” has become perhaps the
most important purpose of financing a project by many agencies and financial institutions.
This means that the transfer of financial resources and the construction of physical facilities,
however valuable in their own right, are less important in the long run than the creation of a
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sound and viable local “institution,” interpreted in its broadest sense to cover not only the
borrowing entity itself, its organizations, management, staffing, policies, and procedures but
also the whole array of government policies that conditions the environment in which the
institutions operates.

Experience indicates that insufficient attention to the institutional aspects of a project leads
to problems during its implementations and operation. Institutional appraisal is concerned
with a host of questions such as whether the entity is properly organized and its management
adequate to do the job, whether local capabilities and initiatives are being used effectively,
and whether policy or institutional changes are required outside the entity to achieve project
objectives.
Economic Appraisal- Through cost benefit analysis of alternative projects designs; the one that
contributes most to the development objectives of the country may be selected. This analysis
is normally done in successive stages during project preparation, but appraisal is the point at
which the final review and assessment are made. During economic appraisal, the project is
studied in its sectoral setting. The investment program for the sector, the strengths and
weaknesses of public and private sectoral institutions, and key government policies are all
examined.

For instance, economic appraisal a typical transportation project perhaps consider the
transportation systems as a whole and its contributions to the country’s economic
development; In agriculture, which is more diversified and accounts for a much larger share
of a developing country’s economic activity, it is more difficult to formulate a
comprehensive strategy for the sector; attention is given to sectoral issues such as land
tenure, the adequacy of incentives for farmers, marketing arrangements, availability of public
services, and government tax, pricing and subsidy policies.

In economic appraisal of a project, “Shadow Prices” are used when true economic values of
costs are not reflected in market prices as a result of various distortions, such as trade
restrictions, taxes, or subsidies. Whether qualitative or quantitative, the economic analysis of
a project always aims at assessing the contribution of the project to the development
objectives of the country.

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Financial Appraisal- financial appraisal has several purposes. One is to ensure that there are
sufficient funds to cover the costs of implementing the project. For revenue producing
projects, financial appraisal is also concerned with financial viability ( i.e. will it be able to
meet all its financial obligations, including debt services; will it be able to generate enough
funds from internal resources to earn a reasonable rate of return on its assets and make a
satisfactory contribution to its future capital requirements). The finances of enterprises are
closely reviewed through projections of the balance sheet, income statements, and cash flow
statements.

Financial appraisal is also concerned with recovering investment and operating costs from
project beneficiaries. For instance, government may expect farmers to pay, over time and
out of their increased production, all of the operating costs and at least a substantial part of
the capital costs of, say an irrigation project. For more understanding of the major outcomes,
tasks and criteria in appraising project refer section 4.1.

Project Selection - after appraisal, the viable project proposals are chosen for
implementation on the basis of the priorities of the stakeholders and the available resources.
For instance, Treasury may impose a ceiling on the ministries with a big portfolio of
investments, calling for prioritizations of the core and lower priority projects.

4.9 Chapter summary

The main purpose of conducting a feasibility study is just to evidentially determine the
worthiness of a given project and to make a rational investment decision which involves the
commitment of huge amount of resources. This chapter included how the output of the
feasibility can be used as an input in preparing the project.

Project preparation is a very technical activity which involves a thorough analysis of all the
critical factors affecting the project and planning for the project. In project preparation, the
concern of the three basic parameters including cost, time and quality would be used as
the determinant factors for planning. Accordingly, a preparatory studies is required to
analyze the technical, contractual and financial aspects and similar aspects of the project.
Relevant project ideas are developed into project plans. The particular stress should be on

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feasibility and sustainability / quality of the suggested intervention. Beneficiaries and other
stakeholders participate in the detailed specification of the project idea that is then assessed
for its feasibility (whether it is likely to succeed) and sustainability (whether it is likely to
generate long-term benefits). Again, checks need to ensure that cross-cutting issues and
overarching policy objectives are adequately considered in the project design and objectives.
A detailed Logical Framework with Indicators, and Implementation, Activity and Resource
Schedules, should be produced. On the basis of these assessments, a decision is made on
whether or not to draw up a formal financing proposal and seek funding for the project.
The term “ex ante” evaluation is now frequently used for “Appraisal” or “Feasibility Study”.
While Appraisal refers to studies during the preparatory phases of the project cycle (pre-
feasibility or feasibility studies), “evaluation” as such concerns the assessment of an ongoing
or completed project, program or policy, its design, implementation and results (see chapter
6):

“Ex ante evaluation is a process that supports the preparation of proposals for new or
renewed Community actions. Its purpose is to gather information and carry out analyses that
help to define objectives, to ensure that these objectives can be met, that the instruments
used are cost-effective and that reliable later evaluation will be possible.

Individual Project
Based on assignment-2[chapter three] for the project idea of your first choice undertake
detail project feasibility study.
Note:
 This assignment should be computer typed, font: times new romans, size 2 12, 1.5
spacing
 Min page number-6, maximum 10

References:
 UNIDO, Manual for Preparation of Industrial Feasibility Studies, UN.1991
 Harlod Kerzner, Project Management
 Chandra, Prasanna Projects-Planning, Analysis, Financing

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