Financial and economic analysis for investment projects

Learning note This Note relates to KSF3: Alignment of design features with IFAD Strategic Objectives and lessons learnt; analysis and results framework Version: January 2008 Core issues The design of rural development investments should include tests of financial viability and sustainability, as well as a demonstration of the value of the project to the economy in general. Financial and Economic Analyses provide the relevant ex-ante evidence within the frameworks of Discounted Cash Flows and Cost Benefit Analysis (CBA). The principles that guide these frameworks are long established and well documented. However, the value of the analysis as a decision tool hinges on the quality of the assumptions that underpin it, as well as its ability to capture a variety of costs and benefits and accurately predict the project outcomes. Related to the above, some core issues to consider in the context of Quality Enhancement are:

Accurate estimation of financial costs. Inaccuracy of early cost estimates can be partly attributed to incomplete information and inherent difficulties in predicting a distant future. However, there is a marked bias towards underestimation, which frequently results from inadequate assessments of: local capacity for diligent and expedient implementation; availability of inputs locally/internationally; efficiency of procurement; and timely availability of counterpart funds. Accurate estimation of financial benefits. A critical variable for the estimation of incremental benefits is the adoption/adaptation rates of new technologies and enterprises. The case for change is usually made on the basis of technical and financial viability, but adoption rates also depend on: the risk perceptions and risk mitigation strategies of the target group, the labour and cash flow constraints of households, reliability and complexity of technology, and other social factors that can determine individual preferences and motives. Moreover, the commercialisation of outputs hinges on the assumption of existing demand and of a functioning market. These assumptions should be appropriately examined in order to arrive at realistic estimates of producer prices and sales volumes. Demonstration of financial viability and sustainability. The routine test of financial viability for IFADs projects is the financial analysis for the indicative private enterprises. The analysis should also encompass the viability of the institutions that are either participating or being formed under the project, in order to ensure that service provision can be sustained past the financing period. Cost recovery is key to financial sustainability and when services are provided on that basis the formulation should include an analysis of demand for them. However, the willingness and ability of the rural poor to pay for project supported services and outputs, and the capacity of institutions and service providers to charge for them, remains an issue that should be critically examined. Assessment of social costs and benefits. Economic analysis is traditionally used to correct financial prices for distortions and transfer payments. Extended CBA can also account for externalities and other social costs and benefits. This may require complex shadow pricing methods and value judgements, but key pecuniary externalities common to agricultural development (e.g. upstream/downstream links in watersheds) should be accounted for in the analysis, when they are linked to a significant portion of the projects costs and benefits. Uncertainties in attribution of costs and benefits: Flexible financing instruments such as Community Development Funds will generate unpredictable cost and benefit streams. An analysis that is based on some indicative activities to be undertaken is feasible in some cases by assuming

a menu of options for the target group. Uncertainty can weigh on more structured project designs as well, especially for research and extension activities. This is due to the large time lags for the accrual of benefits from research and extension services and the inherent serendipity of research outcomes. Lastly, the problem of attribution of costs and benefits applies especially to IFAD projects that engage in wider donor programme initiatives, such as a SWAp, in which case an exante CBA on IFADs contribution may not be the appropriate decision tool. Key tasks for design and review

Describe the project costs clearly and succinctly in the project document and the cost tables, in appropriate depth. Above all, keep the project expenditure accounts transparent and unambiguous in all cases, and include estimates of fees and per diems for services paid by the project in distinct accounts. Use standard software (COSTAB) to enable: the aggregation and display of investment and recurrent costs at different levels and forms; the presentation of unit costs and quantities; the links to disbursement and procurement accounts; and the estimation of physical and price contingencies. Present clearly the assumptions and the sources of data. Formulate the without-project scenario in the financial and economic analysis, taking into account underlying trends in technology, policy, local economy and physical environment in the project and wider system area, in order to reflect changes in productivity (positive or negative) that would have occurred without the intervention. For the with-project scenario in economic analysis, check for possible substitution effects to determine net incremental output and impact. For the financial analysis, present appropriate measures of the attractiveness of the investment to the target group. Return to capital calculations can be supplemented with returns to labour and land. Check the assumptions underpinning the enterprise models with regard to availability of inputs, labour, and when relevant- access to credit. Estimate uptake rates for the proposed project activities based when possible on past project experiences, and preferably with references to M&E and supervision reports. Examine the distribution of incremental benefits and incremental private costs along the value chain in order to arrive at realistic producer prices. Include an analysis of demand (with due consideration to willingness to pay and affordability for IFAD target groups) for project supported services that are provided on a partial or full cost recovery basis. Undertake economic analysis using standard shadow pricing methods for the adjustment of financial prices and the elimination of transfer payments to reflect the economic prices of resources. Extend shadow pricing to estimate significant non-marketed project outputs and impacts. Calculate rates of return at the level of the whole project where the total cost of infrastructure, agricultural development, irrigation, and other hard investments, is dominant in the cost tables. The analysis will be more informative if rates of return are also calculated separately per component and/or a combination of them. Test key project assumptions and risks using sensitivity and risk analysis. At the enterprise level, important parameters for testing are variability of yields and seasonal price volatility; and at the project level implementation delays and availability of counterpart financing (especially the projected contributions from targeted communities and government institutions to meet O&M and other recurrent costs; and donor co-financing for critical investment components). Use switching values for sensitivity analysis, and justify the choice of scenarios examined

5. Economic and Financial Analysis

All assumptions are to be transparent. Information on full lifecycle costs including recurrent costs is to be included. All the overall costs and benefits should be quantified where possible, including social and environmental costs and benefits. The discount rate applied to the net cash flows should be 5 per cent real before tax for very low risk projects (i.e. accommodation and related services). The Use of Discount Rate in Partnerships Victoria Process: Technical Note (July 2003) sets out the relationship between project risk and discount rate.

The source of cost and performance information used as a basis for the analysis and its likely accuracy needs to be covered. This would include whether revenue and cost information has been constructed using accepted methods and techniques prescribed by the agency, and/or accepted industry practice. In the event that estimates are used, the basis of those estimates needs to be disclosed. As part of this economic assessment it is essential not just to consider quantitative measures but also to incorporate measures of a qualitative nature. This is particularly important because many social costs (such as increased pollution) and many social benefits (such as reduced mortality) can be difficult to quantify, much less to value in dollar terms. Furthermore, socio-economic benefits are the prime drivers for many investment choices in service areas of human services, education and law and order.

A financial analysis is used to determine the costs and quantifiable risks (as identified in Risk Analysis and Management in Section 9) of a proposal from governments perspective. It demonstrates the level of cost recovery expected. A financial analysis does not take into account any benefits to the beneficiaries that are not captured as a revenue stream of the proposal. Agency-specific business improvement initiatives need only consider agency costs and benefits (or cost savings). Whole-of-government or cross-agency initiatives must consider costs and benefits from a broader perspective and look to how participating agencies share the benefits, costs and risks. Benefits included in the cash flow analysis should be limited to direct benefits only; flow-on effects or unrelated factors can be mentioned but should not be included in the cash flow analysis.

Because the objectives of financial and economic analysis are different, it may be that a proposal is not seen as financially viable (positive net present value) even when it is economically viable to government. Government proposals, which are economically viable when externalities, market imperfections, etc are considered, will not always be financially viable on narrow cash flow considerations and will need to draw from funding sources. One method of ranking these proposals is to prefer those proposals that meet the service needs at the minimum discounted cost, all other things being equal. Another method, where economic benefits and costs cannot be reliably quantified, is to use a rating system. Comparisons and ranking of options (for example, a high/medium/low ranking-scale and weighted criteria reflecting the importance of the different benefits and costs being ranked) should be used to support the analysis. This ranking and weighting of socio-economic impacts allows non-monetary considerations to be compared with monetary impacts and may be important in areas of health, education and welfare where the market for the outputs from the asset proposal is not fully developed.

More detailed guidance can be found in sources such as Chapters 6, 7 and 8 of the Investment Evaluation Policy and Guidelines. For proposals requesting continued or additional funding (for a new phase, new module, or as a result of increased costs), evidence is required that the newly submitted information reflects any changes to the overall cost, benefit and risk. This section requires further definition. Until further advised, projects should use the CPSP Investment Evaluation analysis approach.